Okay, I know what many of you are thinking.
But FH, my stock XXX has already fallen 50% from highs. You talk about a market crash, but the market has already crashed…
And I agree.
Market breadth is absolutely disgusting of late:
The bulk of the market return to date has come from just 5 stocks – NVIDIA, Tesla, Google, Microsoft and Apple.
Strip out these 5 stocks, and the market performance looks a lot less sexy.
At the same time, insider selling (so-called smart money), is hitting all time highs:
Market breadth and insider selling are leading indicators.
Is the market signalling to us that bigger moves may come in 2022?
To answer this question, we need to dig a bit deeper into the fundamentals.
3 Big Things that Worry me about 2022?
3 things that worry me:
- China slowdown
Let’s discuss each individually.
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Latest Developments in Monetary Policy
Last week was an absolutely monster for monetary policy.
Key developments from the Federal Reserve are:
- Inflation not transitory – Jerome Powell admits that inflation is no longer “transitory” and is a problem (which he conveniently realised only after being reappointed as Fed Chair)
- Accelerated Taper – Feds will accelerate Tapering from $15 billion a month to $30 billion a month from January 2022. This means that the Fed buying of Treasuries will end completely by March 2022, paving the way for rate hikes as early as March 2022
- 3 Rate Hikes in 2022 – Fed’s latest Dot Plot now anticipates 3 rate hikes in 2022.
Market is pricing in rate hikes in May, July and November 2022.
A total of 75 bps (0.75%) increase in 2022.
And if we zoom out into 2023 and 2024, the Fed expects another 3 rate hikes in 2023, and 2 rate hikes in 2024, for a terminal Fed Funds rate of 2.1% by the end of 2024.
In any case, the market just flat out disagrees with this.
The market is pricing in a cycle top for rates at 1.5%, before Feds are forced to cut again (note that cycle top for the 2018 cycle was 2.0%).
Central Banks are behind the curve
I’m just going to put it out there.
I think central banks are way behind the curve on inflation.
I think in hindsight, the Feds pumping $120 billion a month into the economy and keeping interest rates at 0% while inflation is running at 40-year highs may go down in history as a colossal policy mistake.
And I think in 2022, Jerome Powell is going to need to play catch up on inflation. And I think the market is underpricing this risk.
Inflation is everywhere
I’ve been talking to a lot of business owners across industries recently.
And what I’m hearing, is that inflation is everywhere.
Fertilizer, Aluminium, Beef, Petrol, Chemicals, animal feed etc. You name it, there’s probably some supply chain issue in an Emerging Market somewhere that explains why prices are soaring.
And we’re talking 5% – 10% increases in input costs across the board.
For now, producers are absorbing the price increase, but word on the street is that 2022 is when they will start passing on the cost to consumers.
Where is the inflation coming from?
The prevailing wisdom is that inflation is driven by record demand for goods.
Because of COVID, people stay indoors. They spend their money on stuff like Xbox and furniture (goods), instead of restaurants and hotels (services).
Once COVID goes away, people go out again, and switch back to services spending.
And inflation goes down.
At least that’s the theory.
The problem though is that so far at least, the data isn’t backing it up.
Goods consumption has come down slightly, but they haven’t dropped to pre-COVID levels.
And if you look at services inflation, inflation there isn’t as dormant as you would expect.
Don’t forget that services have lower supply elasticity than goods. If demand for services spike, supply cannot increase quick enough to catch up (it takes time to hire and train new chefs etc).
And that’s even before you consider the potential impact from Omicron.
2 ways this plays out
I see 2 ways inflation can play out.
Base Case inflation – Goods spending gradually switches over to services inflation. Consumer expectations on inflation come down. Inflation comes down from Q4 levels (6%+), but stays high for a while in the 4% range. Feds hike 3 time in 2022.
Inflationary spiral – There is a wage price spiral, loss of central bank credibility, and shift in consumer expectations. If this plays out 3 rate hikes in 2022 won’t cut it.
What is a wage price spiral?
Basically – workers demand higher salaries because the price of stuff is going up. Because wages go up producers have to raise prices. Because price goes up workers demand more rate hikes. In a vicious cycle.
