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The U.S. Economy Is Screwed Whether Inflation Slows Or Not

ETF Focus on The Street logo ETF Focus on The Street 1/23/2023 David Dierking

Also, emerging markets are one of the hottest opportunities in the market right now.

The financial markets - both stocks and bonds - have gotten off to a fast start in 2023. The S&P 500 (SPY) is up 3-4%, while small-caps (IWM) and long-term Treasuries (TLT) have gained 6%. Call this the January effect or whatever you want, but there’s an unquestioned sense of optimism right now that isn’t yet fully supported by the data.

If you look at retail sales, industrial production or housing starts, you’d conclude that the U.S. economy is decelerating at an even faster rate than before, possibly into that highly anticipated recession around the end of the year.

But then there’s the counterargument. Inflation is also slowing even faster than expected. If you look at the 6-month annualized rate on headline inflation, we’re already back around the 2% Fed target level.

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That probably means we’re looking at another quarter-point hike or two in Q1 and then the Fed will be done. Whether the Fed will be able to keep the Fed Funds rate as high as it wants to in 2023 is a point of much debate (for the record, I think they will but I’m in the minority).

Setting aside market reactions aside for a moment, it’s important to consider what inflation means right now. Sure, the numbers are trending in the right direction and that’s certainly welcome news for consumers, but is it as good as sentiment suggests it is.

Probably not and here’s why.

There are three potential outcomes here.

Inflation Remains Elevated

Investors aren’t anticipating a resurgence in inflation, but they shouldn’t write it off altogether. A Fed Funds rate of around 5% and the China reopening should both keep disinflationary pressure on the economy throughout 2023, but what about beyond that?

In the 1970s, inflation got above 12% in 1974 before retreating to below 5% by 1976. It didn’t last though. By 1979, inflation was above 13% again and stayed above 9% for the next three years. A second round of hyperinflation isn’t out of the question, but the Fed is probably in a better position now to keep things under control through high rates and QT. As long as they aren’t late to react like they were in 2021.

This is perhaps the worst case outcome. Consumers are already in a tight spot, especially the lower/middle class and a second round of high inflation might cause not just a deep recession, but possibly something resembling a depression.

Inflation Gets Back To The Fed’s Target Level

From an optics standpoint, this is the ideal outcome, but it doesn’t come without consequences.

Let’s imagine that the year-over-year inflation rate at some point in the near future goes to 0%. Great, right? All of those soaring price pressures on everything from gas to groceries to healthcare costs to airline tickets becomes a thing of the past, right?

Not really. A 0% inflation rate merely means that all of the inflation from 2022 has stuck. A 0% inflation doesn’t mean that conditions have gone back to the pre-2022 days. It means we’re still effectively in the 2022 days.

Credit card usage and savings rates prove that a lot of households are still really struggling just to pay the bills, let alone spend on discretionary items. A 0% inflation rate means that those families are still dealing with high price pressures that they did last year. The only advantage is that they’re not climbing even higher. In this scenario, they’re essentially still in the same position of needing to tighten the budget and slow spending (although hopefully some form of wage increase helps offset some of that and real wages improve).

Inflation Turns Into Deflation

This is probably the most likely outcome and we’re already heading in that direction.

If a recession arrives, let’s say, in the next 12 months, that’s almost certainly going to put a deflationary squeeze on the economy. If households need to cut back on spending, demand goes down and prices soon follow. Production of goods slows and companies are also forced to cut prices. Demand for services also decreases.

This is Econ 101. As over-demand shifts to under-demand, prices follow. That means the focus on high inflation turns to deflation. If deflation sets in, that almost ensures that a recession is happening in the United States and probably elsewhere.

We’re not to deflation yet, but the wild card could be the China reopening. If it’s everything that economists and market hopefuls hope it is, we’re about to see an increased supply of everything China typically produces hit the market. That, in isolation, is deflationary. We’ve already seen retail businesses warn about high inventories. The China reopening may make it worse.

Conclusion

Pick your poison.

  1. Hyperinflation returns leading to recession/depression.
  2. Inflation moderates, financial markets likely see gains, but consumers remain squeezed.
  3. Inflation turns to deflation, recession becomes near-certainty.

None of these is a positive unless you’re an investor in scenario #2. Even in that scenario, we’re looking at a lack of growth from low consumer discretionary income.

The markets could be positioned for a short-term rally in both stocks and bonds as investors cheer falling inflation, China provides a growth catalyst and the Fed finally hits the pause button.

Longer-term, it might be a matter of picking the least bad outcome.

ETF in Focus

I’ve been playing around with this net flows/RSI matrix to try to get a sense of what the markets are doing relative to what investors are doing to see if there are disconnects.

RSI is fairly self-explanatory for relative strength. I’m using a ratio of flows relative to assets so we can identify proportional moves in asset classes. Otherwise, it would just be SPY, QQQ and VTI dominating every week.

Here’s what I’m seeing today looking at a number of broad market, sector, region and factor ETFs.

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Most ETFs will fall above the 0% flows/AUM line because, well, ETFs take in hundreds of billions of dollar annually. So I’m looking at 1-month flows to focus on the short-term (1-week flows are too choppy to have high confidence in the results).

Upper-left quadrant would identify ETFs that are performing poorly but are seeing investor money moving in. The lower-right quadrant would be ETFs that are performing well, but seeing money leaving. Both could provide contrarian opportunities. I wouldn’t call them buys or sells. Just more of a way of potentially identifying trends.

High beta (SPHB) looks like the outlier, although it’s working with a relatively small asset base. It’s up more than 10% year-to-date, but is still seeing net outflows on the year.

Emerging markets (IEMG) is the one area that’s really picking up momentum. Emerging and developed non-U.S. markets have performed really well this year, but emerging markets is the group really picking up the inflows.

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EM equities could be a real momentum play here.

Overbought: IEMG, IEFA, VUG, XLC, SHV, FLOT, MUB, PFF, BITO, GLD, CPER

Near Overbought: IWC, LQD, SPHB, ARKK, GDX, BLOK

Oversold: VYM, UNG

Near Oversold: XLP

Note: Oversold/Overbought developed using a combination of RSI and Longbow dashboard.

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