Defensive—for a Reason – October 21, 2022

Defensive—for a Reason – October 21, 2022
Morgan Lewis Posted on October 22, 2022

Defensive—for a Reason

This week, major market indexes in the US recovered from the brink. Commodities were volatile and mixed, the dollar had a rare drawdown, and bonds were utterly crushed as Treasury yields soared to new highs not seen in nearly 15 years. In Asia, the ongoing freefall of the yen forced the Bank of Japan into another currency intervention, and China delayed the publication of anticipated economic data—likely not because of its magnificence. Meanwhile, on an offshore island nation of a different continent, the fallout from the UK’s bond market blow-up led to the second resignation of a British prime minister so far this year. In this case, it was the shortest-tenured prime minister in the nation’s history. Also this week, further indications of escalating economic cold-war dynamics continued between Russia and the West, China and the West, and OPEC+ (Saudi Arabia) and the West. On the domestic economic front, following a report from a Bloomberg Economics team that they now calculate a 100% chance of a recession within 12-months, the highly respected Conference Board recession probability model jumped to 96% as economists now anticipate a US recession and job losses in the coming 12-months. In other words, it was just another typical week by 2022 standards.

Despite the widespread gloom, with the S&P 500 finding support on the 200-week moving average last week, the technical case for a bear market relief rally in the near-term is viable. This week, JPMorgan’s trading desk summed up the (perhaps less than inspiring) equity bull-case perfectly, “nothing good going on out there and long term we’re headed lower, but our trading view has changed a bit…we think…you can now buy (trade) the dip. Seasonality is now on your side, retail flows seem to have stabilized, and every hedge fund and mutual fund is positioned defensively.” Fair enough, and, as stated, we currently have a window for a relief rally with the potential for some further legs, but with an offshore-and-incoming mega-tsunami of economic pain looming, wisdom dictates that technicals, seasonality, sentiment, and positioning take backseat secondary consideration to macro reality. Over the last week, short-term traders and intraday options players have indeed aggressively jumped in to swim with the sharks, but for asset allocation beyond the fleeting moment, consider that, perhaps more so than at any other time in recent market history, “every HF and mutual fund is positioned defensively” for a reason.

The high rate of consumer price inflation and its torturous persistence is taking an increasingly significant and apparent toll on consumers. According to a Bloomberg report this week, as savings rates continue to plummet and real “inflation adjusted” wages fall, over half of working Americans have now considered holding multiple jobs to pay their living expenses. About 38% of workers have looked for a second job, while an additional 14% have plans to do the same. Meanwhile, 18% of working adults said they had moved to an area with a lower cost of living to cut expenses, while another 13% plan to do the same. According to the Brookings Institute, working parents, in particular, are in the crosshairs of the inflation “tax.” The latest Brookings study found that about 70% say their pay isn’t keeping up with rising expenses. Brookings estimates that the current spike in prices means it now costs more than $300,000 to raise a child to age 17, up $26,000 since inflation took hold. The evidence now mounting of an overly stretched consumer carries ominous implications for economic growth going forward in a 70% consumer-spending driven economy. Especially one in which, typically, Americans punch well above their weight.

So, inflation is increasingly threatening economic growth, but that’s not the full story. The cost of borrowing is now also rising significantly as interest rates surge. The effects hit both the consumer and corporate economy. The negative impact of the initial interest rate hikes from many months ago is now just starting to bite. The vast majority of the total rate hikes completed to date, however, given the lag-time to impact, have yet to hit the economy with full force. This heavy damage is on its way, though, and will be increasingly obvious in the months ahead. Even if the Fed paused now, the recessionary writing is on the wall. That said, to add insult to injury, another jumbo 75-basis point hike is already teed-up as a near lock in November.

This week added further confirmation that the negative economic impact of higher rates is starting to manifest. The critically important housing market has seen the most pronounced effects so far of the Federal Reserve’s aggressive rate hike warpath. Mortgage rates have more than doubled this year, and as of Tuesday the average 30-year fixed rate reached a whopping 7.15%, the highest level since 2006. The resulting rate-shock is starting to flash-freeze the housing market. Buyers have evaporated, sales of new and existing homes have tumbled by roughly 25% since January, and mortgage applications have absolutely plunged. This week, the Mortgage Bankers Association reported that mortgage demand has declined to a level not seen since 1997. The MBA said demand fell 4% for the week and 38% Y/Y. Refinance applications dropped 7% from the week prior and 86% Y/Y.

With the market seizing-up, homebuilder confidence is crashing. On Tuesday, the National Association of Home Builders/Wells Fargo Housing Market index dropped eight points, well below expectations, to a 38 reading for the month. October was the 10th straight month of declines. Homebuilder confidence has now almost reached covid lockdown lows, and with the exception of the brief, understandable plunge during the spring of 2020, this was the lowest reading in over a decade, and is consistent with levels that followed the collapse of the 2000s-era housing bubble. Not surprisingly, the Commerce Department said on Wednesday that housing starts fell 8.1% Y/Y last month, and added that data for August was revised lower. It certainly wasn’t a good week on the housing market front. Market fundamentals in the sector are deteriorating far faster than expected. The implications are two-fold. First, a seizing-up of activity in this vital sector delivers an outsized hit to the broad economy. Second, as a highly rate sensitive leading economic indicator, the sudden housing market breakdown foreshadows what may be in store, over time, for the rest of the economy.

