Last year economists were discussing a phenomenon dubbed the ‘vibecession’: ‘the economic vibes were so bad it felt like we were talking the US into a recession’. I.e. talk of a recession was so commonplace the link between sentiment and reality was being called into question – would a recession manifest itself from ‘bad vibes’. With the S&P 500 hitting all-time highs in early February 2024 (its best rally in nearly four decades) the answer is, for the moment anyway, no. Now the market is rallying, lead in large part by the anticipation of rate cuts from global central banks. Although February is historically one of the harder times of the year for equity performance the general market sentiment seems to be broadly very positive. However, this positivity may represent a misguided resurgence of a phenomenon that highlights the perils of over-optimism and subsequently poor economic performance, sometimes even to the extent of recession. This trend suggests that excessive positivity about future economic prospects can initially fuel a boom. However, this often comes at the cost of a later downturn, frequently manifesting as a recession. It’s a classic case of short-term gains versus long-term pains.  

In this article we will unpack the link between overconfidence in the economy and subsequently lacklustre results that follow. 

Drawing on the insights of behavioural economics, particularly the work of Nobel Laureate Daniel Kahneman and his colleague Amos Tversky, we find a theoretical foundation for understanding the ‘vibecession.’ Prospect Theory highlights how individuals’ decision making is often clouded under uncertainty, often influenced by biases like overconfidence or over-pessimism. This theory is crucial in understanding how collective economic sentiment can significantly sway market dynamics and decision-making processes, potentially leading to the real-world impact. Further, the historical analysis provided by Charles P. Kindleberger in “Manias, Panics, and Crashes: A History of Financial Crises” offers a broader perspective on how economic optimism and pessimism have historically led to financial crises. Kindleberger’s work illuminates the cyclical nature of financial markets, showing how periods of irrational exuberance are often succeeded by sudden crashes and panics. The impact of overly positive forecasting on future economic outcomes can be incredibly potent and we have lots of historical examples of this phenomenon; when short term booms are immediately followed by downturns and recessions. When decision-makers, be they governments, investors, or private entities, base their strategies on overly optimistic forecasts, the consequences can be severe. If over optimism characterises analysis and predictions adopted by major financial institutions and used globally, they will hold significant sway over macroeconomic decisions and by extension, outcomes of the general market. Over-optimism tends to drive short term performance, but ultimately diminish long-term future growth. 

Consider the case of Mozambique in 2014, a nation that was once the poster child for economic prosperity and optimism when it came to forecasting. This optimism led to significant investment, such as the boosted levels of government bonds being purchased by investors in 2013. However, Mozambique’s growth stumbled, culminating in a default on its debts and extensive losses for investors. Similarly, Portugal’s 2010 economic crash, fuelled by substantial capital inflows, was preceded by a period of optimism. Investors and policymakers believed that the borrowing against future growth would pay off due to the country’s economic convergence with the European core. In Argentina, the scenario was slightly different but equally instructive. The excitement over President Macri’s reforms led to substantial external borrowing, including a notable 100-year bond issuance. However, this optimism-fuelled borrowing spree left the country vulnerable to changing global financial conditions, leading to an economic downturn and the need for a significant IMF loan. 

The cases illustrated and explored above accentuate a critical error that can arise with particularly bullish economic forecasting: the risk of over-optimism leading to misguided decisions that ignore the fundamentals. When forecasts influence government policies and private sector decisions, the entire economy can become more prone to recession. Thus, adopting a long-term perspective is crucial in understanding the overall impact of optimism on the economy. This phenomenon is not just limited to individual countries. The broader economic literature and analysis suggest that the global economy is susceptible to these cycles of over-optimism followed by underperformance. The IMF states, “recessions, fiscal problems, as well as Balance of Payment-difficulties are more likely to arise in countries where past growth expectations have been overly optimistic”. The key takeaway is that forecasts, while essential for planning, must be tempered with a realistic assessment of potential outcomes.  

In conclusion it becomes clear that the phenomenon of the ‘vibecession’ and the subsequent market surge offer critical insights into the fragile nature of economic optimism. The stark contrast between the fears of a recession driven by negative sentiment and the reality of a market rally underscores the complex relationship between perception and economic performance. This scenario highlights the importance of grounding economic expectations in robust analysis rather than a product of market sentiment, whether optimistic or pessimistic. The lesson here is twofold: first, that economic sentiment, while powerful, must be tempered by a realistic assessment of underlying economic fundamentals; and second, that the economic discourse itself can influence market dynamics in significant ways.  

 Reference:

https://fortune.com/2024/02/08/sp-500-record-high-tops-5000-first-time/

https://www.bloomberg.com/news/articles/2024-02-04/stock-market-s-rah-rah-mob-confronts-february-s-weak-record

https://delong.typepad.com/manias.pdf

https://www.imf.org/-/media/Files/Publications/WP/2018/wp18122.ashx

https://www.imf.org/-/media/Files/Publications/WP/2021/English/wpiea2021275-print-pdf.ashx

https://www.aeaweb.org/articles?id=10.1257/mac.20190332

https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1467-9701.2005.00737.x

https://www.research-collection.ethz.ch/bitstream/handle/20.500.11850/464418/DissertationKomarov.pdf

Zachariah Walker

Content Writer at Finalto

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