Outlook 2023: A Historic and Painful Earnings Recession

By

Tim Kiladze of The Globe and Mail reports the unfortunate market reality is that financial corrections take time, and there’s (very likely) more pain to come:

Everyone wants it to be over. The interest-rate hikes. The housing crash. The stock-market correction.

The reality: The worst, very likely, hasn’t hit yet.

This isn’t crazy conjecture. Crucially, central banks have yet to say they are done hiking rates. The Bank of Canada recently signalled it is getting close to that point, but there is no guarantee that a change of heart is just around the corner. The United States, meanwhile, is even further off. The betting money now expects the Federal Reserve to jack its rate above 5 per cent – and then hold it there through 2023.

At the same time, central banks are taking liquidity, or cash, out of the financial system. All the money they made available to prop up the economy has to be withdrawn, and doing so is a major headwind for credit availability.

Still not convinced? Take it from financial markets history. When there’s trauma, corrections tend to play out over multiple years.

As nice as it would be to rip the Band-Aid off quickly, do not fall for the next market bounce. History is littered with them, only for the real pain to eventually hit. The four scenarios below are reminders of just how long this unravelling could take.

The dot-com crash

The last time technology stocks were in a bubble, in the late 1990s, the Nasdaq Composite nearly quadrupled in value over three years. Then, after peaking in March, 2000, the infamous dot-com crash wiped out 78 per cent of the index’s value, erasing all of those gains and then some.

What’s rarely remembered is that the crash wasn’t linear. In fact, there were eight rallies during the correction – two of which saw the index jump more than 40 per cent. These rallies only prolonged the pain, and the Nasdaq didn’t bottom out until October, 2002, 2½ years after it peaked.

The Nasdaq’s current correction is already a painful one, with the index down 35 per cent from its record in November, 2021. But it’s only been one year, and the low interest rates that propelled the tech rally aren’t coming back soon.

Canada’s cannabis nightmare

Investors were warned, again and again, that there was no way Canada’s licensed cannabis producers should be worth as much as they were before recreational marijuana use was legalized in October, 2018. There were simply too many of them and the legal market was only so big – because the black market would take time to dissolve.

For the first few months after legalization, investors made up excuses for why the companies were still struggling. The real pain started to hit when market leader Canopy Growth Corp. fired its chief executive the next year. But even then, the sector’s shares didn’t completely collapse. The correction was more like a slow drip, because there were always reasons to have hope. Chiefly, some people thought (prayed) that the United States would also legalize recreational use at the federal level, especially after Joe Biden was elected President in November, 2020.

It never happened, and the Horizons Marijuana Life Sciences Index, which tracks Canada’s publicly traded cannabis companies, is down 88 per cent from September, 2018. It’s just that it took years for the bottom to fall out.

The 2008 global financial crisis

The first glaring sign that there was trouble with securities tied to the U.S. housing market came in August, 2007, when French bank BNP Paribas froze US$2.2-billion worth of investment funds with links to subprime mortgage assets. The banks said the market for trading these securities had completely dried up, so it was impossible to value its portfolios. Investors took note, and the S&P 500 started to sell off, but no one panicked.

The same was true when, seven months later, Bear Stearns collapsed. Again, there were concerns, but no one cut and run. It took six more months from that when Lehman Brothers went bankrupt in September, 2008, for true panic to set in.

Looking back, it was all so obvious. The housing market peaked in 2006 and soon after that subprime borrowers started defaulting on their loans. Not all at once, of course, but enough to make BNP freeze its funds. And that was the harbinger of so much more pain to come.

The current correction is vastly different, because global banks are in much better financial shape this time around. But there have been some warning signs. In November, Romspen, one of Canada’s biggest private mortgage lenders, with $3.2-billion in assets under management, froze investor redemptions, citing some trouble with loan repayments. One month later, Blackstone halted redemptions on its giant private real estate fund with US$69-billion in assets, after a wave of redemptions. Time to panic? Maybe not. But can’t be shrugged off, either.

The inflation slaying track record

This summer, two veteran economists released some stunning data about inflation in the United States. Going back to 1950, there have been four periods where a critical measure of inflation, the core personal consumption expenditures price index, needed to fall by three percentage points, like it does now. Crucially, across these four periods, the median time it took to do it was 59 months. As in, almost five years.

It has been so long since inflation has been a persistent problem that an entire generation doesn’t remember what it takes to tame the beast. Add to that the fact that the structural drivers of low inflation over the past three decades have evaporated in almost no time at all.

“The world looks a lot different now than it did during the past 30 years,” Bank of Canada Governor Tiff Macklem said in a December speech. “Greater geopolitical tensions and a backlash in some areas against globalization will make it harder to bring inflation down and keep it there.”

What that means: Anyone with a variable-rate mortgage praying that the central bank will start slashing this spring ought to come up with a Plan B.

No offense but anyone on a tight budget who took out a hefty mortgage in the last few years to buy a house thinking rates will not go up is going to be in big trouble this spring. 

Why Canadian policymakers are so focused on foreign buyers and haven't implemented 30-year mortgages like they have in the US and make mortgage payments tax deductible is beyond me (I know, primary residence isn't taxed but so what?).

Alright, it's 2023 and I've been looking forward to writing my outlook for the year.

Let me first wish everyone a happy, healthy and prosperous New Year.

As you can tell by the title of this post, I'm very bearish on the markets and think investors are in for a whole lot of pain this year and possibly next year too.

