No Place to Hide!

No Place to Hide!

The financial markets around the world have been in a “bear market.” Germany has declined 24%, London 22%, and Japan 19%. The Chinese markets, Shanghai and the Hang Seng, have fallen 24% and 32% respectively. The surprise to many is the bear market in U.S. bonds, down over 25%, the first in decades. The U.S. equity market has had a similar experience.

At the same time, the traditional hedges against inflation have been no help. Gold has fallen 24% and silver over 30%. Even the new hedge, cryptocurrency, has fallen. Bitcoin is down 70%.

The Federal Reserve’s relentless and very aggressive increase in interest rates since March (25 BP), May (25 BP), June (75 BP), July (75 BP), and September (75 BP) raised the interest rate from near zero to 3.00 to 3.25% at the September meeting. The upcoming November 2 meeting is likely to produce another 75 basis point increase, taking the Fed Funds rate to 4%. Market participants expect the rate to move to the mid to high 4s by the middle of next year.

The intensity with which the Fed focuses on the inflation fight stands in stark contrast to the benign approach taken when inflation was accelerating.

The consequences of these unprecedented rate increases have yet to be seen. One to two years should be the expected lag time. However, cracks in the economic system are already being felt. The housing crisis is deepening and likely to get worse with the subsequent rate hikes. Starts, permits, and prices are moving down. Consumer credit continues to grow, and the debt burden is worsening. Banks have substantially increased their reserves for bad debt. Moreover, consumer spending has stagnated, providing little impetus to GDP. A retail and wholesale inventory cycle is working its way through the economy. From shortage to oversupply is the bane of numerous industries, spanning the apparel & footwear to the semi-conductor industry. Freight rates have fallen sharply, between 63% to 80% year-to-date according to two primary logistics indices, suggesting weakness in the flow of goods throughout the economy.

Given the cautious tone of the technology industry (one of the biggest Cap X spenders), capital spending is likely to be under pressure. Such spending provides the basis for productivity growth and thus offsets inflationary pressure.

There is a problem emerging from the Fed actions that is just beginning to be discussed.

A currency crisis has emerged and is likely to get a lot worse given expected rate increases. The yen has fallen 22%, the Euro 15%, and the British pound 17%. Japan has already intervened, attempting to keep the yenabove 145, so far successfully. The Bank of England had to rescue the British pound by direct intervention into the bond market. The Euro has fallen to 0.97, another low. These are reserve currencies acting like the product of third world countries. Unaddressed, an enduring stronger dollar would translate into export headwinds felt by U.S. multinationals across numerous sectors, including consumer, industrial, health care and technology. Further, the emerging market nations are suffering from dollar denominated debt and will have enormous difficulties servicing the debt. All this is taking place at a time when geopolitical pressures are building between the world’s two leading economic powers, the U.S. and China, creating greater economic and security uncertainty.

Although the Fed has paid only lip service to the crisis, any additional Fed action will intensify the crisis and it will have no choice but to respond. The dollar is the world’s premier reserve currency, and the U.S. Central Bank needs to act like it.

One thing is certain: a lot of changes will be forthcoming over the next several months, and many of the Fed’s and others’ forecasts are going to be wrong.

Certain trends seem to have emerged. Industrial commodity prices have declined sharply and made new lows in response to gradually improving supply chains and soft factory orders. Lumber in particular has fallen over 60%. Meanwhile, inflation associated with key consumer-oriented spending categories, such as energy and agriculture, remain stubbornly resilient due to supply constraints.

The equity market is struggling with the rise in the 10-year treasury rate to 4.0%, particularly technology stocks. Many of those stocks have compelling valuations, selling at multiples below the S&P 500. But the algorithms seem to focus upon the rate. Risk of recession in the U.S., recessionary conditions overseas, and dysfunctional currency markets can only be ignored so long by the Central Bank. The negative investor sentiment and the huge cash positions are poised to respond to a crack in the Fed’s armor.