China is up 2 million barrels a day but oil is not going anywhere. It appears there is “ample supply in the market for us to not have a big impact from China coming back.”
Bond market: No place to hide
Advance retail sales were flat in September, reflecting slowing growth, but remain well above their pre-pandemic trend. So far, Fed rate hikes have failed to make a dent in consumer spending.
Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.
The culprit is M2 money supply. While M2 has stopped growing, there has been no real contraction to bring money supply in line with the long-term trend. A fall of that magnitude would have a devastating effect on inflated asset prices.
Inflation is proving persistent, with CPI hardly budging in September. Hourly earnings growth is slowing but remains a long way above the Fed’s 2.0% inflation target.
Treasury yields have broken their forty year down-trend, with the 10-year testing resistance at 4.0%. Stubborn inflation is expected to lift yields even higher.
Inflation is forcing the Fed to raise interest rates, ending the forty-year expansion in debt levels (relative to GDP). Cheap debt supports elevated asset prices, so a decline in debt levels would cause a similar decline in asset prices.
A decline of that magnitude is likely to involve more pain than the political establishment can bear, leaving yield curve control (YCC) as the only viable alternative. The Fed would act as buyer of last resort for federal debt, while suppressing long-term yields. The same playbook was used in the 1950s and ’60s to drive down the debt to GDP ratio, allowing rapid growth in GDP while inflation eroded the real value of public debt.
Conclusion
We are fast approaching a turning point, where the Fed cannot hike rates further without collapsing the bond market. In the short-term, while asset prices fall, cash is king. But in the long-term investors should beware of financial securities because inflation is expected to eat your lunch. Our strategy is to invest in real assets, including gold, critical materials and defensive stocks.
CPI shock upsets markets
The consumer price index (CPI) dipped to 8.25% (seasonally adjusted) for the 12 months to August but disappointed stock and bond markets who were anticipating a sharp fall.
The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.
Services CPI — which has minimal exposure to producer prices and supply chains — climbed to 6.08%. Rising services costs indicate that inflation is growing embedded in the economy.
Fueled by strong growth in average hourly earnings.
But it is not only services that present a problem.
Food prices are growing above 10% p.a. — signaling hardship for low income-earners.
The heavily-weighted shelter component — almost one-third of total CPI — climbed to 6.25%. We expect further increases as CPI shelter lags actual home prices — represented by the Case-Shiller 20-City Composite Home Price Index (pink) on the chart below — by 6 to 12 months.
CPI energy is still high, at 23.91% for the 12 months to August, but the index has fallen steeply over the past two months (July-August).
The decline is likely to continue until the mid-term elections in November, as the US government releases crude from its strategic reserves (SPR) in order to suppress fuel prices.
The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.
Conclusion
Strong CPI growth for the 12-months to August warns that inflation will be difficult to contain. Services CPI at 6.08% also confirms that inflation is growing embedded in the economy.
Energy costs are falling but this may be unsustainable. Releases from the strategic petroleum reserve (SPR) are likely to end after the mid-term elections in November.
The Fed is way behind the curve, with the real Fed funds rate (FFR-CPI) at -5.92%, below the previous record low of -4.97% from 1975.
We expect interest rates to rise “higher for longer.” A 75 basis-point hike is almost certain at next weeks’ FOMC meeting (September 20-21).
Long-term Treasury yields are rising, with the 10-year at 3.42%. Breakout above resistance at 3.50% is likely, signaling the end of a four decade-long secular bull trend in bonds.
Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.
The best short-term haven is cash.
Luke Gromen | The Dollar end game
Base case: global recession
The Treasury yield curve is flattening, with the 10-year/3-month yield differential plunging sharply, to a current 0.24%. Another 75 basis point rate hike at the next FOMC meeting is expected to drive the 3-month T-Bill discount rate above the 10-year yield, the negative spread warning of a deep recession in the next 6 to 18 months (subsequent reversal to a positive spread would signal that recession is imminent).
The S&P 500 is retracing to test short-term support at 4200. Breach would warn of another decline, while follow-through below 3650 would signal the second downward leg of a bear market.
21-Day Volatility troughs above 1% (red arrows) continue to warn of elevated risk.
Dow Jones Industrial Metals Index is in a primary down-trend, warning of a global recession.
Supported by a similar primary down-trend on Copper, the most prescient of base metals.
Brent crude below $100 also warns of an economic contraction. Goldman Sachs project that crude oil will reach $135 per barrel this Winter, while Ed Morse at Citi says that WTI Light Crude will likely remain below $90 per barrel. Obviously, the former foresees an economic recovery, while the latter sees an extended contraction. Of the two, Morse has the best track in the industry.
Natural gas prices are climbing.
Especially in Europe, where Russia is attempting to choke the European economy.
Causing Germany’s producer price index to spike to 37.2% (year-on-year growth).
Conclusion
Our base case is a global recession. A soft landing is unlikely unless the Fed does a sharp pivot, Russia stops trying to throttle European gas, and China goes all-in on its beleaguered property sector. That won’t address any of the underlying problems but would kick the can down the road for another year or two.
CGEP | The energy transition will be massively disruptive
Jason Bordoff, Founding Director, The Center on Global Energy Policy, Columbia University:
“We are going to have a severe energy crisis in Europe this winter. That’s almost inevitable.”
Ed Morse | Oil will fall to $85 per barrel
Citi’s Ed Morse says that supply is growing faster than expected, while demand is contracting as recession fears grow. His base case is that crude will fall to $85 per barrel.
Global recession warning
Copper broke primary support at $9,000 per metric ton, signaling a bear market. Known as “Dr Copper” because of its prescient ability to predict the direction of the global economy, copper’s sharp fall warns of a global recession dead ahead.
