Market Lab Report - Xmas crash postponed? Why the recession will be deep and long

by Dr. Chris Kacher

Xmas crash postponed?

It was shaping up to be another Xmas crash as markets look poised to retest prior lows on Thu and Fri just before Xmas which fell on a Sunday. But then volatility diminished and a floor was found as people started to leave work for the long weekend holiday. Nevertheless, Powell has made it clear rate hikes will continue at least twice more with any further hikes as data dependent.

Food and shelter are still running hot, well above the quoted CPI and PCE numbers. The food index climbed 10.6% over last year. Just because the inflation rate starts to drop doesn't mean food is getting cheaper. It's just not rising in price as quickly. Supply chain disruptions, the conflict in Ukraine, climate change, and transportation costs are all contributing to higher food prices. Meanwhile, rents "are going to be renewed into a market where rates are higher than they were when the original leases were signed," Fed Chair Jerome Powell said in a recent press conference. "But we see that the rate for new leases is coming down. So once we work our way through that backlog, that inflation will come down sometime next year." Rentals are the largest component of core CPI, making up 40%.

The upshot is expect CPI and PCE to stay stubbornly elevated for much of this year thus forcing the Fed to hike by further 25 bps increments, otherwise, the terminal rate will be kept at elevated levels, much as predicted by Goldman Sachs (GS). Either way, major stock market averages should find new lows while crypto as the ultimate risk-on asset should also fall materially further from current levels. Crypto has never been through a recession, and the one that's coming is looking to be historically deep. So it's 10k and pray for Bitcoin suggesting at least another -50% drop for altcoins, many which have already dropped 80-90% off peak.

Why the recession will be deep and long

Persistently high inflation will remain well above the Fed's target of 2%. Ray Dalio's view that a revised target of 3-4% could become the new norm. The lengthy period of high inflation remains underestimated by many economists. For those who wish to hold bonds, inflation bonds (i-bonds) are a good bet as their yields are correlated to inflation.

Stock and crypto valuations don't reflect the extreme macro picture as of yet so markets have not yet reached a major bottom. With at least two more rate hikes on the way, bond yields are bouncing higher. Goldman Sachs believes the terminal rate will reach 500-525 which would imply another three rate hikes of 25 bps each. But this is a best case scenario as GS earlier said further 25 bps rate hikes could occur beyond these three depending on the persistence of high inflation, suggesting a terminal rate closer to 6%. Regardless, something key is likely to break in the economy before then due to record levels of debt. This would force the Fed to pivot. Until the yield curve normalizes, bonds of shorter duration pay better yields. Even the 3-mo is paying 4.27% vs. 3.85% for the 30-year.

Supply-side inflation remains stubbornly high due to supply chain issues caused in part from COVID and also in part from geopolitical tensions. Worker shortages are becoming standard as the population ages. Also, net-zero carbon emissions are often uneconomic thus a significant part of inflation. All these factors could trigger a wage inflation price spiral. The Fed has no tools to deal with this so are left with no choice but to fight inflation by raising rates to lower demand. This will deal a serious blow to the economy, so expect the recession to be deep and long.

To add fuel to the fire, earnings expectations have not yet caught up with the macro picture. They are not yet pricing in even a mild recession.

But at some point, the Fed will pivot by halting then lowering rates. This does not guarantee a major bottom or the start of a new bull if prior historical examples leave any clue. The Fed stopped hiking then started to lower rates in 1930-32 and 2000-02, yet major averages continued to fall for well over a year. These were two major bubbles that had to be unwound. We are currently sitting on one of the largest bubbles in history, so market carnage could be equivalent to these past two cases when the NASDAQ Composite lost -78% peak-to-trough by Dec-2002 and the DJIA lost -90% by Jun-1932.

Goldman Sachs vs. Blackrock

GS says this cycle is different from the 1970s when inflation got out of hand for a number of years because at present, wage growth has slowed and excess savings is dropping. They therefore think unemployment will only go up by 0.5% in the current cycle instead of the normal soaring rate of unemployment. In agreement, Blackrock says due to the aging population, the number of people looking for work continues to decline, plus many who left the workforce during COVID have not returned. But this will keep inflation elevated due to the lower supply of people to employ thus push the Fed to overtightening. GS instead assumes the US will avoid recession because GDP will remain just above 0%. In contrast, Blackrock assumes GDP will fall below 0% due to the Fed being forced to overtighten due to persistent inflation.

GS goes on to write this cycle is different from the 70s because supply chains are normalizing, inventories are soaring, and the cost of shelter will fall. This will eventually bring inflation down but not for at least the first half of 2023 as GS admits to the stubborn nature of high food and rental prices. This is another reason the Fed is likely to overtighten thus expect a deep recession before recovery. That said, Fed officials have said that they are focused on more leading indicators such as asking rents on new leases, which have slowed sharply in recent months, instead of existing rents, so perhaps this will somewhat temper how far the Fed overtightens.

Europe

GS says Europe and the UK are probably in recession due to the dramatic increase in household energy bills. This will boost inflation to 12% in Europe and 11% in the UK and impact real income, consumption, and industrial production so expect GDP to average -0.1% in Europe with Germany averaging -0.6% and -1.2% in the UK for 2023. But GS still underestimates the persistence of high inflation which will cause the ECB and Bank of England to likely overtighten.

Circling black swans

In any event, a number of things could go wrong as rates are hiked which could force the unleashing of a new round of QE. Whether markets head lower as they did in 1930-32 and 2000-02, move sideways, or start into a new bull depends on the magnitude of QE which depends on the magnitude of the black swan. Perhaps the black swans should be called hawks because they are circling.