One of the ways central banks break the ice to markets is via their research. While said research is not the official opinion of any Central Bank, it is nevertheless an outcome that is likely.
The latest research from the Federal Reserve Bank of NY, based on their DSGE model is not good. And I quote from their most recent blog post:
“The model’s outlook is considerably more pessimistic than it was in March. It projects inflation to remain elevated in 2022 at 3.8 percent, up a full percentage point relative to March, and to decline only gradually toward 2 percent thereafter (2.5 and 2.1 percent in 2023 and 2024, respectively).
This disinflation path is accompanied by a not-so-soft landing: the model predicts modestly negative GDP growth in both 2022 (-0.6 percent versus 0.9 percent in March) and 2023 (-0.5 percent versus 1.2 percent).
According to the model, the probability of a soft landing—defined as four-quarter GDP growth staying positive over the next ten quarters—is only about 10 percent.
Conversely, the chances of a hard landing—defined to include at least one quarter in the next ten in which four-quarter GDP growth dips below -1 percent, as occurred during the 1990 recession—are about 80 percent.”
So the NY Fed is telling us to expect 2 years of negative GDP growth, with the possibility of a 1990s recession at 80%.
The above wording confirms my suspicion that the US economy is in worse shape that what Mr. Powell is telling us, and that achieving a soft landing is far-fetched. Then again, the above predictions are a function of the Fed’s forward guidance. In other words, if the Fed gets too spooked of the economic reality and backs-off (as I think it will at some point), then the above prediction will probably not happen.
The bottom line is that if the Fed continues its current path, not only will the US economy have negative GDP growth for the next 2 years, but a hard landing and a lot more economic pain is probably in the cards, according to the NY Fed.
Apple is by far the most widely held stock in the world. Either directly or indirectly (via ETFs and Funds), almost all fund managers have some exposure to Apple in their portfolios. And because Apple and several other stocks are so widely held, when markets fall there is a plethora of these names that are sold. And when funds or ETFs have redemptions, fund managers sell what they can, not what they want. And if you have not noticed recently, Apple and the other top components of the S&P have been falling off a cliff.
At the same time, the 10 biggest companies by market cap in the S&P 500 Index comprise about 30% of the total market cap. This means there is the risk of high concentration in indexed products, and the market as a whole.
This was fine when markets were rising and no one questioned the valuation of the top components, but now after 7 weeks of lower lows, investors are asking themselves if Apple and many other stocks were worth what they paid for them.
But whether valuations were warranted or not, the risk of concentration remains. And this in turn might mean that, unless Apple and several other top constituents stop falling, it might be very difficult for the S&P Index to rally.
The bottom line is that there is much turbulence in markets today. In additional to supply shock issues, high energy, war, Central Bank tightening, we also have concentration risk. Obviously the more diversified investors are, the better, but when the top S&P 500 components are in most institutional portfolios (directly or indirectly), it’s difficult to avoid concertation risk at the current time. As Apple and other top brass components go, so will markets, for the time being.
As expected, and as economists expected, the Fed raised rates by 50 basis points and announced policy pertaining to QT (quantitative tightening). The wording from Chairman Powell suggests that there are at least 1-2 more 50 basis point hikes ahead, and then a slowing down of tightening policy. The Fed has no easy choices because as rates increase, the risk to growth also increases. However, Powell made it clear again and again that his No1 priority is inflation and will use all means to combat it no matter what the cost.
Chairman Powell made the point that the labor market was very tight, with job openings outstripping the available supply of labor. In fact, he even said that unemployment needed to go up a bit for labor supply imbalances to even-out.
But as depicted in the above chart, employment levels in the US have not returned to pre-pandemic levels. There is plenty available labor out there, it just does not want to return to work.
The Fed wants to reduce the “surplus demand” in the US economy, and it admitted that there is no easy way to do that. As such, the Fed has decided to increase the cost of capital as a way of achieving this goal. The latest data from FreddieMac shows that 30-year fixed mortgages in the US are 5.27%, up from about 2.5% of a year ago.
