There is a likely recession occurring that could be mitigated with a soft landing. If there is a recession, it will occur in two parts:
- First phase: The fed indicates rate hikes. Increased rates results in the market demanding a higher return on equities to compensate for the additional risk, which results in a contraction in the overall market P/E ratio. But, while this is happening, the underlying performance (earnings) of equities generally remains strong. Unemployment remains low, consumers continue to spend as they have jobs and money in their pocket, and companies can pass along inflationary impacts to the customer through higher prices. I think we are at the end of this first phase.
- Second phase: Prices continue to increase to a point where demand begins to slow. As demand slows, companies have a harder time passing along increased costs to their customers. Companies tighten the belt, resulting in layoffs, which increases unemployment (obv) and reduces overall demand. At this time, the underlying performance of equities is impacted and the market falls into a death spiral. Less demand -> less earnings -> layoffs -> less demand, etc. This death spiral is only stopped by the fed stepping in, usually through an injection of cash and lowered interest rates, to spur demand. The bottom of the market is right before this happens.
I think we are at the end of the first phase. The second phase won’t start until consumers stop spending. I see a few factors that could contribute to this starting in Q3/Q4 this year:
- Consumers dip into savings this Summer to enjoy the warm weather. They will come out of the Summer with less savings available.
- Inflation on mandatory goods remains strong and outpaces salary increases. After accounting for mandatory goods, house hold budgets have very little money remaining, and the summer spending blitz extinguishes their savings. The result is less discretionary spending.
- Freeze on student debt ends in September, further tightening household budgets.
- Increased mortgage rates further tighten household budgets for any new home buyer. This will have a slower impact on demand but still contributes.
So, what would have to happen for this not to occur? It all depends on if supply can recover and meet the demand of the market, and how quickly this occurs. If this happens quick enough, the inflation on mandatory goods will stabilize, consumer discretionary spending flatlines or contracts slowly, companies manage costs without large layoffs, the market slows/stalls for a bit but then continues with moderate growth as supply/demand are back in line with each other. This is what the soft landing would look like.
My best guess is that this soft landing won’t be achieved. Due to the Ukraine conflict and COVID lockdown in China, supply is disrupted long enough for us to begin the death spiral. Supply will only recover to meet demand once demand is decimated, and around this time we will see the bottom and the fed intervene.
Market prediction: Market rallies on the back of strong earnings until ~3Q of this year. At this time, people will start to talk about FOMO since they missed the bottom. At the same time, consumer demand begins to contract and the death spiral begins. This will result in a strong recession in 2023 and we will see the bottom only when the fed steps in.
3/4Q Trades: Shorting common on MAT, ULTA. Buying SQQQ.
Disclaimer: I’m likely wrong as no one knows what’s going to happen.