In 2021 the markets were rebounding from the Covid-19 recession, one that was notably short but deep. Nevertheless, the economic outlook was far from clear. Zachary Cefaratti, founder of alternative asset management firm Dalma Capital and the financial thought leadership platform AIM Summit, took the opportunity to interview economist Nouriel Roubini, who earned the sobriquet Dr. Doom by calling the 2007 housing crisis and subsequent Great Recession two years before each happened. Surprisingly, Roubini thought the government was on the right track with its massive fiscal stimulus programs, but he raised alarms over their sustainability and the danger that they could lead to high levels of inflation. Both problems subsequently came to pass.
Cefaratti asked Roubini, now an emeritus professor at NYU’s Stern School of Business, for his take on that tumultuous time. “Nouriel, this has been an interesting start to 2021. The storming of the U.S. Capitol, markets on fire, millions of low-information young retail traders using gamified platforms like Robinhood. What are the major upsides and downsides for this year?”
“The outlook for the markets depends on the outlook for economy – whether it will rebound in a healthy “V” shape or in a more anemic “U” shape,” Roubini said. “Worse would be a double-dip recession shaped like a ‘W’.” He estimated that there was a 40% chance of above-expectation growth, or a V-shaped recovery, a 50% chance of a U-shaped recovery, and the remainder would be the economic tail risk of a W-shaped recovery. As it turned out, the V-shaped recovery paradigm would eventually emerge.
Zachary Cefaratti noted that former Federal Reserve Chairman Ben Bernanke had recently said the main risk to the economy was undershooting the Fed’s inflation target, not overshooting it. Roubini disagreed. In this, history has proven him right. “Medium term, the very large and monetized fiscal deficit will lead to a return to inflation well above target, and if there are negative supply shocks, it could lead to deflation outright,” he said. “In the 1970s, the negative supply shocks led to the stagflation of that decade.”
Those shocks included the Yom Kippur War in 1973, the Iranian Revolution in ‘79, and the oil shocks caused by the Arab embargo in response to those events, Roubini said. “Today we won’t see those types of issues, but I see several factors that could act as supply shocks. These can reduce production and increase the costs of production and lead to economic contraction.” Roubini said these factors are deglobalization and inward-looking trade policies; the decoupling of the U.S. and China, bringing more risk of deglobalization; and the aging of populations, which can lead to an increase in the costs of production. These could lead to a stagflationary environment over the medium term.
Cefaratti noted that the size of the fiscal stimulus is another issue. Sixty-eight percent of YPO members in a poll held shortly before their conversation said it was too large and only 9% said it was appropriately sized. “What is your view?”
Roubini said that, in the short run, policymakers did the right thing. The mini recession in 2020 could have turned into a much more serious recession on the scale of the 2008 downturn. Policymakers learned from the Great Recession that the stimulus then was too small, and that then they compounded the problem by turning to austerity in the U.S., the U.K, and Europe. That is why the recovery after the Great Recession was anemic and U-shaped. “To avoid that, we needed a bigger fiscal stimulus.” Roubini estimated that the $1.9 trillion Biden stimulus was probably too much, but the economy did need over $1 trillion to avoid the double-dip recession that Europe suffered.
Roubini warned, however, that over the medium term the huge buildup in public and private debt was unsustainable, and the economy would need fiscal consolidation. “But in my view, you first do the stimulus, and then, when the economy is stronger, you can do the fiscal consolidation,” he said. The sharp rise in 10-year Treasury yields in 2023, caused by often-tepid demand at bond auctions, has borne out Roubini’s concerns about the government's debt load.
Meanwhile, the equity market in 2021 seemed disconnected from the underling challenges to the economy, Cefaratti noted. “Do you see an ongoing rally in the stock market, or do you expect a correction?”
Roubini said that the outcome for long interest rates and shares depends on whether the economy is in a V scenario or a U scenario. If it is in a V scenario, there is a risk that central banks will start tapering too soon. In a strong V-shaped recovery, 10-year Treasuries could go up to 1.3% and inflation could go up 20-30 basis points, he said. That means that rates would rise, but not by much. Real interest rates would not rise more than ten basis points, he predicted, and there would be a rotation away from risk if the Federal Reserve tapers too soon.
If there is a strong recovery, long rates will be higher, but real rates will not tighten too much, Roubini said. This is precisely what happened, although in a more dramatic manner than Roubini anticipated, due to the large increase in long-bond yields and the 40-year highs in inflation seen in 2022. Roubini expected that a strong, or V-shaped recovery would prompt investors to rotate from bonds into equities and into credit, from defensive stocks to cyclicals, and into emerging economies and commodities, except for gold. “So, there are two tracks,” he said. “On one track, you have rising real rates so the rising nominal yields are greater, and you could see damage to equity markets, but that is a small risk because the Fed is very dovish and will keep rates down near zero at least until 2024,” he predicted.
But, he warned, if the recovery is U-shaped, growth in the U.S. would stay at about 1%, and you would have a risk-off environment and a weaker dollar. So disappointing growth would be a problem. Credit risk would be higher, and markets, commodities, and emerging markets would all be softer. More firms would file for bankruptcy.
Cefaratti noted that 75% of YPO respondents in a recent poll saw a threat of a taper tantrum in the next 12 months. That does not mean the Fed actually has to taper, it only has to unnerve the market by talking about it, Cefaratti said. Roubini disagreed, arguing that the Fed was committed to average inflation targeting, it was giving more forward guidance, it had asymmetric employment goals, and it was reacting more to unemployment being below the goal than above it. He predicted the Fed would wait a year to taper.
Returning to one of the odd developments of the year, Cefaratti asked Roubini about his opinion of the participation of retail traders using gamified trading platforms like Robinhood to attack short sellers around names like GameStop and AMC. ”What are your views on these moves – are they short-term noise, just the result of being in a bubble, or something more?”
Roubini said he thinks that, in terms of market valuation, stocks are priced for a Goldilocks scenario – growth at 6% or more in the U.S. without inflation and a risk-on strategy that assumes global equities go up another 10% in 2021. The looseness of monetary policies has led to levitation of asset prices just because there was so much liquidity sloshing around. The Case Shiller PE ratios were above 33 at the time of their conversation, a number last seen before the Great Recession or the dotcom crash, Roubini noted.
“If you look at phenomena like SPACs and millions of kids going on Robinhood, it is all just driven by liquidity,” Roubini said. Markets are frothy and then you have the Reddit people who think they’re populists, but I don’t buy it. I don’t have sympathy for hedge funds, but the rhetoric has been of poor people getting back at hedge funds that are suffering short squeezes, but on what – a bunch of assets that fundamentally have no value. The rhetoric is not reflecting reality and the short options positions, coordinated among thousands of traders over something like Reddit, can be seen as market manipulation,” Roubini said. “It's not a populist revolt. Many of these kids have no jobs and think they can get rich through these get-rich-quick schemes. That’s not how you get rich.”
Cefaratti noted that Robinhood had to step in and halt trading on some of these stocks, and regulators are worried about who is going to be left holding the bag when the market for these terrible companies goes back down. He said that it will probably be retail traders who suffer losses. He asked Roubini whether he thought Robinhood was right to suspend trading on those names.
Roubini noted that Robinhood did not have a choice. It had to put an extra billion dollars in collateral with its clearinghouses and had to go to its backers to raise the money to do so. “If they did it for any other reason they might have been sued by investors and lost,” Roubini said. “But needing to manage their collateral exposure was a legitimate reason.”
Speaking of novel problems stemming from financial innovations, Roubini said that if the digital central bank currencies then being designed take off as modes of payment for individuals, rather than just as tools for banks to offload their clearing and settlement functions, it would have profound implications for banks. In a system like that, called “narrow banking” because only the central bank acts as a deposit taker, the banks would no longer be involved in retail or commercial deposit-taking at all, and no longer have maturity transformation risks.
Rather, they could borrow long-term and lend long-term, making the risks of runs like the ones that brought down Silicon Valley Bank, Signature, and First Republic in early 2023 much less likely. Switzerland held a referendum on narrow banking which was only narrowly defeated, Roubini said. “If a country did adopt narrow banking, its institutions would no longer be banks in the sense that we have known them for hundreds of years.”
This article was written in cooperation with Tom White