A Period of Consequences – September 21, 2023

A Period of Consequences – September 21, 2023
Morgan Lewis Posted on September 23, 2023

A Period of Consequences

This was a very volatile week on Wall Street as asset prices whipped around at breakneck pace. Ultimately, however, the overall trajectory for prices was decidedly lower. Without question, the theme of the week was higher interest rates for longer, and markets didn’t like it one bit.

On Wednesday, the Federal Reserve released an updated version of the summary of economic projections (SEP) from the FOMC committee members. This latest SEP reflected that FOMC committee members have shifted their projections in several key and consequential ways. One major change is that the FOMC now assumes a stronger and more resilient economy. Given that inflation remains significantly above the Fed’s target, and that, according to the Fed, getting to target “is expected to require a period of below-trend economic growth as well as some softening in labor market conditions,” the Fed is adjusting its fed funds interest rate expectations “higher for longer” to keep pressure on the economy and allow inflation to fall further.

To be clear, when it comes to interest rates, “higher for longer” is likely an industrial-sized batch of kryptonite for risk assets and the economy. Specifically on the policy front, the Fed held interest rates unchanged at this meeting, but indicated it still expects one more hike before year-end. Most importantly, however, the Fed’s updated SEP expects 50 basis points less in rate cuts next year than previously indicated.

For markets, higher for longer has generally been little more than a theoretical threat to date. Markets have consistently expected the Fed to cut interest rates next year and ease conditions for the economy. This week, however, with the Fed scaling back those 2024 rate cuts in its official SEP “dot plots,” higher for longer is no longer theoretical. It’s an outright threat that can no longer be ignored.

Fed Chairman Powell said in his August Jackson Hole speech, “we are navigating by the stars under cloudy skies.” This week’s FOMC, however, implied to HAI, and perhaps to a growing number of market participants as well, that the FOMC is navigating by actively steering the ship into the recessionary iceberg. With their hands shackled by inflation, the Fed’s course now seems fixed. They can’t change direction until inflation magically evaporates or we hit the recessionary iceberg very likely needed to lower inflation, at least temporarily, to target.

It is as BofA chief investment strategist Michael Hartnett recently warned: the big risk for the remainder of the year is “‘soft landing’ = higher yields/tighter FCI [financial conditions] = ‘hard landing.’” Sure enough, the loose financial conditions we’ve seen so far in 2023 in response to soft-landing enthusiasm in markets have kept inflation stickier. Now, with sticky inflation ticking up again and oil prices reaccelerating higher, financial conditions are beginning to tighten (stronger dollar, surging yields) as the Fed is forced into “higher for longer” until, eventually, on a “long and variable lag,” this series of toppling dominoes leads to a hard-landing recession.

Ironically, while key elements of the FOMC’s new SEP clearly indicate expectations for a soft landing with stronger economic growth expectations and only a very muted uptick in the unemployment rate, Powell was quick to distance himself from any notion that he actually expects a soft-landing as a base case. In one of the more interesting and revealing exchanges in Powell’s Q&A with reporters, Howard Schneider of Reuters asked the chairman, “Would you call the soft landing now a baseline expectation?” In response, Powell nearly jumped out of his shoes to distance himself from endorsing the soft-landing narrative that, as HAI reported last week, Arif Husain of T. Rowe Price called an almost impossible “fairytale in every sense of the word.” Powell almost cut off Schneider to immediately insist, with curiously emphatic vigor, “No, no. I would not do that. I would just say…this may be decided by factors that are outside our control at the end of the day. But I do think it’s possible.” Despite the rosy soft-landing portrait painted by his own FOMC’s SEP, Powell himself seemed anything but convinced. Markets had been little changed on the week, but as soon as Powell insisted that a soft-landing was not his baseline, markets fell into a determined sell-off that didn’t stop until Friday’s closing bell.

In HAI’s view, the sell-off was for good reason. For the soft-landing potential to upgrade from “fairytale” to “possible,” interest rates would have to drop, drop aggressively, and drop soon. However, the exact opposite is happening. The combination of the upturn in energy prices threatening to boost inflation further, the massive new upcoming Treasury issuance needed to fund runaway government deficits, and now an official higher-for-longer rates stance from the Fed is putting significant upward pressure on bond yields. Before this week, Treasury yields had already been racing higher and threatening to break out to new cycle highs. After this week’s FOMC higher-for-longer message, however, the breakout happened. Ten-year Treasury yields spiked to 16-year highs. Recall Jeremy Grantham’s recent quip that “In the end, life is simple. Low rates push up asset prices. Higher rates push asset prices down.”

Now, it’s too early to know if this week’s market sell-off was a pre-shock or the beginning of the earthquake. Further volatile price action across assets is to be expected, and, technically, a breakout to new highs in the S&P 500 is certainly still possible. That said, in the context of the increasing weight of the current bearish setup, if the Fed maintains higher rates for longer until either inflation drops sufficiently or recession hits, HAI takes the over on recession (perhaps starting in three to six months) and a renewed bear market in stocks that could commence much sooner.

Time will tell how current dynamics play out exactly, but in addition to the Fed meeting, this week piled a few more pounds onto the increasing weight of the current bearish setup referred to above.

Last week, HAI mentioned that the EIA warned an oil supply deficit would continue to put upside pressure on oil prices. This week, oil market news again stoked the threat of higher energy prices, added further fuel to the inflationary fire, and ultimately supported the higher-rates-for-longer thesis as well as all its market-threatening kryptonite.

