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What's the next step for epochal change?

Look no further than the inverted yield curve for a strong clue.

Inverted yield curves matter because this indicator has a perfect track record of forecasting recessions with no misses and no false positives. That accuracy is not an accident. There's a reason.

In addition, other leading indicators for economic recession are pointing to the same conclusion, which increases the likelihood.

So it appears the Fed's interest rate increases are working to slow the economy. Congratulations! The next likely stop on the "epochal change" train is an economic recession.

While that sounds simple on the surface, it's a serious problem for most investment strategy because it tells you the range of potential outcomes is widening (not narrowing). It's getting more uncertain and more volatile. Let me explain...

When this new investment epoch (epochal change) began in late 2021, interest rates were artificially low and inflation was about to skyrocket. The range of outcomes was narrowly defined making investment strategy easy. The Fed would have to increase interest rates dramatically. That meant asset values across the board would decline because the value of any asset is the discounted present value of its cash flows.

Simple enough.

And of course, that's pretty much how it has played out... so far. The only surprise was the Ukraine war exacerbating the problems already in place, and the fact that the stock market fell as little as it did despite the dramatic interest rate increases.

Looking forward, it's worth noting that no credit/debt bubble has ever resolved without a subsequent debt implosion to clean the system of prior excesses. That expected debt implosion is still lurking out there as one of the "dead bodies" waiting to surface, as explained in last week's office hours/podcast resource shared from my private Expectancy Wealth Planning community. (If you didn't listen last week, make sure to listen to this recording now so you have all the required background knowledge.)

Dead bodies are a crude, but properly descriptive, term used to described the hidden problems lurking in the economy that don't appear (or float to the surface) until after the tide goes out (the previous bubble implodes during regime change).

Now that we have a yield curve inversion (with other leading indicators confirming similar), the next most likely step in the changing epoch is an economic recession. But how deep will the recession decline? Will it be mild, or will it be sufficiently severe to transform the current liquidity crunch into a solvency crisis?

It's an essential question that nobody knows the answer to... yet.

In other words, as corporate earnings decline, government tax receipts decline, and unemployment rises with the expected recession, debt defaults and solvency risks will rise. So much debt and financial leverage got built into the system at artificially low interest rates during the previous epoch that it's unlikely to unwind gracefully. That's because debt defaults can become self-feeding during recessions as borrowers scramble for liquidity by selling any asset with a liquid market. Declining asset prices feed the spiral resulting in more debt defaults, and so on. These self-feeding, selling spirals in desperate search of liquidity are why correlations of most assets rise toward one during severe bear markets.

A potential recession in the future puts the Fed between a rock and a hard place because they can't simultaneously solve both inflation with higher interest rates and recession with lower interest rates. They'll have to make a choice, which means something has to give because each situation requires diametrically opposite policy response, and the policy that fixes one crisis exacerbates the other crisis (and vice versa).

So the risks of this epochal change are now asymmetric:

• On one hand, we have an intolerable inflation problem that requires steadfast commitment to rising interest rates by the Federal Reserve. They must continue to hike rates until a positive real interest rate is achieved because no inflation has ever been stopped without first achieving positive real interest rates (defined as the interest rate minus inflation). This will only occur through either increased rate hikes, declining rates of inflation, or a combination of the two. But ultimately, the Fed's policy end game is fully understood - they must achieve a positive real interest rate, and we're nowhere close to that outcome right now.
• However, the yield curve has already inverted giving a strong indication that an economic recession is now baked into the cake. We don't know exactly when it will start or how deep it will decline, but the time frame to find out is measured in months, not years. Given the leverage built into the system from the prior credit/debt bubble, the risk of a recession and liquidity crisis morphing into a solvency crisis can't be ignored.

• Pension fund collapse: Both British and German pension systems are already acknowledged problems. Since all pension fund managers are fiduciaries following similar models, it stands to reason that other pension funds can't be far behind these two front-runners. Given the massive size and known underfunding issues (all guaranteed by government), this is a serious issue to keep an eye on. (One of the resources below specifically addresses this problem)
• National debt: Rising interest rates cause national debt to compound at mathematically unsustainable levels. Adding insult to injury, tax receipts are expected to decline in a recession further increasing deficits. There is almost nothing being written about this in popular media right now, but I'm providing a resource below that shows why this may become timely.
• Bond market liquidity: Janet Yellen has already publicly acknowledged problems with bond market liquidity. In a nutshell, the major buyers of US Treasury securities are now sellers at the same time the Fed must float ever-increasing levels of debt while simultaneously unwinding (selling) previously purchased debt. The result is insufficient market liquidity to accomplish the required objectives. We don't know how this problem will play out because it has never occurred before.
• Corporate and personal solvency risk: The expected recession will cause declining corporate earnings and rising unemployment which could transform the current liquidity driven downturn into a solvency crisis.

