A Viscous Stagflationary Environment

Today’s restrictive Fed policies in a rapidly deteriorating economy are the preconditions for a steep recession.

Contrary to the unprecedented monetary and fiscal support we had following the last economic downturn, we are currently experiencing a major withdrawal of liquidity at a time when corporate fundamentals are starting to contract.

Despite the deepest yield curve inversion in decades, the Fed is raising rates at its fastest pace since '84 as it prepares to shrink its balance sheet by $90B/month, starting in Sept.

Already, in the last 3 months, M2 money supply also contracted by its largest amount in 63yrs!

In the meantime:

Inflation remains deeply entrenched in the economy. These are arguably the most challenging set of circumstances the Fed has confronted in decades.

Central banks can sacrifice economic growth as long as unemployment rates stay low, which is highly unlikely.

Looking back at the Great Inflation period from the late 1960s to the early 1980s, the rise in consumer prices preceded substantial increases in unemployment rates. On average, after two years of the initial appreciation in inflation rates, labor markets started to falter.

Today, it has been exactly two years and three months since CPI rates began to trend higher.

With such a level of monetary tightening with already eroding economic conditions, we strongly believe unemployment rates are poised to rise significantly from their current levels.

In 1973-4, it took a decline of 48% in stocks for inflation to start trending lower for the next couple of years. The persistent increase in consumer prices at the time forced the Fed which had to radically tighten financial conditions.

As a result, a brutal inflationary recession followed and, outside of precious metals, overall equities and Treasuries collapsed together. A similar macro setup is unfolding today.

The US and most other developed economies have decisively entered an inflationary regime.

The role of monetary policy will be much more directed towards price stability which inhibits the backdrop of excessive central bank liquidity that drove overall market prices to today’s unsustainable levels.

We believe January 3rd marked the peak for US stocks and this is just the beginning of a bear market from truly historical overvaluations.

Equity markets are not priced for the vicious stagflationary environment that we envision.

Overall, stocks are behaving as if we were still in a secular disinflationary environment which allows the Fed to loosen monetary conditions without causing inflationary pressure.

As prices for goods and services continue to increase at historically elevated levels, so will the cost of capital. That is not a positive scenario for growth stocks, particularly relative to value companies.

The Russell Growth vs. Value index spread still is near the peak levels reached in the Tech Bubble of 2000. This further supports our view that the decline in the overall equity markets is just the beginning.

Additionally:

Maybe it is just a coincidence, but 774 CEOs have left their roles this year in the US alone. That is the highest number in 20 years!

What do these high-profile executives know that investors don’t?

There have been significant changes in labor market indicators recently. Job opening just had their largest 3-month decline in the history of the data, excluding the initial shock of the pandemic.

This is probably just the beginning.

Fed tightening with PMIs already at levels only seen in the Global Financial Crisis is just one more nail in the coffin for the economy.

Another interesting data:

Nonfarm payrolls recently surprised the markets with a surge of 528,000.

Despite what seems to be very positive news, here is a reminder that nonfarm payrolls also surged by almost 500,000 right at the peak of the tech bubble in March 2000.

In contrast to what most investors believe:

The “FAANG” stocks are starting to show serious signs of weakness in their fundamentals.

The median real revenue growth for these companies has officially turned negative for the 1st time in almost 2 decades.

"Growth" stocks, really?

After years of attracting investment flows from capital markets on the back of incredibly successful business models, these stocks are deteriorating fundamentally, and most investors are not even paying attention.

Aggregate profit margins for the Russell 2000 Technology index members are now at their lowest level since the Global Financial Crisis.

Let's not forget:

In the last 30+ years, every time the yield curve inverted, the Fed was forced to end its tightening cycle as the economy was heading into a recession.

Over time, the sharp reversal of these policies, i.e., subsequent easing cycles, are what have fueled the excesses we see in financial asset valuations today.

For every economic downturn we have had since the late 1980s, government and Fed support became progressively larger.

Such policy behavior is only achievable in a macroeconomic environment where inflation is not a long-term problem. In the inflationary late 1960s to early 1980s, in contrast, central banks were much more limited in their ability to deploy liquidity measures during recessions.

We think we are entering a similar macro setting today.

This potential lack of liquidity is yet to be reflected in the prices of risky assets, which remain near historic high levels. Nonetheless, despite the steep inversion in the US yield curve, we think the Fed will be forced to remain hawkish for longer.

In our strong view:

The tightening of financial conditions in a fragile economy should be detrimental to equity markets.

-- Tavi Costa