Gloomy Look Ahead to 2023
Without liquidity coming, expect rough start for risk assets to start the New Year.
The framework I continue to operate under is that financial markets are in constant need of the "perpetually accelerating liquid machine (PALM)" that comes from the Federal Reserve. In a low population growth/low productivity world that is highly levered, economies need central bank liquidity in the form of low rates (and often asset purchasing) to achieve higher rates of growth and profits. Without this central bank assistance, economies will struggle and financial assets, which lead the economy, struggle even sooner. Thus, figuring out the timeline toward incremental central bank liquidity additions, specifically from the Fed, has become perhaps the most important determinant of whether or not broad based risk assets (equities) are going up or down. If this timeline to Fed liquidity is expanding, because the Fed is too far from its mandate to act (like now), this is generally bad for risk assets but when this timeline to Fed liquidity narrows (typically due to data deterioration that brings market's expectations of the Fed's reaction function closer in time), then asset markets tend to rally. The correlations of central bank liquidity and risk assets (SPX, bitcoin, etc) are too strikingly high to ignore.
So the question for now is how do we get liquidity to resume. In order for this to happen, as we have discussed, three conditions need to be met in order: 1) weaker growth is needed to bring down 2) headline inflation and this fall in inflation will lead to 3) rising unemployment, which will lead to lower wages and stomp out the core services inflation that worries the Fed so much. In my view, we really have really only begun to see some early stages of item #1 with falling ISMs as a proxy for deteriorating growth momentum. I suspect ISMs will continue to roll over nicely in the coming few months, particularly as China growth has been sluggish and only now re-opening while the lagged impacts of higher interest rates are finally catching up to the US economy in a large way (first housing and autos, now becoming more broad-based). We have seen the peak in headline inflation and oil/commodities prices are falling amidst global growth concerns but the issue for the Fed and thus market liquidity junkies is that the US labor market remains still too resilient to expect a material move higher in unemployment to lead to lower wage growth to lead to rollover in core services inflation. Wage growth remains robust, companies are reluctant to lose employees given still tight labor market and those that lose jobs continue to have an easy time finding new employment (even in technology).
It is this gap between current labor market conditions and the market’s need for perpetual need for liquidity that has us more concerned about risk assets for the early part of the year as the Fed is unable, given its mandate, to address the signs of deteriorating economic momentum clearly visible in the economy. It is my contention that as risk asset prices come to grips with this reality in the first quarter, and we see materially lower equity prices, we will begin to accelerate this labor market slowdown which can lead to a pausing of rate hikes and an eventual easing of financial conditions from the Fed, perhaps in 2Q. But first things first. Asset markets need to correct substantially lower in order to get headline inflation down much more quickly in order to bring about concerns about labor market momentum. Expect a rocky start to 2023. We are set-up risk off (long gold/short equity indices)
*Important Disclaimer: This blog is for educational purposes only. I am not a financial advisor and nothing I post is investment advice. The securities I discuss are considered highly risky so do your own due diligence.