Inflationary Fire or Recessionary Ice
This week was relatively calm for markets and uneventful on the economic data calendar. These were welcome and merciful developments from the perspective of this author. Yours truly has been hit hard by a sickness that stubbornly and frustratingly just won’t let up. As a result, HAI will be brief this week.
While it was a relatively calm week, it wasn’t inconsequential. Top Wall Street economist David Rosenberg likes to say that if he were stranded on an island with only one economic indicator, “it would be the yield curve.” This week, the 2s10s yield curve hit a new extreme level of inversion not seen since April 1981. The last time the curve was this inverted, the US was three months away from the infamous 1981 “double-dip” recession, and every inversion since then has correctly foreshadowed a rising unemployment rate and incoming recession. Singing the same recessionary tune, along with a laundry list of other economic indicators with excellent historical track records, the Morgan Stanley US economic cycle indicator this week flipped to “downturn” for just the fourth time in recent decades. The three prior downturn signals accompanied the Covid recession, the Great Financial Crisis, and the dot.com bubble crash.
Meanwhile, as former Treasury Secretary Larry Summer put it this week, inflation is still running hot at levels that would have been “unimaginable” just two years ago. To make matters worse, a number of factors, including China’s reopening and accompanying economic stimulus, are currently conspiring to slow further progress on inflation. The dynamics continue to have the Fed caught squarely between a rock and a hard place. If they give up on the inflation fight to save markets, the economy, and the government’s worsening fiscal situation, the Fed invites an incendiary calamity. Finish the job on inflation with higher rates for longer into an economic downturn and a deeply inverted yield curve, and the Fed invites the hardest of hard landings.
Let’s highlight the broad strokes emergent this week. The market appears to be showing signs of giving both persistent inflation and the inverted yield curve some credit. This week, the market was questioning the popular Goldilocks scenario in which an economic soft landing and renewed bull-market emerge from a combination of still resilient growth, “immaculate disinflation,” and an imminent end to the Fed tightening cycle.
Reflecting this questioning of the viability of Goldilocks, financial conditions across the board showed initial signs of tightening this week. The dollar gained for the second consecutive week, yields were up across the curve, the VIX volatility “fear gauge” jumped 12% to close back above $20, and stocks dropped. Most importantly, the market is giving the threat of further Fed rate hikes more credit. This week, the market’s terminal-rate expectations for the fed funds rate jumped by 35 bps.
These tightening developments are all relatively slight. However, they seem to reflect mounting evidence and some increased market recognition that the Fed’s inflation fight may not be the swift and glorious conquest markets have hoped for, but rather a protracted quagmire. Such a scenario would drive rates higher for longer and keep the threat of a hard landing very much alive.
This week, in a very consequential data release, the recessionary hard landing scenario was significantly bolstered by the latest findings of the Fed’s Senior Loan Officer Opinion Survey. Senior loan officers at banks reported significant further tightening of lending standards and constriction of bank credit availability. These data points are now at extremes that have occurred only in the midst of recessions or systemic crisis. The tightening extended across the board, and included commercial and industrial loans, commercial real estate loans, residential real estate loans, mortgages, credit cards, and auto loans. Credit availability leads economic growth, and unless offset elsewhere, the degree of bank tightening is the latest evidence suggesting the US is either already in recession or about to head into one.
Furthermore, both high yield bond default cycles and commercial and industrial loan charge-off spikes follow tightening lending standards with remarkable consistency on a three to nine month lag. These phenomena have occurred without exception over the past 35 years. If history repeats, we could be months away from a credit event.
Meanwhile, consumer sentiment has been and remains deeply recessionary. Indeed, 21 straight months of negative real “inflation adjusted” wages and a savings rate hovering around the lowest levels seen in data going back to 1959 will tend to set a recessionary tone. This week, University of Michigan Surveys of Consumers Director Joanne Hsu provided a good synopsis of the consumer backdrop at our current critical economic juncture. Director Hsu explained, “Consumer sentiment was essentially unchanged at 1.5 index points above January… Overall, high prices continue to weigh on consumers despite the recent moderation in inflation, and sentiment remains more than 22% below its historical average since 1978. Combined with concerns over rising unemployment on the horizon, consumers are poised to exercise greater caution with their spending in the months ahead.”
Remember, American consumer spending, typically punching above its weight, is the prime engine of the economy. It drives 70% of GDP. In addition, at the lower and lower-middle ranges of the income spectrum, the much talked about “excess savings” held by consumers is long gone. By most estimates, the excess savings that remains among higher income consumers is expected to fully evaporate by mid-year.
So, inflation is still a problem weighing on the consumer, excess savings are going or gone, and the consumer sees “rising unemployment on the horizon.” University of Michigan’s conclusion is logical, “consumers are poised to exercise greater caution with their spending in the months ahead.”
With China reopening and its economic stimulus adding demand to tight global commodity supplies, the easy part of the inflation fight is likely over. According to the International Energy Agency, oil demand will likely rise by 1.9 million barrels per day in 2023, bringing total demand to a record high. In the face of this demand, Russia this week followed through on threats to cut production by 500,000 barrels per day in response to Western energy sanctions. At the same time, OPEC+ won’t fill the production gap after cutting production by two million barrels per day last year. Meanwhile, major oil companies still aren’t aggressively reinvesting to grow production, US shale is falling behind, and the US government will soon have to slow draw-downs and eventually replenish the strategic petroleum reserve. Energy is the great inflation force multiplier. A reacceleration higher in oil will throw a tremendous wrench into the inflation fight.
Inflation is still very much a live threat. The Fed can either give up on the 2% inflation target or maintain a higher-rates-for-longer trajectory. Assuming the latter, when adding up the combined interplay of a hawkish and tight Fed, a now undeniably recessionary level of bank lending standards, and an already weakening economy in which consumer spending is set to diminish, the consumer is right to expect “rising unemployment on the horizon.” Taken together, the portrait painted depicts an uncomfortably hard landing. January CPI data set to be released next Tuesday will no doubt further influence expectations. In the short term, it will act to either confirm this week’s repricing of expectations or unwind it. With that said, regardless of next week’s CPI data, the “easy” disinflation period since June’s peak inflation readings is likely nearing an end. Soon the hard part will begin. How the Fed proceeds from here will likely be a powerful influence on whether 2023 is remembered for inflationary fire or recessionary ice.
Weekly performance: The S&P 500 was up 1.62%. Gold was down 0.11%, silver lost 1.47%, platinum was lower by 2.91%, and palladium got smacked lower by 5.78%. The HUI gold miners index lost 3.39%. The IFRA iShares US Infrastructure ETF was down 2.66%. Energy commodities were volatile and higher on the week. WTI crude oil spiked 8.63% while natural gas finally turned higher, up 4.32%. The CRB Commodity Index gained 2.43%. Copper was off 0.99%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 2.04% on the week, while the Vanguard Utilities ETF (VPU) was down 0.64%. The dollar was up 0.77% to close at 103.54. The yield on the 10-yr Treasury surged 21 bps to end the week at 3.74%
Investment Strategist & Co-Portfolio Manager