Why Are Stock Markets Not Freaking Out?

US stock market valuations are reaching record levels last seen in the dot com bubble. This time it's just another type of tech boom, is history repeating itself. But whilst a few big tech firms are booming, at the same time, the US has record tariffs, inflationary pressures, the dollar is falling, debt is soaring, and the independence of the Fed under threat. The NBER suggests a 71% probability the economy was already in recession in May. Gold is soaring to record levels as investors hedge against the dollar. Now there are two different explanations for what's going on. Firstly, you could argue the US economy is still relatively resilient, and it will shrug off these challenges. It's not as bad as it looks, and it will continue its economic exceptionism, where it has outperformed the EU. The second, though, is that markets just don't want to recognise the seismic changes hitting the economy, and therefore prices are overvalued. Now, if we look at, say, Turkey, President Erdogan railed against high interest rates, saying they're the devil's work kind of thing. In 2019, he sacked the governor of a central bank and pushed for interest rates to fall from 19% to 9%, claiming lower interest rates would reduce inflation. But the problem is, you can't rewrite the laws of gravity. The cut in interest rates caused inflation to soar. Even in 2022, with inflation once again rising, Erdogan wanted lower rates. Again, it failed dismally. Inflation soared, the lira devalued, and Turkish people sought foreign currency. And ironically, it left Turkey with high inflation and interest rates of 50%, a failing currency, danger of debt default, and a real economic crisis. Now, you might think that could never happen in the United States. Markets are certainly not contemplating the possibility, but maybe anything is possible. Erdogan's intervention in monetary policy showed how quickly inflation can become a problem, and wanted to break confidence and credibility. It can be very hard to get it back. And the irony is that cutting Fed rates by 300 basis points would probably push up mortgage rates even higher. The Fed doesn't set mortgage rates, and if inflation goes up, so will long term mortgage rates. Now, US tariffs have been up and down like a roller coaster this year. But amidst all the noise, the basic factors have gone up to levels last seen in the Great Depression, 17.4%. So far, firms have absorbed most of these extra tariffs. But this will drop away by October. Stock powers have been used up, and ordinary households will struggle with a rise in prices. The chief of McDonald's has said that lower income households are already skipping on breakfast, reducing their spending. More than ever, the US economy is reliant on spending by the richest households. Now, looking ahead, input costs, service sector inflation are all rising faster than expected. And this is a guide to future inflation. Now, in theory, tariffs could be just a one-off price increase. The Supreme Court could even strike down a large part of the tariffs as illegal. But inflation pressures are building for other reasons in the economy. Firstly, consumers in the US are still expecting higher inflation. The survey from Michigan University suggests an expectation of 4.5%. And this really matters. The stagflation of the 1970s lasted so long, because people started to expect high inflation. And this made it very difficult to bring it down. If Fed independence is reduced, political pressure in setting interest rates, then that's unlikely to increase expectations of inflation. Another inflationary pressure comes from the crackdown in illegal migration. This is hitting agricultural production, meat processing, which relies on immigrant labour. The result is that farmers do complain about crops rotting in the field. Food prices are rising, meat prices especially, actually all around the world. But this does feed into inflationary pressures, especially for low income households. Also, US energy prices are rising, 7% increase in 2025. For two main reasons. Firstly, AI data centres are causing a huge increase in demand. Secondly, the federal government are blocking new renewable energy development. For example, Allstate Wind Farm in Rhode Island forced to stop construction despite being nearly 80% completed. Demand for electricity is soaring, but supply is not keeping up. Even the US oil and shale gas industry are struggling, ironically, because of falling oil prices. And it is worth pointing out that falling oil prices is really helping to keep a lid on inflation, which is reducing output in that key industry. Now, why does all this inflationary pressure matter? Well, a key pillar of the international financial system is the stability of the US economy, and the value of the US Treasury. If the US were to see a new cycle of high inflation, and loss of credibility, it would undermine the global economy. Already, central banks are diversifying away from dollar assets, with central banks holding more gold than treasury. And the last time this happened was in the 1970s and all that stagflation. So when we say that markets are ignoring inflation risks, it's not entirely true. Gold prices continue to climb to record levels, a clear sign of hedging against the dollar. Yet with some inflationary pressures rising, the economy is also showing signs of slowing