Calm Before the Storm – April 21, 2023

Calm Before the Storm – April 21, 2023
Morgan Lewis Posted on April 22, 2023

Author Nassim Taleb accurately observed that, “experience in finance with a discount rate near zero is like having studied physics except without gravity.” After well over a decade of the most activist and loose monetary policy in history, we have indeed been living in an alternate universe. HAI continues to expect recessionary wreckage and a long list of casualties as a structurally frail economy, now fully acclimated to and dependent upon near-zero interest rate policy and easy credit, increasingly succumbs to tighter lending standards and the new financial physics of interest rate gravity.

This week, markets were generally calm. In fact, as measured by the VIX volatility index—also known as the “fear” gauge, investors’ complacency toward the prospects of a significant stock market decline is as high as at any time since the stock market’s all-time peak in January of 2022. While markets appear relatively sanguine at present, HAI believes the current respite to be the calm before the storm.

On the week, both the S&P 500 and the US dollar were nearly flat, commodities were lower, and precious metals began to correct with a weekly close below the psychologically significant $2,000 per ounce of gold level. The dollar is in a favorable technical position for a bounce. If the greenback catches a bid, the timing could catalyze a further correction of extended and overbought conditions in the gold market. If such a retracement in gold develops, technically, as long as price holds above $1,842, the correction can be considered healthy and the dip a buyable one. In fact, from a fundamental perspective, if a gold correction takes root, buying weakness in gold, silver, and related precious metals equities over the next several months may be the last best opportunity to build positions in the sector before an expected subsequent upside breakout in the gold price to new all-time highs.

Price action in both oil and copper sounded a more bearish note this week, however. Both economically sensitive bellwether commodities were under notable pressure, down 5.63% and 3.09% respectively. Oil has now given back all of it’s supply-side driven gains following the recent surprise 1.16 million barrel per day OPEC+ production cut, and copper registered its first weekly close under $4.00 per pound since mid-March, despite very bullish (for price) weak supply-side news out of Chile over recent weeks. Also of note, despite $2.1 trillion of Chinese stimulus, China-sensitive iron ore prices fell on Friday to their lowest level since December.

Such weak price action in a bullish supply-side context indicates that recessionary demand concerns are overwhelming supply-side action. Perhaps equity markets would be wise to take note.

While leading economic indicators are sounding a deafening alarm bell warning of imminent recession, real time growth has only drifted lower so far. It hasn’t crashed. The market has begun to anticipate the end of the Fed rate hiking cycle, but real-time economic growth has yet to collapse. Complacency has set in, and the “soft-landing” narrative has once again gained the upper hand in setting stock market prices.

So how viable is this latest soft landing scenario? HAI wholeheartedly shares the opinion held by BNP Paribas Senior US Economist Yelena Shulyatyeva, “At this point…the path to a soft-landing is so narrow that it would truly be a miracle.”

Historically, a Fed rate hike pause has been good enough for a short-term stock market bounce, but little else. Sure enough, markets have been pulling that bounce forward by front-running the expected pause. Markets have priced in expectations for a soft landing with a very bullish 19x multiple on still overinflated forward earnings estimates. And while consensus earnings estimates have come down from highs, they forecast only a minuscule 4% peak to trough earnings drawdown in 2023. They expect this 2023 blip on the earnings drawdown radar to then be followed by a powerful reacceleration higher in 2024 and beyond. Such expectations are distinctly “soft landing” territory. If taken at face value, they imply that the stock market made its bear-market lows last October.

Miracles aside, is the current market pricing fantasy or reality? According to economist David Rosenberg, it’s fantasy. As Rosenberg put it this week, “I think the only way that you could believe that the lows from last October are going to hold is if we managed to come out of this without a recession…and I think a recession is staring us in the face.” The former Merrill Lynch legend continued, “When reality sets in, when Wile E. Coyote looks down, the market is going to new lows. We’re not just going to test the October lows of last year, we’re going through them.”

HAI agrees, and believes probabilities greatly favor both recession and new market lows ahead. Even in a garden-variety mild recession, earnings historically drop by over 20% peak-to-trough. Rather than a bullish 19x multiple, the recession multiple is typically no better than 16x. In other words, the “no recession” soft-landing crowd had better be right. The “recession math” of earnings multiplied by the earnings multiple gets you to around 3,000 on the S&P 500 even in a plain vanilla recession.

If 3,000 on the S&P sounds like a familiar number to HAI readers, that’s because it is. Recall Jeremy Grantham’s warning. The first ballot hall of fame investor who successfully called and sidestepped the market collapses that followed both the bubble and subsequent great financial crisis said two weeks ago, “The best we can hope for is that this market bottoms at about 3,000.”

