ASSET CLASSES IN 2023

INTEREST RATES AND INFLATION IN CONTEXT TO STOCK MARKET

The US Federal Reserve (US Fed) started increasing interest rates from March’22 level of
near zero, and till then kept tolerating the high inflation so that the supply is fully
normalized assuming it was a transitory inflation. The production was impacted due to
pandemic and it takes few months for it to get at normal pace to produce, and to
accommodate that, money supply was increased at near zero interest rate. The period of
transitory was never defined. The assessment in the last article proved to be correct that
there was not transitory inflation and inflation kept on increasing further due to ever
increasing money supply at near zero interest rate. It led to rise in stock markets especially
technology growth stocks. Ample money at free cost gave very rich valuations to high
growth stocks irrespective of the accumulated losses year on year basis but high growth on
revenue.

The inflation is a form of tax paid by citizens without realizing it. Inflation is a tax in which
the government expands money supply resulting a decrease in the value of money. Money
hoarders are penalized to hold money. The annual inflation rate in the US kept on rising
steadily from 1.4% (January 2021) to 9.1% (June 2022) which is much above the tolerance
level of US Fed at 2%. In the meeting of June 2022, US Fed increased interest rate to
1.5% to 1.75% which was a quantum leap since so many years, is a sign of aggressive
stance to control inflation. It kept on increasing interest rates aggressively till the end of
2022 at 4.5% (expected), also fastest rise in last 40 years. If we calculate the rise of interest
rate in percentage terms from the bottom of 0.25%, it is the fastest increase in one year,
eighteen times increase recorded ever in the modern globalized world. As we know that
stock markets are smarter than us and discounts the news much in advance, so the stock
markets bottomed out as on 16th June’22, on the day of first-time announcement of largest
hike in interest rates in a single meeting. Stock markets made the final low as on 13 th
October’22 on the news of inflation rate for September month hitting 7.7% which was a
sign of a gradual reduction. Thereafter, inflation rate is reducing gradually and interest rates
peaking at 4.5% or may be terminal rate at 5% by March 2023. The next discounting would
be for recession in the economy.

As the mortgage rate already doubled from the bottom of 2.5% per annum for the housing
market, the monthly instalments also doubled with stagnant wage rate. Soon mortgage rate
shall go up further may be tripled to 7.5% and it shall crack the housing market. High
inflation and sudden rise in monthly instalments would lead to foreclosure of housing
loans. Mortgage rates are still more than double what they were the first week of 2022 and
home prices are more than 6% higher than a year ago, making it harder for potential home
buyers to access affordable housing. The median existing home sales price was $379,100
in October, up 6.6% from a year ago but down from the record high of $413,800 in June,
according to the National Association of Realtors (NAR). Still, the higher housing costs
have taken a toll on home buyers as mortgage applications are at their lowest level in 25
years, according to the Mortgage Bankers Association (MBA). Total existing home sales
dropped 5.9% from September to October, marking the ninth consecutive month of
declining sales, as home buyers were “squeezed out of qualifying for a mortgage,” said
Lawrence Yun, NAR’s chief economist, in the report. This will result in crash of property
markets just like in the beginning period of 2008 financial crisis. The year 2022 may be
compared in parallel to the year 2007 before the actual crash happened in 2008.

High inflation is already nibbling the pockets of the citizens and adding to the woes is high
interest rates. Credit card balances jump 15% which is a highest annual increase in over 20
years, meaning American citizens are falling in deep debt crisis. As daily expenses are
rising, American citizens are taking more on debt. The total credit card debt may touch $1
trillion in the fourth quarter. The under current of the economy is in a bad shape but the
unemployment rate at around 3.7% stills looks comfortable on the face of US economy.
The credit card debt has crossed the $870 billion peak of 2008 financial crisis. The
delinquency rate also shot up from 0.16% to 5.32% compared to previous quarter. The
household debt is increasing at the fastest pace ever. Credit card, mortgage and auto loan
balances continued to increase in the 3rd quarter of 2022 reflecting the higher prices and
the higher interest rates. The rising rate of delinquencies is a worrisome situation.

