No Recession?
In a very real sense, we are at a pivotal moment for the economy, and the markets. Tuesday’s Federal Open Market Committee announcement is expected to bring another 75 basis point increase to the Fed Funds rate. Most analysts agree this rate hike is already baked into current stock prices, and it’s not unreasonable to expect this hike to be market neutral.
There has been some buzz that Fed Chair Powell’s determination to fight inflation will lead to a full 1% rate increase (100 bp). This would probably spook institutional traders, who seem to be holding out hope that the Fed will backstop the equities markets, as it has for the past decade-plus. The result could be the next major leg down in this bear market. On the other hand, a few voices are suggesting that Thursday’s impending GDP print, which is expected to be negative by a good margin, could be the sign of economic weakness the Fed needs to back off their hawkish stance, and begin to pivot.
Even with the expected hike, dovish language from Powell on Wednesday – such as hints that the rate increases may slow in coming months – might be enough to rally the markets, bolstered by the promise that stocks will not be allowed to fall too far. Meanwhile, Treasury Secretary Janet Yellen is insisting that she doesn’t think we’re in a recession, even going so far as to dispute the traditional definition – that two consecutive quarters of negative growth constitute a recession. According to Yahoo! News:
Treasury Secretary Janet Yellen said Sunday that growing consumer spending, industrial output, credit quality and other economic indicators don’t suggest the economy is in a recession, although she acknowledged that “way too high” inflation is straining the system. “This is not an economy that is in recession,” Yellen told moderator Chuck Todd on NBC’s Meet the Press.
This can be taken as a signal that the Biden administration would like to see rates continue to rise, as high inflation is considered the biggest threat to the Democrats’ prospects for the mid-term elections in November. Nonetheless, Yellen’s statement was packed with illogic and fallacies, as described in detail in this excellent article from Seeking Alpha. The TL/DR summary is that industrial output is collapsing, the end of massive COVID-era deficit spending is tanking economic growth, and, yes, inflation is still rising. Together, these factors do in fact indicate a near (or already present) recession, and point to the likelihood of a continuing bear market.
The Perils of Market Manipulation
Price discovery is the overall process, whether explicit or inferred, of setting the spot price or the proper price of an asset, security, commodity, or currency. The process of price discovery looks at a number of tangible and intangible factors, including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment. Simply put, it is where a buyer and a seller agree on a price and a transaction occurs. — Investopedia
One of the most insidious side effects of Fed policy since the Global Financial Crisis of 2008 has been the systematic destruction of price discovery as a means for setting the fair value of financial assets. Due to the tsunami of free money flooding the market since then, and especially over the past two-plus years, every financial market has become subject to rampant manipulation, and speculation based on fictional valuations, driven by massive monetary expansion. There’s a concept called the Cantillon Effect which describes the changes in prices resulting from changes in the money supply. Writing in the 17th century, French banker Richard Cantillon observed that “he who was close to the king and the wealthy” were most likely to benefit from increases in available capital. Sound familiar?
For an in-depth, easy-to-understand explanation of how the Cantillon Effect played out in the post-COVID fiscal and monetary stimulus, watch this video from George Gammon. With the government handing trillions of dollars to the commercial banks and related financial insiders, asset prices across the board were driven “to infinity and beyond,” before average investors even had a chance to participate in the run-up.
The result was a record widening of the wealth gap in America and around the globe. Those closest to the money-printers skimmed hundreds of billions in profits off the top of this unprecedented monetary expansion, leading to growing wealth inequality at the same time as the quality of life for the vast majority got worse. Free markets are supposed to prevent this kind of shenanigans. Fair and open price discovery is the mechanism for keeping the investment playing field level. Sadly, our financial markets will never see REAL price discovery again. Corruption is now hardwired into the system. The Fed is just playing Tip-It, trying to balance rate hikes with market expectations and balance sheet issues within a manipulated game.
Something’s gotta give… the funny man balancing atop the pole is doomed to fall. This week? Maybe not… 75 bp is already priced into the markets, and everyone expects a lousy GDP print, so that’s not likely to surprise. Things fall apart slowly, until they fall apart fast. We’re getting close, but not there yet.
Here’s our take on the most likely outcome to this week’s events: Wrong-as-usual Yellen will eat her words shortly, as she’s done several times recently. Powell will obfuscate, and complacent institutional traders will calmly ride the slow wave down – with or without a face-ripping rally or two — until the next unanticipated event (which does not describe this week’s announcements) shocks them into panic mode, followed by the inevitable freefall.
Geopolitical Wild Cards
Last week we discussed how stubbornly high food and energy prices are offsetting declines in other commodity markets and contributing to high inflation worldwide. Of course, the conflict in Ukraine and resultant Western sanctions against Russia are at the heart of the supply issues driving these prices. We wrote about this back in March (here and here.) While practically everyone (except for the Neocon hawks on the Biden team and the munitions makers who underwrite them) was rooting for a quick end to hostilities, this has not been the case. The war is now dragging into its fifth month.
The Nord Stream 2 natural gas pipeline was in the news this week, as supply began to flow again, in limited quantities, to Russia’s customers in Europe. This helped ease the tensions around the prospects of energy shortages in Germany, in particular. Nonetheless, European gas prices are near their all-time highs, set in March at the outbreak of hostilities. Here’s what tradingeconomics.com had to say this week about the outlook for NatGas on the continent:
EU natural gas futures soared towards the €200-per-megawatt-hour mark, moving closer to their March record peak, on lingering concerns about tightening European supplies. Russia’s Gazprom said it would reduce flows through the Nord Stream pipeline, citing issues with turbines, delivering only 33 million cubic meters daily, roughly 20% of its capacity, jeopardizing the region’s objectives to fill 80% of storage capacity before winter. Such supply concerns brought together the EU members to sign an agreement to cut their gas use by 15% over the following months. At the same time, Russia’s natural gas weaponization sparked a rush for supplies from other main buyers, including Japan and South Korea, which are moving through with plans to buy more LNG cargoes for the winter, fearing that Europe will similarly stockpile supplies at a faster pace.
With negotiations between Europe’s NATO-aligned economies and Putin’s Russia at such a critical juncture, one has to wonder if support for the U.S.-ordained sanctions will crumble in the face of a threatened winter without heat. What seems likely is that Russia, now clearly seen to be thriving despite the sanctions, will not respond well to renewed pressure.
The danger of cutting off the gas to Europe, and what that would mean for those economies, is just one example of the geopolitical wild cards that continue to threaten global financial systems. Fertilizer supplies also depend on natural gas, which, along with the oil used for fuel to transport the goods, is vital to food supplies in marginal nations. As Sri Lanka recently demonstrated, anywhere serious food supply disruption arises could lead quickly to starvation, putting governments are at risk.
In a very real sense, the world economy is hanging by a slender (Russian) thread. And at the same time, the Biden administration is ratcheting up its rhetoric against China, which has its own economic calamity on its hands. With their real estate debt bubble threatening to implode and a looming liquidity crisis that led to a recent run on several commercial banks, Xi Jinping and the CCP may feel that their back is against the wall, and push back forcefully against U.S. maneuvers.
All in all, the international situation remains as tenuous as a house of cards, and equally prone to collapse.