A New Set of Rules
This week, the stock market finally took a breather with just its fifth weekly decline in the last 22 weeks. Despite the off week for stocks, however, hard assets, including precious metals and many commodities, are now getting some notable pep in their step. Gold finished the week at a new record high. Silver, while still miles away from its all-time highs, is starting to play some catch-up with a 10.37% surge. Both oil and copper popped significantly as well. All in all, it was a very good week for the hard asset thesis. Unfortunately, it was a very bad week for Jay Powell and the Fed.
While many asset classes are now moving higher together, not all asset classes are positioned the same. In financial assets, we’ve never seen such an extreme market cap concentration in the top 10% of the largest US stocks—outside of one lonely exception: 1929. The top 10% of S&P 500 stocks now account for a staggering 75% of the entire index’s overall market cap. Meanwhile, according to HAI favorite John Hussman, our nose-bleed-high U.S. financial asset valuations have been matched only twice in history. Most recently, comparably high valuation extremes were seen in the week ended December 31, 2021. The only other historical precedent matching present all-time high valuation extremes was the week ended August 26, 1929. Specifically, that’s the post-Covid peak and the roaring ’20s peak that preceded the great depression.
HAI isn’t suggesting that the ongoing bubble in financial assets is going to implode tomorrow. Policy makers may continue to huff, puff, and blow this monster-bubble ever bigger with Herculean might. But, as it’s said, nobody rings a bell at the top. All we know is that, at these valuations on top of today’s ultra-high level of policy and economic risk, the threat of significant downside to financial assets is extremely real. At the same time, cheap hard assets have a massive tailwind the market is just now cluing in to.
In other words, the relative risk-adjusted return proposition for the hard asset thesis vs. financial assets may be more attractive today than ever before.
We’ve had 36 consecutive months of inflation over the Fed’s target. Since 2020, a U.S. dollar has depreciated to just $0.80 today, and according to the Fed’s latest forecast we will remain above the Fed’s 2% inflation target for another two years yet.
Year over year we’re still stuck at a 3.2% headline CPI inflation rate and a 3.8% rate on core. Shelter inflation is running at a 5.7% clip, and the Fed’s preferred “supercore” measure is smoking hot at an eye popping 8.04% annualized pace over the last two months. Meanwhile inflation has been picking up. Core CPI on a three-month annualized basis is back up to 4.3%. In the face of all of this (an inflationary onslaught that’s making a mockery of the 2% target), Powell is dismissive of inflation concerns. The FOMC is still guiding towards monetary policy easing.
As former Treasury Secretary Larry Summers put it following Powell’s last FOMC presser, “My sense is still that the Federal Reserve has itchy fingers to start cutting rates, and I don’t fully get it… I don’t know why [the Fed] is in such a hurry to be talking about moving towards the accelerator.”
Last week, it was Mohamed El-Erian expressing his confusion. As he put it, “It is not often that you see a reputable central bank revise up its inflation and growth projections and yet strengthen a dovish tilt to its policy stance. Yet that is what happened in Washington…when [the Fed signaled] a willingness to tolerate higher inflation for longer and an openness to slow the ongoing reduction in its balance sheet.”
El-Erian then delivered the real punch line (one HAI fully agrees with): “It would not surprise me if future economic history books were to look back at the last week in central banking as marking a move away from strict inflation targeting by the world’s most influential central banks.”
In other words, welcome to a brave new era of central bank tolerance for inflation. Given the amount of inflation suffered in a world in which central banks claimed to have a price stability mandate, the push towards a higher tolerance for “higher inflation for longer” is a frightening prospect.
Inflation may be set up now to burn far hotter for far longer than the consensus expects. And hard assets seem to be just starting to respond to the increasingly more obvious highly inflationary outlook.
Broader market recognition seems to be growing that the Fed is doing something different today than in prior cycles. What had been speculation that we might be approaching a turning point in central banking and monetary policy may now be in the process of becoming verified fact. The broad market may be realizing that the US has a fiscal problem and that policy makers will be forced to sacrifice the “low” inflation target in an effort to ease the strain on the fiscal side for as long as possible.