• The investment epoch changed, and this change is structural (long term) - not cyclical.
• The setup for this epochal change was the debt bubble and high market valuations combined with the Covid fiscal stimulus.
• The resulting inflation was the catalyst, or pin, that popped the bubble because it forced the Fed to become the problem instead of the solution.
• Epochal change means the investment strategy that worked in the prior epoch will no longer work in this new epoch.
• Buy and hold investors (the prior epoch's preferred strategy) will endure a decade or longer of extreme volatility with no positive return net of inflation for 10-15 years.

• I don't know if the next step in epochal change is a continued inflationary spiral or a change to a deflationary collapse. Unfortunately, that outcome matters a lot because it determines proper asset allocation.
• I don't know if the expected coming recession will be mild or large enough to accelerate the existing liquidity problem into a solvency collapse (which again, determines proper asset allocation).
• I don't know which "dead bodies" will float to the surface, and what order they will appear (again, this determines proper asset allocation).
• And I don't know the exact timing of each cyclical market rise and fall as this epochal (regime) change evolves (which determines evolving asset allocation through time).

What I Learned About The Fed's Fight Against Inflation From Richard Fisher - LinkedIn Article

This is a quick read with lots of good insights about what to expect from the Fed. Don't expect Powell to blink when he keeps a copy of Paul Volcker's book on his desk and quotes it in speeches. His intention is clear, and his power base to enact those policies remains intact.  I've said before that the Fed will pivot only after it breaks something. We are on a path to positive real interest rates. The only question remaining is how we get there.

Germany's Pension System Will Collapse Without Reform- CNBC Article

There's never one cockroach. If you see one, then you know there are hundreds more behind the wall. So when the British pension system nearly collapsed a few weeks ago, we knew it wasn't alone. It was just the most obvious cockroach in plain site. It appears Germany is another. And of course, there are hundreds more behind the wall. They all use similar models and produce correlated results. We need to watch this issue closely...

Investing Through A Structurally Inflationary Regime- Bloomberg Powerpoint Presentation

You gotta love it when Bloomberg publishes a Powerpoint mimicking what I've been teaching you in this newsletter for the past year. It's a succinct, well-structured explanation of key points I've been asserting for 12 months now that's well worth a review. Notice how they also confirm momentum/trend-following as the recommended investment solution for this new economic regime. That's not a coincidence. These tactical asset allocation models have worked brilliantly this year saving my clients retirements, and they're fully proven as the best strategy for this economic environment by independent academic research, including this Bloomberg study. Learn more here.

The Long Term Fiscal Spiral- Lyn Alden

I've been looking for a solid research article to share with you that explains how rising interest rates cause an unsustainable Federal debt spiral to help you prepare for another potential "dead body." The math of this problem is overwhelming, so I'm surprised that almost nobody is looking at this serious issue. That concerns me because no disaster ever comes announced. You want to pay attention to the obvious thing that everyone else is ignoring. I suppose this surprising public blindness is because this topic has been thrown around for so many decades that people are tired of talking about it. But a broken clock is right twice per day, so maybe now is finally the time to take a serious look at this risk, particularly given the recent problems with Treasury market liquidity. Here's Lyn Alden with her usual well-reasoned, comprehensive, level-headed insights.

Investing In An Increasingly Uncertain World- MacroVoices Podcast with Mike Green

Mike Green always delivers unusual insights. I was stunned to hear him explain the same extreme uncertainty in market outcomes that I was starting to notice, and how he came to the same investment conclusion I've been pitching you on for the past 12 months - trend following. The only difference is Mike applies trend following using commodity futures contracts, and I'm advocating tactical asset allocation for improved risk management across all asset classes using this software platform. It's a distinction without difference because the strategic outcome is what matters. If you have time for just one resource this week, then this podcast episode is it. You may have to listen more than once to understand the extreme uncertainty and the polar opposite outcomes that are possible because what Mike shares is not conventional wisdom. Few people are talking about this now, but I'm confident you'll hear more about this topic soon as others start to figure it out. My recommended investment solution shows you how to manage the risks Mike refers to. It's both cost effective and easy to apply in your portfolio. Learn more here.

Take Action Now So You Can Grow Your Wealth During Epochal Change:

1. This investment software solution includes two of Todd's top investment systems. You'll learn the smart, proven way to manage portfolio risk during epochal change. Once you understand it, you'll wonder why you tolerated the unmanaged risk in your  old "buy and hold" investment strategy.

2. My Expectancy Wealth Planning group coaching program shows you how to maximize the expected growth of your wealth in every market condition regardless of epochal change. My students were prospering during the good times, and they're still prospering during this adversity. Join this smart community of active wealth builders to secure your financial future.