Base case: global recession

The Treasury yield curve is flattening, with the 10-year/3-month yield differential plunging sharply, to a current 0.24%. Another 75 basis point rate hike at the next FOMC meeting is expected to drive the 3-month T-Bill discount rate above the 10-year yield, the negative spread warning of a deep recession in the next 6 to 18 months (subsequent reversal to a positive spread would signal that recession is imminent).

10-Year & minus 3-Month Treasury Yield

The S&P 500 is retracing to test short-term support at 4200. Breach would warn of another decline, while follow-through below 3650 would signal the second downward leg of a bear market.

S&P 500

 

21-Day Volatility troughs above 1% (red arrows) continue to warn of elevated risk.

S&P 500

Dow Jones Industrial Metals Index is in a primary down-trend, warning of a global recession.

DJ Industrial Metals Index

Supported by a similar primary down-trend on Copper, the most prescient of base metals.

Copper

Brent crude below $100 also warns of an economic contraction. Goldman Sachs project that crude oil will reach $135 per barrel this Winter, while Ed Morse at Citi says that WTI Light Crude will likely remain below $90 per barrel. Obviously, the former foresees an economic recovery, while the latter sees an extended contraction. Of the two, Morse has the best track in the industry.

Brent Crude

Natural gas prices are climbing.

Natural Gas

Especially in Europe, where Russia is attempting to choke the European economy.

Russia: EU Gas

Causing Germany’s producer price index to spike to 37.2% (year-on-year growth).

EU: PPI

Conclusion

Our base case is a global recession. A soft landing is unlikely unless the Fed does a sharp pivot, Russia stops trying to throttle European gas, and China goes all-in on its beleaguered property sector. That won’t address any of the underlying problems but would kick the can down the road for another year or two.

Jay Powell is selling but the bond market isn’t buying

Fed Chairman Jerome Powell declared that the Fed’s commitment to taming inflation is “unconditional”:

June 23 (Reuters) – The Federal Reserve’s commitment to reining in 40-year-high inflation is “unconditional,” Powell told lawmakers on Thursday, even as he acknowledged that sharply higher interest rates may push up unemployment.

“We really need to restore price stability … because without that we’re not going to be able to have a sustained period of maximum employment where the benefits are spread very widely,” the Fed Chairman told the U.S. House of Representatives Financial Services Committee.

Under questioning by members of the House panel on Thursday, Powell said there was a risk the Fed’s actions could lead to a rise in unemployment. “We don’t have precision tools,” he said, “so there is a risk that unemployment would move up, from what is historically a low level though. A labor market with 4.1% or 4.3% unemployment is still a very strong labor market.”

He also dismissed cutting interest rates if unemployment were to rise while inflation remained high. “We can’t fail on this: we really have to get inflation down to 2%,” he said.

The Fed chief was also asked about the central bank’s balance sheet, which was built up to around $9 trillion during the pandemic in an effort to ease financial conditions and is now being pared. The Fed aims to get it “roughly in the range of $2.5 or $3 trillion smaller than it is now,” Powell said.

But the bond market isn’t buying it. Treasury yields from 2-year to 30-year are compressed in a narrow band above 3%, indicating a flat yield curve. Expectations are that the Fed can’t go much higher than 3.0% to 3.5%.

Treasury Yield Curve

The dot plot from the last FOMC meeting similarly projects a 3.4% fed funds rate by the end of 2022, 3.8% by 2023, and lower at 3.4% by the end of 2024.

FOMC Dot Plot

You cannot cure inflation with a Fed funds rate (FFR) of 3.5%.

CPI is growing at 8.6% YoY, while the FFR target maximum is 1.75%. Another 1.75% just won’t cut it. You have to hike rates above inflation. Positive real interest rates are the best antidote for inflation but the economy, in its current precarious state, could not withstand this.

