Difference in differences
The pace may be different, but there are important parallels between 2008 and today
- 2008 was a lot slower than today
- The observed economic data was really similar to today prior to the 2008 selloff
- The question today boils down to fiscal stimulus vs consumption shock
- I think the consumption shock is bigger
- My base case is another few weeks before that becomes the majority view
It’s tempting to compare the Covid19 recession to the 2008 financial crisis. So lets. This quick note will be a reference point for discussions that compare the two events.
For the sake of easy comparison, we’ll take as our starting point the new all time high in the S&P 500 that preceded each event. October ‘07 for the GFC, Feb ‘20 for today.
The first and most obvious difference is the pace of events. In the two months following October ‘07, not a lot happened. The pace was slow despite problems in the mortgage market being readily apparent - ‘07 had seen REIT bankruptcies, hedge funds stopping withdrawals and a Fed reaction - with rates lowered in August and October. Stock prices declined modestly to January, they were 15% lower by the 17th. 2 months on from our own pre crisis peak, we’ve had a 33% decline in Stocks followed by a 30% rally, and a 1.5% decline in the Fed funds rate. It took another 8 months in 2008 for the market to tank to the same extent it’s already done today.
That’s the market, what was going on in the economy? Here we’ve got the two components of private expenditure - consumption and investment - on an annual rate basis in nominal $, indexed to 100 in 2014 for ease of comparison:
Source: Bloomberg. White: Consumption, Yellow: Investment
Over the course of the GFC, investment spending fell by 1/3rd. Consumption declined by approximately 4%. We don’t have a consumption number for this March, but the advance estimate of investment puts it 3% below the post crisis peak. We’ve experienced a 1/3 decline in stock prices all on the basis of expectations - but 2008 was actually very similar in this regard. Stocks declined by 1/3rd in the summer of 2018, at which point consumption had not fallen and investment was off by around 5%. The analogy to the present day is a good one, a modest realised fall in investment along with the prospect of a crisis seems to get us a 1/3 decline in stock prices. In 2008, consumption peaked just as the crisis did - and fell modestly afterwards.
Of course, effective demand for any product including stocks is as much about the ability to pay as the willingness. For that, my favourite starting point is the MzM number as I wrote earlier this week. In the year leading up to October 2007, MzM grew a healthy 13%, much of it before the Fed cut rates. Private balance sheets were expanding fast. Another 10% expansion preceded the stock selloff in August. So, a modest fall in investment plus the prospect of a crisis with 1/4 more money stock gets us a 1/3 sell off. How does today compare? Well, after a period of relative modesty in 2018, the Fed change course in 2019 and presided over a 9% increase in the money supply. Since February, they’ve manage another 13%, over 2 trillion. Just like 2008, a 25% money supply expansion combined with a modest fall in investment and the expectation of a serious crisis adds up to a 1/3 selloff in stocks - only this time stocks have rebounded strongly.
What is categorically different to 2008 is the pace and quantity of the fiscal response. The 2008 Stimulus bill in February had a price tag of 150bio, a mere 1.5% of Consumption. However in terms of the loss of expenditure, it wasn’t a bad match, being around equal in size to the 6% decline in investment spending that occurred over the first two quarters of 2008. The big shock to investment spending came after the bankruptcies and bailouts of that summer - at which point private sector balance sheets started contracting in earnest. The bigger fiscal response in 2008 was to address that. Today, we haven’t seen that stage yet. We’ve had the stock market decline without the bankruptcies and bailouts. It seems we skipped a narrative beat.
The purpose of this note was to observe the differences rather than predict the future - but I think it’s possible to say useful things about the outlook, and rule out some narratives. Plus, it’s best to have a view, so I’ll give one. The idea that growth in the money supply will save us is dubious. If a mostly private sector expansion of 25% didn’t save us in 2007/8, a mostly reserve expansion of 25% today likely won’t either. The outlook today seems to boil down to how effectively the fiscal response will make up the shortfall in consumption and investment expenditure. I have my own view on that. My only question is how fast the prevailing narratives around the ‘strong’ monetary and fiscal response come undone. It’s not a perfect analogy because the bounce was weaker, but as Ben Hunt points out , the market sustaining narrative at a similar crisis point in 2008 that Bear Stearn’s failure represented the last systemic risk took 2 months to unravel. 2 months from the low is in 4 weeks time - and if investors are rationally following the narrative about the fiscal stimulus, they’ll look through poor April data over the next couple of weeks. For the moment then I’m still looking for short term risk on trades, with an exceptionally wary eye on a strongly risk off future.
NB: This post is not investment advice and is not a trade recommendation. The views expressed here are my own and do not reflect those of my employer.