Category: GDP and Activity

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Hard or Soft Landing?

Almost every recession in history has been preceded by speculation that the economy is in for a “soft landing.” After the early warning signs, nothing much happens. The stock market keeps climbing despite rising interest rates, raising hopes of a “lucky escape”.

The four most expensive words in the English language are: “This time it’s different.” ~ Sir John Templeton

The economy takes time to adjust to changed circumstances and there can be a lag of two years or more between the first rate hikes and the inevitable rise in unemployment. Plenty of time for self-delusion as stocks keep rising and unemployment stays low.

The difference between a hard and soft landing is best measured by unemployment. At 3.5%, the March reading shows no sign yet of an approaching recession.

Unemployment

The lag between an inverted yield curve — caused by Fed rate hikes — and unemployment can vary quite widely between recessions, depending on other influences. The chart below shows how an inverted yield curve in July 2000 was followed by the first sign of rising unemployment in January 2001, and shortly afterwards by a recession in March. The next yield curve inversion started in February 2006, the first sign of rising unemployment in July 2007, and the recession only in December of that year. Red bars below represent the lag between yield curve inversion and the first sign of rising unemployment.

Treasury Yields: 10-Year minus 3-Month & Unemployment

The current yield curve inversion (10-Year minus 3-Month Treasury yield) started in November 2022, so the earliest we are likely to see a rise in unemployment is late-2023.

Treasury Yields: 10-Year minus 3-Month

Why is unemployment expected to rise?

Every yield curve inversion (10-Year minus 3-Month above) since 1960 has been followed by the NBER declaring a recession within two years.

Every time the Conference Board Leading Economic Index declined below the red line at -5.0% has signaled recession.

Conference Board Leading Economic Index

Why do we expect a hard landing?

Every economy runs on credit and the US is no different. The severity of a recession is determined by the extent of the contraction in credit growth, as shown by the red circles below. Note how late the contraction generally is, often occurring after the official recession (gray bar) has ended.

Bank Credit

What determines the size of the credit contraction?

Firstly, bank net interest margins.

Banks tend to borrow short-term and lend long, enhancing their net interest margins in good times. But an inverted yield curve pulls the rug from under them, with short-term rates spiking upwards.

The more that net interest margins of commercial banks are squeezed, the more they avoid risk, restricting lending to only their best clients.

The percentage of domestic banks tightening lending standards on C&I loans climbed to 44.8% in March 2023.

Commercial Bank: Tightening Credit Standards for Commercial & Industrial Loans

Second, is the level of uncertainty facing banks.

The S&P 1500 Regional Banks index plunged after the collapse of Silicon Valley Bank (SVB), Silvergate Bank and Signature Bank.

Bank Credit

Shocks in the financial system tend to occur in waves. Latest is the threatened collapse of First Republic Bank (FRC) which has lost almost 100% of value in the past few months**.

First Republic Bank (FRC)

The CSBS Community Bank Index of Business Conditions is lower than at the height of the pandemic.

CSBS Community Bank Sentiment

Third is liquidity.

A strong surge in money market assets, warns that money (+/- $450 bn) has flowed out of the banking system and into the relative safety of money market funds.

Money Market Fund Assets

Money market funds are primarily invested in Fed reverse repo and Agency and Treasury securities, bypassing the banking system.

Money Market Fund Investment Allocation

Conclusion

Bank net interest margins are being squeezed, uncertainty is rising following the Silicon Valley Bank collapse, liquidity is being squeezed, and banks are tightening lending margins. The only party who can prevent a severe credit crunch is the Fed. By reversing course and injecting liquidity (QE) into financial markets, the Fed could attempt to create a soft landing for the economy.

But the Fed is bent on taming inflation and restoring their lost credibility after their earlier “transitory” error. The cavalry is likely to arrive late and low on ammunition.

We expect a hard landing.

Latest News**

Reuters: First Republic Bank (FRC)

Acknowledgements

EPB Research for the Conference Board LEI chart.

