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Fund Manager Expects Markets to ‘Break Badly and Painfully’ Within a Year

By Dinah Wisenberg Brin

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Inflation, central bank tightening, slowing consumption and a European energy crisis, among other factors, should stir significant troubles for economies around the world in coming months, Michael Taylor, Critical Mass Partners managing director, said on a webcast last week.

Taylor, hosted Thursday in a “Real Conversation” webcast by Keith McCullough, founder and CEO of research firm Hedgeye, said he expects things to “break badly and painfully” within a year in many places.

“This is the worst setup I have ever seen coming into stocks. And I said it in November coming into 2022 and I’ve said it all year,” said Taylor, who holds significant short and long positions and noted he is “up triple digits” on the year.

“I’ve had to modify the way that I trade and be a little bit more nimble about it because I’ve been of the mindset for this year … everything’s going lower, a lot lower. And I’ve changed that to actually trade these inflections and I don’t normally do that,” he said. “There’s just so much money to be made on trading both sides that … this is really an ideal condition to be nimble and active.”

Hedgeye’s McCullough titled the talk the “Biggest. Bubble. In. Capital. Market. History.”

“This is a Main Street, concentric market crash from China to El Salvador, to the biggest retail buying bubble,” McCullough said.

Taylor touched on the forces affecting economies and markets in the U.S. and globally, including rising energy and materials prices. Here are five economic predictions he made for the coming months.

1. Ailing U.S. Economy

The Federal Reserve Bank isn’t likely to pivot soon and has little choice but to weaken the U.S. economy — to a certain extent — according to Taylor.

“We’re going to have this period of time where we have tightening positions and a very quickly ailing economy,” he said, adding that there will be a lag time where the Fed can’t pivot and must stay the course on tightening.

“No matter what the Fed says they have one job, and that is to finance the Treasury and to make sure that the government can borrow money at a rate that is appropriate. And that rate that is appropriate is probably around 2%,” Taylor said. “So in my view the central bank has very little choice but to tank the economy until there is a spot on the yield curve where the government can fund itself.”

The U.S. government “has been wildly overspending and creating all of the growth” in the country’s  gross domestic product for a decade, he said. “So if we have 3% growth in GDP, 5% is the government overspending,” he added. If the government balanced the budget, the U.S. at minimum would be at negative 2% GDP growth, he said.

“The cascading problem the Fed is very worried about, and they’re trying to walk this fine line in not tanking the economy too bad, is the tax receipts,” Taylor said. If tax receipts decline too much the government would have to borrow to maintain spending levels, which would mean turning to international buyers, who would demand higher prices, he explained.

The Fed might start to pivot and taper down quantitative tightening when jobless claims go up by 50 or 75 or 100 basis points, Taylor said.

(In the week ended Sept. 3, 222,000 people filed new claims for unemployment benefits. Jobless claims have fallen most weeks since mid-July and are down significantly from 361,000 a year earlier.)

Hedgeye co-founder and CEO McCullough said a Fed pivot to easing shouldn’t automatically be taken as a buy signal for investors. Taylor agreed but said a pivot would be a time to start looking at valuation.

2. Forced Home Sales

Businesses are already showing signs of slowing, especially around the housing market, according to Taylor, who predicted the U.S. would see distressed sellers in several months.

“Essentially every single builder who did flipping and spec homes over the past year is underwater badly on everything they did,” he said, citing the cost of goods sold, overvalued property and monetary policy.

“If you give people a trillion dollars in their pocket, they’re going to bid everything to the moon,” Taylor said.

“Come winter, come spring next year, we’re going to have, I believe, forced sales everywhere,” he said. “We’re going to come into a realm where we have distressed sellers.” 

3. European War Escalation

Investors need to understand what’s happening in Europe, said Taylor, who considers it likely that Russia’s war in Ukraine will escalate in a matter of months.

“Putin’s game is A) I exit in a pine box, B) I strangle Europe so bad that it begins to fracture. And so he’s gunning on B. There’s no peace deal, it’s not going to happen,” he said. “In my view the probability of, at the end of winter or during the winter, that we see a major escalation in defending Europe is extremely high.”

Various factors make escalation likely, Taylor said, noting that political leaders in Europe, who range in age from about 60 to 75, remember the story of then-U.K. prime minister Neville Chamberlain’s disastrous negotiations with a dictator in the runup to World War II.

“The probability of them wanting to negotiate with Putin is unlikely,” he said.

“There’s the war machine, and the war machine would love to get paid by an escalation,” he added.

Taylor also cited political incentives for leaders to escalate their defense of Europe, saying they’d likely lose their seats in office if they caved to Putin. With an escalation, political leaders can create a distraction from a “really miserable economy” and an energy crisis, he explained.

“War and an escalation is a really nice political out to rally around the leaders,” he said. “It might be convenient for them to escalate. And I’m sad to say it.” 

4. Troubles in China

China faces a serious problem in its housing market and a major inflationary problem, Taylor said, noting the nation is seeing the consequences of rising energy and materials prices amid longer-term issues.

The country’s command economy has made “a massive, multi-decade-long malinvestment in order to keep their wheels moving,” with housing the predominant vehicle, he said. “Right now, it is blowing up, blowing up to the degree where this is exactly what happened in the U.S. in ‘07, ‘08, ‘09, where they stopped paying the mortgages, and said fine, take the property.”

“Or in the case of China, they’re paying mortgages for properties that they may or may not ever receive. In China they buy all these properties up front before they’re even built, and so you get the financing, you’re paying the mortgage,” and now builders in China “don’t have the funding to build a property that people have already bought. And honestly people don’t even want delivery now,” he said.

Taylor also suggested China’s strict lockdowns, which the country has announced to contain COVID-19 outbreaks, really may be intended to prevent inflation. “They’re being successful at that,” he said. “Of course at the same time they’re destroying their economy and they probably don’t have a choice either way on that outcome.” 

5. Troubles Around the World

Taylor expects “off-menu events” to happen in China, Europe and many other places, including El Salvador, as economies deal with multiple pressures.

“I expect meaningful off-menu events to happen in the next eight months to a year and maybe sooner, between food, energy, materials, the cost of capital. All of these things are happening all at the same time in a global fashion.” 

The U.S. economy in 2008 is the best proxy, he said, noting that was a “localized” situation.  “There is a lot of china being broken by the elephant in the china shop right now and things are going to very likely break badly and painfully,” Taylor said.

Taylor said people ask him why bonds are selling off globally while “stocks are not down remotely as much as they should be.” He cited low U.S. jobless claims as a major reason why market correlations are out of sync. In addition, people may be underestimating “persistent dip buying” from new retail investor money, he said, adding that dip buying is getting weaker “as their ammo gets all used up.”

He expects the disconnect between stocks and bonds to run out when jobless claims start to go soft. “We are going to have quantitative tightening ongoing at $90 billion a month, a fracturing credit market globally, a three-alarm energy crisis and consumption crisis in Europe — in my view the U.K. is going to be the worst. And as I said jobless claims and U.S. consumption going down.”

Dinah Wisenberg Brin

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