To The Moon

The global equity market is only just below its highest point ever. This is probably caused by the rotation out of bonds and even cash into equities. This is because the real interest rate (interest minus inflation) is so negative that investors are, as it were, fleeing in equities. Contrary to bonds or a savings account, companies are able to compensate for inflation, which is also demonstrated by the strong rise in producer prices. In the last quarter of last year, the US economy grew (annualised) by a nominal 14 percent. This year, nominal growth of 9 percent is still expected. The extremely negative real interest rate is also undermining purchasing power. This phenomenon can also be seen in countries like Venezuela or Argentina, as soon as hyperinflation occurs. Then these stock markets (in local currency) take the lead. At the same time, however, there are increasing signs that the picture is tilting. 

SPDR MSCI ACWI IMI UCITS ETF

First of all, there is the inverse yield curve. Over the last 70 years, each time an inverse yield curve has been followed by a recession, although here too, correlation is not the same as causation unless someone dares to argue that there is a link between the inverse curve a few months before the corona outbreak and the deep, short recession that followed. Furthermore, the yield curve is no longer the yield curve. Quantitative easing has pushed interest rates to the long side. This is not only done by the central bank but also so-called DC pensions buy more bonds as soon as interest rates fall. Furthermore, investors still flee into bonds when there is turmoil. All in all, this is an effect of almost 1 percent and, corrected for this, the curve is much steeper. The Fed is also probing an inverse curve via the dot plot. If interest rates rise to around three percent, but the dot plot assumes a long-term neutral interest rate of 2.5 percent, the curve quickly inverts to what is currently discounted. In 1994, interest rates were even 1 to 1.5 percent above neutral and there was the scenario of a soft landing in 1995. An inverse interest rate curve is especially a problem when the profit share in GDP (profit margins) is high and unemployment is low.

What is an indicator of more bad news is that unemployment is now below the level where there is full employment. This is evident from a large number of job vacancies and the many people changing jobs (for higher wages). Combined with high inflation, this means a high probability of further wage increases. It is said that comparisons with the 1970s are not valid, because the unions were much stronger then, but now there is the transparency of the Internet and social media are much more capable of campaigning than the unions. Everything shows that wages are starting to rise and that the end is not yet in sight.

Despite the already priced-in rate hikes, interest rates can still go up a lot further. The Fed has two objectives, maximum employment and 2 percent inflation. According to the FOMC, the objective of maximum employment has been achieved. Furthermore, the average inflation rate according to the FOMC (Core PCE) has stood at 2.1 percent since 2018. For the future, the Fed is assuming 2.3 percent at the end of 2024. At that time, the five-year inflation forecast according to the Fed is 2.4 percent. If both targets were met, the Fed would not need to raise interest rates again. But apparently, the Fed itself is not convinced that future inflation will be limited to 2.4 percent either. In the past, much higher interest rates were required to suppress current inflation.

In the past, the valuation of the stock market fell as soon as inflation rose above 3%. Nowadays, the actual inflation is much higher, but for the longer term, it is better to look at the inflation expectations (as shown, for example, by the 10-year break-even). Whenever interest rates rose more than 1.8 percent in the past, a correction in the stock market always followed.

Rising interest rates are also causing the risk premium to fall rapidly, and the stock market is no longer undervalued.

Earnings valuations are about to go negative, and markets then tend to fall. It is the Fed's explicit aim to ensure that prices do not rise further, for example by slashing the pricing power of companies. Profit margins in the US are at their highest point ever. The moment the Fed succeeds in preventing companies from raising prices while wage costs continue to rise, things can get rough.

The credit surcharges give the warning that more bad news is on the way.

The stock market normally peaks before there is a recession and well after the central bank has started to raise interest rates. It is interest rates that then stifle growth. But there are more negative feedback loops these days. For instance, rising energy prices also act as an interest rate hike, they inhibit economic growth. Growth is also inhibited by rising food prices (12 percent European CPI and 14 percent American CPI). The problems with corona in China and the war in Ukraine are causing further problems in the supply chain. Furthermore, growth is being depressed by the collapse of the Russian and Ukrainian economies. Business confidence has fallen sharply, as shown by the IFO, for example. Consumer confidence is under pressure due to high inflation. Finally, there is a risk that the sanctions taken will cause financial accidents, just as LTCM was an accident as a result of the Russian default in 1998.