Remember when inflation was "transitory"? Now, we've had the ongoing "soft landing" explanation about how the economy will settle.
But should we believe it? Does the Fed believe it? And what happens if our hero in a red cape, China, flops?
Let's take a look at past few months. For the more recent month, the S&P 500 has been trying to decide whether to break higher from its recent breakout range of 3800-4400, or go back down to the lows of March this year. Since the U.S. regional banking crisis in March, the market has been on a one-way uptrend, breaking the previous year's range as the Fed induced, or rather pumped, liquidity to assuage market fears of banking contagion. This came at a time when the Fed had promised to reduce its balance sheet and taper its holdings via quantitative tightening, yet another silent injection bolstered the markets higher.
The Fed pumped liquidity to assuage market fears of banking contagion at a time when the Fed had promised to reduce its balance sheet and taper its holdings via quantitative tightening. Yet another silent injection bolstered the markets higher.
What took the Fed one year to do, was almost unwound in a few weeks, so much for normalizing the balance sheet. This rally then became self-fulfilling, as the market reached new highs. Most do not expect a recession at all, or assume that the Fed has magically avoided one altogether. Sell-side estimates moved from earnings declines in the first half of this year to a full recovery at the end of this year now, as the recession never came.
A lot of the initial fourth-quarter hype was built around China coming back post Covid lockdowns and its consumers spending with a vengeance. There is a problem with that assumption, as China is having a hard time getting its consumer to spend, buy or splurge, as its population worries about its future and job security, not to mention the draconian Chinese policies. The confidence in the system is lost and China is doing whatever it can to boost the economy.
The world has gotten so used to China just stimulating its way out of anything, and assuming the same playbook -- i.e. growth and cyclically focused policies -- that it may be disappointed. China's bubble only works when the rest of the world is growing and interest rates are closer to 0, not in a world of inflation, and certainly not in a world when consumer is strapped. The entire property market is like a house of cards and is only sustainable if second hand land sales pay for the existing ones and so on and so forth. Today they have a choice to either boost the consumer, print more, or let their currency devalue even further. It cannot have both. Its growth is a lot more fragile especially when the rest of the world and its export markets are falling short as well.
The Fed on the other hand has an economy that has held up very well, compared to the rest, given its lax fiscal and monetary policies, but it does not mean that the U.S. is immune to the global slowdown. Investors assume just because it has not happened, it cannot happen. We know things work on a time lag, especially when some fiscal policies and consumer help just ended in September. Employment may be holding up better than expected, but inflation is not coming down as we saw the recent uptick of 0.1% higher for August consumer price index. Oil prices are about 20% higher since the June lows, so one would be naive to assume that inflation is done and dusted.
The market is complacently thinking that the Fed's next move is to cut, since it has always done so, but that may be premature thinking as the Fed has a much higher hurdle rate to pause let alone cut. The longer the markets hold here, and inflation and employment remain stubbornly strong, the Fed will not do anything. It is important to note that they are trying to weaken demand to get inflation lower. Credit spreads are tight, but it does not mean it will stay that way as banks are not lending, this is seen in the smaller to mid-sized ones.
An economy that is used to free liquidity and ample monetary help is not able to grow on its own. The majority of the market performance is in the large-cap Tech names, which now trade at 50-plus cash multiple, with top line slowing, they have done their best to squeeze any profit margin uplift possible. But the slowdown will be inevitable for them, too.
Remember, the Fed only reacts to emergencies and as far as it sees, there is none, for now. But, again, remember what happened with inflation ...
