Goldilocks – Between a Rock and a Hard Place – March 1, 2024

Wealth Management • Mar 02 2024
Goldilocks – Between a Rock and a Hard Place – March 1, 2024
Morgan Lewis Posted on March 2, 2024

Goldilocks—Between a Rock and a Hard Place

The artificial intelligence (AI) themed, perpetual-Goldilocks inspired Wall Street bubble-bash continued to push financial asset prices further into record high territory this week.

But, as last week’s HAI put it, beware the magician and his sleight of hand. When the crowd is captivated by the bright and shiny object in one hand, the best question is often, what’s the crowd missing in the other hand?

Hype over artificial intelligence (AI) and the perpetual-Goldilocks narrative have certainly combined to provide Wall Street with a captivating bright and shiny object. The party is enthusiastically “on” for financial asset prices, but the Goldilocks narrative powering the rally is beginning to unravel.

At this point, its bubble momentum and FOMO-turned-POMO dynamics are driving further market gains. Those dynamics can continue to power markets higher—for a time—but they eventually run their course and reverse at extremes. We appear to be rapidly approaching those extremes, so the stock market is highly vulnerable to a reversal.

Market technicals and sentiment remain strongly compatible with very late-stage rallies and market tops. The VIX continues to diverge against the S&P’s new highs, and CNN’s Fear and Greed Index has been pinned at Extreme Greed for the past week and a half. As far as financial asset valuations, recall John Hussman’s recent warning that, according to his “most reliable valuation measures,” “current market conditions now ‘cluster’ among the worst 0.1% instances in history—more similar to major market peaks and dissimilar to major market lows than 99.9% of all post-war periods.”

As last week’s HAI pointed out, and it is worth repeating, the set-up is eerily similar to 2000. Back then, investors’ attention and money were completely focused on the bright and shiny stock beneficiaries. In the magician’s other hand? Then, as now, the other hand featured alternative sectors completely abandoned by hot-money FOMO investor flows.

But unlike bubbled-up financial assets skating on a narrative as thin as ice (at the 99.9th percentile of historically high valuations), alternative hard asset sectors are poised for a significant positive narrative change whenever reality resurfaces on Wall Street, while remaining at deeply depressed valuations. In 2000, it paid handsomely not to fall victim to the bright and shiny object, but rather to focus on the alternative opportunity in the magician’s other hand. HAI suspects this time will be no different.

In HAI‘s view, at the tip of the spear of alternative hard asset opportunities are precious metals and, specifically, precious metals mining stocks. Currently, the discrepancy between the low price of the gold miners’ index relative to the higher price of physical gold is at an historic extreme. The depressed ratio of the price of mining stocks to physical is now just a hair above the record low reached at the end of 2015. That extreme marked the 2015 precious metals sector bear market low. Following that extreme, in the span of just over seven months, the gold mining index rallied 189% vs. physical gold’s 30% gain. In HAI‘s view, given that the best-in-class gold miners are in far better fundamental shape today (night and day), and have far more conservative reserve price assumptions, the 2015 analog for the miners could be a mere appetizer for the entrée to come.

In HAI‘s view, all we are waiting for is a sustained breakout into new all-time high territory for the price of gold—and we expect just that. Let’s examine why.

In short, inflation is still alive and well, but policymakers look increasingly likely to cut interest rates into that elevated inflation anyway. If they do, cutting rates into an existing inflation problem is a perfect recipe for dramatically higher gold prices.

This week offered the latest confirmation that inflation is a problem—one far from solved. The last CPI report had the Fed’s preferred core services ex-housing reading 10.67% annualized. This week, the same core services ex-housing inflation number in the PCE inflation report also came in extremely hot at an accelerated 0.6% month-over-month rate. That was the highest reading since December of 2021, and annualizes to a searing 7.2% rate. Again, these are the two measures the Fed claims to care most about. They are both reaccelerating higher, far beyond the Fed’s 2% target, at levels not even in the ballpark of “price stability.”