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Economic Outlook, March 2023

Here is a summary of Colin Twiggs’ presentation to investors at Beech Capital on March 30, 2023. The outlook covers seven themes:

  1. Elevated risk
  2. Bank contagion
  3. Underlying causes of instability
  4. Interest rates & inflation
  5. The impact on stocks
  6. Flight to safety
  7. Australian perspective

1. Elevated Risk

We focus on three key indicators that warn of elevated risk in financial markets:

Inverted Yield Curve

The chart below plots the difference between 10-year Treasury yields and 3-month T-Bills. The line is mostly positive as 10-year investments are normally expected to pay a higher rate of investment than 3-month bills. Whenever the spread inverted, however, in the last sixty years — normally due to the Fed tightening monetary policy — the NBER has declared a recession within 12 to 18 months1.

Treasury Yields: 10-Year minus 3-Month

The current value of -1.25% is the strongest inversion in more than forty years — since 1981. This squeezes bank net interest margins and is likely to cause a credit contraction as banks avoid risk wherever possible.

Stock Market Volatility

We find the VIX (CBOE Short-term Implied Volatility on the S&P 500) an unreliable measure of stock market risk and developed our own measure of volatility. Whenever 21-day Twiggs Volatility forms troughs above 1.0% (red arrows below) on the S&P 500, that signals elevated risk.

S&P 500 & Twiggs Volatility (21-Day)

The only time that we have previously seen repeated troughs above 1.0% was in the lead-up to the global financial crisis in 2007-2008.

S&P 500 & Twiggs Volatility (21-Day)

Bond Market Volatility

The bond market has a far better track record of anticipating recessions than the stock market. The MOVE index below measures short-term volatility in the Treasury market. Readings above 150 indicate instability and in the past have coincided with crises like the collapse of Long Term Capital Management (LTCM) in 1998, Enron in 2001, Bear Stearns and Lehman in 2008, and the 2020 pandemic. In the past week, the MOVE exceeded 180, its highest reading since the 2008-2009 financial crisis.

MOVE Index

2. Bank Contagion

Regional banks in the US had to be rescued by the Fed after a run on Silicon Valley Bank. Depositors attempted to withdraw $129 billion — more than 80% of the bank’s deposits — in the space of two days. There are no longer queues of customers outside a bank, waiting for hours to withdraw their deposits. Nowadays online transfers are a lot faster and can bring down a bank in a single day.

The S&P Composite 1500 Regional Banks Index ($XPBC) plunged to 90 and continues to test support at that level.

S&P Composite 1500 Regional Banks Index ($XPBC)

Bank borrowings from the Fed and FHLB spiked to $475 billion in a week.

Bank Deposits & Borrowings

Financial markets are likely to remain unsettled for months to come.

European Banks

European banks are not immune to the contagion, with a large number of banking stocks falling dramatically.

European Banks

Credit Suisse (CS) was the obvious dead-man-walking, after reporting a loss of CHF 7.3 billion in February 2023, but Deutsche Bank (DB) and others also have a checkered history.

Credit Suisse (CS) & Deutsche Bank (DB)

3. Underlying Causes of Instability

The root cause of financial instability is cheap debt. Whenever central banks suppress interest rates below the rate of inflation, the resulting negative real interest rates fuel financial instability.

The chart below plots the Fed funds rate adjusted for inflation (using the Fed’s preferred measure of core PCE), with negative real interest rates highlighted in red.

Fed Funds Rate minus Core PCE Inflation

Unproductive Investment

Negative real interest rates cause misallocation of capital into unproductive investments — intended to profit from inflation rather than generate income streams. The best example of an unproductive investment is gold: it may rise in value due to inflation but generates no income. The same is true of art and other collectibles which generate no income and may in fact incur costs to insure or protect them.

Residential real estate is also widely used as a hedge against inflation. While it may generate some income in the form of net rents, the returns are normally negligible when compared to capital appreciation.