Fed Funds Rate & CPI

Taming inflation in the 1980s

Paul Volcker killed inflation by hiking the fed funds rate to 20% in 1980, but we live in a different world.

In 1980, federal debt to GDP was less than 50% of GDP. Today it’s 118%.

Federal Debt/GDP

The Federal deficit was 2.5% of GDP. Now it’s 12%.

Federal Deficit/GDP

Private debt (excluding the financial sector) was 1.35 times GDP in 1980. Now it’s more than double.

Private Non-Financial Debt/GDP

Powell can’t hike rates like Volcker. If he tried, he would collapse the economy and the US Treasury would be forced to default on its debt. Collapse of the global reserve asset is about as close as you can get to financial Armageddon.

Pricking the bubble

Instead, the Fed plans to use QT to deflate the asset bubbles in stocks and housing, in the hope that a reverse wealth effect — as households feel poorer — will slow consumer spending and reduce inflation.

So far, the S&P 500 has dropped by 25% and the housing market is likely to follow. The 30-year mortgage rate has climbed to 5.81%, more than double the rate in August last year.

30-Year Fixed Mortgage Rate

Housing starts and permits are both declining.

Housing Starts & Permits

Powell talks of a $2.5 to $3.0 trillion reduction in the Fed’s balance sheet. That would increase the supply of Treasuries and MBS in financial markets by an equivalent amount which would be sucked out of the stock market, causing a fall in prices.

The two largest foreign investors in US Treasuries — Japan and China — have also both become net sellers to support their currencies against the rising Dollar. That will further increase the supply of Treasuries, causing an outflow from stocks.

Since 2009, stock market capitalization increased by $47.4 trillion, from $16.9T to $64.3T at the end of Q1. At the same time, the Fed’s balance sheet increased by $7.9 trillion, from $0.9T to $8.8T. Market cap increased by $6T for every $1T increase in the Fed’s balance sheet (QE). The multiplier effect is 6 times (47.4/7.9).

Stock Market Capitalization & Fed Total Assets

If the Fed were to shrink its balance sheet by $2.5 trillion and net foreign sales  of Treasuries amount to another $0.5 trillion, we could expect a similar multiplier effect to cause an $18 trillion fall in market capitalization ($3Tx6). Market cap would fall to $50T or 26.5% from its $68T peak in Q4 of 2021.

That’s just the start.

“Inflation is always and everywhere a monetary phenomenon”

Nobel prize-winner Milton Friedman argued that long-term increases or decreases in the general price level were caused by changes in the supply of money and not by shortages or surpluses of oil, commodities or labor.

The chart below shows the supply of money (M2) as a percentage of GDP. The economy thrived with M2 below 50% throughout the Dotcom boom of the late 1990s but has since grown bloated with liquidity as the Fed tried to revive the economy from the massive supply shock of China’s admission to the World Trade Organization in 2002 — the introduction of hundreds of millions of workers earning roughly 1/30th of Western-level wages.

Money Supply (M2)/GDP

The massive supply shock helped to contain prices over the next two decades, perpetuating the myth of the Great Moderation — that the Fed had finally tamed inflation. Fed hubris led them to pursue easier monetary policy with little fear of  inflationary consequences.

All illusions eventually come to an end, however, and the 2020 pandemic caused the Fed to purchase trillions of Dollars of securities to support massive government stimulus payments. The MMT experiment failed disastrously, causing a $5 trillion spike in M2 without an accompanying rise in GDP. M2 spiked up from an already bloated 70% of GDP to more than 90%, before GDP recovered slightly to reduce it to the current 89%.

Trade tensions with China, coupled with supply chain disruptions from the 2020 pandemic and a sharp rise in natural gas prices — as industry switched from coal to reduce CO2 emissions — triggered price increases. These were aggravated by Russia’s invasion of Ukraine and resulting sanctions, leading to oil shortages.

Normally, high prices are the cure for high prices. Consumers cut back purchases in response to high prices and demand falls to the point that it matches available supply. Prices then stabilize.

