- Our mini boom bust cycle thesis is that macro-economic indicators will continue to be volatile, increasing the probability that the Fed will make policy errors;
- In the first half of 2022 an inelastic supply curve bumped up against fiscal and monetary stimulus, leading to a series of inflationary shocks. CPI is overall a lagging indicator, but within CPI, goods such as furniture, appliances and autos are swing factors and prices for such items are now deflating and will increasingly feel the downward pressure of the supercharged USD;
- The outlook for growth continues to deteriorate. Inventories are being rebuilt just as inflation is beginning to destroy demand. Housing indicators are all flashing warnings and CapEx spending is down;
- We believe we are likely in the early stages of a recession, but the Fed is still tightening and simultaneously reducing the balance sheet at an aggressive clip. That’s to say the brakes are being slammed on hard;
- At some point, it’s likely that central banks globally will need to shift their focus from fighting inflation to supporting their economies, but that remains difficult whilst inflation numbers are robust;
- Monetary policy lags the economic cycle generally by about 12 months. This is where the potential for central bank errors reside in that monetary policy is often backwards looking focusing on inflation and employment metrics, which are lagging rather than leading indicators;
- At market lows we have repeatedly observed that real relative valuation support for equities depends on the convergence of 10yr government bond yields and stock market dividend yields. Currently these metrics are far apart, with the 10 year at roughly 2.8% and the divided yield at 1.6% in the US. Bonds may rally yet equities may have further to go on the downside.
- Increasingly, government bonds are offering better value although as yet we haven’t seen price action that confirms a bottom. Building positions which benefit from volatility is likely a fundamental building block to weathering the storm.
From Inflationista …
Inflation was already on the rise as the economy reopened in 2021. Then we were hit with a series of inflationary supply side shocks. Omicron impacted the labour participation rate and China shut down 400 million people in key port cities. The Russian invasion of the Ukraine started a global food and energy crisis. Demand was fuelled by massive stimulus checks under Trump and Biden. So, we had a sclerotic, inelastic supply curve bumping against fiscal and monetary stimulus, giving us inflation coupled with supply bottlenecks.
This post pandemic shock wave is in the rearview mirror, but the CPI is overall a lagging indicator. In 2008, with oil touching $150 a barrel and inflation at 6%, no one would have believed that a year later CPI was going to be -2% year over year. When looking at CPI, we have to distinguish the price performance of services from that of goods. Services, including rents, tend to be sticky with year over year price changes slowing in a recession, but not deflating.
Rents, 30% of overall CPI are primarily determined from OER (rent and owners’ equivalent rent) and OER is a wonkish metric imputed by surveying homeowners and asking them to estimate the current monthly rent for their homes. Market rents will eventually follow the housing market lower, but it will take a number of months for repricing to show up in CPI.
Goods, making up 40% of the CPI are now the swing factor. Commodity prices have softened significantly.. Core crude PPI, which is a leading indicator for goods, was -4% in May and -2% in June. Prices including furniture, appliances and are now deflating and will increasingly feel the downward pressure of the supercharged USD. So, the question will be how much of goods deflation will offset lingering service sector inflation.
Supply delivery delays in practically every manufacturing survey are not yet back to pre-COVID levels but are going down. Order backlogs are going down. Freight rates are coming down. The Baltic Dry Index, an average of transport prices, is down about 40%. The supply chain is less inelastic than it was, and demand is contracting. So, inflation, for now, is yesterday’s story and we turn our focus to what is changing at the margin.
New York Fed Global Supply Chain Pressure Index VS CPI YoY% ( 5mo Lag )
… to Recessionista
Growth is threatened by a trifecta of risks that can potentially damage the inventory cycle, the property cycle and CapEx. Inventories are being rebuilt just as inflation is beginning to destroy demand. Tim Fiore, the Chairman of the Institute for Supply Management (ISM) Business Committee, does an excellent parsing of the survey each month and has been inclined to stay optimistic. However, we believe this is to underestimate the inventory cycle that has turned. reading at 52.8. A move below 47 over the next two or three surveys would help cement our recessionary view. US regional manufacturing surveys would certainly suggest we have lower to go in the ISM numbers.
ISM vs US Regional Manufacturing Survey
Housing indicators are all flashing warnings. There is a sudden rise of properties on the market. Lead time for sales are rising and sellers have begun to discount prices. CapEx spending is also down, completing the trifecta.
