Is recent bullishness justified? … Powell is transparent about what’s coming … the problem with horror movies … Europe is a preview of what Powell is determined to avoid
Recent market commentary suggests the bear market is over because investors have capitulated. In other words, retail investors have finally given up hope and sold.
Does it feel that way to you?
Perhaps it’s because I read market analysis all day long for work, but it feels like – despite plenty of bearishness – there’s also plenty of bullishness.
But let’s say retail investors have, in fact, capitulated.
Even if so, arguments that make this the basis of a bullish narrative miss the primary driver of today’s market pain…
And the Fed may not play nice with the bulls for a while to come.
Federal Reserve Chairman Jerome Powell is walking a razor-thin tightrope with you and me sitting on his shoulders.
If he missteps to the left, we fall onto a pile of bricks.
Will that be painful?
Absolutely. We can expect broken bones, cuts, and bruises.
But he missteps to the right, we fall into a pit of sharp metal spikes.
As you’ve likely inferred, “the left” represents the U.S. economy slipping into a recession. “The right” is runaway inflation that turns into stagflation, with the end point being our economy in the toilet and our currency on fire.
A fall to the left would be terrible, but there’s an obvious pathway to healing. The Fed slashes interest rates to zero, breaks out the stimulus bazookas, and we edge back from the brink.
But a fall to the right would bring extraordinary economic pain with no obvious, easy solution. We’ll get to that shortly.
Well, we don’t have to guess which option Powell will choose. He told us explicitly at his press conference last week (emphasis added):
We may ultimately move to higher levels than we thought at the time of the September meeting.
The incoming data since our last meeting suggests the ultimate level of interest rates will be higher than previously expected.
The risks are asymmetric. If the Fed does too much, it can cut. If it doesn’t tighten enough, then you’re in real trouble…
It is very premature to be thinking about pausing… We think we have a ways to go.
Powell could not have been any clearer as to which misstep he’s willing to endure.
The Fed, horror movies, and the real horror show
It’s one of my biggest cinematic annoyances…
You’re watching a horror movie. The Monster has been terrorizing the Hero for about 75 minutes, but finally, the Hero one-ups the Monster and hits him a baseball bat or something. The Monster crumples to the ground.
And what does the Hero do?
He or she sprints out of the room.
This drives me crazy.
The logical thing to do is stay there and keep whacking the Monster with that bat until you’re 100% sure it’s not getting up again.
Failure to do this enables the Monster to take a moment, regroup, and continue terrorizing.
In what will be a massive disappointment for the bulls, the Fed is not going to hit the monster once and run away.
I wonder if there’s a case of confirmation bias happening. In other words, bulls believe blue skies are on the way, so they’re seeking out data to support that narrative, brushing aside contradictory data.
For example, last Friday, regional Fed presidents Thomas Barkin and Susan Collins both said they think more interest rate increases are needed, but maybe at not such an aggressive pace.
I believe bulls hear this and focus on the “not such an aggressive pace” part of it. To them, that’s evidence of the coming dovish pivot. By extension, after we get that initial dovishness, it won’t be long until we get actual rate cuts and everything goes back to normal.
But listening to the complete broader message suggests a different takeaway – to me, at least. Here’s more of Barkin’s comments:
I’m ready to [act slower with rate hikes], and I think the implication for that is probably a slower pace of increases, a longer pace of increases and a potentially higher point.
So, yes, “slowing down” is a part of Barkin’s comments and gameplan. But the bigger message he’s delivering is “a longer pace [of hikes]” and “a potentially higher point.”
Now, we can avoid this if the data begin falling in line.
That’s the outcome everyone wants – inflation cools organically, which means the Fed whisks us across the tightrope without falling either direction.
But, in what I believe is the primary source of the disconnect between bulls and bears, the Fed will not be satisfied by the same degree of falling inflation data that would satisfy Wall Street.
In other words, while Wall Street might wallop the Monster once, assume victory, then sprint out of the room, Powell is going to settle in, roll up his sleeves, and go “full Fight Club.”
U.S. economic strength isn’t slowing to the degree that Powell & Co. want.
The latest evidence of this is last Friday’s jobs report from the Labor Department.
Job growth was stronger than expected in October despite Federal Reserve interest rate increases aimed at slowing what is still a relatively strong labor market.
Nonfarm payrolls grew by 261,000 for the month while the unemployment rate moved higher to 3.7%, the Labor Department reported Friday.
