Powell has an inflation dragon to slay, and your portfolio might be in the way
Inflation, Fed policy, recession, stock-markets, and what to expect next
Note: I publish long-form articles here on Medium, but for more frequent content, follow along on twitter:
https://twitter.com/JohanKirsten1
“Sell in May and go away?” might be a cliché, but it is a very relevant question at this juncture — and not for the usual seasonal reasons — there is much more at play here.
In my March 2022 article (From Pandemic to Putin to your Portfolio) I discussed my investment approach to dealing with uncertainty. All the points made there are still relevant, and you can read it here:
Now the picture is becoming a bit clearer, and in this article, I will describe the predicament market participants find themselves in, outline my thought process around forming a view on what to expect next, what to look for to invalidate my thesis, and how to incorporate this into my investment strategy.
An investor’s predicament
(4 paragraphs)
1. As of writing this article, the S&P 500 is 18% below its 4 Jan 2022 intra-day high after briefly dipping below the -20% bear-market threshold three trading sessions ago. The Nasdaq 100 is 28% off its highs, while early-stage technology stocks as a sector (Using ARKK as proxy) is 73% below its Feb 2021 peak and now near the March 2020 Covid-crash lows: A complete bubble-pop-reset.
2. Recession fears are now creeping into the market as PMI’s (Purchasing Managers Indices), consumer sentiment readings, consumer spending, and real household disposable income, are all starting to roll over. More on this later.
3. In April, the US CPI (Consumer Price Index) declined slightly from 8.5% year-on-year to 8.3%. This was marginally higher than the expected 8.1% and when one adjusts for base effects, it’s clear that inflation momentum has not yet slowed. The US Federal Reserve has hiked interest rates by an additional 0.5 percentage points in May, and they have indicated that they are more concerned about high consumer prices than asset price stability. And it would be difficult to argue with them because it seems that the inflation dragon has yet to be slain. The chart below shows that CPI (YoY % change) is still at 40-year highs.
4. With the Federal Reserve taking a very hawkish stance (monetary tightening), and the market pricing in another 225 basis points worth of rate hikes in 2022, while the market is grappling with recession fears, the question is now whether the stock-market has entered a prolonged bear market for the first time since the long bull-run started in 2009, or if this is just another routine consolidation in a secular bull-market. The chart below shows where the S&P 500 is currently, compared to previous major bear markets. If we are indeed on a similar path, then there is still a long, long way to go.
What does history teach us about inflation, Fed policy, recessions, and the stock-market?
(5 Sections)
With the backdrop outlined above, the pertinent questions are:
- What happens to the stock market when the Fed starts raising rates?
- How does inflation affect the stock-market?
- How does the stock market react to recessions?
- What does the Fed do when recession hits?
- Do recessions bring inflation down, or does inflation cause recessions?
Let’s jump in and look at what happened in the past. Note that the past cannot predict the future, but it sure can teach us something about the cause-effect relationships between various economic and financial determinants.
1. The stock-market and interest rates
Let’s examine the S&P 500 over the past 33 years (1989–2022) and how it reacted to the start of Fed rate hiking cycles. In the chart below, the top panel shows the S&P 500 index while the bottom panel shows the Federal Funds Rate (The interest rate which is controlled by the Fed). The red bars indicate recessions, and the black lines mark the start of each rate hiking cycle.
It’s clear that over this 3-decade period, each rate hiking cycle corresponded with the stock market going up in the subsequent 18 to 24 months. BUT, just because this was the case over such a long period, it does not mean it is necessarily likely to be the case again. There were only 3 data points (rate hiking cycles) in this period, and that is not enough to have any degree of certainty about what is likely to happen. We will have to dig deeper…
Let’s look back even further to the 35-year period (Chart below, 1954–1989) prior to the previous chart. Here we find 8 rate hiking cycles, three of which saw the same result as in the previous chart (S&P 500 moving up after the start of rate hikes), and 5 instances where the stock-market moved sideways or down after the start of a new rate hiking cycle. So, now the picture becomes more complicated. Over the entire 68-year period, there were 12 rate hiking cycles: In 5 instances the stock-market went up, and on 7 occasions it went sideways or down. Why so? Let’s see if we can find out.
