2023 Will Likely Begin With A Profit Recession
See video below
The Economic Growth Downturn Is Both Cyclical and Secular
“There was a time when markets tried to force the Fed’s hand by crashing. Now markets are enabling the most hawkish Fed in 40 years.“
~ Wolf Richter
“If you can’t describe what you are doing as a process, you don’t know what you’re doing.”
~ W. Edwards Deming
The equity rally since October can be attributed to peak cycle inflation and improving interest rates prospects. These are necessary but insufficent conditions for a durable equity market rally. Corporate profits, consumer sentiment and balance sheets, and economic growth are not in a good place.
This Weekly Insight reviews allocations and examines the prospects for the three key cycles that have to play out to get to a durable equity rally. Interest rates, earnings, and growth cycles.
Historically the equity market usually bottoms only well after the first actual interest rate cut, and the Fed is clearly not close to that. Even then equities need much more than just interest rate cuts for a bull market. They also need earnings and growth to become favorable on a rate of change basis.
Peak Interest Rates
First the good news. Peak interest rates may not be far off. The chart below shows the record rise in two year treasury yields this year. It also shows the record amount of short speculative positions in two year treasuries. It is increasingly likely that the worst prospects have been more than priced in. The record shows that this is often when yields begin to fall.
“Speculators just went RECORD short US 2-Year Bonds as a % of Total OI at -25.8%!!! The only other reading anywhere close was back in May 2007… Back then, yields fell 3.8% over the next nine months… What’s that saying? Be wary when everyone is on the same side of the boat…“
~ Julien Bittel, Head of Macro Research at GMI
Two year yield volatility has begun to decline and, for the first time, a credible consensus peak Fed funds rate target seems to have been reached at around 5%. With inflation possibly falling below 5% in Q2 2023 this would reach the Fed’s objective of a positive real yield. The ongoing weakness of the economy may make it very difficult to realistically expect rates could get any higher, let alone to 5%.
In that scenario the peak in the two year yield could well be somewhat below 5%. Short term treasuries seem to have limited downside, they offer the highest yields in over a decade, and eventually the prospect of capital gains.
For Equities The Earnings Cycle Looks Problematic
S&P 500 real earnings have never been further above the average long term growth level, which is 50% below. Is it likely that equities can hold up as profits start declining, while the Fed continues to target a 2% inflation objective?
Last week Hedgeye took a detailed look at the immediate outlook for profits. Long story short, the timing and scale of the earnings down cycle looks problematic in the near term.
The Economic Growth Cycle Has A Double Problem:
Cyclical and Secular Declining Trends
The current US cycle manufacturing decline has fallen into recessionary territory and is declining on all key metrics.
“November ISM Manufacturing down to 49 (contraction territory) vs. 49.7 est. & 50.2 prior; new orders dropped to 47.2 vs. 48.5 est. & 49.2 prior … prices paid sank to 42 vs. 46.6 prior; employment fell to 48.4 vs. 50 prior“
~ Liz Ann Sonders, Chief Investment Strategist, Charles Schwab & Co., Inc
The current global economic cycle is in a similar place but is more established in its downturn, and there remains no indication of any upturn even in the leading indicators.
The 70 Year Secular Growth Problem
Following the record stimulus for the recent bubble, policy makers need time for reflection on the next policy stimulus. If that stimulus only produced inflation, a further debt explosion, and only temporary growth, can it be called a success? How does swinging from extreme policy setting to the opposite create a stable basis for economic development?
Investors should take account of the substantial decline in the average economic growth rate over the last 70 years. This poor growth performance has mirrored the explosive growth of total debt as a percentage of GDP. There is no sign that debt growth will reverse and productivity is reaching a record low, as recently discussed.
If there is no review or change in policy, one can only assume the outcome will be more of the same that has been experienced over the last 70 years. This means weaker long term growth with increased inflation risk, and an increasingly unmanageable debt problem.
To paraphrase Edward Denning, if policy makers can’t describe what they are doing as a process with 70 years of data, they don’t know what they are doing.
Gold has become a very attractive alternative and gold miners have begun to significantly outperform equities.
Gold held up well during 2022, and Gold miners have significant room to run.
Investors need to consider carefully the prospects for the current down cycle. The scale of the bubble over the last 2 years, on most metrics, was a record over the last 70 years and the downcycle is far from complete. The experiment initiated by the BIS in 2019 to boost growth through maximum policy stimulus appears to have had at best only short term benefits, while leaving even greater debt, instability, and long term growth and inflation challenges. Increasingly, real assets should play an increasing role in a portfolio, and risk management will be increasingly important.
Transform Your Investment Experience
The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs “Best Investor” metrics and techniques as never before.
Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.
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