But consumers are sitting on a mountain of cash, as illustrated in the above M2 chart. They continued spending despite higher prices and demand didn’t fall. Investors who have access to cheap debt also, quite rationally, borrow to buy appreciating real assets. Unfortunately cheap leverage is seldom channeled into productive investment and instead fuels expanding asset bubbles in homes and equities.

The Fed is forced to intervene, employing demand destruction, through rate hikes and QT deflate asset bubbles, to reduce consumer spending.

An unwelcome side-effect of demand destruction is that it also destroys jobs. Unemployment rises and eventually the Fed is forced to relent.

Conclusion

Fed Chairman Jerome Powell says that the Fed’s commitment to reining in inflation is “unconditional” but the bond market is pricing in rate hikes peaking between 3.0% and 3.5%, way below the current rate of inflation. The economy is unlikely to be able to withstand more because of precarious levels of debt to GDP and a massive fiscal deficit.

Instead, the Fed plans to shrink their balance sheet by $2.3 to $3 trillion. QT is expected to deflate asset bubbles in stocks and housing and achieve a reverse wealth effect. Households are likely to curb spending as their net worth falls and they feel poorer.

Unfortunately, demand destruction from rate hikes and QT will also cause unemployment, inevitably leading to a recession. The Fed seems to think that the economy is resilient because unemployment is low and job openings outnumber unemployed workers by almost 2 to 1.

Job Openings & Unemployment (U3)

But elevated debt levels and rapidly rising credit spreads could precipitate a sharp deleveraging, with crumbling asset prices, rising layoffs and credit defaults.

High Yield Spreads

The Fed may also manage to lower prices through demand destruction but inflation is likely to rear its head again when they start easing. Surging inflation is likely to repeat until the Fed addresses the underlying issue: an excessive supply of money.

Milton Friedman was a scholar of the Great Depression of the 1930s which he attributed to mistakes by the Fed:

“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 … Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”

Ben Bernanke, another scholar of the Great Depression, acknowledged this during his tenure as Fed Chairman:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton (Friedman) and Anna (Schwarz): Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”

Instead the Fed made the opposite mistake. By almost doubling the quantity of money (M2) relative to GDP (output) they have created an entirely different kind of monster.

Money Supply (M2)/GDP

Slaying the beast of inflation is likely to prove just as difficult as ending the deflationary spiral of the 1930s.

Larry Summers: Fed needs same disinflation as under Volcker

Larry Summers highlights a paper from the NBER regarding measurement of CPI since the 1980s. Changes in how cost of housing is measured have lowered core CPI relative to the methodology used prior to the early 1980s (blue line below). Applying the current methodology (red line) retrospectively suggests that comparable core CPI is closer to the Volcker era.

Larry Summers

Summers continues:

“New paper shows past and present CPI inflation are more similar than official data suggests. When correcting for change in how housing inflation is measured, we find a return to target core inflation will require the same disinflation as achieved under Volcker.”

Stocks: Winter is coming

GDP grew by a solid 10.64% for the 12 months ended March ’22 but that is in nominal terms.

GDP

GDP for the quarter slowed to 1.58%, while real GDP fell to -0.36%. Not only is growth slowing but inflation is taking a bigger bite.

GDP & Real GDP

The implicit price deflator climbed to 1.94% for the quarter — almost 8.0% when annualized.

GDP Implicit Price Deflator

Growth is expected to decline further as long-term interest rates rise.

10-Year Treasury Yield & Moody's Baa Corporate Bond Yield

Conventional monetary policy would be for the Fed to hike the funds rate (gray below) above CPI (red). But, with CPI at 8.56% for the 12 months to March and FFR at 0.20%, the Fed may be tempted to try unconventional methods to ease inflationary pressures.

Fed Funds Rate & CPI

That includes shrinking its $9 trillion balance sheet (QT).

