Into the Storm
After another week of data, news, and market moves, the bottom line for markets and the economy is unchanged. In HAI’s view, markets and the economy are incubating dynamics that, in time, are very likely to hatch a nasty recessionary monster. Perhaps relatively sanguine markets at the major index level in this calm before the storm will, in hindsight, mark the moment of peak soft-landing narrative. HAI expects that thoughts of either potentially reaccelerating inflation (if the Fed pivots early), or thoughts of landings without landing-gear (if they don’t), will increasingly rent a growing amount of real estate in the collective mind of investors as we trudge boldly toward the back-half of 2023.
While the major indexes remain at the high end of their recent price ranges, market breadth is historically weak, with strength in just a few mega-cap tech names. For now the few names are holding up markets, but the dynamic is unhealthy. Below the surface, this market is weak. Continued carnage in regional bank stocks is sending financials lower, small caps are on life support, and weakness in the energy and materials sectors is pronounced as producers follow commodity prices lower. The recent declines in commodity prices in the context of tight supply dynamics reflect a weakening economy and increasing expectations for demand destruction. This is especially true of the falling price of copper. In its fourth straight week of selling pressure, it dropped nearly 4% to its low for the year despite a tight supply-side story as far as the eye can see. 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 the economy is sick.
Previous HAIs have painted a portrait of looming recession. This week, let’s add some detail to that image. In our fractional reserve banking system, credit expansion is the heart of the system and the life blood that keeps the growth gears cranking. You deposit $100 into a bank, the bank is required to hold 10% as reserves. That bank lends $90 of your deposit to someone else, who deposits it back into a bank. The second bank, once again, holds 10% in reserves and lends out the rest to yet a third person or business. So on and so on; wash, rinse, repeat. At the end of the day, your original $100 cash deposit translates to an additional $900 in credit money that supports a steady pulse for economic growth.
What happens, however, when you withdraw $100? The whole process reverses. The system works like a dream when deposits flow in, as has almost always been the case, but these gears don’t work in reverse. When they try to crank backwards, they send consequential shockwaves throughout the system. Things seize-up. They break. This is where we stand today. The Fed is withdrawing cash from the system through quantitative tightening (QT), and high money market rates keep the deposit drain open at the bottom of the bank liquidity tub as the “bank walk” continues. As long as the Fed maintains QT and a high fed funds rate, the banking crisis will linger. If current conditions remain as they are right now, the banks that are not “too big to fail” are in big trouble. Casualties will mount.
A potential further accelerator of bank deposit outflows was flagged by the Wall Street Journal this week. The Journal pointed out that 14 million homeowners have mortgage rates below 3% and another 20 million have rates between 3-4%. That means that 34 million homeowners have a massive, outsized incentive to pull their cash out of banks and redeploy it into US Treasury money market funds. At current interest rates, homeowners that do so can earn positive net interest margins of 100-300 basis points, getting 5% in money market funds while only paying 4% or less on their mortgage. In short, that’s potentially 34 million highly motivated bank-walkers, or, perhaps likely more accurately, bank-joggers. This is quite the deal for homeowners, but very problematic for the US banking system—and by extension credit and lending—and by further extension the US economy.
Beyond existential risks to troubled small banks, the most crucial aspect of the deposit flight is in its likely impact on tightening credit and lending. In that regard, it becomes a key ingredient in the making of our looming recessionary stew. On Monday morning, Chicago Fed President Austan Goolsbee foreshadowed the afternoon release of data on lending standards and loan demand when he suggested banks are indeed pulling back on providing credit to the economy. Goolsbee said, “I am certainly getting vibes…in the market and in the business context that a credit crunch, or at least a credit squeeze, is beginning.”
The Monday afternoon release of the Fed’s April Senior Loan Officer Opinion Survey (SLOOS) on bank lending practices highlighted a trend only likely to grow in intensity until the Fed pivots, cuts rates, and/or adds liquidity to the system. Keep in mind that the percentage of banks tightening lending standards had already reached high levels consistent with past recessions as of last quarter. Now, the latest SLOOS reported, “On balance, tighter standards and weaker demand for commercial and industrial (C&I) loans…[and] tighter standards and weaker demand for all commercial real estate (CRE) loan categories… Lending standards tightened across all categories of residential real estate (RRE) loans…[and] demand weakened for all RRE loan categories. In addition, banks reported tighter standards and weaker demand for home equity lines of credit (HELOCs). Standards tightened for all consumer loan categories; demand weakened for auto and other consumer loans, while it remained basically unchanged for credit cards.” Again, the fractional reserve process is the means of credit expansion. With deposit inflows, the system works beautifully. With outflows, the system breaks.
