Crisis is a Process
The market narrative this week was split between stagflation, as economic growth slows but elevated inflation signals remain far stickier than hoped, and worsening systemic bank crisis concerns. While HAI believes that the process of crisis in the banking sector and throughout the economy is well underway, it has yet to fully mature. Present stagflationary conditions will eventually be eclipsed by hard recessionary reality as crisis dynamics fully bloom. In the meantime, stocks were volatile and higher on the week. Overall weakness in commodities persisted, the dollar was slightly lower, and bonds were bid.
Despite ending higher, stocks started the week under significant pressure. The bearish tide rapidly turned bullish after better-than-expected earnings from mega-cap tech names bailed out the indexes, triggered a short squeeze, and touched off a bit of late week FOMO in market participants with bullish rose-colored glasses. Market breadth is historically weak at present. Only 28 stocks in the S&P 500 account for all of the market’s year-to-date (YTD) gains, and a mere six mega-caps account for 53% of the S&P’s YTD performance. That amounts to the narrowest leadership ever for an up market in JPMorgan data back to the 1990s. The market cap concentration of the largest 10 stocks in the S&P 500 relative to the overall index is now at the 96th percentile in history, and the weight of the largest two stocks relative to the S&P 500 is at a new record high. This weak breadth and anomalously high concentration is, unequivocally, neither a sign of overall market health nor of a strong and enduring rally.
On the contrary, while the concentrated flight to mega-cap tech and short squeeze dynamics are good for a temporary trade higher, ultimately, in the context of a deeply fundamentally bearish market and economic backdrop, the equity index ramp up is almost certainly unsustainable.
This week, the U.S. Bureau of Economic Analysis said the advanced reading of first-quarter GDP showed the economy grew at an annualized rate of 1.1%, down from the 2022 Q4 rate of 2.6%. The results dramatically disappointed consensus estimates that expected between 1.9% and 2.3% growth. Across the GDP report, the numbers were unequivocally disappointing and stagflationary. Almost all the GDP growth in Q1 was from January consumption that was dramatically impacted by unusually warm weather and, more importantly, by an 8% cost of living adjustment (COLA) bump to social security payouts. Even more disappointing than slow growth, the core PCE deflator, gauging inflationary price pressures, lifted from 4.4% in the final quarter of last year to 4.9% in Q1, two ticks above what the market was expecting. In addition, this week the employment cost index, a broad gauge of wages and benefits, increased by 4.8% in the first quarter. It’s still running at levels entirely inconsistent with bringing inflation down to the 2% target. In short, stalling growth paired with continued sticky-elevated inflation data that offers no easy excuse for an imminent Fed pivot is, for the economy, a recipe for trouble with a capital “T.”
Like an airplane with wing flaps extended, the economy is losing speed as the drag from the accruing impacts of a record 24-straight months of negative inflation adjusted earnings, higher interest rates, and tightening credit conditions slow forward momentum. The real problem will occur when, with the flaps still extended and drag mounting, the economic engines fully cut out. Given that manufacturing and both residential and commercial real estate engines are already shutting down, the economic nose-dive moment unambiguously forecasted by the leading indicators is rapidly approaching.
On the manufacturing front, the average of all five regional Fed Manufacturing surveys has been in contraction. However, this week’s data hit a new cyclical low with the lowest levels in the data outside of Covid lockdown and the great financial crisis.
Meanwhile, the U.S. pending home sales index dropped 5.2% in March following an unchanged reading in February. The result underwhelmed the consensus forecast of a 0.6% increase. Year-over-year, pending home sales are now down 23.2%. The 5.2% drop is a significant reacceleration of the downtrend in a series that, importantly, is a leading indicator for the overall housing market.
Transactions are already frozen in both residential and commercial real estate. Inflation-adjusted residential real estate prices are already down roughly 7% from the 2022 peak. That’s already on par with past recessions. Notably, the decline has occurred even before recession and any significant break in the labor market.
Even more alarming for the economy and the banking sector, inflation-adjusted prices in the commercial real estate sector are down a staggering 22%. We’ve never seen commercial real estate prices plunge like this before a recession has hit. Even worse, commercial real estate now has record debt leverage. Without an immediate turnaround, these severe price declines are going to translate to seriously increasing defaults and bad loans.
The problem feeds right back into already strained small banks and a looming credit crunch. Forty-three percent of small bank assets are real estate loans, of which two-thirds are commercial. Sure enough, last week Moody’s Investor Service downgraded 11 regional banks. The rating agency said strains in the banks are becoming “increasingly evident.”
Friday brought with it two more troubling banking developments. Reports surfaced early Friday that the FDIC is preparing to place First Republic Bank under receivership. If that happens, it will be the second largest bank failure in US history. Earlier in the week, the Wall Street Journal described First Republic as facing “a grim and unusual situation where it may have to pay more on its liabilities than it is earning on its loans.” HAI would agree with the description of “grim,” but most certainly challenge the characterization of an “unusual situation.” Regional small banks paying more on liabilities than is made on loans is increasingly likely to be common—and as systemic as systemic gets.
