Confidence Bubbles and Pipe Dreams – November 17, 2023

Wealth Management • Nov 18 2023
Confidence Bubbles and Pipe Dreams – November 17, 2023
Daniel Fairbanks Posted on November 18, 2023

Confidence Bubbles and Pipe Dreams

This week, the stock market boomed. The number one instigator for the bullish surge in equity prices was a weaker-than-expected consumer price index (CPI) inflation report. How much weaker was CPI than expected? Year-over-year (Y/Y) CPI missed expectations by just one tenth of one percentage point for both the headline and the core inflation readings. Putting aside, for the moment, that inflation’s underachievement was largely due to energy (a drop in energy prices HAI views as very suspect over time) and a supposed (read: highly suspect) 34% drop in the cost of healthcare, the stock market’s adoption of mega-boom rally mode on a 0.1% inflation undershoot points toward a joyous market extending its “confidence bubble” in government policy and in the ability of policymakers to effectively manage markets higher in perpetuity.

To be clear, the market’s rally is all about speculation that, with the weaker-than-expected non-farm payrolls report earlier this month now combined with this week’s lower-than-expected CPI report, the Federal Reserve now has sufficient cover to declare victory over inflation, end rate hikes, and pull forward the timetable on both central bank rate cuts and a broad, large-scale, stimulative policy easing cycle. The assumption on the part of market bulls is that inflation is effectively dead, the perpetual easy-policy punch-bowl party is back, the next round is about to be served, and a new secular bull-market in financial assets is right around the corner.

On the surface, it all sounds great for the stock market and the economy. Under the surface, a far more complicated and precarious set of dynamics are steering the ship, and both the economy and markets continue to face the grave risk of colliding with either a recessionary iceberg or a devastating inflationary reef.

Of this latest optimism that a softer-than-expected CPI will start a chain reaction seamlessly resulting in an imminent new era of financial market bliss, Wells Fargo’s Sameer Samana put it simply and best: “It’s a pipe dream.”

In a summation of the untenable logical contradiction undermining the current market rally premise, Samana explained (with logic similar to that underpinning HAI’s longstanding “catch-22” thesis) why this week’s market enthusiasm is misplaced. Samana observed, “Either the economy will reaccelerate and inflation along with it, which will lead to the Fed starting another round of rate hikes and there will be a harder landing later. Or the soft landing will quickly turn into a broader and deeper economic slowdown.”

To be clear, the economy has held up better than expected over the last year, but better than expected doesn’t mean booming, well balanced, and healthy. While government deficit spending to the tune of $2 trillion dollars has indeed “boomed” the government’s 25% spending contribution to GDP, the private sector economy is still in what appears to be a pre-recessionary state.

According to data from Refinitiv and Capital Economics this week, the majority of sectors in the U.S. economy now have a negative three-month GDP growth rate. In fact, outside of the forced Covid shutdown and the 2008 great recession, the current 60% of negative GDP growth sectors is the worst performance since at least 1998 (and that includes the 2001 recession and tech bubble bust).

Similarly, the latest tax receipt data paints the same recessionary portrait. As of October, trailing 12-month Federal tax receipts are down 8% y/y, the seventh straight month of y/y declines. The last time trailing 12-month receipts fell y/y for seven straight months or more was also during Covid, and before that during the 2008 great recession.

Despite the celebratory stock market gains this week, much of the week’s data actually reinforced the concern that a full-blown recession rather than imminent recovery awaits unsuspecting stock market bulls.

For starters, the all-important housing market offered plenty of reason for worry. In a new and very unwelcome housing market record, a homebuyer now must earn $114,627 to afford the median-priced U.S. home, according to new Redfin data. That’s up 15% since last year, and up over 50% since 2020. That’s not exactly the supposed victory over inflation the market was celebrating this week.

Meanwhile, compared to that $114,627 income needed to afford a median home, the current median household income in the US is just $75,000. In other words, the median household income needs to rise 53% to be able to afford the median priced home and bring this market back into balance. Make no mistake, we have an absolute affordability crisis in the housing market at present. Something’s got to give. Either incomes must surge or home prices must come careening back down to earth—with resulting recessionary negative wealth-effect consequences. The one certainty, however, is that the present unaffordability in the housing market is absolutely unsustainable—full stop.

According to Arend Kapteyn, UBS Global Head of Economics and Strategy, don’t count on a 53% increase in median incomes to bring balance to the force anytime soon in this housing market. Kapteyn told CNBC on Tuesday that the starting conditions for the economy are “much worse now than 12 months ago.” With private payrolls (excluding non-cyclical health care and education) already down close to a zero percent growth rate, some of the 2023 fiscal stimulus rolling off, excess savings “thinning out,” and corporate margin compression deepening in the U.S. (a very strong historical precursor to layoffs), the consumer is in a very precarious place. It’s increasingly hard to see where such an enormous surge in incomes would come from.

Where that leaves us, according to Kapteyn, is a “massive gap” between real incomes and the current rate of spending, and “much more scope for that spending to fall down towards those income levels.” At present, the over-spending is facilitated by debt, but now, with debt servicing costs in the U.S. rising faster than incomes, that debt-fueled spending looks tentative and temporary at best.

This week, the housing market appears to be broadcasting that the consumer’s ability to borrow and spend may have already breached its natural limit. At the consumer level, the ultimate capital expenditure is a new home. With that said, consider the implications of this week’s National Association of Home Builders sentiment report. The report revealed that the index for buyer traffic has cratered to a level of 21. That’s a historically recessionary level that’s now only slightly better than the pandemic low—when the economy and prospective home buyers were frozen in forced lockdown.

Given the extent to which prospective buyer foot traffic has dried-up, it’s not surprising that overall homebuilder sentiment has now plunged into recessionary territory as well. That’s a troubling sign for an industry that, up until more recently, had been upswinging for the last year and has an outsized impact on overall employment in the cyclical economy.