During the pandemic, the Fed purchased almost $5 trillion of securities. The resulting shortage of Treasuries and mortgage-backed securities (MBS) caused long-terms yields to fall and a migration of investors to equities in search of yield.

The Fed is expected to commence QT in May at the rate of $95 billion per month — $60 billion in Treasuries and $35 billion in MBS — after a phase-in over the first three months. Long-term Treasury yields are likely to rise even faster, accompanied by a reverse flow from equities into bonds.

S&P 500 & Fed Total Assets

S&P 500 breach of support at 4200, signaling a bear market, would anticipate this.

Conclusion

Fed rate hikes combined with QT are expected to drive long-term interest rates higher and cause an outflow from equities into bonds.

A bear market (Winter) is coming.

S&P 500 rallies as Fed tightens

Stocks rallied, with the S&P 500 recovering above thew former primary support level at 4300. Follow-through above 4400 would be a short-term bull signal.

S&P 500

Markets were lifted by reports of progress on a Russia-Ukraine peace agreement — although that is unlikely to affect sanctions on Russia this year — while the Fed went ahead with “the most publicized quarter point rate hike in world history” according to Julian Brigden at MI2 Partners.

FOMC

The Federal Reserve on Wednesday approved its first interest rate increase in more than three years, an incremental salvo to address spiraling inflation without torpedoing economic growth. After keeping its benchmark interest rate anchored near zero since the beginning of the Covid pandemic, the policymaking Federal Open Market Committee (FOMC) said it will raise rates by a quarter percentage point, or 25 basis points….. Fed officials indicated the rate increases will come with slower economic growth this year. Along with the rate hikes, the committee also penciled in increases at each of the six remaining meetings this year, pointing to a consensus funds rate of 1.9% by year’s end. (CNBC)

Rate hikes are likely to continue at every meeting until the economy slows or the Fed breaks something — which is quite likely. To say the plumbing of the global financial system is complicated would be an understatement and we are already seeing reports of yield curves misbehaving (a negative yield curve warns of recession).

Federal Reserve policymakers have made “excellent progress” on their plan for reducing the central bank’s nearly $9 trillion balance sheet, and could finalize details at their next policy meeting in May, Fed Chair Jerome Powell said on Wednesday. Overall, he said, the plan will look “familiar” to when the Fed last reduced bond holdings between 2017 and 2019, “but it will be faster than the last time, and of course it’s much sooner in the cycle than last time.” (Reuters)

The last time the Fed tried to shrink its balance sheet, between 2017 and 2019, it caused repo rates (SOFR) to explode in September 2019. The Fed was panicked into lending in the repo market and restarting QE, ending their QT experiment.

SOFR

QT

Equities are unlikely to be fazed by initial rate hikes but markets are highly sensitive to liquidity. A decline in the Fed’s balance sheet would be mirrored by a fall in M2 money supply.

M2 Money Supply/GDP & Fed Total Assets/GDP

And a similar decline in stocks.

S&P 500 & Fed Total Assets

Ukraine & Russia

Unfortunately, Ukrainian and French officials poured cold water on prospects of an early ceasefire.

Annmarie Horden

Neil Ellis

Samuel Ramani

Conclusion

Financial markets were correct not be alarmed by the prospect of Fed rate hikes. The real interest rate remains deeply negative. But commencement of quantitative tightening (QT) in May is likely to drain liquidity, causing stocks to decline.

Relief over prospects of a Russia-Ukraine ceasefire and/or any reductions in sanctions is premature.

The bear market is likely to continue.

Biden needs to double down on banking oversight

Crony capitalism at its worst.

Banks and the coal-mining industry, with the help of lobbyists, blocked Joe Biden’s appointment of Sarah Bloom Raskin — a former deputy Treasury Secretary and member of the Fed board during the Obama years — as the Fed’s primary regulator to oversee the banking industry.