Goldman Sachs upped their oil price target to $100 per barrel, the CEO of one of the world’s largest integrated oil & gas companies called $100 dollar oil “a certainty,” and, most importantly, the EIA released another round of concerning production data. Over the early summer, HAI cited Goehring and Rozencwajg’s (G&R) findings that U.S. shale production, responsible for 90% of global oil supply growth over the last 12 years, had significantly slowed. According to G&R at the time, “The only growing non-OPEC basin is the Permian in West Texas.” Well, this week, in their drilling report, the EIA estimated that U.S. shale production will decline in October. Alarmingly, that decline will be led by the Permian. In fact, October will mark the third straight month of Permian production declines. With Permian basin production now rolling over, U.S. shale is now definitively rolling over. With the strategic petroleum reserve at 40-year lows, OPEC+ extending production cuts through at least year-end, and now U.S. shale production rolling over, calls for $100 per barrel oil look very reasonable. So, too, by extension, do stickier inflation and higher interest rates until the resulting recession hits.

Also this week, in a sector already falling victim to higher-for-longer interest rate policy (and in the process adding further to growing consumer stress), the National Association of Realtors (NAR) announced that mortgage affordability has hit an all-time low in data back to 1989. Specifically, what NAR data says is that a median income family no longer has the income needed, by a wide margin, to qualify for a mortgage on a median priced home. At least since 1989, we’ve never seen anything close to as large a disconnect in this data as we have at present. We’re in uncharted territory. Needless to say, this is incredibly unhealthy and frankly tragic. Either real incomes need to surge, mortgage rates need to fall, or home prices need to materially drop. If not, a cornerstone of the “American dream” will be absolutely unattainable for an entire generation of low- to median-income Americans. We can and must do better.

Jay Powell continues to repeat that “Without price stability, the economy does not work for anyone” and HAI agrees. But we have had decades of inflationary credit expansion policies. At first, those policies triggered only financial asset price inflation, now, however, as one would expect eventually, we’re finally seeing a new and devastating cycle of structurally higher consumer price inflation as well.

As Austrian economist Ludwig Von Mises explained, “Credit expansion is the governments’ foremost tool… In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms.”

But credit expansion is inflation, and inflation has been policy—and bad policy at that. As Mises warned, “If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system flounders… The final outcome of the credit expansion is general impoverishment.”

So, inflation as policy initially facilitates the boom, but ends in “general impoverishment.” Unfortunately, both bad economists and policy makers sell today’s boom and deny tomorrow’s bust. In the words of economist Henry Hazlitt, however, “Today is already the tomorrow which the bad economist yesterday urged us to ignore.”

The evidence is now mounting that the “magic wand” has been used and abused, and that we’re far along the path Mises cautioned us to avoid. Total government debt breached $33 trillion this week, deficits project north of $2 trillion, interest alone is nearing $1 trillion, “official” consumer price inflation (far from “price stability”) is up 18.1% since August 2020, and last week’s update from the Census Bureau confirmed that the median inflation adjusted income was $74,580 last year compared with $76,330 in 2021, $76,660 in 2020, and $78,250 in 2019.

We’re rapidly moving in the wrong direction, and may be, as Ray Dalio suggested last week, at the point where the problems we face threaten to compound and accelerate in disorderly fashion. Policy makers must choose to double down on the inflationary road to impoverishment or voluntarily backtrack and fundamentally reorient policy objectives at the risk of incurring the hardest of hard landings. It’s a choice that comes with very tough consequences either way. For now, the Fed assures us that it’s committed to a higher-for-longer interest rate policy. That policy, in HAI’s view, is likely to end in recession and/or crisis, and perhaps in a brief respite from rapidly increasing consumer prices. That apparent commitment, however, will have to be closely watched like a hawk. It could vanish at any moment.

In late 1936, several years before the outbreak of WWII—the deadliest conflict in human history, Sir Winston Churchill gave a speech to the British House of Commons in which he warned, “The era of procrastination, of half-measures, of soothing and baffling expedients, of delays is coming to its close. In its place we are entering a period of consequences.”

Churchill’s famous and prescient words were a perfect fit for the era in which they were spoken. HAI believes they are profoundly applicable within the context of our modern moment as well.

Big policy choices loom, and a seemingly unavoidable “period of consequences” awaits in the form of either recessionary ice or inflationary fire. The stakes are high. HAI sincerely hopes that both U.S. fiscal and monetary policy authorities can and will ultimately rise to the challenge, and in so doing validate another great Churchill observation: “The Americans always do the right thing—after they’ve exhausted all the alternatives.” HAI is rooting for policy makers to “do the right thing” and find and pursue the healthiest possible path out of the current minefield. As we await “a period of consequences,” however, gold as financial insurance continues to be a must-own asset.

Weekly performance: The S&P 500 was down 2.93%. Gold was nearly flat, off 0.03%. Silver gained 1.92%, platinum gained 0.49%, and palladium was higher by 0.27%. The HUI gold miners index lost 2.67%. The IFRA iShares US Infrastructure ETF dropped 2.29%. Energy commodities were volatile and mixed on the week. WTI crude oil was nearly flat, up 0.01% while natural gas jumped by 8.89%. The CRB Commodity Index lost 1.25%, and copper dropped 2.76%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 5.07%. The Vanguard Utilities ETF was down 1.77%. The dollar index was higher by 0.26% to close the week at 105.26. The yield on the 10-yr U.S. Treasury was up 11 bps to end the week at 4.44%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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