Productive investments, by contrast, normally generate both profits and wages which contribute to GDP. If an investor builds a new plant or buys capital equipment, GDP is enhanced not only by the profits made but also by the wages of everyone employed to operate the plant/equipment. Capital investment also has a multiplier effect. Supplies required to operate the plant, or transport required to distribute the output, are both likely to generate further investment and jobs in other parts of the supply chain.

Cheap debt allows unproductive investment to crowd out productive investment, causing GDP growth to slow. These periods of low growth and high inflation are commonly referred to as stagflation.

Debt-to-GDP

The chart below shows the impact of unproductive investment, with private sector debt growing at a faster rate than GDP (income), almost doubling since 1980. This should be a stable relationship (i.e. a horizontal line) with GDP growing as fast as, if not faster than, debt.

Private Sector Debt/GDP

Even more concerning is federal debt. There are two flat sections in the above chart — from 1990 to 2000 and from 2010 to 2020 — when the relationship between private debt and income stabilized after a major recession. That is when government debt spiked upwards.

Federal & State Government Debt/GDP

When the private sector stops borrowing, the government steps in — borrowing and spending in their place — to create a soft landing. Some call this stimulus but we consider it a disaster when unproductive spending drives up the ratio of government debt relative to GDP.

Research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggests that states where sovereign debt exceeds 100% of GDP (1.0 on the above chart) almost inevitably default. A study by Cristina Checherita and Philip Rother at the ECB posited an even lower sustainable level, of 70% to 80%, above which highly-indebted economies would run into difficulties.

Rising Inflation

Inflationary pressures grow when government deficits are funded from sources outside the private sector. There is no increase in overall spending if the private sector defers spending in order to invest in government bonds. But the situation changes if government deficits are funded by the central bank or external sources.

The chart below shows how the Fed’s balance sheet has expanded over the past two decades, reaching $8.6 trillion at the end of 2022, most of which is invested in Treasuries or mortgage-backed securities (MBS).

Fed Total Assets

Foreign investment in Treasuries also ballooned to $7.3 trillion.

Fed Total Assets

That is just the tip of the iceberg. The US has transformed from the world’s largest creditor (after WWII) to the world’s largest debtor, with a net international investment position of -$16.7 trillion.

Net International Investment Position (NIIP)

4. Interest Rates & Inflation

To keep inflation under control, central bank practice suggests that the Fed should maintain a policy rate at least 1.0% to 2.0% above the rate of inflation. The consequences of failure to do so are best illustrated by the path of inflation under Fed Chairman Arthur Burns in the 1970s. Successive stronger waves of inflation followed after the Fed failed to maintain a positive real funds rate (green circle) on the chart below.

Fed Funds Rate & CPI in the 1970s

CPI reached almost 15.0% and the Fed under Paul Volcker was forced to hike the funds rate to almost 20.0% to tame inflation.

Possible Outcomes

The Fed was late in hiking interest rates in 2022, sticking to its transitory narrative while inflation surged. CPI is now declining but we are likely to face repeated waves of inflation — as in the 1970s — unless the Fed keeps rates higher for longer.

Fed Funds Rate & CPI

There are two possible outcomes:

A. Interest Rate Suppression

The Fed caves to political pressure and cuts interest rates. This reduces debt servicing costs for the federal government but negative real interest rates fuel further inflation. Asset prices are likely to rise as are wage demands and consumer prices.

B. Higher for Longer

The Fed withstands political pressure and keeps interest rates higher for longer. This increases debt servicing costs and adds to government deficits. The inevitable recession and accompanying credit contraction cause a sharp fall in asset asset prices — both stocks and real estate — and rising unemployment. Inflation would be expected to fall and wages growth slow.  The eventual positive outcome would be more productive investment and real GDP growth.

5. The Impact on Stocks

Stocks have been distorted by low interest rates and QE.

Stock Market Capitalization-to-GDP

Warren Buffett’s favorite indicator of stock market value compares total market capitalization to GDP. Buffett maintains that a value of 1.0 reflects fair value — less than half the current multiple of 2.1 (Q4, 2022).

Stock Market Capitalization/GDP

Price-to-Sales

The S&P 500 demonstrates a more stable relationship against sales than against earnings because this excludes volatile profit margins. Price-to-Sales has climbed to a 31% premium over 20-year average of 1.68.

S&P 500 Price-to-Sales

6. Flight to Safety

Elevated risk is expected to cause a flight to safety in financial markets.

Cash & Treasuries

The most obvious safe haven is cash and term deposits but recent bank contagion has sparked a run on uninsured bank deposits, in favor of short-term Treasuries and money market funds.

Gold

Gold enjoyed a strong rally in recent weeks, testing resistance at $2,000 per ounce. Breakout above $2,050 would offer a target of $2,400.

Spot Gold

A surge in central bank gold purchases — to a quarterly rate of more than 400 tonnes — is boosting demand for gold. Buying is expected to continue due to concerns over inflation and geopolitical implications of blocked Russian foreign exchange reserves.

Central Bank Quarterly Gold Purchases

Defensive sectors

Defensive sectors normally include Staples, Health Care, and Utilities. But recent performance on the S&P 500 shows operating margins for Utilities and Health Care are being squeezed. Industrials have held up well, and Staples are improving, but Energy and Financials are likely to disappoint in Q1 of 2023.

S&P 500 Operating Margins

Commodities

Commodities show potential because of massive under-investment in Energy and Battery Metals over the past decade. But first we have to negotiate a possible global recession that would be likely to hurt demand.

7. Australian Perspective

Our outlook for Australia is similar to the US, with negative real interest rates and financial markets awash with liquidity.

Team “Transitory”

The RBA is still living in “transitory” land. The chart below compares the RBA cash rate (blue) to trimmed mean inflation (brown) — the RBA’s preferred measure of long-term inflationary pressures. You can seen in 2007/8 that the cash rate peaked at 7.3% compared to the trimmed mean at 4.8% — a positive real interest rate of 2.5%. But since 2013, the real rate was close to zero before falling sharply negative in 2019. The current real rate is -3.3%, based on the current cash rate and the last trimmed mean reading in December.

RBA Cash Rate & Trimmed Mean Inflation

Private Credit

Unproductive investment caused a huge spike in private credit relative to GDP in the ’80s and ’90s. This should be a stable ratio — a horizontal line rather than a steep slope.

Australia: Private Credit/GDP

Government Debt

Private credit to GDP (above) stabilized after the 2008 global financial crisis but was replaced by a sharp surge in government debt — to create a soft landing. Money spent was again mostly unproductive, with debt growing at a much faster rate than income.

Australia: Federal & State Debt/GDP

Liquidity

Money supply (M3) again should reflect a stable (horizontal) relationship, especially at low interest rates. Instead M3 has grown much faster than GDP, signaling that financial markets are awash with liquidity. This makes the task of containing long-term inflation much more difficult unless there is a prolonged recession.

RBA Cash Rate & Trimmed Mean Inflation

Conclusion

We have shown that risk in financial markets is elevated and the recent bank contagion is likely to leave markets unsettled. Long-term causes of financial instability are cheap debt and unproductive investment, resulting in low GDP growth.

Failure to address rising inflation promptly, with positive real interest rates, is likely to cause recurring waves of inflation. There are only two ways for the Fed and RBA to address this:

High Road

The high road requires holding rates higher for longer, maintaining positive real interest rates for an extended period. Investors are likely to suffer from a resulting credit contraction, with both stocks and real estate falling, but the end result would be restoration of real GDP growth.

Low Road

The low road is more seductive as it involves lower interest rates and erosion of government debt (by rapid growth of GDP in nominal terms). But resulting high inflation is likely to deliver an extended period of low real GDP growth and repeated cycles of higher interest rates as the central bank struggles to contain inflation.