This week, we had even more inflationary data hit the wires. Monday’s March U.S. manufacturing PMI showed the prices paid component surging to 55.8 vs. expectations for 52.7 and up from 52.5 prior.
As S&P chief economist Chris Williamson put it, “both among suppliers and manufacturers, input costs rose for a ninth month running, increasing at one of the sharpest rates seen over the past year. Average selling price inflation consequently lifted higher as producers passed these higher costs on to customers, with the rate of inflation reaching the highest for 11 months.” Ominously, Williams added that, “Worryingly, from a consumer inflation perspective, the steepest rise in prices reported in March was recorded in the consumer goods-producing sector, where the rate of inflation hit a 16-month high.”
S&P compiles a global PMI as well. The latest global PMI prices paid survey also accelerated higher. Here’s Chris Williamson’s take on the global inflation front; “Average prices charged for goods and services rose worldwide at a steeper rate…hinting at historically elevated stickiness of consumer price inflation at the global level in the coming months.” According to Williamson, the data “found average prices charged for goods and services to have risen globally at the fastest rate for ten months in March.” As for the hot-inflation heat map, Williamson specifically singled out both the U.K. and the U.S.
Adding to the overall inflationary environment, commodity price momentum is picking up. West Texas Intermediate Crude jumped to highs not seen since last October with a 4.50% weekly gain, while copper blasted to its highest level in over a year with a 5.72% weekly launch.
Goldman Sachs’ commodity desk helped put some of the charge into copper with a very bullish note, calling for 50% upside by 2025 on the basis that, “Decarbonization, EV & solar demand, AI driven electrification, and a power demand surge are driving more demand for copper in a tight supply backdrop.” That said, copper prices had already decisively broken higher out of the recent range, and already looked to be responding to inflation and ultra loose financial conditions.
Oil strength is likely the combination of several factors in addition to inflation and ultra loose financial conditions. As HAI has discussed numerous times in recent months, industry supply dynamics are tightening. U.S. shale cap-ex is expected to be flat in 2024, meaning there won’t be the added investment necessary to offset rapidly rising decline rates. At the same time, OPEC+ has recently pledged to maintain production cuts, and Russian Deputy Prime Minister Alexander Novak just ordered Russian companies to cut production in the second quarter. Amid this tightening supply backdrop, we now have a significant increasing geopolitical risk premium supporting oil prices in response to the growing threat of expanded conflict between Israel and Iran.
So, we are still well above target on inflation; the inflation data is getting hotter again; oil, copper, and the commodity complex more broadly are becoming a powerful additional inflationary tailwind; and inflation expectations are likely to follow commodity prices higher. This is not the typical backdrop for the Fed to pivot to rate cuts. The current set-up is conspiring to make it extremely difficult for the Fed to credibly cut rates and cut them meaningfully in 2024.
As a result, in a credibility building exercise following more hot inflation data and another strong non-farm payroll report on Friday, Federal Reserve Bank of Minneapolis President Neel Kashkari was one of a gaggle of central bankers in the media hawkishly pushing back on rate cut expectations. According to Bloomberg, Kashkari said “interest-rate cuts may not be needed this year if progress on inflation stalls, especially if the economy remains robust.”
In the past, gold would have been hammered on the more hawkish outlook, the strong dollar, and higher yields. Not anymore, apparently. Gold’s behavior is changing. Rather than getting crushed, gold ripped higher. In HAI‘s view, a growing pocket of the market is seeing through the Fedspeak and beginning to grasp the greater reality of trapped central bankers. Gold’s recent price action is now indicating that the market is beginning to embrace the idea that gold is in a win/win position, and HAI believes the market is exactly right.
In HAI‘s view, the reason for the difference in price action is that it’s now increasingly obvious that the Fed’s monetary policy is irreparably compromised. The market seems to be grasping that if the Fed doesn’t cut, or even raises rates further to fight inflation, higher-for-longer interest rates will trigger a debt doom-loop that’ll fast track a US fiscal crisis that could blow up the bond market. As BofA’s Michael Hartnett warned this week, without rate cuts, government interest expenses will swell to $1.6 trillion while simultaneously becoming the government’s largest outlay by year-end.
The fiscal crisis message is now getting out. Just this week, Bloomberg released an article titled: “US government debt risk: A million simulations show danger ahead.” The article states that, “With uncertainty about so many of the variables, Bloomberg Economics has run a million simulations to assess the fragility of the debt outlook. In 88% of the simulations, the results show the debt-to-GDP ratio is on an unsustainable path.” According to Bloomberg, policy makers are “playing with fire.”
Then there was an article this week in Fortune magazine warning, “National debt is fast becoming the thorn in the side of the American economy that nobody wants to extract—and it will continue to damage the economy until the nation is facing down a financial crisis.” Fortune continued, “That is increasingly the opinion of a growing number of experts who are sounding the alarm on the pace at which the U.S. government is gathering debt.” In the article, Fortune even quotes the Congressional Budget Office warning that the growing likelihood of a financial crisis “could erode confidence in the U.S. dollar as the dominant international reserve currency.”
The market seems to be grasping that even if the Fed doesn’t cut rates soon, a resulting fiscal crisis that infects the bond market will force the Fed into easing policy by lowering rates and providing more liquidity—regardless of what is happening on the inflation front.
As a result, gold is now behaving night-and-day different. When the market believed the Fed was functional and that monetary policy was intact, it was axiomatic that hotter inflation data meant a more hawkish Fed, higher yields, a stronger dollar, and lower gold prices. Now, in sharp contrast to just several months ago, gold rallies hard on hot inflationary data because the data puts the Fed into an even tighter, seemingly inescapable, bind.
Indeed, gold’s relentless breakout in the face of higher yields, a strong dollar, and a narrative rapidly turning more hawkish seems to suggest a newly blossoming financial insurance bid for the yellow metal is in play and helping to light a fire under gold’s rally. HAI suspects we are watching gold break out in real time in response to the breakdown of the Fed standard and the end of the era of effective modern monetary policy as we’ve known it.
As Merrill Lynch legend Bob Farrell once said, “In a shift of secular or long-term significance, the markets will be adapting to a new set of rules while most market participants will still be playing by the old rules.” Clearly, for now, most market participants are still playing by the old rules. They’re still aggressively playing the Fed-backed bubble in financial assets. But we’ve got a new set of rules on our hands. If one looks closely, Goldilocks and the Fed standard are both breaking down in front of our eyes.
Again, recall the words of Mohamed El-Erian, “It would not surprise me if future economic history books were to look back at the last week in central banking as marking a move away from strict inflation targeting by the world’s most influential central banks.”
Gold’s recent surge into record territory in the face of higher yields and a stronger dollar is a powerful indication that a growing number of market participants are waking up to the new rules and beginning to adapt. In HAI‘s view, precious metals and other select hard assets are the best risk-adjusted way to align investments with this new reality. At this point, gold’s rally is short-term overextended. As such, HAI expects a correction soon. That said, at this point, given supporting background fundamental factors now supporting higher prices, a strategy of buying on weakness for both gold and silver is very likely to be rewarded.
Weekly performance: The S&P 500 declined 0.95%. Gold gained 4.78%, silver blasted higher by 10.37%, platinum was higher by 2.12%, and palladium was off 1.38%. The HUI gold miners index popped by 7.27%. The IFRA iShares US Infrastructure ETF was off 0.60%. Energy commodities were volatile and higher on the week. WTI crude oil was up 4.50%, while natural gas gained 1.42%. The CRB Commodity Index was up 2.51%. Copper was up big with a 5.64% gain. The Dow Jones US Specialty Real Estate Investment Trust Index was off 2.78%. The Vanguard Utilities ETF was down 0.62%. The dollar index was down 0.19% to close the week at 104.29. The yield on the 10-yr U.S. Treasury gained 19 bps to close at 4.39%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
