Plain English with Derek Thompson - Market Meltdown FAQ: Recession Fears, Global Stock Wipeout, and the Case for Calm

Episode Date: August 5, 2024

In a special emergency-ish episode, Bloomberg's Conor Sen joins the show to discuss a buffet of economic and financial fears, including a disappointing jobs report, a meltdown in global stocks, the "carry trade" heard round the world, the smartest criticisms of (and smartest defense of) the Federal Reserve's decision not to raise interest rates, and more. If you have questions, observations, or ideas for future episodes, email us at [e-mail]. Host: Derek Thompson Guest: Conor Sen Producer: Devon Baroldi Learn more about your ad choices. Visit podcastchoices.com/adchoices

Greetings, it's Mal. Call your banners because it's time to head back to Westrose for House of the Dragon, season two. The ringers dragon riders will soar alongside you each week with a heron-hall-sized slate of conversations. The dragon has three heads, and on Sunday nights immediately after Hot D concludes, Chris Ryan, Joanna Robinson and I will be with you for Talk the Thrones. Then on Mondays, two more shows away. Dan Lath and Charles Holmes, Steve Allman, and Jomea Denneron, aka the Midnight Boys, Pugh!

Pee! We'll head to the tourney grounds to share their reactions. And of course, Chris Ryan and Andy Greenwald will sip the Arbor's finest vintage on the watch. Then on Tuesdays, Joanna and I will head to the bowels of a pleasure den for our House of our deep dyes. Then on Thursdays, Joe, Neil Miller, and Dave Gonzalez will gather the Ravens for trial-by content. In this season, full episodes of Talk to Thrones, House of Ar, and the Midnight Boys will also be available on video on Spotify and the new Ringervverse YouTube channel. Podcast episodes available on Spotify or wherever you get your podcast. Hello and welcome to a special edition of plain English.

We've been on a once-a-week schedule this summer while I finish up my book and settle in to Chapel Hill, North Carolina, where my wife and I recently moved. We have a fantastic episode for you coming later this week on Friday, but so much has been happening in economics and finance that I felt a bit itchy to do another show. You might recall that two weeks ago, we had a great conversation with Chicago Fed President Austin Woolsbee about the state of the economy, and the prospect of the Federal Reserve cutting interest rates. Well, the Fed met and decided to not cut interest rates, at least now, and days later, after that decision was announced, the Bureau of Labor Statistics published a jobs report that sent chills down the spines of some business analysts.

Then, Sunday night into Monday morning, Eastern Standard Time, global markets puked all over themselves. Japanese stocks fell by the most in almost 40 years. Asian and European stocks were routed, one measure of trade volatility hit its third highest rate ever. And so when you add it all up, the recession fears, the global equity wipe out, the critiques of the Federal Reserve's decision to sit pat on interest rates, I felt like we simply had to do a quasi-semi-emergency show. Our Johnny on the guest spot is return guest Connor Sen, Bloomberg Financial Colonist.

And here we go. I'm Derek Thompson. This is plain English. Connor Sen, welcome with the show. Thanks for having me back, Derek. We are recording this at 304 p.m. EST, and the state of things is as follows. The Nekay is down by the most since 1987. Asian stocks are a bloodbath. The Dow is down 1,000. The S&P is down more than 3%. And this all comes just days after a jobs report showed that the unemployment rate has increased by 0.8 points in the last 12 months,

triggering, potentially triggering a threshold that has historically predicted the imminence of a recession. Let's start with today and then maybe work our way back in time to talk about Friday's Jobs Report. Do you think that today's big market moves are primarily about something happening within finance that is between traders, between investors, or is this telling us something very profound about things that are happening in the labor force, in manufacturing, in the flesh and blood macro economy? I'd say the information we got last week put traders on notice that something might be changing in the future, but then today itself is really a trader mess. So there were a lot of trades that had been in place for a long time. And information we've gotten recently finally got people

