Leading up to mid-term elections, the official narrative is: We are NOT in a “recession” (the economic term was unilaterally redefined by no less than the POTUS himself) and the economy is “doing great”. Got it! Accordingly, buy-EVERY-Dip continued into Aug, especially upon release of July CPI data (which showed 8.5% year-on-year increase, as opposed to the June figure of 9.1%). Equities jumped and commodities dumped. The justification was simple: Peak inflation (bad for commodities) meant peak rate hike (which must be good for equities). Is this sound justification? NO! Month-on-month inflation can peak one month and subsequently pick up again. Even if it stays at zero, the current year-on-year inflation of 8.5% has a long way to go before reaching the Fed’s “neutral rate” of 2% (a nonsensical target to begin with, given the “new normal” created by Covid/Ukraine). With the labor market (a lagging indicator) still intact and the equity market rallying, the Fed is obligated (for the sake of political optics) to keep hiking until something breaks. The Jul/Aug equities rally actually reduces the chance of Fed pivot (because nothing has “broken” yet). Therein lies the fallacy in justification.
Truth is, inflation will stay stubbornly high for a good while longer because it is the result of gargantuan past money-printing over a decade and “the pig that hasn’t yet passed through the python”. Specifically, even with money velocity picking up in 2020 (trigger for inflation spike in 2021), there is still a dramatic buildup (result of $6T from Biden via the Fed, and $4T directly from the Fed in response to Covid in 2020) of “cash in the bank” (especially for the top 1%), as shown in the chart below.
With consumers shopping at home with this printed cash, US imports increased from $250B/month to US$350B/month. This added to global inflation because the extra (unearned) cash competed for the same amount of available goods (US exports did not increase one iota). To the extent some of this cash is “banked”, it will fuel later inflation. The top 1%(the green line in the preceding chart) will be acquiring assets on the cheap (after financial market crash), — renewing asset inflation. We will then be watching Milton Friedman’s famous MV = PQ (Money supply X Velocity= Price X Quantity of products, services, and assets) play out in real time (as P rises with V). But this is a post-Fed pivot (2024 and beyond) story. Between now and then, deepening recession and financial market crash (deflationary-bust) will temporarily ameliorate the new inflationary regime (which is likely to last a decade or more, just like the 1970s). There is no return to “normal” (i.e. 2019); Covid and the Ukraine War have created chronic shortage of essentials — most pronouncedly energy and food — from which there is no prompt recovery thanks to past policy mistakes (shutting down oil and gas exploration and production without a transition plan to ESG). We are already in a new (and much worse) era; get used to it.
From a long cycle view, the disinflationary regime that ended in 2021 had reigned for 40+ years, thanks to (technology enabled) productivity and globalization. As recently as 2020, monetary policy makers (i.e. central banks) were still fretting about reflation because the 2020 global shutdown abruptly turned disinflation into deflation. They didn’t bargain for rapid transition to double digit inflation when they bomber (not helicopter)-dropped $10T of “printed” money to create an artificial and brief “recovery” in 2021. Now in 2022, the world is in early stage of inflationary-bust (i.e. stagflation). De-globalization in progress is inherently inflationary. So is wartime economy (we’re deep in global currency and trade war even though kinetic war is isolated in Ukraine). So is “stay-at-home economy” with increased demand for goods. We will continue to see 1970s-like “shocks” from dislocations, amplified this time around by much higher debt level and the steepest/fastest interest rate hike in central banking history. All this is bad for equities.
The Jul/Aug equity melt-up was fueled by retail money with TINA (There Is No Alternative) psychology. As high net worth as the members of Tiger 21 are, they were unwise in deploying 20% of the fund’s cash to equities in Aug. Fundamentals argue against it. Return on equities comes from earnings + dividend — inflation. Earnings and dividend (especially in recession with rate hikes) will no way exceed 8.5% over the next couple of years; so we are staring at negative return on equities. These guys were premature. Even for a trade, I think the timing was wrong. Corporate credit downgrades have picked up within the past quarter. Considering there is roughly $1T of debt on the books of zombie companies, the credit event(s) I previously wrote about is neigh and debt defaults may pick up as early as Sep. Incidentally, the 2022 auto loan story is the “new 2007 home loan story”: Upside-down loans, payment defaults and bad debt are everywhere in the system. This time bomb will profoundly affect regional banks and credit unions, — which will in turn hurt small to medium size businesses, — the backbone of the economy.
Alas, the equity melt-up slammed into options expiry on Aug 19, and the Nasdaq and smallcaps each dropped 2+% (SPX faired better and dropped only 1%). Then the market puked up another 4% on Aug 26 when Powell concluded the annual Jackson Hole shindig with “… we will take forceful and rapid steps until the job is done, despite bringing pain to households and businesses (read: Soft landing is out, hard landing is in)…”. With that, the sell-off continue into the final week of August, notwithstanding multiple oversold signals flashing red. Two months of magma melt-up thus disintegrated into lava down-flow in late August. The rule of 20 — which suggests equities are overvalued when the sum of the S&P P/E (currently 31) ratio and the inflation rate (currently 8.5) is greater than 20 — tells us equities have a lot lower to go. How much lower? Well, according to the Buffet Indicator, market valuation is still one standard deviation above long-term trend. Correcting back to trendline would bring us back to 2020 Covid-low. This is a good 1000 S&P points below the 3,000 downside target set by most pundits; and a minimum correction since corrections typically overshoot. The top ten stocks (AAPL, GOOG, V et al) are owned by hundreds of ETFs (in turn owned by hundreds of mutual and pension funds),— the result of a perverted “passive investing” culture cultivated by Fed money printing since 2008. This is why the broad indices are held to only <20% decline since January when hundreds of individual names are already down >50%. When that ETF flow reverses (with “something breaking”), the broad indices will finally (be the last ones to) fall.
In my July update, I discussed the “E” of “PE”, but didn’t mention the nuance that profit margin is at a historical high (6% of GDP), thanks to decades of disinflation made possible by productivity and globalization (both are reversing now). Profit margin (a metric of wealth disparity) is highly mean-reverting (because past a certain level it causes social unrest and invites policy response such as increased corporate taxes). We have reached that level NOW and the trifecta of high interest rates, rising Dollar and spiking energy prices conspires toward contraction of profit margin and corroborates equity crash underway since January. (Of the trifecta, the first is the most damaging. Since 2008, The addict had been kept on life support for 14 years by ever larger dosages of dope. Now, the dealer is pulling the plug, seemingly expecting the addict to still stay alive. Fat chance. Something will break.)
Arguably, even more important than the depth is the duration of equity crash. Recency Bias would have us expect the impending equity market crash to last 1–2 years, — just like 2000 or 2002 (see chart below):
People forget the swift V-shape recoveries in 2002 and 2009 were made possible only by the Fed’s printing press (aka QE/ZIRP). Even then, the market continued its decline for a quarter or longer after Fed started easing. In the (albeit unlikely) event that the Fed decides against “hyper-print”, this crash may resemble the slow crash that started in late 1968 and took 13.5 years to finish a 62% (classic Fibonacci) retracement in 1982. That decade+ coincided nicely with the Commodity Super-cycle (see preceding chart). The two bear market rallies within that period lasted 2 and 3 years respectively, — a nightmare for shorts. Looking ahead, 62% retracement of a 4-decade-long (five-wave) bull market that started in 1982 will bring us to 2020 Covid-low (corroborating projection per the Buffet Indicator). Credit events and their severity (discussed later) will determine whether it will take 1–2 years or 10+ years.
Meanwhile, by Aug-end, oil and gas recovered half of their (temporary) 17% price-drop since June (primarily due to Biden’s release of SPR). Demand destruction from China’s rolling Covid lockdown (and global recession) is still ongoing but this too is a temporary situation. The secular energy shortage (from decades of under-investment), evident by futures being in heavy backwardation, continues to exert long term upward price pressure. Commodities in general are positively correlated with inflation expectation. So “sticky” inflation is consistent with a new Commodity Super-cycle (which started in April, 2020 with the global Covid lockdown) underway:
Due to relentless melt-up of equities (enabled by the Fed) since 2009, the commodity-to-equity ratio was still at a generational low in 2022. This cyclical ratio will soon turn with resumed crash in equities (as it did in 2000 with the Dot Com Bust).
Over a century, commodity bull cycles typically last 10+ years, and bear cycles typically last 20 years (see chart below). Further, midway in a bull cycle, commodity (especially energy ) producers generate huge free-cash-flow. Thus, energy should be a sector (dropped from being 15% of the S&P total cap in 2008 to 4% now) of choice for post-equity crash recovery (it is an early cyclical in the same vein as long-duration growth assets). That said, secular energy shortage will limit post-crash growth this time around (which in turn will limit the “degree of financialization” and rise in equities). Oil and gas prices won’t go up in a straight line. Demand destructions (e.g. small businesses shutting down because of skyrocketing electricity prices) and supply surprises (e.g. OPEC increasing production) can cause sharp (albeit ephemeral) pullbacks in oil and gas prices (such as what happened on August 30th) even amidst a Super bull cycle. All in all, commodities, though volatile, should outperform equities for the next 10+ years:
And what about the “U.S. Dollar Wrecking Ball”? The U.S. Dollar resumed up trend mid Aug. It is now at a 20 year high. As the Dollar carry-trade unwinds with de-globalization, it will likely continue rising a year or two, which will be a headwind for commodities, but especially gold. Rising U.S. dollar means other currencies — especially the euro and yen (soon to be the Chinese Yuan also)— are dropping. The result is relative rise in standard of living in the U.S. at the expense of reduced purchasing power in those other countries (while all suffer from currently high inflation). This manic rise will end like a Supernova when a new global currency (likely some digital variation of IMF’s SDR) — with much lower weighting of the U.S. dollar in the “basket”— is introduced. The U.S. Dollar regime, in place since 1944, will then fade quietly through stealth default (of gargantuan debt created) via devaluation of currency masked by global currency reset. Until then, notwithstanding some repatriated Eurodollars finding their way into equities, the rising Dollar should reinforce equities sell-off (the U.S. Dollar runs inverse to equities — see chart below).
Elsewhere, I believe credit events are inevitable and imminent (if not in Q4 2022, then in early 2023). The systemically important (aka “too big to fail”) banks (hammered all year in part because their bond holdings have been down 12% in just the first six months this year, — the biggest ever in bond market history) are currently leveraged up 11 times (asset to equity). If they sniff out $1T at risk (as Jamie Dimond did with his ominous “hurricane” warning back in July) and start to deleverage, then system-wide bank credit (8X “money in the bank” per earlier discussion) can contract precipitously (plunging the economy into deflationary bust, as previously mentioned). This recession may be long (because of rate hikes into a recession that already started; economic woes won’t show up till 6–9 months later) and sharp (“things happen slowly, and then all at once”). I look for the recession to end toward the end of 2024. Financial markets typically bottom 3/4 of the way through a recession. Call it roughly mid-2024. The Fed pivot will have already happened (most likely in reaction to some credit events), sometime in 2023. This pivot (to “hyper print”, — because injecting badly needed liquidity at this stage will be far more crucial than lowering interest rates in order to arrest credit collapse ) will start the hyperinflation that necessitates global currency reset.
Gold rose in tandem for a decade with the Commodity Super-cycle both in the 1970s and the 2000s. It will probably rise spectacularly in this next Commodity Super-cycle with hyper inflation (real rates sharply going negative) from “hyper print”. Massive global re-allocation from sovereign debt to gold will most likely presage global currency reset.
Finally, what about real properties? Demand destruction is rampant, evident by double-digit sales-drop, inventory-rise, and price decline in just 3 months from market peak in May, 2022. Markets most reliant on capital inflow from both developers and investors (to prop up prices unsustainable by local income levels) are the most bubbly and will see the most carnage in the coming 2–3 years. Of those, markets with heavy institutional investment will see much sharper price decline than those with mom-and-pop investments in vacation, work-from-home, and Air-B&B properties. Price decline will be exacerbated by lower rental income due to consolidation of the rental market (moving back in with parents or taking on more room-mates) necessitated by unaffordable rents (which skyrocketed during 2020–2021) and increasing layoffs.
On the flip side, unlike 2007 (where 50% of U.S. homeowners were on variable mortgages), 90% of homeowners today have fixed mortgages, and are thus less vulnerable to rising rates. Markets of primary residences and little outside speculation are a lot more stable today than 2007. As well, thanks to retired Boomers, 40% of owned homes are mortgage free. Of existing mortgages, 90% are fixed (vs 50% in 2007), the median LTV is 33% (i.e. there is 67% equity in the median house), lending standards are tight, so the housing market is nothing like that in 2007. So with “sticky” inflation (as previously discussed), what is the one asset that must be owned? Real estate! Existing investors should hold but aspiring investors should wait because real estate down cycles take roughly 5 years to complete, with the steepest price decline occurring in the first 2–3 years. So the earliest time to bottom-fish is toward the end of 2024.
The inevitable end-stage of the global fiat currency reset is already in motion for the Euro and Yen. Elsewhere, furious buying of the Hong Kong Dollar (and selling of the U.S. Dollar) has been going on (to keep the U.S. Dollar peg intact as capital flight from Hong Kong progresses with shrinking capital formation from political instability). This is is an unsustainable effort in futility and the final breaking of the peg — unlike steady decline of the Euro and Yen — will be sudden and sharp. Can the Chinese Yuan be far behind? The point is, fiat currency failures are already in progress around the globe. Monetary/currency failures historically start at the periphery and finish at the core. It was the case for the Roman Empire (back then they had money, — gold coins — albeit adulterated), it will be the case now (we have currency, backed solely by belief). More “interesting times” are ahead before this 4th turning is done, and 2023/2024 look tougher than 2022. But then I get ahead of myself. First we have to get through what I expect to be an implosive Q4 2022. Why implosive? Take a look at the Fed’s rate-hike track record:
