AFMC - Primer On Starts Of Cyclical & Stagflation - Weekly Blog # 771

Summary

• Looking at the current US stock market, the determination of the next important market call is not known.
• Believers think the Fed can change inflation by controlling the interest rates. On the other side, there are pragmatists who see a much more complex world where stock and other prices can fall meaningfully for an indefinite period.
• Here we examine the nature of possible material downsides. There is significant, but not conclusive, evidence that such a period is coming.

Looking at the current US stock market, the determination of the next important market call is not known, at least not by me. On one side, the believers think the Fed can change inflation by controlling the interest rates. On the other side, there are pragmatists who see a much more complex world where stock and other prices can fall meaningfully for an indefinite period.

Recognizing that I, like everyone else, am a gambler, I look at how to prepare investors for either extreme. As usual, I find an imbalance born from a “liberal arts” education and the short-form media. We have been conditioned to find an easily understood important trend demonstrating future growth. Because of its relative rarity, there is little knowledge concerning the downside of recessions/depressions and stagnation. Unlike the happy talk of growth, most people don’t want to focus on periods where people get hurt financially and emotionally.

Without predicting a significant move to the downside, I am gambling our time by examining the nature of possible material downsides. There is significant, but not conclusive, evidence that such a period is coming. If such a period does not come soon, at least you will have learned what to watch for in the future.

Troubling Signals

As with many laundry lists, the order of observation is accidental and not meant to signify rank of importance or order of future troubles.

• Continued short-term US Treasury rate inversion.

The 2-year rate is 4.51% which for many is attractive. This is quite competitive with stocks yielding less with uncertain futures.

• Stock prices fell for 4 days last week.
  
  
• Excluding energy earnings, other companies lost -7.1% in ’22.

Are we beginning stagflation starting with 2016?

• $2.2 billion going into international equity ETFs vs. $1.7 billion going into domestic ETFs.
  
  
• Reasons for poor earnings from a successful importer:

High and expensive customer inventory leading to low replacement sales and dollar weakness. There appears to be a switch in strategy from profit focus to cash management.

• OPEC+ did not raise prices when Russia cut production.

Quite possibly they felt that Biden was inflationary, which could reduce demand.

• China’s Belt and Road Initiative is slowing and shifting.

Need more US imports to pay for China’s exports.

• S&P Global is not issuing guidance, as the future is uncertain.
  
  
• A number of financial services companies are changing CEOs or making material changes, like Goldman Sachs.

One of our concerns is that most organizations are currently led by people with political skills, not operating skills.

• 31.6% of net ETF equity flows are in Chinese investments.
  
  
• Liquidity is declining again.
  
  
• WSJ article headline “Retailers Hesitate to Accept More Inventory” from apparel makers.
  
  
• Global minimum taxes are inflationary.
  
  
• Wonder if the 60/40 ratio of stocks to bonds is misapplied.

Should it instead be applied to risk and less risk, with less risk defined in terms of income?

What is the Future?

While the gambler is forced to deal with possible changes to the present, the speculator accepts the present as the base case to build her/his model of preferred change. I am a combination of both, and don’t like the present or its logical path. With that in mind, I suggest the following radical changes, any of which might change our current trajectory to a better future.

Possible, But Unlikely, Changes

Recognize current economic problems are not a function of too little demand but of too little supply. Demand in the commercial world for the most part is a function of competition and customer desires. However, in far too many transactions, the heavy hand of government dictates what the customer will buy and at what price. It would be an interesting exercise to calculate how much government interference costs the economy!! My guess, it’s of the same order of magnitude as the cost to consumers of raising interest rates to somewhat ineffectively bring down inflation. (Inflation is caused by demand exceeding supply and excessive government grants.)

There are two other ways the government can reduce its costs and improve its services:

1. In an electronic age, there is precious little advantage in having major government departments and agencies located in D.C. for the ease of lobbyists and the enshrinement of the government working class.
2. Government at the Federal and State/local levels are monopolists. The existence of Chartered Schools largely demonstrates that the school system can benefit from competition. I wonder whether the same could be said for hospitals and other medical institutions.

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