to say, okay, if the world has changed, we need to get out of these trades. We don't know what's next, but what we were doing is now over. Let's talk about one of those trades, which is the Yen-Carrie trade. And here, I would love it if you could explain carry trades to me as if I am 10, 15, five years old. Like, assume I know absolutely nothing about finance. What is going on with this carry trade that everybody in finance is talking about today? Sure. So basically, in the U.S., we have increased interest rates significantly over the past two or three years to five and a quarter to five and a half percent, which many of your

listeners will know. Japan, which has struggled with deflation for a very long time, has had some of the inflation that the U.S. has had over the past few years, but the Bank of Japan did not raise interest rates the way that the Federal Reserve did. And so essentially, you could borrow in Japanese yen and pay basically nothing on your money and invest in the U.S., earning 5%, or in any other number of assets around the world. And by doing so, you are essentially selling Japanese yen to buy something else. That has pushed the value of the Japanese currency down and also inflated the Japanese. Japanese stock market because the Japanese economy is so tied to exports like automobiles with

Toyota and Nissan and companies like that. And so that's essentially the carriage trade in a nutshell, and that's essentially what blew up over the past 24 hours or so. And why did it blow up? And that's due to information in the U.S. primarily. So the Bank of Japan had been reluctant to raise interest rates. They did raise them last night. But I think the bigger deal was the labor market data in the U.S. last week of a softening job support. softening labor market, which is pushed down interest rates in the U.S., sort of reduce the attractiveness of that carry trade because that interest rate differential between the U.S. and Japan has compressed. So you have sort of less desirable investing overseas, and at the same time,

the Bank of Japan raised the cost of borrowing in Japan, which made that borrowing in yen less attractive. And so those two forces collided, and everybody's rushed for the exits. Right. One thing that I heard from some people is that there have been margin calls on the yen that were borrowed. So essentially, you know, I'm an investor. I borrow a million yen. I convert it to dollars, say, $6,000. Those dollars, suddenly, after this new currency rate adjustment, don't buy the same amount of yen, right? They might only buy, say, 900,000 yen rather than the one million that I borrowed. So now I'm in a position where I have to acquire a 100,000 extra yen in order to pay back my counterparty, that means that not only do I have to sell

out of my position, maybe it was in meta, maybe it was in alphabet, but also I now have to buy yen, and that has the effect of raising Japanese currency and also reducing the value of these tech stocks that were such a popular buy, especially around hedge funds. Is that also a piece of it, this sort of rush among traders to shore up their position? It definitely. It definitely, It definitely is, and at the same time, that increase in the value of the Japanese yen makes your Toyotas and Nissan's less competitive in global markets. So that led to the crash in the Niki, the Japanese stock market, which was up significantly this year, just like AI stocks in the U.S., and is now basically flat on the year after a huge

correction. So just to connect all the dots here, someone is going to be thinking, okay, well, I guess I understand from this description why the Japanese stock market might be having such a terrible day, the worst day in what, like 40 years, 38 years. But why is this sell-off so broad? Like, why are we seeing all of the markets in Asia down at, you know, multi-decade lows, but the rate of decline is a multi-decade high? Stocks down in Europe, stocks down in the U.S. What explains the global nature of this sell-off? Is it just that the people who were trying to execute this carry trade were essentially buying everything in the world? And so in order to unwelcome,

is the biggest carry trade ever? They essentially have to sell everything. Well, it falls on to that weak U.S. data we got last week. So the unemployment rate in the U.S. rising to 4.3%. People are now worried about recession in the U.S. in a way they haven't been in quite a while. And so people were already ready to sell Japanese securities or sort of Asian securities based on a weakness in the U.S. Then you have this Japanese carry trade mess on top of that. And it's just like a giant traffic jam in markets where everyone is trying to get from their current position to somewhere else. But sort of the the pipes are all clogged because so many people are trying to move at the same time. And this leads to the historic volatility that we're seeing, the third largest VIX in, what,

