“….We need to make an adjustment fundamentally and price wise. And if you look at the market, in the non-QE world, free world, 15 times earnings was about right. We’re at 20 times earnings. I don’t know what we’re doing 20 times earnings. It’s hard for me to get excited about the long side of the overall market with the market, say, 20% above its normal valuation. When you have a federal fiscal recklessness problem, you have supply chain problems, you have the worst geopolitical situation I’ve seen in my lifetime.
’78, ’79 was bad. But I mean, for the first time, it’s a very low probability, but you gotta put the potential outcome of World War on the table. Not exactly an environment that excites me about paying 20 to 30%, above the multiple for equity prices. The next six months, who knows? And we’re certainly washed out to some extent.”
Rising long-term rates could spoil the party
Real GDP for the September quarter reflects an annual growth rate of 2.9% for the US, well below the Atlanta Fed GDPNow estimate of 5.4%. Growth in weekly hours worked declined to 1.5% for the 12 months ended September, indicating that GDP is likely to slow further in the fourth quarter.
New Orders
Manufacturers’ new orders for durable goods, adjusted for inflation, shows signs of strengthening.
Transport
Transport indicators show a long-term down-trend but truck tonnage has grown since May 2023.
Container (intermodal) rail freight likewise grew for several months but then turned down in August..
Growth in weekly payrolls of transport and warehousing employees slowed to an annual rate of 3.6% in September but remains positive.
Consumer Cyclical
Light vehicle sales continue to trend higher, suggesting consumer confidence.
Housing
New housing starts (purple) have been trending lower since their peak in 2022 but new permits (green) are now strengthening.
New single family houses sold are trending higher.
Despite a steep rise in mortgage rates. In a strange twist, higher rates have reduced the turnover of existing homes on the market, with owners reluctant to give up their low fixed rate mortgages. Low supply of existing homes has boosted sales of new homes, lifting employment in residential construction.
The National Association of Home Builders Housing Market Index (HMI), however, reflects falling sentiment — likely to be followed by declining new home sales and housing starts.
HMI is a weighted average of three separate component indices. A monthly survey of NAHB members asks respondents to rate market conditions for the sale of new homes at the present time; sales in the next six months; and the traffic of prospective buyers. (NAHB)
Financial Markets
The ratio of bank loans and leases to GDP declined to 0.44 in the third quarter but remains elevated compared to levels prior to 2000.
The cause of ballooning debt is not hard to find, with negative real interest rates for large parts of the past two decades.
Now real rates are again positive and money supply is contracting relative to GDP, the days of easy credit are at an end. A significant contraction of credit is likely unless the Fed intervenes, either by cutting rates or expanding its balance sheet to inject more liquidity into the system.
Commercial banks continued to raise lending standards in Q3, making credit less accessible.
Conclusion
This is not a normal market cycle and investors need to be prepared for sudden shifts in financial markets.
The US economy is slowing but cyclical elements like light vehicle sales and new home sales are holding up well.
The rise in long-term Treasury yields, however, is likely to cause a sharp credit contraction if the Fed does not intervene by cutting rates or expanding its balance sheet (QE).
The Fed is reluctant to intervene because this would undermine their efforts to curb inflation. But they may be forced to if there is a credit event that unsettles financial markets.
Fed intervention is unlikely without a steep rise in credit spreads. But would be especially bullish for Gold.
Strong US retail activity unlikely to last
Real retail sales remain strong, holding above the pre-pandemic trend (dotted line) in September.
Supported by a strong jobs market, with low unemployment.
The labor market remains tight, with employers holding on to staff — cutting weekly hours rather than resorting to layoffs.
The consumer sentiment trough in June 2022 coincided with a peak in gasoline prices. Sentiment has been rising over the past 12 months but this could be derailed by a spike in gas prices.
The up-trend in light vehicle sales reflects growing consumer confidence.
