Black Gold, Yellow Metal, and a Green Light – September 15, 2023

Black Gold, Yellow Metal, and a Green Light – September 15, 2023
Morgan Lewis Posted on September 16, 2023

Black Gold, Yellow Metal, and a Green Light

In this week’s update of the University of Michigan Surveys of Consumers, survey director Joanne Hsu noted that, “Throughout the survey, consumers have taken note of the stalling slowdown in inflation, but they do expect the slowdown to resume.” HAI hopes those consumers (a group that includes all of us, and whose collective spending is responsible for 70% of GDP) don’t have their expectations for resumed disinflation dashed.

This week, however, the facts pertaining to consumers’ hopes for renewed price disinflation weren’t encouraging. Inflation metrics ticked back up and oil prices continued to move higher. After a 44% surge off of summertime lows, if upward oil price momentum continues, it will have the potential to completely upend current consensus expectations for both lower inflation and lower interest rates over the year ahead. Further, it will completely upend the market’s current expectations for a benign soft-landing. If the hope for soft-landing goldilocks dies an inglorious death, expect volatility fireworks to return to a market near you as the current bubble-market mispricing turns toward rapid and distinctly negative repricing.

On Wednesday, following July’s modest rebound in the headline consumer price index (CPI), August CPI was expected to see a further reacceleration of prices in response to recently surging energy prices. Sure enough, headline CPI rose 0.6% month-over-month (M/M) as expected, but the year-over-year (Y/Y) reading pushed up to +3.7%, just a touch hotter than the 3.6% expected (and up from 3.2% in July and 3.0% in June). Core CPI (excluding food & energy) recorded a M/M increase of 0.3%, vs. the 0.2% expected. On a Y/Y basis, however, core CPI declined to 4.3%, as expected, from the 4.7% level the prior month. Perhaps most importantly, the Fed’s new favorite inflation signal—core services CPI ex-shelter (the so-called “super core,” which measures CPI excluding everything you care most about)—surged 0.53% M/M (the most since Sept. 2022) while Y/Y super core remained stuck above 4%.

A day later, on Thursday, producer prices (PPI) rose 0.7% M/M in August (up from +0.3% in July and much hotter than the +0.4% expected). For both headline CPI and PPI, the M/M prints were the hottest since June 2022. For a Federal Reserve expected to be at or near a pause on rate hikes and itching to declare victory over the most significant outbreak of inflation since the early 1980s, the upturn in energy, the increase in Y/Y headline CPI, and the hottest M/M headline inflation prints since June of 2022 represent a clear setback and a complication not just for the Fed’s hoped-for victory lap, but to the economy and the market’s beloved goldilocks narrative as well.

While Y/Y core CPI did decline from 4.7% to 4.3%, that won’t last if upside energy momentum continues. Energy prices eventually get into everything. Energy is the great inflation force multiplier. If you have an energy price problem, you have a consumer price inflation problem—full stop. Right now, already 44% off the summer lows, oil prices are rising, and they’re rising for good reason.

After last week’s extension of oil production cuts by Saudi Arabia and Russia, the International Energy Agency (IEA) warned this week of a “significant supply shortfall.” The IEA said global oil markets will now face a 1.2 million barrel a day supply deficit for the remainder of the year that threatens a renewed surge in price volatility.

Furthermore, according to Ole Hanson, head of commodity strategy at Saxo Bank, the OPEC+ move raises “questions about the group’s true intention… OPEC+ increasingly looks like it’s focusing on price optimization instead of a balanced and stable market.”

If that’s true, as it now appears, they are accomplishing, and can likely continue to accomplish, that goal.

The U.S. strategic petroleum reserve (SPR) has already been drawn down to a 40-year low. Unless the U.S. plans to draw the SPR down to tank bottom sludge, current levels will likely slow the pace of new product releases and compromise efforts to subdue oil prices as effectively as was possible last year. At the same time, with 90% of global oil production growth over the last decade coming from U.S. shale production, shale has been the global swing producer. At present, however, U.S. shale production decline rates are rising, and shale production is rolling over. As a result of the current state of both the SPR and U.S. shale, it appears OPEC+ has, for the time being, greater control over global prices. If OPEC+ aims to drive oil prices higher, shale production will pick up again, eventually at higher prices. In the meantime, if cartel nations maintain quota discipline, OPEC+ may have enhanced leverage to set the higher prices they’re looking for.

