Answer is who the hell knows! In this super complex world, this year market has been on a precipitous decline with Russia, China, pandemic, and supply chain issues in the mix.
However, for fun and games, let me lay out a framework. Broadly, in the near term (next 6 months), I would expect a recession and potentially additional 10% declines in the market. Here is my Base Case:
- Recession in 2nd half of the year
- Inflation eases off
- Equity market (S&P) drops by another 10+% in the next couple of months, but start to recover from that point onwards as…
- …Fed starts backing off tightening
Recession in the 2nd half of the year, to me, seems to me like a high possibility – ISM readings which are leading indicator for the economic growth are heading closer to 50, which is close to recession predictor. Yield curves have inverted lending further weight to this theory. Mortgage rates jumping higher by 300bps will likely kill the housing market – when someone said that housing is the business cycle. Dollar is also connected to business cycle – when it goes up, the cycle goes down. Overall, I think pretty high chance of recession.
The direction of inflation is perhaps the most important question that will determine the directions markets take in the next half of this year. Typically markets are up 12 months after a fed tightening begins, except when the inflation remains high. If the inflation remains high and job market continues to remain strong, Fed will continue to tighten the “financial conditions” through rate hikes, until the demand is pummeled into control.
However, to me inflation looks like it may peak soon. Inflation easing off is just a mathematical necessity at some point due to base effect. However, the question is whether the inflation momentum eases off. I think the prices remaining high will continue to drive the demand lower, as it has already done for some commodities. My overall view is that the demand is currently going down as a result of higher rates (e.g., mortgage servicing costs, etc.), declines in wealth effect, and the slowdown in growth. This will drive cooling off of inflation in the later part of this year.
So, if we consider an impending recession, strong job growth, continued inflation (at least for the next couple of months), what happens to the equity market? We have gone down 15-20% already (depending on if we look at S&P or NASDAQ). Typically, recessions will bring about 30-50% declines in the stock market – I think we are easily looking into another 10% fall over the next month or so. This could be much worse, if inflation does not cool off. Fed has kinda taken off the anticipated 75bps increase in the FOMC meeting for the next month, but it could easily be another 50 bps increase. Overall, in my base case it is likely that market reamins in this bear market territory for the next 2-3 months. Keep in mind that markets predict recession months in advance and when the economy is actually undergoing recession (say second half of the year), markets may actually be starting to look at the recovery.
On Fed, the question is whether we have lost the Fed put? I.e., is Fed going to come back in with Quantitative Easing if “financial conditions” (aka stock market) starts tightening again. I think that the Fed will continue to provide a “Fed put” while giving the impression of fighting inflation. We are at the end of the long term debt cycle – debt levels vs GDP are currently so large that in order to reduce them, monetary denominators have to be increased. This means an overall negative real rate, continued fiscal and monetary stimulus with a significant inflation component. This policy is needed to effectively inflate portions of the debt away. What I am implying is that Fed will at some point come back in, and effectively prop up the market again through fiscal spending (and who knows, may be even some rate cuts).
Regarding, long term asset allocations – in my mind targets have not yet changed. Are there some undervalued assets to own in the near term. I think gold seem pretty good right now for a long term buy and hold – dollar is very strong and having gold in the portfolio provides hedge against the end of long term debt cycle currency depreciation theory (if that ever happens). Banks may also look appealing. Due to all the stress testing requirements, they are well positioned to handle recession and benefit from higher yield environment. I think bonds are also semi-attractive right now – given economic slowdown I would expect the yields to come down at some point. Not sure, if I would think about investing into anything else for now, given the near term headwinds.
| Asset Classes | Near Term Outlook (Rest of 2022) |
|---|---|
| Traditional Equity – USD Exposed | 25% (Hold, Bank stocks may be interesting to slightly increase exposure, e.g., GS) |
| International Equity | 10% (Hold, Both Europe and China have seen major correction) |
| Precious Metals and Commodities | 20% (Overweight, Strong dollar and recent dips provide opportunity for long term hold) |
| Cryptocurrencies | 5% (Hold, BTC has shown surprising strength vs. NASDAQ, where earlier it was super correlated) |
| Total Bonds and “Bond Like” | 5% (Overweight, the long duration yield increase has diverged from economic indicators like ISM – may lead to yields dropping) |
| Real Estate | 15% (Underweight, I would expect housing market to correct significantly due to higher mortgage rates) |
| Cash | 20% (Overweight, near term equity headwinds expected – preserve cash for opportunistic investments) |
These are complicated times. It is the “Fury road” ahead! Good luck.
Macroeconomic and investment musings 