Andy Krieger's Thoughts on the Market - 2 December 2022

For the past forty years investors have been trained to buy dips in the equity markets. Whenever badnews arose and the economy started to sputter, the Fed would come to the rescue, supplying ampleliquidity to the banks to keep the U.S. economic machine running relatively smoothly. Stock markets would sell off and then rebound with a vengeance, making new highs before long. Investors could always rely on the Fed bailing them out once bad news emerged. In fact, just as Pavlov’s dogs salivated everytime they heard the bell ringing, investors relished the chance to buy market pullbacks on bad news, knowing that the Fed bailout was just around the corner. This de facto Fed put option on the stock markethas been a sure-fire way for speculators and investors to make money for a long time. Bad news got discounted by the market so efficiently that the “bad” in bad news never really materialized, except for a fleeting moment. Instead, bad news quickly morphed into good news.

This strategy was all well and good when a number of other conditions were also at play. One key factor was that the global economy was in a long-term disinflationary cycle. Additionally, government debtlevels were sensible. Central bank balance sheets were likewise sensible. During this disinflationary cycle, the global economy also benefitted from enormous economies of scale brought on by multiple factors. Among them were the information technology boom, the entry of China into the global markets and their cheap production of goods, the development of India as low-cost supplier of IT services, and the continuedtrend of globalization in general. The list of supporting factors is much longer, but this is a decent start to some of the most important ones.

What will happen, however, when conditions in the world change? How will investors react when bad news actually leads to sustained bad developments? The critical questions in this regard are whether the world has really changed, and whether we have entered a new cycle that will be structurally and fundamentally different from the prior one. If so, then we need to brace ourselves for market conditions that almost none of today’s traders have lived through. For sure, the markets are assuming that the status quo will hold, i.e., that the Fed will bail out the economy at every sign of serious weakness, that markets will recover quickly from every downward blip, inflation will dissipate, and the stock market can march onto ever-higher levels once the Fed’s rate hikes have vanquished the inflationary pressures in the system. Just as it was naïve for the Fed to blindly presume that “inflation was transitory,” so too was it naïve to presume that we will continue to benefit from the forces that brought us the wonderful disinflationary cycle. I contend that it was logical for the Fed to presume that inflation was transitory. After all, inflation had been transitory for forty years. It was, however, naïve to think that the world couldn’t change, and it was irresponsible to ignore all of the warning signs that the data was flashing. We will all pay the consequences for this naiveté.

In any event, let’s look at some of the macro factors that helped our economy grow steadily, with minor hiccups, for the past forty years. One obvious factor is the entrance of China into the world economy. Kissinger’s visits with the leaders in China helped usher the sleeping giant into the global economy. As China has opened up and developed, it has become a critical low-cost supplier of all sorts of manufactured goods. At the same time, China has enjoyed favorable trade arrangements since it entered the World Trade Organization in 1986 as a Developing Nation. One of the absurdities of today’s geopolitical arenais the fact even though China is the world’s second largest economy, it still maintains “developing nation” status. China is not very keen on playing with a level playing field. One can understand that China is not anxious to change their status, but does it make sense that China is given the same trade advantages as countries like Papua New Guinea? The West (and Australia) have complained bitterly about China’s unfair trade practices, lodging numerous formal complaints while trying to pry open their very tightly controlled markets. This has proven next to impossible. The government’s vise-like grip on their internetand communications network, coupled with a challenging record on human rights, continue to underpin some of the tension we are witnessing between East and West.

Another point to consider is that China’s global aspirations don’t align very well with those of the West. The Taiwan issue is thorny, and could very easily lead to a military conflict. China’s zero covid policy is another topic that is very tricky, because it has led to China’s supply of goods becoming far less than reliable. China’s massive population is not well inoculated so the zero-covid policy has thus far been the best alternative for the ruling party, but the political pressure in China is growing dangerously tense. People are desperate, and desperate people are willing to take extreme risks. This doesn’t bode well for companies which are heavily reliant on China as their main supplier of critical goods. Moreover, the tension between China and the West puts future trade relations on shaky footing. Sure, China will continue to supply products at relatively attractive prices, but the political tension is making many major companies cautious about future reliance on the Chinese export machine. The prior U.S. administration was quite vocal about the danger of excessive reliance on Chinese supply chains, and the current administration voices many of the same concerns.

