Authored by Michael Pento through Pento Portfolio Methods,

Inflation is supposedly on its method to falling gently again to 2% like a fluffy snowflake whereas the US economic system roars forward. Or at the very least that’s what the deep state of Wall Avenue wants you to suppose.

Nonetheless, the US economic system is within the eye of the hurricane proper now; and the opposite outer eye wall is approaching because the storm is intensifying. Therefore, the next are the 4 explanation why the January rally will fail.

1. The soft-landing fantasy, which could have the Fed chopping charges within the context of a wholesome economic system, shall be busted. That’s fiction with none foundation in logic. The situations essential for a change to a looser financial coverage wouldn’t be extant given the present record-low unemployment price and rising GDP. We would wish to see inflation plunge in direction of the two% vary, however that might seemingly solely happen if the labor market was faltering together with EPS and GDP. Up to now, GDP elevated at a 2.9% SAAR in This fall, the unemployment price fell to three.4%, whereas the ROC of inflation slowed from 9.1% in June of final yr to six.5% by December. Therefore, there exists the present hope that inflation will gradual to 2% whereas development stays robust. Nonetheless, the street from 6% inflation to 2%, and even 3%, shall be rather more tough given the stickiness of wage inflation, which is at the moment up 5% y/y. And, OER is not going to be falling almost as shortly as items sector inflation. The truth is that actual GDP elevated by simply 0.8% for all of final yr. That’s, for those who imagine CPI elevated by solely 6.5%. So, in reality, the economic system shouldn’t be all that robust proper now in actual phrases—after you issue out inflation. However Powell remains to be satisfied that GDP is robust.

2. China reopened a couple of months sooner than predicted, and that led to a flurry of enthusiasm concerning the communist nation pulling financial development out of the ditch. China did certainly pull the worldwide economic system out of disaster through the Nice Recession. It did this by rising debt from 143% of GDP in 2006 to over 300% in the present day. However within the technique of taking over the best enlargement of debt in historical past, China created a large misallocation of capital and a humungous fastened asset bubble. China’s economic system is now so unstable that it can’t endure something near the identical course of that boosted international development 14 years in the past. The PBOC injected the equal of $581 billion over previous two months in preparation for his or her reopening. Clearly that tempo of stimulus can’t proceed with out creating runaway inflation and a Yuan forex disaster, not to mention rescuing the worldwide economic system but once more. Most significantly, China can solely reopen as soon as. Subsequently, the expansion impulse will peter out over the course of the subsequent few months.

3. The Treasury Division is offsetting QT by emptying the Treasury Basic Account on the Fed. The Treasury parks cash on the Fed. Type of like banks park extra reserves. This cash lays fallow and is out of the economic system, however could be drawn on by the Treasury throughout occasions of emergencies–like now, because of the US hitting the debt ceiling. Secretary Yellen can’t challenge new debt, solely rollover expiring debt. Subsequently, she is tapping the TGA, which is including new cash into the economic system—a sort of QE that’s for now, offsetting the Fed’s QT program. However the TGA shall be tapped out come June. So, this increase to the cash provide is short-lived.

4. Tax loss promoting on the finish of ’22 brought on these erstwhile sellers to pile again in after the 30-day wash-sale rule expired. The beaten-down, profitless tech sector misplaced 70% of its worth final yr. Buyers realized these losses in December after which needed to wait 30 days to lock in these write-offs. By the best way, a inventory down 70% wants to extend by 233% simply to interrupt even. So, who cares if these shares are up 30%? In any occasion, that brought on a cascade of purchase quantity into this sector all through the month of January. However that rush again into shedding bets is over and achieved now, and these profitless tech buyers get to now witness their corporations exit of enterprise as a result of they can’t afford to service new debt on the much-higher rates of interest.

All of that is why final week’s quick masking rally was one of the crucial vital on file.

So, what’s the setup now?

The underside line is that the US economic system needs to be in recession by the second half of 2023. This flips the wrong way up the broadly held perception that the first half of this yr could be weak, however the second half would see a robust rebound in shares and GDP. To re-emphasize why the soft-landing b.s. is a fantasy, China shall be absolutely reopened in Q1, they usually can’t reopen twice; the Treasury Basic Account on the Fed will should be replenished, and that may exacerbate the $95 trillion monthly QT program on the Fed. Come June, it is going to be QT on steroids. We are going to then be left to endure the lagged results of essentially the most coordinated international tightening of financial coverage in historical past that came about over the previous yr, which has but to totally financial development and EPS however ought to completely achieve this by the top of Q2. The yield curve continues to sink additional into inversion. It’s now essentially the most inverted since 1981, which presages not simply an abnormal recession however one that’s extraordinarily trenchant. The price of capital for Zombie companies and shoppers has surged over the previous yr. This may trigger large layoffs from the 20% of listed corporations that must challenge new debt simply to pay curiosity on present obligations. The plethora of hiring freezes and layoffs introduced over the previous couple of months will start to vastly inhibit consumption. And, the battered US client, 2/3rds of whom reside paycheck to paycheck and have lower than $400 in financial savings, ought to start to close down consumption. The economic system may also be struggling by way of a Fed Funds Fee that’s caught above 5% for a very long time. Most significantly, the good cascade of the bottom cash provide and Fed credit score ought to trigger financial institution lending to start to grab up and trigger chaos in credit score markets. The approaching recession will push the present gentle decline in EPS into a major plunge.

After all, it will finally result in a real Fed pivot, however it should are available in response to an fairness market crash and credit score market freeze…not forward of 1. Sadly, this implies Powell will pivot earlier than inflation has been useless and buried, which in flip means the subsequent inflationary cycle will dwarf the earlier 40-year-high battle fought in 2022-23. Alas, for these 60/40 buy-and-hold buyers, these inflation/deflation growth and bust cycles will develop extra intense and extra damaging over time. However for these lucky to have a sturdy macroeconomic mannequin, it supplies alternatives to outperform the market.