Stock markets in the era of high inflation part 1
As inflation prints are coming hotter and hotter, and the bond market keeps tumbling lower, there is a lot of debate on whether the stock market remains a good ‘hedge’ or ‘bet’ under these conditions. Well, this isn’t an easy debate and there are no easy answers, but in this analysis, I will try to outline certain important things I am looking at. I will also provide both a short term and long-term outlook by using both fundamental and technical analysis, however I will split the analysis into two pieces. This is part one and you will find part 2 in the links below.
First of all, I’d like to look at the big picture and then start zooming in, as it is good to have an idea of where the global economy is right now and how that affects stocks. Well, the global economy is not in a good place as there is too much debt in the world, supply chains have all sorts of issues from the China lockdowns to the war in Ukraine, the population is aging, Covid created a lot of negative imbalances and the underinvestment in commodities has create a lot of shortages. Now all these are occurring after stocks had reached insane valuations in 2020-2021, inflation is at multiyear highs and at the same time the Fed wants to hike rates by 0.5% on every meeting in 2022 in order to fight that inflation. Their goal is to reverse the wealth effect it created in 2020-2021 in order to fight deflation, and they might keep hiking until the stock market collapses.
When someone looks at all the above, he must be thinking that shorting stocks is a great idea and that the market will collapse soon. However, the truth is that the US economy is in a much better shape than many others as it produces a lot of the commodities it needs, US companies have been strong and earning prove that, while several companies substantially benefit from the current inflationary circumstances. For example, consumer staples and commodities producers are greatly benefiting from all the shortages and therefore their stocks have gone up. Of course, not all companies are doing well, as many of the more unprofitable/speculative companies are suffering greatly due to their profits being reduced or the debts repayments being increased. Higher inflation is eating away from the profits of some of those companies, while higher bond yields have increased the borrowing costs for others. These in turn have a negative effect on the stock prices at best some of these companies pay less dividends, while many companies might be pushed to bankruptcy if they can’t repay their debts.
You might now be thinking: ‘If so many companies are doing poorly and bond yields are going higher, shouldn’t we be worried? If the 60/40 portfolio is getting crushed, couldn’t that create a larger crash? If the Fed is ‘telling us’ that it wants stocks to go lower, shouldn’t we get out?’ Well, during all the previous hiking cycles stocks mostly rose at the beginning and fell towards the end, and in our situation the Fed has barely begun hiking. Bond yields going higher means that bonds are being sold, and some of that capital could redirected into the stock market. Stocks are much more of hard asset than bonds are, as companies can profit from bad situation and investors can dump the losers to buy the winners, while the government usually ends up borrowing more and more, diluting the value of existing bonds. The market might have taken yields to 2.5-3%, but based on my analysis this is close to the point where I believe bond yields are going to top (bonds bottom). The more the Fed is raising rates, the more I believe they will create a recession and this in turn could make inflation come down. Inflation won’t go away, though it could be much closer to 3-4%, than 8-9%. In my opinion getting back into a disinflationary trend would greatly benefit stocks, and therefore in case stocks dip because of the Fed, I am a buyer.
My reasoning is that if the Fed keeps raising rates, something will break and they will then be forced to the cut rates and start buying bonds. Essentially based on the current set of circumstances stocks could keep going up for a while, then crash, and then the Fed will be forced to step in to prevent the financial system from melting down. However, one thing is clear and it is very clear. There is so much leverage in the system, there is so much debt, there are so many issues in the economy, that the only way out is by devaluing the dollar, not by making it stronger. Raising rates to crush demand isn’t what ordinary people who can’t pay their rent need. They need cash in order to buy stuff they need, yet can’t afford. Politically this is the only politically acceptable way moving forward, and at the same time is the best outcome for the stock market. It will of course exacerbate the inflation and increase the liquidity in stocks which has been lacking recently. Actually, since Feb 2021 things have started deteriorating for stocks as governments stopped supporting businesses and banks cut down on lending, hence if they resume this would be pretty bullish. Oftentimes we see stocks do well in nominal terms during bad times, as the currency is losing value and people are trying to escape the devaluation. In real terms investors might be underperforming, but it might be better than holding fiat. Hence even if stocks have topped for now, it doesn’t mean the bull market is over, because the devaluation of fiat isn’t over.
Another interesting thing to note here is that real rates have gone back to 0, as they were deeply negative before. These deeply negative rates definitely benefited the stock market as investors were trying to escape cash and bonds, but now cash and bonds have become somewhat attractive again. My belief is that inflation will start slowing down in the next few months and that the Fed is already too late, hence real rates will probably increase even more. This could be either seen as a positive if you believe that the Fed will slow down its rate hikes as they realize they don’t need to hike as much or it could be seen as a negative if you believe that they will completely ignore future inflation prints and raise rates until prices go down or something breaks.
