We have had a number of major indicators warning of a bear market over the year, with the S&P 500 falling by more than 20%, completing a Dow Theory reversal, and 100-day Momentum holding below zero.
On the recession front, GDP recorded two quarters of negative growth — a useful rule of thumb recession measure. The middle of the Treasury yield curve also inverted — with the 10-year yield falling below the 2-year — warning of a recession ahead.
But unemployment (3.5%) is the lowest since the 1960s and the NBER has not moved to confirm a recession.
The front-end of the yield curve also remained positive, failing to confirm the signal from the 10-year/2-year negative spread.
Until now, that is.
On Tuesday, the 10-year/3-month Treasury spread turned negative, confirming the earlier 10Y/2Y recession warning.
Why is that important?
Because a negative 10-year/3-month spread has preceded every recession since 1960. One possible exception is 1966 (orange circle below). The 10Y/3M inverted, the Dow fell by 25%, and the NBER confirmed a recession but later changed their mind and airbrushed the recession out of the record. All-in-all, the 10Y/3M is our most reliable recession indicator, with a 100% track record in our view, over the past sixty years.
Conclusion
Our most reliable recession indicator, a negative 10-year/3-month Treasury yield differential, now confirms the recession warning from other indicators. But the signal is often early and it could take 6 to 12 months for the actual recession to arrive.
After their recent track record, expectations that the Fed will manufacture a soft landing are the triumph of hope over experience.
Employment is a lagging indicator and often only falls during the recession. Inflation likewise lags monetary policy by up to 6 months, before the full impact is clear. We expect the Fed to continue hiking, waiting for employment and inflation to fall, until the lagged impact of past rate hikes comes into view. Instead of cutting interest rates to soften the impact, the Fed has indicated they will hold rates high for longer. If so, we are likely to experience a severe recession.
Our strategy is to invest in cash in the short-term and limit exposure to equities, other than precious metals, critical materials, and defensive stocks.
Advance retail sales were flat in September, reflecting slowing growth, but remain well above their pre-pandemic trend. So far, Fed rate hikes have failed to make a dent in consumer spending.
Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.
The culprit is M2 money supply. While M2 has stopped growing, there has been no real contraction to bring money supply in line with the long-term trend. A fall of that magnitude would have a devastating effect on inflated asset prices.
Inflation is proving persistent, with CPI hardly budging in September. Hourly earnings growth is slowing but remains a long way above the Fed’s 2.0% inflation target.
Treasury yields have broken their forty year down-trend, with the 10-year testing resistance at 4.0%. Stubborn inflation is expected to lift yields even higher.
Inflation is forcing the Fed to raise interest rates, ending the forty-year expansion in debt levels (relative to GDP). Cheap debt supports elevated asset prices, so a decline in debt levels would cause a similar decline in asset prices.
A decline of that magnitude is likely to involve more pain than the political establishment can bear, leaving yield curve control (YCC) as the only viable alternative. The Fed would act as buyer of last resort for federal debt, while suppressing long-term yields. The same playbook was used in the 1950s and ’60s to drive down the debt to GDP ratio, allowing rapid growth in GDP while inflation eroded the real value of public debt.
Conclusion
We are fast approaching a turning point, where the Fed cannot hike rates further without collapsing the bond market. In the short-term, while asset prices fall, cash is king. But in the long-term investors should beware of financial securities because inflation is expected to eat your lunch. Our strategy is to invest in real assets, including gold, critical materials and defensive stocks.
There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.
A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.
Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.
In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.
A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.
Conclusion
We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:
(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).
An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.
A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.
The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.
The consumer price index (CPI) dipped to 8.25% (seasonally adjusted) for the 12 months to August but disappointed stock and bond markets who were anticipating a sharp fall.
The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.
Services CPI — which has minimal exposure to producer prices and supply chains — climbed to 6.08%. Rising services costs indicate that inflation is growing embedded in the economy.
Fueled by strong growth in average hourly earnings.
But it is not only services that present a problem.
Food prices are growing above 10% p.a. — signaling hardship for low income-earners.
The heavily-weighted shelter component — almost one-third of total CPI — climbed to 6.25%. We expect further increases as CPI shelter lags actual home prices — represented by the Case-Shiller 20-City Composite Home Price Index (pink) on the chart below — by 6 to 12 months.
CPI energy is still high, at 23.91% for the 12 months to August, but the index has fallen steeply over the past two months (July-August).
The decline is likely to continue until the mid-term elections in November, as the US government releases crude from its strategic reserves (SPR) in order to suppress fuel prices.
The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.
Conclusion
Strong CPI growth for the 12-months to August warns that inflation will be difficult to contain. Services CPI at 6.08% also confirms that inflation is growing embedded in the economy.
Energy costs are falling but this may be unsustainable. Releases from the strategic petroleum reserve (SPR) are likely to end after the mid-term elections in November.
The Fed is way behind the curve, with the real Fed funds rate (FFR-CPI) at -5.92%, below the previous record low of -4.97% from 1975.
We expect interest rates to rise “higher for longer.” A 75 basis-point hike is almost certain at next weeks’ FOMC meeting (September 20-21).
Long-term Treasury yields are rising, with the 10-year at 3.42%. Breakout above resistance at 3.50% is likely, signaling the end of a four decade-long secular bull trend in bonds.
Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.
“The economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets”.
Vladimir Putin gave some insight, last week, into his strategy to force Europe to withdraw its support for Ukraine. It involves two steps:
Use energy shortages to drive up inflation;
Use inflation to undermine confidence in the Euro and Dollar.
Will Putin succeed?
There are plenty of signs that Europe is experiencing economic distress.
When asked whether he expected a wave of bankruptcies at the end of winter, Robert Habeck, the German Federal Minister for Economic Affairs and Climate Action, replied:
Belgian PM Alexander De Croo also did not pull his punches:
“A few weeks like this and the European economy will just go into a full stop. The risk of that is de-industrialization and severe risk of fundamental social unrest.” (Twitter)
Steel plants are shutting down blast furnaces as rising energy prices make the cost of steel prohibitive. This is likely to have a domino effect on heavy industry and auto-manufacturers.
Aluminium smelters face similar challenges from rising energy costs.
How is the West responding?
Europe is reverting to coal to generate base-load power.
And increasing shipments of LNG. Germany is building regasification plants and has leased floating LNG terminals but there are still bottlenecks as the network is not designed around receiving gas from Russia in the East, not ports in the West.
Also, extending the life of nuclear power plants which were scheduled to be mothballed.
The new British prime minister, Liz Truss, is going further by lifting the ban on fracking. But new gas fields and related infrastructure will take years to build.
The President of the EC, Ursula von der Leyen’s announcement of increased investment in renewables will also be of little help. It takes about 7 years to build an offshore wind farm and the infrastructure to connect it to the grid.
Energy subsidies announced are likely to maintain current demand for energy instead of reducing it. A form of government stimulus, subsidies are also expected to increase inflation.
Price cap
The G7 has also responded by announcing a price cap on Russian oil. The hope is that the Russians will be forced to keep pumping but at a reduced price, avoiding the shortages likely under a full embargo.
Vladimir Putin, however, will try to create an energy crisis in an attempt to break Western resolve.
Putin responded to the price cap at the Asian Economic Forum, on Wednesday, in Vladivostok:
“Russia is coping with the economic, financial and technological aggression of the West. I’m talking about aggression. There’s no other word for it…….
We will not supply anything at all if it is contrary to our interests, in this case economic. No gas, no oil, no coal, no fuel oil, nothing.”
Ed Morse at Citi has expressed concerns about the price cap, calling it “a poor judgement call as to timing.” His concerns focus on the political implications of Winter hardship in Europe, especially with upcoming elections in Italy, the potential effect of lower flows out of Russia, and the impact increased demand for US oil would have on domestic prices.