100 years, 150 years? Talk to us a little bit about what we're seeing in terms of volatility exploding. Sure. So this VIX index is sort of the way of thinking about it. It's a measure of how much volatility people expect there to be in the markets. And so this morning it got to a level of 65, which is sort of basically thinking that the U.S. stock market would move by 4% per day. That's the kind of move you would need to justify the VIX of that level. And we've only seen the VIX that level in the past 20 years in 2008 during the financial crisis and during March 2020 during COVID. So obviously the environment we have right now is nothing like those, but it just shows

sort of the intensity of this move from a low volatility market to a higher volatility market and people who had been comfortable betting on low volatility all having to get out of that position at the same time. Let's bring in the fear that we're in an AI bubble. This is something that I talked about with Bill Simmons the other day. I said, look, I'm someone who generally believes that over a multi-year, multi-decade horizon, artificial intelligence is going to be a big thing. I'm generally a proponent of that technology.

I'm excited by generative AI and what it could potentially do in white-collar industries, in medicine in particular. But also, I think if we're being. being clear-eyed, there is an important and obvious gap between the amount of money that is being spent on GPU and data centers and the amount of money that's coming in. These companies, like Alphabet and Meta and Microsoft, are spending an enormous amount of money sort of on the fundamental guts of artificial intelligence, but there's not as much of a market there. And so I told him, I think, last week, two weeks ago, that I thought we'd probably get a bit of a correction,

kind of dot-com bubble burst before we saw AI become what it would ultimately become. And the reason I thought that the dot-com bubble was a good metaphor here is that clearly we live in a world where a lot of the companies that failed in 2000, 2001, are with us today. You know, webvan, famous, they went bankrupt. They were delivering groceries. Online grocery delivery is an enormous business today. So just because you have an AI bubble now doesn't mean AI won't be a thing in the future. But turning things over to you, how much of what we're seeing right now,

is being driven by fears among analysts popularly shared that there is an important mismatch between the spending on artificial intelligence and the near-term prospects of it actually generating tens of billions of dollars of revenue. Right, and the timing of this question is really important because these companies all reported earnings over the past two weeks. And this was the first quarter where analysts,

because the stock prices had risen so much, because they're spending so much money on these investments, started asking harder questions about what are you seeing in terms of progress on your business models, on revenues, how are you thinking about the return on investment you're getting on these investments? And the questions were sort of unsatisfying. And some companies said we see a lot of progress. We have a lot of usage. Like a lot of people might know that on Instagram, there's a little AI box where you can get a picture of a Chihuahua dribbling a basketball.

Google search has integrated some AI. So there's stuff going on, but it's not turning into dollars the way that investors might have hoped. So you already had sort of a modest sell-off in many of these companies like Microsoft and Alphabet and Amazon, but then sort of you pile on these other things going on and that tech stock volatility sort of was an additional headwind in a market that's already been scrambling to deal with a lot of volatility. You said it's not turning into dollars the way people hoped. Because AI exists, as you just described it, as a technology that is insinuated into all these different parts of the internet that we already recognize, it's becoming more of a part of

Instagram, more of a part of Google search. Is it possible that AI is already actually driving significantly more revenue growth than we can actually see? It's just that it's an invisible input, and so it's harder maybe for these CEOs to convince some skeptical analysts that AI really is returning on top of these tens of billions of dollars of GPU and data center investment? So META was the company that spoke to that the most, where Mark Zuckerberg was saying that there is an ROI on their AI investments in terms of search is better. They're getting higher, sort of the ad you get is better targeted and you can be served fewer ads and META can make more money. And so they're the ones that actually their stock price went up after their earnings

report because people sort of have more confidence in what they're doing. So I think to your point, this could be more of an iterative thing, kind of like auto-complete on email rather than a transformational technology, at least in the short term. I really want to talk to you about the jobs data from last week. I thought this was so interesting. I had just had this conversation with Austin Goolsby where I asked him, and I don't remember if you inspired this question or whether it was from somebody else, but I asked him, if you keep rates this high and the labor market continues to deteriorate, then it's

only reasonable for people to think that higher for longer rates will lead to a continuing deterioration of the labor market. If you don't change the rates, why would the labor market improve? He responded as if he entirely understood where I was coming from. He said, you're absolutely right. That's one way that I think about it. I think that when you compare the inflation rate to where we have the federal funds rate, we are currently restricting growth in the economy. We're constricting potentially supply of housing construction. We're potentially constricting the growth of the labor market. And then the Fed comes out and they don't raise rates. Tell me what your reaction was from this labor market report that showed that unemployment rose to 4.3% again, almost a full percentage point higher than it was a year ago.

