I was having a conversation with my friend Paul Kedrosky and, as usual, it got me thinking. Our banter is usually rapid-fire, centered around the markets and technology, and generally leaves me with a quizzical look on my face, a look towards the heavens and an utterance of "hmm." Today was one of those days.
On the macroeconomic front, I continue to be very, very disturbed by several factors. The fact that anyone cares about third-quarter earnings is beyond me. They are, to my mind, approaching irrelevance. The real story, yet only the beginning of the story, will be what fourth-quarter earnings look like. And while I'm not a betting man, I am pretty confident that they will suck. Hard. It's not that earnings for durable goods manufacturers will fall by 5%, 10%. They could drop by 50% or more. We are in the early stages of a consumer slow-down that does not seem to be factored into current stock prices. My fear is that people will find this as a shock, and that the market will get absolutely massacred when the realization sets in that corporate earnings aren't merely down, but are falling off a cliff.
And this, my friends, will precipitate staff cuts that will make the recent downsizings look like child's play. Falling corporate earnings. Falling stock prices. Firms with limited access to capital and high fixed costs will cut the only thing they can: people. More out of work people means a drop in consumer spending, which means falling corporate earnings, and so on.
Because of the steep drop in consumption, commodities prices will crater. This will cause energy and mining companies to sharply curtail exploration. New refineries will not be built. New mining equipment will not be purchased and proven mines will not be developed.
Through this, the Fed will push rates down to zero. They will do anything to try and stave off a Japan 1990s scenario. They will continue to print money like crazy to pay for the damaged financial sector, the dying auto and airline industries, and other high fixed-cost businesses that employ millions of people that "must be protected."
Eventually, we will hit a tipping point, a point where prices have gotten so cheap, banks will have rebuilt their balance sheets and the wheels of economic activity start to grind, even slowly, that we will find ourselves in the middle of a commodity and energy price inflation cycle the likes of which we've never witnessed. All slack will have been taken out of production during the nuclear economic winter, and the companies will be ill-prepared to gear up. It takes time. But people need stuff to buy! So prices will skyrocket - not up 40-50% but 400-500%. Maybe more. Finished goods prices will then shoot up, causing inflation to extend beyond energy and commodities and into the real economy. And with so much cheap money having been created, it won't take much to ignite an inflationary spiral.
What will the Fed do? Jack up rates from zero to whatever they feel will choke off spiraling inflation, because there is no greater fear in this country than hyper-inflation. But when the Fed jacks up rates, it will cause the nascent recovery to crash back down, pushing us right back into recession.
The Fed will then, of course, lower rates again, and it is hard to see how the cycle doesn't continue to play itself out several more times before things reach a more stable equilibrium. But in the meantime, we will see extreme levels of volatility and fear for a generation. I think if you plot the VIX in my scenario it is almost like a readout on an oscilloscope, one that goes up and down wildly for a period before moving within a much tighter band thereafter. But this "period" - is it 5 years, 10 years, or 20 years?
But I am fairly convinced that 40 on the VIX is the new 20. I think we're in for a prolonged period of uncertainty that we simply cannot innovate our way out of. Will innovation happen? Of course. But there is so much deadweight to lug around that it will still get drowned out among the larger problems of our economy. This is only one scenario, of course. But I think it is a scenario worth discussing.