Trust me, I'm not a permabear or permabull but the main message is with interest rates normalizing all over the world and central banks tightening into a slowdown, we are going to witness a historic and painful earnings and economic recession.

I warned my readers a month ago, this time is different, it's much worse!

And it will last a while, possibly two or more years. 

I'll get into the reasoning below but it's safe to say the era of ultra-low rates and QE is over and as higher for longer settles in, the excesses built into the the system across public and private markets since the great financial crisis will be wrung out and the hangover will be long and painful.

This year, I asked a friend, François Trahan of Trahan Macro Research, to help kick things off.

François and I go back to our days at BCA Research. He is a well-known strategist who counts top hedge funds and long-only funds as his clients.

In 2016, when he was working at Cornerstone Macro before opening up his own shop, he entered the All-America Research Team Hall of Fame after winning No. 1 in Portfolio Strategy for ten of the past 11 years at that time.

What makes François's research different is his excellent grasp of the macro environment and how it influences various stock market sectors (he is top at allocating between sectors).

Most strategists are fundamental bottom-up people but he is very much a top-down macro strategist who knows how to analyze markets by understanding the macro environment and how the US economy is evolving and how it will play out in markets.

I've long recommended that all my institutional readers sign up and pay for the research at Trahan Macro Research.

To all of you who have been getting it for free on a trial subscription, it's time to pay up and pay for excellent market research you simply will not find anywhere else (lots of strategists try to mimic François's calls but there is only one producing the unique research).

What else? If you haven't done so already, make sure you pay so your employees can take the Macro Specialist Designation Trahan Macro Research has developed. Details are available here and I plan on paying for it too (these courses typically bore the hell out of me but this one is worth it, trust me, I worked on a couple of modules).

Alright, enough shameless promotion of Trahan Macro Research and the Macro Specialist Designation, let me get to the Q&A.

I sent François some questions last week and he was kind enough to answer me over the holidays (added emphasis is mine):

1. Hello Francois, thank you for agreeing to answer some questions, I really appreciate it. I’d like to begin with an introduction for those who don’t know you. Please briefly provide a background and tell us why we should listen to your market views in this environment? 

I have been a sell-side strategist for a quarter of a century at various banks including Bear Stearns and UBS. I now work for myself at Trahan Macro Research. I have been ranked in II Magazine's annual survey 16 or 17 times ... 10 of those as the #1 Portfolio Strategist which got me inducted into the All-American Research Hall of Fame in 2016. 

I have always been macro focused, unlike most strategists that are former stock analyst. This worked against me in the early days of my career. It was in the years leading up to the GFC that being macro-focused started to play in favor. Financial markets have been macro-focused ever since and that it a big reason behind my success.  

2. Let’s move on with a brief recap of 2022. What in your opinion are the three most important events that shaped markets over the last 12 months?

  1. Russia/Ukraine War 
  2. Beginning of Fed tightening 
  3. Sticky Services Inflation => tight labor markets 

3. Now, in terms of the economy, what would you say was textbook in 2022 and what was more of a surprise? Clearly interest-rate sensitive sectors got hit first as the Fed embarked in the steepest rate hike campaign in years to fight the highest inflation rate in 40 years but were there other issues at play?

Housing's reaction to higher rates was textbook. Nothing unusual there. 

Inflation mostly behaved in a textbook manner. Headline inflation slowed alongside commodity prices and a slower global outlook. Core inflation is sticky with regard to Services CPI which is the bulk of it. 

NOT textbook is Goods CPI at 12% at the beginning of 2022 ... slowing consistently as supply-chain concerns eased, most of which was due to slower growth. 

NOT textbook is the lack of recovery in the participation rate given such tight labor markets => this is the effect of the retirement in the boomer generation throughout the 2010s and pandemic accelerated the process further. 

4.  In terms of stock markets, we saw a steep rise in interest rates in the US which was followed by other central banks later in the year. As stated above, interest-rate sensitive sectors like homebuilders and autos got hit, value stocks led by financials in the second half of the year after a rough first half in stocks and bonds. The ongoing war in Ukraine boosted energy prices at the beginning of the year and even though energy prices are dropping, energy stocks (XLE) remain relatively strong. Looking at the S&P 500, Energy stocks (traditional and renewable) have far outperformed all other sectors which are negative with a total returns of 60% in 2022. This also helped the S&P Value Index (IVE) outperform the S&P Growth Index (IVW). Is this an outlier year or is this part of a secular regime change as higher for longer settles in? Please discuss the major sector moves as you saw them and the whole value vs growth performance dichotomy. 

The S&P 500 has never been "growthier" than it was at the beginning of 2022. That also made it much more sensitive or vulnerable to a Fed tightening cycle than in the past. Growth stocks behaved normally in that context. Higher rates led to P/E compression. 

Value outperformed for a variety of reasons but the debacle in Growth stocks and their large representation in the Index made that a low bar. 

Energy and the commodity space did benefit from the geopolitical events. That said, we call them late-stage cyclicals for a reason as they tend to outperform (and rise on an absolute basis) until the PMIs cross below 50. In that sense, this was not that unusual. 

5. Now, let’s get into the outlook for 2023 and begin with the outlook for the US economy. Lots of discussion at year-end on whether we are headed toward a hard or soft landing. But with inflation still running over 7% YoY, the housing market in the doldrums and the yield curve the most inverted in 40 years, I believe a hard landing is inevitable. Still, the labor market remains tight and with consumer balance sheets relatively healthy from overly stimulative monetary and fiscal policies when the pandemic first hit, some people believe the Fed can engineer a soft landing. I’m very pessimistic on this outcome and think unemployment will spike in the second half of next year. What are your thoughts on the US economy next year? 