The NAHB homebuilder sentiment index (blue below) is falling sharply, however, warning that the recent recovery in new building permits (red) is about to reverse. Residential housing is a major cyclical employer and a collapse of building activity would warn that recession is imminent.
Industry & Transport
Industry indicators show gradually slowing activity but no alarming signs yet. CSBS Community Bank Sentiment index indicates slightly improved business conditions in Q3.
Investment in heavy trucks — a useful leading indicator — remains strong.
Intermodal rail freight traffic — mainly containers — declined in August after a four-month rally. But the longer-term trend is down.
Truck tonnage increased in August for the fifth month but earlier breach of the long-term up-trend (green) warns of weakness ahead.
Manufacturers new orders for capital goods, adjusted by PPI, indicates declining activity which is likely to weigh on future growth.
Conclusion
The tight labor market supports strong consumer spending but high mortgage rates are likely to slow homebuilding activity causing a rise in cyclical employment. A sharp increase in crude oil could also cause higher gasoline prices which would damage consumer sentiment.
Industry and transport activity is gradually weakening but has not yet caused alarm.
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually, then suddenly.”
~ Ernest Hemingway: The Sun Also Rises
Copper breaks support while crude gets hammered
Copper broke support at $7900/tonne, signaling a primary decline with a target of its 2022 low at $7000. The primary down-trend warns of a global economic contraction.
The bear signal has yet to be confirmed by the broader-based Dow Jones Industrial Metals Index ($BIM) which is testing primary support at 155.
Crude oil
Crude fell sharply this week, after a 3-month rally.
The fall was spurred by an early build of gasoline stocks ahead of winter, raising concerns of declining demand.
Gasoline inventories added a substantial 6.5 million barrels for the week to September 29, compared with a build of 1 million barrels for the previous week. Gasoline inventories are now 1% above the five-year average for this time of year….. production averaged 8.8 million barrels daily last week, which compared with 9.1 million barrels daily for the prior week. (oilprice.com)
Crude inventories have stabilized after a sharp decline during the release of strategic petroleum reserves (SPR).
Releases from the SPR stopped in July — which coincides with the start of the recent crude rally. It will be interesting to see next week if a dip in this week’s SPR contributed to weak crude prices.
Stocks & Bonds
The 10-year Treasury yield recovered to 4.78% on Friday.
Rising yields are driven by:
- a large fiscal deficit of close to $2T;
- commercial banks reducing Treasury holdings; and
- the Bank of Japan allowing a limited rise in bond yields which could cause an outflow from USTs.
The S&P 500 rallied on the back of a strong labor report.
The S&P 500 Equal-Weighted Index test of primary support at 5600 is, however, likely to continue.
Expect another Russell 2000 small caps ETF (IWM) test of primary support at 170 as well.
Labor Market
The BLS report for September, with job gains of 336K, reflects a robust economy and strong labor market.
Average hourly earnings growth slowed to 0.207% in September, or 2.5% annualized. Manufacturing wages reflect higher growth — 4.0% annualized — but that is a small slice of the economy compared to services.
Average weekly hours worked — a leading indicator — remains stable at 34.4 hours/week.
Unemployment remained steady at 6.36 million, while job openings jumped in August, maintaining a sizable shortage.
Real GDP (blue) is expected to slow in Q3 to 1.5%, matching declining growth in aggregate weekly hours worked (purple).
Dollar & Gold
The Dollar Index retraced to test new support at 106 but is unlikely to reverse course while Treasury yields are rising.
Gold is testing primary support at $1800 per ounce, while Trend Index troughs below zero warn of selling pressure. Rising long-term Treasury yields and a strong Dollar are likely to weaken demand for Gold.
Conclusion
Long-term Treasury yields are expected to rise, fueled by strong supply (fiscal deficits) and weak demand (from foreign investors and commercial banks). The outlook for rate cuts from the Fed is also fading as labor market remains tight.