US Debt stood at nearly $31.5 trillion which is an annual increase by approximately $3.1
trillion but it is ballooning at faster pace than that. In 2021, the trade deficit in goods and
services stood at $859 billion. For the year 2022, the trade gap in US should be at $1 trillion,
a historical record. As per Washington Post, US government’s interest payment on its debt
would be around $580 billion in the current fiscal year. US Fed is increasing interest rate
with the target of 5% per annum to curtail the inflation and starting of Quantitative
Tightening (QT). In the coming years, the US federal government will spend more than
$1.5 trillion for debt servicing (interest payment = debt service). Higher debt service with
the trade gap would amount to more than $2.5 trillion fiscal deficit, which also needs to be
addressed by further increase in money supply to fill up the deficit. Hence, annual increase
in US debt is imminent. Higher the debt means further increase in debt servicing. The US
Fed is dangerously exposed to higher debt and any increase in risk of debt default would
need faster than ever increase in money supply. This will put pressure on inflation which
could turn into hyperinflation. This is how it becomes an ideal environment for
‘Stagflation’. Higher money supply will help inflation and higher interest rate will restrict
growth. Eventually US Fed must stop QT to fund the twin deficits without tinkering the
interest rates. Currently we are observing the QT with increasing interest rate. Inflation rate
is trending down and it may halt at 5 to 6%. Bond markets are dangerously exposed to such
a turmoil that US Fed has to fund its own deficits and trading volumes becoming shallower
than ever before, because US treasury holders like China, Japan and others are selling it to
maintain their own currencies. It is a vicious circle where the end is nearer. Geopolitical
scenario is also bad around the world. China is gradually dumping US treasuries due to
mistrust, Russia already sold it completely, Japan selling it to maintain Yen against US$
and other western countries are facing the problem of their own for fighting stubbornly
high inflation. It is a currency war.

Global debt level is highest ever and it could be anywhere above US$ 300 trillion while
the cost of funds is increasing due to higher interest rates. Estimated size of the global
economy is US$ 80 to 85 trillion which is much lower than the global debt. Global debt is
nearly four times the size of global economy which was three times may be 2 years ago.
The stock markets and commodities have entered the bear market after a long bull run of
21 months. What does it mean? The stock markets have discounted the news of hike in
interest rate and peaking of inflation as there is no room left to go down other than the
recession news. Interest rates nearly peaking and inflation rate already been peaked out, so
the stock markets have bottomed out for discounting such events. Bear market rallies are
sharp and short lived, so it has started.

Inverted yield curve is also one of the strongest factors of expected recession in the US
economy. Bond market is the most matured market of all the markets in the world as it
involves the sovereign nations money. What is an inverted yield curve? An inverted yield
curve occurs when the short-term interest rates cross over the long-term interest rates. It is
also called “negative yield curve” and it is proven to be reliable indicator of a recession.
Generally, there is comparison between 2-year (2Y) US treasury yield and 10-year (10Y)
US treasury yield. Inverted yield curve occurs at the time when 2Y yield is above 10Y.

The above chart shows the negative yield is highly inverted at negative (-)0.79%. Currently
2Y yield is at 4.28% and 10Y yield is at 3.49%, meaning spread of (-)0.79%, imminent
recession. Inverted yield curve precedes the recession and the stock market crash. An
inverted yield curve for a longer period (12 months or more) appears to be more reliable
than a shorter period. In 2006, the inverted yield curve remained for almost a year and long-
term treasury bonds kept on outperforming the stocks during 2007. The Great
Recession began in December 2007. In April’22, the negative yield curve remained for a
brief period then again from July’22, it is steadily going deeply negative, almost
completing 9 months. Situation is grim and any Black Swan event would lead to
capitulation in all the financial markets along with commodities.

Money Supply (M1) often be a useful indicator of economic activity for predicting
recessions. US M1 was reported at $20.0999 trillion in the month of October’22 declining
trend from the peak at $20.6991 trillion in the month of March’22. US M1 is at 12 month
low indicating a recession. M1 is not going to improve in 2023 as US Fed is determined to
bring down the inflation by the way of QT. Brace for the impact on global economy.