More and more, over time, we will see a growing impetus for U.S. manufacturing to start migrating backhome. This migration has started, but it will take time. This will eventually make the supply chains more reliable -- and certainly less vulnerable to potential political vagaries -- but this shift towards deglobalization will definitely reverse some of the cost benefits that we have enjoyed for the past several decades.

The trend toward deglobalization overall will likely continue over the coming years. Globalization and deglobalization are massive cyclical forces that are not easily changed. The recent cycle of globalization really started in earnest after World War II, but for a host of reasons, this trend is now facing serious headwinds. Aside from China, we have the added problem of Russia’s heavily sanctioned status in the global economy due to its invasion of Ukraine. Sanctions against Russia have created supply problems in a variety of markets, which have caused prices, especially of food and oil, to surge. Russia is trying to skirt the sanctions by buying “decommissioned” ships to create a “shadow fleet” of boats to move its energy products surreptitiously, but the global inflationary impulses are felt, nevertheless. Deglobalization will undoubtedly bring a reversal of some of the benefits we have enjoyed over the past seventy years.

Of course, we are far from the nasty tariffs of the 1930s, but we have become spoiled over the past decades by the relatively frictionless global trade conditions. Yes, there are some stark exceptions such as the restricted nature of certain Japanese and European markets that are skewed aggressively in favor of protecting their “essential” domestic industries, but overall, we have enjoyed wonderful international trading conditions for a very long time. There are numerous examples of these unfair trade practices, but they are generally the exception rather than the rule.

On the technology front, the breathtaking technological advances of the past fifty years have also facilitated non-inflationary benefits in many industries. Is there a limit to the pace of future improvements? Carrying a computer in our pockets is amazing. There is no argument that the technological advances of cell phones, for example, have been seismic, I think it is plausible, however, to expect the cadence of advances and improvements to slow. This will lead to upward price pressures that we will likely experience in many diverse sectors, such as telecommunications and transport.

Domestically, although Covid brought a terrific amount of suffering and great challenges, there have also been some strong benefits. Savings in the U.S. shot up, and savings are still quite high, although they are being drawn down at a fast rate. There have also been significant challenges since the economy opened up. Aside from the Fed being astonishingly late in recognizing the very real and very serious danger of the inflationary pressures in the economy, the Fed is also dealing with the effects of having pumped financial reserves into the system at an unprecedented rate. Interest rates were effectively zero and bubble conditions developed in many markets all at once. Stocks, bonds, and real estate all surged to shocking levels, creating a trifecta for the Fed to now address. Some of these bubble conditions are finally bursting, but the markets are far from balanced.

The housing market is very vulnerable due to the ugly combination of overvaluations and sharp rises in mortgage rates. So far, the impact has been a slowdown in turnover, with sellers and buyers being somewhat paralyzed. The risk of serious downward pressure on prices, however, is definitely there. AmI expecting a collapse? No. I do expect, though, a serious corrective cycle that balances out the sharp gains of recent years. In many markets, prices will drop at least 25%. In the meanwhile, workers in housing-related jobs are already feeling the pressure of the slowdown. This will certainly continue over the next year.

Overall, the labor market is still very tight, and job participation levels are very low. This is not a healthy combination, as new hires are demanding higher wages to compensate for the inflationary pressures inthe system. Food, energy, rent, cars, and pretty much all services are now significantly much more costly than they were a few years ago. Secondary education has spiked higher in a dramatic way, putting added pressure on families across the country. Childcare services are much more expensive, which is one reason that many age-eligible workers are staying out of the job market. We now have over ten million available jobs in the U.S., and this number far exceeds the number of workers seeking employment.

Therefore, Jay Powell has a real problem on his hands. We don’t yet have a wage-spiral crisis, but the tightness of the job market -- despite interest rate hikes of nearly 4% in less than one year --speaks legionsabout the severity of the problem. Powell is likely going to have to take rates higher, and hold them there longer than most people expect. We have seen some progress with an easing in inflationary pressure on goods and housing, but wage pressures – particularly in the service sector – remain very sticky. The recent sharp rallies in stocks and bonds have complicated his problem still further; these market moves have been a de facto easing of financial conditions. The discounting of bad news has become so extreme that Powell’s recent rate hikes has yielded a loosening of financial conditions as the market discounts a higher probability of an imminent recession and Fed easing. The Fed must break this cycle to really tighten market conditions further and drive inflation towards its targeted levels. Breaking this cycle will bringpain to the markets, and to the investors who want to think that nothing has changed.

So where do we go from here?