The chart below shows the entire 68-year period examined above, with the start of rate hiking cycles marked off as before. This time, I added the CPI inflation (YOY % change) to see if there is anything to glean from this. I have shaded (in red) the period of 5 consecutive rate hiking cycles, where the stock-market did not go up. We see that this was a period of high and volatile inflation, while CPI was fairly tame in the periods where the stock-market moved up along with interest rates. And where are we now…..? Oops!
2. The stock-market, inflation and recessions
The chart below, shows that since 1955, 7 out of the 10 recessions in that time-period, were preceded by a sharp rise in inflation and interest rates. So now the question is whether recession is caused by high inflation or by the Fed raising interest rates? I think the answer is that recessions are caused by tight financial conditions (Access to credit and liquidity is difficult) and both inflation and higher interest rates have a severe tightening effect on financial conditions. High prices (inflation) dampen economic activity, while higher interest rates increase the cost of credit and capital. So why does the Fed then, add fuel to the fire by raising rates when inflation is high? There are two reasons for this:
- If interest rates are kept low while inflation rises, it will keep rising until the high prices themselves cause a collapse in demand and economic activity, and thereby halting inflation. But the hot economy which caused the inflation, will run into bubble territory first, and the collapse will be much more painful than if the bubble was prevented in the first place by raising rates.
- If inflation rises too fast before an economic slowdown can cool it down, it could become unanchored and turn into runaway or hyper-inflation. This usually ends in a total collapse of the currency, financial system and economy. (E.g.: the Weimar Republic in the 1920’s and more recently Venezuela and Zimbabwe). Obviously, this is to be avoided at all cost.
3. Recessions and the Federal Reserve’s reaction function.
As marked out in red on the chart below, in 9 out of the 10 recessions since 1955, the Fed cut rates immediately as a recession hit. This was even the case in the 1970’s when inflation was sky-high and debt levels were relatively low.
Only on one occasion, in 1974, did they keep raising rates into a recession. This is probably because they were too far behind the inflation curve and had to keep raising despite the recession. This seems very similar to what might be happening today. The Fed is far behind the inflation curve and recession seems imminent. See the chart below.
What did the stock-market do in the 1973/1974 recession when the Fed kept raising rates? The following 2 charts show the S&P 500 index versus Fed Funds Rates in the same two splits as before. (1954–1989 and 1990–2022)
In the 1973/74 recession when the Fed kept raising rates regardless, the stock-market had a larger and longer (in time) drawdown than in all the other recessions in the 1954–1989 split. However, once rates were eventually cut, the market found a bottom and started a recovery before the end of the recession. In fact, this initial S&P 500 drawdown into the recession, and turnaround before the end of it (Nike-swoosh shape, indicated in red on the charts) was the pattern in all but one of the 10 recessions in the 68-year period in our sample. Only in the 2001/2002 recession, after the tech-bubble burst, did the S&P 500 find a bottom long after the recession ended.
4. What about valuation?
The Shiller CAPE (See chart below) is a good long term valuation metric. It’s clear that in 1929 and 2000, valuation played a large part in the bear markets that followed. But in 1973 and 2008, valuations were clearly not the main drivers of the bears. Valuation is certainly one of the main concerns today.
5. What were the drivers behind the 3 major bear markets since WW2?
Let’s now compare the three major bear-markets in our 68-year sample and see what the major drivers were.
1973/74
Inflation was high and the Fed was far behind the curve which meant that they had to raise rates into a recession. This is much like our current situation. However, unlike today, stock valuations were not in bubble territory — at least according to the Shiller PE Ratio. The OPEC oil embargo of October 1973, and the Watergate scandal that led to President Nixon’s resignation in August 1974, were further contributors to the sell-off. The oil embargo was very similar to the Russia-Ukraine war of today, which both led to skyrocketing oil prices.