Those payroll numbers were better than the Dow Jones estimate for 205,000 more jobs, but worse than the 3.5% estimate for the unemployment rate…
Average hourly earnings grew 4.7% from a year ago and 0.4% for the month, indicating that wage growth is still likely to serve as a price pressure as worker pay is still well short of the rate of inflation.
Translation: the baseball bat beatings must continue.
Now, to understand why the Fed is so worried about this, we have to look at the pile of spikes below us to our right…which is where Europe is currently impaled.
Europe is catapulting into stagflation
Let’s jump to euronews.next:
Inflation in the eurozone is expected to have hit a new record high of 10.7 per cent in October, according to the bloc’s statistics body Eurostat.
Its October estimate predicts that prices for food, alcohol and tobacco, non-energy industrial goods, and services will all be up on the numbers for August and September when annual eurozone inflation was forecast at 9.1 per cent and 9.9 per cent respectively.
Energy prices were again the main drivers of inflation, with a 41.9 per cent year-on-year rise, compared with 40.7 per cent in September and 38.6 per cent in August…
More than half of the eurozone countries recorded double-digit inflation rates in October, including Germany (11.6 per cent), Belgium (13.1 per cent) and the Netherlands (16.8 per cent). France showed the lowest rate, at 7.1 per cent.
There’s your inflation, which is still rising, mind you.
Actually, let’s clarify: There’s your “relatively light” inflation.
The Eastern European countries have it far worse. Estonia is at 22.4% inflation year-over-year. Lithuania just hit 22%. Latvia is at 21.8%.
(I have to mention that Turkey’s inflation is at 85%.)
About what about the “stag” part of stagflation?
We now expect a deeper prolonged recession and more persistent elevated inflation due to the impact of higher energy prices, a more decisive European Central Bank tightening cycle and weaker…demand.
Barclays forecasts a Q4 eurozone recession that will last until the second quarter of 2023, with a 1.7% real GDP contraction (some specific countries, like German, are expected to contract far more).
But this doesn’t really paint the picture of what Europe is experiencing
Here’s Forbes for that:
With natural gas prices over $100 more per megawatt hour than they were a year ago, the Western European economies are heading to the Middle Ages.
Forests are being cut for firewood as Russia retaliates with its own Ukraine war sanctions by shutting off the trickle of natural gas it was still piping into Europe…
This no longer looks like a short-term crisis.
Stories from Western Europe are like stories one once heard in countries like Bolivia. High inflation and resource rations imposed by the state.
And yet as this is happening, as prices are skyrocketing, euro-central bankers are having to hike rates, which adds to the consumer pain.
But wait, there’s more!
Over in Britain, the new Chancellor of the Exchequer Jeremy Hunt is thinking about jacking up taxes.
From The National News last Friday:
The UK chancellor is considering raising taxes on the sale of assets such as shares and property to fill a £50 billion ($56bn) black hole in the public finances, according to reports.
An increase could also be imposed in dividend tax, in a move that would come as a blow to entrepreneurs.
Let’s put it all together…
Double-digit inflation that’s still climbing… astronomical energy prices that are leading to cutting down trees for fuel … a multi-quarter recession … higher and higher interest rates … and new, higher taxes.
That is a lot of metal spikes.
The Fed is watching this and is determined not to slip off the tightrope in that direction.
And what’s the best way to avoid that?
Keep whacking the Monster, even if you slightly slow down the beatings.
But haven’t we seen past markets when stocks rise during high rate-environments?
Absolutely. And that’s one of the hopes of the bulls – as rate hikes slow and then eventually pause, it will invigorate the bulls. Stock prices will climb as this process unfolds.
That could happen.
But remember the potential issue such bullishness could create…
All the while that bulls might be pumping up stock prices in anticipation of the Fed Pivot, lingering nosebleed interest rates will be kneecapping consumers’ ability to keep spending, and eroding the health of corporate bottom lines.
That sets up the potential for a disconnect sometime in 2023 where higher stock prices are not in sync with lower corporate earnings.
In fact, just this morning we learned that Goldman Sachs has lowered its 2023 S&P 500 earnings estimates from $234 down to $224.
And where does Goldman think S&P earnings will end this year?
Also $224 – which means Goldman is calling for 0% earnings growth next year.
And since, long-term, stock prices reflect earnings, what conclusion do you draw from this?
Bottom line: Maybe some retail investors have thrown in the towel, but Powell hasn’t. He’s got the Monster on the ground and more beatings are coming.
And that’s going to be a big headwind for consumers, corporate earnings, and bulls in the coming months.
Have a good evening,