Editor’s Note: Van Bryan here, Jeff Brown’s longtime managing editor. We’re rapidly approaching the end of the year. And that means it’s time to sit down with Jeff and take stock of the year that was and look ahead to 2023.

Every year, Jeff shares his biggest predictions for the new year, and we look back on how his predictions for this year turned out. Stay tuned to The Bleeding Edge over the next two weeks as we discuss the biggest trends in high technology taking shape for 2023.

But to start, I sat down with Jeff to get his view on the historically difficult market, how it all unfolded, and what he expects to come next.

Read on…

Van Bryan (VB): Jeff, thanks for taking the time to share some new predictions for the new year.

Jeff Brown (JB): Of course, always happy to do it.

VB: To start, I think we should look back on what’s been a difficult market for investors this year. What’s your take on the recent market weakness?

JB: Well, you’re right that it’s been a historically tough market for virtually all asset classes. In fact, I would argue that this year is a once-in-a-lifetime year in the markets for most of us. As you and I are talking, all three of the major American indices are in negative territory for the year.

And what’s really remarkable is that virtually every asset class has been impacted. Equities have struggled terribly due to current monetary and economic policies. At the same time, Treasurys have had one of the worst years on record.

The conventional wisdom is that bonds will outperform stocks in volatile times and vice versa. But that hasn’t happened.

Treasurys have actually underperformed the S&P this year. In other words, they’ve fallen more. I’ve been an active investor since I was 16 years old and I’ve never seen anything like this.

Click To Enlarge

And even supposed “safe haven” assets are not performing well. We’d think precious metals would at least deliver a positive return. But both gold and silver are negative on the year. 

Even some of the assets that rose in this environment, like oil and gas, haven’t done so in a straight line. They’ve been quite volatile. There’s been almost no place to hide.

VB: What do you view as the cause of all this?

JB: It’s a combination of terrible monetary, fiscal, and economic policy. It’s rare to have all three things go terribly wrong at the same time.

The Federal Reserve (the Fed) made a massive mistake not addressing inflation in 2021, instead calling it “transitory.” It was absurd, and most understood that. After all, when a government prints $5 trillion and throws it around irresponsibly, we’re going to see inflation.

And that’s what we have now. Persistent, not transitory, inflation. The Fed backed itself into a corner, and now it is trying to dig its way out. 

This year, the Fed has been hiking rates higher and faster than almost anybody predicted. It took the Fed Funds Rate from a mere 25 basis points to 400 basis points in the span of a few months, and there is more to come.

And it’s not necessarily the level of the Fed Funds Rate that is having such a negative impact on the market. It’s the speed at which these hikes are happening. The Fed is going higher and faster than any other time in recent history.

It’s the speed and aggressiveness of these hikes that’s largely causing chaos in the markets right now.

VB: And what about on the fiscal side of things?

JB: Compounding things is some very poor fiscal and economic policy. The U.S. government has spent more than $5 trillion in response to COVID-19 and other forms of stimulus like the Inflation Reduction Act – which has nothing at all to do with inflation. 

Much of that was stimulus funds or increased unemployment benefits, essentially extending the “emergency” and paying people to stay home.

At the same time, the world effectively tried to “pause” the global economy with the ineffective lockdown policies over the past two years. That led to a decrease in production capacity and all the supply chain troubles.

The U.S. government continues to run record-level deficits, which has compounded national debt levels to more than $31 trillion. This has resulted in a debt-to-GDP ratio of 121.5% and growing. To state the obvious, this is not sustainable.

And economic policy has been largely overlooked by the press. Yet the primary reason for the rapid spike in energy prices (oil, natural gas, propane, jet aviation fuel, and electricity) has been restrictive economic policies. 

Land leases for oil and gas exploration have been revoked. And the government won’t permit new plants for domestic production. It also shut down the XL pipeline.

The most ironic part is that in the absence of natural gas, the U.S. has increased the amount of electricity production from coal. Coal has now risen to 25% of all electricity production in the U.S. 

The energy industry won’t invest in more natural gas production if it doesn’t have clear and consistent economic policy.

Now, we’re stuck with decades-high inflation and a weakening economy, which was all avoidable. And the Fed is going to overcorrect in its efforts to catch up to what it should have done back in 2021.

VB: That begs the question: What will the Fed do next?

JB: My working assumption is that the Fed will hike rates again in December and early February. I’m expecting 50 to 75 basis points in December and 50 basis points in early February. 

Depending on when subscribers are reading this, the December hike may have already happened. Either way, the direction is clear. Higher rates, at least reaching a Fed Funds Rate of 5% within the next few months.