2000–2002
The Dot Com Bubble of the late 1990’s which popped in 2000, the September 11 Twin Towers terrorist attack, and accounting scandals, (Arthur Andersen, Enron, and WorldCom) were the main drivers of the 2001/2002 bear market. Valuations were in bubble territory, but inflation was low, and the Fed cut rates aggressively as the crisis hit. The only similarities between then and now I can see here, are high valuations and maybe the uncertainty created by terrorist attacks in 2001, and the geo-political uncertainties today.
2008/09
The bear market that started in 2008 and lasted well into 2009, was caused by the sub-prime housing market bubble-pop which triggered a liquidity cascade and subsequent global financial melt-down. I see this crisis as a major event in the current monetary regime and as much more than a routine flush such as 1974 and 2000 were. This was the failure of a financial system that was founded after WW2, and which evolved into an unsustainable, highly levered time-bomb which eventually exploded. I think we are today still paying the price for that explosion, but this is perhaps a topic for a separate article.
Stock valuations were far from bubble territory, inflation was at manageable levels and again, the Fed cut rates swiftly when the crisis hit. Interestingly, oil prices were again sky-high as the China-boom consumed oil and all other industrial commodities like there was no tomorrow. Other than high oil and industrial commodity prices, and high debt levels, I can’t really see many similarities between 2008 and now. The banking and financial systems of today are much more resilient and well capitalized than they were back then.
Looking for a suitable analogue for current conditions
(2 Sections)
1. The 1970’s
So, indeed, from our 68-year sample, it seems like the 70’s is the most analogous period to where we are today, so we’ll have to zoom in to this decade:
Apart from the similarities discussed above (high inflation, high oil prices,recession, and rising interest rates), there are also stark differences between now and the 70’s which might drive a different outcome:
a) Debt levels in the 70’s were much lower than now. See chart below
When debt levels are low, the Fed has much more room to raise interest rates before debt servicing costs become unaffordable. Therefore, if interest rates rise too high in a highly indebted system, such as today, it will cause mass insolvency and trigger a deflationary default and liquidation cascade. And if there is one thing that central banks fear more than high inflation, it is a deflationary spiral. Therefore, the ability of the Fed to raise rates this time, might be limited.
b) Supply-side, versus demand-side driven inflation: Supply-side driven inflation is caused when supply constraints cause shortages and therefore higher prices, while demand is constant or declining more slowly than supply. Demand side inflation is caused during strong economic expansions when demand increases rapidly while supply can’t keep up.
Today, inflation is largely driven by monetary stimulus, supply chain disruptions, commodity production constraints, and deglobalization. It is hardly driven by robust economic growth. The chart below shows the GDP-growth rate-of-change since WW2. It is striking how the growth rate dropped into a shallower channel in the 1980’s as debt levels started to rise. The GDP-growth rate spiked above the shallow channel in 2021 after the Fed fired its stimulus bazooka during the Covid-19 pandemic, but it has since dropped back into the channel as stimulus dried up. The argument here, is that the economy is not strong enough to absorb the rate hikes of the 1970’s, when GDP-growth was still in the strong pre-1980’s era.
c) In the 70’s, the Baby-boomer generation, which was the largest demographic cohort ever, entered the labor market and household formation surged, leading to an insatiable demand for homes, cars and appliances. This led to high inflation, but the economy was strong and could absorb substantial interest rate hikes by the Fed, who had to bring inflation down.
Today, we have the inverse. The same Baby-boomer generation is now exiting the workforce and retiring. The gen-X-ers right behind them is a much smaller cohort and will not replace the demand of the Boomers. Next in line are the Millennials. They are about the same size as the Boomers, but they are not known as “early launchers”. Household formation, income growth and creating a demand-driven economic boom, are not exactly their claims to fame (apologies to Millennials). It is therefore hard to see where the demographic demand needed for robust economic growth will come from to absorb any aggressive Fed tightening shenanigans.
So now we know that except for high inflation and high oil prices, many other important economic conditions in the 1970’s were much different from today and therefore this is not a good analogue to study for signals of what might happen next.
