A bear market for bonds?

In 2009, Warren Buffett wrote:

“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation…..”

He was wrong about inflation. The next decade enjoyed low inflation, despite loose monetary policy, for two reasons. First, globalization had flooded the global economy with hundreds of millions of Chinese workers — earning a fraction of Western wages — a huge deflationary shock that depressed wages growth. Second, a contracting US economy, after the global financial crisis, added to deflationary pressures. The combined effect offset the inflationary impact from profligate monetary policy.

Manufacturing wages

The world has now changed. On-shoring of critical supply chains and geopolitical tensions with Russia and China are stoking inflationary pressures. Warren Buffett’s warning now seems prescient as the Fed struggles to cope with inflation fueled by combined fiscal and monetary policy during the pandemic.

The abrupt reversal in Fed monetary policy has increased the risk of recession. All traces of the word “transitory” have disappeared from press announcements, switching to the mantra “higher for longer”. The Fed funds rate is expected to reach 5.0% in the next few months, causing job losses later in the year.

Fed Funds Target Rate

10-Year Treasury yields broke former resistance at 3.0%, reaching 4.0% before retracing. Respect of support at 3.0% would confirm that the almost forty-year bull market in bonds is over.

10-Year Treasury Yield

Falling long-term yields caused a massive surge in private debt during the bull market, with non-bank debt more than doubling relative to GDP.

Non-Financial Debt/GDP

Federal debt, even worse, grew four times relative to GDP.

Federal Debt/GDP

The surge in debt inevitably fueled speculation in real assets, with a similar rise in stock market capitalization relative to GDP.

Stock Market Capitalization/GDP

Conclusion

The significance of debt to GDP ratios should not be underestimated.

Increasing debt to fund investment in real assets is a sound investment strategy in a bond bull market, so where’s the harm?

When an individual or corporation invests, their goal is to generate income from the investment. The income stream is applied to pay the interest on the debt and repay loan capital over a reasonable period. An investment that fails to generate sufficient income and requires the borrower to capitalize interest against the loan is generally considered a failure. And likely to lead to a forced sale when the economy contracts and access to credit dries up.

The overall economy is headed for a similar predicament. When debt growth outstrips income, it warns that borrowers are capitalizing interest and headed for a disaster. The Fed can attempt to postpone the day of reckoning by suppressing interest rates and injecting liquidity. But this just encourages more debt growth and investment in even riskier assets, compounding the problem.

We are now approaching a watershed. An inverted yield curve warns that credit growth is about to dry up. Banks borrow short and lend long, so a negative spread between long-term and short-term interest rates discourages lending.

Treasury Yields: 10-Year minus 3-Month

The Fed faces a tough choice: (A) allow a bond market to cause a sharp fall in asset prices and an inevitable deep recession; or (B) kick the can down the road, suppressing long-term yields to postpone the inevitable collapse, but make the problem even bigger.

Recent falls in CPI do not mean that the Fed has won the fight against inflation. This is likely to be a long, protracted battle. Winning the first round is a good start, but does the Fed have the political cover to stay the distance?

The bond market is pricing in rate cuts by the end of the year, expecting that the Fed will pivot to plan B.

Gold investors appear to share their conviction.

Spot Gold

Nouriel Roubini: “We are in a debt trap”

Nouriel Roubini was mocked by the media — who christened him “Dr Doom” — because of his prescient warnings ahead of the 2008 global financial crisis.

He has now published a book identifying 10 mega-threats to the global economy.

First and foremost is the debt trap. Private and public debt has expanded from 100% of GDP in the 1970s, to 200% by 1999, 350% last year — advanced economies even higher at 420%, China at 330%. Inflation forces central banks to raise interest rates. High rates mean many debtors will be unable to repay.

If governments print money to bail out the economy they will cause further inflation — a tax on creditors and savers [negative real rates threaten collapse of the insurance and pension industry].

We face prolonged high inflation.

Central Banks hiking rates is misguided, economic crisis will be so damaging they will be forced to reverse course.

Supply shocks from pandemic, Russia-Ukraine war and China zero-COVID policy.

Fiscal deficits will rise due to increased spending on national security and reducing carbon emissions.

Twenty years of kicking the can down the road [short election cycle incentivizes this], with politicians unwilling to support short-term costs for long-term gain because they are unlikely to be in power to reap the rewards. Older voters are also unlikely to support change as they may not be around to reap the benefits.

Carbon emissions are increasing due to the energy crisis from Russia-Ukraine war. Carbon tax of $200/tonne required, currently $2.

We need to reduce our energy consumption.

Also increase productivity. Technology is the only solution. AI and automation could lift GDP growth, providing sufficient income to fund the changes needed.

But technology is also a threat. It provides more dangerous weapons which risk greater destruction in the next conflict.

Democracy is still the best system. Autocracies are often corrupt and way too much concentration of power [echo chamber] leads to mistakes. They also increase inequality and political instability.

Nouriel seems bullish on gold because of geopolitical tensions. Also “green metals” because of the need to reduce CO2 emissions.

Our 2023 Outlook

This is our last newsletter for the year, where we take the opportunity to map out what we see as the major risks and opportunities facing investors in the year ahead.

US Economy

The Fed has been hiking interest rates since March this year, but real retail sales remain well above their pre-pandemic trend (dotted line below) and show no signs of slowing.

Real Retail Sales

Retail sales are even rising strongly against disposable personal income, with consumers running up credit and digging into savings.

Retail Sales/ Disposable Personal Income

The Fed wants to reduce demand in order to reduce inflationary pressure on consumer prices but consumers continue to spend. Household net worth has soared — from massive expansion of home and stock prices, fueled by cheap debt, and growing savings boosted by government stimulus during the pandemic. The ratio of household net worth to disposable personal income has climbed more than 40% since the global financial crisis — from 5.5 to 7.7.

Household Net Worth/ Disposable Personal Income

At the same time, unemployment (3.7%) has fallen close to record lows, increasing inflationary pressures as employers compete for scarce labor.

Unemployment

Real Growth

Hours worked contracted by an estimated 0.12% in November (-1.44% annualized).

Real GDP & Hours Worked

But annual growth rates for real GDP growth (1.9%) and hours worked (2.1%) remain positive.

Real GDP & Hours Worked

Heavy truck sales are also a solid 40,700 units per month (seasonally adjusted). Truck sales normally contract ahead of recessions, marked by light gray bars below, providing a reliable indicator of economic growth. Sales below 35,000 units per month would be bearish.

S&P 500

Inflation & Interest Rates

The underlying reason for the economy’s resilience is the massive expansion in the money supply (M2 excluding time deposits) relative to GDP, after the 2008 global financial crisis, doubling from earlier highs at 0.4 to the current ratio of 0.84. Excessive liquidity helped to suppress interest rates and balloon asset prices, with too much money chasing scarce investment opportunities. In the hunt for yield, investors became blind to risk.

S&P 500

Suppression of interest rates caused the yield on lowest investment grade corporate bonds (Baa) to decline below CPI. A dangerous precedent, last witnessed in the 1970s, negative real rates led to a massive spike in inflation. Former Fed Chairman, Paul Volcker, had to hike the Fed funds rate above 19.0%, crashing the economy, in order to tame inflation.

S&P 500

The current Fed chair, Jerome Powell, is doing his best to imitate Volcker, hiking rates steeply after a late start. Treasury yields have inverted, with the 1-year yield (4.65%) above the 2-year (4.23%), reflecting bond market expectations that the Fed will soon be forced to cut rates.

S&P 500

A negative yield curve, indicated by the 10-year/3-month spread below zero, warns that the US economy will go into recession in 2023. Our most reliable indicator, the yield spread has inverted (red rings below) before every recession declared by the NBER since 1960*.

S&P 500

Bear in mind that the yield curve normally inverts 6 to 18 months ahead of a recession and recovers shortly before the recession starts, when the Fed cuts interest rates.

Home Prices

Mortgage rates jumped steeply as the Fed hiked rates and started to withdraw liquidity from financial markets. The sharp rise signals the end of the 40-year bull market fueled by cheap debt. Rising inflation has put the Fed on notice that the honeymoon is over. Deflationary pressures from globalization can no longer be relied on to offset inflationary pressures from expansionary monetary policy.

