The Fed must first prick the inflation bubble before any attention can be paid to the faltering stock market.
How did we get here you ask? The Fed’s balance sheet, the rough equivalent of the base money supply, went from $800 billion at the start of 2008 to $9 trillion today. This has led to the most expensive stock market, real estate market and bond market in history.
Into these record asset bubbles you will have to add an economy that is slowing rapidly due to the $6 trillion of Pandemic-related helicopter money that has suddenly grounded to a halt. Add to this, the fact that inflation is at a 40-year high of 8.3%. That is, if measured with changes made to the inflation calculation in the 1980’s. The pre-Boskin Commission metric would show that the actual rate of Consumer Price Inflation would be around 17%. We also have the headwinds of spiking interest rates and debt services costs. Which, for example, have caused home equity refinancing activity to fall into a depression.
INTEREST RATE SUPPRESION AND DEBT
The list goes on: real incomes are plunging, the war in Ukraine is causing more supply chain bottlenecks, China’s COVID obsession is leading to lockdowns and pushing prices even higher—just as it also further attenuates global growth.
The situation is dire but the Fed cannot come to the rescue at this time because inflation is tying his hands. Fed Chair Jerome Powell is forced to aggressively tighten monetary policy into a weakening economy and falling earnings growth. The Q4 2021 GDP was 6.9%; but by Q1 2022 that growth rate plummeted to -1.4%. The 2021 S&P 500 EPS growth was 47%. And yet, the first half of 2022 is projected to show EPS growth of just 5%. On top of all this, the Fed is forced to hike rates when the all-important recession indicator of an inverted yield curve is already manifest.
Jerome Powell has to become the most hawkish Fed Chair since Paul Volcker. He will be hiking the Fed Funds Rate by 50bps increments in June and July; in addition to the 50 bps already administered in May. At the same time, he is starting Quantitative Tightening (Q.T.) in June, which will peak at $95 billion per month come September, which is twice the peak level of the last Q.T. program.
In other words, the Fed will be destroying over a trillion dollars in money supply per year. In fact, central bankers throughout the world are concurrently fighting inflation. The Fed’s last Quantitative Tightening cycle was not at all like watching paint dry. It sent the Russell 2000 down 25% between Halloween and Christmas of 2018; and caused the credit markets to completely shut down in 2019.
Interest rate suppression has vastly distorted markets and the level interest rates can climb to before the financial system breaks continues to decline. In 2000, it took a Fed Funds Rate (FFR) of 6.5% before the market melted down. Leading up to the Great Financial Crisis of 2007-2009, that level dropped to 5.25%. Then, due to the massive leverage prompted by the Fed and Treasury following that crash, it took a FFR of just 2.5% to cause the credit markets to freeze and stocks to falter in 2018. Today, it will probably take a FFR of just 1.5% before the financial markets once again meltdown.
The reason for this is clear: We have the most overleveraged economy in U.S. history. Much greater than the previous peak in 2007, which led to the Great Recession.
Let’s review, in December 2007 corporate debt was $6.3 trillion (42% of GDP). At the end of last year, corporate debt soared to $11.6 trillion (48% of GDP, a record high). Total Non-financial debt was $33.5 trillion (227% of GDP) at the start of the Great Recession. But now, total non-financial debt has skyrocketed to $65 trillion, which is an incredible 270% of GDP. We have had an 84% increase in corporate debt and a 94% jump in total non-financial debt in just the last 14 years!
TIMING THE MARKET IS CRITICAL
The fed ”put” is much lower than ever before because you can’t fix an inflation problem with more money printing. We are now facing a pivotal moment where the 50-year experiment with fiat money has failed. Equities have entered a bear market that should slowly devolve into a credit crisis and market crash later this year. The entire fixed-income spectrum has sold off violently, and yields have spiked across the board. I expect Treasuries to catch a strong bid soon, as slowing U.S. growth devolves into a recession, causing Treasury yields to fall just as corporate debt yields spike inexorably.
To sum it up, the worst bear market of our lifetimes has already begun. For now, you must own the assets that tend to prosper when inflation and growth are slowing. For most investors, it will set their retirement plans back a decade or longer. Once the credit and liquidity crisis begin, nearly all asset classes get sold off in tandem. However, if you own what I have termed the four horsemen of the economic apocalypse: Cash, Treasuries, US Dollar and Equity Shorts when the time is right, history has shown you can turn a period of chaos into a time of great prosperity.
Inflation is preventing the Fed from pivoting back to dovish like it has done over the previous few decades. This means the bear market will continue unabated until that eight percent rate of inflation retreats by at least four or five percentage points. And that won’t happen anytime soon. Timing the market when the macroeconomic conditions are this horrific is crucial to your investment success. EG