Weekly Hard Asset Insights
By David McAlvany
Clown Kookooland vs. the Economic Truth
This week, the Federal Reserve, economy, and financial markets took a big step into the middle of a lethal minefield of the Fed’s making. Flanked on one side by raging inflation and on the other side by an economy already set for significant slowdown, the Fed faces the threat of a suffocating stagflation that could roll over into a serious recession. The cumulative effect of over a decade of unprecedented monetary and fiscal stimulus, near-zero interest rates, record loose financial conditions, and the inflating side of a global financial asset bubble all conspire to paint a misleading façade of strength on the economy.
The underlying reality, however, is far more troubling. The economy is dependent on myriad forms of artificial stimuli increasingly doled out for more than a decade, not by the spoonful, but by the boatload. The consumer, whose spending is now responsible for 70% of GDP, is “punching above its weight.” To continue to do so without direct government checks, consumers require either the combination of cheap goods and services, cheap credit, and rising stock prices or strongly positive real (inflation-adjusted) wage increases.
Either situation is severely impacted by excessive inflation. Well, we now have inflation at 40-year highs and going higher. At current levels of inflation, the government-gone-wild era may be temporarily suspended. Any further increase in direct checks would be utterly incendiary at this point. Goods and services are increasingly expensive, credit conditions are tightening, and stocks appear vulnerable to the deflating side of a financial asset bubble. Meanwhile, “real” wages are not increasing, they are deeply negative with no sign at all of any timely relief.
In addition, consumer sentiment is already at low levels not seen in over a decade, and sentiment continues to decline significantly. The present state of the real-world consumer is described in chilling terms by the University of Michigan’s Surveys of Consumers when observing that, “Personal finances were expected to worsen in the year ahead by the largest proportion since the surveys started in the mid-1940s.”
Let that finding by survey chief economist Dr. Richard Curtin fully sink in. Then consider its impact on the real economy and overly inflated financial assets. Remember, to a very significant extent, extreme expectations are self-fulfilling. In a circular dance, expectations for the future largely determine behaviors in the present that then act towards the realization of the expected future condition. Well, consumers are expecting future pain at off-the-charts levels. Unless dynamics change dramatically—and fast—we can expect behavior to increasingly reflect these dire expectations.
It’s not just consumer sentiment raising eyebrows, either. This week, the latest Bank of America global Fund Manager Survey (FMS) revealed that global growth expectations are now at lows not seen since the 2008 financial crisis. As BofA chief investment strategist Michael Hartnett wrote in a note to clients, at this point, “Economic growth and profit expectations are recessionary.”
So, despite robust assertions by some, including Federal Reserve Chairman Jerome Powell, regarding the strength of the economy, a closer look under the economic hood punctures the narrative and tells a very different story. There is a world of difference between a “hot” and a healthy economy. Hot turns cold as boom makes bust, while healthy remains sustainably strong. We’ve had an extremely hot—not healthy—economy in the Covid recovery era. Sure enough, inflation has emerged as the 800-pound gorilla, and now we must be attuned to the increased risk for potential bust.
Unless a fundamental variable in the current equation changes dramatically and immediately, the crucial factors determining the direction of the economy and markets are increasingly coalescing around contraction, and are synchronizing a powerfully bearish momentum.
This week, the spotlight was firmly on Jerome Powell, the Federal Reserve, and Wednesday’s highly anticipated FOMC meeting. The ostensible questions at hand were whether and by how much to raise the federal funds rate. The real questions, however, were a bit more weighty: Is the Fed the crucial variable that can positively rewrite the badly bearish equation looming over the economic landscape? Is the Federal Reserve “the great and powerful” wizard, or the mere mortal hiding behind the curtain? Let’s review Wednesday’s FOMC.
As expected, the Federal Open Market Committee raised its target range for the fed funds rate this past week by one-quarter of a percentage point, to 0.25%–0.50%. The official FOMC statement said that, “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” Speaking to the major developments on the geopolitical front in Ukraine, the Fed said, “The implications for the US economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.” The statement proceeded to offer a very vague update on the initiation of balance sheet run-off. The statement said the Committee “expects” to begin reducing its $8.9 trillion holdings of Treasury securities, agency debt, and agency mortgage-backed securities “at a coming meeting.”
As past HAI’s have pointed out, coming into this meeting the Fed was faced with the challenge of having to walk a perilous tightrope. The task at hand? Initiate a policy course correction that will proceed to effectively rein in raging inflation while simultaneously avoiding a painful economic slowdown that, if severe enough, could cascade into a full-blown recession.
In its Summary of Economic Projections (SEP), the Fed confirmed that indeed it does intend to walk the tightrope, and the SEP outlined what a successful threading of the needle will look like. The policy-setting panel unveiled a SEP that assumes sharply higher inflation, a much more aggressive fed funds rate trajectory, and slower projections for the economic growth outlook in 2022 compared to what had been predicted in the previous SEP.
