September: The Bear Returned to Maul

(just like in The Revenant)

In my July update, I predicted the second down leg for equities would start in the Sep/Oct time frame, culminating in a Q4 implosion. Well, like clockwork, the equity market plunged 4.3% on Sep 13th in response to hotter-than-expected August CPI print (despite lower energy costs engineered by Biden’s SPR release). That wiped out $1.5 trillion in S&P 500 market value, making Sep 13th the worst trading day since June, 2020. Biden’s $6T COVID-relief direct transfer payments to households and businesses (MMT under another label) are now slowly showing up as CPI inflation, as I warned in my August update. Much of the $6T is still “banked”, evident in low money velocity from lack of business investment (e.g. Amazon is canceling 10 million square feet of preplanned expansion) and subdued discretionary consumer spending (food first, a pair of new Nike’s later). So further inflation awaits, — after the financial markets corrects and recovery from recession begins. We are now in a new secular inflationary regime, and there is no return to “normal” (i.e. 2019). We simply don’t have cheap labor, cheap finished goods, or cheap energy anymore, — as we did for four decades prior to 2020.

Internationally, a counterintuitive picture is coming into focus. Despite $8T+ created out of thin air in a short 14 years (the Fed’s balance sheet ballooned from $800B in 2008 to a whopping $9T by 2022), there is now a liquidity crunch in financial markets outside of the US (i.e. in the Eurodollar market). Reason? Debt! Global commerce and finance are built on the bedrock of the US dollar (70%+ of global trade is settled in US dollars even though the US accounts for only 20%+ of global GDP; as well, 60% of global deposits and loans are denominated in U.S. dollars). Rapidly rising interest rates drive up the cost to roll over gargantuan dollar-denominated debt (at virtually zero interest) taken out since 2008 that come due continuously. Moreover, numerous debtors competing for the same dollars to refinance make dollars scarce. An increasingly scarce and expensive dollar thus becomes a wrecking ball for the rest of the world, as discussed in my August update. Inflation outside the US will inevitably rise (as countries devalue their local currencies in order to secure scarce and expensive U.S. dollars). Too, the global recession already in progress will become more acute and protracted (risking credit crises and debt defaults). Currently inverted Eurodollar Futures (i.e. prediction of lower future overnight lending rate) — a recession predictor even more accurate than the 2Y/10Y yield curve inversion — corroborates this view.

Further corroborating this view is the upcoming “winter of discontent” in Europe. As Credit Suisse’ Zoltan Pozsar so aptly put it, “$2 Trillion of German economic value now depends on $20 Billion of Russian gas”, and things don't look good when Putin responded to Ursula von der Leyen’s “We must cut Russia’s revenues which Putin uses to finance this atrocious war,” with “We will not supply gas, oil, coal, heating oil — we will not supply anything”. While mainstream media dutifully keep the mass narrowly focused on the localized kinetic war in Ukraine, WW3 is already stealthily underway. The US had weaponized the US dollar (and the global messaging system controlling its flow), and the Russians had weaponized commodities (oil and gas, grain, and fertilizer). The result is shortages and choke-points around the world which threaten dislocations in global economies and financial markets. Out-of-control commodity markets have already resulted in global surges in collateral requirements, reduced open interests, and volatile (even intraday) prices. And then, something will break. (And when it does, the sleeping deflation dragon can emerge lickity split!)

Can this backdrop (and deepening recession in the US, witness Fedex’s wakeup call on Sep 16th followed by Amazon’s own two weeks later) be good for US equities? Of course not. So why had the bottom not fallen out of US equities earlier when other asset classes (bonds, commodities, and even precious metals) — normally hedges against risk — already started their violent downdrafts?

For one, when the world is in turmoil, money flees to the relative safety of the US (which further drives up the US dollar). Normally, this inflow would seek the safety of Treasury bonds. But when Treasury bonds are tanking in response to Fed tightening, some of the inflow seeks “bargains” in enterprises (read: buy dips in equities).

Another reason is, global liquidity tightness typically leads equity downdraft by six months (see chart below):

Finally, the current crop of money managers have been conditioned by 35 years (since Black Monday 1987) of the Fed’s unfailing monetary easing at the first hint of recession. So their Pavlovian reaction is “buy every dip” in anticipation of the Fed’s imminent pivot from any (bound to be short-lived) tightening, despite Powell’s repeated message that “this time is different (because my hands are tied by hideous inflation)”. These same money managers also seem oblivious to the fact that when interest rates move with inflation which doesn't stem from true economic growth, equities and bonds become positively correlated (see chart below): Eventually equities will follow bonds down (as profit recession deepens with rising rates).

Then came Sep 21st, when the Fed hiked FFR by another 3/4%. Equities sold off hard again, not so much because of the (widely expected) hike itself but Powell’s reiteration of hawkishness going forward. This round of mauling was apparently enough for money managers to finally “get the memo” — that the Fed actually wants the equity market to crash. It is out to destroy demand from the “wealth effect” in order to not only rein in inflation but (in conjunction with Biden’s stealth MMT) to also optically address the “Great Gatsby 2.0” problem itself created. Sure, the Fed will eventually pivot, — but only after equities crash (to much below current levels).

Equity sell-off intensified in the days following Sep 21st. The Dow took out its June low just 2 days after (when the controversial new crop of UK politicians unleashed MMT on steroids). Notably, energy stocks were the worst mauled, — putting the nascent Commodity Supercycle in doubt. (More on this in my future updates: MMT + Pivot = hyperinflation and runaway equities; and death of business cycles, active investing, and eventually currency).

The S&P took out its June low in the closing week of September, confirming the overall market’s second down leg. Then came this exogenous shocker (with scant press coverage) on Sep 27. Just as I looked to the thus-far “slo-mo” crash to pick up speed, the BOE surprised the world and pivoted the very next day, because of dislocation in the U.K. bond market triggered by margin calls on British pension funds! Fear spiked in the US bond market (witness the MOVE index greatly outpacing its stock market counterpart, — the VIX index):

Simply put, current ghastly levels of global debt cannot handle positive real rates which the central banks are trying to engineer in the name of fighting inflation (which they themselves created). In other words, there is no way to maintain orderly financial markets while raising rates to fight inflation because the current financial markets are built on a foundation of artificially low rates. Blow up the foundation and the house (of cards) collapses. The only way to deal with untenable global debt (which dooms physical economies to below-trend growth forever due to backbreaking debt servicing costs) is to inflate it away. And the only way to do that is to have negative real rates (i.e. through financial repression). The BOE’s abrupt pivot (aka “folding like a cheap suit”) now opened the door for other central banks to soon revert to the negative real rate regime. Since negative real rates are risk-asset positive (overvaluation be damned), US equities spiked (with rates and the US Dollar going the other direction even more spectacularly) on Sep 28.

Alas, this “risk-asset reprice” was but a one day wonder. Equities turned right back down the very next day when it became obvious that although the “BOE moment” will inevitably happen in the US, it won’t till much later. (Although I forecasted a credit event in the Sep/Oct timeframe in my original January roadmap, this BOE incident is probably not “it”. More likely BOE is the new Bears Stern, with the new Lehman yet to come.)

Whiplash, anyone?

Heading out for coffee with a neighbor, I am wrapping up before close-of-market on this last (quarter-end options expiry and profit-taking by the shorts) day of September. This tumultuous month of disturbing and ominous events is best summed up by these two memes:

Going into (likely even more chaotic) October, the VIX is the indicator to watch. It is too subdued for this stage of market decline. If it finally spikes (it should, because bear markets end with fear and not complacency), then equities have a lot lower to go. Consensus among pundits now places the S&P bottom at 3,000. That may indeed be a pit stop, but I think the 2,392 level is a much more likely target. Time will tell.