I don't see how we avoid a recession. I think it is normal to see the crowd argue "it's different this time" at this stage of the cycle and the folks pushing the soft landing rhetoric have to come up with some funky arguments to get there.  

Most Fed tightening cycles are followed by recessions so this should be your default scenario at this stage. Then consider the fact that this is the most aggressive tightening cycle since Paul Volcker was at the helm of the Fed AND we are doing Quantitative Tightening which frankly is a great unknown that skews the risks to the downside.   

Every single time CPI has risen above 5% post-WWII we have seen a recession. Yield curve already deeply inverted. Housing in complete meltdown mode. 

It's not unusual for economists to still be positive at this stage ... that usually changes when the PMIs closes in on 45 and the crowd becomes more concerned. This is what I call the glass half-empty phase of the cycle. I believe we get there this year. The words "soft landing" will go the way of "inflation is transitory" where people that used them wished they hadn't. 

6. One currency trader I talk to tells me the US economy always leads the rest of the world by six months. If that’s the case, what are your thoughts on the global economy next year? 

He's not completely wrong as the US consumer is source of demand for much of the world's export. We often plot the US PMI with those of EM Export Orders and the lag is indeed six months. This is why a slowdown in the US is often followed by crises elsewhere in the world. I think we will see many countries struggle with debt/downgrades/defaults in the coming two years. 

7. What are the leading indicators you look at both within the US and outside the US? Please elaborate a little. 

Series we use to forecast leading indicators we refer to as AEIs or Anticipatory Economic Indicators. They look terrible at this time in every single developed economy. These are essentially built using interest rates and inflation and they tend to lead LEIs by 18 months and GDP by 24 months. In essence, find the peak in interest rates for a cycle and the economic bottom will be about two years later. This is why I don't understand anyone that thinks we are about to see the economy recover. This is still early innings stuff.  

The one exception is China where lower rates in 2020/21 have helped their LEIs find a footing. It's not enough to carry the world given their massive over-investment but it does standout. 

8. 2022 was the year of inflation and Fed rate hikes. What is your outlook on inflation going forward and how will this influence the Fed’s monetary policy? Admittedly, my biggest worry is the Fed is getting ready to pause (not pivot) its rate hikes and while headline inflation can decline a couple of more percentage points from here as the economy slows, energy prices drop and the strong greenback reduces import prices, core inflation will remain sticky as wage inflation picks up. Do you see a repeat of the 1970s-style double dip recession due to a similar dynamic back then? Please elaborate. 

Headline inflation should continue to slow courtesy of lower energy and commodity prices. This is NORMAL in a global downturn. Core inflation will likely remain sticky for much of 2023 as Services CPI (73% of the weight in core CPI) is a lagging economic indicator (according to the Conference Board) and only starts to move lower AFTER labor market tightness has eased and even then with a lag. I do expect core inflation to slow but not as quickly as the Fed's forecast so I don't think anyone should hold their breath for a Fed pivot. 

9. Now, let’s relate all this back to markets. First, let’s discuss credit markets. A slowing US economy is typically bullish for long-dated Treasurys (TLT) but bearish for high yield bonds (HYG). Do you agree? How do we know when to time the peak of long bond yields? By looking at the short end of the curve (SHY) to time the Fed pivot? Please explain.  

That is true EXCEPT when the Fed is tightening into a slowdown. In that case it is Fed Policy that drives yields and not the business cycle. At least that's how it worked in the four similar episodes we have seen since 1970. I think we will need to see that last rate hike on the horizon before bonds are a buy ... since the Fed has revised their terminal FFR level 8 times thus far it's hard to tell when that is. We suspect it's closer to a 6% FFR. If the Fed started talking about that we would likely look at bonds more favorably. Kashkari is getting there with this morning's comments.

10. As far as stocks, a lot of well-known strategists are bearish and some are bullish. I’d say the consensus thinks the S&P 500 will go lower in the first half of the year as rate hike fears subside but an earnings recession kicks in. 3200 is the oft-repeated number of a low to buy the S&P 500 where valuations make sense historically. I say rubbish! In my experience, equity markets tend to overshoot and undershoot expectations especially when a major regime change is occurring (ie. higher for longer). This is why I openly worry this time is different, it’s much worse. I openly worry that we are headed toward a deep and protracted US and global recession over the next couple of years and that means we should brace for a deep and protracted bear market similar to the ones we saw in 1973-74 or 1982. Do you agree and if so, please explain your thinking on credit (including high yield bonds) and overall tactical positioning for next year.  

We see the S&P 500 somewhere between 2,800 and 3,400 at year end. List of strategist targets is included. Most see the S&P 500 higher this year. Only 3 out of 20 have the Index lower. This shows a poor understanding of macro because that is the same as saying that EPS and GDP will also recover which makes no sense in a world where the Fed is still tightening policy.

Regarding the oil embargo, the market did recover as soon as oil peaked and that was also the driver of interest rates. The bigger story there is that oil had become the soul driver of risk. It had become a perfect inverse with stock P/Es. We are not facing an oil embargo today and that relationship does not hold in 2022/23. I think everyone is declaring themselves an expert on the 1970s and it's bad research. Sorry. Debt is the bigger risk in this cycle. High-yield wont come down this time around simply because CPI tops out ... we still have the downturn to go through. 