Beyond 2022, however, GDP projections were unaffected by the tightening effect of a higher Fed funds rate, and remained unchanged from the previous forecast. Similarly, and perhaps most notably, despite the significant increase in rates and the tighter financial conditions that higher rates will foster, the Fed did not assume any lost ground in unemployment. The Fed projects the unemployment rate, currently at a very low 3.8%, will decline further to 3.5% for 2022 and remain at or near 3.5% through 2024. So, the great and powerful Fed will get much more aggressive with rates, aggressive enough to conquer the raging inflation beast, while inflicting virtually no discernable negative impact on the real economy. This feat, if accomplished, would be a miraculous threading of the needle indeed.
Some observers were encouraged and seemingly satisfied by what the Fed put forth. Certainly, the acknowledgement of higher and longer-lasting inflation and the accompanying need to raise interest rates far more aggressively than previously projected were long overdue and highly encouraging. James Paulsen of Leuthold Group said, “Certainly inflation is very high and the recession risk is a lot higher today than it was 12 months ago – there’s no doubt about that, but I think there’s a fairly good chance that we’ll have a soft landing.” Highly respected economist David Rosenberg sees the set-up a bit differently. He sees the Fed drastically behind the inflation curve and firmly caught in a box of it’s own making. In a client note following the FOMC, Rosenberg wrote, “The Fed has never tightened into such a maelstrom before—a shooting war, a pandemic, a weak and wobbly stock market, and an incredibly flat yield curve.” His final reaction to Wednesday’s developments was simple. He said, “I think the recession risk is very high.”
Many market observers reacted negatively to the Fed’s projections and latest iteration of monetary innovation and experimentation. Diane Swonk, chief economist at Grant Thornton, acknowledged that finally the inflation “reality has hit” the Fed. She went on to say, however, that what “doesn’t add up is their forecast for falling unemployment.” Scott Minerd of Guggenheim Global, commenting on the apparent economic alchemy of tighter financial conditions that kill off inflation but leave the real economy unscathed, said “this is all fantasy land.” Kathy Jones, chief fixed-income strategist at Charles Schwab, offered her rather skeptical two-cents as well. She reacted to the Fed by saying, “What a bundle of contradictions. Raise rates a bunch, bring inflation down but GDP growth and unemployment are steady. Hmmm.” Taking the prize, however, for quote of the week was Dartmouth Economics Professor Danny Blanchflower. After accusing the Fed of engaging in “wishful thinking,” Professor Blanchflower described Fed projections as “clown-kookooland.” Kudos to the professor for the color in that commentary.
Responding to the FOMC meeting in an interview with Bloomberg, former Treasury Secretary Larry Summers expressed the view that policymakers are still badly underestimating inflation. According to Summers, in order to successfully wrestle inflation back under control, the Fed will need to increase the Fed funds rate by more than the pace of rising inflation. “If you want to tighten policy you have to raise interest rates by more than inflation went up.” Summers said, “We’ve got to raise them (interest rates) by 4% to stay neutral and we probably have to raise them more than that.” He then added that these are “levels they’re not even thinking of as conceivable.”
Summers, who has been dead right on the non-transitory inflation surge and miles ahead of the Fed for over a year, also flagged the blatant inconsistencies in the Fed’s projections. He expressed his deep skepticism towards the Fed’s expectation that unemployment could stick around 3.5% while inflation falls “precipitously.” Mr. Summers said, “They’ve got a long way to go in forecasting realistically.” Summers concluded by saying the Fed hadn’t “done all that will be necessary to preserve its credibility in the face of the substantial inflation that I think is likely to come to us.”
Market reactions were fascinating and polarized. Stocks took full advantage of a window of opportunity following the Fed meeting to rally from deeply oversold technical conditions. The surge in US equities was assisted by short squeeze dynamics, options expirations, and a temporarily reinvigorated Chinese stock market.
On the other hand, the “smart money” of the bond market spoke clearly and with a booming voice. The bond market is signaling a likely incoming recession. Inverted yield curves are the most reliable market-based indicators of imminent recession. From the start of the Fed FOMC release through the end of the week, yield curves flattened dramatically in a race towards inversion. In fact, as Fed Chairman Powell spoke Wednesday afternoon, the difference between the 5- and 10-year Treasury yields (5s10s curve) officially inverted. 5s10s inversion is a reliable harbinger of recession. Historically, it tends to lead inversion in the more popular 2s10s curve. 2s10s closed the week in freefall about 20bps from inverting.
