Another day, another 500+ point drop for the DJIA.
Markets have clearly broken below the June 16th low and the trend doesn’t appear to be your friend (unless you’re short).
I think there are three key themes that emerged this week piling onto the overall market pessimism:
1: There is increasing chatter coming from Federal Reserve staff suggesting committee members are striving for positive real yields across the entire curve. This doesn’t necessarily mean that yields rise above current inflation prints. More realistically, rising yields will cause a recession putting simultaneous downward pressure on inflation rates.
Intuitively, many investors expected this, but for officials to come out and confirm their intentions is a clear indication of their determination and a clear signal to investors.
Unfortunately, this neglects the fact that real yields compare the current price of debt with a historical rate of inflation. By the time today’s price changes are captured in the inflation data, we could be in a totally different economic environment and real yields could overshoot to the upside.
Indeed, on-the-ground readings already show that things are deteriorating quickly. Is the Fed acting on what’s happening right now or what happened over the last 12 months?
This leads to the next observation.
2: Big global companies are increasingly issuing a variety of warnings.
Apple is cutting iPhone production in response to declining demand.
FedEx warned global demand is slowing.
CarMax missed on earnings, indicating slowing demand for used cars.
Nike warned on bloated inventories, attributed to its response to pandemic shortages.
Micron Technologies is adjusting spending to reduce inventories to align with slowing demand.
These are near real-time indications that the economy is rapidly slowing, companies are responding in a pro-cyclical manner, employment may soon weaken, pricing power may decline and future inflation will drop. It wouldn’t surprise me if we were talking about deflation risk in mid-2023.
3: Inflation is so high and big factors in core PCE seem to be getting sticky - forget deflation, is the Fed’s 2% target even a possibility?
There are some indications that inflation could be stickier than hoped for - due to owners equivalent rents and wages. This means a bigger economic slowdown is required to bring inflation in line with the Fed’s target. Sticky doesn’t equal impossible. It just means the Fed needs to hammer the nail harder.
The 10 year breakeven inflation rate has plummeted since April 2022 to levels not seen since February 2021, and appears to be pricing in a significant drop in inflation. By association, the 10 year breakeven inflation rate seems to be predicting a big economic slowdown. At the moment, it seems like there’s no other way.