The billionaire hedge fund investor Stanley Druckenmiller has amazingly never had a down year of investing throughout his career, so when he speaks, you know the market is paying attention. Now, Druckenmiller is putting investors on notice and letting them know that a recession, as well as much more difficult market conditions, could be closer than they think. Here's why.
The effects of the Fed have only just begun
While the economy has held up pretty well in the face of high inflation and the Federal Reserve raising interest rates from zero to more than 5% in just over a year, Druckenmiller believes it's only a matter of time before the economy tips into a recession.
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"I don't know the timing, but certainly by the end of '23. I will not be surprised if it's not larger than the so-called average garden-variety," he said at a recent investor summit hosted by CNBC.
Historically low unemployment seems to be powering the economy through this current bout of high inflation, but Druckenmiller believes the Fed's easy-money policies over the last decade involving low interest rates and quantitative easing, which pumped trillions into the economy, are essentially a ticking time bomb in this high rate environment. The Fed's policies inflated assets like stocks, real estate, and more.
"There's a lot of stuff under the hood when you go from this kind of environment, the biggest, broadest asset bubble ever, and then you jack interest rates up 500 basis points in a year, I think the probability is that Silicon Valley Bank, Bed Bath & Beyond, they're probably the tip of the iceberg," he said.
Because the Fed has raised rates so quickly, I do think it's fair to say that the economy has definitely not seen the full effects of these rate hikes yet, and the results could certainly be surprising.
Think about the recent banking crisis earlier this year, which high interest rates certainly contributed to -- a few large banks that had been top performers for a decade failed. Druckenmiller is now warning of a potential credit crunch, in which banks slow their lending to preserve liquidity and avoid risk against a more difficult economic backdrop. Banks also likely face higher capital requirements later this year. This could have a very chilling effect on the economy.
When the economy does eventually turn and endure the hard landing that Druckenmiller is predicting, the 69-year-old expects bankruptcies to skyrocket, unemployment to exceed 5%, and corporate profits to tumble by 20% or more.
A huge drought for markets?
Druckenmiller believes these coming economic conditions will lead to a "high profitability" that the stock market struggles to make gains for at least 10 years. This is a very scary proposition for investors, who have been trained to believe that markets over the long term will always appreciate. Historically, this has largely been true, with the broader benchmark S&P 500 producing an average 10-year return of more than 12%, including dividend reinvestment.
Markets staying flat for 10 or more years would clearly be a worst-case scenario for all investors because there is a big opportunity cost associated with investing money in the market, and it would also likely cause many investors to lose faith in financial markets.
However, one thing I do feel confident saying is that investors and the markets are operating in the unknown right now. The market has never been through this amount of quantitative easing and potential quantitative tightening that could be coming; they've never seen interest rates rise so fast in such a short period of time; and the market is still dealing with the fallout of the recent banking crisis and the pandemic.
Now, Druckenmiller is not the first expert to preach doom and gloom, but given his success as an investor, his concerns shouldn't be dismissed. It's never a bad idea to prepare for a more downside scenario than you believe is possible.