Fed tightening cycles historically have had a 75% chance of triggering a recession. However, as Deutsche Bank’s Jim Reid pointed out this week, while not every Fed hiking cycle leads to a recession, all hiking cycles that invert the curve have led to recession. Interestingly enough, other aspects of the market, such as the forward OIS curve, are jumping even further ahead on this unfolding narrative. The forward OIS curve is already starting to price in a signal of rate cuts—not hikes—in as soon as one year. That’s remarkable. The picture the bond market appears to be sketching out is one where the Fed’s now initiated tightening cycle will rapidly accelerate the sinking of an already slowing economy into recession. The forward OIS curve then suggests that the Fed will respond to that recession with a dovish pivot and the next round of rate cuts and stimulus. What a tragic circus. All in all, stagflation seems in the cards, while recession appears to be a rapidly growing likelihood.
Meanwhile, like the bond market, gold remains unfazed and focused on where events are headed. The messages out of the bond market may shed some light on a price of gold that appears to be in the process of attempting to break out to new all-time highs. The yellow metal is doing exactly what it should be doing. Gold is telling the economic truth. It’s movement is dialed-in and pegged to the long game. Over time, gold is reacting to developments resulting from devastating and unsustainable economic policy mismanagement and its consequences. On a short-term basis, as has been the case since the recent test of all-time highs, gold’s price action will be greatly influenced by technical factors. That said, however, while paying the tolls demanded by market technicals along the way, the big picture set-up strongly suggests gold is poised to cruise up the highway of increasing prices.
Anticipated strength in the price of gold offers some potentially exceptional opportunities at present. The price of gold is significantly uncorrelated to GDP, so while GDP growth may be set to tangle with trouble, we expect gold prices to remain strong. The price of gold, not GDP, is the underlying driver of the gold mining industry. As such, mining companies may well have a tremendous wind at their backs. At the same time, the quality miners are in terrific fundamental shape and offer some of the deepest value of any sector in the market. The sector has also learned from the sins of its past. At this point, miners need only remain smart, focused, and disciplined in order to take advantage of generous gold prices. The keys to thriving for the mining sector are to stay out of the debt trap, focus on margins, and continue to build robust dividend distribution streams. So far, management teams deserve high marks. If they keep it up, the gold mining sector is beautifully positioned for a win every bit as spectacular as last cycle’s mismanaged losses were catastrophic.
Another powerful and presently unfolding market thematic is that of unprecedented negative real (inflation adjusted) yields in the bond market. With raging inflation, negative real yields at these levels haven’t been seen in decades. Trillions of long-term bond investment allocations are now hemorrhaging losses on a negative real yield basis. If the highest quality gold miners continue to manage this environment appropriately, they stand to offer an incredibly attractive alternative landing spot for mistreated bond market money trapped in stale, bleeding legacy positions. The huge sums of institutional money tied up in the bond market are, to a large extent, courtesy of positions built for the market conditions of times past, not for those of the present or likely future.
As the degree and duration of the pain being suffered by bond positions continues to increase, expect mistreated long-term bond allocations to be on an increasingly dedicated search for a more hospitable home. Once searching, asset allocators may well find the compelling offer they are looking for in top quality gold miners. Thriving businesses, literally backed by gold, offering healthy balance sheets, free cash flow streams, and growing dividend profiles may have never looked so good to suffering bondholders. The implications of such a capital reallocation looms large for reflating valuations within the mining sector.
In analyzing the now expired Soviet system of government, Oystein Dahle observed that it “collapsed because it did not tell the economic truth.” Without free markets and a free price system, the artificially constructed economy was fragile, inherently unstable, and unsustainable in the long run. In our modern era of activist central banks, economic orthodoxy has increasingly become defined by large scale and determined efforts on the part of policymakers to manage, control, and direct the economy. These policy interventions are rarely according to the dictates of sound free-market economics, but much more frequently emerge in the service of expedient short-term objectives.
This arrangement increasingly interferes with the market’s ability to tell the economic truth. The interventions and their consequences add up and build over the long term. They exact an array of dangerous consequences. As Henry Hazlitt says, the negative long-term consequences of short-sighted and unsustainable policies are present, in every instance, “as surely as the hen was in the egg, the flower in the seed.” Until economic policymakers recognize this truth and fundamentally re-tether the overarching framework of economic policy to the firm foundations of this wisdom, we will continue to flirt with perpetually escalating levels of economic peril. In the meantime, until we turn to wisdom, gold will react and be the default keeper of economic truth.
Weekly performance: The S&P 500 surged 6.16%. Gold was off by 2.81%, silver was down 4.09%, platinum lost 4.84%, and palladium was hard hit, dropping 10.86% on the week. The HUI gold miners index was lower by 2.73%. The IFRA iShares US Infrastructure ETF gained 1.76%. Energy commodities were volatile and mixed. WTI Crude Oil was down 5.71%, while natural gas was up 2.92%. The CRB Commodity Index was lower by 0.97%, while copper gained by 2.46%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.88% on the week, while the Vanguard Utilities ETF (VPU) was up 0.53%. The dollar was lower by 0.91% to close the week at 98.23. The yield on the 10-year Treasury jumped by 14 bps to end the week at 2.14%.
Have a wonderful weekend!
Chief Executive Officer