So I think the setup coming into this jobs report was that the unemployment rate had gone up three months in a row, which by itself is kind of concerning and like 0.6% in the past year. And to your point, a lot of people were starting to ask tough questions about where is the labor market going? Like the Federal Reserve meeting last Wednesday was followed up by a press conference. And almost all the reporters were asking questions, very pointed questions about the labor market. And Chair Powell, in my opinion, was a bit defensive about it since he was talking about how GDP growth was still quite strong. And then we got the jobs report on Friday, which was quite weak. And to me, the analogy I think of was sort of like the first debate with Joe Biden, where we were all worried about his age. And then we saw it.

And we were like, oh, my God, this is terrible. We have to do something about this. and his response was it was one bad night, and the Fed's response was it was just one data point, and investors don't believe that because they say, no, look, we've been worried about this for a while. Policies are restrictive. You've told us it's restrictive.

We now see the unemployment rate going in a bad direction, and we're projecting forward what this could look like six or 12 months from now and say we have to change course. And the Fed, understandably, doesn't want to be bullied by the market or some commentators into reversing course overnight, but I think we're now in kind of this post-debat, Biden, where there's kind of an uncomfortable tension between the Fed and a lot of market participants.

Okay, so I want to get to Post-J-O Biden equivalent with the Fed in just a second. But first, can we steal man the Fed's case here? I mean, I know that you, like me, you're someone who thinks that fundamentally the Federal Reserve is a pretty strong institution. It's an institution that takes data very seriously. It's an institution with individuals that you admire and respect. So with the understanding that you disagree with what the Federal Reserve is done in the last few months. Let's steal man the Fed's case first. What's the best argument against raising interest rates last month? They would say that they didn't set up the markets to do so, and they feel like

sort of projecting forward what they're going to do is important in terms of institutional credibility, market confidence, not disturbing people too much. They would point to real GDP growth in the second quarter was near 3%, which is very good, that the sort of employment, prime age employment population ratio, which is quite the word salad, the percent of people in their sort of prime working years is near an all-time high. And so that's a good sign. A lot of the rise in unemployment was due to growth in the labor force as well as weak hiring, but not layoffs.

And so there's sort of a mixed picture on the labor market where you can sort of defend the state of it while also acknowledging that it's been cooling, and a lot of things are trending in the wrong direction now. And then to counteract, that's the only man case, because I could just pausing here, say, well, you're right. You know, E-pop is at or near an all-time high, prime age, which is people between the age of 25 and 54, the prime-age population is back at work at levels that we haven't seen in a long time. This is what you want from a strong economy.

It brings lots of people in. Maybe it brings older workers in or younger workers or disabled workers. It brings people into the economy. That is, generally speaking, a good thing. what data points would you look to if you had a moment with Jerome Powell to say, here's what you're missing. Is it the quits rate? Is it U3, the unemployment rate that we're discussing?

What are the data points that you think are the strongest case against the Fed's position? I'd say every single way you want to look at wage growth is trending down and is now at basically 2019 levels and trending lower. So we're probably going to be to sort of below pre-COVID wage growth pretty soon. We also know that inflation has been coming down, and the concern for inflation going forward has been, well, the labor market's so strong, maybe that will drive inflation. That case seems pretty weak at this point. The rate of hiring workers is now at rates that we saw in 2011 at a time when millennials were

very under-employed and nobody felt like the labor market was very strong. So even if layoffs are low, if hires are very low, then if people are joining the labor force, that's going to mechanically lead to a higher unemployment rate over time. And just a higher unemployment rate on its own is the kind of thing where it tends to a trend in one direction or another. And maybe normalization from the crazy levels we saw in an overheated 2022 labor market were desirable, but we're now kind of a balanced level. And if you think about objects in motion tend to stay in motion, we're probably going to be in an uncomfortable place in a bad way in six or 12 months unless we change course on policy. And that leads to a shift