If the Fed tries to declare victory over the war on inflation by citing still falling (for now) core CPI readings, the esteemed institution inside the Eccles building won’t be met with the resounding round of applause it expects. When the impact of higher energy prices spreads into both goods and services on both a headline and a core basis, the Powell Fed, after posing as the Volker Fed, will instead quickly be outed as the spitting image of the Arthur Burns Fed. That won’t fly.

To better illustrate the thin ice upon which we’re all treading with regard to inflation, that 0.6% M/M August CPI reading would annualize out to 7.2%. HAI isn’t suggesting that that will happen, but is certainly saying that we are far from out of the inflationary woods. With energy prices moving higher again, all bets on further disinflation are now off. That said, even at the current 3.7% Y/Y average price hike (not to mention August’s 7.2% annualized rate), current price increases come on top of the 5.2% Y/Y increase as of August 2021 and the 8.2% Y/Y increase as of August 2022. In other words, that’s a total price hike of 18.1% since August 2020. The consumer cannot keep up with that kind of inflation without serious economic consequences.

The San Francisco Fed provides what is widely considered to be the best research among regional Fed banks. In their latest note on the consumer, the SF Fed said “excess savings” held on aggregate by the consumer will run out this quarter. In response to both the end of the line on excess savings as well as a new Bloomberg poll that found only 23% of respondents believed current levels of consumer spending to be sustainable, Bloomberg chief U.S. economist Anna Wong this week called current levels of spending outright “unsustainable.”

It’s no wonder. This week, the Census Bureau confirmed that inflation-adjusted household incomes in the US decreased 2.3% in 2022 from a year earlier, marking the third year in a row of declining real incomes. According to the Census Bureau, the median inflation adjusted income last year was $74,580 compared with $76,330 in 2021, $76,660 in 2020, and $78,250 in 2019. This isn’t healthy. It’s a recipe for pain, not economic growth and flourishing. 

Given this backdrop, its also not surprising that consumers are compensating by turning to credit. Household interest payments as a percentage of wages and salaries have now hit the highest levels since 2008. To make matters worse, as those households run out of excess savings and scramble for more credit, this week, The New York Fed’s Survey of Consumer Expectations (SCE) added tightening lending standards to the blossoming list of household stressors. According to the SCE, “Perceptions of credit access compared to a year ago deteriorated in August, with the share of households reporting it is harder to obtain credit than one year ago hitting a new series high.” Declining real incomes, ballooning debt and interest payments, and deteriorating access to new streams of borrowing all point to the absolute imperative that the inflation war be won, won definitively, and won now. Nevertheless, energy is arguing that the inflation nightmare isn’t over, but rather worsening again. By extension, higher energy and re-stoked inflation are also arguing that a Fed policy of higher rates for longer will remain the rule, likely until something breaks hard.

The combined negative impact of both inflation and the resulting higher interest rates that follow aren’t just a consumer nightmare. It’s a corporate story as well. This week on Bloomberg, economist Mohamed El-Erian warned that a swath of corporations will be hurt by higher interest rates as “massive” corporate refinancing kicks in next year just as the full effects of the Fed’s tightening policy are beginning. As El-Erian put it, “There are things that have to be refinanced in this economy that cannot be refinanced in an orderly fashion at these rates.” So, he continued, “that’s the point of pain.”

From a stock market perspective, if you lose expectations for further disinflation, you lose expectations for timely relief in the form of lower interest rates. If you lose expectations for lower interest rates over the next year, you start to put the wrecking ball to the soft-landing narrative. Accordingly, as mentioned previously, markets now firmly priced for soft-landing would be highly vulnerable.