Sen. Patrick J. Toomey (R-Pa.) and other GOP lawmakers have attacked her view that the Fed should do more to mitigate the financial risks of climate change, including by potentially changing the way it regulates energy producers. (Washington Post)

Democrat Senator Joe Manchin’s opposition was the final straw, adding to the Republican stonewall. Manchin’s West Virginia constituency boasts a strong coal mining industry and the Senator is heavily supported by coal-mining donors.

March 15 (Reuters) – Sarah Bloom Raskin on Tuesday withdrew as President Joe Biden’s nominee to become the top bank regulator at the Federal Reserve, one day after a key Democratic senator and moderate Republicans said they would not back her, leaving no path to confirmation by the full Senate.

“Despite her readiness — and despite having been confirmed by the Senate with broad, bipartisan support twice in the past — Sarah was subject to baseless attacks from industry and conservative interest groups,” Biden said in a statement.

Raskin had become the most contentious of Biden’s five nominees to the central bank’s Board of Governors, generating strong opposition from the outset from Republicans who said she would use the vice chair of supervision post to steer the Fed toward oversight policies that would penalize banks who lend to fossil fuel companies.

Raskin had been favored by progressive Democrats, such as Senator Elizabeth Warren of Massachusetts, who had pushed Biden to install someone who would pursue stiffer banking oversight after regulatory rollbacks under the previous supervision czar, Randal Quarles.

Conclusion

Joe Biden’s administration should not be deterred from appointing a tough regulator to oversee the banking industry. Many bankers would argue the opposite — that the economy would benefit from light regulation of the industry — but their track record says otherwise.

The banking industry is one of the key vulnerabilities in an already fragile financial system. Failure to effectively regulate them would risk another financial crisis, especially with current global volatility.

Dr Lacey Hunt, Hoisington Asset Management | The debt trap

From Dr Lacey Hunt at Hoisington Asset Management on the declining velocity of money:

M2 Velocity

The Fed is able to increase money supply growth but the ongoing decline in velocity (V) means that the new liquidity is trapped in the financial markets rather than advancing the standard of living by moving into the real economy…..

GDP/Debt

Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then velocity will rise since GDP will eventually increase beyond the initial borrowing. If advancing debt produces increasingly smaller gains in GDP, then V falls. Debt financed private and governmental projects may temporarily boost GDP and velocity over short timespans, but if the projects do not generate new funds to meet longer term debt servicing obligations, then velocity falls as the historical statistics confirm.

The increase in M2 is not channeled into productive investment — that fuels GDP growth — but rather into unproductive investment in financial assets. The wealthy invest in real assets, as a hedge against inflation, but these are mainly speculative assets — such as gold, precious metals, jewellery, artworks and other collectibles, high-end real estate, or cryptocurrencies — which seldom produce much in the way of real income, with the speculator relying on asset price inflation and low interest rates to make a profit. Many so-called “growth stocks” — with negative earnings — fall in the same category. Debt used to fund stock buybacks also falls in this category as their purpose is financial engineering, with no increase in real earnings.

In 2008 and 2009 Carmen Reinhart and Ken Rogoff (R&R) published research that indicated from an extensive quantitative analysis of highly indebted economies that their economic growth was significantly diminished once they become highly over-indebted.

…..Cristina Checherita and Philip Rother, in research for the European Central Bank (ECB) published in 2014, investigated the average effect of government debt on per capita GDP growth in twelve Euro Area countries over a period of about four decades beginning in 1970. Dr. Checherita, now head of the fiscal affairs division of the ECB and Dr. Rother, chief economist of the European Economic Community, found that a government debt to GDP ratio above the turning point of 90-100% has a “deleterious” impact on long-term growth. In addition, they find that there is a non-linear impact of debt on growth beyond this turning point. A non-linear relationship means that as the government debt rises to higher and higher levels, the adverse growth consequences accelerate……Moreover, confidence intervals for the debt turning point suggest that the negative growth rate effect of high debt may start from levels of around 70-80% of GDP.

…..Unfortunately, early-stage economic expansions do not fare well when inflation and interest rates are not declining at this stage of the business cycle, which is not the normal historical role, or the path indicated by economic theory. As this year has once again confirmed, in early expansion inflationary episodes, prices rise faster than real wages, thereby stunting consumer
spending. The faster inflation also thwarts the needed continuing cyclical decline in money and bond yields, which are necessary to gain economic momentum.

…..The U.S. economy has clearly experienced an unprecedented set of supply side disruptions, which serve to shift the upward sloping aggregate supply curve inward. In a graph, with aggregate prices on the vertical axis and real GDP on the horizontal axis, this causes the aggregate supply and demand curves to intersect at a higher price level and lower level of real GDP. This
drop in real GDP, often referred to as a supply side recession, increases what is known as the deflationary gap, which means that the level of real GDP falls further from the level of potential GDP. This deflationary gap in turn leads to demand destruction setting in motion a process that will eventually reverse the rise in inflation.

Currently, however, the decline in money growth and velocity indicate that the inflation induced supply side shocks will eventually be reversed. In this environment, Treasury bond yields could temporarily be pushed higher in response to inflation. These sporadic moves will not be maintained. The trend in longer yields remains downward.

Negative real yields

A negative real yield points to the fact that investors or entrepreneurs cannot earn a real return sufficient to cover risks. Accordingly, the funds for physical investment will fall and productivity gains will erode which undermines growth. Attempting to counter this fact, central banks expand liquidity but the inability of firms to profitably invest causes the velocity of money to fall but the additional liquidity boosts financial assets. Financial investment, however, does not raise the standard of living. While the timing is uncertain, real forward financial asset returns must eventually move into alignment with the already present negative long-term real Treasury interest rates. This implied reduction in future investment will impair economic growth.

….research has documented that extremely high levels of governmental indebtedness suppress real per capita GDP. In the distant past, debt financed government spending may have been preceded by stronger sustained economic performance, but that is no longer the case. When governments accelerate debt over a certain level to improve faltering economic conditions, it actually slows economic activity. While governmental action may be required for political reasons, governments would be better off to admit that traditional tools would only serve to compound existing problems.

Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff (which will be referred to as RR&R), in the Summer 2012 issue of the Journal of Economic Perspectives linked extreme sustained over indebtedness with the level of interest rates…… “Contrary to popular perception, we find that in 11 of the 16 debt overhang cases, real interest rates were either lower or about the same as during the lower debt/GDP years. Those waiting for financial markets to send the warning signal through higher (real) interest rates that governmental policy will be detrimental to economic performance may be waiting a long time.”

Growth Obstacles

In 2022, several headwinds will weigh on the U.S. economy. These include negative real interest rates combined with a massive debt overhang, poor domestic and global demographics, and a foreign sector that will drain growth from the domestic economy. The EM and AD (Advanced) economies will both serve to be a restraint on U.S. growth this year and perhaps significantly longer. The negative real interest rates signal that capital is being destroyed and with it the incentive to plough funds into physical investment.

Demographics continue to stagnate in the United States and throughout the world……..Poor demographics retard economic growth by lowering household, business and state and local investment. This keeps intact the observable trend in numerous countries – extreme over-indebtedness reduces economic growth which, in turn, worsens demographics, which reinforces the weakness emanating from the debt overhang. William Stull, Professor of Economics at Temple University, makes the case that for nations’, “demographics is destiny” (a phrase coined by Ben Wattenberg and Richard M. Scammon), highlighting the importance of its critical secular growth in determining economic fortune.

Although fourth quarter numbers are not yet available, the global debt to GDP average for 2020-21 is almost certainly the highest on record for any two-year period. Transitory growth spurts, like the one Q4 2021, are unlikely to be sustained. The sporadic but weakening growth trend evident before the pandemic hit in 2019 will return, reinforcing the debt trap.

