Press "Enter" to skip to content

Recession: Balance Sheets To “Matter Again” During “Great Unwinding”

Fed chair Powell in a speech this week suggested the Fed might relent on its more aggressive stance outlined at the Jackson Hole meeting in August and last month’s FOMC meeting press conferences with smaller rate hikes starting in December. 

Powell suggested it would make sense to moderate rate increases as the Fed reaches levels needed to bring down inflation, suggesting the time to pace the rate increases could come as early as the December meeting. 

“We will stay the course until the job is done,” Powell did insist. “The timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.”

Nonetheless, the Fed chair’s change in tone yesterday resulted in a big day for equities, as the S&P500 rose by more than 3% and closed above its 200-day moving average for the first time since April. 

The Fed’s monetary policies come amid what Tavi Costa, a partner and portfolio manager at Crescat Capital, calls “the great unwinding.” 

As prices and capital costs rise, it becomes increasingly difficult to justify record valuations. Costa also notes changing fundamentals, including smaller profit margins due to energy prices and higher wages and salaries. We’ve seen Wall Street lower earnings expectations for the coming years. 

“That’s going to create a problem when it comes to the aggregate fundamentals of equity markets in the US,” said Costa. That’s a problem the Fed has sought to address with its rate hikes. 

Costa believes there could be more bankruptcies on the horizon. “When we think about why we haven’t seen so many bankruptcies, most of that has been due to government intervention,” said the Crescat Capital analyst. “How much can the government intervene when you have an inflationary problem?” That’s a question without an answer so far. 

“If we want to have [Fed] intervention, that’s fine—then we’re going to have inflation,” explains Costa. “Commodities to equities will rise in this environment, because either they will prop up the equity markets and allow the inflationary problem to get worse, so more folks will be trying to hedge the inflationary problem or they’re going to fight inflation issue and re-rate equity markets much lower, which would cause commodities to rise relative to equities.”

For that reason, Costa is long commodities and short equities markets. Companies with free cash flow relative to their number of employees will be best equipped to succeed during the great unraveling, and perhaps that’s why we’ve seen Silicon Valley as late laying off workers. A rising cost of operations, capital, labor, and more has squeezed businesses. 

“It’s going to be difficult to pay down debt, so balance sheets are going to matter, which they haven’t mattered for many years,” said Costa.