A Flag on the Field – February 16, 2024

Wealth Management • Feb 17 2024
A Flag on the Field – February 16, 2024
Morgan Lewis Posted on February 17, 2024

A Flag on the Field

The stock market financial asset bubble is a confidence bubble. That confidence holds on the assumption that, by hook, crook, or other alchemy, policymakers will successfully reconstitute the Goldilocks economic conditions that allow financial assets in the stock market casino to continue to “pay out” indefinitely.

The promise of reconstituted Goldilocks has been the de-facto message from Fed chair Powell’s numerous assertions that the Federal Reserve is committed to bringing inflation back to the committee’s 2% target “unconditionally.”

Recent HAIs have increasingly pointed to that inflation variable as the soft underbelly of the Goldilocks conditions most likely to turn uncooperative first. If the inflation variable refuses to play nice, it could certainly pull the punchbowl from the ongoing party on Wall Street. The currently raging stock market bubble-bash is, after all, in celebration of both inflation’s purported demise and the resulting renewed confidence in the Federal Reserve’s ability to cut rates and restore the Goldilocks conditions that ensure perpetual bull-market bliss for investors.

This week, however, inflation didn’t play nice. In fact, to use terms inspired by last Sunday’s Super Bowl, inflation threw a penalty flag on the field. Wall Street’s call that inflation is definitively dead and buried is now under review. If the disinflation call is overturned, reemergent inflation could threaten to snatch defeat from the jaws of stock market victory. In short, reemergent inflation could undo all that spawned Wall Street’s latest victory lap. On an even larger level, in fact, reemergent inflation is renewed uncertainty, and renewed uncertainty is a serious threat in the context of a late-stage confidence bubble. Resurgent uncertainty, in fact, would represent a dangerously sharp object at high risk of popping a bubble already long in the tooth.

Now, if inflation proves uncooperative, is that really such a problem given that, on aggregate, American consumers boast record net worth? 

On June 16, 1858, then-Senate candidate and future President Abraham Lincoln famously said that, “A house divided against itself cannot stand.” Well, similarly, an economy built upon the strength of totally misleading aggregate net worth statistics cannot stand either. The top 0.1% in America constitutes about 132,000 households. Their average household net worth equates to roughly $151 million. Amid sustained elevated inflation, they’re surely annoyed, but the threat is likely not existential. For the bottom 50% of American consumers, however—a group that amounts to a slightly larger total of 66 million households, average household net worth is only $57,000. For this cohort, sustained elevated inflation isn’t an annoying inconvenience, it’s an absolute killer. This week offered the latest evidence that you can’t grow prosperity and a truly healthy economy solely on the back of a booming 0.1%.

Now, after a month that saw American consumers’ average real (inflation adjusted) weekly earnings turn negative again, S&P Global reported on Friday that the latest credit union net charge-off ratios have “surged” to decade highs. According to S&P, US credit unions are now “grappling with a rapidly rising level of problem loans, in a similar fashion to their banking brethren.” The net charge-off (NCO) ratio for credit unions in the fourth quarter of 2023 reached peak levels not seen since the first quarter of 2012. The majority of the quarterly jump in NCOs was from used vehicles and unsecured credit cards. According to S&P Global, NCOs for used vehicles spiked 36.1% while unsecured credit card NCOs jumped 30.5%.

Indeed, it is, after all, as Fed chair Powell has repeatedly stated: “Price stability is the responsibility of the Federal Reserve. Without price stability, the economy does not work for anyone. In particular, without price stability we will not achieve a sustained period of strong labor market conditions that benefit all.”

In other words, if we have an inflation problem, we have a comprehensive multifaceted economic problem. Full stop. In a roundabout, long, and vicious cycle, the same inflation that pinches consumers eliminates their ability to save, hits unit consumption, and impairs their ability to pay off the loans they borrow to keep up with expenses. That same inflation ultimately hits the broader economy, the labor market, and the jobs that allow those consumers to spend in the first place. Truly, without price stability, the economy does not work for anyone.

Additional related data on the week saw US NFIB Small Business Optimism for January disappoint at 89.9, down from 91.9 and much lower than the expected 92.3. Retail sales also hit the skids with a big drop that marked the 11th month in the last 15 that inflation-adjusted retail sales were negative year-over-year (Y/Y). Meanwhile, in the all-important housing market, housing starts re-accelerated their downtrend with a much bigger decline than expected.