And as the chart above from the US Mortgage Bankers Association shows, the average monthly mortgage payment went from about $1300 between 2019 and 2021, to a little over $1700 today. So yes, eventually consumers and business will reduce their “surplus demand” and the Fed will get its wish. The question is will this combat inflation?
The US had negative GDP in the first quarter. Generally speaking, as long as the US consumer is doing well, the US economy is generally ok.
However, as the chart above shows, consumer confidence in the US is falling off a cliff and is rivaling the recessions of 2008 and 1980s.
Over the past several years US consumers for a whole host of reason had accumulated lot of savings on the side. Today those savings are gone.
As the chart above shows consumer savings are at the lows of 2013. What this basically means is that it will be very difficult for the consumer to keep the US economy growing over the next several quarters. In other words, it is very likely that the US will see negative GDP growth, perhaps for the next several quarters ahead.
At the same time the Fed admitted (finally) that most of the inflationary pressures have to do with supply shocks, that are outside of tis control. As a reminder, these supply shocks are the on-going Covid pandemic, high energy prices, and the recent war in Ukraine. And since the Fed can’t do anything about energy prices — which is he biggest component of recent inflationary pressures – it has decided to lower demand by making everyone in the US poorer.
Please note this is the opposite of what the ECB has done, saying that monetary policy should still stay as is, because the reason for inflationary pressures are outside of its control.
Adding everything up, in my opinion the Fed is making a policy mistake. In fact, this will prove to be the second policy mistake chairman Powell will make, the first being his insistence on raising rates and trying to shrink the balance sheet in 2018-2019.
Insofar as the markets, after the Fed announcement on Wednesday US market rallied hard, only to give everything back and then some on Thursday.
As I said in our 2022 outlook, there is nowhere to hide with Fed policy being so hawkish. Mind you that the carnage is not limited to equities but has also spread to bonds. On a positive note, a lot of hot air is coming out of the market, especially in Cathie Wood type companies, and overall equity prices here and there are once again becoming compelling investments. But finding companies that can go against this tide requires hard work, and in many cases nerves of steel.
What is the Fed trying to do?
Analysts, pundits, and Central Bankers are mostly right when it comes to economic issues, growth, and inflation. However, their models do not include a pandemic or war. As such, most estimates and projections during the past several months may be treated with skepticism. In fact, market participants have for the most part been positively surprised by most economies, as opposed to the doom and gloom that was forecasted at the start of the pandemic.
But in order to avert a depression, central banks and governments came to the rescue. Central Banks intervened with liquidity and loose economic conditions (lower interest rates and ample liquidity), and governments gave cash handouts to make up for the loss of income.
Now the Fed wants to take everything back. At least that’s what they mean when they want to reduce the Fed’s balance sheet. But there is a small problem. As a general rule of thumb when liquidity is created, it eventually gets backed in the system, and any attempt to take it out again (shrink the balance sheet) causes a lot of harm to the economy and markets.
Will higher rates reduce inflation?
As you all know, there have been many supply-side disturbances because of the COVID pandemic. These supply issues and bottlenecks have in many instances raised prices, caused delays in procurement, or simply made products unavailable. As a result, prices for many products and services have gone up. In fact, higher than originally thought, and longer in duration..
However, COVID price rises were not the end of the world and didn’t bite into consumer purchasing power all that much. The main problem with current inflation dynamics relates to energy costs and commodities. The current rise in energy costs is responsible for a much broader rise in goods and services, as opposed to a rise in computer chips.
As an example, a price-rise in a particular computer chip because of a supply side disturbance, only raises the cost in the specific product in which it is used. A rise in oil and gas prices, raise the price of gas that affects consumers, the cost of transportation, the cost of international shipping, air-travel, and even commodities because of all the reasons mentioned. However, let me make two observations.
