What Financial Markets Are Telling Us: Bad Times Are Ahead And The Fed Doesn’t Care
A recession is on the way and yet the Fed, ECB and numerous EM nations are aggressively raising rates in counter-historical fashion. And just as those central bankers and observers like myself got inflation wrong, so too will they get labor market dynamics and politics wrong. The future looks bleak, but for now the equity markets are keyed off the moderation in economic data that’s yielding optimism in a soft landing. The volatility risk premium points to a market fall over the next few days but my technical reading of key stocks in the S&P 500 is short-term bullish. Yesterday's cross-asset action brought one positive factor for US stocks. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there was also one negative factor across global asset classes. The action in major currencies & EM signifies a risk-off environment. Expect the S&P 500 to rise over the next few days before declining steeply as August begins.
Equity derivatives are bullish and that tells me the bear market rally has more to run, likely to S&P 4100. But from there a steep decline will ensue as economic data gets worse and bond markets continue inverting. The yield curve inversion is unlike a similar experience during the pandemic, as this inversion looks set to last for weeks or longer. That signals recession is on the way, and the key will be whether the labor market gives way in rapid fashion or slowly. I see workers who now regard The Great Resignation as The Great Regret finding the job environment suddenly inhospitable, and this leads to a surge of workers trying to find jobs. The recession will thus feel bad as most recessions do, and that causes uncertainty as people question whether the growth of public sector debt and the rollback of climate change objectives resulting from the pandemic and Ukraine war will stultify the animal spirits that normally turn a recession into a recovery. With the nation’s politics becoming more unseemly and sectarian by the day, the prospect of tax hikes to allow for further spending will loom large in the minds of investors.
Potential tax hikes marry uncomfortably with rising interest rates, and this will cause the current bear market rally to reverse. Interest rates are rising because the Federal Reserve Board is filled with self-centered policymakers who don’t want to risk their reputations and allow inflation to work its way out of the system over time. This is understandable as the 1970s experience showed how costly and long this process could be. But that doesn’t excuse the Fed from making the cardinal mistake of raising rates when an economy is weakening.
Moderation in commodities will undoubtedly help push inflation lower, but ironically this will give little succor to fixed income markets because the Fed is concerned more with core inflation that strips out food and energy prices. Consequently the only beneficiary of falling commodity prices will be corporate profits, which will continue growing and help limit the downturn to the S&P 3500 region.
My current positions are a large but slightly smaller cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETFs UPRO and SPXU.