With inflation starting to head downwards, the markets are getting hopeful the Fed may pivot or at least pause sooner than expected.
And while the Fed is clearly hoping to quell any rampant enthusiasm, investors are busy making up their own minds — which is a big factor why we saw such a massive rally in both stocks and bonds last week after the October CPI number was released.
To get an update on the latest of what the markets, especially the all-important bond market is telling us right now, we have the good fortune to be speaking with former bond portfolio manager Alf Peccatiello.
Adam’s Notes
The economy is clearly slowing down. If you look at things on a rate of change basis, everything, sales, earnings, inflation — even jobs — are decelerating fast.
Alf expects inflation to increase by 0.3-0.4% MoM for the next few quarters, and thinks it will be down to 4% YoY by mid 2023. He thinks, mechanically, it’s near impossible for CPI to fall faster than that. He thinks it will fall faster in the second half of 2023, with core inflation reaching <2% levels by Dec 2023.
Alf expects a bad recession ahead, stemming from the Fed’s hard braking right now. He predicts the unemployment will be double next year, earning growth to be -15%, and US housing prices to fall at least -15%.
Alf doesn’t see Powell pivoting before he raises the FFR to 5%. He thinks Powell is too committed and he doesn’t see anything breaking too badly right now that could force his hand.
That doesn’t mean things will be rosy. Alf estimates the “neutral rate” is around 2-2.5% — which is why he expects a 5% FFR will result in massive damage to the economy. In fact, he thinks it already occurring — for example, the housing market is in full seizure right now.
We’ve never seen rates rise this fast. Yet S&P earnings are still expected to grow by 6% next year. Alf sees that most analysts (stocks, housing, etc) are still far too optimistic in their outlooks/projections. Expect 2023 to deliver rolling disappointments to investors as these estimates are forced downwards.
Alf sees the coming market correction as likely being similar to the DotCom bust in terms of swiftness & severity.
The bond market is clearly telling us it expects inflation to comes down. The inflation swap market is expecting inflation to be at 2.7% a year from now (and Alf expects <2%).
Today’s sharply inverted yield curves are screaming that recession is dead ahead. They predict recessions with 90%+ accuracy. Alf thinks it will really be clear to everyone that we’re in a recession in Q1 of next year. Layoffs will start getting bad around April.
The average housing analyst expects housing to decline by -2% next year. Alf thinks this is way too optimistic. Also, as housing prices get hit hard and transactions/new builds dry up, that impacts a material percentage of the US economy because so many jobs are tied to servicing the housing industry. And of course, other industries will suffering at this same time, too, so Alf expects material job losses next year.
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As for the financial markets, Alf is very skeptical of the recent rally in stocks. He thinks the probability is much higher that the bear market continues from here, even though the market could possibly rise to the end of the year first. In his estimation, S&P 4,000-4,1000 is “thin air” for prices.
Alf expects the bear market to hit a new low next year, likely bottoming around 3,300-3,400.
