Great Expectations & What Isn’t Priced In?
The major market event this week was still the same major market event of last week. In this week’s light holiday trading, the market was still processing the hangover from last week’s big FOMC event, Jay Powell’s all-but policy pivot 2.0 towards unveiling a red-carpet welcome mat for the next policy easing cycle in 2024. So, what happened to the need for tight financial conditions that was the official mantra as recently as December 1st? Well, according to HAI favorite market commentator Jim Bianco, when WSJ reporter Nick Timiraos essentially asked Powell that very same question at last week’s FOMC presser, Bianco said Powell was “asked a question that he doesn’t have an answer for.”
This week, Bianco added comments underscoring the dangerous game Powell and the Fed are now playing. As Bianco put it, “be careful what you wish for. Yes, it’s an election year. Yes…I can’t prove it, it’s just my opinion…that these members are pushing the Fed to be more dovish, going into an election year. And I get it. But if that winds up over stimulating the economy, and winds up making inflation stickier than people think, this isn’t going to work. You’re going to wind up with the wrong reaction out of financial markets, and the wrong reaction out of the economy… Bear in mind that the Fed got the inflation story with transitory completely wrong in ’21. Then they got the forecasts for the economy completely wrong in ’22. So, here we are, at the end of ’23, and they’re going to basically bet their reputation that they’re going to get their ’24 forecasts correct, that the inflation problem is behind us, that the economy is going to moderate to a soft landing? That all of that will work out for them to cut interest rates?”
Bianco is on point. His observation rhymes with HAI’s concerns that, like it or not, policymakers are post-Goldilocks and have instead transitioned to the new reality of policy Whac-A-Mole. Policymakers at this point can attempt to address one problem, but only at the cost of inflaming other key problems. Right now, the Fed has a three-headed monster (at least three heads) staring them immediately in the face: inflation, a debt and deficit doom-loop, and leading economic indicators pointing to incoming recession on the horizon. Perhaps Bianco is correct that politics in an election year is impacting Fed decision-making, but HAI would suggest that more importantly we are watching concerns over the negative impact of higher interest rates on deficits and a possible future recession begin to trump the benefits of higher rates in reducing inflation. In short, as Bianco said, “be careful what you wish for.” There are a lot of ways the current Fed gamble can go very wrong.
As HAI suggested last week, the November deficit data may be the best explanatory factor for the Fed’s sudden change in direction. Historically, when “true interest expense” (interest expense + entitlements) exceeds 100% of tax receipts, that’s a crossing of the insolvency Rubicon. It’s when policymakers are forced to take note.
Well, as of the latest November deficit numbers, we’re now at a new post-Covid crisis high with true interest expense at 125% of tax receipts. As a result, as HAI suggested last week, that November deficit data sure looks like it was a highly impactful lump of coal in the FOMC’s December stocking. This isn’t just conjecture. A Bloomberg article from the day before the latest FOMC meeting testifies that the negative impact of higher rates on the deficit and recession outlook are indeed crowding out concerns over inflation. The Bloomberg headline read, “Yellen: Rising Real Rates May Impact Fed Decision on Rate Path.”
Keep in mind that average government interest expense paid on debt lags in a rising interest rate environment as it takes time for debt refinancing to push aggregate interest rates paid on debt to higher levels. At present, we are at only 3.1% on government debt while the Fed funds rate still stands at a 5.25%–5.50% range. Without committed policy easing to bring interest expense lower on a lag, the tendency will be for still-higher interest expenses over-time—from what are already highly problematic levels.
If HAI is correct, that the reality of rapidly accelerating unsustainability in budget deficit dynamics is forcing its way into current policymaking decisions, we should expect to see the recent Powell pivot 2.0 become actual policy easing in 2024, all else equal. This is so despite the fact that inflation was never tamed to the 2% target, and policy easing will likely reaccelerate already above-target rates of inflation as we get deeper into 2024. This is what recent HAI’s have referred to as the new policy Whac-A-Mole dynamic in action. Policymakers can attempt to address one problem, but only at the expense of exacerbating other key problems.
