October 2022 Market Update – Higher Prices, Higher Debt and Collapsing Wealth Effect are Crushing Consumers

This blog serves as a follow up to our previously released Q3 Investment Themes, as well as an update on what we are seeing and our current outlook.

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Here are the top three things we are covering in this month’s blog (quarterly update):

1. Inflation (food, energy, housing/rent, auto) is still very “sticky”, and will remain elevated on an absolute basis well into 2023.  Any recent drops in prices (rent and gas for instance) have come from historically high levels and have not been significant enough to ease the crushing burden on households all over the world.  The overall Consumer Price Index (CPI) has only dropped slightly from late Summer.  The Fed will not pivot, and the Fed terminal rate (the peak of the rate hiking cycle and short-term interest rates) keeps moving up, which will keep pressure on interest rates on the financial markets through the rest of 2022 and into 2023.^_[1]
2.  The Fed’s goal of continuing to tighten financial conditions will keep upward pressure on the dollar, which will only exacerbate the global currency crisis.^_[2]  As noted from last month, global currencies are experiencing greater volatility, in aggregate, than any other time this century.  Many currencies around the world are experiencing a crash against the dollar.  This is creating a negative feedback loop of rising dollar, struggling global economies with currencies collapsing, which is fueling an even higher dollar.
3. The bullish rally ahead of the November elections that we predicted is now over.  The S&P 500 jumped over 12% off the October lows as traders hoped for the Fed to pivot, for “good news” from corporate earnings and company buybacks, and a bullish October surprise ahead of the election.  None of that materialized.  Inflation, a tapped-out consumer^[3], and the negative wealth effect are starting to crush corporate earnings (outside of the energy sector), and the stock market is heading back down now early in November.

Market

The S&P 500 (SPX) finished out its latest bear market rally in October.  We predicted a bounce in October ahead of the mid-term elections, which is what happened.  The SPX rallied 12% off its lows and peaked on the last day of October.  The SPX finished up 7.99% for the month. The Nasdaq underperformed the SPX in October as worse than expected earnings from Microsoft, Facebook, Amazon and Google weighed heavily on the index.  The Nasdaq finished up 3.90 for the month.

The Dow Jones 30 outperformed the SPX in October.  Part of the outperformance was positive earnings from Chevron and Exxon, and additional performance came from defensive stocks like drugs (JNJ, MRK, UNH and AMGN) and food/consumer non-discretionary (MCD, WMT).  The Dow finished up 11.91% for the month. Small Caps (the Russell 2000 or RUT) outperformed the SPX.  Small caps were bolstered by short-covering as the bears got squeezed during the election season.  The RUT finished up 10.94% for the month.^_[4]

The World Index (ACWI) underperformed the SPX in October.  As is often the case, the major stock markets of the world will follow the U.S. stock market, even when their economies are doing poorly.  When America goes up, it drags much of the world up with it.  However, the combination of runaway inflation, collapsing currencies and crushed consumers has thrown most of the world into a recession.  Global central banks are being forced to continue aggressively hiking into the recession, so there the malaise is likely to continue well into 2023.  The ACWI finished up 7.11% for the month.^_[5]

The commodity index (DBC) rose in October.  Once again, the rising tide of U.S. stocks lifts a lot of boats.  Commodities will often move up with stocks, which is why the Fed and policy makers are in such a conundrum.  They can’t risk igniting stocks without also igniting inflation (commodity prices), which then destroys all those positive political points and then some.  The DBC finished up 1.99% for the month.^_[6]

Gold was once again impacted negatively by rising real yields (interest rates adjusted for inflation) during October.  Eventually gold will catch a bid when the fears of recession outweigh the fears of inflation.  For now, Gold remains in a downtrend.  Gold finished down -1.87% for the month.^_[7]

Longer term interest rates (as measured by the Ten-year Treasury or TNX) increased slightly in October.  However, shorter term interest rates increased more sharply in the month as the market continues to price in more Fed rate hikes and a higher rate before the Fed finally stops hiking rates.  The short end of the interest rate spectrum (called the “curve”) usually prices in Fed policy.  The long end of the curve usually prices in economic outlook.  However, the aggressive tightening by the Fed has had a negative impact on bonds (selling bonds, which increases interest rates) across the curve.  Eventually the long end of the curve will price in a recession and rates will fall, but for now, the bond market is still bearish.  The Ten-year yield (TNX) finished the month of October at 4.10%, up from the end of September._^[8]