11. In terms of sectors, I’m not a specialist like you but I’ve seen a few nasty bear markets in my time which really didn’t end well (2000 tech bubble and GFC). I’d say that Jeremy Grantham and Charlie Munger were right, the froth is quickly evaporating in the market as many bubbles burst concurrently (cryptocurrencies, SPACs, meme stocks, etc.). That’s the easy call. However, last year we saw the flight to quality in Utilities (XLU) and Staples (XOP) which drove their valuations to historic highs. What do you recommend for next year in terms of stock market sectors and why? What worries you most about next year and why? 

My favorite long is the Dollar. It's not a sector but in my mind that is the no-brainer investment of 2023. I said the same thing last year by the way. Sector wise the two standouts we see are Staples and Healthcare. Investors don't care about their valuations in bear markets ... the only thing they seek are steady earnings and in 2023 I suspect lower debt levels. Hence, I am not sure about Utilities here.  

12. What do you think of global equities in this context? Are emerging markets more vulnerable in a Risk Off market? 

I don't call what lies ahead risk-off. I think we are entering the risk-aversion phase of the cycle and EM are the absolute worst place to be as they depend on the DM world for growth and all those economies are headed into recession. Also, EM indices are typically full of cyclical stocks so they just don't do well in a global slowdown. You are looking for the best of a bad lot in 2023 ... Switzerland? An index heavy Staples/Healthcare would be my ideal "relative" investment. 

13.  Trahan Macro Research recently launched the Macro Specialist Designation. Please explain what it is and why in your opinion it’s so useful to have this designation when the CFA and other designations are industry standards right now. 

Academia and programs like the CFA do not train people to be good investors, they are trained to analyze balance sheets. This was great in the 1960s when the average holding period for stocks was over 8 years but in today's world the shorter investment horizons has magnified the importance of macro. The MSD is mostly focused on content that is not covered in academia or the CFA. It is meant to be a complement to the CFA.  

14. Let’s end on an optimistic note. What are you final thoughts on 2023 and is there anything to look forward to? 

The one good thing I see is that there are plenty of investment vehicles available to investors nowadays that can help navigate a bear market. Those were simply not around for most investors in the GFC. You still need the knowledge to know what to own here ... the MSD goes a long way toward providing that knowledge.

I thank François for sharing his insights with my readers.

In his latest weekly commentary, Another Challenging Year For Stocks In 2023, François notes this:

I am afraid I don't have good news for equity investors in 2023. We expect the bear market rally to fizzle out in the next month or so and the downtrend in stocks to resume thereafter. We see the S&P 500 somewhere between 2,800 and 3,400 at year end. Yes, you can drive a truck through that range, but I am biased toward the lower end of it. That said, even our most optimistic scenario (3,400) does not get us close to the lowest S&P 500 target on Wall Street (3,725). After a difficult 2022, we expect 2023 to be soul crushing for long investors. I wish I had better news but those are the macro cards we were dealt. 


The economy (and EPS) is going to start to feel the lagged effects of higher rates in 2023. Friendly reminder that today's economic growth is a byproduct of yesterday's interest rates—yesterday as in two years ago when rates were just beginning to rise. This will eventually lead to a much higher unemployment rate and likely a sustained deterioration in earnings. This is problematic for equities since lower EPS are associated with the worst bear markets across history. The equity market will not likely find a footing until a recovery in EPS and the economy is on the horizon and that is a long way away given that the Fed is still in tightening mode. 

We expect the soft landing vs. recession debate to come to a close this year and make way to what we call "the glass half-empty phase” of the cycle. This is when investor sentiment turns VERY dour. Typically, investors see the world in shades of grey and start to worry about the risks of a crisis. This Outlook 2023 report is too short to cover all the important topics likely to impact financial markets in the coming year. We will elaborate on these in a conference call on Wednesday January 11th at 10:30am (sign up using this link) and in subsequent reports throughout January. As always, we shall see how things pan out. Wishing you all a great year. Best, Francois

Now, I'm only going to share pages 2 and 3 of his report because I asked his approval and it's important to understand his thinking:

François notes: 

This monetary tightening cycle has been far from the typical “25 bps at a time” cycle. In fact, we saw six rate hikes of at least 50 bps in 2022. Regardless of the Fed’s path forward in 2023, we know that there is a TON of tightening in the pipeline already. The fed funds rate has historically led PMIs by about 18 months (chart below left), which means 2023 is setting up to be an abysmal year for economic data. To put it another way, a recession seems almost guaranteed at this point. This should not be too much of a surprise, as most tightening cycles are followed by recessions.

The critical point, this isn't your typical monetary tightening cycle, once it realized inflation wasn't transitory but persistent, the Fed started raising rates abruptly realizing it had fallen way behind the inflation curve.

And while the Fed has hiked rates considerably, François thinks there are more rate hikes to go. 

On page 3, he notes:

There are several proxies of Fed policy that argue that Powell and policymakers still have some work to do. Indeed, the Taylor Rule argues that the fed funds rate (FFR) should be north of 9%. Truth be told, real rates are a better tool to compare the current stance of Fed policy with where rates stood at the end of other tightening cycles. The chart below shows that real rates closed in on 0% under Chairmen Greenspan and Bernanke before they concluded their tightening efforts. In today’s world, even assuming core inflation slows throughout 2023, the FFR would need to be close to 6% to be consistent with history.