down. Unemployment is creeping up, job creation is down, and the chances of a recession increasing. The economy is increasingly reliant on AI and healthcare sector. Of the 600,000 jobs that have been created in Trump's second term, a staggering 515,000, or 86% of them have been in healthcare or social assistant jobs, take out healthcare jobs, and the outlook is concerning, employment is actually falling, and stark contrast to the big job creation of the past decade or so. Now, whilst stock markets may be reaching new highs, the bond market is mostly down, and importantly, the dollar is also down, international investors voting with their feet. So why does the stock market keep reaching new highs? Firstly, the booming stock market is really very highly concentrated in a few big tech firms. AI chip giant NVIDIA accounts a growing share. But here a really good question to ask is whether AI itself is a bit of a bubble. The levels of investment in AI suggest that some think it's a solution to all our economic problems. But whilst AI is being slowly adopted, there is a risk that the huge valuations and level of investment are a bubble, and it is actually reminiscent of that boom in investment in fibre optic cables around the dotcom bubble of the late 1990s. Fibre optic cables, of course, are actually very useful, but it was still a boom, which turned to a bust when markets woke up to the overvaluation in tech in 2001. AI faces threats from cheaper models, e.g. from China, the shortage of electricity, a downturn in the economy, and the general overvaluation of a technology which may not be quite as revolutionary as some might like to claim. Now, a good question to ask is, are markets good at pricing risk and real value? If you look at history, markets are often more like a pool of conventional wisdom. Investors can be focused on short term value and ignore long term risks. In the lead up to the financial crash of 2008, markets were happy to keep buying mortgage assets, even when there were warning signs about falling house prices and rising default. And what we can get is what we call a Willie E. Coyote moment, the moment in the cartoon where a character runs off a cliff, and for a brief second is walking in the air until he looks down, realises there's nothing under him. And of course, he crashes to the floor. So mortgage stocks kept rising, even after house prices fall, until one day the market woke up and realised there was nothing of value underneath. And of course, it all crashed. If you look at the early 2000s, the ratio of house prices to income reached record levels. And interestingly, US house prices have risen to a similar level of unaffordability. Now, some people do short stocks, investors are attracted to gold, but it's rare for people to want to short the whole market. People prefer to be wrong with the majority rather than right in the minority. It's the wisdom of the crowd, safety in numbers, the herding effect of wanting it all to be true. But do we really face a crisis like 2007? True credit card debt levels are rising, but the level of mortgage default is nothing like 2007. For all the unorthodox economic policies, the US economy still retains many strengths, high corporate profitability, high levels of productivity, and a large, relatively open economy, give or take a few tariffs. Now, given the economic slowdown, maybe a big cut in interest rates is actually quite a good idea for stimulating investment and growth. And given the oil prices are quite low, it's not all bad news on inflation, especially if unemployment is going up that will curtail rate growth. Now true, there are inflation pressures in the pipeline, but the actual inflation rate is still 2.7%. And it's a long journey for inflation to get out of control, especially if growth remains low. Also, if you bought stock in Amazon just before the dot com bubble burst, you would still be very grateful that you did. True, it fell in 2001 by 90%, from $108 to $6. But it has more than recovered since then to an adjusted $22,000. So if you buy just before a crash, Amazon actually worked out well, although of course, some other tech stocks completely collapsed. Now, the US economy is increasingly too speed. I have shown this graph before, but it doesn't neatly explain the paradox of the US economy, GDP rising, but median wages stagnating, an economy work that works to some, but not others. Inequality is a real problem in America. But worth bearing in mind, inequality itself will not cause a stock market crash. However, there is a realistic possibility, the valuation of AI and tech shares may be inflated by irrational exuberance. And the rise of stagflation pressures are actually pretty concerning news for financial markets in both the short term and long term. If Fed independence is aggressively targeted, then we could start to see the small inflationary shocks, push up inflation expectations. And once more, inflation could become embedded, like in the 1970s, which makes it very difficult to reduce. Also, while we focus on American, also while we focus on American problems, there's also a huge amount of wealth amongst American investors. The big corporations have been buying up countries like Britain. And this video looks about the American buying up of British assets. Pretty interesting. So do check it out. Thanks for watching. And let me know what you think in the comments.