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It’s only been a couple weeks into the new year but boy does it feel like 2022 is well behind us already. Let’s look at the broader picture.
Stuff is cheaper to ship than pre-COVID.
Financing conditions are getting easier.
S&P hit 4K again.
Inflation has been trending down faster than expected.
I could go on, but you get the idea. Unless something flares up, most of these things (besides equities) have been trending down consistently. Nothing on the horizon is likely to derail the trajectory without a much larger unexpected shock.
So what can mess it up? There are only 3 players in this race. The Fed, China, and Russia. Let’s dig into each one.
As much as the Fed wants you to believe it’s still a big deal for ‘23 (it still sorta is), it’s really running out of juice. Its own predictions have essentially a 5% terminal fed funds rate, with at most half percent variation. That’s really not much room to maneuver when inflation could theoretically go up or down 2 percent next year.
Why can’t the Fed keep raising rates? Well they could… but there’s one sector that’s already waving the white flag frantically: Housing.
A bit tough to read on this chart, but the amount of pending listings last November was below the levels seen in November of 2019. However, rates were essentially zero in 2019. So there’s a lot more pain ahead.
Furthermore, as the Fed has repeatedly said, many of these impacts come with multi-month lags. So if housing is collapsing, how confident is the Fed that they won’t overshoot as they hike faster than any other period in living memory?
If you are feeling the impact of volatile egg prices, imagine what a broken real estate market can do. Housing is the largest component of household wealth, it’ll have huge ramifications on how flexible the labor market is going forward as people have fewer options to move due to mortgage rates, high prices of existing housing stock, and the fact that the desired housing mix has dramatically changed post COVID.
Speaking of COVID…
By far the most unexpected event in the last few months is the about face on its zero COVID policy. It’s still too early to tell the medium term impact, but early reports estimate that over 900 million people have already caught it. That pretty much implies that the whole population will get it in short order.
While China’s financial sector is absolutely nothing like the US, a standard playbook would be the reversal of certain restrictive policies as well as financial easing to help individuals whose livelihoods have been disrupted. This will probably include some form of support for housing which would ease the pain for those that were also affected by the ongoing housing crisis.
However, the financial transmission channels in China are vastly different since bank credit is not as readily accessible to the masses as compared to the US, so opening the spigot only benefits already established businesses.
Fortunately, the prevailing COVID variants are less deadly than the first versions from 2020. And while the inoculation rate in China for at-risk populations is low, China is also a lot denser than the US. This means that the speed at which it’ll achieve herd immunity is likely faster, meaning a recovery should be in store within the next few months. It’s a numbers game.
Beyond that point, the biggest question is whether the reversal of globalization policies will make its presence felt in China faster than anticipated. Recent spats between China and the US mostly focus on export restrictions of high-tech chips and other related manufacturing equipment.
Simultaneously, it is incentivizing supply chain localization in the US. TSMC building out a plant in Arizona is the biggest example of that. Many analysts point out that such an arrangement will be sub-optimal in terms of costs and efficiency since the thousands of related upstream and downstream semiconductor companies that support TSMC will still operate from Taiwan.
It’s hard to say how this will show up in financial markets long term. But in the near term, buying the dip prevails and is likely to continue as China returns as the world’s manufacturing leader. The Hang Seng Index has fully recovered back to early 2022 levels whereas US equities are still meaningfully underwater.
This is by far the aspect that is most murky to me. The political calculus for Russia in 2023 is not primarily driven by financial considerations. Russia continues to earn a lot of money from the continued sale of crude oil despite the recent drop in prices. Many people believe that they are running low on equipment and ammunition, but with enough money, it’s not a problem that cannot be solved, albeit it could take them months.
This likely means that the Russian/Ukrainian war will go on with a slow burn, I wager we’d still be talking about this next year lest NATO/US decides to somehow open the spigot and play a more proactive role in supporting Ukraine. That’s probably not going to happen.
While it’s ok to indirectly help Ukraine, a meaningful contribution of higher-end weapons, or any amount of personnel will essentially be a direct affront to Russia, and would convert an nominally domestic dispute into an international one. No one wants that despite the West’s strong public support of Ukraine’s struggle.
While there are substantial tail risks in the economy in the form of geopolitical tensions and the COVID response of over 1.4 Billion people in China, the most likely outcome is to not rock the boat. And what better way to kick the can down the road than some good old fashioned buy the dip?
One sector I haven’t mentioned yet is crypto. Total digital asset market cap has crossed $1 Trillion yet again. Perhaps we are observing a dead cat bounce, but the negative sentiment and actual developments have been so negative in the last few months that it’s really hard to see what other realistic scenarios remain that could meaningfully crush the sector.
Looking at the chart of Ethereum below, the sector can still be considered dead even if it were to go up meaningfully from here. The risks look asymmetric.
There’s certainly lots to think about for ‘23, but it seems we’ve had a running start. See you next week!