The big news of the week, however, was right back to that inflation and price stability problem. The January Consumer Price Index (CPI) inflation report out Tuesday was a big disappointment, as inflation significantly surprised to the upside. Headline CPI came in at 0.3% month-over-month (M/M) vs. the 0.2% expected, while the Y/Y headline was 3.1% vs. the 2.9% expected. Core CPI was hotter than expected as well. Core CPI increased 0.4% M/M vs. the 0.3% expected, while Core CPI Y/Y was 3.86% vs. the 3.7% expected. Importantly, the six-month annualized rate jumped to 3.7% from 3.2% previously, and the three-month annualized rate lurched up to 4% from 3.3% previously. In other words, inflation data is now outperforming to the upside. And on the shorter six-month and three-month timeframes, inflation data is notably reaccelerating higher again. The biggest stunner of the report, however, was in the Fed’s preferred “Supercore” measure (core services ex-housing services) which skyrocketed to 0.849% M/M—a rate that annualizes to a white-hot 10.67%!

Complicating matters further, the reacceleration of inflation has occurred despite the fact that energy prices have, on net, acted as a disinflationary tailwind for the better part of a year. But, as recent HAIs have detailed, oil market supply/demand fundamentals are now tightening and the risk to crude prices has once again flipped to the upside.

Furthermore, the national average of retail gasoline prices has already established a strong uptrend since January and jumped again this week. In fact, gasoline prices just notched one of the biggest seven-day increases of the last two years. This significant jump in gas prices, importantly, has started even before crude prices have meaningfully reaccelerated higher. Gas prices alone, unless they violently reverse quickly, are already substantially hiking the probability that next month’s inflation data will continue the new disappointingly hot inflation trend.

In addition, CPI “base effects” will now turn more hostile to the disinflation narrative. Starting with the February CPI report (reported in March), “base effects” alone will make any further statistical declines in year-over-year CPI calculations much more difficult over the next seven months.

Indeed, it is bad news for the disinflation Goldilocks narrative. As market analyst Jim Bianco colorfully stated this week, “Inflation ‘last milers’ that believe we are in the final stretch to sustain 2% CPI are close to walking backward.”

Remember that in response to the ongoing post-Covid surge of consumer price inflation, the Fed jacked interest rates aggressively to regain price stability for the benefit of all. Markets have since boomed higher on the assumption that the wicked inflation witch would soon be dead, high interest rates could therefore be cut, and the Fed would swiftly restore stock market-stimulative Goldilocks economic conditions.

But this week, with all CPI components disappointing, the Fed’s preferred “Supercore” measure blasting through the stratosphere, and the foreseeable outlook turning more hostile for disinflation, we’re nowhere near the Fed’s 2% target—nor are we in the realm of “price stability.”

If higher interest rates are the Fed’s primary tool to lower inflation and restore price stability, then, given the latest data, how in the world can the Federal Reserve credibly cut interest rates? Perhaps the Fed must simply disappoint stock market bulls and indefinitely shift back to a “higher for longer” setting on interest rate policy. For the sake of price stability, and for the sake of all, that would seem like the right thing to do.

That said, however, this week, President of the Federal Reserve Bank of Chicago, Austan Goolsbee, said “If we stay this restrictive [high interest rates] for too long, we will start having to worry about the employment side of the Fed’s mandate.” What he didn’t say was that if we keep interest rates this high for too long, we’ll also fast track a U.S. government fiscal solvency crisis due to annualized interest payments now spiking well north of $1 trillion.

In other words, welcome to the predicament of Powell and the 2024 U.S. Federal Reserve. As long as inflation isn’t dead, we have a problem—and yes, Houston, we do have a problem.

If the sizzling stock market’s secret sauce (a dangerous Goldilocks narrative myth of expectations for immaculate disinflation, aggressive Fed rate cuts, and a soft-landing for the economy) turns poison pill (a dangerous reality of higher inflation, higher interest rates, and a high probability hard landing for the economy), then the current risk to financial asset prices is severe.

Remember, above all else this bubble is a confidence bubble. According to the February BofA Global Fund Managers Survey, 90% of fund managers expect the central bank to cut rates and 77% expect inflation to fall in 2024. In market terms, that makes rate cuts and disinflation a nearly unanimous consensus call. But when rock-solid consensus confidence amid an ultimate confidence bubble turns to a renewed surge of uncertainty—and that risk is alive—resurgent uncertainty could put a match to the powder keg.

Recall the recent warnings of John Hussman. As the highly respected analyst recently put it, this bubble-bash is built upon “a skeleton of instability.” On top of that foundation of instability, Wall Street has already built a house of cards Hussman describes as vulnerable to a 50-65% full-cycle drop amid current bubble conditions “more similar to major market peaks and dissimilar to major market lows than 99.9% of all post-war periods.”

Additionally underscoring Hussman’s point this week was a timely reminder from market legend Jeremy Grantham, who quipped matter-of-factly, “Sustainable bull markets don’t start with a Shiller P/E of 33 and full employment.” In other words, we’re not at the start of a new bull-cycle folks, we’re at the end of an old one. And now, after 13 of 15 weekly increases for the S&P 500, this market is a bubble as overextended as it’s been in over 50 years.

At this point, with the Goldilocks myth now beginning to reveal its fairy tale origins, it might be an opportune time for investors to seek hedges and investment alternatives outside of bubbled-up financial assets.

Among alternative investments, in HAI‘s view, gold remains the undisputed best option. The current set-up for the yellow metal continues to ripen toward a significant breakout higher in price—a breakout likely deep into record territory. While the road to new record highs is expected to be extremely volatile, the ultimate case for those new highs continues to strengthen.

In a recent article, Bloomberg explained that as Chinese home prices fell the most in almost nine years while at the same time Chinese stocks capped a third year of losses, gold bullion and silver in all their forms have emerged as the “hottest investment” for the Chinese. According to Bloomberg, “despite international prices trading just a tad off their all-time highs. Retail sales of gold, silver, and jewelry hit a six year high in December.”

Confirming the surge in Chinese gold demand, January data from the Shanghai Gold Exchange registered withdrawals of 271 tons for the biggest single month in over a decade. Importantly, to underscore the scale of that demand, 271 tons annualizes to 3,200 tons. That’s a little more than the estimated full-year total global gold mine production in 2022.

Aggravating the situation, major new gold discoveries of over one million ounces in reserves have crashed from over 180 in the 1990s to near zero since 2019. If China continues to soak up over 100% of annual global mine production as that production sharply decreases, we can fairly expect the supply side of the gold market to continue tightening—substantially.

That’s one reason there was broad consensus among analysts at the RIU Explorers Conference this week in Fremantle, Australia that gold prices will reach new record highs in 2024. As Canaccord Genuity mining analyst Tim McCormack told conference delegates on Tuesday, these dynamics will “feed into a real supply crunch for gold.”

But keep in mind, in regard to yellow metal dynamics, the keen Eastern interest is currently partially offset by total Western indifference. As McCormack pointed out, for now, “your average generalist fund manager is underweight in gold still. There has been a legitimate pull of money into other sectors.” But, as McCormack reasoned, any unwind of currently popular Western investment trends “could see money making its way back into the gold sector.”

McCormack is referring to the explosive potential of a long-awaited reunion between awakened Western investor interest and already existing Eastern demand. Currently, the Western investor is absent the gold market. To many Westerners, gold just doesn’t shine as bright amid the distraction of the frothing and frenzied FOMO and POMO dynamics feeding the bubble-bash on Wall Street.

The problem is that the bubble-bash looks like a stock market party long past its prime, just before the punchbowl gets pulled. The party is in honor of disinflation. The market’s ongoing victory lap is in celebration of the imminent return of Goldilocks. But a penalty flag is on the field—the winning play is under review. If the market’s disinflation call is overturned, then the entire Goldilocks investment narrative reverses. If disinflation (party on) turns re-stoked inflation (party over), those currently popular Western investment trends are in grave danger.

When the stock market music stops, the bubble pops, and the curtain drops on the great and powerful policy making wizards of confidence, the Western investor will come flooding back to gold in droves.

The big questions now are: 1) Just how long it will take? 2) How good will the buying opportunity get in gold, silver, and the mining stocks before Western investors, battered and bruised from painful FOMO and POMO hangover trauma, come crawling back to gold as needed financial insurance?

Regardless, when Western investors rediscover the need for golden financial insurance, the final piece of the demand-side puzzle will be in place. At that point, resurgent Western demand on top of insatiable Eastern appetite will combine to run headfirst into a substantially tightened supply side picture. When those stars align, expect these dynamics to translate into a sustained major breakout higher in the price of gold.

Given the set-up, HAI wants to hold positions in gold, precious metals, and precious metals miners. Before a definitive breakout, however, downside volatility is a distinct possibility. As such, sufficient dry powder is optimal to facilitate the building of positions on further weakness. The short-term risk is real, the longer-term reward, however, appears truly substantial. It’s this precious metals cohort that’s most likely to form the tip of the spear for regime change assets expected to provide new market leadership amid the new rules of the new paradigm in the new market cycle that lies ahead.

Weekly performance: The S&P 500 lost 0.42%. Gold lost 0.72%, silver jumped 3.94%, platinum gained 4.02%, and palladium surged 9.61%. The HUI gold miners index was down 1.44%. The IFRA iShares US Infrastructure ETF was up 1.73%. Energy commodities were volatile and mixed on the week. WTI crude oil gained 2.11%, while natural gas was hammered lower again, down another 12.89%. The CRB Commodity Index was lower by 0.64%. Copper rebounded by 4.35%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 1.31%. The Vanguard Utilities ETF was up 1.66%. The dollar index was up 0.18% to close the week at 104.18. The yield on the 10-yr U.S. Treasury jumped by another 13 bps to close at 4.30%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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