The last time we saw this in the developed economies was the 1970s. It was wave after wave of inflation, until Paul Volcker (Fed Chair at the time) hiked interest rates to 20% to kill inflation once and for all.
I don’t think we’re there yet.
I think base case we still see the Base Case inflation scenario.
But I don’t think it would be wise to rule out the possibility of an inflationary spiral.
Long story short – I think 2022 is going to be volatile. Market may be mispricing inflation here.
There is a small possibility that consumer demand falls in 1H2022 due to rising prices and slowing growth, and inflation goes away by itself. That’s possible especially if you consider the potential impact from Omicron. But for now I think this is a lower probability outcome.
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I shared about my worries for Omicron a while back.
And those worries are playing out at speed now.
To sum up what we know about the Omicron variant so far:
- Transmissibility – Omicron is very transmissible (estimated R0 is 4.0). Reports suggest Omicron replicates 70 times faster than Delta in the Bronchus (windpipe), but 10 times less in the lungs. Which would indicate why it seems to be more transmissible, but less deadly.
- Immune Escape – 2 Dose Vaccine or prior infection isn’t sufficient to prevent Omicron infection, which may explain why Omicron is spreading so fast.
- Vaccine Efficacy – A 3 Dose Vaccine will help prevent Omicron infection, and 2 Dose Vaccine does protect against serious illness. So all is not lost.
- Fatality – Data is mixed. Early reports indicate Omicron is less deadly than Delta, but a recent Imperial study says “no evidence” Omicron is less severe than Delta. Note that Delta is reportedly 4 times more severe than Alpha (the original COVID), so even if Omicron is less deadly it may only take us back to original COVID levels.
I compiled some charts below if you’re interested.
A virus with a lower fatality rate, but significantly higher transmissibility and immune escape, could be a big problem.
More infected people could translate into more deaths even though fatality is lower.
The problem with Omicron is that sometimes it’s not so much about the virus, but how governments react.
If governments deem it necessary to protect the population (sometimes for political reasons), they may impose further COVID restrictions.
More may come as 2022 plays out.
Catch-22 for the Market
And this is truly a catch-22 situation for the market.
If Omicron is a problem and it leads to COVID restrictions, then supply chain bottlenecks get worse, inflation is stickier than expected, and Feds are forced to tighten to combat inflation in 2022.
If Omicron is not a problem then there are little COVID restrictions, the economic impact is reduced, so Feds have no reason not to raise rates to combat inflation.
Either way, it looks like damned if you do, damned if you don’t.
3. China Slowdown
At the same time, the China slowdown is playing out in earnest.
The past week saw Shimao face liquidity issues.
Before this, the property developers who defaulted – Evergrande and Kaisa, were all junk rated developers.
So the market already knew they were in trouble.
But Shimao is the first Investment Grade (IG) rated developer to run into liquidity issues.
This signals to the market that even the IG rated developers are not immune, and is a significant escalation in the real estate crisis.
This will raise borrowing costs for all IG rated China developers across the board, exacerbating liquidity issues.
At the same time, China home sales have collapsed, together with construction activity.
This is a deflationary path… that takes years to play out
The way I see it, the path that China is on – is to restructure their economy away from reliance on real estate, and into things like manufacturing and hard tech.
This is not a path that ends in 1 – 2 years.
This is a 5 – 10 year path, kind of like Japan in the 1990s.
And if the CCP is serious about this deleveraging, they need to keep monetary policy tight.
This is a deflationary path, and it explains why the RMB is so strong of late.
I think many western commentators are missing this point. If the CCP eases monetary policy in a big way then they will undo all the good work they’ve done this year on real estate.
Don’t Expect China to be the growth engine to save the world this time around
If I am right, then China’s growth may stay slow for a while, as they focus on restructuring the economy.
So unlike 2008 where it was China that powered the global economy to new highs, this time around the west is on their own.
This is bad for Emerging Markets because they can’t rely on huge growth in exports to China going forward.
This is bad for the West because they can’t count on China to stimulate growth, at the same time as the West is tightening monetary policy to combat inflation.
Impact on Stocks
Okay, so those are my 3 big macro concerns for 2022.
What is the impact on stock prices?
Quarter to date, the most speculative parts of the market have been getting crushed.
IPOs down 21%. Small-cap growth down 12.2%.
Will the stock market crash in 2022?
I think what is tricky about this market is that the strike price for the Fed Put is now a lot lower than what it was previously.
Or in plain English – Don’t expect Jerome Powell to save the day so soon.
In 2018, it took a 20% drop in the S&P500 before Jerome Powell reversed the path of rate hikes.
In 2020, it took a 30% drop in the S&P500 before Jerome Powell went into unlimited QE and buying of Junk Bonds.
In 2022, if inflation runs hot and Feds hike 3 times, what kind of drop will we need before Jerome Powell reverses course?
As things stand, the S&P500 sits at 4620, down just 3% from all time highs.
I don’t think a 10% drop will cut it given how serious inflation is.
More realistically, we need a 20% drop in the S&P500 before the Feds consider changing path.
So there may be a lot more pain going forward.
As to when the market actually crashes, I don’t have a strong view on that.
Morgan Stanley is calling for huge volatility in the first half of 2022 as we have the first rate hike, which is possible.
Either way I would expect significant volatility.
Nothing goes to hell in a straight line, and there will be plenty of bull and bear traps along the way. Expect vicious rallies and vicious drops.
It will be heaven for traders at least.
How am I positioning? Which parts of the market has value?
As shared previously, I’ve generally dialled back on my rate of purchases the past few months.
China stocks have already collapsed, so comparatively there is more value there compared to US. But the bottoming will take some time to play out, so it would be wise to average in.
US stocks have split into 2.
The speculative growth and small cap names are already in the process of collapse. But rate hikes are truly scary for speculative growth stocks, and I would want to give it some time for the dust to settle.
The big caps like FAAANM that make up the indexes, they’ve been largely immune from the sell-off so far.
Which makes me nervous heading into the first half of 2022, because that’s the last remaining bastion of strength in this bull market. That will probably be the last one to fall.
Cyclicals like banks and commodities are interesting.
Rate hikes are traditionally good for bank stocks, as long as they don’t trigger a recession.
If Omicron causes a sell-off in oil, I think that could be an interesting add as a mid term play. I think all the underinvestment in fossil fuels is going to come back and haunt us in 2023/2024.
I think blue chip S-REITs are the one bright spot in this market where valuations look more reasonable. As shared last week, I bought some recently, and I plan to buy more going forward.
Sure, S-REITs may sell off short term as the Feds hike but comparatively their starting valuations are not as demanding as other parts of the economy, so the decline shouldn’t be as big.
You can check out my full portfolio and stock watch on Patreon if you’re keen.
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My concern is that buy and hold investing may not achieve the same results in this decade, as compared to the previous decade.
The post 2008 period was characterised by easy liquidity and QE from the Feds. This raised all asset prices across the board. And the best way to capture that return was passive indexing.
Going forward, if I am right, I would expect more rotation around asset classes. Money rotates from small cap growth into large cap value. Into cyclicals. Back into growth. And so on.
Think about Crypto and how the alt-coins take turns to pump, while the blue chips like BTC and ETH stay flat.
Which may potentially call for a more active approach towards investing in this decade – to lock in profits and rotate them out.
But who knows. This horse is prone to overthinking, and I might just be wrong on all this.
Whatever the case, I would love to hear what you think!
All views and opinions above are from Financial Horse.
The content is provided for entertainment & informational use only. The information and data used are for purposes of illustration only. No content herein shall be considered an offer, solicitation or recommendation for the purchase or sale of securities, futures, or other investment products. All information and data, if any, are for reference only and past performance should not be viewed as an indicator of future results. It is not a guarantee for future results. Investments in stocks, options, ETFs, and other instruments are subject to risks, including possible loss of the amount invested. The value of investments may fluctuate and as a result, clients may lose the value of their investment. Please consult your financial adviser as to the suitability of any investment.