Is the American equities market trapped between inflation-driven rate hikes and a stagflationary recession?
It’s July 4th, 2022, and a bear market in stocks has begun. As we speak, investors from retirees to school teachers are thinking the same thing. Do I buy the dip? Do I sell my stocks and buy bonds? Should I simply hold cash in a savings account?
My thoughts are simple. The move in equities thus far has been all about inflation, thus common sense would indicate that whether stocks go up or down during the second half of the year is also dependent on inflation.
I’ve been concerned about inflation since early last year, when I warned that it was the biggest threat to the economy. With a reopening economy, record fiscal stimulus, and accommodative financial conditions, I thought that the biggest threat to the financial markets was the economy overheating, which is exactly what has happened. Inflation soared from an average of about 2% before the pandemic to 8.6% last month. Commodity prices, from oil to lumber and even wheat, soared. Home prices, car prices, and grocery prices all rose in tandem. Prices pushed the consumer to the limit and discretionary spending fell alongside savings. The talk on the street shifted from inflation to stagflation to recession.
Within the last two weeks, the beginning signs that inflation may be peaking have emerged. Just yesterday, oil prices fell 10%, falling below $100/bbl for the first time in almost two months. Housing inventory is increasing in key cities, and mortgage demand has fallen off a cliff. Retailers are sitting on large inventories. All of this is promising and bullish for stocks, especially longer duration high growth companies that are sensitive to interest rates; this is because, should inflation go away, the Fed will be able to pause or significantly reduce the intensity of their rate hikes, making stocks more attractive relative to bonds. Inflation disappearing means stocks should recover. This means that right now would be a good buying opportunity; however, I’m hesitant to take the bait. Below, I’ll explain why.
The Fed has committed to focusing on monetary stability — controlling inflation — more than on keeping the stock market elevated. Jerome Powell has implied or even outright mentioned that keeping price pressures under control is more important to him than sending the economy into a recession, which could cause the unemployment rate to temporarily rise. I think this is the right move.
If the Fed prioritizes stock, bond and other asset prices more than controlling inflation, inflation will undoubtedly worsen, which would only force the Fed’s hand in a much more dramatic way a few months or quarters from now, at which point stagflation — low or negative economic growth accompanied by inflation — would be all but certain.
The economy is doing well. The consumer is spending. Real estate prices and rental prices and oil prices are high. Travel is at post-COVID records. Without some sort of slowdown, I can’t see — from a practical perspective — a slowdown in inflation.
That leads me to my next point, which is that in the absence of a recession, inflation will likely persist. That’s the most pivotal and important sentence in this entire article because if it’s true, which I think it is, you have your answer to the million, or billion, or perhaps even trillion-dollar question. If the way to stop inflation is through an economic slowdown, which makes sense, you must assume that stocks will continue to fall.
I’ve been following the markets for a long time and one thing I’ve learned is to not fight the Fed. Accordingly, I think you still need to bearish stocks and risky assets, real estate included, until the Fed says that they’re ramping down their anti-inflationary efforts. Until the Fed pulls back on rate hikes and their balance sheet runoff (reversal of QE), you can’t be long stocks. Doing so runs the risk of attempting to catch a so-called falling knife.
Could the opposite be true? Could inflation moderate while the economy grows? Seems unlikely, but maybe we’ve entered the demand destruction phase of inflation in which inflation is self-canceling instead of self-reinforcing. Inflation is an ultra complicated phenomenon even the Fed has admitted it knows little about. Usually, the self reinforcing element of inflation is more powerful than the demand destruction element of inflation. For the most part, only commodity inflation, as opposed to wage and real estate inflation, causes demand destruction. And, just for a second, slow down to think about what happens if we are to believe that we have entered the demand destruction phase of inflation. If that’s true, a premise upon which some bulls are making their case, then it necessarily means that economic growth will be limited in the quarters to come. This, in turn, is bad for stocks. Either way, stocks aren’t looking too hot for 2H 2022.
Here’s the set of possible outcomes as I see them:
SCENARIO 1: NO RECESSION
Inflation persists, causing more tightening by the Fed, leading to higher rates and ultimately falling stocks.
SCENARIO 2: RECESSION
The Fed doesn’t tighten as much as the market is now anticipating but stagflation becomes reality,
earnings likely fall, causing financial risk to go up, causing the equity risk premium to increase, causing stocks to fall despite lower rates.
As you can see, there’s a serious case to be made that stocks are in a no-win position. This is what happens when the Fed explodes their balance sheet and keeps rates at 0%, artificially low, for too long. Real interest rates that are negative despite record low unemployment and high levels of investment / capex spending are an example of a monetary mistake, the correction of which forces the Fed to do unfortunate things like tighten into a recession.
The situation we’re in today looks strangely and scarily reminiscent of the situation stocks were in after the 2000 tech bubble burst. I’ve talked many times before about how this situation is eerily similar to both 2000 and 1970s pullbacks, perhaps some sort of hybrid of both, where inflation is only half as bad as it was in the 1970s but far worse than it was in 2000; where stock, bond, and real estate valuations are far higher than they were ever. In fact, the situation we are in today looks a lot like an “everything bubble,” much like the one Japan faced in the late ‘80s. If that’s the case, stocks have more room to fall, as well.
When asset bubbles let out air, the aggregate stock market earnings yield quickly spikes from a significantly below-average to a significantly above-average level. In this case the forward earnings yield on the S&P 500 could go from 3% to 8%. For a long time, bond yields and the aggregate stock markets forward yield were in tandem. Today, stocks offer a higher yield than bonds, but bond yields are quickly increasing. An 8% forward earnings yield would imply the S&P 500 at 3,000 by the end of the year, down another 20%.
If we assume there’s a 50% chance of recession and a 50% of no recession, I think a fair year-end price target for the S&P 500 is 3300, with the S&P at 3600 at year-end with a recession and the S&P at 3000 without a recession. This reflects my view that a recession will help mitigate the forces of inflation, allowing interest rate hikes to moderate, ultimately helping stocks.
Of course, I could be wrong. Inflation may be peaking as I write this article. Key commodity prices have begun to fall, such that even the energy sector is now in a technical bear market. Perhaps a year from now the consumer will be as robust as ever, spending and earning, all while inflation is back to the Fed’s target of 2%. After all, job openings still outnumber available workers by a factor of 2:1, and the unemployment rate is still at record lows. Maybe inflation has finally met natural resistance that will cause it to moderate in the face of continued consumer demand. Personally, I have a little bit of trouble envisioning that “Goldilocks” situation in which consumption is up and inflation is down. Sure, inflation may be peaking at 8 or 9% now, but I think getting inflation back to 2%, even if it falls to 5%, will prove more difficult than the bond market is now anticipating. I think we are entering a period of economic and financial normalization, in which interest rates better reflect economic reality. If one thing is for certain, it is that nothing is certain in an ever-changing and unpredictable world. Between Covid-19, supply chains, Ukraine, Taiwan, and the midterm elections, we can be sure that the remainder of this year will be interesting and volatile.
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