Big Four Macro Overview: Part 5

For more detail please refer to the first four pieces in the series (linked below) and the accompanying charts.

Markets entered 2022 with well established trends and trading ranges, but I believe that the coming year holds significant potential for change. This is particularly true in the equity and treasury markets. Because much of the outlook hinges on inflation (see below) it will be particularly important to monitor inflation related markets.

Importantly, while it's easy to make the case that rates should rise significantly this year, modern financial history suggests that rising rates are likely to break the most vulnerable financial link. If that link has the ability to create systemic disruption, rates will fall again, even if inflation is high, as the market runs to the quality of treasuries.

In my opinion, the most important trend of the last four decades has been the decline and subsequent quiescence in the inflation rate. Falling and low inflation allowed Treasury rates to decline. Falling Treasury rates supported equity valuations and home prices. They also enabled the wholesale financialization of the economy and allowed both public and private entities to add leverage without consequence. Importantly low and steady inflation also created the negative correlation between treasury and equity. Without that correlation 60/40 and risk parity strategies may well be in danger.

Inflation: My working thesis has been that many of the trends that supported disinflation have reversed and that rising inflation will act as a headwind to investment for the next decade. Going into 2020 I believed that the stage for higher inflation had already been set and that higher inflation would result in higher rates and ultimately equities.

Consider that in early 2020:
• The output gap had closed for the first time since the Great Financial Crisis.
• The economy had just reached full employment with a U-3 Unemployment rate @ 3.5%.
• Wages as measured by the Employment Cost Index were rising @ +4.4% YOY rate.
• The Cleveland Fed Median CPI had recently set a 10 year high.

If not for the pandemic, by early 2021. the Federal Reserve would have been forced to respond to rising inflation by increasing rates. Instead, Covid crushed the demand side of the economy, derailing the growing inflation. Now the extreme fiscal and monetary response combined with disruptions in logistics and labor have combined to create very high inflation. While I think that many of the issues creating this burst of inflation are moderating, the same set of factors that were reversing in 2020 are still in place. In short, I believe that the broader trend has changed and that when everything settles out, will end up significantly in excess of the Feds 2% average target.

Bottom Line: Above trend growth in inflation and monetary/fiscal tightening suggest higher volatility and a significant chance that many of the trends that have defined the last few decades will falter. My sense of the economy is that the best growth has already occurred as the result of historically supportive fiscal and monetary policies and now both paths are turning restrictive (see the second part of this series for a more in depth discussion) and markets will likely reflect that reality.

Rates:
• Bonds remain in a bull market defined by a broad declining channel, but rising inflation could easily change the trend. The most likely catalyst to end keep rates below 3.25% would be a financial accident created by higher rates.
Equities:
• SPX remains in a technical bull market and there are no overtly bearish behaviors evident in the longest perspectives. However short term weakness can easily morph into a bear market.
Commodities:
• Goldman Sachs Commodities index is in the center of a broad 14 year range, bounded essentially by the low set during the financial crisis and the resultant 2011 high. range. The most notable/useful current chart feature is the clear uptrend from the 2020 pandemic low. Until that uptrend is broken, the most immediate trend is to higher prices.
US Dollar:
• The wide macro range, 70.70 - 121.02 has contained price action over most of my trading career but volatility is more cyclical than price. These periods of low vol. set up conditions that often lead to explosive moves.

Now, back to the charts!

Good Trading:
Stewart Taylor, CMT
Chartered Market Technician

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