The Great Reconciliation Of Asset Prices In 2022
The coming new year will be fraught with risk due to the removal of central bank and government supports. This could very likely lead to the collapse of the most overvalued stock market in history.
According to the Conference Board, US economic growth is set to slow from 5.5% annual growth for all of 2021, to 3.5% during 2022. Of course, Wall Street apologists almost never predict a recession until we are in the middle of one. Nevertheless, it is clear that the growth of the economy will slow significantly next year. And, in the view of Pento Portfolio Strategies, the risk of a recession and an asset bubble collapse is high.
S&P 500 EPS growth will plunge from 45% this year, to just 5-6% in ’22. Again, this is the optimistic view that leaves a great deal of room for error to the downside and virtually zero to the upside. After all, you can only open up an economy once following a global pandemic, and that already happened this year. And, it will be nearly impossible to comp the previous two years’ $6 trillion fiscal support, along with the $4.6 trillion expansion of the monetary base.
We recently learned from the Bureau of Labor Statistics (BLS) that Consumer Price Inflation (CPI) surged by 6.8%, and Producer Price Inflation (PPI) shot up by 9.6% y/y in November. This helped to send Real Average Hourly Earnings down by 1.9 percent from November 2020 to 2021. CPI is running at a 40-year high and is at a rate that is 3.4 times higher than the Fed’s asinine 2% target.
Of course, the clueless Fed finally started reacting to all this inflation by announcing at the December FOMC meeting that it would be speeding up the pace of its taper by two times. But this is happening just when the rate of inflation is actually peaking. In reality, Fed-Head Jerome Powell had no choice but to expedite the tapering of his QE program. After all, it is an untenable notion that the Fed should be adding to the supply of money at a breakneck pace when CPI is the highest since 1982. But without question, Mr. Powell deserves much derision for waiting until inflation reached a multi-decade high before starting to taper asset purchases, let alone begin to raise interest rates off the current level of 0%.
It will take (ten) 25 basis point rate hikes to reach a 2.5% Fed Funds Rate (FFR), which the FOMC now regards as a neutral overnight lending rate. Powell believes a neutral FFR would be 50 bps above the FOMC’s 2% inflation target—assuming inflation falls to that level. In spite of these plans, the chances are very small that the Fed will end up being able to hike rates very much at all before the entire artificial economic construct comes crashing down. This is because the yield curve is already rapidly heading towards inversion even before the tapering of QE has really even begun. An inverted yield curve is a predictor of a recession that has worked 100% of the time. The spread between 2 and 10-year Notes has already contracted from 159 bps at the end of March to just about 75 bps today. Meaning, by the time the QE taper is consummated, there probably won’t be very much room at all to hike rates before an inversion takes place.
But regardless of the Fed’s feckless nature, the fact remains that the biggest buyer and direct supporter of Mortgage-Backed Securities and Treasury Bonds, along with its stated support of corporate debt (including Junk bonds), will be exiting the market entirely come March ‘22. This leaves a tremendously dangerous vacuum in place, especially in non-government-backed debt. The Fed’s QE program has kept the massive real estate and equity bubbles afloat, as well as the $12 trillion worth of Business debt from imploding. But Powell’s Put has expired because inflation is now a big problem.
Then, you must factor in the stubborn COVID Delta variant and the new and more contagious Omicron mutation, which Mr. Powell now views as potentially adding upward pressure on inflation. This could cause the Fed to tighten its monetary policies even more quickly. The consumer will also be left with the complete lack of any fiscal support of any significance next year, after receiving $50k on average per American family over the previous two years.
The truth is, the solvency of nearly every developed nation on earth is contingent on interest rates that remain in the sub-basement of history–AKA, record lows and around zero percent. This is only possible if central banks maintain complete domination of free-market forces and keep their hydraulic presses down on yields. Let’s be honest, without the backstop of these state-owned entities, solvency and inflation concerns would combine to force yields much higher. In the case of the US, with CPI inflation at 6.8% and a national debt-to-income ratio above 725%, it would be impossible for a 10-year Treasury bond to yield just 1.4% without the heavy hand of the Federal Reserve. The point here is that the US has immense solvency and inflation problem now, yet still enjoys record-low borrowing costs thanks to the Fed.
However, this function is now changing. A central bank can usually usurp the free market regarding its sovereign borrowing costs as long as both solvency and inflation concerns are quiescent. For example, the Fed has yet to truly exit its yield curve suppression programs, which have existed for the better part of the last two decades, because consumer price inflation was not an issue. This is true even though our Nation’s debt to GDP ratio is higher today than any time since WWII. Up until this point, that growing trend towards insolvency has been veiled thanks to the central bank’s interventions. But the resurgence of inflation, in conjunction with that humongous debt burden, has become extremely problematic.
In the absence of inflation, central banks have been able to print enough money to ameliorate recessions, bear markets, real estate debacles, and solvency concerns–such as the European debt crisis circa 2012. Where Bond yields in the southern periphery soared to 40% before European Central Bank chief Mario Draghi promised to monetize the debt issues away. Again, he could only accomplish that because inflation was not a concern a decade ago in the Eurozone.
Turning back to the US, the next recession, which is likely to occur in ’22, will cause solvency concerns to spike as revenue collapses and the National Debt-to-Federal-income ratio soars. However, this time around the Fed’s ability to monetize away collapsing asset prices and crumbling economic growth will be fettered by an inflation rate that is already many times greater than it is comfortable with.
That leaves the Fed and Treasury with a dangerous dilemma: allow asset prices and the economy to implode, which will certainly fix the inflation problem; but will most likely lead to a depression. Or, try and pull the economy and assets higher by once again borrowing and printing multiple trillions of dollars, which will send the rate of inflation skyrocketing from its 40-year high. That will risk destroying confidence in the USD and any faith that remains in the bond market. Therefore, the stock market and economy would collapse anyway as inexorably rising inflation pulls yields on sovereign, municipal and corporate bonds ever higher.
Wall Street’s perma-bulls will never admit that the Fed’s Put has now expired. Of course, the Powell Pivot will indeed happen once again as he continues to meander between hawkish and dovish depending on the lagging economic data he receives. But his next pivot back to an uber dove will only occur ex-post the Great Reconciliation of Asset Prices. This is why a buy-and-hold strategy no longer works and why identifying inflation and deflation cycles has become so critical.
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Tue, 12/21/2021 – 08:44