A jobs related contraction may well see a third of the 6 million jobs created in the past year go away. This will further accelerate demand destruction. Earnings, margins and financially sensitive assets (especially housing) will suffer and this suffering will be more severe in a high rate environment. All of this will have nasty multiplier effects on the growth outlook.
Monetary Policy Lags
Monetary policy lags the economic cycle, generally by about 12 months. The Fed relies heavily on data that is distorted, noisy and dated. The economy continually resets to reflect the current or expected interest rate regime. This is where the potential for central bank errors reside as monetary policy is often backwards looking, focusing on inflation and employment metrics, which are lagging rather than leading indicators.
Since March the Fed has raised rates by 225bp and promises to continue with aggressive action. We believe we are likely in the early stages of a recession, but the Fed is still tightening and simultaneously reducing the balance sheet at an aggressive clip. That’s to say the brakes are being slammed on hard.
The Fed IS Hiking Further & Faster Than Any Time In Modern History
Source: Federal Reserve – September 2022.
It’s unusual for central banks to be tightening monetary conditions into a recession. That did occur during Paul Volcker’s reign as Federal Reserve Chair, during back to back recessions. By the end of 1982, unemployment had risen to nearly 10% inflation had fallen 5% and long term interest rates began to decline. It was at this point that the Fed eased the fed funds rates back to 9%, and in today’s terms would suggest the Fed is comfortable with enduring material ‘economic pain’, before any volte face in interest rate policy.
Once a recession is underway, history shows that a catalyst of some sort, habitually a combination of fiscal and monetary policy, has been needed to stimulate the economy. If we are to presume that the Republicans take the House this congress, the resulting grid lock will not be fertile ground for further fiscal stimulus meaning it’s all going to be on the Fed or other central banks to reverse course.
In response to the recession that followed the 2008 credit crisis, in the first months of 2009 the central banks globally dramatically eased financial conditions. The stock market bottomed in March of 2009 and the recession ended in June of that year.
Central monetary policy committees globally have made it clear that inflation is their number one priority, besting global growth. But the Fed does not exist in a political vacuum. At some point, it’s likely that central banks globally will need to shift their focus from fighting inflation to supporting their economies, but that remains difficult whilst inflation numbers are robust.
Asset Allocation Considerations
Fixed Income
Bond markets believe a recession is inevitable, in that the yield curve remains inverted (short term interest rates are higher than long term ones). Recently the expectation for interest rate cuts in the first quarter of 2023 were unwound. All credit as an asset classes remains under pressure, and as yet still seems to trade of inflation concerns rather than economic growth ones.
Equities
At market lows we have repeatedly observed that real relative valuation support for equities depends on the convergence of the 10 year note yield with the dividend yield. This convergence signals the end of the recession. Currently these metrics are far apart, with the 10 year at roughly 2.8% and the dividend yield at 1.6%. So, either the 10 year note goes to 1.6% or the S&P might have to go to– well, it would have to basically go down around 3,200, or there’s a meeting of the minds in between.
Precious Metals
A strong US Dollar and higher interest rates are anathema to precious metals. We do believe they will turn just before the market more broadly senses a turn in monetary policy. We are of the view that precious metals will see a major bottom and new bull run start before the year is out.
Commodities
Planting concerns, higher input costs and continued export restrictions have seen soft commodities perform better than many others. Chinese lockdowns have led to significant weakness in industrial metals, whilst a correction in crude and gasoline prices portends well for inflation numbers, yet reflects global economic conditions softening more generally.
Conclusion: Gathering Storm Clouds
As we have alluded to in the charts above, we feel inflation fears will recede in the coming weeks. In fact, the degree to which financial conditions have tightened lead us to allow for a much more rapid unwind of the inflationary numbers than would appear to be priced in.
In such an environment, bonds remain to us significantly mispriced and that longer term government bonds are in the midst of finding a bottom. However, that does not necessarily mean the green light for equities, as whilst the mood generally is darkening, earnings estimates for the coming quarters remain too optimistic to our mind. Bear markets are not one way traffic and even after the Bear Sterns difficulties in 2008, the S&P 500 went on to rally 17% before rolling over once more. That is why we continue to take an active approach to our market exposure – taking on hedged positions as the storm clouds gather but then seeking to capture the shorter term inevitable rallies that will punctuate the ongoing bear market.