First, there is almost a 100% chance of having a recession next year. There is always a lag between the timing of rate hikes and their impact on the economic data. Based on the data, my guess is that the recession will start in earnest around the middle-to-end of April. I believe the severity and duration of the recession will surprise many.

One of Powell’s major challenges is the sharply reduced labor participation rate. This works against the goal of the Fed to loosen up the labor market and reduce the upward price pressure on wages. This is avery complicated topic, but the net result is that Powell may need to take unemployment uncomfortably high to get the inflation rate back down to 2%. Getting inflation down to 4% is one thing. Getting it to 2% is something altogether different. How does 7% unemployment sound?

While the goods sector is seeing some progress, the service sector is very troubling. Price sensitivity with services falls into a funny basket because it is really quite insensitive to interest rates. For example, people need to go to doctors, and they need to use lawyers whether they want to or not. People want to take vacations – particularly after being cooped up for two years or more – and they need to move about, whether it be by car, rail, or plane. Unfortunately, what the Fed is not telling us is that their determination to prevent a wage-price spiral could lead to shockingly high interest rates and unemployment rates. We will almost certainly see 50bps from the Fed in December and early 2023. Then they will try to pause –but it is not at all certain the Fed will stop there.

Do I see problems with the details of the payroll numbers? Absolutely. The higher hourly wages are largely a function of reduced working hours. On the other hand, I also see problems with the measures of inflation. For example, one of the clever games that many companies use is to reduce the size of their packaging while holding prices steady. People are definitely getting less for their money, whether it be with higher prices or smaller portions. Drug companies play an even sleazier game by reducing the concentration of the key components in a drug, while leaving the packaging the same. Therefore, people need to change their dosages. The result is the same. Less product for the same money, or more money for the same product.

Next year will be a very challenging year on many fronts. We are about to see a stream of generally ugly earnings from a wide array of companies. This bad news will not immediately result in a Fed easing cycle, so for the first time in many decades, we will almost certainly see a very, very sharp sell-off in the equity markets, without the Fed rushing to the rescue. Even with inflation at 3 ½% or 4%, the Fed will have to hold steady with the higher rates. This will likely break the long-term link between bad news equaling an immediate buying opportunity. How far can the markets drop? It wouldn’t shock me to see a move that approaches the lows of 2020 in the S&P’s. Anywhere around 2200 would probably be a great level to buystocks, if only for a major technical bounce. Please bear in mind, however, that my long-term view forequities is far from rosy. Several years ago, I forecasted a decade of basically flat returns from the broader stock indices. I stick to that view at this time.

The Fed hasn’t had to face sticky inflation with catastrophic economic data coming out at the same time for many decades. They can’t give up in their stated fight against inflation and the need to drive inflation back down to 2%, so addressing broad economic weakness is a problem they will just have to face at a later time. This will be the first time since Volcker that the Fed has had to deal with this conundrum, and market participants will finally understand that you can’t always dismiss bad news just because it is expected.

The market will not give up its habits easily. They will see weak economic data coming out and market participants will immediately start buying equities, anticipating a Fed easing to follow. The Fed easing will be on pause, and the market will be confused. Eventually, the market players will capitulate, and equity prices will be adjusted lower as speculative longs are forced out of their positions. This cascading will continue for quite some time, until finally the Fed easing cycle begins. Market bottoms have almost never occurred when the Fed is in tightening cycle with sharply inverted yield curves. Pavlovian reactions don’t always yield the anticipated meal after the bell rings.

Currencies will be tricky. Many large players have been forced out of their long-dollar positions, just as they have been beaten up quite badly with the recent sharp drop in bond yields. Staggering losses have been posted by certain well-known fund managers, and my sense is that they have largely flattened out their positions by now. I think we should have one more strong surge in the dollar over the coming weeks and months. This is not the popular view right now, which in a way bolsters my confidence in this idea. Once this sharp rally is done, then I believe the dollar will start a broad-based sell off against most majorcurrencies. That will be a powerful move, and it should last quite a while.

In case I am wrong, and we start the broad-based dollar selloff early, there will be plenty of opportunities to get on board. Either way, the dollar is dramatically oversold right now, and it needs a sharp rally. Either it will prove to be a corrective rally, or it will be the start of a surge to new highs in the dollar. Even if it is a corrective rally, we will likely see a move that carries on for quite a while. I have already picked out my likely minimal targets, and they are a long way from current levels.

I want to wish you the best of luck with your trading. We should gird ourselves for a wild ride. Overall, Ithink the next five years are going to be the best trading markets of the past fifty years.

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