These risks certainly are rising. This week, renowned bond guru and head of International Fixed Income at T. Rowe Price Arif Husain reinforced that view of rising risks in the keynote address at this year’s JANA conference. His comments echoed HAI’s “recessionary ice” concerns in a simple but important message. His punch line? The near-universal consensus that central bankers and governments can engineer a benign soft landing is dangerously wrong.

Speaking of the soft-landing narrative, Husain pulled no punches, “that is a fairytale in every sense of the word. It is a story that is built for convenience to help people sleep at night…an almost impossible outcome.”

According to Husain, in light of both inflation and the flood of new Treasury issuance needed to fund massive government deficit spending, “much higher bond yields are simply the solution. And those higher bond yields are coming at a time where I believe the global economy is finally starting to roll over.” The risk is that we’re pulling “the rug out from under growth. It’s sort of teetering, and then as soon as it starts, well, it really will go.” On timing, the T. Rowe Price bond authority said, “if I was to put my neck out, it’s months and quarters, not years.” In other words, for Husain we’re rapidly approaching a “Houston, we have a problem” moment.

The goldilocks narrative behind the stock market’s year-to-date gains is that inflation is coming down to target, the economy is strong, a soft-landing is in the bag, and central banks will soon be well positioned to lower rates again. In so doing, according to the narrative, the lower rates will save both the consumer and troubled corporates in line for refinancing. At the same time, the lower rates will greatly increase the wind in the sails of an economy that will boom into another multiyear growth cycle.

HAI is skeptical of this dreamlike set of expectations for inflation, the Fed, and the economy. Incidentally, so is JPMorgan Chase CEO Jamie Dimon, who, this week, told attendees at a New York finance conference that assuming a booming-economy narrative with a blue-sky runway for years is “making a huge mistake.”

In HAI’s view, the key and consequential developments of the moment are surging energy prices, inflation starting to move higher again, a Fed trapped in a “higher for longer” policy corner, higher bond yields at risk of an upside breakout, and emerging government debt and deficit doom-loop dynamics. All of these factors are threatening to dethrone the goldilocks environment we’ve seen so far in 2023, and potentially do so in rather disorderly fashion. Higher energy prices and persistent inflation leading to a higher-for-longer Fed policy stance—all while the consumer has one foot off the edge of the cliff and massive corporate re-financings loom—keeps the hard-landing risk for markets and economy alive and well, and front and center.

The risks are real, the stakes and consequences are high, but all is not lost, and nothing is certain. Maybe we’ll catch a break and avoid the worst-case scenarios on energy prices, inflation, interest rates, and hard landings. Perhaps the government can manage to back out of and avoid a debt doom loop. If not, however, forewarned is forearmed. In HAI’s view, given the current set-up, under the widest swath of probable scenarios, precious metals along with other vital hard assets are the exposures most likely to benefit portfolios.

As legendary investor Ray Dalio explained this week, when debt becomes as big a share of the economy as it is now, and inflation is in play necessitating higher interest rates in response, the situation “tends to compound and accelerate” as deficit-busting interest payments also grow. Dalio added, “We’re seeing that dynamic happen now,” “We’re at that turning point of acceleration.” In HAI’s view, these unfolding dynamics and their “turning point of acceleration” will also mark and fuel an associated, mirrored turning point and acceleration higher toward a major breakout in the price of gold as financial insurance. For now, gold is poised just below all-time highs. At present, it appears the yellow metal is waiting patiently for the green light.

Weekly performance: The S&P 500 was slightly lower, off 0.16%. Gold was slightly higher, up 0.18%. Silver was up 0.95%, platinum gained 3.88%, and palladium was higher by 5.07%. The HUI gold miners index jumped 4.69%. The IFRA iShares US Infrastructure ETF was up 0.92%. Energy commodities were volatile and higher on the week. WTI crude oil gained 2.87%. Natural gas increased by 1.50%. The CRB Commodity Index added 1.81%. Copper was up 2.26%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.52%, while the Vanguard Utilities ETF was up 2.62%. The dollar index was nearly flat, down 0.08% to close the week at 104.99. The yield on the 10-yr U.S. Treasury was up 7 bps to end the week at 4.33%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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