• Gordon Johnson says financial conditions are looser now than when the Fed began hiking.
  • The central bank will need to be much more aggressive in 2023 if it wants to tame inflation. 
  • He believes the Nasdaq will correct by 20% by the end of this year. 

January’s Consumer-Price Index came in at 6.4% from a year ago and up 0.5% from the previous month.

Inflation has proved to be stickier than the central bank expected, said Gordon Johnson, the CEO and founder of GLJ Research, an independent firm. What’s also not helping is the Federal Reserve’s dovish approach by beginning the year signaling a 25-basis-point interest rate hike rather than 50 bps, he said. 

Once inflation gets out of the bag, it's very hard to put it back in, he said. Especially because the services sector is making up a large part of inflation. On an annual basis, services inflation was up 7.2%, the worst year-over-year increase since 1982, he noted. This sector makes up about 58% of the CPI, he added. 

"One of the reasons why services is so hard to get under control is because commodities are driven by the economy, but services are priced from the service provider," Johnson said. "To get services inflation down, you really actually need to create demand destruction. You need jobs to be lost. You need debt to come out of the system. You need companies to stop expanding and employing more debt. You need stocks to stop going up."

Johnson, who has been ranked by Bloomberg among the top stock pickers in the steel, iron ore, graphite electrode, electric vehicle, and solar spaces, says the Federal Reserve isn't doing enough to tame inflation and markets have responded to this by pricing in a dovish pivot.

This can be seen in financial conditions which have loosened significantly, more than where they were when the Fed began tightening, he noted. For the week ending on February 10, the Chicago Fed National Financial Conditions Index (NFCI), a weekly update on conditions in money markets, debt, equity markets, and the traditional and shadow banking systems was at -0.44. In March 2022 that number was at about -0.39. Negative digits are historically associated with looser-than-average financial conditions. 

The bond market is another area that's calling the Fed's bluff, he noted. The US 10-Year Treasury yield was at about 3.76% as of Wednesday. But if the fed funds rate is at 4.50-4.75%, then the 10-year should be in the middle of that if the market believes the Fed is serious about fighting inflation, he noted. 

Stock market outlook 

If the economy contracts as many expect, profit margins would shrink, leading to declining returns on equity (ROE), a metric that gauges how well a company is using its shareholders' investments. 

But Johnson believes central bank policies will further impact the stock market heading into the rest of the year. 

This is because the way out of sticky inflation is for Jerome Powell to raise rates higher and longer than what the market expects, he noted. This will put more pressure on the stock market throughout the year, creating a steeper-than-anticipated decline. Plus, the economy has had massive liquidity injections since 2010 which are now being reversed, he added. 

"Overall the market is going to fall, but I think that it may take a little while longer because until there's a debt ceiling agreement, Janet Yellen is going to continue drawing down the Treasury journal account," Johnson said. "And that's de facto quantitative easing. And that money goes directly into stocks and houses. But when the debt ceiling is agreed upon, you're going to have a significant amount of QT not only from the Fed but from Janet Yellen."

He believes the stock market will repeat the pattern witnessed in 2000 and 2001. In 2000, the Nasdaq was down 39%. By January 2001, the Nasdaq recovered 12%. In 2022, the index plunged by 33%. Similarly, year-to-date, the index has recovered by 15.26%. However, like 2001, when the index fell by about 20%, 2023 will see a similar decline, he said. 

Some investors are already experiencing jarring shifts in their performance, he noted. These include quant-investing funds that entered the year with a strategy that was long stocks that outperformed over the past 12 months and short the underperformers. But Powell's comments, shifting between dovish and hawkish, have hurt these funds.

Then, you have the People's Bank of China (PBOC) and the Central Bank of Japan that started the year off with massive liquidity injections which caused the stock market to rally, he added. However, that's over now. 

The good news for investors is that despite the prospects of a stock sell-off, there are short-term options. You can buy a six-month Treasury bill that yields 5% — that's a multi-decade high, he noted. Plus, it's risk-free.

From an equities perspective, Johnson likes the uranium sector. He expects oil stocks overall to continue to outperform because there has been a massive lack of capital expenditure. Therefore energy security is going to become a problem and demand for the sector will remain strong.