S&P 500

Home prices have started to decline but have a long way to fall to their 2006 peak (of 184.6) that preceded the global financial crisis.

S&P 500

Stocks

The S&P 500 is edging lower, with negative 100-day Momentum signaling a bear market, but there is little sign of panic, with frequent rallies testing the descending trendline.

S&P 500

Bond market expectations of an early pivot has kept long-term yields low and supported stock prices. 10-Year Treasury yields at 3.44% are almost 100 basis points below the Fed funds target range of 4.25% to 4.50%. Gradual withdrawals of liquidity (QT)  by the Fed have so far failed to dent bond market optimism.

10-Year Treasury Yield & Fed Funds Rate

Treasuries & the Bond Market

Declining GDP is expected to shrink tax receipts, while interest servicing costs on existing fiscal debt are rising, causing the federal deficit to balloon to between $2.5 and $5.0 trillion according to macro/bond specialist Luke Gromen.

Federal Debt/GDP & Federal Deficit/GDP

With foreign demand for Treasuries shrinking, and the Fed running down its balance sheet, the only remaining market  for Treasuries is commercial banks and the private sector. Strong Treasury issuance is likely to increase upward pressure on yields, to attract investors. The inflow into bonds is likely to be funded by an outflow from stocks, accelerating their decline.

Energy

Brent crude prices fell below $80 per barrel, despite slowing releases from the US strategic petroleum reserve (SPR). Demand remains soft despite China’s relaxation of their zero-COVID policy — which some expected to accelerate their economic recovery.

S&P 500

European natural gas inventories are near full, causing a sharp fall in prices. But prices remain high compared to their long-term average, fueling inflation and an economic contraction.

S&P 500

Europe

European GDP growth is slowing, while inflation has soared, causing negative real GDP growth and a likely recession.

S&P 500

Australia, Base Metals & Iron Ore

Base metals rallied on optimism over China’s reopening from lockdowns. Normally a bullish sign for the global economy, breakout above resistance at 175 was short-lived, warning of a bull trap.

S&P 500

Iron ore posted a similar rally, from $80 to $110 per tonne, but is also likely to retreat.

S&P 500

The ASX benefited from the China rally, with the ASX 200 breaking resistance at 7100 to complete a double-bottom reversal. Now the index is retracing to test its new support level. Breach of 7000 would warn of another test of primary support at 6400.S&P 500

China

Optimism over China’s reopening may be premature. Residential property prices continue to fall.

S&P 500

The reopening also risks a massive COVID exit-wave, against an under-prepared population, when restrictions are relaxed.

“In my memory, I have never seen such a challenge to the Chinese health-care system,” Xi Chen, a Yale University global health researcher, told National Public Radio in America this week. With less than four intensive care beds for every 100,000 people and millions of unvaccinated or partially protected older adults, the risks are real.

With official data highly unreliable, it is hard to track exactly what impact China’s U-turn is having. Authorities on Friday reported the first Covid-19 deaths since most restrictions were lifted in early December, but there have been reports that funeral homes in Beijing are struggling to handle the number of bodies being brought in.

“The risk factors are there: eight million people are essentially not vaccinated,” said Huang Yanzhong, senior fellow for global health at the Council on Foreign Relations.

“Unless this variant has evolved in a way that makes it harmless, China can’t avoid what happened in Taiwan or in Hong Kong,” he added, referring to significant “exit waves” in both places.

The scale of the surge is unlikely to be apparent for months, but modelling suggests it could be grim. A report from the University of Hong Kong released on Thursday warned that a best case scenario is 700,000 fatalities – forecasts from a UK-based analytics firm put deaths at between 1.3 and 2.1 million.

“We’re still at a very early stage in this particular exit wave,” said Prof Ben Cowling, an epidemiologist at the University of Hong Kong. (The Telegraph)

China relied on infrastructure spending to get them out of past economic contractions but debt levels are now too high for stimulus on a similar scale to 2008. Expansion of credit to local government and real estate developers is likely to cause further stagnation, with the rise of zombie banking and real estate sectors — as Japan experienced for more than three decades — suffocating future growth.

S&P 500

Conclusion

Resilient consumer spending, high household net worth, and a tight labor market all make the Fed’s job difficult. If the current trend continues, the Fed will be forced to hike interest rates higher than the bond market expects, in order to curb demand and tame inflation.

Expected contraction of European and Chinese economies, combined with rate hikes in the US, are likely to cause a global recession.

There are two possible exits. First, if central banks stick to their guns and hold interest rates higher for longer, a major and extended economic contraction is almost inevitable. While inflation may be tamed, the global economy is likely to take years to recover.

The second option is for central banks to raise inflation targets and suppress long-term interest rates in order to create a soft landing. High inflation and negative real interest rates may prolong the period of low growth but negative real rates would rescue the G7 from precarious debt levels that have ensnared them over the past decade. A similar strategy was successfully employed after WWII to extricate governments from high debt levels relative to GDP.

As to which option will be chosen is a matter of political will. The easier second option is therefore more likely, as politicians tend to follow the line of least resistance.

We have refrained from weighing in on the likely outcome of the Russia-Ukraine conflict. Ukraine presently has the upper hand but the conflict is a wild card that could cause a spike in energy prices if it escalates or a positive boost to the European economy in the unlikely event that peace breaks out.

Our strategy is to remain overweight in gold, critical materials, defensive stocks and cash, while underweight bonds and high-multiple technology stocks. In the longer term, we will seek to invest cash in real assets when the opportunity presents itself.

Acknowledgements

  • Hat tip to Macrobusiness for the Pantheon Macroeconomics (China Residential) and Goldman Sachs (China Local Government Funding & Excavator Hours) charts.

Notes

* The yield curve inverted ahead of a 25% fall in the Dow in 1966. The NBER declared a recession but later changed their minds and airbrushed it out of their records.

Australia: Hard times

You don’t have to be an Einstein to figure out that 2023 is going to be a tough year. Australian consumers have already worked this out, with sentiment plunging to record lows.

Australia: Consumer Sentiment

The bellwether of the Australian economy is housing. Prices are tumbling, with annual growth now close to zero.

Australia: Housing

Iron ore, another strong indicator, rallied on news that China is easing COVID restrictions but prices are still trending lower.

Iron Ore

The Chinese economy faces a host of problems. A crumbling real estate sector, over-burdened with debt. Threat of a widespread pandemic as COVID restrictions are eased. Private sector growth collapsing as the hardline government reverts to a centrally planned economy. And a major trading partner, the US, intent on restricting China’s access to critical technology.

China

Rate hikes and inflation

The RBA hiked interest rates by another 25 basis points this week, lifting the cash rate to 3.1%. But the central bank is way behind the curve, with the real cash rate still deeply negative.

Australia: RBA Cash Rate

Monthly CPI eased to an annual rate of 6.9% in October, down from 7.3% in September, reflecting an easing of goods inflation.

Australia: CPI

But a rising Wages Index reflects underlying inflationary pressures that may force the RBA to contain with further rate hikes.

Australia: Wages Index

The lag from previous rate hikes is also likely to slow consumer spending. Borrowers on fixed rate mortgages face a steep rise in repayments when their existing fixed rate term expires and they are forced to rollover at far higher fixed or variable rates. A jump of at least 2.50% p.a. means a hike of more than A$1,000 per month in interest payments on a $500K mortgage.

Australia: Housing Interest Rates

GDP Growth

The largest contributor to GDP growth, consumption, is expected to contract.

Australia: GDP Contribution

Real GDP growth is already slowing, with growth falling to 0.6% in the third quarter — a 2.4% annualized rate. Contraction of consumption is likely to take real GDP growth negative.

Australia: GDP Contribution

Plunging business investment also warns of low real growth in the years ahead.

Australia: Business Investment

Record low unemployment seems to be the only positive.

Australia: Business Investment

But that is likely to drive wage rates and inflation higher, forcing the RBA into further rate hikes.