First, the higher cost of energy is not so much because of an increase in demand, but of lack of supply. The lack of supply however is mostly because of geopolitical turmoil (Russian – Ukraine war). In fact, in many cases these price increases are self-afflicted, because many governments have decided to limit or prohibit Russian energy imports in their countries. Energy prices will eventually come down, but only after Russian oil returns to the market, or an increase in supply comes from another source, or if current producers produce more oil and gas.
In other words, there is not much the Fed can do to lower energy prices, outside of technically crashing the US economy with very high rates. As such, is doubtful if the monetary policy is an answer to current inflation dynamics.
The Fed does not have any easy options.
As you can see from the chart below, consumer sentiment is approaching the lows of the 2008 financial crisis, and only 3 times during the past 40 years has sentiment been so low.
Obviously, the main culprit for such a low sentiment reading is inflation, eating into consumer disposal income. However, what would happen if consumers had even less disposal income because of higher mortgage rates, higher credit costs to buy a car, higher credit card rates, and a many other costs that have to do with higher interest rates?
The answer is probably an even lower consumer sentiment reading, and lower demand. However, lower aggregate demand is what the Fed wants to achieve to lower inflation. By elevating interest rates the Fed can eventually achieve such a goal. Some market participants, however, are skeptical if the price of energy will fall in the absence of an increase in supply.
The Fed aims to achieve lower inflation but without inducing a recession. With consumer sentiment being so low, a soft landing is a very speculative bet. And while nobody knows what the outcome of the Fed’s policies will be, the most probable result will be recession, if it raises rates by 50 basis points several times in a row and shrinks its balance sheet as it has said it will. Obviously, another sector of the US economy that will be affected is housing.
As illustrated on the chart above, the average 30-year fixed mortgage rate is already approaching 5%. There’s an increased probability, when mortgage rates stay elevated long enough, the US housing may break. Is monetary policy the answer?
On the other hand, politicians on both side of the Atlantic are calling for Central Banks to do something about higher prices. Central Banks have been pressured for a while, with many accusing them of being behind the curve.
The problem however is that higher rates might not be the answer. In the absence of a pandemic and war, it is true that monetary policy would have been the answer to an economy that is overheating. However how can monetary policy lower higher energy prices, when there is a lack of supply, or supply side shortages because of the COVID pandemic, something that is still ongoing? This is something that many analysts and economists are trying to figure out. And the truth is that there are no easy answers.
Why does the Fed want to reduce its balance sheet?
First of all, for all the concern pertaining to the Fed’s balance sheet, very few mentions are made about the balance sheet of the ECB or the BoJ. As the chart above shows, as a percentage of GDP, the ECB has more than double the Fed’s balance sheet, and the BoJ almost 4 times the balance sheet of the Fed. So, my question is, why does the Fed think its balance sheet must shrink? Furthermore, how is this connected with its goal to reduce inflation?
This is not an easy question to answer, because nobody knows what is in the Fed’s mind. However, everybody knows that inflation as presented in the article found on the company’s internet side here in both Europe and Japan has not been a function of their balance sheets all these years. As such, there are reservations if the Fed’s balance sheet has anything to do with inflation.
As mentioned above, once liquidity is created it gets backed into the system, it is very difficult to unwind, and it might cause a lot more damage than the benefit of lower inflation. Also, the unwinding of the balance sheet acts like using leverage trade in reverse. In other words, the damage could be much more painful than we could imagine, if the Fed allows its balance sheet to unwind to the tune of about $1 trillion per year.
Bond market shakeout
It does not take much to figure out the kind of carnage bonds might face if the Fed raises rates as advertised with yields so low. According to a recent Financial Times article, “Treasuries set to post worst quarter of returns since at least 1973 on inflation and rate rise fears”.
Indicative of the carnage is the chart below (from Bloomberg).