That's another critical point, with core inflation running at 6% annualized and the effective fed funds rate at 4.33%, real rates remain negative.

Interestingly, just this week, the released minutes of the last FOMC meeting show that Fed officials see higher rates for ‘some time’ ahead:

Federal Reserve officials are committed to fighting inflation and expect higher interest rates to remain in place until more progress is made, according to minutes released Wednesday from the central bank’s December meeting.

At a meeting where policymakers raised their key interest rate another half a percentage point, they expressed the importance of keeping restrictive policy in place while inflation holds unacceptably high.

“Participants generally observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2 percent, which was likely to take some time,” the meeting summary stated. “In view of the persistent and unacceptably high level of inflation, several participants commented that historical experience cautioned against prematurely loosening monetary policy.”

The increase ended a streak of four consecutive three-quarter point rate hikes, while taking the target range for the benchmark fed funds rate to 4.25%-4.5%, its highest level in 15 years.

Officials also said they would focus on data as they move forward and see “the need to retain flexibility and optionality” regarding policy.

Officials further cautioned that the public shouldn’t read too much into the rate-setting Federal Open Market Committee’s move to step down the pace of increases.

“A number of participants emphasized that it would be important to clearly communicate that a slowing in the pace of rate increases was not an indication of any weakening of the Committee’s resolve to achieve its price-stability goal or a judgment that inflation was already on a persistent downward path,” the minutes said.

Following the meeting, Fed Chairman Jerome Powell indicated that while there has been some progress made in the battle against inflation, he saw only halting signs and expects rates to hold at higher levels even after the increases cease.

The minutes reflected those sentiments, noting that no FOMC members expect rate cuts in 2023, despite market pricing.

Markets currently are pricing in the likelihood of rate increases totaling 0.5-0.75 percentage point before pausing to evaluate the impact the hikes are having on the economy. Traders expect the central bank to approve a quarter-point increase at the next meeting, which concludes Feb. 1, according to CME Group data.

Current pricing also indicates the possibility of a small reduction in rates by the end of the year, with the funds rate landing around a range of 4.5%-4.75%. Fed officials, however, have expressed doubt repeatedly about any loosening of policy in 2023.

The minutes noted that officials are wrestling with two-pronged policy risks: One, that the Fed doesn’t keep rates high long enough and allows inflation to fester, similar to the experience in the 1970s; and two, that the Fed keeps restrictive policy in place too long and slows the economy too much, “potentially placing the largest burdens on the most vulnerable groups of the population.”

However, members said they see the risks more weighted to easing too soon and allowing inflation to run rampant.

“Participants generally indicated that upside risks to the inflation outlook remained a key factor shaping the outlook for policy,” the minutes said. “Participants generally observed that maintaining a restrictive policy stance for a sustained period until inflation is clearly on a path toward 2 percent is appropriate from a risk-management perspective.”

Along with the rate hikes, the Fed has been reducing the size of its balance sheet by allowing up to $95 billion in proceeds from maturing securities to roll off each month rather than be reinvested. In a program started in early June, the Fed has seen its balance sheet contract by $364 billion to $8.6 trillion.

While some of the recent inflation metrics have shown progress, the labor market, a critical target of the rate increases, has been resilient. Nonfarm payroll growth has exceeded expectations for most of the past year, and data earlier Wednesday showed that the number of job openings is still nearly twice the pool of available workers.

The Fed’s preferred inflation gauge, the personal consumption expenditures price index less food and energy, was at 4.7% annually in November, down from its 5.4% peak in February 2022 but still well above the Fed’s 2% target.

Economists, meanwhile, largely expect the U.S. to enter a recession in the coming months, the result of the Fed’s tightening and an economy dealing with inflation still running near 40-year highs. However, fourth-quarter GDP for 2022 is tracking at a solid 3.9% rate, easily the best of a year that started out with consecutive negative readings, according to the Atlanta Fed.

Minneapolis Fed President Neel Kashkari said Wednesday, in a post for the district’s website, that he sees the funds rate rising to 5.4% and possibly higher if inflation doesn’t trend down.

The market expects 75 bps more rate hikes to come, 50 bps at the next meeting and 25 bps in the subsequent meeting but I wouldn't be surprised if the Fed hikes twice by 50 bps before it pauses.

On Twitter and LinkedIn, François Trahan notes:


The title tells you most of what you need to know about this article. The chart on the dot plot vs Fed Funds Futures is really interesting though. It shows that the futures market does not believe the Fed's view of the world. This is a HUGE deal given that the Fed has systematically underestimated how much they would need to raise rates in the past year. This chart essentially argues that we are now in a completely opposite world. Bullard was clear in his comments that labour markets were better than he expected in the Fall and therefore he feels better about the odds of a soft landing. I interpret this as a Fed that would not feel bad doing a few insurance rate hikes in H1'23 to make sure the inflation story is indeed dealt with (i.e. the lessons of the 1970s). Powell still talks up Volcker ... we shall see I suppose.

Fed minutes just confirm what I warned about in mid-December, higher for longer is here to stay and Wall Street is only now starting to let that sink in. 

Call it a regime change, call it whatever you want, rates are normalizing fast and long gone are the good old days of ultra-low rates and QE Infinity.

In the current environment of higher rates and QT, you need to earn your alpha, you can't chase beta or pile on the debt and use financial engineering, you really need to roll up your sleeves and take a long-term view of things.

