Given the overtly inauspicious character of recent market developments, a cautious cadence is warranted.
I attempted to communicate as much in a series of articles published here a little over a week ago.
The US economy is dangerously out of balance, the Fed is poised to embark on an aggressive tightening cycle and US equities are exceptionally vulnerable due to a ton of embedded duration risk and elevated multiples. That’s the gist of the three linked pieces (below).
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As I not-so-gently noted on Friday evening, stocks haven’t managed a winning session since those articles were published.
Importantly, I do think markets have behaved more efficiently than critics are willing to admit. For example, Goldman’s basket of non-profitable tech shares is down almost 40% since the beginning of November. Bitcoin is down 50%. Some of the other crypto “generals” more than that. Amazon is in a bear market. Netflix is down 42% from the highs. Cathie Wood’s flagship fund extended its losses this week, and is now 55% below its February 2021 peak.
That’s a lot of damage. Obviously, it doesn’t preclude a deeper index-level drawdown, but it does mean you’re not getting the whole story when folks like Jeremy Grantham tacitly suggest markets have simply ignored the shifting macro regime.
But about that shift. That’s where things get a bit scary, for lack of a more sophisticated adjective.
In a new note, Deutsche Bank’s George Saravelos summed up the situation quite succinctly. And he didn’t mince words. “We worry that in this supercharged economic cycle, we are fast moving from early cycle in 2020, to mid-cycle in 2021, to late-cycle in 2022,” he wrote, on the way to enumerating four reasons for that assessment.
He called the supply side of the US economy “terrible.” “Never before” have things been this bad on the supply side, he said, cautioning that trend growth is threatened by a US labor market that’s shrinking for the first time since the second world war, while capex has “flatlined” since COVID if you don’t count spending on refrigerators and washing machines (i.e., household durables).
Saravelos went on to say that “inflation is turning contractionary.” As detailed here on multiple occasions over the past several weeks, the US consumer suddenly looks exhausted. Retail sales posted a grievous miss in December (figure on the left, below) and red-hot readings on average hourly earnings mask deeply negative real annual wage growth (figure on the right).
“This is very different from the inflationary environment of the 1970s when real wages were growing sharply,” Saravelos remarked, adding that “this is leading to a very different message from confidence surveys, where the consumer is deferring as opposed to accelerating consumption like in the 70s.”
Meanwhile, the fiscal impulse is poised to roll over completely, with the biggest letdown coming from the expiration of the expanded Child Tax Credit which, on Deutsche’s math, equates to a 0.7% drag by itself. “With political deadlock and a potential Republican win in the midterms, the medium-term fiscal risks are turning clearly negative,” Saravelos warned.
Finally, he wrote, the Fed is in unfamiliar territory. For the first time in 30 years, a hiking cycle will commence with inflation above target (figure below).
That means comparisons with benign hiking cycles aren’t useful.
Previously, the Fed’s goal “was to get to neutral with minimal impact on markets,” Saravelos said. “This time around, the Fed’s objective should be to disrupt the market and ultimately bring inflation down.”
The title of his note: “It is not looking pretty.”
The list of negatives is long and well-known by now, even if some players remain in denial (BTD retail, for ex). Withdrawal of fiscal stimulus, monetary tightening, supply chain not rapidly healing, high valuations (still), political gridlock, energy costs, and while BAML FMS respondents seem to care little, Covid continues to suppress and distory while churning out a multitude of variants from which the next immune-evading and potentially not-less virulent one may emerge.
The main positive that is supposed to keep markets pointed up and to the right, or at least flat long enough to “grow into valuations”, is corporate earnings and guidance. They are supposed to be strong, so that an “earnings-led” market can withstand all the negatives.
Which makes 4Q21 earning season a do-or-die affair. The big banks reported meh, but with the Fed on their side (raising rates) and the political balance shifting it their favor (Warren potentially in the minority party), the damage wasn’t too bad. What other groups have the Fed and political winds on their side? Hard to think of many. So meh reports will be treated harshly and outright whiffs will be NFLX’d, meaning $240 billion cap names gapping down like smallcaps.
MSFT reports on the 25th, AAPL on the 27th. That’s the two biggest FAANGs and 12% of SP50. Next week will be critical. Yes, various indicators suggest the market is oversold (others not so much) but is big money really going to bet heavily on a rally until it sees those two?