At present, market pricing revolves around expectations for Goldilocks. As a reminder, Goldilocks can be loosely defined as some simultaneous combination of maintained economic growth, low-interest rates, low government interest expense, fiscal sustainability, low inflation, and stable bond and currency markets. Currently, financial asset pricing reflects broad confidence on the part of market participants that policymakers will deliver a return to Goldilocks in full.
If the recent Powell pivot 2.0 is implemented as premature policy easing in 2024, and HAI’s expected unintended consequences manifest with it, that is a massive problem for the Goldilocks thesis. By extension, it’s also a massive problem for the confidence bubble and the current bubble-like pricing of financial assets.
However, the recent Powell pivot 2.0 might also be an attempt to jawbone market-based financial conditions towards easing (a manufactured bond rally that significantly lowers yields) without any intent to actually implement policy easing. If so, then recent market enthusiasm for easier policy to come will have to be unwound, and both the spiraling debt and deficit trajectory and recession risks will have to be taken into account anew.
Consider this fascinating Bloomberg article from last week titled, “Blistering UST rally quiets deficit-obsessed vigilantes.”
Following the recent rally in Treasurys and drop in yields, Bloomberg writes: “So what happened to all the hand-wringing about reckless government spending and the ballooning national debt? Sure, the bond rally was sparked by a different development—speculation the Federal Reserve will start cutting interest rates next year—but still, the tough vigilante talk disappeared rather abruptly.
“The ‘vigilantes will be back,’ Yardeni, the founder of Yardeni Research Inc., said in an interview. The surge in government spending in recent years and the jump in interest rates is creating a dangerous fiscal mix, he said. ‘This is not an issue that will go away unless it’s fixed. If anything, the deficit outlook is probably worse than is being anticipated.’
“Fitch estimates the government will post a deficit…larger than any posted in the six decades before the global financial crisis. That it comes amid a year of strong economic growth—which tends to lift revenue and hold down expenses—makes it all the more jarring.”
Ed Yardeni (whom Bloomberg quotes in the article) is a perennial mega stock-bull. That Yardeni, of all commentators, is suggesting that the “vigilantes will be back” because “this is not an issue that will go away unless it’s fixed” should make the hair on the back of the neck of all stock market bulls spike like a popped collar.
That cause for concern is especially reinforced when considering Yardeni’s comments in the context of what Nathan Sheets, the global chief economist at Citigroup, had to say in the Financial Times two week ago. As HAI mentioned last week, Sheets described a financial environment defined by “heightened concerns about fiscal sustainability,” and added that what’s needed just to ease the problem (let alone fix it) is a combination of higher taxes and spending cuts that are “unlikely to happen.” He then added that, even if tax hikes and spending cuts could be agreed upon, “the headwinds to growth that would likely accompany fiscal retracement are a further source of reluctance.”
So again, we’re now playing Whac-A-Mole at best while the walls are closing in and the sand in the hourglass runs out. The Fed can broadcast assurances for future policy easing to jawbone a drop in yields, but unless it is backed by an actual policy easing cycle, the dop in yields will prove only too temporary. As soon as yields rebound, deficits, fiscal solvency, recession concerns, and a confidence crisis will come flooding right back. If, on the other hand, the Fed backs up policy easing talk with policy action and an actual premature easing cycle, we’ll face a reaccelerated inflation problem and the same confidence crisis from a different angle. Again, Goldilocks of yesteryear, meet the Whac-A-Mole reality of today. Houston—we have a problem.
As for an update on those future recession concerns, the leading economic indicators are still shouting “batten down the hatches, a recessionary storm is coming.” Just this week, the Conference Board Leading Economic Index (LEI) recorded its 20th straight monthly decline (now only two months shy of the all-time record decline streak set during the great financial crisis) and also recorded a 14th straight month with the lead index below the -4.5% recession threshold that has perfectly predicted eight of the last eight recessions.
In addition, just as the Conference Board was releasing its disappointing economic news, the Philadelphia regional Fed bombed expectations as the release of their latest December Business Outlook survey (among the most reliable regional Fed surveys) came in at -10.5 vs. estimates for -3.0, and down sharply from the previous -5.9 reading. So, despite optimism for notable improvement, we instead had distinct weakening. Worst of all, the Philly Fed’s highly leading cyclical gauge of manufacturing new orders was slammed back to near-cycle lows.