Conclusion

We may hope for a resurgence of the Chinese economy to boost exports and head off an Australian recession. But hope is not a strategy and China is unlikely to do us any favors.

We expect rising interest rates to cause a sharp contraction in the housing market, tipping Australia’s economy into a recession in 2023.

Acknowledgements

Charts were sourced from the RBA and ABS.
Ross Gittins: Hard times are coming for the Australian economy

Chairman Powell’s speech

Fed Chairman Jerome Powell’s remarks to the Brookings Institution, Wednesday 30th November, addressed two key questions:

  1. What does the Fed expect inflation to do in the months ahead?
  2. How is Fed monetary policy likely to respond?

Where is inflation headed?

“Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation.”

PCE & Core PCE Inflation

Powell focuses on core PCE inflation — which excludes food and energy, over which the Fed has little control — as this gives a “more accurate indication of where overall inflation is headed”. Core PCE is divided into three categories: (a) Core Goods; (b) Housing Services; and (c) Non-Housing Services.

Core PCE Components

Core Goods inflation is falling as supply chain issues are resolved and energy prices decline.

Housing Services is rising but tends to lag actual rental increases by 6 to 9 months. Rents were growing at between 16% and 18% in mid-2021 when PCE housing services inflation was still below 4% which means that core PCE inflation in 2021 was understated by a sizable margin. Housing services inflation is expected to fall “sometime next year” as lower rental renewals begin to feed into the index.

Core PCE Components - Housing

Non-Housing Services — the largest of the three categories — “may be the most important category for understanding the future evolution of core inflation” and, by inference, the evolution of broad inflation.

This spending category covers a wide range of services from health care and education to haircuts and hospitality…..Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.

In short, if you want to understand the future of inflation, look at the labor market.

Demand for labor far exceeds the supply, with job openings at 10.3 million in October far above unemployment at 6.1 million.

Job Openings & Unemployment

The primary causes of the current tight labor market are: (a) a large number of workers taking early retirement; and (b) a surge in deaths during the pandemic.

The Fed believes that there is still some way to go:

So far, we have seen only tentative signs of moderation of labor demand. With slower GDP growth this year, job gains have stepped down from more than 450,000 per month over the first seven months of the year to about 290,000 per month over the past three months. But this job growth remains far in excess of the pace needed to accommodate population growth over time — about 100,000 per month by many estimates…..

Wage growth, too, shows only tentative signs of returning to balance.

Today’s ADP data warns of a manufacturing and construction slow-down but growth in services employment and overall earnings:

Private businesses in the US created 127K jobs in November of 2022, the least since January of 2021, and well below market forecasts of 200K. The slowdown was led by the manufacturing sector (-100K jobs) and interest rate-sensitive sectors like construction (-2K), professional/business services (-77K); financial activities (-34K); and information (-25K). The goods sector shed 86K jobs. On the other hand, consumer-facing segments were bright spots. The services-providing sector created 213K jobs, led by leisure/hospitality (224K); trade/transportation/utilities (62K); education/health (55K). Meanwhile, annual pay was up 7.6%. “The data suggest that Fed tightening is having an impact on job creation and pay gains. In addition, companies are no longer in hyper-replacement mode. Fewer people are quitting and the post-pandemic recovery is stabilizing”, said Nela Richardson, chief economist, ADP. (Monex)

Fed monetary policy

Powell continues, hinting at a moderation in the rate of increases:

Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting.

The Fed is deliberately feeding optimism on Wall Street, but we are unclear as to their motive. Possibly it is an attempt to manage long-term Treasury yields. Keeping LT yields low would most likely raise earnings multiples for stocks and lower mortgage rates for home buyers, slowing the decline in asset values.

More likely, as Wolf Richter points out, a buoyant stock market gives the Fed political cover for further rate hikes. Plunging asset prices would ramp up political pressure on the Fed to cut interest rates, whereas market gains take the heat off the Fed, giving them further leeway to hike interest rates.

Conclusion

Fed policy is likely to be determined by two factors:

  1. moderation of core PCE inflation to below the Fed’s 2% target; and
  2. a significant rise in unemployment and/or fall in job openings. Powell describes this as “restoration of balance between supply and demand in the labor market.”

They are likely to continue hiking rates, but at a slower pace of 50 basis points, at least for the next two meetings.

Thereafter, we expect them to raise rates at a slower rate or, alternatively, pause and wait for the impact of past hikes to feed through into the broader economy. It could take 6 to 9 months to see the full effect of past hikes.

Unless something drastic happens, the Fed is unlikely to cut rates. Powell concludes (emphasis added):

It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.

P.S. The Dow rallied 700 points by the close, after Powell’s speech (WSJ). That increases the probability of at least one more 75 basis point hike at the next meeting.

Fed hikes now, pain comes later

Fed Chairman Jerome Powell announced a 75 basis point increase in the Fed funds target rate at his post-FOMC press conference today:

“Today, the FOMC raised our policy interest rate by 75 basis points, and we continue to anticipate that ongoing increases will be appropriate. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. In addition, we are continuing the process of significantly reducing the size of our balance sheet. Restoring price stability will likely require maintaining a restrictive stance of policy for some time.”

The target range is now 3.75% to 4.0%.

Fed Funds Rate

Commenting on today’s announcement, Michael Contopoulos from Richard Bernstein says little has changed:

“Nothing really changed today, the Fed has been hawkish since Jackson Hole. It doesn’t matter how high rates go, what matters is that the Fed is going to be restrictive and they’re going to bring down long-term growth…..The end game is not cutting rates, at least any time soon, the end game is to slow growth and slow the economy.” (CNBC)

Chris Brightman from Research Affiliates, co-manager several PIMCO funds, offers a useful rule-of-thumb as to how far the Fed will need to hike. The unemployment rate has to rise by 1.0% for every 1.0% intended drop in core inflation.

Core inflation is close to 6.0% at present, if we take the average of core CPI (purple), growth in average hourly earnings (pink), and core PCE index (gray). To achieve the Fed’s 2.0% inflation target, using the above rule-of-thumb, would require a 4.0% increase in the unemployment rate.

Unemployment

That means an unemployment rate of 7.5% (red line below), making a recession almost certain.

Unemployment Rate

The recent 10-year/3-month Treasury yield inversion also warns of a recession in 2023.

Treasury 10-Year minus 3-Month Yield

Conclusion

We expect the Fed to hike the funds rate to between 5.0% and 6.0% — the futures market reflects a peak of 5.1% in May ’23 — then a pause to assess the impact on the labor market. Employment tends to lag monetary policy by 6 to 12 months, so the results of recent rate hikes are only likely to show in 2023. The recent inversion of 10-year and 3-month Treasury yields also warns of a recession next year.

The unemployment rate will most likely need to rise to 7.5% to bring inflation back within the Fed’s target range. That would cause a deep recession, especially if the Fed holds rates high for an extended period as they have indicated.

Uncertainty still surrounds whether the Fed will be able to execute its stated plan. A sharp rise in unemployment or bond market collapse could cause an early Fed pivot as the Treasury yield curve and Fed fund futures still expect.

Treasury Yield Curve & Fed Funds Rate Futures

Important recession warning

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.

S&P 500 Index

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.

10-Year Treasury Yield minus 2-Year Treasury Yield

But unemployment (3.5%) is the lowest since the 1960s and the NBER has not moved to confirm a recession.

Unemployment

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.

10-Year Treasury Yield minus 3-Month Treasury Bill Discount Rate

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.

10-Year Treasury Yield minus 3-Month Treasury Bill Discount Rate

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.

There’s always more than one cockroach

There is always more than one cockroach. ~ Doug Kass, 50 Laws Of Investing (#8)

Rising interest rates, soaring energy prices, and plunging exchange rates of major energy importers — Europe, Japan and China — are likely to expose widespread misuse of leverage in financial markets.

