The coming new year will be fraught with risk due to the removal of central bank and government supports. This could very likely lead to a collapse of the most overvalued stock market in history.
According to the Conference Board, U.S. economic growth is set to slow to 3.5 percent during 2022 from 5.5 percent annual growth for 2021. Of course, Wall Street apologists almost never predict a recession until we are in the middle of one. Nevertheless, it’s clear that the growth of the economy will slow significantly next year. And, in the view of Pento Portfolio Strategies, the risk of a recession and an asset bubble collapse is high.
S&P 500 EPS growth will plunge to just 5 to 6 percent in 2022 from 45 percent this year. Again, this is the optimistic view that leaves a great deal of room for error to the downside and virtually zero to the upside. After all, you can only open up an economy once following a pandemic, and that already happened this year. And, it will be nearly impossible to comp the previous two years’ $6 trillion fiscal support, along with the $4.6 trillion expansion of the monetary base.
We recently learned from the BLS that consumer price inflation (CPI) surged by 6.8 percent, and producer price inflation shot up by 9.6 percent year-on-year (y/y) in November. This helped to send real average hourly earnings falling by 1.9 percent from November 2020 to 2021. CPI is running at a 40-year high and is at a rate that is 3.4 times higher than the Fed’s asinine 2 percent target.
Of course, the clueless Federal Reserve finally started reacting to all this inflation by announcing at the December FOMC meeting that it will speed up the pace of its taper by two times. But this is happening just when the rate of inflation is actually peaking. In reality, Fed chief Jerome Powell had no choice but to expedite the tapering of his QE program. After all, it’s an untenable notion that the Fed should be adding to the supply of money at a breakneck pace when CPI is the highest since 1982.
But without question, Powell deserves much derision for waiting until inflation reached a multi-decade high before starting to taper asset purchases, let alone begin to raise interest rates off the current level of zero percent.
It will take (10) 25 basis point rate increases to reach a 2.5 percent Fed Funds Rate (FFR), which the FOMC now regards as a neutral overnight lending rate. Powell believes a neutral FFR would be 50 bps above the FOMC’s 2 percent inflation target—assuming inflation falls to that level. In spite of these plans, the chances are very small that the Fed will end up being able to hike rates very much at all before the entire artificial economic construct comes crashing down. This is because the yield curve is already rapidly heading toward inversion even before the tapering of QE has really even begun.
An inverted yield curve is a predictor of recession that has worked 100 percent of the time. The spread between 2- and 10-year notes has already contracted from 159 bps at the end of March to just about 75 bps today. Meaning that by the time the QE taper is consummated, there probably won’t be very much room at all to hike rates before an inversion takes place.
But regardless of the Fed’s feckless nature, the fact remains that the biggest buyer and direct supporter of mortgage-backed securities and Treasury bonds, along with its stated support of corporate debt (including junk bonds), will exit the market entirely come March 2022. This leaves a tremendously dangerous vacuum in place, especially in non-government-backed debt. The Fed’s QE program has kept the massive real estate and equity bubbles afloat, as well as the $12 trillion worth of business debt from imploding. But that must end now because inflation is a real issue.
Then, you must factor in the stubborn COVID Delta variant and the new and more contagious Omicron mutation, which Powell now views as potentially adding upward pressure on inflation. This could cause the Fed to tighten its monetary policies even more quickly. The consumer will be left with the complete lack of any fiscal support of any significance next year, after receiving $50,000 on average per U.S. family over the previous two years.
The truth is, the solvency of nearly every developed nation on earth is contingent on interest rates that remain in the sub-basement of history—aka, record lows and around zero percent. This is only possible if central banks maintain complete domination of free-market forces and keep their hydraulic presses down on yields. Let’s be honest, without the backstop of these state-owned entities, solvency and inflation concerns would combine to force yields much higher.
In the case of the United States, with CPI inflation at 6.8 percent, and with a national debt-to-income ratio above 725 percent, it would be impossible for a 10-year treasury bond to yield just 1.4 percent without the heavy hand of the Federal Reserve. The point here is that the United States has an immense solvency and inflation problem now, yet still enjoys record-low borrowing costs because of the Fed.
However, this function is now changing. A central bank can usually usurp the free market regarding its sovereign borrowing costs as long as both solvency and inflation concerns are quiescent. For example, the Fed has yet to truly exit its yield curve suppression programs, which have existed for the better part of the past two decades, because consumer price inflation wasn’t an issue. This is true even though our nation’s debt to GDP ratio is higher today than at any time since World War II. Up until this point, that growing trend toward insolvency has been veiled thanks to the central bank’s interventions. But the resurgence of inflation, in conjunction with that humongous debt burden, has become extremely problematic.
In the absence of inflation, central banks have been able to print enough money to ameliorate recessions, bear markets, real estate debacles, and solvency concerns such as the European debt crisis circa 2012, when bond yields in the southern periphery soared to 40 percent before European Central Bank chief Mario Draghi promised to monetize the debt issues away. Again, he could only accomplish that because inflation wasn’t a concern a decade ago in the eurozone.
Turning back to the United States, the next recession, which is likely to occur in 2022, will cause solvency concerns to spike as revenue collapses and the national debt-to-federal-income ratio soars. However, this time around, the Fed’s ability to monetize away collapsing asset prices and crumbling economic growth will be fettered by an inflation rate that is already many times greater than it’s comfortable with.
That leaves the Fed and Treasury with a dangerous dilemma: Allow asset prices and the economy to implode, which will fix the inflation problem but will most likely lead to a depression, or try to pull the economy and assets higher by once again borrowing and printing multiple trillions of dollars, which will send the rate of inflation skyrocketing from its 40-year high. That will risk destroying confidence in the USD and any faith that remains in the bond market. Therefore, the stock market and economy would collapse anyway as inexorably rising inflation pulls yields on sovereign, municipal, and corporate bonds ever higher.
Wall Street’s perma-bulls will never admit that Fed Put has now expired. Of course, the Powell pivot will indeed happen once again as he meanders between hawkish and dovish depending on the lagging economic data he receives. But his next pivot back to an uber dove will only occur ex-post the Great Reconciliation of Asset Prices. This is why a buy-and-hold strategy no longer works and why identifying inflation and deflation cycles has become so critical.
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