While investors’ optimism suffers a death by a thousand cuts, I’ve warned on numerous occasions that old habits die hard. As a result, while the financial markets teetered near a breaking point on Apr. 25, the ‘buy the dip’ crowd swooped in and pushed the S&P 500 higher. In the process, the VanEck Junior Gold Miners ETF (NYSE:GDXJ) also closed off its lows.
However, the lessons investors learned after the global financial crisis (GFC) should be their undoing this time around. Investors buy the dip in hopes that the Fed will come to their rescue. With the strategy making money more often than not since the GFC, why not continue the charade?
Well, the reality is that optimism is contagious. Therefore, when the S&P 500 refuses to die, other areas of the financial markets showcase similar resiliency.
However, with higher asset prices antithetical to the Fed’s goal of taming inflation, buying dips should result in even more pain over the medium term.
For context, I wrote on Apr. 6:
Please remember that the Fed needs to slow the U.S. economy to calm inflation, and rising asset prices are mutually exclusive to this goal. Therefore, officials should keep hammering the financial markets until investors finally get the message.
Moreover, with the Fed in inflation-fighting mode and reformed doves warning that the U.S. economy “could teeter” as the drama unfolds, the reality is that there is no easy solution to the Fed’s problem. To calm inflation, it has to kill demand. As that occurs, investors should suffer a severe crisis of confidence.
Thus, with the optimistic close on Apr. 25 only reinforcing the thesis, investors don’t realize that they’re digging their own graves.
The red line above tracks the one-minute movement of the S&P 500, while the green line above tracks the one-minute movement of the S&P Goldman Sachs Commodity Index (S&P GSCI).
If you analyze the relationship, you can see that both sank at the open, bottomed mid-day, then rallied off of the lows.
However, the important point is that the Fed needs the S&P GSCI to decline to curb inflation. Therefore, when the index says to the S&P 500, “I go where you go,” buying the dip only encourages more hawkish actions from the Fed.
Remember, post-GFC was a period of relatively low inflation and outperformance by technology stocks. As a result, the Fed would be happy to replicate that environment once again.
However, with commodities unwilling to decline materially unless the S&P 500 and the NASDAQ Composite follow suit, the more the latter rally, the more inflation remains.
As such, investors’ inability to see the forest through the trees should cause them plenty of pain over the next few months.
To that point, I warned previously that Canada was the hawkish canary in the coal mine. With more than 76% of Canadian exports sent to the U.S. in February, the two economies are increasingly intertwined.
Moreover, I noted on Apr. 14 and updated on Apr. 22 how the Bank of Canada (BoC) announced a jumbo rate hike and that Canadian inflation was still raging. I wrote:
The BoC announced a 50 basis point rate hike on Apr. 13, and with the Fed likely to follow suit in May, the domestic fundamental environment confronting the PMs couldn’t be more bearish.
Source: BoC
Moreover, BoC Governor Tiff Macklem (Canada's Jerome Powell) said: "We are committed to using our policy interest rate to return inflation to target and will do so forcefully if needed."
Furthermore, while he added that the BoC could "pause our tightening" if inflation subsides, he cautioned that "we may need to take rates modestly above neutral for a period to bring demand and supply back into balance and inflation back to target."
However, with the latter much more likely than the former, the BoC's decision is likely a preview of what the Fed should deliver in the months ahead.
To that point, Canadian inflation data was released on Apr. 20, and, surprise, surprise, the scorching results came in hotter than expected. For context, the figures in the middle column represent economists’ consensus estimates.
Source: Investing.com
Furthermore, after admitting that the first 50 basis point rate hike in 20 years was an “unusual step,” Macklem said on Apr. 25 that investors should expect more of the same in the coming months.
Source: Bloomberg
Again, the Canadian economy is highly leveraged to U.S. economic growth. Therefore, with Macklem increasingly willing to fire a second 50 basis point bullet, the Fed shouldn’t be far behind.
Likewise, Canadian headline inflation hit 6.7% year-over-year (YoY) in March, while the U.S. stands at 8.6%. Thus, with the buy the dippers making Macklem and Fed Chairman Jerome Powel’s jobs even more difficult, don’t be surprised if they drop the hawkish hammer over the medium term.
In addition, while Bank of America notes that the “Hike Brigade” has already staged an offensive, the ramifications of evaporating liquidity are far from priced in.
You Can’t Run From Reality
The blue bars above track the net percentage of global central banks tightening monetary policy. If you analyze the two red circles above, you can see that the current state of play rivals the lead-up to the GFC.
Moreover, the Fed has barely even started its hiking cycle, and if investors keep buying the dip, the BoC may be talking about a third 50 basis point rate hike. As a result, the domestic fundamental environment is profoundly bearish for the PMs.
Furthermore, while Fed officials have warned about the potential “collateral damage” from their war with inflation, I warned on Apr. 6 that recessionary winds should gain steam in the coming months. I wrote:
Does a U.S. economy that “could teeter” sound bullish for the S&P 500 or the PMs? Moreover, while [Daly’s] relatively optimistic assessment assumes that a recession is unlikely, the data suggests otherwise. With annualized inflation at ~8% and the latest PMI and rental market data signaling even more price increases in March, plenty of demand destruction needs to unfold to reduce inflation to normalized levels.
Expecting just that, the Federal National Mortgage Association (OTC:FNMA) (Fannie Mae)—a U.S. government-sponsored enterprise—released its Economic and Housing Outlook report on Apr. 19. An excerpt reads:
“Our updated forecast includes an expectation of a modest recession in the latter half of 2023 (…).”
“While a ‘soft landing’ for the economy is possible, which is where inflation subsides without economic contraction, historically such an outcome is an exception, not the norm. With the most recent inflation readings at levels not seen since the early 1980s and wage growth exceeding that which is consistent with a 2-percent inflation objective, we believe the odds of a soft landing are even lower.”
Source: Fannie Mae
The green line above tracks the U.S. federal funds rate, while the dashed brown line above tracks the YoY percentage change in the headline Consumer Price Index (CPI). More importantly, the red arrows above depict hard landings, while the green arrows depict soft landings. As such, the odds are not in the Fed’s favor.
Even more revealing, if you analyze the green arrows near 67, 83, and 95, you can see that the YoY inflation (the dotted brown line) was no more than ~4.5%. As a result, all of the soft landings occurred alongside manageable inflation, not a headline CPI of 8.6%.
On top of that, with the Fed letting the U.S. labor market run too hot for too long—as evidenced by the nearly five million more job openings than unemployed—the Fed needs to increase the unemployment rate to curb wage inflation.
Moreover, with the blue line below (unemployment) near an all-time low and the brown line below (wage inflation) at/near an all-time high, does a reversal of fortunes sound like fun for the U.S. economy?
Fannie Mae analysts stated:
“The unemployment rate is below the ‘full employment’ level, inflation is accelerating as growth slows, and the Federal Reserve is beginning to tighten policy. These conditions typically mark the beginning of the end of an economic expansion.”
Source: Fannie Mae
The bottom line? While investors remain all-in on the post-GFC playbook, the reality is that this time is different. Before, the Fed could bow down to the financial markets without impacting the real economy.
Now, inflation is raging, and the Fed can’t run from this reality. Not only will the economic consequences worsen the longer the Fed waits, but I’ve noted the political ramifications on numerous occasions.
As a result, plenty of hawkish fireworks should erupt over the medium term.
In conclusion, the PMs declined on Apr. 25, as fundamental realities stifled sentiment. Unless the Fed performs the most reckless dovish pivot of all-time (highly unlikely), the PMs should suffer profound drawdowns over the next few months.