Like housing, the automobile industry is another rate-sensitive leading economic indicator. It often serves as a canary in the coalmine signaling pending economic trouble more broadly. Unfortunately, this week the auto-land canary was singing the same tune as its housing market cousin. As Bloomberg reported Wednesday, “The clouds over the US car industry darkened further on Wednesday after auto-lending giant Ally Financial Inc.’s disappointing third-quarter results showed fewer people than expected took out new loans to buy vehicles.” Of the Q3 results, the Vital Knowledge newsletter wrote, “Ally is among the largest auto lenders in the country—if credit is cracking, this is just the latest giant red flag for the whole auto complex.” HAI would extend the point to add that if credit is cracking, this is just the latest massive red flag for our entire credit bubble economy.

In commodities, a broad-based risk-on sentiment and relief rally generally offered price support in the complex, while, simultaneously, another across-the-curve surge in US Treasury yields provided counterbalancing headwinds. The biggest move in the sector was in natural gas, where the US price crashed 23.15%. As stockpiles continue to build at a faster-than-expected pace, and production continues to increase, tightness in the market is easing. As a result, prices are now mired in their longest weekly losing streak since 1991. Total stocks have risen to 3,342 billion cubic feet to trail the five-year average by only 5%, compared with 17% back in April. European gas prices are also crashing, and are demonstrating the impact of demand destruction on a previously supply constrained market. Obviously supply remains a huge intermediate and long-term issue, but as both consumers and industry have cut demand significantly, supply concerns have been eliminated for a six-month horizon and prices have more than halved off of highs.

Meanwhile, WTI Crude is in a perfect mess. It suffered small losses on the week, but closed right in the middle of its recent range—from a little under $80 to a little over $90 per barrel. WTI prices are being heavily pressured by recession concerns and the accompanying risk of significantly increased demand destruction, while at the same time supply concerns are spiking. For many months, the US has been aggressively dumping oil from the country’s Strategic Petroleum Reserve onto the market to keep prices subdued. At this point, however, with the SPR at its lowest levels since the mid 1980s, the script is about to flip as the US will soon need to replenish reserves. When it does, an important seller in the market will become a significant new buyer. At the same time, the market is trying to gauge the impact of new OPEC+ production cuts starting next month.

In the great financial crisis, gold and gold mining stocks bottomed in October of 2008. Both bottomed before copper, before oil, and before the S&P 500, which didn’t find footing until March of 2009. So, just as you buy insurance ahead of a storm, similarly, one can look to leg into gold as insurance ahead of broad market wreckage. Outside of gold and a few select “special situation” commodities, however, when looking for optimal entry points into other risk assets, it’s best to wait for the incoming recessionary tidal wave to finally crash ashore.

While this bear market’s path to conclusion will be predictably uncertain, with rallies, curveballs, and changeups along the way, HAI agrees with Jeremy Grantham’s assessment that we are witnessing the evolving collapse of a super-bubble.

Grantham equates the unfolding process to a play with multiple acts, one that always begins with a major turning point in the economy. In our case, act one began when, in the context of history’s greatest credit bubble, breakout non-transitory consumer price inflation finally emerged to grip the world like a vice. It set dominos in motion, and was the catalyst destined to eventually produce a pin with the punch to potentially pop the bubble. Price stability was the casualty of inflation and the first domino to fall. The outbreak of inflation and resultant rude end for price stability then triggered a massive change in central bank policy—a response that toppled the second domino, the prevailing “super-accommodative” monetary policy setting, which was a setting necessary to keep the bubble inflated. At present, inflation and the fastest pace of monetary policy tightening in decades are both careening into a final domino—global economic growth. Economic data inevitably lags major turning points in the economy, but based on a broad set of leading economic indicators, this final domino now appears poised to hit the canvas by the second quarter of next year. This seemingly imminent recessionary rug-pull of growth from underneath the global economy is set to inflict significant further pain to financial markets and risk assets.

When the recession hits, depending on the nature and efficacy of an aggressive coordinated emergency policy response on the part of central banks and global policy makers, it threatens to initiate the final act in our super-bubble saga. If the recession is uncontained, it will put the pin to the bubble with the very real risk that recession turns depression. HAI sincerely hopes that wisdom, skill, and luck mercifully avert such an outcome. That said, returning to Grantham’s analogy of a play with many acts, the market hall-of-famer warns that if the history of super-bubbles repeats, “the play will once again be a tragedy…prepare for an epic finale.”

Weekly performance: The S&P 500 was up big by 4.74%. Gold was increased modestly by 0.45%, silver added more substantial gains on the week, up 5.53%, platinum was up 4.36%, and palladium gained 0.41%. The HUI gold miners index significantly outperformed physical, jumping 6.85%. The IFRA iShares US Infrastructure ETF gained 4.74%. Energy commodities were lower on the week. WTI crude oil was down 0.65%, while natural gas was crushed, down 23.15%. The CRB Commodity Index was off by 1.56%, while copper was up 1.46%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 2.04% on the week, while the Vanguard Utilities ETF (VPU) was higher by 1.84%. The dollar dropped by 1.08% to close the week at 111.98. The yield on the 10-yr Treasury surged higher by 21 bps to end the week at 4.21%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist

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