First of all, I’d like to look at the big picture and then start zooming in, as it is good to have an idea of where the global economy is right now and how that affects stocks. Well, the global economy is not in a good place as there is too much debt in the world, supply chains have all sorts of issues from the China lockdowns to the war in Ukraine, the population is aging, Covid created a lot of negative imbalances and the underinvestment in commodities has create a lot of shortages. Now all these are occurring after stocks had reached insane valuations in 2020-2021, inflation is at multiyear highs and at the same time the Fed wants to hike rates by 0.5% on every meeting in 2022 in order to fight that inflation. Their goal is to reverse the wealth effect it created in 2020-2021 in order to fight deflation, and they might keep hiking until the stock market collapses.
When someone looks at all the above, he must be thinking that shorting stocks is a great idea and that the market will collapse soon. However, the truth is that the US economy is in a much better shape than many others as it produces a lot of the commodities it needs, US companies have been strong and earning prove that, while several companies substantially benefit from the current inflationary circumstances. For example, consumer staples and commodities producers are greatly benefiting from all the shortages and therefore their stocks have gone up. Of course, not all companies are doing well, as many of the more unprofitable/speculative companies are suffering greatly due to their profits being reduced or the debts repayments being increased. Higher inflation is eating away from the profits of some of those companies, while higher bond yields have increased the borrowing costs for others. These in turn have a negative effect on the stock prices at best some of these companies pay less dividends, while many companies might be pushed to bankruptcy if they can’t repay their debts.
You might now be thinking: ‘If so many companies are doing poorly and bond yields are going higher, shouldn’t we be worried? If the 60/40 portfolio is getting crushed, couldn’t that create a larger crash? If the Fed is ‘telling us’ that it wants stocks to go lower, shouldn’t we get out?’ Well, during all the previous hiking cycles stocks mostly rose at the beginning and fell towards the end, and in our situation the Fed has barely begun hiking. Bond yields going higher means that bonds are being sold, and some of that capital could redirected into the stock market. Stocks are much more of hard asset than bonds are, as companies can profit from bad situation and investors can dump the losers to buy the winners, while the government usually ends up borrowing more and more, diluting the value of existing bonds. The market might have taken yields to 2.5-3%, but based on my analysis this is close to the point where I believe bond yields are going to top (bonds bottom). The more the Fed is raising rates, the more I believe they will create a recession and this in turn could make inflation come down. Inflation won’t go away, though it could be much closer to 3-4%, than 8-9%. In my opinion getting back into a disinflationary trend would greatly benefit stocks, and therefore in case stocks dip because of the Fed, I am a buyer.
My reasoning is that if the Fed keeps raising rates, something will break and they will then be forced to the cut rates and start buying bonds. Essentially based on the current set of circumstances stocks could keep going up for a while, then crash, and then the Fed will be forced to step in to prevent the financial system from melting down. However, one thing is clear and it is very clear. There is so much leverage in the system, there is so much debt, there are so many issues in the economy, that the only way out is by devaluing the dollar, not by making it stronger. Raising rates to crush demand isn’t what ordinary people who can’t pay their rent need. They need cash in order to buy stuff they need, yet can’t afford. Politically this is the only politically acceptable way moving forward, and at the same time is the best outcome for the stock market. It will of course exacerbate the inflation and increase the liquidity in stocks which has been lacking recently. Actually, since Feb 2021 things have started deteriorating for stocks as governments stopped supporting businesses and banks cut down on lending, hence if they resume this would be pretty bullish. Oftentimes we see stocks do well in nominal terms during bad times, as the currency is losing value and people are trying to escape the devaluation. In real terms investors might be underperforming, but it might be better than holding fiat. Hence even if stocks have topped for now, it doesn’t mean the bull market is over, because the devaluation of fiat isn’t over.
Another interesting thing to note here is that real rates have gone back to 0, as they were deeply negative before. These deeply negative rates definitely benefited the stock market as investors were trying to escape cash and bonds, but now cash and bonds have become somewhat attractive again. My belief is that inflation will start slowing down in the next few months and that the Fed is already too late, hence real rates will probably increase even more. This could be either seen as a positive if you believe that the Fed will slow down its rate hikes as they realize they don’t need to hike as much or it could be seen as a negative if you believe that they will completely ignore future inflation prints and raise rates until prices go down or something breaks.
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