Any policymaker medicine aimed at lowering the risk of economic cardiac arrest, preventing an ongoing string of bankruptcies and a resulting freeze of credit markets would have to come in the form of one of two options. 1) The Fed can cut rates, reinstitute zero-G, and once again suspend the financial physics of interest rate gravity or 2) policymakers can expand BTFP eligible collateral to cover any loan on a US bank’s balance sheet.
Inflation, however, remains the sticky pair of shackles binding the hands of policymakers. Cutting rates is inflationary as it loosens financial conditions and lowers the price of money. Expanding the BTFP program is inflationary because it would ultimately increase the supply of money. Either option, should they be implemented, is likely to be a powerful catalyst for precious metals, commodities, and hard assets more broadly.
Inflationary remedies to the banking crisis may have to wait, however, because the Fed has declared a war on inflation and Powell still claims he’s fighting the good fight. This week, the consumer price index (CPI) inflation gauge indicated some modest cooling of price pressures, but overall, inflation remains sticky and way over target. April headline CPI increased 0.4% month-over-month (M/M), as expected, and was up 4.9% year-over-year (Y/Y), just under the 5% expected and the 5% recorded in March. April core CPI (excluding food and energy) was up 0.4% M/M as expected, and up 5.5% Y/Y, as expected versus 5.6% in the March report. Progress, but frustratingly limited progress.
Echoing New York Federal Reserve President John Williams, who said inflation remains “too high,” was Citigroup chief economist Andrew Hollenhorst who reacted to the CPI report saying, “it’s just hard to look at this number and think that the Fed is going to see anything here that tells them they’re on that path to 2%.”
In response to the inflation data Federal Reserve Governor Philip Jefferson, who President Biden just nominated for the number-two role of vice-chair at the Fed, said disinflation is occurring at “a slower pace than expected” and described progress on inflation as “discouraging.”
Last week it was Fed Chair Powell overtly pushing back on the idea of Fed rate cuts later this year. This week, Jefferson’s comments suggest the Fed’s two top leadership positions are in lockstep on continuing to prioritize the inflation fight and holding the line against rate cuts in 2023. This isn’t what market bulls want to hear. If the Fed won’t take necessary further actions to remedy the bank crisis because the actions are inflationary, then the writing is on the wall, and it spells “crisis” and “recessionary trouble.”
Complicating matters further, on Friday, was an absolutely abysmal University of Michigan Surveys of Consumers report that dropped a bomb squarely on Powell’s lap. Surveys Director Joanne Hsu announced on Friday that already deeply recessionary consumer sentiment has, so far in May, “tumbled 9% amid renewed concerns about the trajectory of the economy.” Without doubt, worries about the economy were manifest in this UMich report at significantly escalated levels. According to Hsu, year-ahead expectations for the economy “plummeted 23% from last month.” In addition, long-run expectations for the economy also fell through the trapdoor, with a 16% nosedive. Director Hsu relayed several key insights. First, the results indicate “consumers are worried that any economic downturn will not be brief.” Second, she observed that, “Throughout the current inflationary episode, consumers have shown resilience under strong labor markets, but their anticipation of a recession will lead them to pull back when signs of weakness emerge.” The real dagger to Powell’s heart, and potentially to any realistic possibility for an imminent Fed policy pivot, was that after two years of relatively anchored and stable inflation expectations, “long-run inflation expectations rose to their highest reading since 2011.” In other words, consumers are increasingly aware that all is not well and that substantial trouble approaches on the horizon. They’re gearing up for a prolonged recession in the context of an inflationary long-term outlook. When the labor market cracks, consumers are done, they’re ready to hop in the bunker, batten down the hatches.
With consumer spending representing 70% of GDP, the consumer is critical to the economy, and as UMich makes clear, the labor market is critical to a continued resilient consumer. If we lose the labor market, we lose the consumer, and if we lose both the labor market and the consumer, then put your helmet on and strap-in for the resulting decidedly hard landing. As HAI mentioned last week, small business is the key to that all-important labor market. While the total number of jobs at big corporations has been stagnant for decades, small businesses with less than 500 employees are entirely the source of job creation in our economy. Regional banks disproportionately serve the small and medium sized business community. As such, credit tightening at small regional banks is set to disproportionately impact small firms, and, in keeping, it’s also set to disproportionately impact the labor market via the particular source of small business job creation in the economy. Again, at present, small business is key, and we’re now starting to see signs of a leading edge of increased small business weakness show up in the data.
This week, NFIB’s Small Business Optimism Index decreased by 1.1 points in April to a reading of 89. This marks the 16th consecutive measure below the survey’s 49-year historical average of 98. As the economy slows while tighter financing at higher costs begins to bite, small business profit trends are a developing concern. After the frequency of positive profit trends reported by businesses began to deteriorate into negative territory at an accelerated clip early this year, the latest reading found that a net negative 23% of companies reported positive profit trends, that’s a substantial five-point elevator drop lower from already weak March data. The top reason cited for profit troubles was weaker sales as even nominal sales (which get an artificial boost from high inflation) dropped further into negative territory with a three-point drop to net negative 9%. Even among this historically optimistic cohort of small business owners, the outlook isn’t any better. The number expecting higher sales volumes in the future deteriorated four points to a net negative 19%. As profit trends weaken while financing gets tighter and costlier, eventually, the release valve for increasingly stressed businesses will be to hit payrolls. As UMich highlights, when that happens, it’s a green light for the hard landing.
Speaking of employment, last week’s April non-farm payrolls were better than expected. That said, especially after factoring in negative revisions to the prior two months’ data (149,00 less jobs than originally reported), the image of a labor market in the initial stages of a downturn can be glimpsed, and the picture is getting clearer. Monthly payroll numbers are still strong, but they have been trending lower. Aggregate weekly hours have contracted in four of the last six months, and claims for unemployment insurance are trending higher. Historically, real-time employment data lags and doesn’t sustainably contract before recessionary periods begin. The cyclical components of the labor market, however, do tend to contract in pre-recessionary and early-recession periods. Homing in on the cyclical components of the labor market, the data reveals that on a three-month rolling average, manufacturing, construction, trucking, and temp jobs have been negative and contracting for the last five months. That’s a warning consistent with pre-recession and early-recession periods historically, and a strong indication that the labor market may be rolling over.
Maintaining the labor market theme, this week, initial jobless claims jumped by 22,000 over the previous week to reach 264,000. That’s the highest level of initial claims since October of 2021. Claims have remained at low levels since the pandemic recovery, but at this point, both initial and continuing claims data has increased sufficiently from the lows to offer some reliable signals related to both the likelihood of recession and its possible timing. Historically, in data back to the 1960s, when six-month average annualized continuing claims increases off cycle lows by 20%, an imminent ensuing recession has never been avoided. If we throw out the oddity of the Covid recession (due to the artificial nature of the layoffs) and focus on the seven recessions that preceded it, the average start time of recession was when the claims data had increased 25% off cycle lows. After this week’s continuing claims data, we are now over 50% above September 2022’s cycle lows. In other words, the continuing claims data is yet another indicator with a 100% track record that has turned unambiguously recessionary. Furthermore, using past recessions, if we apply the average and median time to recession after the cycle lows have been made in initial and continuing unemployment claims, the data suggests a recession likely starts between June and September. That rough timing is given added credibility as it is likely to coincide with the lagged amplifying impact of both Fed rate hikes and bank credit tightening.
As David Rosenberg recently said, “unless you think the business cycle has been repealed…a recession is staring us in the face.” HAI does not think the business cycle has been repealed, sees the gale force headwinds in place, and also believes that if the Fed, overtly or covertly, tries to apply stimulative easy-policy measures intended to preemptively intervene and artificially rescue the banks and the business cycle, such action will likely come at the exorbitant cost of failure on the inflation fight, total credibility suicide, and the very real risk of charting a one-way course toward devastating crack-up-boom dynamics. That’s an excessive price tag on a policy maneuver almost certain to yield a bounty of additional unintended negative consequences. Nevertheless, for a Fed with no good options in hand, we continue to watch the unfolding saga.
For now, the mantra remains the same. HAI expects policymakers to keep policy restraint in place with rates as they are and that further crisis and eventual recession will very likely be the result. As the consequent economic demand destruction knocks inflation (temporarily) lower, and sends unemployment higher, the Fed as firefighter, armed with a greater quotient of resulting political cover, can then more easily pivot to inflationary emergency response measures at the scene of the accident.
When the transmission sequence of bank stress to credit stress, to small business stress, to labor market stress fully manifests, the Fed is likely to aggressively ease policy once the unemployment rate pops. While turbulence is certainly expected ahead of a policy pivot, as we near the pivot, HAI expects precious metals first, and select commodities later, to fly higher amid a secular hard asset bull market tailwind that could last for years. In the meantime, we head—into the storm.
Weekly performance: The S&P 500 was down 0.29%. Gold lost 0.25%, silver was clubbed by 6.86%, platinum was down 0.12%, and palladium gained 1.82%. The HUI gold miners index lost 4.08%. The IFRA iShares US Infrastructure ETF was down 0.70%. Energy commodities were volatile and mixed on the week. WTI crude oil lost 1.82%, while natural gas gained 6.04%. The CRB Commodity Index lost 1.41%, while copper dropped by 3.92%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 0.37% on the week, while the Vanguard Utilities ETF was nearly flat, up 0.8%. The dollar was up 1.50% to close at 102.51. The yield on the 10-yr Treasury was up 2 bps, ending the week at 3.46%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager