I find 2023 a disturbing number since it doesn’t fit neatly into my sense of mathematical order. I asked DH if 2023 is a prime number. DH told me that 17 squared X 7 = 2023 so now I feel better because 2023 isn’t prime and I like 7. But 17 is a strange prime number so I’m still a little uneasy about it. (Sorry for being meshuggena.)
I think it’s justified to start 2023 feeling uneasy about the investment scenario since the Federal Reserve has predicted a fed funds rate of 5% for 1Q23 and also mentioned that they have raised their “dot plot” scenario at every meeting since 1Q22.
I probably don’t have to remind METARs that all assets (stocks, bonds, real estate, crypto, etc.) have fallen since 1Q22. And all the markets are still dramatically overvalued on a historical basis. (I will post all data below to avoid breaking up my Control Panel.)
Russia is still attacking Ukraine. A study of Russian history shows that Putin, like past Russian autocrats, will not stop until he has conquered Ukraine, regardless of destruction and loss of life. Defending Ukraine is a long-haul commitment. Abandoning Ukraine would lead to attacks on other parts of the former USSR and Russian empire, including the Baltic countries, Poland, Moldova, etc. Potentially leading to use of nuclear weapons and even World War 3.
China is building up a formidable military force for land and sea. It’s possible that China will try to take over Taiwan in 2023. Probability calculation is way above my pay grade. But this could also lead to a cataclysmic war which the U.S. could lose.
The U.S. federal debt is already over 120% of GDP. The latest omnibus budget for fiscal year 2023 will increase the debt by $4.8 Trillion over the next 10 years. If 2024’s budget is similar to 2023, it will add a similar amount of debt. In addition to the entitlements that are already locked in, such as rapidly growing government transfer payments.
3Q22 GDP was $25.7 Trillion. But REAL GDP (inflation adjusted based on 2012 dollars) was $20 Trillion.
Government expenditures are fiscal stimulus that goes directly to individuals as transfer payments or as wages to provide government goods and services.
Inflation is caused by growth in consumer demand that is faster than the growth of supply of goods and services. Productivity is not growing. Goods may be imported (worsening the trade deficit) but services must be provided by workers in the U.S. This is the reason for the wage inflation which concerns the Federal Reserve.
I think that this setup is inherently inflationary and will be for the foreseeable future. Fiscal stimulus (from Congress) is battling monetary restriction (from the Federal Reserve). The Fed can only control the fed funds rate and long-term interest rates by QE or QT (increasing or reducing its gigantic book of long-term bonds).
Treasury will need to sell an immense amount of debt to finance the expenditures already approved by Congress. (Watch out for a politically-driven battle over the debt ceiling in 2023 which could damage the AAA rating of Treasury debt. Utterly stupid since all the expenditures were already voted on and approved by Congress.)
The Federal Reserve has been suppressing the long-term Treasury yields by buying up to 40% of some auctions. Beware of the central bank buying much of the government debt – this has led to hyperinflation in different countries in the past. (cf. “This Time is Different,” “The Price of Time,” “Secular Cycles.”) The Fed has begun to reduce its Treasury debt holdings but it could turn on a dime and start buying again. They are not likely to do this in an ordinary recession. They would in the event of a major credit freeze – keep an eye on the Financial Stress chart. (Which is currently neutral, up from ultra-loose.)
The Fed has stopped buying and in fact is (very gradually) rolling off its Treasury and mortgage bond holdings. China and Japan are also reducing their Treasury holdings. Foreign holdings of U.S. Treasury debt declined 6% over the past year. Who will absorb new Treasury debt issuance if the Fed, China and Japan are all shedding, rather than buying, Treasury debt? This points toward higher interest rates in the future.
As I said in early 2022, rising interest rates will hurt high-flying “growth” stocks of companies with low (or negative) current earnings, high debt and an exciting pie-in-the-sky story of future growth. “When money is basically free…you’re willing to place a high value on future earnings, particularly of growth stocks,” said Erik Knutzen, chief investment officer of multiasset strategies at Neuberger Berman. “That all changes when rates rise.”
Although the mainstream financial press is ignoring the problem of zombie companies, rising interest rates will gradually crush them as their debt matures over the next few years. The Fed-induced approaching recession will reduce their top line cash flow which can barely cover their expenses, including interest. Between 2015 and 2019, the Fed’s filters select roughly 10 percent of public firms and five percent of private firms as zombies. That was published on July 30, 2021 before the Fed started to raise the fed funds rate in earnest. As of last week, junk-rated debt is yielding over 15%. These zombies are embedded into the indexes.
Throughout 2022, the SPX has followed a pattern of lower highs and lower lows. The highs came when the market (erroneously) believed that the Fed would not raise interest rates as it announced. The lows came after Fed Chair Jerome Powell reiterated that the Fed would hang tough until PCE inflation maintained its target of 2% for an “extended period of time.”
Powell is painfully aware of the 1970s when inflation resurged after the Fed cut interest rates. He doesn’t want to see a repeat of 2022.
The Control Panel is showing this pattern as we end 2022. The trade is neutral, not risk-on or risk-off. The Fear & Greed Index is in Fear.
The USD is falling. Gold, silver and copper are rising. The “mungofitch index” of copper to gold is stable. Oil is in a rising trend. Natgas is in a falling trend.
The Treasury yield curve is beginning to flatten by rising yields at the longer maturities. This flattening after an inverted yield curve always happens before recessions start.
The 30 year mortgage rate is beginning to rise after a slight dip.
On the good side, inflation has been gradually declining on a month-to-month basis. So the Fed may raise once or twice more and then hold steady for several months.
In 2023, the squeeze will continue. China will suffer massive Covid losses which may significantly reduce their exports. Russia will continue to attack Ukraine. The Fed will continue to hold interest rates at a much higher level than the past few years.
The Fed is anticipating a recession and so should we as investors. I am planning to follow the “mungofitch 99-day rule” and buy stocks only after the stock market has made new highs for 99 trading days to avoid being fooled by volatility. I would carefully avoid any stock with “zombie” character, such as high debt-to-equity and GAAP low earnings-to-share despite healthy EBDITA.
Bond investors should buy short-term Treasuries and CDs. It’s hard to know whether the Fed will allow the longer-term yields to rise as the free market would have them do. I expect inflation to be inevitable in the future so I would only buy TIPS, not regular Treasuries. Any long-term TIPS yield of 2% or better is a buy for safe, inflation adjusted income.
Crypto investors would do better to buy tulips and plant them. At least they would get pretty flowers to enjoy. The government will be cracking down on crypto in 2023 so it will get even worse as an investment (speculative gamble).
The METAR for next week is cloudy. More of the same we have seen in December.
Wendy