We’ll have to go back even further in time to find a suitable template. To me, the most important determinants to look for is high debt levels and high inflation occurring at the same time, after a fiscal spending impulse. This is because now, for the first time in our 68-year study, we have these three conditions all at the same time.
2. The 1940’s
If we look back over the past century, there is only one other instance where we had these same conditions — 1946 to 1949. See chart below). Debt levels were high as a result of massive government spending on the war effort (WW2). Just as today, debt as a percent of GDP started to roll over and inflation picked up sharply. So let’s dig deeper and see if this is a good template for current times.
a) As mentioned above, in 1946 debt levels were high after massive government spending on the war, which led to high inflation. Similarly, in the recent past, governments spent massively on stimulus to fight the effects of the Covid-19 pandemic which led to high government debt levels and ultimately resulted in inflation levels not seen in the past 40 years.
b) Fiscal spending during the war was largely unproductive because spending money on destroying the enemy, is hardly a constructive effort. However, after the war, fiscal spending was directed towards rebuilding and retooling of the economy. Similarly, today the Covid-19 spending was unproductive as people were paid to stay home, but now, fiscal spending will turn to productive rebuilding of infrastructure for a green economy and on-shoring of supply chains.
c) The chart below shows that short term interest rates were at very low levels (close to zero). Rates were kept low in order to stimulate the war-ravaged economy and because the resulting rise in debt servicing costs on a mountain of debt would have crippled the government. Secondly, the low rates at the same time as high inflation, meant that real rates were deeply negative, this was a mechanism to bring down the debt as a percentage of GDP at a rapid pace. Today, we find ourselves in a very similar situation, which makes me wonder how far the Fed will actually be able to raise rates in the months ahead. Negative real yields for an extended period of time might be the only way out of the current debt trap.
d) During WW2, ports were destroyed, global shipping was a disaster, commodity producers in war zones were bombed and widespread food and commodity shortages were the norm. Today, supply chains are struggling to recover after the lockdowns. Geopolitical tensions are placing further pressure on global trade and long supply chains. The Russia-Ukraine war has directly impacted the availability and flow of agricultural and energy commodities. Under investment in energy and base material exploration over the last decade crimps the ability of supply to replace waning and aging commodity deposits. All these factors are causing shortages and high prices, as was the case after WW2.
e) During the war, food and energy supplies were rationed in an attempt to deal with shortages. Personal savings rates were at record highs as everyone was working on the war effort, paid by the government, while their spending was curtailed. This excess savings and pent-up demand contributed to a strong recovery after the war. We saw a similar pattern during Covid lockdowns where people couldn’t go out and spend but, were getting paid to stay at home. The chart below shows the increase in personal savings during 2020/2021, although not as massive as during WW2. As we shall see later, it also seems that those savings are rapidly being drawn down now and therefore the economic injection from personal savings might be short-lived.
f) Skills mismatches occurred at scale after the war, as soldiers were difficult to integrate into the labor market and they had to be retrained. Today we see the same skills mismatches and tight labor market conditions as in those days. The chart below shows the gap between job openings and job openings per unemployed person. These two metrics usually track each other closely, but since the pandemic, they have diverged dramatically.
g) During the 40’s and 50’s, technologies that were invented before the war, hit mainstream adoption and boosted the economic recovery that followed, by driving demand and productivity. These technologies were: electric household appliances, shopping malls (trolley miles), motor vehicles, refrigeration and landlines. Today we see that internet users, broadband usage, and mobile phones have entered their mature adoption phases, whereas drones, robotics, automation, AI, genomics, energy storage, electric vehicles and blockchain technologies are rapidly growing in adoption. Granted, these last 8 technologies mentioned above, are perhaps a story for the 2030’s when they will become widely adopted, and they might not be that relevant to our medium-term outlook.
h) Due to the rapid adoption of motor vehicles and the building of roads and highway infrastructure after the war, people moved out of the cities which created a housing boom, much like we saw during 2020/2021 as people started working from home and moved to the countryside.