Overpriced assets

Vulnerable asset classes include:

  • Growth stocks, trading at high earnings multiples
  • Commercial real estate (especially offices) purchased on low yields
  • Banks, insurers and pension funds heavily invested in fixed income
  • Sectors that make excessive use of leverage to boost returns:
    • Private equity
    • REITs (some, not all)

Relative Safety

  • Cash (insured deposits only)
  • Short-term Treasuries
  • Gold
  • Defensive sectors, especially Staples
  • Commodities are more cyclical but there are long-term opportunities in:
    • Energy
    • Battery metals

Notes

  1. The Dow fell 25% in 1966 after the yield curve inverted. The NBER declared a recession but later changed their mind and airbrushed it from their records.

Questions

1. Which is the most likely path for the Fed and RBA to follow: the High Road or the Low Road?

Answer: As Churchill once said: “You can always depend on the Americans to do the right thing. But only after they have tried everything else.” With rising inflation, the Fed is running out of options but they may still be tempted to kick the can down the road one last time. It seems like a 50/50 probability at present.

2. Comment on RBA housing?

We make no predictions but the rising ratio of housing assets to disposable income is cause for concern.

Australia & USA: Housing Assets/Disposable Income

3. Is Warren Buffett’s indicator still valid with rising offshore earnings of multinational corporations?

Answer: We plotted stock market capitalization against both GDP and GNP (which includes foreign earnings of US multinationals) and the differences are negligible.

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Stocks retreat as Treasury yields rise

The S&P 500 retreated from resistance at 4100. Reversal below 4000 would warn of another test of primary support at 3500. We remain in a bear market, with 12-month Rate of Change below zero.

S&P 500

The recent rally was caused by falling long-term yields, with 10-year Treasuries testing support at 3.5%. Rising yields are now precipitating a retreat in stocks.

Treasury Yields: 10-Year

Slowing Treasury issuance, ahead of debt ceiling negotiations, may have contributed to declining yields but this has been offset by foreign sales, notably by the Bank of Japan.

Bank of Japan Sales

The Treasury yield curve remains inverted, with the 10-Year minus 3-Month at an alarming -0.97%, warning of a recession in 6 to 18 months.

Treasury Yields: 10-Year minus 3-Month

Commercial banks borrow short, with most deposit maturities less than a year, while lending on far longer terms in order to capture the term premium. When the yield curve inverts, net interest margins are compressed, making banks willing to lend only to the most secure borrowers. Credit standards (green below) are being tightened but credit growth (pink) remains strong. Credit growth is likely to decline in the months ahead and would warn that a recession is imminent.

Domestic Banks Tightening Standards & Credit Growth

Fed operations reduced liquidity in financial markets but this has been partially offset by Treasury’s running down their General Account (TGA) at the Fed (which injects money into the economy). The net result is a $1.2 trillion reduction in liquidity.

Fed Net Asset Purchases

The breakdown is illuminating, with the Fed reducing its balance sheet (blue below) by $469 billion to the end of January, while reverse repo operations (green below) removed $2.4 trillion. Treasury, however, partially offset this by running down their TGA account (red) from $1.8 trillion in July 2020 to $0.5 trillion in January 2023.

Fed Net Asset Purchases

The net effect is a fall in the money supply (M2) relative to GDP, from 0.90 to 0.82. But there is still a long way to go. The ratio of M2 to GDP should ideally be a constant, with money supply growing at the same pace as GDP. Lax monetary policy instead allowed money to grow at a faster pace than national income, resulting in high inflation as aggregate demand runs ahead of output.

M2/GDP

Conclusion

The primary cause of bull and bear markets is liquidity. Stock prices could well remain high, even while the Fed hikes interest rates, if financial markets are awash with cash. Only when credit growth slows, and the Fed sells more Treasuries, are prices likely to collapse. External factors, like foreign investor sales, may also shrink liquidity but are a lot harder to predict.

The pig is still in the python. The large gap between deposits at commercial banks (blue below) and bank lending to private borrowers (pink) is represented mainly by commercial bank holdings of Treasury and agency securities.  Only when that has been worked out of the system will financial conditions be restored to some semblance of normality.

Bank Credit & Deposits

Acknowledgements

Christophe Barraud for the Bloomberg link on BOJ Treasury sales.

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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

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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.

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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.

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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

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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

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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.

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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

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