Further Weakness in Equity Markets Seems Likely

Updated: Sep 1

Inflation hasn't gone on vacation

The disparity between G7 policy rates and inflation is among the largest ever, suggesting that not only do central banks have powerful motivation to keep tightening, but also that if inflation isn't brought down imminently through demand destruction, it could become even more deeply structurally embedded in to advanced economies.

Intractable inflation seems like such a strange notion after decades of disinflationary economic growth powered by a combination of globalization, technology, demographics, and abundance.

But the era of abundance seems to be coming to an end, whether we're talking about natural resources or capital. Many structural changes are happening underneath the surface that suggest inflation is likely to become a secular quandary moving forward.

Not the least of which is the imbalance of supply vs demand, whereas exploration, production, and transportation remain woefully insufficient. While demand can be destroyed, and inflation's velocity temporarily subdued, longer term these entrenched factors are likely to be increrasingly problematic in the next several credit cycles.

As a result it is reasonable to expect shorter, more shallow bull markets, and compressed credit cycles.

Economies seem set to continue slowing

While inflation remains robust, US and EU macroeconomic data is softening, suggesting that G7 countries are more likely to see continued economic weakness, which will likely drag emerging markets down with them.

Weak economic data is unlikely to convince central banks to pivot back toward easing, however, as inflation is the primary concern and economic weakness is actually necessary to achieve policy goals of destroying demand to subdue the velocity at which prices are increasing.

Therefore, unless the Fed truly breaks something or manage to subdue inflation, their path toward hiking further and reducing their balance sheet, with QT set to accelerate to a run rate of $95 billion per month in September, is likely to remain on course.

Global economic weakness is likely to pull down equities in combination with further central bank tightening. Earnings could decline about 20%, as the average earnings decline during a recession is 17.2% and it is unlikely that this will be a shallow and short recessionary period.

Therefore, when factoring for the cost efficacy of capital allocation, bear in mind that the E in P/E may drop by about 1/5th. As a result equities may not be as discounted as they may appear to be, at least in some areas of the market.

Watching the trajectory of Fed policy

Fed Funds Futures are now looking at a potential terminal rate as high as 4% to be achieved in the first half of 2023. This is a step up from the former ceiling seen at 3.75%.

Meanwhile, unfounded talk of an imminent Fed pivot led equity and bond markets to rally since the July Fed meeting, as well as after the CPI and PPI data sets from the same month, where energy volatility gave the impression to some that peak inflation was behind us.

An impression that may be proven wrong, but even if not, does not deter the Fed from their policy objectives of tightening to subdue inflation on a longer term basis.

2-year note rates suggest the Fed is at least targeting a 3.25% terminal rate, and we've seen no sign of the 2-year note completing its decline in price and rise in yield, something that often prefaces policy changes.

With QT set to accelerate in September, as the Treasury has also increased issuance in Q3 by 2.5 fold, it is likely that this will add to distributive pressure within risk assets as well as credit. Important to be mindful that the Fed and other central banks helped to juice this entire post-GFC party with 13 years of near constant emergency-level monetary stimulus and artificially low rates.

That is why the correlation between central bank balance sheets and the S&P 500 matters, and why QT is likely to cause further selling. Because central