The sharp drop in crude oil seems an overreaction when the labor market is strong and demand is likely to be robust. Further releases from the strategic petroleum reserve (SPR), a sharp fall in Chinese purchases, or an increase in supply (from Iran or Venezuela) seem unlikely at present.
Falling copper prices warn of a global economic contraction led by China, with Europe likely to follow. Confirmation by Dow Jones Industrial Metals Index ($BIM) breach of primary support at 155 would strengthen the bear signal.
Strong Treasury yields and a strong Dollar are likely to weaken demand for Gold unless there is increased instability, either geopolitical or financial.
A tectonic shift hurts highly-leveraged sectors
The global economy is experiencing a tectonic shift — from a lack of demand (requiring stimulus) to a lack of supply (requiring suppression of demand).
The sharp rise in interest rates is just part of the adjustment to the new reality.
The rise in short-term rates did not have much impact on consumer spending. Personal Consumption is still above pre-pandemic levels relative to disposable personal income, while the savings rate has fallen to almost half of pre-pandemic levels.
High prices are the cure for high prices
The bond market and oil markets are now testing the assumption that the economy can cope with high interest rates and pull off a soft landing.
Two key prices — long-term interest rates and crude oil — are rising. This is likely to cause a strong contraction.
Mortgage rates (7.49% for 30-year) are at their highest level in more than 20 years.
Corporate debt more than doubled relative to GDP since the 1980s, as corporations took advantage of cheap debt. When they roll over borrowings, they are now confronted with a sharp increase in debt servicing costs, forcing them to de-leverage.
Telecommunications Sector
The impact is clearly visible on sectors with high debt levels — like telecommunications, utilities, and real estate. The chart below compares performance of major telecommunications companies.
Only Orange (FNCTF), the French national carrier, has held its value since the start of 2022. Some, like Telstra (TLS) and Vodafone (VOD), succeeded in reducing debt by selling key assets (e.g. mobile phone towers) into a separate infrastructure trust. Spanish carrier Telefonica (TEFOF) has also done reasonably well, selling off some international interests. Many — notably Verizon (VZ), AT&T (T), Vodafone (VOD), and BT Group (BT) — have lost 40% of value in less than two years. Belgian carrier Proxima (BGAOF) gets the wooden spoon with a 60% loss.
Further adjustment will be necessary as the recent rise in long-term interest rates forces corporations to rein in capital expenditure and shed non-core assets in order to reduce debt exposure. That in turn impacts on equipment manufacturers like Ericsson (ERIC) and Nokia (NOK).
Conclusion
Rising long-term interest rates and crude oil prices are likely to cause a global economic contraction.
Sectors with high debt levels — like telecommunications, utilities, and real estate — will be forced to restructure due to rising interest rates. This is likely to have a domino effect on other sectors of the economy.
Acknowledgements
- Mohamed El-Erian: The US may no longer avoid recession
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.
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.
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.
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.
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.
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.
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.
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**.
The CSBS Community Bank Index of Business Conditions is lower than at the height of the pandemic.
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 funds are primarily invested in Fed reverse repo and Agency and Treasury securities, bypassing the banking system.
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**
Acknowledgements
EPB Research for the Conference Board LEI chart.
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:
- Elevated risk
- Bank contagion
- Underlying causes of instability
- Interest rates & inflation
- The impact on stocks
- Flight to safety
- 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.
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.
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.
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.
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.
Bank borrowings from the Fed and FHLB spiked to $475 billion in a week.
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.
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.
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.
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.
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.
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).
Foreign investment in Treasuries also ballooned to $7.3 trillion.
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.
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.
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.
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).
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.
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.
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.
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.
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.
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.
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.
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.
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
- 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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Acknowledgements
Christophe Barraud for the Bloomberg link on BOJ Treasury sales.
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.
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.
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.
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.
Federal debt, even worse, grew four times relative to GDP.
The surge in debt inevitably fueled speculation in real assets, with a similar rise in stock market capitalization relative to 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.
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.
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.