Interesting Times – June 2, 2023

Wealth Management • Jun 04 2023
Interesting Times – June 2, 2023
Morgan Lewis Posted on June 4, 2023

“May you live in interesting times” is said to be an ancient Chinese curse. HAI doesn’t know about Chinese curses, but is certain that these are interesting times. On the week, stocks surged, bonds were bid, commodities dropped, the dollar was slightly off, while gold popped. Meanwhile, “interestingly,” stock market complacency is fully upon us as the VIX volatility “fear gauge” index clocked its lowest weekly close since the pre-Covid era.

Despite year-to-date-gains in the overall market cap weighted S&P 500 index, the rally in 2023 has really been driven by exceptional strength in what can be described as the “generative AI 5” rather than any contribution from the remaining S&P 495. Most technical measures of stock market internals are raising serious red flags. Under the hood, this market has been weak. Whether it’s advancing volume measures, new highs versus new lows data, advance/decline figures, or trend uniformity among stock indexes, the varying ways to measure the potency of a stock market rally have been weak all year.

Late this week, after a debt ceiling deal was reached in Congress and a better-than-expected headline May U.S. jobs report (the details of the report were far more mixed) was released, markets exuded a palpable sigh of relief and kicked into rally mode. That rally was assisted by messaging from several Federal Reserve speakers that signaled the likelihood of a rate hike pause or “skip” at the June 14th FOMC meeting. So, all told, the rally spark in the market was from a combination of debt ceiling resolution relief and a sense that the labor market may be strong enough for a soft landing/no landing scenario in which inflation subsides as the Fed starts to make a graceful exit from its tightening cycle and risk assets don’t skip a beat. Importantly, in this late-week melt-up, the rally wasn’t just in the AI 5. Breadth was stronger and volume was improved. Also encouraging for short-term price action was that the S&P rally cleared and closed the week well above the 4,200-resistance level that has capped the upside of the index trading range all year. It’s only been a couple of days of improved market internals, but if we can continue to see wider participation in a broad market rally that holds above 4,200 on the S&P, then in the near term the melt-up has further legs.

Beyond the short-term, however, little has changed. By the Fed’s own measure, they are failing on the inflation fight. Last Fall, the Fed projected that they would get core PCE inflation down to 4.2% by now. With core PCE now at 4.7%, core PCE has marginally increased since they made that forecast. So, despite talk of a Fed rate hike pause or skip in June, the data isn’t giving the Fed any firm excuse to lower interest rates just yet. In fact, this week, former Treasury Secretary Larry Summers said that if the Fed doesn’t add a 25 bps hike on June 14th, the FOMC should deliver a 50 bps hike in July. In short, the Fed’s job is getting harder. They know the hard landing damage higher rates for longer will do, on a lag, to the economy. As a consequence of keeping rates high on $31.8 trillion of national debt, they also know what higher rates for longer will do to the ballooning deficit, US balance of payments problem, and Treasury market instability. That said, they have to balance those concerns with the risk that any premature policy loosening while inflation is still high will permanently assassinate their institutional credibility, reveal that monetary policy has no effective brake, and risk unleashing an unhinged and uncontrollable market crack-up if monetary policy takes one dovish step too far.

Speaking of the late 1920s’ stock market bubble and speculative craze, Dr. Benjamin Anderson observed that “Every era of speculation brings forth a crop of theories designed to justify the speculation… We were in a new era in which old economic laws were suspended.” If the market starts to sniff out that Fed monetary policy is already fully broken, and suspects that the Fed will ultimately capitulate and ease policy into still elevated inflation, then that will represent a “new era” in which old economic laws are “suspended” and it will likely fuel unhinged speculative crack-up-boom dynamics. What we are seeing in the AI/tech baby bubble right now bears watching as it may be an early hint that markets are leaning in that direction. At present, there is no definite sign that we’re there yet. The broad market message is very mixed. While the AI/tech sector looks fully speculative and unhinged, a very subdued commodity market appears to be looking squarely at an incoming credit crunch and hard landing. HAI believes commodity markets are correctly reading the tea leaves.

For one thing, if we use the Nasdaq 100, the most heavily concentrated tech index, as a proxy for the AI/tech baby bubble, a few helpful insights can be teased out. The Nasdaq 100 is, without doubt, the undisputed year-to-date market leader. The Nasdaq 100 led major indexes in May with a 7.6% gain (remarkable strength vs. the Dow Jones’ 3.5% drop) and is, amazingly, now up 39% off of its October 2022 low. That’s an incredibly impressive move higher, but, crucially, it’s also not one without previous bear market precedent. After the bubble had popped and was deflating towards its 2002 bear market bottom, the Nasdaq 100 staged two different 44% bear-market rally rippers. In each instance, the index rolled over to make new lows. The subsequent drawdown after the peak of each highly convincing bear market surge was -81% for the first and -49% following the second.

Right now, we can surely say that we have unstable price action in a highly unstable environment. However, at present, Nasdaq 100 bubble market mania is still firmly bounded within bear market precedent. HAI will watch closely to see if the speculative rally can push further as a potential indication that the overall market is beginning to tilt towards crack-up-boom dynamics. In the meantime, unless tech and generative AI’s speculative rocket launch can fully escape the strong gravitational pull of an economy likely headed for credit crunch and recession, the group’s exceptional recent outperformance may end as it did in the tech bubble—with a dramatic catch-down to reality.

So, with one eye on AI/tech, what is the economically sensitive commodity market saying? The Bloomberg commodity index has now dropped more than 10% since the start of the year to its lowest level since 2021. Driving the downtrend in commodity prices are numerous economies flirting with recession across the globe, a newly declared outright recession in Germany, a deepening pre-recessionary growth cycle downturn and industrial slump in both Europe and the US, all while China’s recovery from Covid Zero policies has, to date, been notably weaker than many expected.

As one of the most economically sensitive commodities, “Doctor Copper” is said to hold a PhD in economics. When the red metal tumbles, it’s usually strong confirmation of economic sickness. When copper is down among tight supply dynamics, it’s particularly crucial to seek the red doctor’s diagnosis. Codelco is the world’s number-one copper supplier. Its output is running at the lowest level in a quarter century. Codelco’s production is down by about a fifth from only six years ago, and after a double-digit-percentage drop in 2022 production is expected to fall another 7% this year to just 1.35 million metric tons. In the latest monthly numbers, production, again, fell short of expectations. In the company’s latest shareholder meeting, Codelco CEO André Sougarret said, “There’s no easy mining left—not in Chile nor the rest of the world.” Given Codelco’s number-one global producer status, its production problems have an outsized impact on a market where warehouse inventories are already near their lowest levels in 18 years. Given this supply situation and the serious issues plaguing the world’s number one supplier, the fact that copper prices are still down 14% off year-to-date highs amounts to an absolute scream on the part of the “doctor” that the copper market is grappling with some serious demand concerns.

The WTI Crude price is also down 14% from year-to-date highs and diesel prices in the US have fallen more than 30% from their 2022 peak and 16% year-to-date. The price declines in oil and derivative products have commenced despite an agreement by OPEC+ to cut crude oil output by a million barrels per day. This week, the crude market continued to slide even as Reuters reported that OPEC+ is discussing the possibility of an additional million barrel per day production cut at the June 4th meeting. At the same time, further crimping the supply outlook, the Baker Hughes weekly Rig Count data slumped this week to a 13-month low. In addition, oil prices have declined despite the latest EIA data showing that US crude oil exports set a new monthly record as China, amid reopening, became the largest importer of US crude oil. So, despite a weaker than expected China reopening, the Chinese are still pulling extra demand from the global oil market post reopening, OPEC+ is still looking to further cut production, US shale productivity is rapidly declining, and the US rig count is dropping. Given the bullish supply side backdrop, the oil market is singing the same tune as Dr. Copper, an ongoing aggressive oil price slide despite a bullish supply side backdrop amounts to a blaring public service announcement that the oil market is grappling with very real demand concerns.

What could commodity markets be looking at that U.S. equity investors are not yet concerned with? Perhaps global commodity markets are taking note of signals being sent by the U.S. consumer. This week, after a slew of retailers recently missed estimates, Goldman Sachs managing director Rich Privorosky picked up on the theme of interesting times when he said in a note that, “something is not quite adding up on the consumer” and then asked, “have we just run out of excess savings?” Responding to poor retail results and pervasive downbeat commentary from retail management teams Privorosky said, this “feels like more of an indictment that consumer spending is truly slowing and has spread, it’s not just company specific issues.”

The Goldman managing director may be onto something. Real retail sales are usually falling at a 1% annualized rate when recessions begin, but, currently, while many are touting consumer strength, real retail sales are, after factoring in recent revisions, contracting at a -2.1% annualized rate, or more than twice what is typical at the onset of recession. In data back to the 1960s, the economy has never avoided a recession when real retail sales meaningfully and sustainably contract.

If the US consumer, an economic force punching above its weight and responsible for 70% of GDP, is finally reaching a material inflection point, perhaps current soft-landing/no-landing enthusiasm in equity markets is misplaced.