The Dollar Index (DXY) shows that US Dollar is the safe haven in current scenario as the
major asset classes are depreciating including Bonds. Euro US Dollar ratio had come to a
low level of 0.956 (20 years low) in September’22. DXY rallied from the low of 89.20 to
114.75 and now the prices corrected at 104.11. It has briefly breached 200 DMA, a support
level and Fibonacci retracement also nearly at same level of 105. Soon it should resume
upwards being reserve currency and the only currency of the developed nation with higher
interest rates compared to other developed nations, attracting money to flow in US$.

US Dollar is proving to be a safe haven even after being a flaw currency as explained
earlier. The interest rate in USA is much higher than any developed nations so attracting
money to flow in and at the same time strong currency means an attempt for lower inflation.
It shall work well in the short run but looking at the fundamentals, US Dollar has to
depreciate in long run at much faster pace due to money printing for financing the twin
deficits and supporting the economy. Indications are clear from the statements of top
corporates to cut down the jobs. The increasing unemployment is evident with sharp
increase in interest rates and proposed reduction in money supply by the way of QT. There
shall be no choice left for US Fed but to increase money supply by the way of QE
(Quantitative Easing), money printing to fund the deficit and stopping the increase in
interest rates or may be reduction in the future. It is a classic example of Stagflation, high
unemployment, high inflation and degrowth.

Conclusion:
There are several indications in the US economy to go in deep recession and likelihood of
having its impact on global economy with worsening geopolitical scenario. The impact on
stock markets shall be sudden and swift, discounting the news much earlier than known to
all.
To sum up the reasons are as follows:
1. Higher interest rate at 5% to remain throughout 2023.
2. Inflation may slow down but to remain higher above 5% rate in 2023.
3. A record high of household debt.
4. A record high in US national debt.
5. A record high Global debt.
6. A looming currency war between developed nations.
7. The rising rate of delinquencies in credit card, auto loan and mortgage loan.
8. A worsening geopolitical scenario.
9. An inverted yield curve in bond markets.
10. Faster than expected decrease in M1.
11. US Dollar as safe haven status in gloomy scenario.
12. A warning by top global CEOs.
13. An announcement of job cuts by big corporates.
Technically Speaking:
As per the Elliot Wave Theory, 5 waves DOWN completed in June month and now 3
waves UP (3 to 6 months) should be completed at or around 200 Daily Moving price
Average (DMA) of S&P 500. The next capitulation (final) phase of bear market will be a
fresh 5 waves DOWN (6 to 9 months) on the upcoming news to discount the recession.
This time the stock markets would discount the news of bad corporate results and official
recession news. The impact on economy of hike in interest rates take around 6 to 12 months
and 9 months are already completed from March’22 (first interest rate hike news). First or
second quarter of 2023 should be the phase of capitulation as recession news should come
anytime from now. Around November’21 was the peak of major stock markets in the
world, and in June’22, it bottomed out though it made a new low in October’22. The first
quarter of 2023 is dangerously exposed to recession news with expectation of worst
corporate results. In the month of January’23, April’23 and July’23, GDP numbers and
other economic factors will come out (expected to be not good).

The above chart of S&P 500 (3rd December’22) shows the 5 waves down (A,B,C,D,E)
discounting the high inflation and interest rates, and the next wave of correction (bear rally)
in bear market. S&P 500 at 4072 facing a resistance from downtrend line at 4080 as well
as 200 DMA at 4055 (though breached upward briefly). It completed the final E wave of
bear market at 3675 (June’22). It again breached the low of 3675 and made a new low of
3583 (October’22) but not qualifying as new wave due to 3% breach. It was about to qualify
for new bear phase cycle of capitulation but could not sustain and moved up again to 200
DMA (a red line in charts). 6 months are completed from the June low of 3675. S&P 500
may at its best go to 4280 level before resuming a new capitulation phase. 4080 to 4280 is
the level to resume short sell. RSI on weekly basis also no more oversold and in fact at
neutral zone. The bear market, if it resumes would be the worst phase with target below
3000 level.
By Ankur Sharda

Published on 6th December, 2022