In light of the recent data, Paul Mortimer-Lee, veteran economist and former forecaster for the Bank of England and investment bank BNP Paribas, described the housing market as “a disaster waiting to happen.” Mortimer-Lee warned that when recessions arrive, they can strike fast. A workforce that took time to build can be sacked almost immediately. He added that “once people start losing their jobs and have to sell their houses, you are going to see a big correction in the market.”

Recall that American business is overwhelmingly small business. According to the U.S. Chamber of Commerce, there are 33.2 million small businesses in America, which account for 99.9% of all U.S. firms. Small businesses are also credited with 63% of new job creation, they employ almost half of America’s private sector workforce, and they represent 43.5% of GDP. By almost any measure, small business is an economic bellwether.

That said, this week’s National Federation of Independent Business (NFIB) Small Business Optimism Index indicated that members unambiguously foresee recessionary levels of both sales and earnings on the horizon. Real-time NFIB highlights include a net negative 17% of all owners who reported higher nominal sales in the past three months. That number plunged nine points from September to reach what is now the lowest reading since July 2020. Similarly, the frequency of reports of positive profit trends plummeted eight points to a net negative 32%, down eight points from September. The leading causes credited for lower profits were weaker sales volumes followed by a still rising cost of materials. As NFIB Chief Economist Bill Dunkelberg put it simply, “owners are not optimistic about better business conditions…making it a gloomy outlook for the remainder of the year.”

Unless the incredibly tight historical correlation between sales and profit trends and the subsequent employment trend is suddenly suspended, job losses that could TKO the consumer, unhinge the housing market, and catalyze recession may be close behind.

Building on the recent plunge in commercial real estate prices and the ominous potential consequences on already strained bank collateral detailed in last week’s HAI, data this week exacerbated the potential trouble for banks, businesses, consumers—and by extension the economy. This week, a Financial Times report confirmed that overdue commercial property loans just hit a 10-year high at U.S. banks. In short, for already stressed banks, any further collateral issues can be expected to translate directly to a further tightening of credit and a diminished rate of lending to both consumers and small businesses. Again, the result is another economic stressor likely to ultimately hit employment and, in so doing, contribute to a vicious recessionary cycle.

While stock market bulls and “confidence bubble” believers continue to treat every potential inch toward a central bank easing cycle as a panacea for all ills and a certain harbinger of the next secular financial asset bull-market, recession warnings are real. In his most recent note to clients, legendary economist Lacy Hunt said matter-of-factly, “The U.S. economy has very serious problems… The economy is headed into a hard landing.”

Again, the assumption on the part of market bulls is that the perpetual easy-policy punch-bowl party is back, the next intoxicating round of stimulus is about to be served, and a new secular bull-market in financial assets is right around the corner. That said, remember that in previous recessionary hard landings, the vast majority of outsized market losses occurred after the Fed cut rates. Forewarned is forearmed.

By returning to the observations of economist Paul Mortimer-Lee, we can see how, on one hand, the economic ship may be on course for a particularly hard recessionary iceberg impact that could certainly sink markets. This week, Mortimer-Lee astutely perceived that, while “we’re on the verge of a recession,” central banks may be more reluctant than markets currently assume to cut rates and stimulate because, “inflation is high…and budget deficits are bloody awful.” In asking and then answering his own question, Mortimer-Lee crystallized the serious nature of the potential risk markets face in a recessionary outcome: “How can governments respond to that recession[?]… The answer is, they can’t. They have put us up the proverbial creek without a paddle.” Just to highlight the point, the risk Mortimer-Lee is flagging is one of recession without recovery, and recession without recovery is otherwise known as depression.

On the other hand, few would argue that modern governments have shown any appetite for depressionary recessions without recovery. That observation is only amplified when considering that any material economic slowdown in the U.S. would further crush tax receipts and fast-track government insolvency risk. With tax receipts already down 8% year-over-year, deficits already north of $2 trillion, and interest expense on the debt our fastest growing “program” (and now, shockingly, a bigger line item than defense spending), that sovereign debt insolvency risk is real and rising. As a result, the economic ship could crash on a reef of inflationary fire if, despite conventional wisdom that “they can’t,” governments abandon inflation concerns by drastically cutting rates and printing super-quantities of QE to keep the economy pumping and tax receipts flowing while inflating down the total debt burden.

Neither recessionary ice nor inflationary fire are ideal paths forward for anybody. But, in HAI’s view, on our current unsustainable policy trajectory, the likelihood of achieving a perpetual goldilocks state of stable government solvency, ongoing economic growth, and a low inflation environment remains the most improbable outcome. In either of the more likely scenarios, gold as financial insurance is the best bet as a portfolio core holding until firm clarity over policy trajectory can be established. For now, be patient. Amid confidence bubbles and pipe dreams, hope for the best, prepare for the worst, hold sufficient gold, and sleep easy at night.

Weekly performance: The S&P 500 jumped 2.24%. Gold gained 2.43%, silver surged 7.05%, platinum rebounded by 6.63%, and palladium shot up 8.18%. The HUI gold miners index gained 4.31%. The IFRA iShares US Infrastructure ETF was up 4.40%. Energy commodities were very volatile and down on the week. WTI crude oil was down 1.46%, while natural gas lost 2.41%. The CRB Commodity Index was nearly flat, up 0.10%, and copper jumped 4.15%. The Dow Jones US Specialty Real Estate Investment Trust Index gained 4.60%. The Vanguard Utilities ETF was up 3.37%. The dollar index was down 1.80% to close the week at 103.82. The yield on the 10-yr U.S. Treasury dropped by 17 bps to end the week at 4.44%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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