Besides the similarities discussed above, there are two important differences between the post-war era of the 40’s and the post-pandemic era of today: Valuations now are much higher than then, and demographics are also different. Back then, there was a huge population boom after the war, which is not the case today. The high valuations today adds further downside risk to stock prices, while the demographic situation could mean a comparatively weaker economic recovery.
Despite these two differences, I think the similarities discussed above, makes the 1940’s the closest historical analogue for the period we are in now. Let’s now look at what happened to inflation, Fed policy, and the stock-market in the years that followed 1946.
During the first half of WW2 (1940–1942) stocks were in a bear market, but recovered during the latter half and beyond, reaching a top in 1946. At this point, interest rates were very low, inflation started climbing rapidly and the stock-market sold of by 26.3%.
In 1947 inflation was at 20% and interest rates started rising very slowly. Notice that as rates started rising, inflation immediately reversed and declined rapidly from its high of 20% in 1946, down to zero in 1949 — even though interest rates did not rise much. After the sell-off in 1946, the stock-market went sideways and as inflation bottomed inside the 1949 recession, stocks took off on a major secular bull-run.
See below, a good chart by Jurrien Timmer that zooms in on 1946 and compares the stock-market price action with today.
My base case for the next 12 to 24 months
(5 Points)
Now, I am not saying I’m expecting a major bull run to occur in the near future as did from 1949 onwards, but my base case for the next 12 to 24 months is something similar to the 1947–1949 period. My best guess follows:
1. A recession is coming.
Here are a few early recession indicators:
a) Manufacturing PMI (Purchasing Manager’s Index) is a leading indicator for future manufacturing activity. And it is declining fast. Similarly, mortgage servicing costs are a strong indicator of consumer sentiment and disposable income. This metric is at 30-year lows. This is of course linked to rising yields.
a) The chart below shows the year-on-year change in three metrics: Real disposable household income is declining, while household spending is still increasing, but decelerating. Per definition, this means that personal savings are being used to fund the spending and is evident in the chart.
c) When looking at the absolute levels of personal income excluding transfer payments from government, as stimulus programs have ended, it’s clear that the trend is decelerating.
d) The slowing real household income is starting to show in declining retail sales volumes, which is nominal sales, adjusted for inflation.
2. Inflation comes down, but settles at higher than 2% averages
“The cure for high prices, is high prices” might be another cliché, but add a recession with job losses on top of that, and the cliché becomes very relevant. Inflation has probably, or is close to peaking and my guess is that it returns to somewhere in the range of 3% to 4% before the next spike.
Based on my analysis of inflation over the past century, I doubt that inflation spirals out of control any time soon. Conditions in the 70’s were very different from now and is therefore not a good template to use for inflation projections. Having said that, I do expect inflation to enter a regime of higher volatility and higher averages. The point is that 8%+ is probably going to be the peaks of the more volatile inflation spikes ahead. Deglobalization and commodity supply constraints are real problems which will ensure that average inflation rates (on a 5-year rolling basis), settle well above the 2% average we have become used to over the past 2 decades.
3. Rates will rise moderately, until….
Fed chair Jerome Powell has made it clear that he thinks the job market is strong and therefore he is determined to slay the inflation dragon without having to deal with rising unemployment. If he wounds your portfolio in the battle, then so be it, I (Powell) warned you well in advance. While I believe he is serious about this, I have also seen how quickly he can pivot (2018) when something breaks. While he will not be phased by an orderly market sell-off, panic-selling, a bond market freeze or a recession will do the trick. And as I have mentioned before, the high debt levels make the markets so much more susceptible to any of these events.
As far as rates are concerned, I think the Fed will keep raising to where short term rates are currently priced in the rates futures market (2.5–3.5%) and by then one or more of the above events will most probably force a pivot. The 2-year Treasury yield is a good leading indicator of Fed Funds Rates as shown below. I am keeping my eye on this indicator for where the Fed Funds Rate might top out.