JPMorgan Chase CEO Jamie Dimon says investors should expect more blowups after a crash in U.K. government bonds last month nearly caused the collapse of hundreds of that country’s pension funds. The turmoil, triggered after the value of U.K. gilts nosedived in reaction to fiscal spending announcements, forced the country’s central bank into a series of interventions to prop up its markets. That averted disaster for pension funds using leverage to juice returns, which were said to be within hours of collapse. “I was surprised to see how much leverage there was in some of those pension plans,” Dimon told analysts Friday in a conference call to discuss third-quarter results. “My experience in life has been when you have things like what we’re going through today, there are going to be other surprises.” ~ CNBC

Contagion

Financial turmoil in one market soon spreads to others as market bullishness collapses.

Extreme Fear

Financial chaos in the UK is hitting the shores of Japan and roiling the $1 trillion global market for collateralized loan obligations. Norinchukin Bank, once known as the “CLO whale”, has stopped buying new deals in the US and Europe for the foreseeable future because of volatility sparked by UK pension funds…. (Bloomberg)

Misuse of debt

Speculators in a bull market, encouraged by the low cost of debt and the consequential rise in asset prices, borrow money in expectation of leveraging their gains. Companies, encouraged by the low cost of debt and rising stock prices, also borrow money to invest in projects with low returns or without proper consideration of downside risks should the economy go into recession. Companies may generate sufficient cash flow to service interest on their debt but insufficient to repay the capital. Their survival depends on rolling over their debt when it matures. Known as “zombies”, they are vulnerable to rising interest rates, shrinking liquidity and stricter credit standards during an economic down-turn.

Zombie Companies

The Great Repricing

“We’re seeing the beginning of the Great Repricing…and that repricing is going to have significant impacts on portfolios of many investors…But this is an inevitable consequence, in my view, of a return to more normal levels of interest rates…” ~ Mervyn King, former Governor of the Bank of England

Rising interest rates and tighter liquidity force speculators to sell off assets to repay debt. The sell-off causes a fall in asset prices, prompting further margin calls, fire sales and a downward spiral in asset prices. Also, zombie companies, devoid of support from creditors, go to the wall. Publicity surrounding bankruptcies and layoffs raises fears of further corporate failures and increases the difficulty for borderline companies to roll over debt, reinforcing the downward spiral.

The ratio of stock market capitalization to GDP — Warren Buffett’s favorite long-term indicator of market valuation — has fallen sharply to 211% (Q2) but is still well above the Dotcom bubble high of 189%. And a long way from the long-term average of 104% (dotted red line below).

Stock Market Capitalization to GDP

Government intervention

Attempts to support inflated asset prices, as in China’s real estate markets, prevent markets from clearing and merely compound the problem. They simply prolong the bubble, allowing further debt accumulation and increase the eventual damage to financial markets.

No soft landing

In the past few recessions the Fed has stepped in, injecting liquidity to end the deflationary spiral but this time is different. The recent rapid surge in inflation has tied the Fed’s hands. They cannot inject liquidity to slow the rate of descent without risking a bond market revolt as seen in the UK.

30-Year Gilts Yield

Portfolios with a 60/40 split between stocks and bonds are showing their worst year-to-date performance in the past 100 years as both asset classes suffer from shrinking liquidity.

60/40 Portfolio Performance

Conclusion

“The investor who says, ‘This time is different,’ when in fact it’s virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing.” ~ Sir John Templeton

We should not underestimate the ingenuity of governments and their central bankers in postponing the inevitable pain associated with sound economic management. Instead they kick the can down the road, compounding the initial problem until it assumes Godzilla-like proportions, making further avoidance/postponement almost inevitable. It takes the courage of a Paul Volcker to confront the problem head-on and restore the economy to a sound growth path.

The million-dollar question facing investors is whether Fed chair Jerome Powell can do another Volcker. But Volcker had the advantage of a federal debt to GDP ratio below 50% in 1980. Treasury could withstand far higher interest rates than at the present ratio of well over 100%. So Powell is unlikely to succeed in meeting financial markets head-on.

Federal Debt to GDP

We expect the Fed to pivot. Just not this year.

Acknowledgements

Bond market: No place to hide

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.

Advance Retail Sales

Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.

Advance Real Retail Sales

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.

M2 excluding Time Deposits

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.

CPI & Hourly Earnings Growth

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.

10-Year Treasury Yield

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.

Non-Financial Debt/GDP

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.

Federal Debt/GDP

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.