A year ago, almost to the day, the SPX hit an all-time high. It was clearly a bubble, pumped up by the Covid-driven combination of the Federal Reserve’s zero-interest monetary stimulus added to Congress’ fiscal stimulus, which send wads of money to households that didn’t need it and could invest it in new, easy-to-use apps like Robinhood.
The bubble peak was very easy to see. It was driven by exponential increases in a few growth stocks which took over a large percentage of the S&P500 based on a combination of TINA, FOMO and speculation driven by zero interest money. On a historical basis, CAPE is still in a bubble.
When the Federal Reserve decided to tackle rising consumer price inflation by raising the fed funds rate from a strong negative REAL yield to a restrictive rate the air was let out of the bubble. Since January 1, 2022 the stock market has seen a pattern of lower highs and lower lows.
Having been trained to buy the dips by the “Fed put” over the past 20 years, the market can’t quite believe that the Fed won’t immediately cut interest rates at the first sign of trouble.
But Fed Chair Jerome Powell is clear: The Fed will stay the course until their preferred inflation measure is back down to 2% and will hold it there for months until they are sure that inflation will not resurge as it did in the 1970s. The 12-month inflation rate isn’t even close to 2% even though month-to-month inflation is declining. The “sticky” inflation rate is still high.
They have published their expected “dot plot” of the fed funds rate reaching 5% in 2023.
The Fed also said that they want to eventually want a “neutral” fed funds rate that does not stimulate or slow the economy. Since a negative REAL rate is highly stimulative, the implication is that they want 2% inflation, a fed funds rate of at least 2.0 - 2.5% and a 10 year Treasury with the historical average of 2% over the inflation rate or about 4%. (The bond market sets the long-term rate as long as the Fed isn’t tampering with QE or QT.)
These rates will pressure all companies that rely on debt, especially zombies that can barely make their interest payments. Slowly, as their debts mature but cost far more to roll over, these zombies will be strangled. If the Fed holds steady to their policy these zombies will default, one by one. CCC and below rated bonds have an effective yield of 15%. The yield spread of junk over Treasuries is 11%, showing that the bond market recognizes the increased risk of default. The Fed has analyzed that about 10% of listed companies are zombies, so defaults will impact the indexes as well as individual companies.
Higher rates also pressure stock prices since the Net Present Value of a stock (especially a stock whose value is based on growing future earnings) declines exponentially as interest rates rise.
Many institutional investors (insurance companies, pension funds, etc.) have to rebalance their portfolios at the end of the year. If they have a stated balance of (say) 60% stock, 40% bond holdings they have to restore the balance by selling and buying.
Recessions have a pattern which can be seen in the Dynamic Yield Curve chart by sliding the red vertical line at the right edge of the SPX chart and watching the response of the yield curve.
Like a weather system sweeping across the country from the Pacific Coast to the midwest to the Atlantic, there is a wave-like pattern that has repeated many times.
This can be seen in the change of the yield curve from a positive slope to a negative (inverted) slope, most clearly in the difference between the 10 year and 3 month Treasury. This difference is the deepest it has been since 1980 but it is beginning to turn around as it always does just before a recession starts. In most cases, that is because the Fed begins to cut the fed funds rate. But they won’t do that this time. Instead, the 10 year Treasury yield is rising – nobody knows how high it will get.
The Fear & Greed Index is in Fear. The trade is neutral, neither risk-on nor risk-off, as the stock and Treasury markets and also junk bonds and Treasuries are balanced. Financial stress is neutral.
The USD is dropping as foreign central banks are rising their lending rates. As a result, gold, silver and copper are all rising.
Oil and natgas prices have fallen from the peak. They are always volatile so it’s hard to predict where they will go from here.
In the medium term (early 2023) the fed funds rate will rise to 5% by March to May. Depending on inflation the Fed may pause and hold it there for the rest of 2023. The Fed is watching the labor wage inflation closely more than goods inflation.
Early to mid 2023 will see a recession. Since 3Q22 GDP growth was so strong the recession may be mild. But it’s hard to say since zombie and “growth” companies may start to default.
There’s no sign of a financial crisis from any direction. China will probably have serious problems with Covid. The impact on the U.S. would be from rising import prices due to labor difficulties in China. And possibly a new Covid variant from the huge Chinese population. At the moment, global supply chain problems have dramatically improved although they are not yet back to pre-Covid levels.
The METAR for next week is cloudy. I expect the markets to be quiet and stable until after New Year’s Day. There is no news that will upset this in the short term.
Wishing all METARs a very happy holiday season.
Wendy