In addition, Saudi Aramco CEO Amin Nasser recently corroborated HAI‘s concern over tightening supply dynamics, supporting the risk that higher energy prices could further inflame inflation. Recent HAIs have highlighted significant increases in shale production decline rates (shale is responsible for 90% of global production growth over the last decade) as a materially negative supply-side factor. The decline rates are particularly significant because offsetting increases in cap-ex spending are not expected in 2024.

Aramco’s Nasser, however, expanded the scope of the problem, citing 7% decline rates for total existing conventional and unconventional resources globally amid a 40% decrease in industry cap-ex investment from 2014 levels. That’s a cocktail for concern that global oil supply will fail to match demand. Unless we have a sharp global recession or a change of heart from OPEC+ on their production cuts, the tightening oil supply/demand dynamics flip the oil price risk to the upside—and the inflation risk right along with it.

At the same time, gas prices have already begun to rally meaningfully over the last month and a half. Additionally, inflation base effects through next autumn will make further year-over-year progress on inflation very difficult.

Lastly, the Bloomberg financial conditions index is already signaling financial conditions among the loosest seen in two decades outside of the immediate aftermath of the explosively loose policy response to both the great financial crisis and Covid. Historically, financial conditions this loose highly correlate with increasingly hot inflation data—on a lag.

But inflation isn’t the Fed’s only concern. In December, the National Bureau of Economic Research (NBER), the same organization tasked with declaring official recessions, released a working paper titled “Monetary Tightening, Commercial Real Estate Distress, and U.S. Bank Fragility.” In the paper, the NBER outlined the risk to the banking system stemming from the “higher for longer” interest rate policy. The paper focused specifically on the banking stress potential that could emanate from the Commercial Real Estate (CRE) sector.

Crucially, the NBER findings are based on several key assumptions that obscure an even greater risk potential. According to the NBER, “First, we only focus on CRE distress, and we do not account for potential distress affecting 17 other types of bank loans… Second, in all our calculations we assume that bank assets are liquid. If uninsured deposit withdrawals cause even small fire sales, substantially more banks would be at risk.” The NBER then goes on to add that, “as the regional banking institutions play an important role in lending to local businesses, their distress could lead to a credit crunch with adverse effects on the real economy.”

The NBER went on to state that their analysis “suggests that as long as interest rates remain elevated, the U.S. banking system will face a prolonged period of significant insolvency risk.” The NBER continued that while in the near term the creation of the Bank Term Funding Program in March 2023 together with other policy responses to the recent banking vulnerabilities “may put a pause on the crisis,” “these are temporary measures that do not really address the fundamental insolvency risk identified, which, as we show, the CRE distress would only make worse for a non-trivial set of banks.”

In short, the NBER found that the impact of higher interest rates for longer would translate to significant CRE losses for banks. “Due to these losses, up to 482 additional banks with aggregate assets of $1.4 trillion would have their mark-to-market value of assets below the face value of all their non-equity liabilities.”

Now, of crucial importance, over the last two weeks, CRE stress has started to intensify again. According to the FT, “Bad commercial real estate loans have overtaken loss reserves at the biggest US banks after a sharp increase in late payments linked to offices, shopping centers and other properties.”

The FT continued, “The average reserves at JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley have fallen from $1.60 to 90 cents for every dollar of commercial real estate debt on which a borrower is at least 30 days late, according to filings to the Federal Deposit Insurance Corporation.”

Critically, these aren’t small regional banks the FT is flagging. On the contrary, now it’s the Too Big to Fail (TBTF) behemoths that are getting caught in the CRE quicksand. That’s an extremely important development with numerous complicating implications for the banking sector, the economy, the Treasury market, and the Fed.

If high interest rates are crippling the CRE market to the point that bad loans are overtaking loan loss provisions, then banks will need to raise capital to increase loan loss reserves. That means selling Treasurys into an already stressed and relatively illiquid Treasury market. The impact would likely pressure interest rates higher and further the underlying banking stress, as well as exacerbate the U.S. government’s fiscal “situation” that’s really a crisis in disguise, waiting to be unmasked.

