As the year starts with markets on a firmer footing, and hedge funds peruse through the year ahead outlook notes from the various sell-side institutions, one theme stands out: Recession!
It is not that a recession is not talked about, but the debate lies as to the extent of it. Most predict a mild one and almost like clockwork, expect markets to fall in the 1H and then rally into the 2H as the Fed will be eager to cut and provide QE once again.
It is almost too perfectly captured and much ink has been spilled about how it is a matter of time the Fed is about to pivot soon. Investors seem to be following this advice and seemingly buying up all the interest rate sensitive stocks into this "expected" event. It is as though they are willing to move past the event where the Fed may be forced to pivot, if at all. However, as we know, if one does the crime, one must also do the time, but it seems the market prefers to have their cake and eat it too.
Do markets work that way? Historically speaking, past cycles have shown how each time the economy undergoes a system failure during a Fed rate hiking cycle. To say this time is different may be naïve. Each rate hiking cycle saw a financial event of some sort. This time will not be different. The hard part is to predict where it will or can come from.
There is no doubt that the soft and the hard data is showing significant weakening across the board. ISM and PMI prints sub 50 correspond to an economy that is slowing down hard. The amount of global stimulus pumped in the markets from 2020, of course, would see an abrupt pause as the patient is not weaned but yanked off its fix.
In the past the Fed would "typically" pause its rate hike stance and even provide QE to support markets. But in those times, markets fell like a rock and more importantly repo and actual credit markets froze, which is more important than just looking at what the Nasdaq and technology stocks are doing. Just because ARK Next Generation Internet ETF (ARKW) and non-profitable tech is down 80%, one can argue if they were ever "fairly valued" to begin with. The Fed is not concerned by that as it is about inflation staying higher for longer.
The Fed has been consistent in its message that it will do whatever it takes to fight off inflation, its nemesis, one that has not been existent since the 70s. The market chooses to ignore that each time rallying on hopes after each soft data that the Fed will now be done. This will seem to be a futile strategy until inflation comes down to the Fed's 2% goal, and they will keep on going.
What is really not priced in and not known is how bad will the "higher for longer" rates of 5% be taken by the economy that is so levered in debt. We have the highest levels of debt globally and 3% let alone 5% is detrimental to banks and the credit cycle.
The long-awaited December CPI report just came out in line with market expectations for a 0.1% month on month decline and 6.5% y/y increase, with the core at 5.7% y/y. However, the whisper in the market saw there being a huge miss, which seemed to imply that a more dovish scenario was priced in than actually was the case.
More importantly, factors like rent inflation, used car prices, and gasoline prices are all coming down, but services inflation soared to its highest since 1982. This has been the part of the market that the Fed says it has "more work to do".
The problem is traders over the past decade know only how to make money by buying the dip, after all, they have been rewarded for it as well. Do we blame them? But they have not been around to see what higher for longer inflation does to risk assets nor a system that is so levered and fixated only on QE to take it higher.
In a world of no QE and no longer an active Fed put, traders of today are not used to looking at fundamentals and balance sheets to make investment decisions. Instead they prefer chasing MEME stocks and playing charts. Markets and economies move in cycles and one thing is certain, the 2020s will not be like the 2000s. Time to dust off real economic textbooks.
