- Gordon Johnson says financial conditions are looser now than when the Fed started raising rates.
- The central bank will have to be much more aggressive in 2023 if it wants to contain inflation.
- He believes the Nasdaq will correct 20% by the end of this year.
The CPI for January was 6.4% yoy and up 0.5% mom.
Inflation has proved more stubborn than the central bank expected, said Gordon Johnson, CEO and founder of GLJ Research, an independent firm. Also not helping is the Federal Reserve’s dovish approach in signaling a 25 basis point rate hike earlier in the year instead of 50 basis points, he said.
Once inflation comes out of the pocket, it’s very difficult to put it back in, he said. Mainly because the service sector accounts for a large part of inflation. On an annual basis, services inflation rose 7.2%, the worst year-on-year increase since 1982, he noted. This sector accounts for about 58% of the CPI, he added.
“One of the reasons services are so hard to control is because commodities are driven by the economy, but services are priced by the service provider,” Johnson said. “To bring services inflation down, you really have to destroy demand. You have to lose jobs. You need to get debt out of the system. They need to stop companies from expanding and take on more debt.”
Johnson, who has been ranked among the top stockpickers in steel, iron ore, graphite electrodes, electric vehicles and solar equipment by Bloomberg, says the Federal Reserve is not doing enough to curb inflation and markets have responded by pricing in a dovish pivot.
This is evidenced by financial conditions, which have eased significantly, more so than when the Fed began tightening, he noted. For the week ended February 10, the Chicago Fed National Financial Conditions Index (NFCI), a weekly update of conditions in money markets, debt, stock markets, and the traditional and shadow banking systems, was -0.44. In March 2022, that number was around -0.39. Negative numbers have historically been associated with better than average easy financial conditions.
The bond market is another area showing the Fed’s bluff, he noted. The US 10-year Treasury yield was about 3.76% on Wednesday. But if the fed funds rate is 4.50-4.75% then 10-year bonds should be somewhere in the middle if the market thinks the Fed is serious about fighting inflation, he noted.
Stock market outlook
If the economy contracts as many are expecting, profit margins would shrink, leading to falling return on equity (ROE), a metric that measures how well a company is leveraging its shareholders’ investments.
But Johnson believes central bank policy will continue to affect the stock market through the end of the year.
That’s because Jerome Powell’s way out of stalled inflation is to hike rates higher and for longer than the market expects, he noted. This will put more pressure on the stock market throughout the year and result in a steeper than expected decline. Also, the economy has received massive liquidity injections since 2010, which are now being reversed, he added.
“Overall the market is going to fall, but I think it may take a little longer because until there is a debt ceiling, Janet Yellen will continue to draw on the Treasury Department’s journal account,” Johnson said. “And that is de facto quantitative easing. And that money goes straight into stocks and houses. But when the debt ceiling is agreed, you will get a significant amount of QT not only from the Fed but also from Janet Yellen.”
He believes the stock market will repeat the pattern seen in 2000 and 2001. In 2000, the Nasdaq lost 39%. By January 2001, the Nasdaq had recovered 12%. In 2022, the index plunged 33%. Similarly, the index has recovered 15.26% year-to-date. However, like 2001, when the index fell about 20%, 2023 will see a similar drop, he said.
Some investors are already seeing staggering shifts in their performance, he noted. These include quant investing funds, which started the year with a strategy that included long stocks that have outperformed over the past 12 months and short positions in underperformers. But Powell’s comments, which alternate between dovish and hawkish, have hurt those funds.
Then you have the People’s Bank of China (PBOC) and the Central Bank of Japan, which started the year with massive injections of liquidity that prompted the stock market to recover, he added. However, that is now over.
The good news for investors is that despite the prospect of a stock sell-off, there are short-term options. You can buy a six-month Treasury bill that yields 5% — a multi-decade high, he noted. Plus, it’s risk-free.
From a stock perspective, Johnson likes the uranium sector. He expects oil stocks as a whole to continue to outperform as there has been a massive lack of investment. Therefore, energy security will become an issue and demand for this sector will remain strong.