Making matters worse, distress is growing in other loan markets as well, not just the CRE market the NBER white paper was solely focused on. Delinquency rates at credit unions, on consumer credit cards, and on auto loans are also accelerating to the upside. In fact, this week Bloomberg picked on auto-land specifically. Bloomberg noted that, “Access to auto credit is the lowest since August 2020, with the approval rate for loans down 1.6 percentage points year-over-year, according to Cox Automotive. At the same time, the percentage of U.S. auto loans 90 days or more delinquent rose above pre-pandemic levels to 2.66% in the fourth quarter of 2023, according to data from the New York Federal Reserve. That compares to 2.37% at the beginning of 2020 and a 15-year average of 2.16%.” Now, the big pushback to any concerns over rising delinquency rates has been that they had been rising from very low levels. But as the Bloomberg article makes clear, in the auto market, those still spiking delinquency rates are now increasing from levels already well above the 15-year average.

The conclusion of the NBER’s findings is the real kicker. It serves as both a prescription and a warning. As the NBER put it, “a significant decline in interest rates would largely eliminate the consequences of CRE distress on bank stability. [However,] this fragility of the US banking system to higher rates can significantly constrain the conduct of monetary policy, adversely affecting its price stability objectives.”

In HAI‘s view, the message is clear: monetary policy as we’ve known it is now materially compromised. The Fed’s interest rate monetary policy setting is too tight for the CRE market, and, by extension, too tight for the banking system, the credit system that feeds small businesses and the economy, and the all-important Treasury market. On the other hand, interest rates appear too low and financial conditions too loose to continue forward progress on lowering inflation.

With inflation still alive and kicking while other systemic stresses due to high interest rates are reemerging and intensifying, the Fed has run out of runway to postpone a definitive policy choice. It must choose to live with inflation or live with the consequences of fighting it—insolvency threatening both the private and public systems. Right now, it’s the 2% inflation target that looks most likely to be sacrificed on the altar of TBTF banks, financial and bond market stability, and slow walking the fiscal crisis.

This week, the market appeared to recognize the choice. Tellingly, despite the highly uncooperative recent inflation data and the increasingly inflationary outlook, the market increased its bets on rate cuts. In other words, the market is starting to appear more confident that the Fed will choose a significant decline in interest rates to reduce distress and instability—at the cost of an unresolved inflation problem. Again, the current Goldilocks narrative looks increasingly set to fail.

The situation appears exactly as the NBER warned in December: the “fragility of the US banking system to higher rates” is significantly constraining the conduct of Fed monetary policy, and it is likely to be “adversely affecting its price stability objectives.” Welcome to the narrow space in which policymakers now live—it’s a snug spot between a rock and a hard place.

As former Treasury Secretary William E. Simon famously said, “the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it.” Unfortunately, the risk is extremely high that while Wall Street loves the rate cuts, loose financial conditions, and a booming stock market casino, Americans may be just about to reap the rebound in the inflation tax they hate.

Cutting rates into an inflation problem is a perfect recipe for higher gold prices. If Powell’s Volker act turns Arthur Burns 2.0-plus—with rate cuts amid elevated inflation—expect gold, in its post-Bretton Woods role as financial insurance against policy malpractice, to make the definitive break higher.

At that point, HAI expects the move in physical precious metals to catalyze an epic surge higher in the best-positioned precious metals mining companies. With gold surging back to the upside to test highs again late this week in response to the increased risk of rate cuts into an inflation problem, we may not have much longer to wait.

In the context of the current market set-up, it’s worth remembering the old saying that “you never need patience more than when you’re about to lose it.” So remain patient and keep a close eye on the magician. The sleight of hand is at work, just as the Fed and Goldilocks are caught between a rock and a hard place.

Weekly performance: The S&P 500 gained 0.95%. Gold gained 2.26%, silver was up 1.65%, platinum was off 2.37%, and palladium lost 2.63%. The HUI gold miners index gained 2.02%. The IFRA iShares US Infrastructure ETF was up 2.17%. Energy commodities were volatile and up on the week. WTI crude oil jumped 4.55%, while natural gas registered a second consecutive up week and an 8.00% gain. The CRB Commodity Index added 2.32%. Copper lost 1.03%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 2.65%. The Vanguard Utilities ETF was nearly flat, down 0.04%. The dollar index was down 0.06% to close the week at 103.8. The yield on the 10-yr U.S. Treasury lost 7 bps to close at 4.19%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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