To The Moon

A rising stock market must climb a "wall of worries". When everyone is positive about shares, the time has come for the stock market to fall. The reverse is more or less true. A falling stock market has to deal with a 'wall of hope' along the way. When hope is lost, all seems lost. But at the moment when no one is happy anymore, the moment has come for the stock market to rise. After all, the only possible change for market participants is that they become more positive. After seven or eight weeks (depending on the index), it finally happened on 20 May and all hope seemed lost. The sentiment was so negative that the stock market was bound to rise. Not that there was any good news, just the fact that the bad news was no worse than feared was enough. What is striking is the still widely supported hope for a soft landing for the US economy. Despite the fact that Powell has already indicated that it will not be such a soft landing this time, many parties remain convinced that the high inflation rate can be reduced to 2 per cent or even below relatively painlessly. In the 1970s, 1980s and 1990s, this required policy rates to rise well above the level of inflation, but a strikingly large number of investors continue to believe that disinflation is the norm and inflation a major (temporary) exception. What the Fed actually wants with a soft landing is for the number of job openings to come down without unemployment rising. In the past, when the number of job openings fell, this was always combined with rising unemployment. Hoping for an impossible soft landing, some investors believe we have seen the bottom of this correction. The dollar has turned and interest rates have spiked, after all. The problem, however, is that the Federal Reserve does need to trigger a recession to get inflation under control, and it remains to be seen whether the US central bank is panicking enough to make that happen. There is a chance that Powell will point to slowing growth and gradually falling inflation as a sign that Fed policy is working. This would give the Fed room to ease off a little, if only because the central bank does not want to get in the way of elections in early November. If the Fed were to do that, it would be making a mistake (just as it was wrong to see inflation as a temporary phenomenon) and inflation would stay high for longer. The probability of a recession has increased this year, but it is probably overestimated. For the time being, the US economy is benefiting from higher oil and gas prices, high food prices and the greatly increased demand for weapons. Unfortunately, there are just not enough people to fill all the vacancies resulting from that extra demand. The latest jobs figure does not show that a recession is imminent. Rather, given the number of job openings and ever-increasing wages, it looks like the Fed is stimulating the economy. So it is good news for the economy, but bad news for the Fed. Nevertheless, there are clear signs that the economy is slowing down. The purchasing managers' indices are falling, for example, and if one subtracts the lagging indicator of inventories from the most influential sub-indicator (orders), the picture is decidedly gloomy. CEOs, too, are clearly becoming less enthusiastic, as the media revealed last week. Now there is plenty of speculation that they know something that the rest of the world cannot see, but that is not so bad. The CEOs simply see sales growth slowing and costs rising. This negative shear is eating into profit margins and a typical Pavlov reaction is to fire people to cut costs. There are indeed several companies that have announced 'mass layoffs', but this is not yet visible in the broader unemployment figures. Only retail is doing less, but the number of jobs is growing in the other sectors. In May, almost 400,000 jobs were added, and the unemployment rate was 3.6 per cent (the lowest point in the past five years was 3.5 per cent in September 2019). The worsening picture is also visible in earnings valuations, which are at a tipping point where there are more downward revisions than upward ones. It is going down gradually, after all, there is no recession. Last week, Microsoft warned of the impact of the strong dollar on the results, but then Microsoft is a company that realises a large part of its turnover is outside the US. Negative earnings surprises and rapidly disappearing liquidity make for a dangerous combination. In the past, both factors almost always went hand in hand with a further falling stock market. Even if there is no recession, for the time being, earnings estimates are simply too high. All in all, this creates an additional downside risk for US equities of around 20 per cent from current levels. However, this does not apply to all companies. In particular, there is a normalisation of valuations, after years of widening differences between shares. Expensive shares are correcting, but cheap shares - with the energy sector in the lead - are rising, including in valuation. It is striking how well the oil price is holding up and even rising. OPEC came up with a disappointing increase in production, probably in the knowledge that it would not be able to deliver anyway. In the past, OPEC members always produced too much when the oil price was above USD 100 per barrel. Now, 8 of the 10 largest OPEC countries are already failing to meet the agreements previously made. In addition, both the Americans and the Russians are producing 1 million barrels less than before the corona crisis. For the time being, no new capacity is being built and we are waiting for a drop in demand as a result of the sharp rise in oil prices. There is a strong correlation between rising oil prices and a further rise in inflation. Read more about the perfect inflation storm here. The price of oil is trickling down into the wider inflation rate. For example, a striking number of farmers are sowing smaller areas this year because of sharply increased costs. The price of diesel has risen sharply for farmers. Fertiliser prices have risen even more sharply. This means that a farmer has to make much larger upfront investments and then wait for an uncertain return. Now, on balance, there is still enough food for the entire world, but stocks are dwindling and changing weather patterns, which the IPCC has linked directly to the climate crisis, are increasing the likelihood of a 'dust-bowl' scenario. Putin says he wants to allow exports of grain and sunflower seeds from Ukraine, but only after the rest of the world eases sanctions against Russia. The chances of that happening are, for the time being, nil. Meanwhile, he is bombing grain silos in Ukraine. Higher food prices are the result. Food and energy are not part of core inflation, but since everyone needs food and energy, this allows inflation to rise across a much broader front. In a month's time, the Federal Reserve will go full bore with quantitative tightening. Instead of 120 billion purchases per month, 95 billion will now be sold. The impact of liquidity on financial markets is often underestimated. Research by Morgan Stanley shows that it is precisely this liquidity of the central bank that has made the mantra of 'buy the dip' (BTD in the graph) work since the Great Financial Crisis. The new mantra is then 'sell the rally' because the Fed put no longer works, or at least it has been given a much lower strike. Meanwhile, financial markets are starting to feel the pain. In any case, the absence of the Fed put is causing more volatility. Next Friday, the United States will publish inflation figures, and a disappointment there could lead to a further continuation of this correction. The stock market usually uses only one narrative at a time: in the first three months of this year, markets were worried about rising inflation, but after the Fed announced its 50 basis point rate hike, this was replaced by the narrative of fear of recession. Inflation data next Friday could shift the narrative back towards inflation fears. The problem is still that long-term inflation is structurally underestimated.