Wealth Effect In Reverse. 3% decline in GDP For Starters?
“Won’t hesitate to go above neutral if needed.” Jerome Powell
“Going into bubbles breaking, profit margins are always at a peak. Bubbles don’t peak for no reason. They peak because economic conditions are nearly perfect. The first thing to go is the profit margin.” Jeremy Grantham
Jerome Powell’s statements last week reinforced the Fed’s full policy reversal from the most reckless policy stance in history as confirmed by data on money supply, debt, QE, and real interest rates. The Fed now says it needs tightness of “financial conditions” just as the growth downcycle is gathering pace.
In these publications it has been stated, fully 7 months ago, that a growth slowdown as inflation peaks was a 95% probability for Q2, 2022, the current quarter. The Fed chairman, with hundreds of economics PHDs at the Fed, has continued to characterize the economy as “strong” despite a preliminary report of negative GDP for Q1 2022, from around 7% in Q4 2021.
A growth slowdown should not be a surprise to the Fed. The chart below shows the consensus forecast for 2022, which peaked last September.
Yet only this year has the Fed become agressive about tightening. How does policy work exactly? Apparently, “There’s a sense of false precision…..”, no kidding!
The Fed apparently is simply focused on stated information relative to arbitrary targets, with limited apparent allowance for economic cycle dynamics. Powell also confirms that policy is so imprecise that it is necessarily highly discretionary. This means that apparently the Fed can run to policy extremes without boundaries if it feels right, even negative 8% fed funds interest rates which have never existed before.
This puts the Fed in great danger of acting procyclically, or in other words accentuating the economic cycles and so actually being the cause of instability, the opposite of their stated purpose.
Investors need accurate cycle awareness to navigate the markets successfully. Signals from the Fed and the choir from Wall Street are unlikely to be effective.
“If you don’t do macro, macro will do you”, is a common refrain in investing, and it is so true! Make sure your allocation is moving with the cycles and that your investment process has an effective cycle system.
A great number of other factors kick in as the cycle develops and Quad 4 intensifies.
QT starts on June 1
If QE inflated the stock market then it stands to reason that QT will have the opposite effect. It is now just two weeks away starting on june 1. QT will be a negative for the markets.
Buybacks
Buybacks have possibly contributed to as much as 40% of the post 2008 bull markets performance, as shown in a previous insight. The record shows that buybacks have been highly procyclical. If this activity declines as the market falls this will create a buying vacuum on the downside.
The Wealth Effect
Previous insights have also described how the wealth effect became a significant component of stimulating economic growth once credit growth proved to be too weak post 2008. The problem with this economic tool is that it also works in reverse. Already, it is possible to estimate that, with the fall in markets so far in 2022, fully 3% may be a good approximation for the GDP growth cut from the decline in wealth this year.
Credit still confirming hostile conditions for equities
The chart below shows that credit spreads are still trending wider and have broken above the 2018 highs.
The Cycle Outlook
Even without considering the Federal Reserve interest rate rises, QT, buybacks and negative wealth effects, the cycles still suggest that the next few quarters will likely remain in Quad 4 conditions of declining growth and finally, declining inflation too.
This has been a brutal investment environment with real yields rising too. Hopefully there will be some relief soon as the forwards are indicating that real yields may be closer to peaking.
While many commodity sectors remain in uptrends at least base metals have begun to correct.
So at last it seems that conditions have improved for bonds and gold to possibly stabilize. These are both asset classes that can perform well in Quad 4 conditions.
In Summary
It is still very premature to expect a sustainable low in US equities given how far the quad 4 cycle still has to go and particularly with the Fed still far from indicating an all clear. Profit margins are still not far from record highs and have only just recently started to correct.
Quad 4 allocations remain the recomended approach with tight risk management. The “Fed Put” remains off table.