Mr. Market Found His Enemy—In the Mirror

Due to travel associated with a conference this week, HAI will offer weekly prices and just some brief thoughts on an eventful week. In short, the set-up discussed in previous HAI’s remains. Markets are getting an energetic relief rally, but hopes that the bear has returned to the den for another long hibernation are, very likely, extremely misguided.

Despite a 75 basis point rate hike by the Fed on Wednesday, followed by a second quarter of negative GDP growth on Thursday, stock indexes continued to gain ground this week. That said, decades-high inflation causing the Fed to keep raising interest rates in the face of a slowing economy continues to provide an extremely negative economic environment.

Two consecutive quarters of negative growth is usually the “technical” definition of a recession. This week, we checked that box with a negative 0.9% Q2 GDP contraction on the heels of Q1’s negative 1.6% decline. That said, the brunt of the economic slowdown very likely remains ahead of us. Nevertheless, the bear market rally discussed in last week’s HAI did indeed carry still higher this week. In fact, it did so aggressively into the month-end close on Friday. The current bullish narrative maintains that we’re only dealing with the threat of a “mild recession,” all the bad news is priced into markets, and the much-anticipated Fed policy pivot is just around the corner. In other words, the voice of Mr. market seems to be saying, “Let the good times roll—again. If you reluctantly set down your speculative mania stock picking playbook in early 2022, go ahead and pick it up again.”

This take on the state of the market, however, may be just a bit too good to be true. It is very likely quite premature, and rather ill conceived. Going back to early 2021, it was the emergence of inflation that started to drain the punchbowl at the party. If inflation was going to make its presence felt, then the writing was on the wall for consumer pain, eventual corporate stress, and a less accommodative Federal Reserve. 

Remember, at this stage in the progression of our debt-laden credit-based financial system, it’s not low interest rates that markets are addicted to, but falling interest rates. In other words, it’s not just easy financial conditions that make bull markets, it’s ever-easier financial conditions. We do not have such conditions now—quite the contrary; and we are unlikely to have such conditions for some time. Interest rate hikes have already started to contribute to a slowing economy. The slowing effect of higher rates takes time to fully manifest. This week, the Fed added another 0.75% jumbo rate hike at the FOMC meeting. While a significant relief rally is standard operating procedure in a bear market, there is a very real Catch-22 opposing a resumption of the speculative bubble bull market of old.

Inflation is exceedingly high all over the world, and has yet to demonstrate any downward trajectory. As markets embrace the all-clear narrative, stocks rip, financial conditions loosen, and key commodity prices begin to surge again. The “bad news is good news” view means poor economic data will cue the Fed pivot. However, that view is negated by the fact that consumer prices never actually fall. In such a quagmire, the market’s attempt to continually front-run a policy pivot negates the necessary preconditions for such a pivot.

For this economy and markets, higher rates and tighter financial conditions are similar to exposure to radiation. There is a delay between the exposure and its negative effects. It would be a costly error to absorb higher doses of radiation for a longer period of time just because the devastating effects have yet to appear. The economy and markets are playing with a similarly dangerous dynamic. Efforts to front-run a Fed policy pivot may keep ultra-high levels of inflation in place and continue to force the Fed to raise interest rates further. The net effect is to push the timeline of a pivot—the pivot the market’s rally is predicated upon—ever further out in time. As that happens, the rally finds itself on increasingly shaky ground while the economy sinks into an ever more problematic trajectory. 

Nevertheless, the markets needed a risk-on relief rally, and they’re getting it. Probabilities, however, are still extremely high that the awakened bear still has substantial unfinished business ahead.

Weekly performance: The S&P 500 gained 4.26%. Gold was up 3.15%, silver was up 8.49%, platinum was higher by 2.61%, and palladium was up 5.49%. The HUI gold miners index gained by 3.04%. The IFRA iShares US Infrastructure ETF was up 7.11%. Energy commodities were higher. WTI crude oil was up 4.14%, while natural gas was up slightly by 0.41%. The CRB Commodity Index was up 3.88%, while copper rebounded by 6.57%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 4.73% on the week, while the Vanguard Utilities ETF (VPU) was up 6.51%. The U.S. Dollar Index declined by 0.79% to close the week at 105.78. The yield on the 10-yr Treasury lost 10 bps to end the week at 2.67%

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC