Making Sense of Mixed Signals
This was a down week for most asset classes. Stocks, cap-ex commodity metals, precious metals, and Treasurys were all lower on a volatile week. The three lonely weekly winners on the podium by Friday’s market close were crude oil with the gold medal, the dollar index landing silver, and agriculture sporting a competitive bronze. Helping oil claim that top performer prize was the Tuesday announcement that Saudi Arabia and Russia agreed to extend current production and export cuts to help keep a clamp on supply through year-end.
For the last several weeks, both asset prices and economic data have been volatile. Often, they’ve been sending mixed signals. However, a relatively stable and emerging constant in this volatile financial world has been the recent trend towards higher oil prices, higher Treasury yields, and a strengthening dollar. In this HAI, let’s examine recent data and market price action, and then consider the possible ramifications of the recent trends in oil, yields, and the dollar in the context of a potential hard landing. In addition, we’ll also consider whether extreme government deficit spending might deliver a benign soft-landing for markets and the economy.
On one hand, the incoming recession case is undeniably tight. A newly reintroduced regime of interest rate gravity has replaced the preceding era of zero-G, bank lending standards have tightened to historically recessionary levels, and, in an indication that the economy is slowing, tax receipts have been falling. The latest S&P Global manufacturing PMI significantly missed estimates, and described a manufacturing sector in a contraction that’s now reaccelerating to the downside. Further, the S&P services PMI disappointed expectations and warned of a slowing services sector now only barely clinging to expansion. At the same time, the St. Louis Federal Reserve Bank’s GDP “nowcast” currently anticipates real Q3 GDP of negative 0.7%. We have deeply inverted yield curves screaming of incoming recession, dwindling “excess savings,” a seriously unhealthy boom in consumer credit card debt at record high interest rates, and the imminent resumption of student loan repayments for 40 million Americans looming. We also have a strong pre-recession warning from the record divergence between GDI and GDP, along with a set of historically perfect leading economic indicators unambiguously mired in deep recessionary territory.
Let’s also not forget that we continue to have serious and yet-unresolved bank problems. Just this week, usage of the Fed’s emergency bank funding facility jumped by $328 million. The emergency facility now stands at a new record high of $108 billion. Separating the reality of sickness from the narrative of bank stabilization, these banks that almost collapsed are now borrowing record levels of alarmingly expensive 5.5% debt from the Fed, even as the regional bank crisis is said to be over. In addition, the FDIC reported this week that U.S. banks’ unrealized losses on securities jumped 8.3% in Q2 2023 to $558.4 billion. Given the sharp rise in interest rates so far in Q3, that number is likely to balloon further. Meanwhile, the Fed’s “higher rates for longer” campaign certainly isn’t helping to convincingly sell the “crisis over” narrative. Nor does it inspire confidence to hear Fed Chairman Powell say, in his recent Jackson Hole speech, “we are navigating by the stars under cloudy skies.”
Taken together, the many colors of paint and multitude of brushstrokes on the canvas combine to paint a crystal-clear portrait of a hard landing, already cued-up and prepared for impact—on a lag.
On the other hand, the stock market has been recovering from 2022 losses as if the worst is over, and it looks hungry for new all-time highs. Analysts’ forward corporate earnings estimates are rising again. This week’s ISM (as opposed to S&P Global) manufacturing PMI surprised to the upside (despite remaining in contraction), while ISM’s services PMI is in expansion, surprised to the upside, and argues that we are seeing a renewed round of strength in the services sector. At the same time, as if the St. Louis Fed and the Atlanta Fed exist on two completely different planets, the Atlanta Fed’s GDPNow tool has real Q3 GDP tracking at a booming 5.6%, and importantly, on the fiscal side, the U.S. government is essentially stimulating the economy by deficit spending (expected to be north of $2 trillion for FY 2023) on a level only seen during wartime or outright crisis.
Needless to say, we’ve got a lot of mixed signals right now in the economy, and the fog of war is thick. How all these factors play out in the stock market is equally complicated. Will the stock market boom as it rides on the back of a deficit spending rocket, or bust as the lagged effect of higher interest rates and tightening bank lending standards slowly but surely snuff out the private sector?
So far in 2023, loose financial conditions, ample liquidity, and the full stimulative blast of a wartime-like deficit spending spigot—along with growing expectations for continually fading inflation, a soft landing, and a subsequent Fed pivot to policy easing—have all translated to markets in rocket ship mode. Recently, however, the economically sensitive sectors of small caps, housing, transports, and financials all appear to be rolling over again towards underperformance.
