The economy and the stock market are stuck in a circular loop, preventing the resumption of meaningful growth. The U.S. Federal Reserve has been doing what it can to try and talk the stock market lower since late 2021, with a goal of reducing wealth-generated spending pressure on inflationary imbalances. For many months, the Fed has even been hinting at the necessary pretext for a pivot in interest rate policy from a rising (tightening credit) to falling regime (expanding liquidity), namely a bigger equity decline on Wall Street. The problem is Fed attempts to talk down prices and valuations are not getting much traction.
In addition, actual bank interest rate increases have not been able to sink the economy enough to reverse policy into a neutral or easing stance. The conundrum facing Fed governors is inflation will not come back to 2% or 3% annual targets on their own, while Treasury deficit spending and interest expenses are spiking on credit tightening efforts.
Sure, a technical bear market drop of -20% became reality in 2022 for the major indexes. But, with headline inflation and “core” cost-of-living numbers still in the 5% to 6% annual range, banking policy is completely trapped into further rate increases until something breaks. I have mentioned the possibility of something breaking in the financial system several times since the summer, as now a prerequisite to end this tightening cycle. For example, (1) the dollar could tank on foreign exchange markets as confidence about U.S. deficit spending trends reverses, (2) banks may refuse to originate new loans as creditworthiness deteriorates and affordability issues come to the fore on rising rates, or (3) the stock market might crash on corporate profit issues in a developing recession.
My cautious view has not really changed in January, meaning the latest rally in the S&P 500 (SPX) (SP500) (SPY) (VOO), NASDAQ 100 (NDX) (QQQ) and Dow Industrials (DJI) (DIA) has done NOTHING to change the status quo.
Today’s loan, debt, and Treasury bond rates are honestly too high to sustain the economy, but too low to slow inflation down to 2% YoY Fed targets. Absent something breaking to add weight to macroeconomic downside pressure, while encouraging more conservative consumer/business decision making, interest rates may not change dramatically in 2023. So, if corporate profits begin to backpedal and interest rates do not fall, where will sustainable buying power for the stock market come from?
Treasury Debt Problem Gets Bigger
Without doubt, spiraling interest expense on $31.4 trillion in sovereign debt could crush all hope for a prolonged economic recovery past 2023. From a low around $400 billion in total expense during fiscal 2015, 2022’s interest paid number almost doubled to $724 billion (on crazy pandemic borrowing and now rising interest rates on hefty refinance activity yearly), and is set to eclipse $1 trillion as soon as fiscal 2023 ending in October!
Given rising deficits (again as the economy slows) and today’s interest rate setting of 4.6% on the short end of the duration curve (where most of our deficit funding and refinance needs exist), Treasury supply may soon crowd out capital flows into the productive parts of the U.S. economy, especially when the Fed is QE tightening itself (selling Treasuries). $1 trillion for interest expense works out to better than $3000 per capita in America, or $12,000 for a family of four as your share each year, just to pay interest on decades of past borrowing. If interest rates do not come down soon, escalating interest costs for Uncle Sam, businesses, and consumers may make future economic expansion all but impossible. My estimates are every 1% rise in the whole yield curve adds about $100 billion in yearly expense over 12-18 months and up to $200 billion annually over a 10-year span, with an average maturity a little over 6 years (assuming annual deficit financing needs of $2 trillion per annum in the future are financed at sharply higher rates than 2021).
Newly elected Republicans in the House of Representatives believe they can magically cut spending to balance the budget, but such would likely only invite an economic depression this year or next, as the government spending supports for the U.S. economy are kicked away (emergency deficit outlays since the 2008 Great Recession financed by Fed QE Treasury buying). I suggest we don’t try this medicine, because a hyperinflationary or deflationary bust will not be fun or constructive for any subset of the population (perhaps a select group of individuals that are prepared properly).
Recession Odds Growing Daily
So, if the stock market continues to rise, which encourages the Fed to keep tightening, where is this all leading? My simple answer is – TROUBLE. While numerous market followers are thinking a stock market rise in early 2023 means a recession won’t happen, I have news for you. We are in a Catch-22, tightening noose situation, where good news makes an inevitable Wall Street swoon and U.S recession MORE probable in the long run, not less. The stronger the economic news in early 2023, the tighter the rate noose will get, pushing a legitimate credit crunch into overdrive.
The 40-year record inversion spread in the Treasury yield curve has become quite pronounced since November. In fact, the spread of yet higher rates on the short end vs. now falling yields on the long end is telegraphing a dire warning vs. 3 months or 6 months ago. It is loudly forecasting a wicked slowdown in the economy sooner, rather than later. Consequently, I will follow the facts with my investments and not chase fluctuating crowd sentiment this week or next.
What To Do?
I am sitting at just 10% invested in regular stocks today, because an economic slowdown into recession may be all but assured, in my opinion, having followed the markets and traded them since 1986. I have about 35% invested in cash earning 4%, plus another 30% in intermediate and long-term bond funds earning 5% as a trade for 3-6 months (under the assumption a recession is next, and the Fed can prevent a Treasury confidence crisis). Lastly and most importantly, I have around 25% invested in gold/silver/platinum bullion and related miners of the monetary metals. A shockingly bad economy later in the year may cause a flood of buying interest as investors, institutions, and governments rush to the purest form of financial safety. If we only experience a mild recession, with another 15% to 20% of stock market downside, this combination of assets should also survive just fine. I am estimating the net portfolio asset allocation should grow a little in value, maybe +10% to +15% for annualized rates of gain.
The point is I am largely stepping aside from the market for a spell (not short equities mind you), waiting for a smarter entry setup. I am still doing my usual research and writing about the stocks I can find with momentum characteristics and misunderstood share valuations – truly worthwhile ideas in a risky market environment.
Plus, I am willing to forgo intermittent 5% or 10% rallies, like we have witnessed during July-August and November and January, patiently waiting for something to break. My view is significant upside on Wall Street is rather unlikely, as the stock market remains overvalued (a function of total worth still near all-time highs vs. GDP output, excluding the 2020-21 bubble) and interest rates remain in the 4% to 5% range (a 15-year high for most durations). The Fed has no defendable excuse to cut interest rates with inflation above 6%, and negative “real” yields (adjusted for inflation) still the here and now.
A stock portfolio fully invested now is actually positioned to “Fight the Fed,” which has proven a difficult task throughout history. The Fed would prefer a recession and lower stock market so it can quickly lower interest rates pressuring Treasury debt expense. That’s the end game in all this – keeping the Treasury solvent and able to function.
Otherwise, we get a real dollar confidence crisis and a recession far worse than any of us have experienced. Record sovereign debt to GDP of nearly 140% has grown to catastrophic proportions, where another deep recession could knock our economy into submission not easily recovered from. Modeling a severe recession $3 trillion in new federal deficits annually on a shrinking or flat GDP number (depending on inflation rates) could convince foreign investors that America’s financial prowess is coming to an end. Overseas capital inflows to continually finance our deficit spending are not a guarantee going forward. Don’t kid yourself. America is no exception. Eventually, the rotten federal deficit/debt math will catch up with us. Successfully living dangerously for decades may still end in a fiscal crash-landing, maybe out of the blue when a new black swan event appears.
Please refrain from calling me a bear or bull or pig for the time being on the market’s direction. Count me as a chicken. My goal is to live to fight another day. This tiger will pounce out of his chicken costume when the timing is right, perhaps when the stock market is forced to discount declining corporate profits in a recession and the Fed can shift back to money printing again.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.