Market conditions are starting to shift at a faster pace lately. Geopolitical tensions are starting to drive some of the narrative and the Fed is threatening to push tightening too far, too fast. Darius Dale, the founder and CEO of macro research firm 42Macro, joins the ETF Think Tank to discuss where he sees things heading and if investors should be worried.
Currently, Dale’s macro models are saying we’re in an inflationary environment, but it’s not necessarily a compelling signal. He says the current economy could flip very easily into a reflationary or deflationary regime pretty quickly depending on where things move from here. He feels it’s likely the current regime will be mitigated or interrupted by the post-omicron bounce. He can see this happening sometime in the spring, but the question is can it be sustained. He also notes that we’ve historically seen some pretty significant drawdowns in the financial markets following cycle peaks in jobs, earnings and growth. We don’t know when it might happen, but it’s easy to make the case that the setup for a similar situation is developing, especially considering the Fed.
Not surprisingly, the Russia/Ukraine situation comes up quickly. Dale says there are some difficulties in figuring out how a political conflict impacts his models because there’s so much noise and some potentially crazy signals. In general, he finds that the markets don’t price in black swan events, but they soon price in the result of the black swan and its impact on the economy. If a Russian invasion of Ukraine (or even a Chinese invasion of Taiwan) were to occur and result in war, the current low labor force participation rate could lead to a stagflationary environment. In China’s case, it would be a particularly high risk move for Xi since he’s trying to establish his legacy and doesn’t want to risk alienating trade partners.
Would the Fed change its current course of action in the event of a larger scale conflict, and could it decide to delay its monetary tightening plans? Dale says that the most important thing the Fed can do right now is reestablish its credibility. The broad consensus is that the Fed is way behind the curve in terms of handling inflation. The central bank has a job to do in managing rapidly rising prices and it will ultimately need to follow through on its mandate.
While many say that the Fed can’t possibly hike interest rates into an inverted yield curve, Dale disagrees. He notes that inflation rates are at their highest level in decades and the index for current financial conditions are at their lowest level in many years. If conditions are really that poor with inflation as high as it is, a recession might be inevitable regardless of what the Fed does. The question is which would be better for the Fed – a recession with the Fed losing its credibility or a recession with the Fed regaining its credibility on inflation? The median CPI just rose to the highest level it’s ever recorded. That’s all the Fed should need, and it can’t half-respond to conditions.
Other key takeaways:
- Dale says there’s a struggle right now between deteriorating fundamentals and positive liquidity dynamics. Shortly, we’re going to have deteriorating fundamentals and negative liquidity dynamics. He expects the impact of that could start manifesting in mid-2022.
- The markets judge things based on the rate of change. There have been many cases where you don’t need a recession in order for the asset markets to crash. You just need a sharp deceleration in growth. It looks like that could happen in the 2nd half of 2022.
- What could happen that would surprise the markets positively? Dale quickly points to a potential post-omicron bounce and notes that the faster-than-expected slowdown we saw during the initial wave could result in a mean reverting rebound. He also points to a short-term positive earnings dynamic ahead of us, but also says that when things start to decelerate and the trendlines start sloping down, that’s where the adverse event happens.
- Self-directed investors should not base their market outlooks as “I’m bullish” or “I’m bearish”. Instead, get away from the concept that a portfolio needs to be a singular bet. Dale’s work involves identifying regimes and assigning probabilities to those outcomes. There should be consideration given to probabilities, time frames and other factors. Some things work in some environments, others work in others. There’s no “right” way to skin the cat.
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