Andy Krieger's Thoughts on the Market - 30 January 2023

This year the stock markets have started off with an explosive rally, with the Nasdaq, last year’s laggard, up almost 12% as of Friday’s close. To some extent, this rally has been led by short-covering, with a number of tech stocks staging astonishing recoveries. Tesla, one of my favorite shorts for a long time, has rallied almost 80% from its recent lows. Bed, Bath & Beyond, another stock I recommended selling over a year ago has rallied almost 40% from its lows. Meta, yet another stock that I loved to hate, is up over 74% from its lows in November, and almost 30% since the New Year. Apple, another struggling stock, is up over 18% from its recent lows, a relatively tame performance. The broader indices are also much higher on the year, continuing their strong rallies since last October.

What is driving these moves? Clearly, it isn’t robust earnings, and it isn’t forecasts of surging corporate profits. Tech firms have been laying off employees in droves, and their projected prospects are quite modest. Economic forecasts on a broader scale are far from encouraging, with modest to flat growth being the optimistic version of most U.S. economic forecasts. Rather, there is currently a combination of short-covering, fresh stock buying based on a widespread fear of missing out on a new, sustained upturn in equities, and a rather bizarre expectation that the Fed will pull off a near-miraculous immaculate disinflation with no recession, and inflation dropping sharply back to 2%. Do I expect this wonderful outcome for our macro-economic environment? No! Do I expect the investors who are buying stocks aggressively out of fear of missing out to have a lot of joy? Not for very long. In fact, this time things will likely be different, and the investors will likely experience the pain of buying the top of a corrective rally.

We have already had a massive easing of financial conditions over the prior four months, with yields having dropped by roughly 20% from their peaks, and stocks having recovered between 15% and 20% since the October lows. This is exactly what the Fed doesn’t want. Investors have decided that inflation will continue its sharp decline towards 2% in short order, economic growth with stagnate but not turn sharply negative, and the Fed will revert to its old habit of cutting rates drastically before long. This plan worked great before, but things have changed.

Financial conditions have eased due to the market’s blatant and explicit disbelief in the Fed’s words about holding rates higher for longer. Is the Fed going to come to the rescue yet again with its highly predictable “put” on risky assets? It is possible, but the global macro-economic conditions have changed a lot over the recent years.

For the past 35 years, ever since Alan Greenspan’s time at the Fed, the Fed has consistently sprinted to the rescue, cutting rates aggressively at the first signs of economic trouble and distress. In fact, many economists had even started forecasting the end of economic cycles. Goldilocks was here to stay, they said. Happy times forever! Unfortunately, economic cycles are a natural part of the human condition, and boom times will almost always be followed by corrective cycles to digest the prior period of rapid growth and expansion. These giant cycles usually take decades to play out, and unfortunately, no one rings a giant bell to announce to the world that the cycles are changing.

In the prior disinflationary environment, aggressively reducing interest rates to stimulate growth was a relatively safe move for the central bank to take. In fact, Central Bank Governors looked like true economic wizards. All they had to do was pump money into the system at the first sign of trouble, and cut rates to boost economic activity. High inflation was hardly a problem, and it was certainly not an imminent threat. Japan was an extreme example of how powerful the disinflationary pressures really were, as near unimaginable amounts of monetary easing haven’t been able to move the inflationary needle of that huge economy after thirty years of trying. Overall, there were many massive disinflationary global forces at work which helped suppress price pressures which otherwise could have proved to be very dangerous for long-term price stability. China’s entry into the global market as a major supplier of cheap goods was one of these massive forces. India’s entry as a provider of cheap IT services was another. There were other forces as well, such as the advent of the internet and the broad spread economies of scale to many industries which other technological advances brought.

In case people haven’t noticed, however, globalization of the world’s economy has run into some serious stumbling blocks. China and the U.S. are frenemies at best, as the United States has clearly decided that China is a threat to the U.S.’s long-term hegemonic ambitions. In fact, this is one of the few things that both sides of the largely fractured U.S. political environment actually agree on. Russia’s invasion of Ukraine has created a host of additional challenges for the world, such asthreats to global food production and to global energy supply chains. The reduction of significant fuel supplies has come at precisely the worst time, as the U.S. has taken significant steps to curtail future domestic fossil fuel exploration and development. Unfortunately, we are probably fifty years away from being able to wean ourselves completely from fossil fuels, so the major risk in oil prices is that they move higher, not lower – and potentially much higher than we can imagine over time. No, the world is not the same as it was four or five years ago. Covid complicated things, and many other global challenges are staring us right in the face.

Jerome Powell was shocked when his “transitory” inflation exploded out of control. He was late in recognizing the problem, but he has taken aggressive steps to address it by hiking rates seven times in one year – including an unprecedented four consecutive hikes of 75 basis points. Still, he has many challenges facing him. Among them are how to navigate the re-entry of China into the global economy and the surge in new demand this re-entry will bring, the incredibly tight U.S. labor market, the apparent resilience of the U.S. economy in the face of 450 basis points of rate hikes, the shortage of workers in the U.S. (the combination of Covid deaths, immigration policies, and the demographics of aging baby boomers make this problem seem more structural than temporary), possible supply problems with the oil markets, and the recent dramatic easing of U.S. financial conditions. Managing all of these challenges at once will be quite a daunting task.

The easing of financial conditions will help the housing market stabilize and start to pick up again as mortgage rates have come down sharply. Auto sales will start to pick up as well. In fact, we could very well see a sharp pick-up in spending, adding to the underlying inflationary pressures, if we have any further significant easing of financial conditions. As noted, the last thing Powell and the Fed want to see is a resurgence in spending and economic activity. Stock market rallies and further drops in bond yields are absolutely not welcome right now. These things can easily lead to a resurgence in inflation, which would be followed by yet another sharp increase in interest rates, trapping us in an unholy business cycle of potential stagflation that we suffered through fifty years ago. Alternatively, if Powell is too aggressive with his rate hikes and maintains relatively tight conditions for too long, then we could see a sudden sharp drop in economic output and a hard landing. Given the leverage in the system, this too would be an ugly alternative for Powell.

Betting on the immaculate disinflation is clearly a highly risky game right now, and I would be shocked if later this week Powell does not aggressively emphasize the importance of maintaining high interest for a very long time in order to make sure that the inflationary pressures have truly abated. What Powell really wants, but can’t say, is that he would like to see unemployment rise above 5% so that the underlying pressures of a tight labor market could be truly squashed. That is just too politically unpalatable. If I consider the probabilities of all the possible outcomes, I have a very hard time concluding that the equity markets are ready for a sustained rally. Rather, I think it is time to take a very cautious approach and wait until the Fed’s easing cycle has truly begun. The Fed will not be pressured into a premature easing just because we want it that way. Fighting the Fed is a dangerous game, and in my 35+ years of trading, it has rarely been a clever approach. Stocks could be close to a significant turning point. Let’s see how things play out from here, but be careful. The downside in stocks could be much sharper than you might expect. I will write about forex in my next letter.

Good luck