Why all the bearishness? Coincident real-time economic growth has already slowed towards the pre-recessionary state that is the typical starting point for historical recessions. At the same time, consumer sentiment is deeply recessionary following a US-record stretch of 24 consecutive months (and counting) of negative real “inflation adjusted” wages. The yield curve is at its most inverted since 1981. At least 250 bps of lagged Fed rate hike impacts have yet to be felt. Bank deposits continue to fall (another $76.2 billion this week), and already recessionary tight bank lending standards, working through the economy at a minimum of a six-month lag, are expected to have significantly tightened further after the SVB crisis. In other words, from an already precarious pre-recessionary state, the lagging impact of both Fed rate hikes and bank credit tightening assures that an awful lot of tightening is still in the pipeline and on its way. Even if the Fed pauses immediately, the gears are in motion. The economy looks poised to receive a knockout blow.

The recessionary case only strengthens when considering the leading economic indicators. Such indicators—including the Conference Board Leading Economic Index (LEI), a composite of 10 key leading economic variables—provide highly accurate insight into where coincident “real-time” growth is headed in the future. LEI’s recession signals have a perfect track record in data back to the 1960s. At present, the leading indicators are painting a broad and overwhelmingly compelling portrait of incoming recession.

In the March update of the Conference Board’s LEI released this week, the LEI plunged an accelerated 1.2% month-over-month (versus -0.7% expected). That print marked its 12th straight negative monthly reading in what is its longest weakening trend since the great financial crisis. The Conference Board’s threshold for initiating an official recession call forecast is when the LEI drops to -4.2%. Past that point, a recession has never been avoided. The average start date of forecasted recessions has historically occurred when the LEI has dropped to -4.8%. Currently, the LEI is at a new cyclical low of -8.1%. At that level, the LEI is unambiguously and massively recessionary. Since the 1960s, every recession except one has started with an LEI growth rate higher than it is today.

As time drags on and the ominous predictions made by the plummeting leading data do not materialize, a strong temptation arises. That temptation is to disregard the leading data and conclude “its different this time.” History and consideration of the facts strongly caution against such conclusions. Leading economic indicators have a mechanical relationship with real-time growth. The leading indicators always lead. Reality follows. It’s the timing that’s historically most variable and unpredictable.

In regard to timing, perhaps an interesting historical parallel is helpful in understanding what has so far been surprisingly persistent coincident economic momentum. Economist Benjamin Anderson, in his classic Economics and the Public Welfare: A Financial and Economic History of the United States, chronicled a phenomenon he observed during the late stages of the “roaring” 1920s that carries intriguing relevance to our modern moment:

So much new money had been created in the period from 1922 to early 1928 that the problem of reabsorbing it and getting it under control was a very difficult one. When a bathtub in the upper part of the house has been overflowing for five minutes, it is not difficult to turn off the water and mop up. But when the bathtub has been overflowing for several years, and the walls and the spaces between ceilings and floors have become full of water, a great deal of work is required to get the house dry. Long after the faucet is turned off, water still comes pouring in from the walls and from the ceilings. It was so in 1928 and 1929.

As it was in the 1920s, so it is again in the 2020s. The work “required to get the house dry” is utterly immense. However, while it has taken time, and may take some additional time yet, as long as the financial physics of interest rate gravity are reasserting themselves, and the “faucet” is turned off on our credit creation-dependent modern economy, the ultimate Wile E. Coyote outcome is in little doubt. The leading indicators make clear that this economy has been living on borrowed time, and time is now rapidly running out.

In short, HAI’s view of the current dynamics and present market set-up is that we’re not so much identifying a set of canaries in the coalmine as watching the recessionary gorilla emerge out of the mist and charge straight for us. Soft-landing advocates beware. Over the long history of economic recessions, it’s always a soft landing until the “hard” part hits. Markets have been lulled into complacency, but many economically sensitive equities are currently at extreme risk of soon catching down to the reality of a looming recessionary hard landing.

The thesis remains the same. Given the complicated dynamics in play, HAI expects Federal Reserve policy to remain inclined toward tightening for now. The central bank will likely require the further eruption of crisis before having the political cover needed to make a full pivot from restrictive inflation fighting policy to aggressive emergency response policy easing. While the Fed will likely pause rate hikes after another expected 25 basis point hike in May, a pause is not a pivot. A forceful pivot is likely what’s required to forestall imminent recession. In the meantime, we linger in the calm before the storm.

Weekly performance: The S&P 500 was nearly flat, down 0.10%. Gold was down 1.26%, silver lost 1.57%, platinum was up 8.04%, and palladium gained 7.42%. The HUI gold miners index was off 4.87%. The IFRA iShares US Infrastructure ETF added 0.30%. Energy commodities were volatile and mixed on the week. WTI crude oil lost 5.63%. Natural gas was up 13.91%. The CRB Commodity Index lost 1.96%, and copper dropped by 3.09%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.53% on the week, while the Vanguard Utilities ETF was up 1.06%. The dollar was up 0.30% to close at 101.55. The yield on the 10-yr Treasury gained 5 bps to end the week at 3.57%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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