After aggressively courting inflation for years, it appears Mr. Powell and his merry band of money printers at the Fed have finally achieved victory. However, they now want to spurn it–happily, in my opinion.
Hence, recently they pulled forward the dot-plot to indicate two rate hikes by the end of 2023. And, Powell has confirmed what Wall Street fears the most…that the tapering talks have begun.
Here’s a glimpse of what lies ahead for the market: by the second quarter of 2022, the year-over-year rate of change in growth and inflation will not just be slowing down; it should be plunging. At the same time, virtually all the fiscal stimulus will be over and done. No more expanded child income tax credits, no more stimulus checks, enhanced unemployment will have ended, student loan/mortgage and rental forbearance will have expired. And, the Fed won’t just be talking about tapering; it will be in the middle of eliminating its $120 billion per month bond-buying scheme.
In other words, the credit markets should be freezing up, and the stock market should be plunging from record-high valuations by that time. The buy and hold portfolio is a danger to your retirement’s health. The time to get into a dynamically managed strategy is now.
Today’s interest rates are the most distorted and manipulated in the history of the United States. This is a direct result of relentless central bank intervention. Historically low yields could only exist if the current rate of growth and inflation is deemed to have peaked. But still, the current inflationary environment is confounding many investors and most in the mainstream financial media, who tend to just perform the exercise of linear extrapolation to predict the future.
During most economic downturns, the economy goes through a period of sharp deleveraging. But the exact opposite occurred during the COVID-19 recession. Total debt, both public and private, has now soared to just below $80 trillion, which is now 380% of GDP. The previous cycle-high was 370%, which occurred back in Q2 2009—at the nadir of the Great Recession. And debt is still being piled on. Household debt totalled $16.9 trillion for the 1st quarter of this year. It soared at a 6.5% annual rate, which was the fastest pace of debt growth since 2006.
The fact is, the economy was late-cycle before the pandemic and has simply returned to late-cycle once again. Meaning, there has been no deleveraging of the corporate or consumer balance sheets, as is the usual case at the end of a recession and a new business cycle. Debt levels have increased significantly across the board–especially at the Federal government level. The U.S. economy was debt-disabled before the pandemic, and it will be even more so ex-post. An economy with a debt to GDP ratio near 400% just can’t grow quickly and will experience low inflation–that is, of course, unless and until the currency plummets and causes interest rates to soar in an uncontrollable fashion.
ASSET BUBBLES AT ALL-TIME HIGHS
Not only this but there has been absolutely zero reconciliation of asset prices this time around. In an ordinary recession, asset prices are sold as debt is paid off. In this case, real estate, equities and bond prices are trading at all-time record-highs. Hence, the economy should soon return to its pre-pandemic late business cycle conditions below-trend growth and inflation, with the most dangerous and deflationary asset price correction in history still ahead.
But it is important to remember that interest rate manipulation is far from solely a U.S. phenomenon. One should not seek protection from a dollar decline in another fiat currency such as the Japanese Yen. On the contrary, the Japanese Government Bond market is nearly $10 trillion in size—it is the 2nd biggest bond market in the world. However, this important market barely trades any longer.
The government of Japan has systematically supplanted and killed the entire private market for its bonds. Meaning, there are almost no private investors who will touch it. The Bank of Japan has bought so much debt that it forced interest rates below zero percent, and the result is the free market has subsequently died.
Investors are now refusing to buy JGBs, which are guaranteed to lose principal in nominal terms—and deeply negative results after adjusting for inflation. But at the same time, these same investors are not in any hurry to sell their existing holdings because they understand the government will be propping up bond prices.
And Europe is no better; the 5-year Greek yield recently turned negative. This is prima facie evidence that central banks have committed murder-one when it comes to markets. Back in February of 2012, at the height of the European debt crisis, the Greek 5-year Bond Yield skyrocketed to 63%. The free market deemed the nation insolvent and could never pay back its debt without returning to the Drachma and then turning it into confetti. Hence, bond yields surged—makes perfect sense, correct? Also, in 2012, the Greek National debt to GDP ratio was 160%. Today, that ratio has soared to an all-time record high of 210%. And yet, these bonds display a negative cash flow going out five years in duration. Only one thing has changed: central banks deemed it mandatory to step in and replace the entire demand for government debt in order to force interest rates towards zero percent. It is the only way these countries would have any semblance of solvency.
A PRECARIOUS SITUATION
Sadly, the U.S. is headed in this exact same direction as Greece and Japan. And, that is why we can be certain central banks’ monetary tightening cycles can’t last for very long and will end in disaster–as per usual. In fact, Mr. Powell will probably torpedo markets before he is able to end his current historic and massive Q.E. program.
If you want to know how fragile markets really are, just look at the 2.5% selloff during the week surrounding Powell’s June FOMC press conference. The Fed has not started to end Q.E. yet. In fact, it has not even set a date to start the taper. All the Fed’s money printers have done is admit that they have begun to discuss when to think about a time for the start of tapering its $120b per month in asset purchases.
The simple truth is, asset values and debt levels have grown to become such enormous monstrosities that they prohibit the tightening of monetary policy much at all before the entire fragile and artificial edifice collapses.
Avoiding huge draw-downs in your investment portfolio is absolutely mandatory. According to NED Davis research, since 1960, the average time for the S&P 500 to recover from a 20% correction is three years. But a 20% correction isn’t the real risk. The more likely danger is a 50%+ plunge. That is how much the market would have to drop just to get back to fair value, according to the most relevant metric, which is the total market cap of equities to GDP. Hence, the next greatest opportunity to make money in this market should be to short it.
THE END OF THE BULL MARKET?
The catalyst will be the same as what caused the downdrafts in 2000, 2008, 2018, & 2019: The Fed believes its own hype and begins to remove the monetary stimulus in the hope the economy has recovered. However, what the fed doesn’t understand, or refuses to acknowledge, is its massive manipulation of interest rates has caused the level of debt and asset prices to skyrocket far beyond the support of the free market, which places the economy in a much more dangerous position. Therefore, an innocuous removal of its falsified stimulus is impossible.
Bottom line: the bull market is ending because the Fed is set to kill it. This process may be slow to evolve because Mr. Powell probably won’t start tapering until the end of this year. However, once the process is in full gear, the reality check should begin.
Wall Street’s favourite mantra post the Financial Crisis was: either the economy improves enough to boost earnings and the market, or the Fed will keep printing money to support stocks and engender a perpetual bull market. Now, as a result of the Fed’s “success” with creating runaway inflation, the exact opposite calculation is now true: either the economy soon slows down significantly enough on its own, which will depress EPS & inflation, or the Fed will tighten monetary policy until inflation is tamed, which will cause asset bubbles to collapse.
Central banks have destroyed price discovery across the board. As these maniac money printers begin to exit their market manipulations, the free market will demand much lower asset prices. The challenge for investors is to actively manage your portfolio in order to maintain—or perhaps even increase–your standard of living, in spite of the carnage that is set to occur once again on both Wall Street and Main Street. EG