The price of Austria’s 100-year bond has more than halved in price. After starting at around 110 in 2020, investors holding these bonds have lost around 40%. Not from the highs, but from their initial investment.
The Fed has reiterated via proxy (ex-Fed officials) that it wants to take the market down, to take away the wealth effect created by the market. The logic being, if everyone feels poor, they will curtail spending. Well, insofar as bonds are concerned, the Fed is doing a great job.
But how much fixed income carnage is the Fed willing to tolerate in the name of lower inflation? Impossible to know, but please keep in mind that many have characterized the current Fed as the most hawkish since Paul Volker.
Chairman Powell has suggested that QT (quantitative tightening) will proceed at about $1 trillion per year. Taking into account the addition to the QT of the expected net issuance by the US Treasury at around $1,5 trillion per year, market forces (or non-Fed buyers) are expected to purchase about $2 trillion on average for the next 3 years. It is not sure where this money will come from neither the yield that this debt will maintain.
So, as bad as the bond market seems at the moment, if the Fed’s playbook materializes, we might just be in the beginning of a lot more pain for bonds.
The bottom line
Be it stocks or bonds, if the Fed delivers on its threat to increase interest rates as it has hinted ( 2.25% – 2.50%), investors have no place to hide. There are no safe havens at the moment, not to mention that sentiment is limit down.
Also, this is still a very expensive market. Not so much at the average stock level, but at the mega cap and index level. I would be a lot calmer if the S&P 500 Index had a 15 multiple, but instead its trailing multiple is around 24, with the forward multiple at around 20.
Now having said all this, I do not believe that the Fed will be able to raise rates past 1.5%. The reason is that it will probably cause a lot more damage than the benefit. Also, one thing that seems wrong about current Fed policy is that it is aiming at inflation instead of growth.
Hawkish monetary policy usually aims at cooling down the economy. This colling down is expected to lower inflation and inflation expectations. This time around the Fed is aiming at inflation with a disrespect for growth. Furthermore, the Fed has a total disrespect for the market and the wealth effect.
At some point, I think the Fed will notice the damage being done and do an about face. But the question is how much damage will be done until then, and how long will it take for the Fed realize this. I do not have an answer, but my target as I said is the 1.5% mark.
Finally, remember that the market is forward looking. At some point, even as monetary policy continues its path, markets will bottom out. But trying to time the market at the moment, while the covid pandemic is still in play, with geopolitical turmoil in full blown mode, and with perhaps the most hawkish Fed sine Paul Volker, is an impossible task.
Just 1 week into 2022 and something interesting is happening. The rotation we have been witnessing for some time now has accelerated. While financial sites report a rotation from growth to value, I see it as an exodos from ultra-high valuation stocks to something else.
So far the S&P 500 has retreated by about 2.5%, the Wilshire 4500 index 4%, The Nasdaq 100 5.5%, but the ARKK innovation ETF has corrected by 13%. And that’s on top of the 25% slide in 2021.
Again, while the headlines point to the fact that this correction in growth stocks is the result of monetary policy, the truth is that it is probably more of a return to reality and investors becoming less complacent. Investors have been complacent for the past several years now, but at the end of the day valuation gravity always comes into play. And that is what I think is happening.
And the question is, what might happen if the mega-cap stocks start to fall also? Will that take down the entire market down or will the money flow to other names thus acting as a cushion at the index level?
Because if the rotation becomes a self-fulfilling prophecy, then eventually even mega caps will also correct, for no other reason than sentiment as opposed to anything wrong with their business. Remember we said Fed policy is probably a headwind in 2022. And while the mega cap stocks are not in bubble territory as many of the stocks that have correct by 80% recently, they are not cheap. Yes, there is the possibility that they could correct by 20% or more, and yes that will probably bring down the major indexes. But also keep in mind that just as many stocks corrected in 2021 with the major indexes up, many stocks can go up even as the major indexes go down.