I provided the following short note to my work colleagues this morning and I think it’s worth sharing here. I’ve added my thoughts to what it means for markets at the bottom.
Covid lockdowns caused fiscal and monetary authorities to turn on the proverbial printing presses in order to stave off a deflationary economic situation caused by shutting down the global economy for a year. Once the economy reopened the economic upside momentum from low base effects, combined with record spending and stimulus (including literal checks in the mail – not just quantitative easing) caused inflation to run wild.
The Federal Reserve, having decided to let inflation run hot since they’ve been unable to generate any in over a decade, then became materially behind the curve. Meaning bond markets began tightening (rising rates) due to inflationary pressure and inflation expectations even before the Fed turned hawkish. By the time the Fed removed the word “transitory” in regards to inflation, in their policy statements, the actual economy was probably nearing peak inflation anyway, from a year over year standpoint.
The Fed then began raising interest rates, following the bond market, but economic growth was already moderating and will probably now begin decelerating as they tighten monetary conditions. Markets are now beginning to price in a recession, yield curves have inverted, and equities are throwing a temper tantrum as a result of the tightening.
There are very real structural issues related to energy which should cause energy prices to rise until supply and demand reach equilibrium. The Russian invasion of Ukraine, and the political responses in the forms of sanctions only make the supply situation worse. Decelerating economic growth plus structural energy supply shortages is a recipe for stagflation, which is a worse case scenario from policy holders perspectives.
For deflation, the playbook is easy – implement QE and do fiscal stimulus.
For inflation, the playbook is also easy – tighten monetary conditions and slow the economy until inflation is subdued.
For stagflation, QE and fiscal stimulus will cause energy prices to accelerate even higher; and tightening monetary conditions will only slow the economy it will not solve structural energy problems. The Fed cannot print oil and gas (or coal); they could provide lending facilities to O&G exploration and production/infrastructure projects – but that’s probably politically untenable with today’s administration!
Currently, China is implementing a zero Covid policy and has locked down Shanghai, one of the world’s largest cities, among other areas. This is causing global supply chain bottlenecks – and is hurting global growth. There’s a lot hurting global growth:
Sanctions on the Russian economy is hurting global growth.
Chinese real estate and construction sectors are hurting global growth.
High energy prices are hurting global growth, particularly in Europe.
My forecast: the supply chain issues will cause an inventory problem felt in the USA sometime this summer. Concurrently, the Fed’s rate hikes will have had a detrimental impact on economic growth and by the late summer/early fall we will be in a mini-recession. If the Chinese reopen by that time there will be material impetus by US wholesalers and producers to restock inventory levels (especially ahead of the US holiday season). This will lead to a call on manufacturing, which will start the demand pull on raw material resources. By then, the Fed will most likely pivot back to an increasingly dovish stance. The dovish impacts on monetary conditions (rates peaking and then dropping substantially) plus the positive manufacturing impacts from the inventory cycle, should cause the global economy to accelerate back out of the mini-recession.
Covid shutdowns, and the policy reactions to cope with them, have compressed the normal business cycle causing mini-booms followed by mini-busts. You can see this playing out in inventories as well as many sectors of the economy. Since it’s such a unique situation, classic policy techniques and reaction functions from monetary authorities and governments are either not effective altogether, ill-timed at least, and/or exacerbate the situation at worst.
Long term however, the world will have to come to grips with the numerous energy policy errors of the last decade and a long term energy capex cycle is required to stabilize stagflationary economic conditions. Real growth (as opposed to nominal growth) requires abundant and cheap energy. It always has, in nature and in economics.
What this means for markets is summarized as follows:
Broad equity indexes and bonds will continue to selloff until expectations of a Fed pivot are realized. Continue to watch TLT and HYG for directional cues.
Mining and metals will pullback until China re-opens completely and Chinese manufacturing and raw materials processing begins demand pulling commodity resources to it’s shores ahead of the next compressed manufacturing cycle.
Energy will continue it’s march upward and relative outperformance as the E&P industry starts allocating long term capital to the new capex cycle.
Please let me know if you have any questions with regards to anything discussed in this post.
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Great analysis thanks. I am thinking about closing all my energy longs and just shorting tech directly until the pivot happens. When equities sell off, we see that energy (coal, uranium etc) gets taken with it, and the trading is very stressful when you constantly trying to time hedges.
Do you have any reason to believe that energy will outperform after this dead cat bounce in equities (and we have the next round of sell-offs). Holding mostly cash and holding a short seems like the stress free way of making money here - then using that to deploy in longs when the pivot happens.
Thanks
Don't you think that by end of summer we'll see production inflation (which is 15 to 40% YoY right now, especially in Europe) move to consumer prices, hence impacting consumer ability to spend massively on holidays?
I honestly do not think that retailers or producers can absorb this production cost hike and not transfer it to consumers..