4. Debt to GDP should come down.
As we saw during the 1940’s & 50’s, Total debt (Public + Private) to GDP peaked initially in 2009 after the financial crisis, then had an enormous bump up due to the pandemic stimulus, and it’s now coming back down again. This down-trend should continue if real yields stay negative going forward. Although this will not affect the market in the short term, It might provide a more normalized environment for markets in the long run.
5. A sluggish stock-market in the medium term (6–12 months) but bullish in the short run (2–6 weeks)
While inflation remains high and there are no signs of a dramatic turnaround, while the Fed is draining liquidity from markets on an inflation hunt, and while recession looms large, I can’t really be bullish on stocks on a medium-term timeframe. As was the case in 1947 to 1949, I think markets go sideways to down over the next 6 to 12 months. However, If something (Bond market freeze, recession, sharp inflation decline) forces the Fed to pivot or even just pause, that would change the picture drastically.
The dizzying high stock-market valuations of three months ago adds to the case for a prolonged bear market because overshooting on the upside, usually means overshooting to the downside as well. However, valuations have come down considerably as prices declined and earnings kept growing. The chart below, also by Jurrien Timmer, illustrates this forward PE reset very nicely.
If my recession expectations do not materialize and companies keep growing earnings, markets could be very close to the bottom already.
Unprofitable tech as a sector, has already lost almost ¾ of its value and it seems like this bubble has deflated completely. Perhaps this will be the sector that leads the way out of the current market drawdown. Note the bearish divergence at the top which led the S&P down, and now, there are early signs of bullish divergence forming towards the bottom of the chart. This is a sign that selling pressure in ARKK is waning. See the chart below.
I’ll be looking for ARKK to form a base and to break out as one of my early indicators for a potential market turnaround. As it led into the downturn, a turnaround in this sector will most probably feed into the rest of the mrket.
In the short term, I am actually feeling rather bullish. Even if this is going to be a long bear market (and this is not a sure bet by any standards), there will be sharp rallies along the way, and I think one might be around the corner. There are several indicators pointing to extreme oversold conditions, and a relief bounce is probably to be expected. While I don’t want to go into the details of these oversold indicators, I have included 4 examples from @macrocharts below.
My investment strategy for dealing with the current market conditions.
While the above is my base case, it remains a (hopefully educated) guess and cannot form the basis of any specific investments or trades. I acknowledge that my guessing could, and most probably would, be wrong and I will be monitoring all the abovementioned trends, determanants and indicators to evolve my view.
So will I sell in May? No, I will remain invested, albeit with a defensive stance, as was my position since March of this year. For a detailed description of what I think it means to be defensive, check out my previous article “From Pandemic to Putin to your Portfolio” here:
I will keep looking for high potential gain, low potential risk opportunities, but will be very strict in applying my investment criteria and be conservative in my position sizing. I will keep a substantial part of my portfolio in cash while liquidity is being drained from the financial system. When money becomes tight, cash is king.
Once inflation has started to come down, the Fed has paused their tightening, and all the “naked swimmers” have run for the shores, I will start moving into risk-on mode again. Ideally, I’d like to start turning up the risk dial before this point, but I’d rather be a little late than way too early. Picking tops and catching knives are fool’s errands. Catching the meat of large swings, is where the money is made.
Conclusion
As we have seen in our analysis of markets over the past century, in a fragile economic recovery after a war or pandemic, when debt levels are high, inflation can be volatile, but not necessarily persistent. The high inflation itself can reduce demand sufficiently to self-destruct. Recession risks are high and monetary policy officials should be careful not to overdo their tightening.
I think risk remains skewed to the downside, but barring any external shocks, markets are probably closer to the bottom than the top. It might be too late to “sell in May and go away”. You should have turned defensive before May. But it is certainly also not “Buy in June and go to the moon” either. The tide is going out and I suspect many are still swimming naked. Keep your trunks on and wait for the tide to turn.
Good luck out there.
Follow along on Twitter for updates:
https://twitter.com/JohanKirsten1
Disclaimer
The views expressed in this article are the views of Johan Kirsten and are subject to change at any time based on market and other conditions. This is not financial or investment advice, nor a solicitation for investment funds and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
