A Perilous Path – January 13, 2023

A Perilous Path – January 13, 2023
Morgan Lewis Posted on January 14, 2023

A Perilous Path

It may not be the return of the “everything bubble” just yet, but the “everything rally” has certainly taken hold of both markets and the hopeful minds of investors. Stocks, bonds, gold, silver, commodities broadly, oil and copper specifically, meme stocks, and low-quality heavily shorted equities aplenty are all in gear and racing higher. Fear is out, FOMO is back, and bullish investor enthusiasm has reached its highest levels since the bear market began. The most notable decliners on the week were the dollar, which extended its dramatic collapse off of September highs, and the VIX volatility index “fear gauge” that closed the week at its lowest levels since the start of 2022.

Forget a slowing economy and recession fears. Forget that the global debt pile is 349% of global GDP and rising. Forget the fact that the rate hiking cycle has added what S&P Global estimates to be at least an additional $3 trillion (and rising) debt servicing cost drag on the economy. Forget that the money printing machine that had been the leveraged buyout (LBO) market during the days of easy credit and zero interest rates is now “all jammed up” with a growing $40 billion of losses on bank balance sheets. Forget that banks have tightened lending standards to recessionary levels, and are significantly increasing loan loss provisions across the board in preparation for credit market deterioration, all while serious cracks have appeared elsewhere in the alternative private credit markets. Also forget that the service sector and manufacturing sector are both in contraction, the housing and auto sectors are in big trouble, and that zero interest rate-dependent tech companies are cutting cap-ex and employees at a vigorous pace. Disregard the fact that more U.S. businesses closed in the month of December than in any month since the great financial crisis in 2009, and that thirteen days into January, business closings are on pace to exceed that of December by 30%. Pay no mind to the fact that, as HAI has elaborated at length in recent weeks and months, a laundry list of recession indicators, many with perfect historical track records, are blaring a recessionary warning in unison.

For now, stocks care about only one narrative—inflation is slowing, will soon be a distant memory, and the “transitory” Fed tightening cycle will seamlessly become another financial asset-boosting easing cycle in short order. As a result, risk assets are ignoring hawkish rhetoric and are aggressively front-running an expected Fed pivot.

Pivot enthusiasm was further buoyed this week by the latest inflation data. The headline consumer price index (CPI) fell 0.1% month-over-month (M/M) in December as expected vs. a 0.1% increase in November. The 0.1% decline marks the steepest M/M decrease since April 2020. On a year-over-year (Y/Y) basis, headline CPI came in at 6.5% as expected vs. 7.1% the previous month. Core CPI (ex-food and energy) increased 0.3% M/M as expected vs. 0.2% in November, and 5.7% Y/Y as expected, down from 6% last month. 

A sharp drop in energy prices drove the negative M/M headline CPI decline, while goods prices more broadly are entirely responsible for the overall easing in price pressures. In fact, the services portion of the CPI is still accelerating, and notched the highest reading in over 40 years. To timestamp that with a cultural reference, it was the highest services CPI since “E.T. The Extra-Terrestrial” graced movie theaters, and the Pointer Sisters’ “I’m So Excited” debuted on Billboard’s Top 100 in September 1982. While services CPI is red hot, investors, perceiving many services inputs to be lagging, were thoroughly encouraged with the overall goods-fueled CPI downshift. Retail investors as a cohort were particularly feeling the Pointer Sisters’ enthusiasm. Retail buyers were extra “excited” with the CPI news, and were specifically responsible for getting the pivot party started anew.

As Goldman’s Michael Nocerino wrote in a note on Friday, the firm’s trading desk confirmed that this week retail investors, frisky again, are piling back into equities, and are flooding back into the old “meme stock” favorites along with other low-quality names most-shorted by institutional money. At the same time, Goldman reports that institutions are selling aggressively. In other words, the retail buying frenzy is the marginal price setter in stocks right now, and this dynamic has set up a huge sell imbalance by institutions relative to the overall bullish move in stocks this week.

