2023 a parallel to Summer 2007 with a positive twist

Estimated reading time: approximately 5 minutes

Dear Investors,

In this letter, I aim to share my thoughts on the current state of the financial markets by drawing parallels and one notable difference to the summer of 2007, just before the global financial crisis.

Currently, the markets are eerily calm, with volatility (VIX) at a new minimum. This tranquillity has attracted people to invest in equities, as expected. The Federal Reserve has increased rates by 500 basis points, and growth has visibly slowed down. However, we are not in an unambiguous recession territory.

The Fed appears to be done with raising rates, and nothing “systemic” has seriously broken down yet. But, as we look back at the summer of 2007, we may see some uncanny similarities to our present situation.

Back then, the Fed hiked rates non-stop from 3% to 5.25% in 2005-2006 to slow down a stubbornly resilient economy and a red-hot housing market. Core inflation was trending above 3%. Even as core CPI decisively trended back towards 2% between March and September 2007, the Fed only paused the hiking cycle but didn’t cut rates.

In 2022 and early 2023, the Fed raised funds aggressively to cool down a red-hot economy, kill inflation, and temper market exuberance. By summer 2023, it might be clear that core inflation is trending down, but the Fed may again decide to pause the hiking cycle rather than cutting rates, just as it did in summer 2007.

As in 2007, the Fed may decide to keep rates high at the end of a growth cycle. The US was not in a recession until early 2008, but in summer 2007, the growth impulse had decelerated. Today, similar to 2007, the US Conference Board Leading Indicator is negative, and EPS growth is at zero. In a recent Dallas Fed declaration to Reuters, Fed officials expressed confidence in a soft landing, echoing sentiments from 2007.

One difference with that time is the fact that the central banks today are better equipped for dealing with liquidity shocks and balance sheet recessions. One important thing to notice is that the Treasuries that piled up over the years in the Fed’s balance sheet and are held to maturity determined an unexpected monetary losing effect that the losses due to high inflation are not recorded by the private sector.

If the markets are indeed in a situation analogous to summer 2007 then, a specific group of asset classes can generate larger than 1 Sharpe ratios. Please contact us for entering in details of what will be in our portfolio in the coming months.

Thank you for your continued trust and support.

Best regards,

Federico Polese