The Dow Jones Industrial Metals Index broke support at 175, confirming the above bear signal. A Trend Index peak at zero warns of strong selling pressure across base metals.
Iron ore retreated below $125 per metric ton, warning of another test of $90. Further sign of a slowing global economy.
The Australian Dollar is another strong indicator of the commodity cycle. After breaking primary support at 70 US cents, follow-through below support at 68.5 confirms a bear market. A Trend Index peak at zero warns of selling pressure.
Brent crude remains high, however, propped up by shortages due to sanctions on Russian oil. Penetration of the secondary trendline (lime green) is likely, as signs of a slowing economy accumulate. Breach of support at $100 per barrel is less likely, but would confirm a global recession.
Long-term interest rates are falling, with the 10-year Treasury yield reversing below 3.0%, as signs of a US contraction accumulate.
ISM new orders fell to their lowest level since May 2020, in the midst of the pandemic.
The Atlanta Fed’s GDPNow forecast for Q2 dropped sharply, to an annualized real GDP growth rate of -2.08%.
Conclusion
We would assign probability of a global recession this year as high as 70%.
ASX confirms a bear market
The ASX 200 broke primary support level at 7000, confirming a bear market.
Long-term interest rates are rising, with bond ETFs falling.
A-REITs respected resistance at the former primary support level of 1500, confirming the primary down-trend. Trend Index peaks below zero warn of strong selling pressure.
Financials fell dramatically last week, testing primary support at 6000, as the prospect of falling residential property prices and rising defaults looms. Higher interest rates and wider net interest margins should offset this to some extent. Expect retracement to test resistance at 6000. Follow-through below this level would confirm a primary down-trend and strengthen the overall bear market (Financials have been one of the stronger sectors).
Consumer Discretionary respected resistance at 3000, signaling another decline with a target of 2600 [3000-400]. Trend Index peaks below zero warn of strong selling pressure.
Consumer Staples broke support at 13K, with respect of the new resistance level warning of another test of 12K.
Utilities continue their primary up-trend, rising Trend Index troughs indicating strong buying pressure.
Industrials are headed for another test of support at 6350. Breach would warn of another test of primary support at 6000.
Telecommunications broke support at 1400, signaling a primary down-trend. Trend Index peaks below zero warn of strong selling pressure. Breach of support offers a target of 1200 [1400-200].
Health Care is consolidating below 42.5K. Reversal below 40K would warn of another test of primary support at 37.5K. A Trend Index peak close to zero would warn of fading buyer interest.
Information Technology continues in a primary down-trend, with Trend Index peaks below zero warning of selling pressure. Follow-through below 1400 would offer a target of 1100 [1500-400].
The Energy sector is advancing strongly, while Trend Index troughs above zero signal buying pressure. The prospect of Chinese lockdowns easing is likely to boost demand for oil and gas, sending prices soaring.
Metals & Mining respected resistance at 6250, warning of another test of 5500. Declining Trend Index peaks suggest buyer interest is fading. Respect of support at 5500 would signal that the up-trend is intact but breach seems more likely and would offer a target of the November ’21 low at 4750.
The broad DJ Industrial Metals Index respected resistance at 200, while Trend Index peaks below zero warn of strong selling pressure. Easing of lockdowns in China may increase demand but a bear market remains likely.
Iron ore is also undergoing a correction. Breach of support at 125 would warn of another test of primary support at 90.
The All Ordinaries Gold Index is again testing support at 6000, while Trend Index below zero warns of selling pressure.
The price of Gold in Australian Dollars, however, is trending upwards, with rising Trend Index troughs indicating increased interest from buyers. Expect a test of A$2800 per ounce. Breakout would offer a target of A$3400 [2800 + 600].
Conclusion
ASX 200 broke support at 7200, confirming a bear market. Rising long-term interest rates and a poor global economic outlook are expected to weaken most sectors, while easing of China’s lockdown restrictions should provide some relief to energy and metals.
Our weighting for ASX sectors is:
- A-REITs: heavily underweight
- Financials: neutral
- Staples: neutral
- Discretionary: heavily underweight
- Utilities: overweight
- Industrials: neutral
- Telecommunications: underweight
- Health Care: neutral
- Information Technology: heavily underweight
- Energy: heavily overweight
- Iron ore & Base Metals: underweight
- Critical Materials (e.g. Lithium and Rare Earth Elements): heavily overweight
- Gold: overweight
Current turmoil and its impact on Gold
Michael Every from Rabobank is bearish on Gold in his recent video:
“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”
Several readers have written, asking if this changes our view on Gold.
The short answer is NO, for three reasons:
1. The Fed can only hike rates until something breaks
Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.
The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.
Bank credit still grows at a healthy rate.
The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.
Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.
Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).
Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.
A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.
2. A strong Dollar is destroying US industry
The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.
This has allowed the Financial sector to grow to a point where it dominates the US economy.
Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.
In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.
The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.
The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.
The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.
Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.
The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.
3. US debt above 120% of GDP would destroy the bond market
Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.
Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.
That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.
The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.
Current turmoil
The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.
China & the Dollar
After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.
China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.
The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.
In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.
The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.
The Belt-and-Road initiative
In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).
China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.
The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.
Funding the federal deficit
China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.
But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.
The US is faced with a difficult choice:
- Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
- Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.
It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.
China
Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.
Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.
Team USA
This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:
- Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
- The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.
Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.
There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.
Conclusion
Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.
It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.
The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.
The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.
Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.
Acknowledgements
- Tom Mclellan for the Unemployment/Consumer Sentiment comparison
- Frankoz for the BRI insight