The markets have recovered substantially in January, buoyed by declining inflation and optimistic economic forecasts. The Chinese recovery is a significant contributor to this optimism, as well as the relief in European attitude as the eurozone may emerge from recession. These are market elements that may prove to be a mirage. All of these developments may lower the likelihood of a recession, but stagnation remains a certainty.
Europe’s transition from a severe recession to stagflation due to a mild winter is hardly a bullish indicator. In addition, the Chinese reopening aids the sluggish global GDP prospects, but it may also perpetuate inflationary pressures. We cannot forget that the widely applauded inflation figure for November and December is a result of weaker global demand for commodities, and that the Chinese reopening will result in a massive increase in demand for oil, coal, natural gas, and copper at a time when inventories remain below their five-year average.
Concerning the markets, we must recognize that investors demand an accommodating monetary policy in addition to a positive earnings and cash flow generation surprise in order to justify the current multiples and bond values. Bond investors bet on the solvency of sovereign issuers that continue to adopt deficit spending policies and anticipate a bull market in tax receipts in order to accomplish fiscal consolidation. The majority of corporate issuances have shifted from extremely expensive to just costly. Indeed, yields have improved slightly, but many investors continue to be overly optimistic about cash flow generation, margins, and inflation.
Bonds are only attractive if you predict inflation will plunge into deflation in 2023 and 2024. Those who wager on a precipitous decrease in inflation may, however, overlook the causes of such a decline. A huge recession.
Note that when governments continue to overspend and raise taxes in an inflationary environment, the only way prices can fall is if private demand collapses. Consider the implications for earnings.
We cannot rely on both of these outcomes. As investors, we cannot truly think that inflation would fall to 2% with negative real rates, no balance sheet reduction by the central bank, and no reduction in government deficit spending. Either inflation falls due to a recession, resulting in more profits and solvency downgrades, or it remains higher due to high debt and government incentives, resulting in valuations that remain too high.
That reminds mt times in August 2022 when a 7% CPI print and hopes of a FED turn caused the market to surge. Remember, what happened in September and October.
We can not live or trade without optimism. Yes, there is a lot of cash on the sidelines, everything is already discounted, Europe will surprise to the upside, and central banks will begin cutting interest rates in July. These are optimist expectations.
However, I’ll attempt to be septhic and look from a different angle.
The myth that “cash is waiting to be invested” has been refuted numerous times. When mark-to-market impacts leveraged books and margin calls are triggered, liquidity evaporates rapidly. Numerous times, the notion that losing portfolios will begin to buy drops to double down has been refuted. Never bet on “money waiting to be bought,” because every day, everything sold gets bought. Furthermore, if we truly believe that there is capital waiting on the sidelines after the greatest January in decades, then we must wonder what they are waiting for (a 2008-style market crash? Can we allow that in our tiny books and portfolios?
The notion that “everything is discounted” is absurd because this is never the case. Since 90% of global funds are long-only, the markets are logically and naturally optimistic. In addition, the exact same rationale was used in August and March, yet earnings projections continued to decline. If we truly believe that the consensus has already discounted a decade of stagnation, which is quite probable, we should reconsider. nowhere near.
The fact that the majority of European stocks are value traps should not even be debatable. But it is even more evident that a transition from recession to stagnation due to a mild winter is not a positive indicator, but a fantasy. Remember that the profits estimates for Europe’s 600 top corporations still assume margin and earnings growth through 2024. Europe is inexpensive, but it is always inexpensive for a reason. It is illogical to think that European corporations are concealing unidentified growth and earnings gold nuggets.
Never before have tech companies shed so many workers. They are not foolish in their actions. They do so because they observe what consumers and citizens do each and every second. It’s not only technology, however. In addition to higher taxes, the reality of dwindling profit margins and constrained cash flow is impacting businesses worldwide.
A decline in earnings is more likely than an earnings surprise. Why? Analysts maintain high valuations based on a significant recovery in 2024, despite the fact that current earnings predictions already reflect estimates of mediocre growth and even recession. We cannot claim that earnings already account for the worst-case situation when Wall Street employs the oldest trick in the book. Say that their forecasts for the current year are extremely conservative and inflate those for the following year.
Remember that exceeding highly lowered fourth-quarter profit projections only to continue dropping estimates for subsequent quarters as a result of bad guidance is hardly “bullish.” It is a Wall Street tradition to manipulate consensus.
Central banks are also aware that they are not able to decrease inflation below 2% without a major decline in aggregate demand or a change in the mechanism of computing the CPI to conceal inflation, or both.
Changes in technique are currently occurring, although CPI inflation remains elevated. We read all over Wall Street that if you subtract the rising prices, inflation is already negative, which is obviously absurd. Inflation is never overestimated by the official CPI; the reverse is true.
It demonstrates our desperation for more cheap money to expand our portfolios.
The only thing that can diminish aggregate demand is a huge decline in private sector demand, as public sector demand remains steady or rises as governments continue to increase spending. Therefore, if we bet on central banks slashing interest rates beginning in July, we are equally betting on a massive private sector slump that is in no way reflected in mainstream forecasts.
Given that central banks are currently operating at a loss, it makes little sense to bet on rate cuts if we actually believe in a soft landing.
Both there will be stagnation and high inflation, which will cause rates to remain elevated for a longer period of time, or there will be rate decreases owing to a massive recession, which is negative for stocks and bonds.
Carefully consider your desires. If we bet on rate cuts in the second half of the year, we could also be betting on a massive economic and earnings collapse.
