The financial markets – both stocks and bonds – have started rapidly in 2023. IS&P 500 (SPY) rose 3-4%, while small-caps (IWM) and long-term Treasuries (TLT) gained 6. %. Call this the January effect or whatever you want, but there is an undeniable sense of optimism that is not yet fully supported by the data.
If you look at retail sales, industrial production or housing starts, you can conclude that the US economy is slowing down at a faster rate than before, perhaps even to the point of recession expected by the end of the year.
But there is a counterargument. Inflation is also falling faster than expected. If you look at the 6-month annualized rate of inflation, we are already back around 2% of the Fed’s target level.
That means we’re looking at another quarter-point or two in Q1 and then the Fed will be done. Whether the Fed will be able to keep the Funds rate as high as it wants in 2023 is a point of great debate (for the record, I think they will but I’m not).
Putting aside the market reaction for a moment, it’s important to consider what inflation means now. Sure, the numbers are moving in the right direction and that’s certainly welcome news for consumers, but is it as good as sentiment suggests it is?
Probably not and here’s why.
There are three possible outcomes here.
Inflation remains elevated
Investors aren’t expecting a rebound in prices, but they shouldn’t write them off completely. A Fed Funds rate of around 5% and the reopening of China should both keep disinflationary pressure on the economy through 2023, but what about beyond that?
In the 1970s, inflation peaked at over 12% in 1974 before falling to below 5% in 1976. In 1979, inflation was over 13% again and remained over 9% for the next three years. A second round of hyperinflation is not out of the question, but the Fed is probably in a better position now to keep things under control by using higher rates and QT. As long as they don’t hesitate to react like they did in 2021.
This is probably the worst outcome. Consumers are already in a tight spot, especially the lower/middle class and a second round of high inflation could cause not just a deep recession, but perhaps something like a depression.
Inflation Returns to Fed’s Target Level
From an optics point of view, this is a good result, but it does not come without consequences.
Let’s assume that the annual inflation rate for some time in the near future will be 0%. It’s good, isn’t it? All that price pressure on everything from gas to groceries to health care costs to plane tickets is becoming a thing of the past, right?
Not really. A 0% inflation rate simply means that all inflation from 2022 stops. 0% inflation does not mean that conditions are back to the days before 2022. That means we are still working on the 2022 dates.
Credit card usage and savings rates prove that most households are still struggling to pay their bills, let alone spend on discretionary items. A 0% inflation rate means that those families are still facing the pressure of higher prices that they did last year. The only advantage is that they don’t go up too much. In this case, they are still in the same position of needing to tighten the budget and slow spending (although hopefully some kind of wage increase helps offset some of that and improve real wages).
Inflation has turned into deflation
This is probably the most likely outcome and we are already heading in that direction.
If a recession were to hit, say, in the next 12 months, that would almost certainly put a squeeze on the economy. If households have to cut back on spending, demand falls and prices quickly follow. Production slows and companies are forced to cut prices. Demand for services is also declining.
This is Econ 101. As excess demand shifts to less demand, prices follow. That means the focus on high inflation is turning to deflation. If deflation begins, that almost guarantees that a recession will occur in the United States and possibly elsewhere.
We won’t discount it yet, but the wild card could be the reopening of China. If that’s all they’re hoping for in the economy, we’re about to see an increase in everything China produces on the market. That, in itself, is deflationary. We have already seen retail businesses warn about high inventory levels. China’s reopening could make it worse.
To conclude
Pick your poison.
- Hyperinflation returns leading to bankruptcy/depression.
- Inflation rates, financial markets may see gains, but consumers remain under pressure.
- As inflation turns into deflation, recession becomes a near certainty.
None of this is constructive unless you are an investor in exhibit #2. Even in that case, we’re looking at a lack of growth from low consumer discretionary income.
Markets may be set for a short-term rally in both stocks and bonds as investors cheer inflation, China provides a growth catalyst and the Fed finally hits the stop button.
In the long run, it may be a matter of choosing the worst outcome.
ETF in Focus
I have been playing around with this net flows/RSI matrix to try to get a sense of what the markets are doing versus what investors are doing to see if there is a disconnect.
RSI defines relative strength. I use the flow rate relative to assets so that we can identify structural movements in asset classes. Otherwise, it would be SPY, QQQ and VTI that dominate each week.
Here’s what I see today by looking at a number of broad markets, sectors, regions and ETFs.
Most ETFs will fall above the 0% flow/AUM line because, well, ETFs take in hundreds of billions of dollars a year. So I’m looking for a 1 month walk to focus on the short term (1-week walk is too choppy to have high confidence in the results).
The upper left quadrant identifies ETFs that are underperforming but seeing investor cash flow in. The lower right quadrant will be ETFs that are performing well, but are seeing money leave. Both can offer opposite opportunities. I will not call them buying or selling. More than one possible way to identify trends.
High beta (SPHB) looks like an outlier, even though it operates with a smaller asset base. It’s up more than 10% year to date, but still sees net outflows for the year.
Emerging markets (IEMG) are the area gaining momentum. Emerging and developing markets outside of the US have performed very well this year, but emerging markets are the group that really takes the money.
EM equity can be a real game here.
Overbuying: IEMG, IEFA, VUG, XLC, SHV, FLOT, MUB, PFF, BITO, GLD, CPER
Near Overbought: IWC, LQD, SPHB, ARKK, GDX, BLOK
Sold out: VYM, UNG
Near Sold Out: XLP
Note: Oversold/Overbought is developed using a combination of RSI and Longbow dashboard.
