Ahead of the Game
This week markets got a big dose of economic data. Ultimately, however, that data didn’t change the overarching narrative. Debt has become a huge problem, the economy is slowing, a Fed rate cutting cycle appears set to commence in September, and market instability has accumulated like snow in an avalanche zone. Despite the rebound in stock prices off the recent lows, a resumption of the previous bull trend for stocks is far from certain. It’s a good time for market participants to hunker down patiently, dial back risk exposure, and wait to see how markets react to the Fed’s next move.
One thing is clear, however. Last week’s yen carry trade “Minsky moment” exposed late cycle market vulnerabilities that can’t be unseen or easily forgotten. Recall, volatility matters in and of itself. When prices turn volatile, financial leverage must be unwound. By extension, risk-on markets can turn risk-off—in a hurry. The question at hand is whether, after the convincing ongoing retracement rally, recent volatility will ultimately trigger a forced unwind of the dominant trades that have powered markets higher since late 2022. After all, as BCA Research’s excellent strategy team concluded this week, “The analysis of price complexity strongly suggests that the ‘yen carry trade’ and the AI bubble are one and the same trade, premised on three conditions: Japanese interest rates must not increase; the yen must not appreciate; and US superstar stocks must continue delivering high and stable returns.”
In other words, BCA is warning that unless we can stack an improbable series of “musts” on top of each other, and the notoriously blunt instrument that is monetary policy can suddenly thread a most complex needle to significantly quell further downside market volatility, the global trade powering the latest surge in the everything bubble has much further to unwind. While short term traders may, for the time being, press their bets for a continuation of the bubble, the recent volatility strongly suggests that prudent investors are beginning to prepare for the popping of it.
One of the data points this week allowing markets—in fear of a growth scare—to breathe a sigh of relief was a better-than-expected nominal retail sales report. While the stronger-than-expected retail sales data was broad-based, the gains in autos and building materials were particular standouts. On a month-over-month (MoM) basis, auto sales rose an impressive 3.6% and building materials gained a very solid 1.0% MoM.
While the MoM gains in the two categories were impressive, that data was also contradicted by other industry analysis. For example, according to the latest industry-leading research from Cox Automotive, “Incentive spending has been climbing as inventory builds. New-vehicle incentives in July were nearly 60% higher than a year ago, and while we’re not back to the crazy days of incentive packages equal to roughly 10% of Average Transaction Price (ATP)—we’re close to 7% today—the market sure looks to be heading that way.” A 60% increase in year-over-year (YoY) incentive spending by auto dealers to boost car sales is hardly a sign of a robust revival in auto land.
Similarly, the increase in spending on building materials is another head scratcher. It would be great news for the economy if the data is accurate and a new uptrend can be sustained. After all, as Ed Leamer of UCLA argued in 2007, “housing IS the business cycle.” But HAI can’t reconcile the reported increased spending on building materials with the following boots-on-the-ground observation from housing experts Zelman & Associates. This week, similarly confused by the retail sales data for building materials, Zelman & Associates noted that the data contradicted their findings that, “The start to 2024’s third quarter was weak across the board as all end markets declined on a year-over-year basis.”
Other housing data this week supported Zelman & Associate’s skepticism. This week revealed that July building permits dropped back to the cycle low. July also revealed that both single-family and multi-family housing units under construction declined to fresh new cycle lows, and total housing units under construction are now falling at a 12.5% annualized rate. Furthermore, the leading housing permits data forecasts even more downside ahead for units under construction. In short, at least through July data and other than the one lonely report of increased retail sales on building materials, we’re just not seeing any improvement in housing related data.
All in all, despite the reported pop in July retail sales, real retail sales are still running flat at a 0.1% annualized growth rate—a figure inconsistent with a healthy and expanding economy. Furthermore, new research from the Federal Reserve Bank of San Francisco demonstrates that the aggregate data doesn’t tell the whole tale. According to the San Fran Fed, “middle- and low-income U.S. families now have significantly fewer liquid resources like bank deposits than they were on track to have before the disruptions of the COVID-19 pandemic, creating financial strains that pose a risk to consumer spending, the backbone of the economy.” Research published on Monday showed that for the top 20% of households by income, liquid assets—including cash and funds in savings, checking and money market accounts—rose sharply in 2020 into early 2021. They then dropped gradually and are now about 2% below what would have been expected without the pandemic shock.
The San Fran Fed data showed that the trend is even worse for the American households that represent the lowest 80% by income, who saw their assets rise less sharply and depleted their excess savings more quickly. That has left their liquid assets about 13% lower than the projected path of their finances before the pandemic. That development comes as credit card delinquencies among middle- and low-income families rose earlier, faster, and to “notably higher” rates than those of high-income families, the research found.
Markets also cheered this week when initial jobless claims dropped to 227,000, below the estimate of 235,000 and down from an upwardly revised 234,000 the previous week. While excited by the relief seen in initial jobless claims, the market ignored the gloom emanating from continuing claims. The four-week moving average of continuing claims continued its streak of gains with a rise to 1.862 million. To be clear, with 13 straight weeks of increases now in the books, continuing claims are in rarified territory, we’ve only seen previous precedents when the economy was in recession.
As for an additional gauge on real-time employment in the cyclical manufacturing economy, two regional Federal Reserve manufacturing surveys out this week flagged weakness, not strength. The Empire State Manufacturing Survey showed employment remained in contraction, while the average workweek (the last lever for struggling employers to pull before widespread firings commence) collapsed 17.7 points to -17.8. In the Philly Fed’s factory sector, the index for the number of employees crumbled 20.9 points to a -5.7 reading, and the workweek slipped 0.7 to a -2.3 read.
The reading on backlogs, however, which dictate future employment, was the real eye opener. In the last three months, the Philly Fed’s Future Backlogs index slid sharply from optimism to pessimism. May saw this forward guide for factory labor resources advance to 26.7, a new high for the cycle. By August, however, future backlogs had plummeted to -9.7, a level in line with every pre-pandemic recession since the series’ 1968 inception. More importantly, the -36.4-point swing from May to August was the second worst on record. All told, this week’s inputs on continuing claims, the workweek, and future backlogs were all inconsistent with a healthy and expanding economy.
Also contradicting the pop in retail sales was a drop in industrial production growth, which fell from a 1.5% annualized pace previously to a 0.2% growth rate. Furthermore, that marginal industrial production growth remains hyper-concentrated in aerospace & defense equipment specifically. Beyond that, we’re seeing declines throughout the vast majority of the economy. That’s another stat inconsistent with a healthy and expanding economy.
Also inconsistent with an economy expanding at a healthy pace is the recent downshift in CPI inflation data. July CPI data out this week continued the recent downtrend in inflation. Headline CPI inflation dropped below 3% for the first time since March of 2021, and core CPI came in at 3.2%—its lowest since April 2021. While that’s great news for the consumer, it also warns of an accelerating weakness in the broad economy.
What is booming right now isn’t the economy, it’s the federal deficit. This week we learned that July’s US Federal budget deficit was the second highest on record. July’s deficit is second only to that of July 2021, when post-Covid spending was in full force. For the government’s deficit, however, this isn’t the sort of silver medal you celebrate on the podium. This July the unemployment rate was 4.3%. In 2021 it was 5.4%. So, despite still being at or near full employment, and far removed from an obviously acute crisis like Covid, “True Interest Expense” (Social Security + Medicare + Health + Veterans’ Benefits + Net Interest Expense) was 120% of tax receipts in July. Needless to say, that’s 120% of tax receipts before we even put a dollar into defense spending and other critical line items.
In HAI’s view, this is the rot at the core of the entire financial system that quietly lurks beneath all other risks. The US is trapped in debt spiral dynamics. At this point, even with max tax receipts flowing in from a record high stock market and near full employment, the government is falling behind at an accelerated pace. Unless Jay Powell is every bit the Man of Steel that Danielle DiMartino Booth suggested he is several weeks ago, the Fed is going to have to aggressively cut rates, end quantitative tightening, and expand their balance sheet one way or another—and soon.