As HAI has discussed repeatedly in the past, in the current macro backdrop, a market that is watching falling inflation and front running an expected resulting Fed pivot is creating a vicious catch-22. Rallying markets and expectations that we are past peak Fed hawkishness have caused financial conditions to ease dramatically. Easy financial conditions stoke economic demand, and any increase in economic demand threatens to slow or reverse progress made on inflation. Perversely, however, the Fed can’t deliver the pivot the market is already celebrating without continued further progress on inflation or, alternatively, without completely shattering its institutional credibility and removing itself from relevance. Furthermore, the drastic easing of financial conditions since October, now bolstered by the new economic demand impulse ensured by the end of China’s Covid-zero policy, is already starting to be reflected in rebounding commodity prices—a primary source of goods inflation.

For example, copper prices, up 7.93% on the week, are already up 35% from lows. And this week crude oil started to react to the unfolding dynamics with pep in its step and an 8.26% gain. The situation is troubling. Energy is the great inflation force multiplier as its cost gets into everything. Recall that commodity supplies are already extremely low across the board, and oil is no exception. Shale output gains will be weaker in 2023 due to higher costs and dwindling reserves, and OPEC+ is already screaming no excess capacity. OPEC+ also appears to be laying the groundwork for additional 2023 production cuts, as it continues to reduce its demand guidance for the year in a growing outlook divergence with the major international energy agencies. So, increased demand into tight supply dynamics means higher prices, and higher prices mean reaccelerating inflation pressures. We’ve looked at the supply side. What about demand?

In addition to the broad loosening of financial conditions stoking economic demand, oil demand is set to rebound from the second quarter and beyond. This week, a Bloomberg poll of China-focused consultants expected that an end to Covid-zero and economic re-opening will boost Chinese oil consumption by 800,000 barrels per day (bpd) to a record 16 million bpd this year. China is preparing for the re-opening with the issuance of a huge batch of import quotas for its private refiners. As ING strategists said this week, “Higher quotas support the view of recovering Chinese demand this year, and the quicker-than-expected change in Covid policy means that the demand recovery could be more robust than initially expected.” 

After warning of upside risk to their forecast, ING said they expect global oil demand to increase by 1.7 million bpd, of which 50% will be driven by China. Goldman Sachs’ head of commodities research, Jeff Currie, also sees the dynamic, and is now calling for $110 per barrel Brent prices by this year’s third quarter. Huff and puff as it might, its hard to see the Fed keeping its promise to bring inflation down to its 2% target “unconditionally” if commodity prices broadly, and oil specifically, reaccelerate higher again. It gets even more challenging to imagine as the U.S. is forced to switch from major oil seller to significant buyer given the necessity to replenish the heavily depleted strategic petroleum reserve.

Meanwhile, elsewhere on the economic front this week, the December NFIB small business report out on Tuesday included some ominous findings. The concerning data is consistent with last week’s very disappointing contraction-indicating PMI data. According to the NFIB December survey, a net negative 51% of small business owners expect the economy to improve over the next six months. Amid a typically optimistic crowd, this is a problematic finding. Expectations impact business plans and capital outlays. As such, pervasive pessimism over the economic outlook has a circular, self-fulfilling, impact on actual future economic activity. 

Worse yet, like last week’s services PMI data, the December reading plummeted month-over-month (M/M) with an outsized eight-point elevator drop lower. Equally brutal was the December sinkhole that developed within the NFIB small business profit trends data. Apparently, someone left the trap door open, and profit trends fell right through it. Again, seemingly corroborating last week’s PMI data, NFIB findings indicate that a net negative 30% of small businesses reported positive profit trends in December. That finding, like other economic data in December, was also in freefall—down a whopping eight points from November. In fact, of the component constituents for the small business optimism index, on a M/M basis, eight categories, including expected credit conditions, declined, and one was flat. The only M/M increase was notched right where we don’t want it—inventories. Interestingly, the data also revealed that over the last two months the average interest rate paid on short maturity loans has also climbed to over 7.5%. That’s the highest levels since March 2008—amid the early days of the great financial crises era.

