The Shock That Surely Isn’t ‘Priced In’

If you were so inclined, you might argue that two of this year’s three shocks are already “in the price,” so to speak.

Regular readers are tired of hearing this, but most of 2022’s equity selloff comes down to de-rating. The contraction in multiples has moved in lockstep with the rise in real yields. The rise in real yields is a function of policy expectations. And policy expectations are a function of elevated inflation.

Taken together, that suggests both the inflation shock and the rates shock are at least partially priced in — they’re inextricably bound up with one another. The figure (below) shows the last three major drawdowns in US shares.

2018’s Q4 swoon was catalyzed by Fed tightening, 2020’s plunge by the pandemic and 2022’s ongoing slide by the Fed’s response to an epochal shift in the macro regime. In short: We’ve been leading up to this for five years.

2018 offered a preview of what to expect from stocks in the event the Fed attempted to get rates to neutral while simultaneously normalizing the balance sheet. 2020 showed just how unprepared the world was for an event with the potential to upend decades of globalization and thereby destabilize a macro regime that many took for granted. 2022 finds market participants coping with double-barreled Fed tightening necessitated by the end of that macro regime — the demise of the so-called “Goldilocks” backdrop, wherein subdued inflation and slow growth gave policymakers in advanced economies plausible deniability to persist in crisis-era monetary settings despite the conspicuous absence of a crisis.

“Feral, fearful, dystopian price action. This is what bear markets are, and the tape shows big damage already,” BofA’s Michael Hartnett said this week. “Bulls can say the ‘inflation shock’ is largely priced in and the ‘rates shock’ too.” But that still leaves one shock left: The recession shock.

Anyone who doubted the US might be headed for a downturn is likely rethinking their position (and perhaps their positions, too) after a week defined by guidedowns from big-name retailers, many of whom flagged a slowdown in discretionary spending, rising inventories and crimped margins. As one bank put it, “investors are now left to ponder if the decline in the share prices of consumer staple retailers will ultimately prove the ‘Aha’ moment that signaled the beginning of the end for Jerome Powell’s soft-landing ambitions.”

You could easily argue a recession is already in the price too. The median post-War recession drawdown is 24%. The S&P was nearly there on Friday afternoon before the benchmark trimmed losses into the close. But earnings estimates haven’t come down yet, and, as BofA’s Hartnett noted, “housing and labor markets are only just at inflection points.” Jobless claims are beginning to rise, and the cracks are starting to show in the US property market, but in both cases, you have to squint to see the weakness.

Hartnett regaled readers with a list of potential “unanticipated cyclical risks,” including a compendium of possible catalysts for a credit event. “[We] still think $18 trillion of negatively-yielding debt to $2 trillion in nine months means liquidation, deleveraging and default risks are high,” he said, adding that the “systemic risk from bond/stock/real estate deleveraging in risk parity and private equity” may be elevated as well. He also mentioned potential “credit events in speculative tech, shadow banking, US consumer buy-now/pay- later models,” emerging market stress as the Fed tightens, the prevalence of zombie corporations “and so on.” All of that, “and the Fed hasn’t yet begun QT,” he wrote.

One irony in all of this is that the inflation fight is being conducted in the name of Main Street, but as Neel Kashkari conceded earlier this month, Main Street is where the pain from any growth slowdown will be felt most acutely. Recall the figure (below) which shows the ratio of private sector financial assets to GDP.

“Wall Street assets are 6.3x greater than US GDP,” Hartnett remarked. “As seen in 2020, the quickest route to a deep recession is via a Wall Street crash and vice versa,” he added.

I always have a difficult time grappling with that contention. On one hand, orchestrating a controlled demolition of financial assets doesn’t directly affect the poor and barely touches lower-income cohorts. They don’t own any stocks. Certainly not in a relative sense, and depending on which demographic you’re looking at, they may not have any financial assets at all.

But there are countless middle- and upper-middle income households who’ve worked decades to build retirement funds worth, say, a few million. Seeing that decimated is soul-crushing and, depending on the circumstances, could be life-altering. Over the weekend, Bloomberg ran a version of the figure (below) using the header “Five Tech Stocks Dominate Retirement Funds.”

With the exception of a Vanguard balanced index vehicle I’ve owned since I was a teenager, I manage all of my money outside of mutual funds. So, I frankly don’t know whether Bloomberg is correct to suggest the funds shown in the chart are representative of America’s retirement allocations. That said, they obviously weren’t chosen at random. The linked article called them “leading,” “popular” 401(k) funds, and said they’re “stuffed” with tech.

In that context, the rise in real yields that bled big-tech over the first five months of 2022 certainly hurts on “Main Street.” I use the scare quotes because this discussion always leads me to the conclusion that there are actually two Main Streets — one comprised of generally well-off households who’ve jumped through sundry hoops and toed various lines on the way to a few million, and another comprised of everyday people, whose plight is perpetual precarity.

One way or another, I’ve never been less confident in the notion that it’s all going to turn out ok, where “ok” just means the system isn’t going to break down entirely. It’s not just market sentiment that’s in the doldrums. Everyone’s irritated with everyone else about something. There’s no consensus on anything, and problems are never resolved.

Subjecting a restive populace that can’t agree on anything to a stock market crash and a prolonged period of stagflation is a recipe for unrest. That, at least, isn’t priced in. In a worst case scenario, Hartnett’s “feral, fearful and dystopian” description won’t just apply to the “price action.”