Circular Logic Driving The American Economy And Its Bulls Will Soon Straighten Out And Empower The Bears — The Latest On The Global Economy

Rising debt levels and rising interest rates logically mean recession lies ahead unless one remains cosseted within the circular logic of positive thinking begetting more positive thinking. This is the sole logic of the bulls as estimates for current earnings decline while corporate guidance sways negative; the bulls comically read this as good vibrations since the economy hasn’t fallen off a cliff yet. But as summer transitions to Autumn the data will bear out the bearish case. For now the bulls rule and markets are melting ever higher, with the volatility risk premium pointing to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), while my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought several positive factors for US stocks. The US yield curve is falling and in the current context that is bullish. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. Expect the S&P 500 to rise modestly over the next few days toward 4600 before correcting.

The global economy continues to moderate as evidenced by downturns in expectations for China and Europe and profound debate regarding the US and Japan. The US is faced with the circular logic of high consumption driving high employment driving high consumption, fueling the bull run in American equities. But this is contradicted by the logic of high interest rates depressing spending, which hasn’t happened yet to affluent consumers but is devastating low income consumers. Japan is faced with the contradiction of a demographically aging population that veers naturally towards deflation while the Bank of Japan tries to stimulate positive thinking by monopolizing the equity and bond markets. What is clear is that both the Fed and BOJ will someday reduce liquidity in order to maintain confidence, and this will weaken consumer spending, their economies and equity prices in turn.

This hasn’t been reflected yet but will shortly since American retail sales are inching lower and same store sales have gone negative. This is problematic because inflation expectations to the consumer’s thinking are at 3% for the next 5 years, which is significantly above zero and makes the Fed determined to keep interest rates higher for longer. And while Japanese household spending continues to be lackluster the BOJ will face a crisis of confidence if it doesn’t let up on yield control curve soon, given its promotion of the idea for months. Lower liquidity will reverse the Yen carry trade to detriment of equities around the world.

The remaining hopes for the bulls are China and Europe, which have opposite problems and so can’t coordinate their policies. Chinese household consumption is weak, so the Communist Party is offering targeted stimulus to try to keep GDP growth on a 5% trajectory. But Europe faces high inflation so they must hike rates, lessening demand for Chinese exports. Europe is in recession and isn’t expected to get a V-shaped recovery, remaining in a near-zero growth pattern for the balance of the year. As Chinese equities decline in recognition of this parlous global state of affairs so too with equities across Western markets.

My current positions include 3M (MMM), Pfizer (PFE), and a large position in SPXU, which nets out to an extremely short position in equities.