The Dollar
Attempts to undermine the Dollar have so far failed, with the Dollar Index climbing steadily as the Fed hikes interest rates.
While Gold has fallen.
Conclusion
The West is engaged in an economic war with Russia, while China and India sit on the sidelines. War typically results in massive fiscal deficits and soaring government debt, followed by high inflation and suppression of bond yields.
We expect high inflation caused by (1) energy shortages; and (2) government actions to alleviate hardships which threaten political upheaval.
The Fed and ECB are hiking interest rates to protect their currencies but that is likely to aggravate economic hardship and increase the need for government spending to alleviate political blow-back.
We maintain our bullish long-term view on Gold. Apart from its status as a safe haven — especially when the Dollar and Euro are under attack — we expect negative real interest rates to boost demand for Gold as a hedge against inflation. In the short-term, breach of support at $1700 per ounce would be bearish, while recovery above the descending trendline (above) would signal that a base is forming. Follow-through above $1800 would signal another test of resistance at $2000.
The Treasury yield curve is flattening, with the 10-year/3-month yield differential plunging sharply, to a current 0.24%. Another 75 basis point rate hike at the next FOMC meeting is expected to drive the 3-month T-Bill discount rate above the 10-year yield, the negative spread warning of a deep recession in the next 6 to 18 months (subsequent reversal to a positive spread would signal that recession is imminent).
The S&P 500 is retracing to test short-term support at 4200. Breach would warn of another decline, while follow-through below 3650 would signal the second downward leg of a bear market.
21-Day Volatility troughs above 1% (red arrows) continue to warn of elevated risk.
Dow Jones Industrial Metals Index is in a primary down-trend, warning of a global recession.
Supported by a similar primary down-trend on Copper, the most prescient of base metals.
Brent crude below $100 also warns of an economic contraction. Goldman Sachs project that crude oil will reach $135 per barrel this Winter, while Ed Morse at Citi says that WTI Light Crude will likely remain below $90 per barrel. Obviously, the former foresees an economic recovery, while the latter sees an extended contraction. Of the two, Morse has the best track in the industry.
Natural gas prices are climbing.
Especially in Europe, where Russia is attempting to choke the European economy.
Causing Germany’s producer price index to spike to 37.2% (year-on-year growth).
Conclusion
Our base case is a global recession. A soft landing is unlikely unless the Fed does a sharp pivot, Russia stops trying to throttle European gas, and China goes all-in on its beleaguered property sector. That won’t address any of the underlying problems but would kick the can down the road for another year or two.
I know what the numbers say. I can read the returns. By those hard, cold, simplistic measures, Liz Cheney was defeated overwhelmingly in her House Republican primary in Wyoming on Tuesday night, and her time in Congress is winding down.
But it’s impossible for me to say that she lost.
She got many, many fewer votes than her opponent, an unscrupulous shape shifter unfit to shine her shoes, because she chose the tough world of truth over Donald Trump’s underworld of lies. That’s a moral victory.
She was spurned by conservatives in Wyoming because she had the clear-eyed vision to see Trump for what he is and — unlike Mitch McConnell and Kevin McCarthy, whose titles perversely include the word “leader” — she wouldn’t don a blindfold. That makes her a champion in the ways that count most.
Come January, she will no longer be Representative Cheney because she represents steadfast principle in an era with a devastating deficit of it. History will smile on her for that. It will remember the likes of McConnell and McCarthy for different, darker reasons. You tell me who’s the winner in this crowd…..
Conclusion
We try to stay out of party politics but Liz Cheney’s stand is about principle — the preservation of American democracy — which should be above politics. Sadly, that is no longer the case.
CPI dipped to 8.5% for the 12 months to July. But this still leaves the Fed way behind the curve, with a real Fed funds rate of -6.0% (8.5%-2.5%).
Monthly CPI figures, however, show a sharp slowdown, with CPI falling 0.01% in July (-0.14% annualized rate).
The primary cause is energy prices, which fell 4.53% in July (-54.7% annualized rate).
Food CPI continues to climb, up 1.06%for July (12.75% annualized rate).
CPI Shelter, heavily weighted at 32.1% of the total CPI basket, remains a major source of upward pressure on CPI. The Shelter index tends to lag home prices by up to 12 months and the Case-Shiller 20-City Composite Home Price Index grew at 20.8% for the 12 months to May.
The Rents component of CPI shelter shows a similar lag, a long way behind the Zillow rent index which is up 14.8% over the 12 months to June.
Wages & consumer expectations
Consumer expectations for inflation were unchanged, at 5.3% in June.
While average hourly wage rates moderated slightly, growing 6.2% in the 12 months to July.
Upward pressure on wages is likely to continue for as long as job openings exceed unemployment, with a current shortfall of 5 million workers.
The Fed
The real Fed funds rate (FFR adjusted for CPI) rose to a weak -6.0% after the latest rate hike, still lower than any previous trough in the past sixty years. Real FFR (red below) should be positive when unemployment (blue) is below 5%. Past lows, circled on the chart below, were in response to high unemployment — when the economy had spare capacity. We now have the opposite, with a tight labor market, and negative real rates are likely to give rise to high inflation.
Conclusion
Some are calling this “peak inflation” but the decline in CPI growth is due to a large monthly drop in energy prices. Food and shelter costs are still rising.
The energy crisis is not over, with Winter approaching in Europe while gas storage levels are at record lows and Russia is restricting pipeline flows in an attempt to create division within the European Union. Energy prices are likely to remain volatile.
The Fed is way behind the curve, with a real Fed funds rate of -6.0%. We expect them to continue hiking interest rates despite the recent fall in energy prices.
According to Larry Summers and Olivier Blanchard, the Fed will only be able to bring inflation down when unemployment is well above 5%. The danger is if the Fed is forced to halt rate hikes before it has tamed underlying inflation. We are then likely to end up with both low growth and high inflation.
Our strategy remains defensive: overweight Gold, critical materials, defensive stocks which enjoy strong pricing power, and cash.
Acknowledgements
Hat tip to Wolf Richter for the CPI Rent/Zillow chart.
British-born Fiona Hill is an expert on Russia and Vladimir Putin and served as security adviser to US Presidents George W. Bush, Barack Obama and Donald Trump. Her take on Russia’s invasion of Ukraine is that Vladimir Putin still thinks he is winning. The Kremlin has a far higher tolerance for troop losses than Western governments and Putin believes that he can grind out a victory of sorts. He thinks he has the upper hand in terms of leverage, through his influence on energy markets and food shortages, and is prepared to wait out the West — waiting for them to lose patience and attempt to force a negotiated settlement.
“Putin is a contingency planner. If one thing doesn’t work, he’ll try another. If things get dire, expect more nuclear sabre-rattling. They already rhetorically deployed nuclear weapons, and used them, on national television.
Bear in mind they take a very careful read of us and how we react. Think about when they moved through the Chernobyl exclusion zone into Ukraine….People said they wouldn’t possibly do that but they did. This scares the heck out of everyone….Same thing with Zaporizhzhia nuclear power plant. They deliberately shelled it. Think about the timing. It was just when Germany and Japan were considering recommissioning their nuclear power plants. All this happens because Putin knows he can push our buttons. He knows our fears and can play to those fears.”
The West has to get ahead of this. But we always tend to do things too late. Earlier action in Ukraine — in terms of supplying weapons — may have deterred Putin.
“Putin and the Kremlin have a major advantage: continuity. They have been in power for a long time and have no effective opposition.
The West, by contrast, has no continuity. This is the main obstacle to getting ahead of the game. Democracies tend to lose focus over time…..The more domestic problems you have, the more likely you are to lose focus.
….Putin’s business is to find points of leverage.
Political donations. Corruption. Germany’s pact with the devil — it’s economy is built on reliance on cheap Russian gas. We have to wind this all back.