But I’ll share my first prediction for 2023…

I predict that sometime in the first half of next year, the Fed will pause its rate hikes. Then in the second half of the year, it will introduce some form of quantitative easing to get the economy going again. And finally, I predict the Fed will have to cut rates to effectively stimulate the economy and the markets late next year.

My working assumption is that the Fed will wait until the Fed Funds Rate is within 50 basis points of the core CPI. That would give it enough cover to declare “mission accomplished” and back off.

[Editor’s Note: “Core CPI” is the Consumer Price Index minus notoriously volatile items like food and energy. By removing these items, it can give a “smoother” view of inflation.]

VB: What makes you believe the Fed will reverse course?

JB: At a certain point, it won’t have a choice. Something in the financial system will “break.” I’d argue cracks are already starting to form in foreign debt markets.

Back in September, the U.K. Gilts – their version of Treasurys – dropped to such an extent that it forced many pension funds to start selling their bond holdings to meet margin requirements. It got so bad that the Bank of England had to step in to prop up the market.

Something similar happened in Japan, my adopted home country. The government has been engaging in a very aggressive yield curve to control the price of its own bonds so that the country doesn’t have runaway inflation.

But one of the consequences is that trading for Japanese debt has dried up and the value of the Japanese Yen has plummeted.

Back in October, there were four straight days of zero trades for new government bonds. The institutional traders want nothing to do with the bonds because the yields are being held down artificially.

VB: Could something similar happen in the U.S.?

JB: The conventional wisdom is that it’s impossible. The U.S. dollar is still the world’s reserve currency. The thinking is that there would always be sufficient demand for dollar-denominated assets like Treasurys. But we shouldn’t entirely rule it out.

One of the consequences of the rate hikes is that the U.S. dollar is the strongest it’s been relative to other currencies in two decades. This is a problem for countries – especially developing nations – that have dollar-denominated debt. It makes it harder to service that debt.

It’s also a problem for countries that need to find dollars to purchase commodities like oil, which is almost exclusively priced in dollars.

What’s happening is that foreign governments are actually selling Treasurys to raise dollars to pay for necessities like oil and natural gas. They’ve been shedding U.S. Treasurys at an alarming rate.

And while this is happening, the U.S. government is still spending more. The most prominent example is the so-called Inflation Reduction Act. That’s an additional $737 billion in new spending.

Let’s put aside whatever we think of this on its merits and just consider how the U.S. government will pay for this. Tax revenue won’t do it. The U.S. government is already running a massive deficit. It was more than $2 trillion last year.

The capital will have to be raised with new Treasury sales. But who will buy them? Foreign countries won’t be able to purchase at levels anywhere near what was normal in the past. The strong dollar is the impediment. They’ve been net sellers this year, as we’ve seen.

There’s really only one option left. It has to be the Fed, the “lender of last resort.” Sometime next year, the Fed will weigh the dangers of inflation versus the danger of a debt crisis and choose to address the latter. They really won’t have any choice.

VB: And what does this mean for investors?

JB: I’d say we still have a bumpy few months ahead of us. Like I said, I do predict the Fed will keep hiking rates – albeit at smaller increments – into early 2023.

For the time being, we’ll want to stay nimble. We’ve done a number of things in our portfolios to weather this. We added an “insurance policy” to our Near Future Report portfolio.

And we’ve been adding some great convertible bonds to our portfolio in Exponential Tech Investor. I really like these assets. I call them “X-bonds.” They give us great downside protection while keeping the door open to equity-like upside.

[Editor’s Note: Subscribers who missed the research on these new strategies can catch up here and here.]

For early 2023, we will stick with our game plan. We’re going to stay defensive. We’ll continue to focus our portfolios on assets that have limited downside, and yet still have upside potential. 

Stay nimble. Stay vigilant. Wait for the tide to turn. And it will turn. And when it does, it will be easy to shift our portfolios back to growth.

I predict sometime in the second half of 2023, we’ll have a generational opportunity to load up on some best-in-class growth companies at valuations we may never see again.

It may be difficult to see, but in the midst of all this market volatility, some truly incredible things are happening in the high-tech and biotech industries.

We will get through this moment in time. And when we come out the other side, these companies will lead the market for the next leg higher.

VB: Thanks for your time, Jeff.

JB: Anytime.

Editor’s Note: Tune in tomorrow for our next conversation with Jeff Brown, where we’ll discuss “The Great Recalibration.”

What’s the impact of the CHIPS Act on American manufacturing? Is there a new Silicon Valley taking shape in the American heartland? And what will be the fate of Taiwan?

Check back tomorrow for that and much more.