Before I get into that, let me discuss the hard vs. soft landing debate.

While astute market observers note the yield curve is the most inverted since 1962, flashing a clear red flag that recession lies ahead, this week, the inventor of the yield curve, Duke University finance professor Campbell (Cam) Harveys said it's not a harbinger of recession:

On LinkedIn, Cam, a fellow Canadian and really smart & nice guy (met him years ago), elaborated on his views:

My yield-curve indicator has gone Code Red. It is 8 for 8 in forecasting recessions since 1968 —with no false alarms. I have reasons to believe, however, that it is flashing a false signal.

My 1986 thesis shows that the yield curve (10yr Treasury yields–3mo bill yields) predicts real economic growth. In June 1989, the New York Times discussed my research for the 1968–1989 period: “All four of those inversions were followed by recessions.” Over the next 32 years, the yield curve inverted another four times—and a recession followed each inversion. The yield curve has now inverted for a ninth time since 1968. Does it spell doom? I am not so sure. Here’s why: 

Labor excess demand. Of course, unemployment is low before every recession, but it is unusual to have excess demand for labor. In this environment, laid-off workers can find work quickly. That is, the economy can better absorb slower or negative growth.

Tech layoffs. Laid-off workers from FB, Twitter, and other tech firms are highly skilled and have very short duration of unemployment. Contrast this with the global financial crisis. Employees laid off by Lehman had no place to go. Likewise, in the COVID recession, when restaurant workers were laid-off, they had nowhere to go.

Consumers in a much stronger position. Even if housing prices decline, the amount of equity to debt is much higher now than before the financial crisis. As a result, a drop in housing prices will unlikely result in contagion. Consumers’ balance sheets are in much better shape than in the past.

Financial sector is healthy. The global financial crisis started with the financial sector and the sector’s problems spread, rapidly deepening the recession. It is unlikely that the financial sector would deepen a recession this time.

Model is about inflation-adjusted yields. The published version of my thesis is called “The Real Term Structure…” Inflation expectations are also inverted (short-term inflation is much higher than long-term inflation). When yields are inflation adjusted, the curve is flat (suggesting lower growth, but not necessarily a recession).

The yield curve now impacts behavior. Given the inverted yield curve is in the news, companies are unlikely to “bet the firm” on big projects. Consumers are being cautious and have plenty of savings. This situation leads to a self-fulfilling prophecy, i.e., lower growth. We can also view this as risk management. Even if growth slows, companies can make it through without large, painful layoffs, making a soft landing more likely.

These circumstances raise the possibility of dodging the bullet. Ideally, we avoid the hard-landing recession and realize slow growth or minor negative growth. If a recession arrives, it will be mild.

The major wildcard is the Fed, who was late in raising rates. The Fed cannot err twice by overshooting-i.e., continuing to increase rates well beyond when they should have stopped. I believe the time to end the tightening is now.

I replied to Cam's post:

I respectfully disagree. With the Fed tightening in a slowdown, it’s impossible that the US economy will avoid a hard landing. All this talk of the yield curve flashing a false signal, even from the man who invented it, is totally wrong on so many levels. Stay tuned for my Outlook 2023, will get into it there.

And Cam replied back and attached a chart:

You correctly point to the wildcard - which is the Fed. They might fumble and drive us into a serious recession. Here is an interesting graphic regarding my point on housing. The housing sector is unlikely to cause a hard landing. Prices have already come down but there is lots of equity. Thanks for your comment.


Now, I agree with Cam, the Fed is the wildcard but as I stated above, I think it will overshoot on its rate hikes just as it overshot on its rate cuts when the pandemic hit in March 2020.

As far as housing, there may be more equity than in 2008 but I take all these stories that the "US consumer is in great shape" with a shaker of salt.

With real wages declining over the past year, I just don't buy it and when unemployment starts surging in the second half of the year -- and it will -- the real US consumer will show up, in debt and struggling to make ends meet.

As far as housing, François Trahan always reminds us of Ed Leamer's seminal paper, Housing is the Business Cycle, and the charts are ugly and show the recession is already upon us:

Clearly, the US economy is already in a recession and pipe dreams of a soft landing are just that, pipe dreams:

What about today's stronger-than-expected US jobs report? What about it?

When you look underneath the hood, it too is pointing to a decline in the economy:

Again, I reiterate, by this time next year, the US unemployment rate will spike close to 9%, at a minimum it will double from these levels.

"Impossible Leo, the labor market is too tight!!"

Be very careful with this tight labor market theories.

There's a reason why Big Tech and other companies are laying people off, they see the pipeline and it's pitch black!

What about wage inflation? Jason Furman notes that wage growth came in at 3.4% annualized, reverse of last month, slowed a lot, but he fails to see that it won't last, placing the Fed back in a pickle this year:

Also, if the FTC's proposal to ban non-compete clauses goes into effect, it will put significant pressure on wage inflation this year:

And that brings me to the stock market, the real reason you are all reading this comment.

If you haven't figured it out already, I'm very bearish, think years of froth and excess caused by ultra-low rates, QE and very stimulative fiscal policies to combat the pandemic are over and as rates normalize all over the world, QE is replaced by QT, and governments cut back spending, we are in for a very long hangover.

As I stated a month ago on why I believe this time is much worse:

The biggest risk next year is the Fed and other central banks will pause but inflation pressures will remain sticky because wage inflation will pick up, potentially forcing the Fed to hike more even as unemployment spikes (stagflation).

And even if the Fed pauses, beta drag will continue as it is hiking in a slowdown.

What does this mean for risk assets?

It means you can forget unicorns, cryptocurrencies, SPACs, meme stocks, Tesla, Ark Innovation hyper-growth stocks, venture capital, private equity, leverage loans, private debt, real estate, infrastructure, whatever.

Let me be crystal clear, all asset classes will get clobbered over the next two years with exception of liquid alternatives -- and only top hedge funds will survive the shakeout coming to that industry.

Who else will thrive this year? Short sellers who are coming off a great year after being struck by monetary and fiscal coronavirus during the pandemic. They have awoken for their hibernation early and they're hungry, very hungry:

"What the hell Leo, why are you so damn bearish? This isn't 2008, it's not a repeat of the GFC."

You're right, it isn't 2008, this time is different, it's much worse, it will be a deeper and more prolonged global recession. There is so much debt across private and public markets that when the chickens come home to roost, it will send shockwaves through global financial markets.

Don't worry, there's still plenty of liquidity out there, but I warn you, the real bear market has yet to arrive and when it does, it will feel god awful:

The scary thing is investors are saying they're bearish but they aren't positioned for the deep and prolonged recession I'm warning of:

As far as earnings go, we are entering a brutal earnings recession which will last another year at least:

The real cracks will start appearing in the debt markets prior to stocks get hit really hard:

I keep telling my readers to keep their eyes peeled on credit markets and high yield bonds:

High yield bonds remain weak and if this index starts declining precipitously as high yield spreads blow up, watch out, all hell will break loose in the stock market.

A lot of young investors never experienced a prolonged and nasty bear market, they'll see firsthand what I'm talking about, when credit markets explode, really nasty things happen across the risk spectrum.

And by the time the Fed pivots (not pauses but actually cuts rates), it's too late, the damage is done and stocks will head lower.

With this in mind, I will share with you how low I think the S&P 500 will go, I expect it to hit 2500 some time in the first half of the year, possibly in the third quarter:

"OUCH! That is scary!"

Yeah, I didn't say this will be a fun ride, it will be a painful and drawn out one but with rates normalizing all over the world, it's going to be ugly, really ugly, led by growth stocks with the Nasdaq falling another 30% this year:

"Holy crap! Now I know you're really off your rocker! How can the Nasdaq decline again by 30%?!?

Because it went up like crazy for over a decade in an era of ultra-low rates and QE. 

As rates normalize back to historic levels, the party is over for long duration tech stocks. Yes, some of the mega cap stalwarts -- Apple, Microsoft, and Alphabet -- will do relatively better because of their strong balance sheets, but even they will get hit hard.

In a really bad bear market, stock prices tend to undershoot just like they overshot in January 2021.

That's why I always remember John Maynard Keynes's famous saying: "Markets can stay irrational longer than you can stay solvent."

That's true when markets are going up like crazy and it's true when they're going down like crazy.

"Geez, Leo, before I slice my wrists, is there any good news in your damn long comment?!??"

Yes, Private Equity has tons of dry powder and elite PE funds are going to use that dry powder to take companies private again, bidding up prices when some of these companies get clobbered hard.

 We saw it late last year when Thoma Bravo took out Coupa software in an $8 billion deal:

Also, I expect companies with strong balance sheets to take out competitors during this prolonged recession, so M&A activity will pick up at one point, just not yet.

But don't be fooled, we are heading for a historic and painful earnings recession and the real pain lies straight ahead.

Forget about last year, it was an appetizer for what's in store for us.

Last year was all abut multiple contraction -- ie. the P in P/E got hit. This year will be al about earnings contraction -- ie. the E in P/E. And it will be brutal.

If 2020-21 was buy the dip, 2022-2023 will be SELL THE RIP!!:

I'm pretty much short everything HOWEVER there will be stock specific stories in biotech and some other sectors as this beast of a bear market drags on.

The problem? The beta drag will be huge and even safe sectors will feel the pain.

Short cyclicals like Financials (XLF), Energy (XLE), Material (XME) and Industrials (XLI), they're going to get clobbered even if rates stay higher for longer because the global recession will ravage them.

Industrials are particularly vulnerable here and I see them getting hit very hard this year:

Also, AQR's Cliff Asness posted an update this week on global value spreads, stating the bubble hasn't burst:


What else? Two months ago, when I tracked top funds' activity in Q3, I said the real killing in shorting Tesla shares lies straight ahead.

My (not so) bold prediction for 2023 is Tesla shares will be trading below $30 this time next year and Ark Innovation Fund will be closing its shop:

Yeah, I know Cathie Wood is a woman and I'm all for gender and other diversity but here's the thing, in a really bad bear market, the market will dictate how good you are, and the market will be brutal, it doesn't care about your gender, race, religion, disability, sexual orientation, etc.

The Cathie Wood honeymoon is over, it's been over since I wrote my comment on the unARKing of the market, but now it's really over.

I have nothing against the lady, her time has come and passed. 

In the environment we are headed toward, the men and women will be separated from the boys and girls. 

And that brings me to my other piece of advice, you'd better hire experienced people in your organization, people with brains, brawn and intestinal fortitude because a prolonged and nasty bear market requires true leadership.

Enough of this ESG fluff, responsible investing is here to stay, everyone with half a brain knows and understands this, but it's time to return the focus on money and risk management.

