What Financial Markets Are Telling Us: Inflation Won’t Come Down Until 2023, Which Is Bad News For Everyone But the GOP
A sense of futility reminiscent of the Jimmy Carter era is growing in both financial and political circles, erasing the lazy optimism that presupposed a soft landing in the US economy and the rapid end of inflation. Now expectations are for continued inflation until politics and policies start to normalize in 2023, suggesting the bear market is far from over. The volatility risk premium points to a higher market over the next few days, but my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought one positive factor for US stocks. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. I expect this to reverse and the dollar to begin rallying again, setting global equity markets up for another rout on the way to lower lows next week.
Financial markets are telling us that inflation isn’t going away now because of policy choices and consumer behaviors that are locked in. But these choices will have to shift by 2023, as Russia finds it untenable to decouple from the West, Europe builds a stable infrastructure for fossil fuel imports and the US moves away from threatening and harassing the its native fossil fuel industry. At the same time consumers will have drawn down excess savings and pent-up demand will evaporate, setting in motion the economic normalization that brings in massive disinflation. So near term pain will be followed by long-term relief, unless more horrific geopolitical events emerge and destroy confidence altogether.
Fixed income markets affirm the optimistic long-term scenario, as US treasury interest rates are set to rise back to old highs because things are bad now, but level off in the 3% area, well below long-term norms. The leading indicator of inflation expectations, the MOVE index, predicts expectations will rise back to the 3% level, which is too high for the Fed, but low enough to reflect dramatic disinflation over the next 5-10 years. Fed speakers echo this sentiment as even the most liberal of Governors suggest a restrictive policy in the near-term may be warranted. Equities are thus grappling with the contrasting effects of high current inflation on earnings (typically positive as firms boost nominal profits) with high interest rates that reduce valuations. Since the primary risk is that disinflation doesn’t actually happen the sentiment in equities veers to the downside.
Equity derivatives are bullish, but stocks are showing rotation and individual names are dropping off like flies as earnings miss and guidance comes in lower. The tug of war between bulls and bears won’t get resolved until there is a washout victory for the bears, which suggests a continuing grind lower.
Key to watch is commodities, which have led the inflation data. Energy commodities have rolled over but this looks temporary, while ags have largely begun rallying again and precious and industrial metals have both stabilized after severe downturns. This suggests commodity inflation will continue through 2022. The only true beneficiary of this is the GOP, which looks set to trounce the Democrats in the mid-terms. The only positive for equities from this political scenario is a return to fiscal rectitude, a long-term positive but irrelevant in the present.
My current positions include a large cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO