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From inflation to recession: the Fed's path

Updated: Nov 11, 2022

The Fed is left with few choices but to pop the bubble that was the last 13 year credit cycle, as inflation is running out of control, the economy is slowing as it is, and the institution is feeling increasing pressure from consumers and leadership.

The ever rising cost of goods, services, and capital is constraining the appetite for spending in real terms, even while nominal readings continue to appear healthy.

The bottom tier of consumers are set to suffer the most in this inflationary environment, with pressure likely to further increase as 2022 goes on. Compression of budgetary elasticity further constrains appetite for discretionary spend, even with many sales from leading retailers. Knock on impacts with ripple throughout the economy as the American consumer drives many global consumption trends.

The top 1% of American households hold 50% of their wealth in equities, which has been a boon for them over the last 13 years, but that time may be coming to an end soon, and with it the wealth destruction it foments could compress their discretionary spending trends. For now, though, the top tier of consumers are still spending at a relatively healthy clip on both discretionary and staple purchases.

Less affluent households continue to struggle with very low savings rates, which will put pressure on their ability to withstand a recession, inflation, and in particular the combination of the two as we likely experience them together this year.

Between less affluent households struggling for much of 2022, the middle tier beginning to struggle, and more affluent households potentially pairing back spending as an inverse wealth effect hits home as monthly statements show losses instead of gains, we can certainly expect that the consumer's outsize impact on the economy will be felt. A technical recession is much more likely in 2022 than many economists may feel at present as a result of this increasing pressure.

One of the largest bubbles ever to exist in human history, crypto, seems to be popping. It's noteworthy as the scale of this bubble so thoroughly outpaces others that it's .. off the charts. Almost. A big reason the crypto, ARKK, and FANG+ bubbles are popping together is the harmonized deleveraging being motivated by tightening financial conditions.

A trend set to continue until the Fed eventually pivots. For now they are effectuating policy goals by taking the wind out of the sails of various asset classes, which destroys wealth and as a result compresses economic activity over time.

We can see the impact of ever tightening financial conditions causing further harmonized deleveraging as multiple asset classes saw major weekly losses over the last two weeks.

This trend of relentless multi-asset selling has led to the largest wealth destruction in modern market history, historic selling that is certainly damaging sentiment among everyone with stock and bond exposure.

Meanwhile, the real estate market is not escaping the carnage as mortgage demand is falling to levels not seen since 2000. This further suggests that the housing market is set to fall as home buyer sentiment is the worst in history, rates are rising rapidly, and many remain priced out. This matters a great deal as housing is about 15-18% of US GDP.

In sell-side analyst land, S&P 500 earnings estimates remain hopelessly optimistic in the face of a near certain recession. Not a good sign for bulls that may be hoping a lower P/E suggests that equities are cheap.

Recent bear markets lasted a lot longer and declined more than the COVID crash, suggesting that this bear market may have much further to go both in price declines and in time. The Fed has no interest in pivoting until they're able to give the appearance of temporarily subduing inflation. Until they do a new bull market is not likely to be born. The longer this multi-asset bear market rages on the more likely it is that we see the second order impacts drag the economy lower until the Fed eventually pivots.

Eventually global debt will matter to the world's central banks, as increasing rates and tightening liquidity are going to cause an untenable situation. But for now inflation remains the name of the game being played, and until the velocity drops or something breaks spectacularly, it seems unlikely that major central banks will blink.

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