Failure to do so appears mathematically certain to trigger the sort of sovereign debt crisis the Bank for International Settlements (BIS) warned of in June. To refresh, according to the BIS, with “historically high debt levels…confidence could quickly crumble if economic momentum weakens and an urgent need for public spending arises on both structural and cyclical fronts. Government bond markets would be hit first, but the strains could spread more broadly, as they have in the past.” The US bond market is the core of the entire global financial system. A continuation of higher-for-longer interest rates and an economy that slips into recession will fully expose that rotten core. If that rot is exposed, the system-wide fallout would be nothing short of profound.
While an unwind of the yen carry trade and a bursting of the AI bubble would no doubt cause considerable pain and end the bull market in financial assets, a bursting of the sovereign debt bubble that caused a failure in the US bond market would be a financial catastrophe likely only comparable with depression-era realities. What’s even more frightening in our unstable and fragile modern financial moment is that, like dominoes or the butterfly effect, the unwind of the yen carry trade or the popping of the AI bubble could trigger a cascade ultimately culminating in a broken bond market and a worst-case outcome. This is not a time for complacency and risk indifference. In short, given the stakes, expect looser monetary policy, increased forms of stimulus, and even more inflation as policy with the passage of time. That combo is likely to be perceived by policymakers as the lesser of two evils.
This week HAI was reminded of the words of former Treasury Secretary William E. Simon, who served during the last great inflation. Simon observed that “the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it.” With confidence in the rotten core of the system increasingly threatening to “quickly crumble,” and a market narrative swinging rapidly toward “mission accomplished” on inflation, HAI expects D.C. lawmakers and Federal Reserve policymakers to soon be busy delivering “everything that causes it” all over again.
Right on cue, this week Democratic presidential candidate Kamala Harris announced some of her key economic policy proposals should she gain the White House. Highlights included the elimination of medical debt for millions of Americans, numerous price controls (ultimately extremely inflationary), a $25,000 subsidy for first-time home buyers, and a child tax credit providing $6,000 per child for the first year of a baby’s life. With easier monetary and fiscal policy on the horizon, and seemingly no turning back without a catastrophe that no one in power seems willing to endure, it is as Von Mises warned decades ago: Inflation is policy.
No surprise then that the Nikkei Asia reported this week that “Central banks are diversifying away from the dollar and yuan while loading up their foreign exchange reserves with a ‘stateless currency,’ gold… The proportion of the U.S. currency in global foreign reserves has dropped significantly, from over 70% in the early 2000s. Currently, the dollar’s share of foreign reserves held by central banks and governments worldwide sits at a historic low.”
This is a shift of long-term significance. To paraphrase Merrill Lynch legend Bob Farrell, markets are beginning to adapt to a new set of rules, but most market participants are still playing by the old rules.
It isn’t what central bankers say but what they do that matters most, and in our modern moment global central banks are adapting to a new set of rules while most market participants are still playing by the old ones. Global central banks are wholeheartedly endorsing gold with their actions. Gold’s new record high this week suggests the yellow metal sees what’s happening in addition to what’s coming and is well ahead of the game.
Weekly performance: The S&P 500 was up 3.93%. Gold was up, with a 2.60% gain. Silver added 4.57%. Platinum was up 3.49%, and palladium gained 5.27%. The HUI gold miners index surged 8.67%. The IFRA iShares US Infrastructure ETF was up 1.60%. Energy commodities were volatile and lower on the week. WTI crude oil was off 1.69%, while natural gas was down 0.93%. The CRB Commodity Index surged 5.14%. Copper was up 3.77%. The Dow Jones US Specialty Real Estate Investment Trust Index was nearly flat, down 0.13%. The Vanguard Utilities ETF was up 1.12%. The dollar index was down 0.63% to close the week at 102.31. The yield on the 10-yr U.S. Treasury was down 6 bps to close at 3.89%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