Commodity markets may also be eyeing a looming credit crunch. We already know that the latest Fed Senior Loan Officer Opinion Survey (SLOOS) has indicated that the percentage of banks tightening lending standards has reached high levels consistent with past recessions. We also know that the Conference Board’s Leading Economic Index, when deeply recessionary, as it is now, strongly correlates, on a lag, historically in data back to the 1960s not just with credit growth slowdowns, but with outright credit contractions.

This week, however, as many market participants remain captivated and distracted by the generative AI/tech stock spectacle, the outlook for an expected pending credit crunch received further confirmation. The latest update of the ASR Senior Loan Officer Survey Composite Indicator, a leading indicator for credit, now forecasts that the tightest corporate and industrial lending environment since the great financial crisis is incoming. According to ASR managing director Ian Harnett, “the key reason to remain cautious is that the credit crunch for corporates is only just starting.”

Also helping us get a lead, from a different perspective, on the credit environment that lies ahead is the Equipment Leasing and Finance Foundation’s (ELFF) Monthly Confidence Index (MCI). The index reports a qualitative assessment of business conditions from key executives in the $1 trillion equipment finance industry. Sentiment from this group of equipment finance executives from banks (48%), captive finance firms (15%), and independent equipment leasing & finance companies (37%) is a good leading indicator for industrial production and manufacturing.

In the latest report, the ELFF MCI slumped by 6.4 points, and the index is now in free-fall. Over the last three months, the index has fallen 9.7 points from 50.3 in March, to 47 in April, to now only 40.6 in May. Putting the forced pandemic economic shutdown aside, May’s 40.6 is the lowest on record. The data speaks volumes: “3.6% of the survey respondents believe that U.S. economic conditions will get “better” over the next six months, a decrease from 7.4% in April. 32.1% indicate they believe the U.S. economy will “stay the same” over the next six months, a decrease from 48.2% last month. 64.3% believe economic conditions in the U.S. will worsen over the next six months, an increase from 44.4% the previous month.” These executives are boots on the ground at the intersection where lending and the industrial economy meet. Their outlook is incredibly negative, and that negativity is trending sharply in the wrong direction at an accelerated pace.

Given the outlook from the ELFF on sharply deteriorating economic conditions and industrial leasing, the ongoing contraction in the manufacturing sector may be set to worsen. This week, the latest ISM manufacturing PMI report for May came in at 46.9, below estimates and down from April’s 47.1 reading. Most importantly, supporting the negative outlook from ELFF, prices paid collapsed, and the most leading component of the report, new orders, was down big to 42.6 vs. 45.7 previously. With the deepening manufacturing contraction, ongoing monetary restraint, a looming credit crunch, and recessionary leading indicators, HAI expects the manufacturing malaise to spread into a widespread economic contraction.

While attempting to pierce the fog of war, HAI will continue to watch the speculative statement made by the AI/tech bubble, Dr. Copper and the commodity sector’s diagnosis on the global economy, evidence of an incoming credit crunch 3-6 months out on the horizon, and the leading economic indicators as they continue to paint a portrait of imminent recession. The leading economic indicators are particularly valuable at this point in the cycle as massive revisions are now increasingly popping up in economic data sets. As a result, the scene being set by coincident data is increasingly little more than a mirage. This week, in discussing the state of the leading economic indicators, Lakshman Achuthan of the Economic Cycle Research Institute offered his words of caution warning of a potential market panic attack once the current soft-landing/no-landing narrative rediscovers the pending hard landing reality. As Achuthan put it, “It’s like a doctor giving the patient bad news…it’s horrible…everything we’re looking at says hard landing.”

Like it or not, we do indeed live in interesting times. We’re sitting on a $31.8 trillion national debt pile while spending $6.2 trillion at a $1.6 trillion and rising deficit all while lifting the debt ceiling and running inherently unsustainable monetary and fiscal policies. That sort of “interesting” does start to feel more like a curse. As economist Henry Hazlitt observed, “the value of any monetary unit, such as the dollar, depends not merely on the quantity of dollars but on their quality.” With a mountain of dollar debt and a red-hot printing press, in these interesting times, gold is looking good.

Weekly performance: The S&P 500 was up 1.83%. Gold gained 1.30%, silver added 1.67%, platinum was down 2.39%, and palladium lost 1.58%. The HUI gold miners index was up 2.47%. The IFRA iShares US Infrastructure ETF was up 3.14%. Energy commodities were volatile and lower on the week. WTI crude oil lost 1.28%, while natural was hit by 10.14%. The CRB Commodity Index was lower by 0.39%, while copper gained 1.36%. The Dow Jones US Specialty Real Estate Investment Trust Index was 3.33% on the week, while the Vanguard Utilities ETF was up 0.96%. The dollar was down 0.18% to close at 103.95. The yield on the 10-yr Treasury lost 11 bps, ending the week at 3.69%

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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