At the same time, the recent trend toward higher yields, a newly re-strengthening dollar, and international trade frictions related to geopolitical fracturing and deglobalization are collective poison for the all-important tech sector and the market leadership it has been so crucial in providing throughout 2023. In fact, just this week, Apple took a big, China-sized blow to the gut. Apple is not only the largest company by market cap in the world, but it also carries the highest weighting of any company on the benchmark S&P 500 index. This week, the tech behemoth’s ability to provide ongoing stock market leadership was jeopardized after China extended a domestic ban on certain Apple products.
Since the stock market bottomed out last fall, Apple’s share price has been rising aggressively even as company fundamentals have deteriorated. In technical terms, Apple stock has been in a chart pattern called a “bearish rising wedge.” After the product bans by China, that bearish wedge broke to the downside. With Apple’s technical price chart floor broken and fundamentals deteriorating, the stock now resembles Wile E. Coyote heading over the cliff and scrambling for a foothold. Meanwhile the entire tech sector, and by extension the entirety of global financial markets, hold their collective breath. If Apple’s stock breaks down, tech more broadly could crack. If tech leadership falters and economically sensitive small caps, banks, transports, and housing continue to lose steam and roll over to the downside, it will constitute a message—a message warning that we may be marking a turning point lower for the year-to-date 2023 stock market rally.
All of these developments need to be watched closely. The technical momentum now behind major market indexes making new highs is currently intense. So, too, will be the influence of FOMO on investors wanting to position long ahead of the typical year-end Santa Claus rally over the coming months. That said, markets throw curve balls. If HAI is correct to anticipate recession and further financial breakages under the strain of higher-for-longer at some point in the not-too-distant future, then the soft-landing party could end at any time, abruptly and painfully. Depending on timing, new highs could come first, but the risk of a vicious rug-pull will remain until recession risks are cleared. At present, they are not.
As HAI has stated many times, the labor market is key, and some recent alternative labor market data reinforces the need for maintained vigilance. With the consensus expecting only a modest drop in job openings from 9.582 million to 9.5 million, the latest Bureau of Labor Statistics (BLS) Job Openings and Labor Turnover Survey (JOLTS) report came in significantly below expectations at just 8.827 million, for the first sub-9 million print since March 2021 and the 3rd biggest miss in JOLTS survey history.
The JOLTS miss also came with a sharp BLS revision to the prior month’s number from 9.582 million down to 9.165MM. Looking now at the newly revised data with a fresh pair of eyes, the trends in the labor market are looking far shakier than the “bullet proof” jobs market narrative perpetuating soft-landing hopes. In fact, the 1.5 million three-month decline in the number of job openings is, outside of the artificial impact of Covid lockdowns, the worst three-month deterioration in JOLTS history.
In addition, the decisive break south in the recent JOLTS data is now being corroborated by other alternative labor market data sets. Evidence of recent cracks in the labor market are backed by the latest NFIB small business survey and data collected by the UBS evidence lab. NFIB tracking of the number of businesses with open positions that need filling has slid meaningfully from 65% to under 35% in just over a year. The UBS data tracking the same number of open-but-unfilled positions is even more dramatic. In just over a year, the UBS data has dropped from 70% down to 20%. Even Goldman Sachs is now looking at official U.S. job data with a skeptical eye. As Goldman put it recently, “Official and alternative job openings measures track each other reasonably well in most countries, but official measures have significantly overshot alternative data in the U.S.” For now, official job numbers have “significantly overshot alternative data,” but that, of course, is subject to revision.
On top of the negative JOLTS data revision previously mentioned, we are now seeing a consistent pattern of official economic data sets continually being revised lower after the fact, throughout segments of the economy. As HAI warned this past summer, late-cycle economic data tends to get serially revised lower once in the rearview mirror. It’s one of the reasons to focus disproportionately on the leading economic data rather than its real-time coincident cousin. Late-cycle real-time data, like a mirage, appears to verify economic strength just before that apparent strength vanishes at the hand of the revisionist’s pen.
For example, every single non-farm payroll number released so far in 2023 has been subsequently revised materially lower, as has every single monthly release of single-family homes sold.
Similarly, we’ve also seen recent nasty negative revisions transform apparent bright spots into trouble spots with industrial production, manufacturing production, and capacity utilization. This is the thick fog of late-cycle war, and it now appears that heightened skepticism over real-time reported data is especially warranted.
Two weeks ago it was Q2 GDP revised lower. While still strong at a downwardly revised 2.1% (from 2.4%), it’s important to note that the vast majority of the GDP strength came from a special one-time contribution from the auto sector. It’s also important to remember that in the horrific 2008 cycle, despite the fact that the recession had already started in December of 2007, nobody looking at GDP or employment data knew, in real time, that the recession had arrived until late 2008. For the first two quarters of the Great Recession, GDP was positive and rising. In Q1 2008, GDP grew at 1.0%, while in Q2 2008, GDP actually increased to 1.9%. Similarly, the labor market didn’t peak until after the recession had already started. Nevertheless, despite GDP and employment data, the recession had already started and was about to intensify into the most brutal recessionary crisis since the great depression.
Last week also offered the latest update from the National Association of Credit Management (NACM) Credit Managers’ Index (CMI). Frankly, it wasn’t good. The descriptive image of an incoming economic contraction was best illustrated by the combined manufacturing and services sales CMI. In June, the index was boasting a stout 62 reading, in July, the gauge got knocked to 55.6, and by August, the manufacturing and services sales CMI slipped into outright contraction with another elevator drop to 49.5. Isolating the more cyclical and leading manufacturing sales CMI reinforces the concerning message. Outside of Covid lockdowns, the -16.3 collapse over the last two months has been outpaced by only the -19.3 drop from October to December 2008. For those who remember, that was the absolute heart of the Great Financial Crisis.
According to NACM chief economist Amy Crews Cutts, “Now the message is clear that businesses are starting to break under current economic stresses.” The report, she added, “points to recession.”
The NACM may be onto something. Historically, the manufacturing and services sales CMI has a tight correlation with GDP. Based on its historical relationship, after its recent plunge, the sales CMI is decisively siding with the St. Louis Fed’s contractionary growth outlook.
As BofA chief investment strategist Michael Hartnett said recently, the big risk for the remainder of the year is that “‘soft landing’ = higher yields/tighter FCI [financial conditions] = ‘hard landing.’” Harnett’s point is the same thesis that HAI has long referred to as the “catch-22” scenario in which a market rally, based on soft-landing hopes and Fed pivot dreams, ultimately sows the seeds of its own destruction. Through a cascading series of knock-on effects, soft landing enthusiasm keeps financial conditions loose; loose financial conditions keep inflation sticky (along with the risk of a renewed rally in energy prices as we are now seeing); then, with inflation remaining sticky (along with the constant reacceleration risk), the Fed is forced to lock-into “higher for longer” until, eventually, on a “long and variable lag,” the toppling dominoes lead to a hard-landing recession.
We may be just starting to see this catch-22 dynamic play out with the recent jump in oil prices, the spike higher in yields, and the re-strengthening dollar index. These moves in key assets may reflect and suggest growing awareness of the following set of connections: loose financial conditions are letting oil prices run; with energy prices rising, inflation isn’t done; if inflation isn’t done, the Fed will stay higher for longer; and a Fed policy indefinitely higher for longer invariably ends badly. Perhaps this is why some of the economically sensitive cyclical sectors in the market are starting to roll over and underperform again. Time will tell.
The alternative view of the present state of the economy and markets is interpreted through the lens of “fiscal dominance.” If the U.S. is already in fiscal dominance—meaning that government fiscal spending (with extremely high debt, massive deficits, and a ballooning interest component) is now overriding and compromising the ability of monetary policy to function effectively—then, in theory, the immense deficit spending could act as stimulus that keeps both GDP and inflation elevated, balances out the negative economic impact of the Fed’s higher-for-longer campaign, and pushes out recession. Under this logic, these wartime-like levels of deficit spending could be supportive of the soft-landing narrative.
While at present it does appear that immense deficit spending is continuing to funnel growth into certain segments of the economy, signs are emerging that the private sector is still not immune to the impact of higher interest rates. In effect the current dynamic translates to lopsided economic performance where government deficit spending keeps overall GDP elevated for a time, but private sector non-beneficiaries of the deficit spending are still getting pulled under due to the increasing strains of higher interest rates.
The immediate question is, if we are already in fiscal dominance, before the dynamic ultimately creates existential solvency and currency risk, can the deficit spending keep the economy afloat, a recession at bay, and stock prices high even as higher interest rates bite the private sector? Will deficit spending deliver a soft landing? It’s possible, but not probable. And if it happens, it will likely work for only a time.
When relying on a government fiscal spigot to keep the economy afloat, it’s important to consider findings from famed economist Lacy Hunt and numerous confirming studies by economists that conclude, unambiguously, that while private sector spending has a positive economic growth multiplier, government spending has a negative growth multiplier over time. In other words, after the initial government spending-induced sugar rush, government spending and accumulated debt actually subtract from potential future economic growth.
As Dr. Hunt recently illustrated, increases in government size relative to the private sector translate to more of the economy being funneled “away from the high positive multiplier private sector and into the negative multiplier government sector… Two different rigorous studies, one completed in 2011 and the other in 2012, each using different methodologies, both concluded government fiscal policy actions that either increase the size of government relative to GDP or increase the government debt relative to GDP significantly weaken the trend rate of economic growth. The evidence, from more than a decade since this research was published, confirms those findings and indicates that the government multiplier is becoming increasingly negative.”
According to Dr. Hunt, “the government expenditure multiplier is positive [for GDP growth] for the first four to six quarters after the initial deficit financing, then turns negative after three years.” If correct, that finding is a major vulnerability for the soft-landing thesis because the literal mountain of unprecedented government spending during the year after the Covid pandemic is just now turning three years old. Its net effect is just about to roll over into an economic growth suppressant.
In other words, using deficit spending to keep the economy afloat carries with it the law of diminishing returns. Eventually those diminishing returns turn negative. According to Dr. Hunt, we’re rapidly approaching that point. Even after taking into consideration the stimulative effect of the current deficit spending, the famed economist concludes that given the lagged negative multiplier effect from the colossal deficit spending of 2020-2021, overall, “deficits are likely to have a negligible, if not contractionary, impact on economic growth this year and next.”
Unless the government wants to spend ever larger amounts of deficit-spending money in perpetuity until completely consumed by the inflationary fire scenario (discussed in recent HAIs), then higher interest rates, tighter bank lending, and the lagging negative multiplier effect of past deficit spending all argue that market participants should remain, for now, squarely focused on the primary risk of the hard landing recessionary ice scenario unfolding before anything else. If Dr. Hunt is right, and deficit spending is about to stop propping up growth, then watch out. A stock market currently priced at bubble valuations may quickly fall through the trap door as monetary policy bites just as government spending efficacy is reduced to little more than pushing on a string.
Maybe we will have a deficit spending-induced soft landing. Perhaps markets will just crack up as opposed to first cracking down. That said, the underlying premise for a greater concern over market losses is sound, sensible, and straightforward. As legendary investor Jeremy Grantham recently put it, “I suspect inflation will never be as low as its average for the last 10 years; [as such, I suspect] that we have reentered a period of moderately higher inflation and, therefore, moderately higher interest rates… In the end, life is simple. Low rates push up asset prices. Higher rates push asset prices down. We are now in an era that will average higher rates than we had for the last 10 years.” As the lagging impacts from those higher rates continues to creep further into the economy, Grantham said the Fed is kidding itself on avoiding a recession, and that the U.S. will see “a recession running perhaps deep into next year and an accompanying decline in stock prices.”
Again, as we continue our quest to make sense of mixed signals, the primary market risk is unchanged: a nasty recessionary stew served up cold to a suddenly unsuspecting stock market. As a result, the HAI mantra remains the same: buckle-up and prepare for recessionary ice with an overweight holding of short-term cash equivalents with yield; hedge against runaway fiscal dominance and inflationary fire with quality hard assets, select commodity exposure, and allocations to precious metals and related.
Weekly performance: The S&P 500 lost 1.29%. Gold was down 1.24%, silver fell 5.65%, platinum was crushed by 7.63%, and palladium was down 2.86%. The HUI gold miners index lost 3.00%. The IFRA iShares US Infrastructure ETF was down 3.08%. Energy commodities were volatile and mixed on the week. WTI crude oil gained 2.29% while natural gas dropped 5.79%. The CRB Commodity Index was nearly flat, up 0.04%, while copper was down 3.52%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 0.98%, while the Vanguard Utilities ETFS was up 0.71%. The dollar index gained 0.84% to close the week at 105.07. The yield on the 10-yr Treasury was up 8 bps, to end the week at 4.26%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager