Both investors and policy makers cannot avoid thinking of the economy, or investment portfolios, in terms commonly used for flight. For instance, the words “soft landing”, “stall-speed”, and “crash”, all have connotations that are equally valid, and indeed guide, albeit metaphorically, policy decisions as they do the decisions of aviators. The only difference is one is a life and death matter, the other just causes pain in the bank account. The temptation to go higher and faster is also common to both.
In this note, I will discuss a phenomenon that is typically studied by professional airline pilots flying turbojets which are extremely relevant for investors and policymakers today as markets reach new heights and the economy seems to be humming along with no apparent inflation in sight.
As a jet aircraft gains altitude (or the air gets hotter), its stall speed — i.e. the speed below which it has no lift and can literally drop out of the sky — starts to increase. This means that to maintain flight, the aircraft has to be flown increasingly faster as altitude increases to avoid stall. But there is a limiting factor to the speed on the upper end as well. If a non-supersonic aircraft is flown too fast — i.e. close to the speed of sound (the “critical mach number”) — shock waves can develop, which can result in a catastrophic loss of controllability. The aircraft can literally nose over even though it is very fast. This is known as the “mach tuck”. At a specific altitude accurately called the “coffin corner”, the aircraft becomes essentially uncontrollable.
Now think of high flying asset markets. In the implicit desire to keep the economy, stock, bond and other asset markets high, global policymakers have been “going big” and going fast. With no inflation in sight (using traditional inflation metrics), the temptation to push pedal to the metal by printing money and extending credit to solve all problems is just too high. Central banks, especially the ECB, are justifying this by saying that if they don’t keep policy easy and buying assets, the economy will “stall”. But what could really be happening is that with high asset markets, the economy might actually be going too fast – if deeply negative yields are not the financial analogue of breaking the sound barrier, I am not sure what is.! As Ed Yardeni recently wrote, in the desire to go warp speed, there is a risk that the “starship” is incinerated.
Fortunately, there are solutions to escape the coffin corner in flight, and I think the market’s current message of both stocks and bonds selling off together will start to get attention from the pilots of our economy as well. The easy solution is to not even get to the coffin corner. To prevent reaching the coffin corner, modern aircraft are “thrust limited”; i.e. they are simply not allowed to get too fast. I suspect that with interest rates at zero, and a massive amount of future liquidity coming, current policy is already past this limit. The other solution is to react once in the coffin corner. The correct response by a pilot in the coffin corner is to lose altitude, and to go down to where the stall speed is lower. In other words, if a pilot unfortunately finds himself in the coffin corner, he has to descend quickly. If he doesn’t do it, the aircraft will do it for him with disastrous consequences.
From this perspective it is no wonder that both the stock and bond markets have gone through convulsions in recent days, whipsawing from highs to lows. Unless we believe that the economy is a supersonic fighter jet, to try to break the sound barrier and to try to make asset prices higher through easy money can result, counterintuitively, in a collapse. Empirical analysis based on decades of data shows that when shocks emanate from the equity markets, bond markets are a good diversifier for portfolios. This is the experience that most of us have had for the last three decades. But when shocks begin to emanate from the bond markets, which typically happens due to inflationary fears, diversification does not work as well. One reason is that arithmetically an inflation risk premium increases long term yield expectations, i.e. via steepening of the yield curve, and this is bad for both stocks and bonds.
I believe that policy makers in the US will get the message loud and clear, and I expect them to start preparing markets for a gradual rise in rates, past statements of easy policy not-withstanding. A new “hawkish pivot” is in the making, or else markets will force the pivot for self-preservation. Unfortunately for folks in Europe, the ECB is intent on flying through the coffin corner, and the outcome will likely not be pretty.
In this environment, passengers, i.e. investors, should tighten their seat belts; i.e. consider becoming defensive, and possibly allocating more to cash and low duration bonds. Both turbulence and volatility could continue to rise. Markets and economies are not aircraft, to be sure. But the basic principles of aerodynamics apply to both in spirit, and certainly there are limits that cannot be pushed too hard in either case, without risking catastrophic consequences.