We Do NOT Want a FED Pivot!

We really do not want a FED pivot. Why?

First, let’s go right to the “pink elephant” in the room – QE! It was the negative rates and massive liquidity injections into the system that led us to where we are today. Banking crisis is the symptom. Is the “everything bubble” bursting? As Albert Einstein said, “We cannot solve our problems with the same level of thinking that created them.”

The recent rising rates and restrictive monetary policy are not what is causing our problems, creating a debt crisis, and leading to a recession rather it was the “cheap” “free” money by lowering rates to zero and increasing its balance sheet that laid the seeds for a recession, or more likely, stagflation.

The excessive “risk taking” fueled by this cheap money that eventually leads to a recession. We had negative rates and massive money printing. As a result, the world accumulated so much debt – $17T negative yielding bonds and central banks balance sheets soared to more than $20T.

A negative yielding bond is not a worthwhile investment. Even though the price will rise, it will not compensate for the loss of yield. This thinking can instead create a bubble.

Valuations ran up excessively in 2020 because the quantity of money (money supply) rose much faster than nominal GDP regardless of macro weakness and earnings downgrades.

Recall the velocity of money formula. V = PT/M

So as money supply increases faster than nominal GDP, then the V (velocity of money) comes down. Inflation is caused when the money supply in an economy grows at faster rate than the economy’s ability to produce goods and services. Monetary inflation.

Money printing made investing in the “riskiest” stocks the most lucrative. Now this is massive asset inflation.

Earnings estimates are falling and continue to fall. This is what we have been experiencing in the publicly traded sectors. Margins compressed so earnings declining for many. Once rates continue working through the system and real rates continue to rise, riskier asset valuations should continue downward along with price. An earnings recession is possible with 2 Qs back to back of declining Y/Y earnings. Venture capital and start-ups challenges are also beginning to emerge and most likely in 2023.

Inflationary pressures are very sticky and stickier than most are aware of. Wage and services inflation is interrelated.

The labor market holds key to inflation. Nominal wages have grown significantly. Increased tightness in labor markets is placing pressure on consumer prices. Services spending is mostly a function of employment and wages. Employment stretched so services spending is compensating for the contraction in goods and real estate spending. As FED tightens monetary policy, with goal of higher unemployment, services should weaken which will likely weaken GDP.

Wage inflation fuels nominal spending which continues to drive nominal demand in a loop which further facilitates entrenchment but it cannot sustain itself as it needs either more output or more money. Goods will contract (durable) as they have already. Remember during COVID goods were inflated due to major supply chain issues, so now they are deflating. So it comes down to wages & services.

Per Deutsche Bank, once inflation exceeds 5% in developed economies it can take a decade for it to come back down to 2%.

Even the OECD (Organisation for Economic Co-operation and Development) expects persistent inflation for 2023 against the backdrop of weakening growth. Stagflation is most likely the outcome.

Stagflationary environments are not a healthy environment for the 60/40 portfolio (stocks & bonds) and even worse when governments aren’t willing to cut deficit spending because the crowding out effect of the private sector works against the rapid recovery. The crowding out is a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market. It is an economic theory that argues that rising public sector spending drives down private sector spending.

Commodities tend to fare better in stagflationary environments.

Even a FED pivot cannot drive a bull market run up because inflationary pressures are very sticky and stickier than consensus prefers. Additionally, it will not do much if we are in stagflation.

3 strategies needed to combat inflation:

Hike rates

Reduce balance sheets

Stop deficit spending

There has been broad money accumulation and very large central banks’ balance sheets that have barely reduced in their currency.

Many investors that see the FED as too hawkish only see that the money supply growth is falling which is not seeing the entire picture. So this can lead them to believe that the tightening cycle will be over soon.

Central banks do not print growth, governments do not boost productivity. However, both can fuel inflation and have incentive to increase debt.

Investment analysis is paramount. Earnings are important, economic cycles should be respected. Avoiding riskier assets that do not produce real returns with significant growth and excessive debt. (increasing costs in debt and capital)

Fundamentals Matter!