Friday brought acutely negative commentary from Capital One. While ominously noting that the bank’s figures tend to lead the industry by a quarter or two, Capital One warned of its deteriorating credit metrics as delinquency rates jump, write-offs soar, and provisions for bad debt leap higher by over 300%. CEO Richard Fairbank also told analysts that, “We are assuming a material worsening of labor markets with the unemployment rate rising from today’s very low levels to above 5% by the end of 2023.” In other words, Capital One is expecting an imminent recession significantly worse than the 4.5% unemployment rate the Fed is currently forecasting and describing as a “mild recession.”
In 2011, professors Robert J. Barro and José F. Ursúa of Harvard engaged in an exhaustive study of broad and comprehensive data on macroeconomic crises since 1870. Their examination found that crisis is not a single event, but a series of events. In other words, their analysis made clear that crisis is a process. The crisis has clearly begun. However, the process is far from finished.
Investors tend to see crisis too late. They stick to their bullishly oriented plans and dramatically underestimate the severity of developments until disaster looms. As Mike Tyson famously said, “everyone has a plan until they get punched in the mouth.” Similarly, it’s always a soft landing until the “hard” part hits, and it’s always a “mild recession” before a bona fide doozy manifests.
Historically, 80% of all Fed hiking cycles have ended in a recessionary hard landing. Not all Fed tightening cycles are equal, however. Just as surely as “the hen was in the egg, the flower in the seed,” crisis and recessionary hard landing outcomes have always emerged from every Fed tightening cycle that has occurred in conjunction with both elevated inflation and tightening bank lending. These are the dynamics we face today with the Fed poised to hike rates by another 25 basis points next week, inflation still running too hot, and already recessionary bank lending standards only getting tighter.
As this week’s data attests, this monstrous three-headed hard-landing maker (inflation, Fed rate hikes, and bank tightening) is hammering away at an economy that’s already lost the engines of manufacturing and real estate, and in which slowing growth is already sputtering at stall speed. Indeed, the massively recessionary leading indicators discussed in last week’s HAI appear to point the way and paint an ugly portrait of a pending rough patch for markets and the economy.
Oft repeated wisdom fundamental to success in sports is to “keep your eye on the ball.” Asset management is far from a game, but the saying nevertheless applies equally in the investment arena. In the near-term, market bulls front-running an expected Fed policy pivot, FOMO, short squeezes, and zero-day-to-expiration option games may continue, but HAI suggests investors keep their eye on the ball and position around the assumption that an incoming recessionary hard landing is staring us in the face. It likely commences sometime between June and autumn.
Arthur Schopenhauer once made the difficult to parse yet trenchant observation that, “The task is not so much to see what nobody has yet seen, but to think what nobody has yet thought about that which everybody sees.” So it is with the endless challenge of investing in our modern markets and considering the myriad interacting variables and timeframes relevant in shaping the market’s fate. We must decipher both the risks in markets and the opportunities in the risks. While the recession and hard landing in markets is staring us in the face, so, too, are the opportunities.
Whether it’s political fracturing, deglobalization, structurally higher secular inflation, slow burn de-dollarization themes, a chronic commodity supply problem, rising resource nationalism, a green “new” energy transition and the growing need for the “old” energy and metals needed to power it, we are, on so many levels, at various degrees of market, macroeconomic, and geopolitical regime change. Amid such a large-scale unfolding transition, HAI expects the financial asset leaders of yesteryear’s market to cede dominance to “new regime” market leadership in hard assets.
Among the hard assets with the brightest of outlooks is gold. After record central bank gold buying at a 152% year-over-year increased pace in 2022, the Financial Times polled 83 central banks that manage a combined $7 trillion in currency reserves around the globe. The publication’s findings, out this week, are that 66% of respondents expect their peers to further increase gold holdings in 2023. Changing market, macroeconomic, and geopolitical regimes are forcing central banks to “rethink their investment strategies.” They’re not alone.
The opportunities are present and ripening, but the process of crisis has been unleashed. Already hard at work are the uncontrollable forces that threaten to touch the match to the powder keg that triggers a recessionary explosion. For now, in light of that risk—especially as it pertains to economically sensitive commodities, HAI suggests patience, relatively light position sizing in select hard assets, and elevated cash. Cash offers protection on the front end of recession and the dry powder optionality to take full advantage of the best opportunities that develop on the way out. When markets begin to reprice toward recessionary reality, look to deploy that cash by further legging into generational hard asset opportunities in the best-positioned regime change assets. Crisis is a process, and so are the regime changes that follow. Both the process of crisis and regime change are underway. Amid the risk, opportunity builds.
Weekly performance: The S&P 500 was up 0.87%. Gold gained 0.43%, silver was up 0.68%, platinum was down 4.27%, and palladium dropped 6.07%. The HUI gold miners index was little changed, up 0.15%. The IFRA iShares US Infrastructure ETF was down 0.62%. Energy commodities were volatile and mixed on the week. WTI crude oil lost 1.40%. Natural gas was nearly flat, up 0.8%. The CRB Commodity Index lost 0.97%, and copper dropped by 2.26%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.08% on the week, while the Vanguard Utilities ETF was down 1.05%. The dollar was off 0.15% to close at 101.40. The yield on the 10-yr Treasury lost 13 bps to end the week at 3.44%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager