What Financial Markets Are Telling Us: Policymakers Won’t Reform Their Stagflationary Ways Unless Equities Perish

The modest rally in global equities that began Friday afternoon looks set to peter out this week as the bulls try digesting the wealth of stagflationary data coming out every region of the world. 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 several positive factors for US stocks. The US yield curve is falling and in the current context that is bullish. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. These trends look temporary and I expect the bond market to reverse course and consequently the S&P 500 to be range-bound over the next few days, before beginning a new and final leg lower in June.

Financial markets are telling a consistent story that inflation has peaked but likely to decline slowly, confounding hopes the Fed will moderate its pace of rate hikes. The impact of Fed hawkishness extends to many countries in the less-developed world who are perilously close to defaulting, so the geopolitical consequences are significant. The US can hardly muster a wide coalition of the willing to stop Russia when it’s seen as causing economic destruction across the less-developed world.

Equity derivatives paint a moderately bullish picture, as the implicit forecast of volatility (the VIX) is lower than the actual volatility experienced in the S&P 500 over the past month. Similarly bond market volatility has declined and paints a bullish picture of higher prices and lower yields, another plus for equities. But my technical reading of the top 100 stocks in the S&P tells me lower lows are in store, particularly as volume has been modest over the recent 4 day rally. Similarly I see interest rates retesting their highs from early May, likely coinciding with new lows in the S&P.

Bearishness is supported by the action in currencies against the $US. Both the majors and key EM currencies have made weak rallies and are likely to retest their lows from early May, reflecting the stark slowdown in China that ramifies to global trade and Chinese FDI in every region of the world. Compounding the decline in global growth is inflation from the relentless uptrend in most fossil fuels and the elevated levels of agricultural commodities. Among commodities only precious and industrial metals look set to retest old bottoms and contribute a disinflationary impulse. Stagflation is here to stay until China reverses is moronic COVID policies or global equities decline enough to turn the Fed away from 50bp rate hikes. I expect that scenario to play out in June, and consequently a new bull market in equities to emerge in a few weeks, assuming the dismal geopolitical context doesn’t worsen.

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.