Oil prices increased in October as commodities in general caught a bid from rising stock prices, and also because of OPEC production cuts.  The White House has no leverage over OPEC because of the pressure they brought to bear on U.S. oil production.^_[9] Saudi Arabia knows this and basically thumbed their nose at the demands for increasing production.  Note that commodities are priced in dollars, so a rising dollar causes oil prices to go down.  Saudi Arabia actually has a mechanism to counteract the ramping up of the dollar and using that as a means to manipulate down oil prices.  They can simply cut production and ramp oil prices right back up – negating all the sacrifice of dramatically hiking rates to increase the dollar.  Oil finished up 8.30% for the month.^_[10]

Economy

The preliminary GDP number for the third quarter (Q3) of 2022 printed 2.6%.^_[11] It broke a string of negative GDP prints, but not because the economy has moved back into expansion.  The entire gain in the GDP print was due to record exports of weapons, oil and gas to Europe.^_[12]  Projecting forward, our analysis is that GDP will roll back down to another two quarters of negative prints on a QoQ basis. And will continue to decelerate on a year over year (YoY) basis.^_[13]  It bears repeating from last month the following note: 2/3rds of GDP is personal consumption, and our projection is that consumer spending is dropping off a cliff because of higher prices, higher debt, and a collapsing Wealth Effect.  In economics, the Wealth Effect suggests that people spend more as the value of their assets rise.  The inverse is true as well, so with prices falling in real estate, stocks and bonds (while prices go up in gas, food, and many other consumer items), the United States middle class is feeling much less financially secure.  This is showing up in the overall trend of consumer sentiment.^_[13] In addition, we are still at the front end of the real-estate market imploding.^_[14] Therefore, the Wealth Effect dissipation is likely still in the very early stages and set to implode over the next year. This will lead to significantly more cautious consumer behavior for multiple quarters, which will impact both GDP and corporate earnings.  All this adds up to a Quad 4 outlook for the next four quarters.  As a reminder, Quad 4 means a period of decelerating growth along with decelerating inflation.

Once again, nothing has changed with inflation.  In fact, as noted above, it actually got worse in October.  It continues to be the most important financial issue on planet earth.  And once again: Historically high prices have been crushing consumers all year and will continue to crush consumers through the rest of the year and into 2023.  The Fed and global central banks have no control over supply.  Until we see real structural fixes in the global supply chain, more effective and production-friendly policies, and some type of resolution to the Russia-Ukraine war, the higher absolute readings on inflation will persist.  The net result will be an ongoing drag on the global economy.  Europe is the most afflicted region currently due to energy policies, and European consumers are dealing with record-high natural gas prices.  Although we project CPI to decelerate as we plunge deeper into recession, the real numbers will still be double and triple the historical average.^_[15]  The impact of stubbornly high real inflation numbers, along with a slowing economy, will keep the Fed and other central banks stuck between a rock and a hard place, which is tightening into a deepening global recession.

Summary

1. Inflation (food, energy, housing/rent, auto) is still very “sticky”, and will remain elevated on an absolute basis well into 2023.  The Fed will not pivot, and the Fed terminal rate (the peak of the rate hiking cycle and short-term interest rates) keeps moving up, which will keep pressure on interest rates and on the financial markets through the rest of 2022 and into 2023.
2.  The Fed’s goal of continuing to tighten financial conditions will keep upward pressure on the dollar, which is crushing global currencies and throwing foreign central banks into a panic.  As noted from last month, global currencies are experiencing greater volatility, in aggregate, than any other time this century.  Many currencies around the world are experiencing a crash against the dollar.  This is creating a negative feedback loop of rising dollar, struggling global economies with currencies collapsing, which is fueling an even higher dollar.
3. The bullish rally ahead of the November elections that we predicted is now over.  The S&P 500 jumped over 12% off the October lows as traders hoped for the Fed to pivot, for “good news” from corporate earnings and company buybacks, and a bullish October surprise ahead of the election.  None of that materialized.  The theme for the next several quarters will be “Higher Prices, Higher Debt and Collapsing Wealth Effect.”  The result will be ongoing economic recession, a collapse in corporate earnings and eventually a collapse in employment.
4. Having a hedged and cross-asset class approach to investing can help you navigate the multiple storms blowing through the global economy and financial markets.  This type of strategy will increase in importance as we go deeper into a global recession, and as volatility and uncertainty increase across financial markets, the global economy and major governments and political organizations.

We hope you have enjoyed getting a deeper look into our investment research and look forward to providing this to you each month going forward. Thank you from the entire Konvergent Team!

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