There’s No Escaping Inflation Unless You Decide To Just Drop Out Of The System: The Geopolitical — Stock Market Connection

This morning’s CPI print reveals that all the Fed’s caution about higher for longer inflation is justified and likely ties into low productivity and increasing populism. This is bad news for a highly leveraged economy and as investors digest this they will call an end to the bear market rally that has lasted for an unprecedented four months now. For now the volatility risk premium still 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. But there was also one negative factor across global asset classes. The action in currencies signifies $US strength. Expect the S&P 500 to be range-bound over the next few days before beginning a new leg lower.

The cultural and political changes wrought by the pandemic build on similar trends that followed the Great Financial Crisis and the War on Terror, namely radical discontent, anomie, escapism and growing reliance on drugs. But these trends are rarely discussed on Wall Street, largely because until now there hasn’t been any impact on profit margins and worker productivity. But there is a growing likelihood these changes won’t mean-revert but instead persist and thereby alter the productivity and profitability landscape for American firms. That will kill Wall Street since America is already well beyond prudent levels of debt, such that servicing that debt requires a profitable and productivity private sector, else discontent breeds more discontent.

White and blue-collar workers who haven’t accumulated wealth and instead live with toxicity in numerous forms have always faced a choice to simply opt-out of the work-hard/play-hard mentality that’s defined American culture since the 1980s. But now with millions opting to take government largesse and even greater numbers challenging basic cultural norms of law and order, those that remain in the workforce are more likely to engage in ever growing degrees of quiet quitting and cultural confrontation than is manageable for American firms. The 1970s are back and reflected in culture wars, commodity price inflation and a hangover from malevolent politics and intractable geopolitics. But things could get much worse, as Schroeders Asset Management notes:

“The pandemic may have temporarily distracted attention, but the general concerns that economic policy was failing a significant proportion of the population who had seen no increase in real incomes in a decade have re-emerged. One sign of this can be seen in the wave of strikes to hit the UK economy. Workers are seeking higher pay awards to claw back some of the loss of real earnings from high inflation. Such a pattern ties in with research from the IMF which has shown that social unrest often follows pandemics. Those who made sacrifices during the health crisis are often disappointed at the lack of change after it has ended and are willing to push harder for something better. Figures from the IMF show that the government debt to GDP ratio for the Advanced G20 surged to over 130% in 2020, an increase of over 20 percentage points when compared to pre-pandemic levels in 2019. The key will be the impact on borrowing costs. Although the government is effectively controlling interest rates through financial repression, some borrowing costs will increase as inflation rises such as those on inflation or index-linked bonds. The UK is particularly vulnerable in this respect given it has one of the highest levels of outstanding inflation-linked debt at 25% of the total. Other major economies are running at 10% or less, according to the Bank for International Settlements.”

The risk-reward ratio is tilting negative because the worst-case scenario outlined for the UK is becoming more likely for America as well, especially as our leaders take hypocrisy and contradictory policies to ever greater heights. Even if quiet quitting and other forms of escapism mean-revert to the old standard of the work ethic, it will take all of 2023 to discern this since corporate guidance so far has been highly negative. That’s a key reason to doubt the legs of the current rally and position for another leg lower in an ongoing bear market.

My current positions include a significant cash position, 3M (MMM), Pfizer (PFE) and the inverse levered ETF SPXU, which nets out to a significant short position.