in the labor market to a stronger labor market. What do you think the Fed does now? I think they're going to internalize a lot of what we said. Again, this sort of gets to the post debate Joe Biden. And they're not going to come out and say, look, you finance Twitter people are right and markets are right, but they're going to watch for next week's inflation report. They're going to internalize where we are. And I think either at the Fed's big meeting in Jackson Hole, Montana later this month or the next Fed meeting in September, they're going to sort of signal that they're going to cut rates probably a pretty substantial way at a relatively short period of time. And it might not be on the time frame that markets want, but I think we're going to get probably at least 100 basis points of rate cuts over the next six months. And 100 basis points for the non-nerds out there. That's 1% reduction in the federal funds rate, which would, among other things, bring down mortgage interest rates, bring down rates on car loans.

It would make it cheaper for lots of people to borrow money, which I think would make a lot of people feel like it was cheaper to live in the economy. Because one interesting thing that I thought a lot about over the last few years is that when you look at inflation, inflation is the price of goods. there's another way to look at how expensive it is to live in an economy, and that's how much it cost to borrow money. And right now we're in a place where mortgage rates are much higher than a lot of people feel comfortable buying a house. And so maybe as rates come down, we see a little bit more liquidity there.

To sort of sum all of this up, you know, we've talked about the fact that a lot of the market momentum that we see in the last few days is, number one, about a carry trade that involved the yen. That is a finance move that doesn't really necessarily have anything to do with the state of the U.S. economy. We talked about the possibility that this is about a business cycle happening in Silicon Valley with AI. And we talked about the fact that this might have something to do with data coming from the U.S. macro economy in the labor market. If this is mostly, if what we're seeing right now in the world is mostly about finance, and it seems likely that a month from now, trades will be unwound, and today's events won't leave much of a wake in terms of anything in the

world a month from now. How likely do you think it is that in a month or two months, we'll look back at August 5th and say, oh, that was an enormously interesting, quote-unquote, day in finance, but it didn't necessarily tell us a lot about the state of the U.S. or global economy. I think there's a really good chance that's the case. And what's interesting right now is that that the unemployment rate might be ticking up very slowly, but we're seeing that mortgage rates can fall very quickly as people price in interest rate cuts in the future. So we could be in an interesting world

where maybe the unemployment rate on election day is 4.5%, 4.6%. But if mortgage rates drop to 6%, the typical Americans probably feeling better about the state of things just because, to your point, the cost of living will be lower and the fraction of people who are unemployed in this transition is marginal compared to 150 million working Americans. I think we need to make sure that a year from now, we've reversed the momentum in the labor market, and the unemployment rates trending lower again.

But in the meantime, a lot of people might feel like this is a better place than we were a few months ago, even if it means higher unemployment. I agree. I think I just wrote an article for The Atlantic about the market moves today, and I ended with the observation that every article about a stock market meltdown should end with the words calm down. Like, if you look at a graph of the S&P 500 of the last 100 years, or you look at a graph of the Dow Industrials of the last 100 years, equities generally go up, but also equities are volatile. Like, both things are true.

And so if you insist on living your life in high arousal, 12-hour increments, you're going to freak out every single time. There's a 2% correction in the S&P 500. But from the broader picture, these kind of corrections seems to happen once every three, four, five years. This is not the most unusual thing to happen to stocks, and one should keep their head about them. Any closing words on retaining sanity at a time when global stocks need to be melting down? Well, I think we talked about on a show last year that there was nothing wrong with the economy that rate cuts couldn't fix, and I still believe that's the case. And it might take more rate cuts faster than people think, but ultimately rate cuts will fix

the situation we're in. Connorson, thank you very much. Thanks, Derek. Thank you for listening. Today's episode was produced by Devin Boraldi. Our summer schedule for plain English for the next few weeks will be one episode a week on Fridays. We'll see you next week.