My contention is that the severity of the market downturn this year was caused by three events: Russian Invasion of Ukraine, China’s no COVID policy, and UK fiscal drama. These surprises made the declines in the S&P 500 worse than they otherwise would have been.
If we were just facing Fed rate hikes and high inflation, I contend that the markets would not be down as much as they are today. That is because, as I have been demonstrating for weeks, the nominal U.S. economic growth has been very strong. Essentially there is a lot of cushion for the economy to absorb these intense rate hikes. Secondly, the real economic growth has been strong throughout 2022. Final sales to Domestic Purchasers, Unemployment, and Personal Savings were all very strong throughout 2022.
Despite the dramatic rise in rates, growth is slowing, but only barely.
I believe that the path to higher stock and bond prices is right around the corner.
- The Fed will end its rate hike campaign likely in the next few months. Rate hikes are much closer to an end than they ar to the beginning.
- Economic growth will slow going forward. But, it’s still positive and employment is still solid (not showing signs of deterioration).
- It’s possible that, as growth slows in 2023 the Fed does “pivot” to focusing on growth as inflation declines.
- Just as strong growth has provided an economic cushion against rate hikes, the Fed signaling a “pivot” in 2023 could boost the market multiple just as growth really slows, creating that “soft landing” in the markets.
- This works given the S&P 500 is already down 20%. A lot of pain has been priced in, and this scenario is possible, and I believe it would lead to positive equity returns in 2023, as long as there are no surprise crises.
Here are the potential crises that will be on my watch list that could drop the S&P 500 an additional 10% to 20%. They are not likely, but are possible:
- Currency Crises
- Disorderly Yield spike
- Geo-political crisis
- Bank liquidity crisis
The Currency Crises would be if China or Japan do not support their currencies. The disorderly yield spike would be possible in Japan and Italy. The geo-political crisis would be in the Russia/Ukraine war escalating to other countries. The bank liquidity crisis would be similar to what we experienced in 2008. Banks and regulations are much stronger than 2008 and thus this crisis is minimal.
Bottom line is that the outlook remains challenged until inflation peaks and the Fed pivots, China reopens, and Geo-politics calms down. The good news is that growth remains solid and the Fed is almost done. Unless there are surprises, we are close to an end of this bear market. Stay the course because the resulting move up will be strong.
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