As HAI has tried to illustrate over recent weeks, the long-lead and now short-lead economic indicators strongly imply more downside ahead for coincident (real-time) growth. To use NFIB’s words, “the economy is clearly slowing,” and at this point history suggests we are now on the doorstep of a recession.

Now, last week’s non-farm payroll release saw the unemployment rate drop to 3.5%, a level matching five-decade lows, so how could we be entering a recession? As HAI has pointed out for months, labor data and the unemployment rate are terrible recession indicators, and are among the most lagging economic data. They’re also subject to significant subsequent revisions. Historically the unemployment rate usually marks its cyclical low when the economy is just entering or is already in recession. In 1974, for example, the unemployment rate didn’t begin to rise until the economy was several months into recession, and in the 1982 “double-dip” recession, the unemployment rate offered no advance recession warning at all. In addition, despite the current narrative that our apparently “strong” labor market will stave off recession, history disagrees.

Aggregate weekly hours is a crucial measure of labor market strength because it includes both the number of payrolls and the average workweek. While official non-farm payrolls have been building, average weekly hours have been crashing. So, while non-farm payrolls are up 2.5% over the last six months, aggregate weekly hours (payrolls plus hours) has increased at a much more modest 1.3% rate. In other words, headline jobs are still being added. That’s a sign of strength. But hours are being cut drastically, and that’s a sign of weakness that always comes before employers resort to outright firings. While the 1.3% aggregate weekly hours growth rate is slightly higher than the average historical rate at recession onset, it’s dropping—and it is still significantly lower than the growth rates that accompanied the start of the 1970, 1974, and 1982 recessions.

In addition to navigating the dual threats of reinvigorated inflation and imminent recession, the Fed’s interest rate hikes are also rapidly encouraging a federal government balance-of-payments problem. As the strain of growing deficits and increased debt servicing costs on excessive debt becomes increasingly acute, it adds another powerful point of pressure on the Fed to pivot. The Fed is trapped. A pivot into still-elevated inflation comes with devastating incendiary inflation consequences, the definitive death of their institutional credibility, an effective end of Fed relevance, and dangerously unhinged financial markets. Stay hawkish for longer, push back against markets and the dramatic loosening of financial conditions, and the Fed chooses the path of a potential federal balance of payment nightmare, a resulting sovereign debt crisis, and a serious recession that could be far worse than markets are currently considering. The Fed is stuck in the middle of a minefield where a perilous path out is assured. The best it can do is make a choice and hope for the very best. 

The better than $300 dollar increase in the price of gold since October is the metal’s most powerful advance since the 2020 Covid response. While short-term overextended technically, the strength of the move suggests the yellow metal clearly perceives the Fed’s predicament. Gold is reacting to the Fed’s next, fast-approaching, bad decision amid a lose/lose array of options. Additionally, whether the Fed chooses fire or ice, gold may also have begun to reflect a future in which its unique characteristics are preferred to Treasurys as the primary global reserve asset. Perhaps that’s why, according to the LBMA, the world’s biggest gold repository in London has seen 500 physical tons, or more than 5%, exit the vault year-over-year as of November. MWM will continue to monitor developments closely.

Weekly performance: The S&P 500 was up 2.67%. Gold was up 2.78%, silver gained 1.63%, platinum was lower by 2.88%, and palladium lost 1.07%. The HUI gold miners index added 3.38%. The IFRA iShares US Infrastructure ETF was higher by 3.53%. Energy commodities were volatile and mixed on the week. WTI crude oil surged 8.26%, while natural gas was crushed again, down another 7.84%. The CRB Commodity Index was up 4.19%, while copper jumped 7.93%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 4.46% on the week, while the Vanguard Utilities ETF (VPU) was up 0.74%. The dollar was smacked lower by 1.59% to close at 102. The yield on the 10-yr Treasury lost ground, losing 6 bps to end the week at 3.49%

Have a wonderful long weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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