Responsible investing can complement this but the key work is complement not supplant it.

That brings me to some other advice.

In a bear market, it's all about return of capital not return on capital.

Learn the beauty of dividends and really understand which companies with strong balance sheets can continue to offer them:

But again, be careful here, just because your favorite bank offers a 5% dividend, doesn't mean the stock price can't crater 30%+ in a year.

You need to pick your spots carefully and forget REITs, they're toast!

Bill Gross recommended the Alerian MLP ETF (AMLP) on CNBC recently, it's a pipeline ETF which yields 7%:

Gross also discussed why he's long mortgage backed securities (MBB) here, stating with long bond yields coming down, they have room to do well this year:


I think US long bonds (TLT) should fare a lot better his year but I agree with Trahan, with the Fed continuing to hike rates, we we might see a retest of lows (yield highs) before the real rally takes hold:

As far as the US dollar, I've been bullish since last year when I wrote my Outlook 2021, Beauty and the Inflation Beast.

I remain bullish on the greenback but the big money was already made here last year. Still, I would add on recent weakness and think it;'s headed higher again:

What else? You might want to look at preferred shares (PFF) and covered call strategies here but I'm no expert on these ETFs so do your due diligence and ask experts:

I also heard Bryn Talkington on CNBC Halftime Report today recommending JPMorgan Equity Premium Income ETF (JEPI), Innovator U.S. Equity Power Buffer ETF - January (PJAN) and Pacer US Cash Cows 100 ETF (COWZ).

She's very sensible and good but again, do your due diligence and ask experts if you're not sure.

Lastly, to all institutional readers, please, PLEASE!!!, DO NOT CHASE AFTER THE BEST PERFORMING HEDGE FUNDS OF 2022!!

Seriously, this is what I wrote on LinkedIn: 

Great performance BUT having allocated to the best hedge funds in the world, a word of caution here. Is this performance repeatable? These eye-popping returns are all due to the effects of leverage which works both ways, amplifying returns on way up and down.

When you sit down with your macro fund managers or any hedge fund manager at the beginning of the year, ask them what are the three worst trades they made last year and ask them to explain what went wrong and how they managed risk or didn’t manage it.

I can assure you just by reading this, I’d be cautious here. Not saying they can’t produce great returns this year as I’m very bearish but their use of leverage is a concern:

“His highly leveraged strategy took advantage of central banks’ retreat from years of quantitative easing as they attempted to rein in spiraling inflation. The money manager was shorting rates in the US and UK, along with the G7 countries in general, which have seen bond yields soar as traders aggressively bet on the pace and extent of interest rate hikes.”

I can't stand when people tell me about some hedge fund returning eye-popping returns in a down year, it's totally meaningless if you don't understand the process!!

Here's another prediction for 2023: CalPERS will restart its hedge fund program under the direction of its new CIO Nicole Musicco (mental note to talk to Nicole and Marcie to do it right this time).

Before I forget, as my buddy texts me to tell me the "market exploded higher today and to buy Tesla", here is how to short Tesla, you wait till the shares pop back up close to the 5-week exponential moving average and BAM!, SHORT the crap out of them:

 

Today was a nice day to play it long, shorts covered on the news of China deliveries, the stock initially tanked and then rallied. It won't last long, I assure you of this. Play it more on the short side.

Alright, I'm rambling on and need to wrap it up and have a late dinner.

I hope you like all my comments and remind you that while they are free, I appreciate those of you who take the time to support my work my clicking on the PayPal options under my picture on the top right-hand side. 

Just this comment alone is worth $5,000 a year but hey, I appreciate all of you who support the hard work through your hard earned money!

Below, I am embedding a lot of clips for your viewing. Please take the time to watch all of them as I cannot explain them all but they're definitely worth watching to understand the outlook for 2023.

Enjoy and remember, no matter what curveball the markets and life throw at you, as Nietzsche famously stated: "What doesn't kill you, makes you stronger."

Keep your cool and focus throughout this long and nasty bear market and always sweep the table when you're up nicely on a trade and cut losses fast when you're down. Keep the eye of the tiger!! :))

Update: Hedge fund billionaire Paul Tudor Jones likened Jerome Powell’s war against inflation to an attempt at a perfect moon landing, saying the Federal Reserve chair is facing the most challenging economic environment in 40 year:

“There’s huge amount of savings that consumers have from all the Covid-relief bills and the stimulus that was applied both from a fiscal and monetary standpoint,” Jones, the founder of Tudor Investment Corp., said Tuesday in an interview with CNBC. “He is faced with that very difficult proposition of working that down without breaking things.”

If Powell succeeds, Jones said stocks could climb 7% to 8% this year, but if inflation worsens he’ll need to continue raising rates, increasing the risk of a downturn.

The latest jobs report showed robust hiring and an unemployment rate of 3.5% — a five-decade low. Wage growth also began to slow in December, suggesting the Fed may be making progress in its efforts to tamp down inflation.

“Most of the inflation we’re seeing right now is not because the fact that the American worker is getting their fair share of the pie,” said Jones, 68. “The inflation that we have right now is primarily because of extraordinary fiscal stimulus and extraordinary monetary stimulus.”

The Fed raised rates by 50 basis points in December to the highest level since 2007, and Powell suggested that the central bank would continue its monetary tightening.

Bottom line: The Fed is still raising in a slowdown and even though Tudor Jones isn't saying it bold faced, a soft landing is a pipe dream and he expects stocks will crater from these levels.

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