Caught between a rock and a hard place, recent strength in gold prices and repeated breakout attempts seem to be keying off all of the above-mentioned dynamics. As such, 2024 could well be a pivotal year for a collapse in policy confidence and, conversely, a resulting surge in the price of golden financial insurance.
In short, if confidence in a plausible perpetual Goldilocks thesis is about to transition into acceptance of unsustainable policy Whac-A-Mole, then the seeds of unsustainability sowed over decades will flower in 2024, and the prescient words of economist Henry Hazlitt will be fulfilled: “Today is already the tomorrow which the bad economist yesterday urged us to ignore.”
Furthermore, despite continued expected volatility, gold holders may be wise to hold tight to their golden financial insurance given that, as economist Peter Bernholz recently reminded us, “When a confidence bubble finally breaks, it tends to break abruptly.”
Just this week, in fact, Société Générale legend Albert Edwards warned of a similar risk to current bubble dynamics, albeit from a slightly different vantage point. After stating that he understands “all the arguments” as to why the current market moment is sustainable, the always colorful market veteran said, “but you know what, I’ve been doing this job for 40 years and I’ve heard it all before.” As Edwards continues, he elaborates that if he had to warn of “one seismic shock for 2024 that would shake investors to their core, it is not whether the US or China does or doesn’t go into recession or if inflation and interest rates are a bit higher or lower than expected. No, the biggest surprise that could send a shockwave through portfolios is the US IT market cap bubble bursting and tipping the entire US market into a slump.”
If one replaces “the US IT market cap bubble” with HAI’s concern over a bursting financial asset bubble (the two are almost one and the same) then HAI is in good company with concerns over a bursting bubble in 2024.
What bubble? As Edwards describes it, “2024 begins with the US tech sector accounting for as much of the US broad market index as it did for a few months of madness in the summer of 2000.” As Edwards (and HAI, for that matter) sees it, that’s a problem. As recently as the end of 2018, US tech was trading at only a slight valuation premium relative to the overall market. Today, that valuation has stretched to a gargantuan 7x premium. To be sure, plenty of great expectations are priced into current financial asset prices. The best question for investors heading into 2024, however, may be: What isn’t priced in?
Now, on this last opportunity before the best day of the year, HAI will give just a little bit more:
… And the Grinch put his hand to his ear.
And he did hear a sound rising over the snow.
It started in low. Then it started to grow.
But the sound wasn’t sad! Why, this sound sounded merry!
It couldn’t be so! But it WAS merry! VERY!
He stared down at Whoville! The Grinch popped his eyes!
Then he shook! What he saw was a shocking surprise!
Every Who down in Whoville, the tall and the small,
Was singing! Without any presents at all!
He HADN’T stopped Christmas from coming! IT CAME!
Somehow or other, it came just the same!
And the Grinch, with his grinch-feet ice-cold in the snow,
Stood puzzling and puzzling: “How could it be so?”
“It came with out ribbons! It came without tags!”
“It came without packages, boxes or bags!”
And he puzzled three hours, till his puzzler was sore.
Then the Grinch thought of something he hadn’t before!
“Maybe Christmas,” he thought, “doesn’t come from a store.”
“Maybe Christmas…perhaps…means a little bit more!”
And what happened then? Well…in Whoville they say,
That the Grinch’s small heart grew three sizes that day!…”
From the bottom of HAI’s heart: “Happy Christmas to all, and to all a good-night!”
Weekly performance: The S&P 500 gained 0.75%. Gold was up 1.64%. Silver gained 1.74%, platinum added 1.86%, and palladium was up 2.15%. The HUI gold miners index gained 3.90%. The IFRA iShares US Infrastructure ETF was higher by 0.93%. Energy commodities were volatile and mixed on the week. WTI crude oil was up 2.94%, while natural gas was off 1.28%. The CRB Commodity Index was up 0.57%, and copper was gained 0.26%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.09%. The Vanguard Utilities ETF was down 0.92%. The dollar index was off 1.22% to close the week at 101.34. The yield on the 10-yr U.S. Treasury lost 2 bps to end the week at 3.90%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager