Why A Recession May NOT Happen In 2025
Contrarian's View and Why Markets are Inefficient in the Short-Term
There’s a saying “Markets Climb A Wall of Worry”, and this saying is actually quite intuitive. The general idea is that market prices are a function of liquidity (i.e. supply:demand) — and in modern-day markets, liquidity is influenced to a significant extent by governments and central banks.
The latter will have every incentive to keep markets humming, which implies that they can be relied on to prop things up every time things turn down — that is, until they have taken things to such excess that they can no longer do so. Hence, the irony is that when markets are still worrying, it’s unlikely that things have peaked — rather, that usually occurs once there's irrational exuberance resulting from peak stimulus.
The top half of the chart above demonstrates the 3 big needle-movers of US liquidity — the Fed (yellow), Treasury (red) and Reverse Repo agreements (blue). It’s a slightly outdated chart from May 2024, but for all intents and purposes it may as well be current. These represent country-level flows which typically span entire decades, and a quick check on FRED (click links above) reveals that all of their balances remain at similar levels since 5 months ago1.
Since at the end of the day funds remain scarce, the interplay of flows between these 3 lines interact in a “when one goes up, another goes down” sort of way. By playing with the flows between these three liquidity facilities, the Fed and Treasury can ensure sufficient liquidity in the system to keep the economy humming, thus allowing the private sector to do its job.
If you’re new to this, all you need to know about the chart above is that if the line goes up, it’s good for liquidity; and if the line goes down, it’s bad for liquidity. Higher liquidity implies stronger market valuations, and vice versa.
The bottom half of the chart compares the S&P500’s valuation (yellow) to aggregate Net Liquidity (grey). The latter is simply the net effect of combining the first 3 lines in the top chart. In other words, it demonstrates the impact of aggregate Net Liquidity on US equity markets (in contrast to fundamentals per se).
Most readers can monitor the positive correlation between the grey and yellow lines in the bottom chart, and conclude that fundamentals barely matter when informing equity valuations in the short-term. When Net Liquidity (grey) goes up, S&P valuations (yellow) go up faster in anticipation of pre-announced liquidity indicators; and vice versa in the opposite direction.
It bears repeating: fundamentals barely matter to short-term valuations. It’s almost all macro.
It’s also quite the coincidence that both lines happen to intersect by the end of the chart in May 2024 — sufficiently demonstrating how correlation exists between the two even over the medium-term, if not outright causation.
Explanation: The Net Liquidity Chart
As the grey line shows, Net Liquidity initially surged throughout the pandemic period before hitting a peak in end-2021. We can clearly see what contributed to this — the Fed’s balance sheet (yellow, top) climbed as it engaged in further QE, whereas the TGA (red, inverted) initially soared from this newly printed money. It subsequently cratered after March 2021, amidst debt ceiling concerns and the passing of the American Rescue Plan.
This surge in Net Liquidity (grey) starting from March 2020 clearly coincided with the huge jump in S&P 500 valuations (yellow, bottom) — with equity markets anticipating future liquidity and staying there until end-2021.
In June 2021, Powell gave his first indication that he would hike interest rates to combat rising inflation. The prospect of higher risk-free rates led banks and MMFs to channel excess funds towards overnight reverse repos (blue, inverted), which drove up overnight reverse repo (ON RRP) balances as the TGA’s drawdown persisted (red, inverted).
However, the onset of the Ukraine War in Feb 2022 sparked panic in equity valuations, even as the Fed grappled with soaring inflation and felt compelled to raise interest rates. This is evident in the persistent increase of reverse repo balances (blue, inverted) at around this time2. The TGA (red, inverted) also saw an increase during early-2022, owing to higher tax receipts and debt issuances following the suspension of the debt ceiling in Oct 2021.
By June 2022, the ON RRP (blue, inverted) had reached its highs while the TGA (red, inverted) stepped up to the plate, given that the Fed (yellow, top) had already started to engage in QT. The net effect of all three was to keep Net Liquidity (grey) flat for a year until roughly June 2023.
The last leg of the chart begins at around the same time, when the ON RRP started draining (blue) despite interest rates remaining high. As the increase in the TGA (red, inverted) alludes to, this was due to the Treasury shifting their issuing preferences towards shorter-dated bills, which competed directly with the ON RRP for scarce liquidity.
The resulting outflows from the ON RRP continued to stimulate the economy, enabling flat Net Liquidity conditions (grey) until the end of the chart in May 2024. As a result, S&P valuations (yellow, bottom) saw a marked increase from its lows since mid-2022.
Must A Recession Happen In 2025? No.
The entire point of the chart above is to demonstrate the incredible correlation between aggregate Net Liquidity (grey) and equity market valuations (yellow, bottom). Given that all this effectively takes place at the government level, the ideal scenario for policymakers is to create flat and non-volatile Net Liquidity conditions so that the private sector can focus on doing their jobs in the real economy, rather than worrying about things happening above.
If so, then logically this should also be the goal of policymakers. All else being equal, they should strive to create flat and non-volatile Net Liquidity (grey) conditions going forward — as they’ve previously done since June 2022. And if so, then it’s pretty obvious what their next step would be.
Given the recent uninversion of the yield curve, it’s almost certain that the Fed will lower interest rates soon. As long as the current inflation trajectory persists, the Fed should see fit to restart QE again sometime in the future, especially amidst deteriorating economic conditions.
This should result in the Fed’s balance sheet (yellow, top) inflecting upwards again, which should have a subsequent effect of refilling the TGA (red). Treasury can subsequently use that to stimulate the economy again via government spending.
The astute amongst you will recognize that this is a similar description of what happened in 2020 (observe the trajectory of the yellow & red lines during that time). It has been done before, and it can be done again.
To be clear, doing this only amounts to kicking the can down the road, and policymakers will eventually still have to pay the piper. But if we change the question to, “Must A Recession Happen In 2025?”, then the answer becomes markedly less clear.
Simply eyeballing the levels of the respective 3 liquidity facilities above and comparing their latest levels to previous levels3 implies that there could be enough room for policymakers to kick the can down the road for up to another year (e.g. 2026?) before they hit rock bottom. That is to say, when all 3 liquidity facilities run out of room and policymakers have zero options left besides highly unconventional monetary policies4 (e.g. negative interest rates).
Especially considering that this year is an election year, it is almost certain that whoever ends up winning the White House will embark on a colossal stimulus program in 2025, funded by the Fed engaging in QE (yellow, top). If 2020 is any indication, the trajectory of the red & yellow lines should look roughly similar in 2025 — the Fed’s balance sheet should start inflecting upwards (yellow, top) while the TGA (red) should see a spike and subsequent drawdown as it spends everything that it takes in5.
If we reframe the question from “Will A Recession Happen Eventually?” to “Will A Recession Happen In 2025?”, the answer to that is truly up in the air. While most economists can achieve consensus on the former, the exact timing of when it will take place is far less certain. As I’ve explained above, there is plenty of room to make the argument that policymakers can stave off a recession from happening in 2025, given ample policy tools to keep Net Liquidity conditions flat and non-volatile for at least a year.
And while that narrative may be insufficient for many struggling households and businesses, it’s still a quantum leap from saying that the economy will definitely crash or that a recession is certain to happen by next year. If anything, I find comfort in the fact that the Wall of Worry is still standing strong — it’s when irrational exuberance occurs that you want to start panicking.
Value Investing: Macro Is Unpredictable
As one might imagine, this “Recession 2025 Maybe?” narrative has huge implications for the near-term outlook of certain businesses. I won't spell out which ones, but you can already see which sectors are currently experiencing sector rotation from the ongoing recession fears.
Conversely, if policymakers are able to keep a recession at bay until 2026, you might see a similar recovery in market valuations as the one we saw throughout 2023. And 2019. For largely the same reasons.
However, keep in mind that the macroeconomic environment remains highly in flux, with many extraneous events like geopolitics (or even local politics) not making its way into this analysis. Given the excessive uncertainty that abounds, many famous value investors such as Warren Buffett and Howard Marks have straight up confessed their position on this matter — Macro Is Unpredictable!
This is why value investors tend to adopt a stance of asymmetric risk:reward — where “Heads I Win, Tails I Don’t Lose Much”. While this is something recognized outside of value investing as well, far too many investors still attempt to forecast future market outcomes with precision. This is a futile exercise — just think about how many things could go wrong if the Net Liquidity description above doesn’t play out as expected.
Unfortunately, it remains a fact that macroeconomic factors have an outsized impact on equity valuations in the short-term. This is why Howard Marks has previously stated that the 2nd quartile of performers in the short-term tend to occupy the 1st quartile in the long-term — there are simply too many factors to control for in macro, and you cannot possibly beat the lucky ones every single year. The best any investor should hope for is that the underlying business fundamentals play out correctly over the long-term, and simply leave the short-term to fate.
It’s possible I got something wrong in my analysis above — and if so, please feel free to let me know in the comments. Also, why not check out some of my previous stock analysis below?
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Disclaimer: This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the authors. To the best of the authors’ abilities and beliefs, all information contained herein is accurate and reliable. The authors may hold or be short any shares or derivative positions in any company discussed in this document at any time, and may benefit from any change in the valuation of any other companies, securities, or commodities discussed in this document. The content of this document is not intended to constitute individual investment advice, and are merely the personal views of the author which may be subject to change without notice. This is not a recommendation to buy or sell stocks, and readers are advised to consult with their financial advisor before taking any action pertaining to the contents of this document. The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. Any or all forward-looking assumptions, expectations, projections, intentions or beliefs about future events may turn out to be wrong. These forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks, uncertainties and other factors, most of which are beyond the authors’ control. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment of the relevant markets prior to making any investment decision.reverse repo balances have almost halved to $285B since, but that’s barely material considering it fell from over $2.2T at its peak.
higher interest rates leads to greater inflows into the ON RRP, as banks/MMFs seek better risk-free returns.
as aforementioned, only the ON RRP has changed materially since May.
Author’s note: what a world we live in that QE is now considered part of the expected monetary policy toolkit.
The ON RRP (blue) wouldn’t be contributing much to this 2025 scenario, given its low existing balance and declining interest rate trajectory.
What is meant by 'a recovery in market valuations'? SPX is approaching 6000... what on earth would it be recovering from?