Inflation

The University of Michigan indicates consumer sentiment in the fourth quarter was worse than during the height of the 2020 pandemic and at the levels of the beginning of the very deep 2008-09 recession. Consumers cut back significantly on their buying plans as expectations for increases in future income slumped. To fund the sharply higher cost of necessities, households have been forced to reduce the personal saving rate in November to 6.9%, or 0.4% less than in December 2019. Needing to tap credit card lines undoubtedly contributed to the erosion in consumer confidence measures. Without the sizable cut in personal saving, real consumer expenditures were barely positive in the fourth quarter. With money growth likely to slow even more sharply in response to tapering by the FOMC, the velocity of money in a major downward trend, coupled with increased global over-indebtedness, poor demographics and other headwinds at work, the faster observed inflation of last year should unwind noticeably in 2022.

Fed way too slow, way too late | Wolf Richter

“This most reckless Fed ever has had some kind of come-to-Jesus-moment late last year when it did acknowledge the problem it had set off. And now it’s trying to act way too slowly, way too late, and way too timidly to break up this spiral without causing the whole house of cards – the magnificent asset bubbles everywhere – that its money-printing and interest-rate repression created to come crashing down all at once.”

~ Wolf Richter, Wolfstreet

No soft landing

10-Year Treasury yields have climbed in response to the December FOMC minutes which suggest a faster taper of QE purchases and faster rate hikes. Breakout above 1.75% would offer a medium-term target of 2.3% (projecting the trough of 1.2% above resistance at 1.75%).

10-Year Treasury Yield

The Dollar Index retreated below short-term support at 96, warning of a correction despite rising LT yields.

Dollar Index

Do the latest FOMC minutes mean that the Fed is serious about fighting inflation? The short answer: NO. If they were serious, they would not taper but halt Treasury and MBS purchases. Instead of discussing rate hikes later in the year, they would hike rates now. The Fed are trying to slow the economy by talking rather than doing — and will be largely ignored until they slam on the brakes.

Average hourly earnings growth — 5.8% for the 2021 calendar year — is likely to remain high.

Hourly Wage Rate

A widening labor shortage — with job openings exceeding total unemployment by more than 4 million — is likely to drive wages even higher, eating into profit margins.

Job Openings & Unemployment

The S&P 500 continues to climb without any significant corrections over the past 18 months.

S&P 500

Rising earnings have lowered the expected December 2020 PE ratio (of highest trailing earnings) for the S&P 500 to a still-high 24.56.

S&P 500/Highest Trailing Earnings (PEmax)

But wide profit margins from supply chain shortages are unsustainable in the long-term and are likely to reverse, creating a headwind for stocks.

Warren Buffett’s long-term indicator of market value avoids fluctuating profit margins by comparing market cap to GDP as a surrogate for LT earnings. The ratio is at an extreme 2.7 (Q3 2020), having doubled since the Fed stated to expand its balance sheet (QE) after the 2008 global financial crisis.

Market Cap/GDP

Stock prices only adjust to fundamental values in the long-term. In the short-term, prices are driven by ebbs and flows of liquidity.

We are still witnessing a spectacular rise in the M2 money stock in relation to GDP, caused by Fed QE. The rise is only likely to halt when the taper ends in March 2022 — but there is no date yet set for quantitative tightening (QT) which would reverse the flow.

M2/GDP

Gold continues to range between $1725 and $1830 per ounce with no sign of a breakout.

Spot Gold

Conclusion

Expect a turbulent year ahead, driven by the pandemic, geopolitics, and Fed monetary policy. Rising inflation continues to be a major threat and we maintain our overweight positions in Gold and defensive stocks. A soft landing is unlikely — the Fed could easily lose control  — and we are underweight highly-priced growth stocks and cyclicals, while avoiding bonds completely.