Is It Safe Yet?

June 27, 2022

Since the last entry into these unusual views, the market has suffered another significant selloff, taking the S&P 500 to 3,650 before last week’s bounce to 3,900. It is probably the case that most people reading this blog aren’t ‘chartists’. Those people that trade based off of ‘pictures’ on a chart or historical price and volume information, but there is little good news for investors.

The two obvious issues are inflation and rising interest rates. There was hope in the middle of June that inflation had peaked, but then when official data was released inflation was proven to be raging still (+8.6%). This removed the hope that the Federal Reserve would stop interest rate increases.

What happened instead is that the Federal Reserve was clear and adamant after their meeting on June 14/15 that further significant increases in interest rates were coming. The Federal Reserve publishes a chart called ‘the dot plot’ which shows where their members think interest rates need to be at different intervals over the coming few years and some believe that rates will need to be as high as 4.5% by the middle of next year (the consensus is at about 3.4%).

A lot of very smart people predict what will happen with the economy, and that makes the stock market a leading indicator for what is happening economically. The stock market has taken a big hit so far in 2022 as these projections for interest rate risks have worked their way through the forecasts. It would be reasonable to ask the question “Is it safe yet?”

The answer is that the bad news is just starting; don’t get excited.

The Federal Reserve is just now (starting June 1) starting to withdraw the stimulus that has been levitating markets for over a decade. Their plan (available here) is short on specifics related to timing, but all of the evidence suggests they will be working for years to come at REDUCING liquidity and that will begin to slow the economy in many ways.

Economists expect certain things when this process starts. A rise in interest rates increases the costs for financing, which reduces investment. For consumers, it reduces the money available for consumption. One objective is to reduce demand ‘a little bit’ without sending the economy into a recession.

The market is starting to understand the ‘reduced consumption’ part of the story. Over the past week copper prices (a bell weather/proxy for the economy) have dropped precipitously. At the same time, oil prices have come down from their highs and measures of consumer investment (like housing and auto sales) and other spending (leisure, grocery) are starting to drop.

Another impact of rising rates is that companies, indeed sovereign nations begin to have difficulty sustaining their illusions of greatness. That’s not to say all countries are in trouble, but those that were begin to show cracks.

Over the past few weeks a number of countries have faced some difficulty. The EU convened a special meeting to discuss Italy’s financial strain (mentioned here many times), because unlike Greece, if Italy’s finances falter, all of Europe will be in very difficult straits. Sri Lanka also failed to meet its obligations in June, forcing a default as did Russia just this morning.

Another interesting experiment has been the world of Cryptocurrencies which is not a highlight of this article, but over the past two weeks, this ‘imaginary’ money went into a tailspin, and the market showed aspects of the wild west. The mention is only relevant here because one country (El Salvador) has been trying to force their citizens to use Bitcoin as an official tender for transactions. That project isn’t going well, and the country has effectively cut their sovereign reserves by 1/3 without obtaining any value for the citizens.

Companies are again starting to fail and individuals are certain to follow soon as well. On the corporate side, Revlon is a notable name that has filed for bankruptcy as did Electric Last Mile Solutions (an electric vehicle company). A few of those ‘crypto’ companies are preparing for bankruptcy as well. As for consumers, a report over the weekend highlighted that over 8 million Americans are struggling to pay rent in the first half of June. That number is likely to increase substantially in the coming months.

Beyond these things, there is a LOT more evidence that things will not be improving anytime soon. It is arguable that the world will be able to put off further significant declines, but it is unlikely that the Federal Reserve will ease their interest rate path, or loosen financial constraints if asset prices were to start rising again. The corollary of course is that asset prices will (on balance) likely fall, or at least remain where they are.

Look at market reversals as short term bounces until there is more clarity on the economic front. As mentioned in other posts, this is not a call to ‘sell everything’. It is a suggestion that liquid assets (think cash) are an excellent way to avoid unmanaged risks, and there are likely to be more of those in the coming weeks and months.

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