This market is set up for a potentially very significant correction (baseline of 10-20% given the magnitude of the recent draw-up) in the coming weeks as the post-pandemic policy cycle is coming to an end, likely bringing with it the prospect for a semi-stagflationary environment that will render ineffective both the fiscal and monetary policy stimulus that so profoundly stimulated the economy – and even more so markets – in the wake of the covid pandemic. In this article, we look at:
- Why the point of danger has been reached as the Fed is finally taking away the punchbowl that was so crucial in pumping up global markets, from equities, to credit and possibly even treasuries.
- Evidence that parts of this market and the market narrative that has developed in the wake of last year’s pandemic outbreak are already falling apart in serial fashion
- Why the risk is that both monetary and fiscal stimulus will have limited impact from here
- Ways for traders to mitigate risks to their portfolios, especially those heavily geared long growth- and momentum equities.
Sure, we could be very wrong, or very early, but we think it is worth giving these points some serious thought at this point in the cycle, when the pandemic stimulus has peaked in its impact on the real economy and as the economy and markets will theoretically need to stand on their own two legs, now that the central banks are set to withdraw support.
It’s not just about the Fed, it’s also about “the beef”.
In a brilliant old advertising campaign from the 1980’s, US burger chain Wendy’s came up with the slogan “where’s the beef” to differentiate itself from competitors, touting its thicker, juicier beef patties relative to the stingy competition. In the policy response to the global Covid pandemic, the really significant new policy “beef” was the enormous fiscal stimulus that was unique in scale relative to anything outside of wartime or perhaps the Great Depression. The intention was for the stimulus to offset the correctly anticipated enormous drop in the demand side of the economy as the pandemic saw millions losing their jobs and hunkering down under a massive cloud of uncertainty.
Fast forward to today and we see the unanticipated consequences: soaring demand for consumer goods and chaos in supply chains as companies were caught off guard by the magnitude of the demand and didn’t have the means to increase production due to poor forecasting, new inefficiencies caused by virus testing and quarantining and the unavailability of workers due to shutdowns from the outbreak itself. At the margin, some workers may have been slow to look for work again as they prefer to stay on unexpectedly generous benefits as long as possible.
In the background, central banks did their part in slashing rates to zero and have kept right on purchasing assets at a furious pace to ensure maximum accommodation until some pre-pandemic norm has been achieved. But their efforts are not the “beef” of fiscal stimulus and they are finally recognizing that their activities are not only not really supporting the recovery at this phase, but could have aggravated the alarming acceleration of inflation in places (housing market), as well as the glut of liquidity that has unnecessarily over-stimulated asset prices, particularly in housing.
EM central banks have been the first to respond to the inflationary outcomes with rate hikes. Among developed markets, Canada’s and New Zealand’s central bank tapered asset purchases in recent months and New Zealand and Norway are expected to be the first to hike rates later this year. The Fed has dragged its heels in finally shifting to a less accommodative stance. But the mid-June FOMC meeting finally marked a turning point as Fed forecasts brought the anticipated date of the first interest rate hike forward as inflation forecasts were raised. More recently, the minutes of the July meeting and speeches from a number of Fed officials indicate an increasing urgency to slow and eventually stop the over-generous pace of QE. As we lurch toward Q4, asset markets will increasingly scream for the Fed to refill the emptying punchbowl, while as we discuss below, the real economy will wake up with a stimulus hangover and ask “Where is the (fiscal) beef?”.
Markets have started rolling over even before the Fed is set to pull out
Here are a few charts offering evidence that the most speculative corners of this amazing market rise began peaking out and rolling over already months ago. The process began even before the last blast of fiscal excess in the Biden stimulus check in March was dropped into an already rapidly recovering economy. Since then, we have seen important asset classes and individual proxies rolling over in serial fashion as noted below.
The Saxo Bubble Stock portfolio
The Saxo quantitative team put together a basket of tens of global, potential bubble stocks as defined by a number of quantitative metrics, ironically around the time that these stocks turned out to have peaked in February. That peak came about two weeks after the bubble stock poster child, Tesla, peaked in late January, as did a number of so-called “meme stocks”. Elsewhere, the Russell 2000 small cap index peaked in March and is challenging its 200-day moving average as of this writing. (Important: note the Log format on the price axis).