Inflection Point
This week, HAI wishes a happy 4th of July to all, and a very happy birthday to the land of the free and the home of the brave! While this year’s Independence Day revelry comes amid great challenges for the nation, always remember that serious times bring forth serious people, and serious people aiming to solve problems brings serious hope. It is an American tradition to triumph in the face of peril. May we continue that tradition—soon.
This holiday-shortened week perpetuated the recent trend toward weakening economic data. Highlights came in the form of a nasty ISM Services survey that shook the Street, and from an unexpected uptick in the unemployment rate to 4.1%—a level already above the Fed’s year-end target of 4.0%. However, bad news is good news again on Wall Street. This week’s data reinforced bets that the Federal Reserve will indeed begin the process of cutting interest rates to ease monetary policy in September. The market loved it.
First off, the ISM manufacturing PMI came in at 48.5 vs. an expected 49.1, down slightly from the prior 48.7 reading. It was the third straight month of contraction (below 50) for the ISM manufacturing PMI, and significantly the employment index unexpectedly dropped into contraction as well with a 49.3 read vs. the 50 expected.
As previously noted, however, it was the ISM Services PMI that really turned heads this week. Throughout the Fed tightening cycle, a strong services sector has been credited with keeping the overall economy resilient. This week, the ISM Services PMI came in at a contractionary 48.8, far short of the 52.6 expected and a huge five-point elevator drop below the prior reading of 53.8. This was the weakest ISM Services read since the Covid lockdown four years ago. What’s worse, one of the poorest performing subcomponents was new orders, a high-quality leading indicator. In June, services new orders plunged 6.8 points to 47.3 from May’s 54.1. Even more concerning, it was the first contraction for services new orders since December 2022. Furthermore, the services employment index sank further into contraction with a 46.1 reading, down from 47.1 in May.
As for non-farm payrolls, Friday’s establishment report beat expectation at 206k payrolls vs. consensus expectations for 190k. On the other hand, the Household survey underperformed expectations with 136k jobs vs. 160k expected. Notably, however, the change in total nonfarm payroll employment for April was revised down by 57k, from 165k to 108k, and the change for May was revised down by 54k, from 272k to 218k. With these revisions, total employment in April and May combined is now 111,000 lower than previously reported—and as mentioned, the unemployment rate jumped to 4.1% from 4% previously. Again, more significant than a one-point uptick in the unemployment rate itself, the Fed had already indicated at the last FOMC meeting that it expected a 4% unemployment rate at the end of the year. Breaking above the 4% Rubicon in June can be used later this year to justify rate cuts on the basis that employment has weakened more than the Fed expected. While market-based rate cut odds were rising all week, after the unemployment rate registered at 4.1%, the odds of two cuts in 2024—one in September, one in December—spiked to almost 100%.
In what appears to be a narrative shift toward justifying a path of more rate cuts sooner, this week some Fed governors were increasingly vocal in their concern over a weakening economy and rising unemployment. Chicago Federal Reserve Bank President Austan Goolsbee on Tuesday said he sees some “warning signs” of weakening in the economy. He emphasized that the U.S. central bank’s goal is not just to get inflation down to target, but to reduce inflation without stressing the labor market. He added, “I see some warning signs the real economy is weakening… You only want to stay this restrictive for as long as you have to.” Once again, the narrative appears to be shifting in the direction of the rate cuts the market craves and the government needs in order to forestall a sovereign debt crisis.
This week’s release of the minutes from the last FOMC meeting also showed increasing caution about the economy and the labor market. According to the minutes, “Several participants specifically emphasized that with the labor market normalizing, a further weakening of demand may now generate a larger unemployment response than in the recent past when lower demand for labor was felt relatively more through fewer job openings.”
San Francisco Fed head Mary Daly, who votes on monetary policy this year, said in a speech this week that, “So far, the labor market has adjusted slowly, and the unemployment rate has only edged up. But we are getting nearer to a point where that benign outcome could be less likely.” Daly warned that the US labor market is nearing an “inflection point” where a further economic slowdown could mean a more pronounced jump higher in unemployment. Like Goolsbee paving a path toward rate cuts, Daly added, “At this point, inflation is not the only risk we face.”
It isn’t just dovish central bankers who are concerned and are now signaling pending rate cuts. Goldman Sachs Chief Economist Jan Hatzius also warned of reaching an inflection point where a further softening in demand for workers could result in a significant rise in the unemployment rate.
The fear is that we’re close to tripping a recessionary spiral. Any further economic weakening will hit the labor market, and any further hit to the labor market will snowball into accelerating the economic contraction in a vicious cycle. The Fed is well aware that labor-market losses can pile up quickly once the recession spiral gets rolling. The risk is real. Amid soft landing cheers, unemployment rose gradually from 4.4% in March 2007 to 5.1% a year later, as the economy “softly” slowed amid the onset of the financial crisis. As the recession that started in December of 2007 took hold, however, the jobless rate spiked rapidly, reaching 7.3% by the end of 2008 on its way to a 10% peak the following year.
To date, as in 2007, the unemployment rate has “softly” marched higher in a gentle fashion from a trough of 3.4% to 4.1%. With the historically “tight” post-pandemic job market having now returned to pre-pandemic levels, the danger is that the weakening trend could continue and evolve into something far more ominous the longer the Fed keeps rates at present levels. Given the Fed’s rather obvious easing bias, it’s understandable that the market is ramping up rate cut expectations.
Concerns over a weakening economy, a sharper rise in unemployment, and increasing expectations for the resulting emergency rate cuts that would follow are also validated by the most recent update from HAI favorite economist and prescient market strategist Dr. John Hussman. In Hussman’s latest missive, “You Can Ring My Bell,” the data driven analyst responsible for accurately calling each of the major market tops of the last several decades is at it again with talk of another inflection point. Hussman wrote matter-of-factly; “I may as well just say it. Based on the present combination of extreme valuations, unfavorable and deteriorating market internals, and a rare preponderance of warning syndromes in weekly and now daily data, my impression is that the speculative market advance since 2009 ended last week. Barring a wholesale shift in the quality of market internals, which are quickly going the wrong way, any further highs from these levels are likely to be minimal. In contrast, current valuation extremes imply potential downside risk for the S&P 500 on the order of 50-70% over the completion of this cycle.”
Given that dark and menacing clouds are already on the economic horizon and that this author has had an S&P 500 “top watch” in effect since the tightening cycle began, when Hussman rings the bell and calls the top, this author listens. Rest assured, if Hussman is right, then a much more aggressive rate cut cycle and stimulative government response than the market currently envisions is indeed right around the corner.
But the increasing odds of imminent rate cuts come as inflation is still well above target; fiscal policy is injecting nearly $2 trillion of deficit spending stimulus into the economy; and the mean 5-10 year inflation expectation reading from the University of Michigan has just spiked to a new all-time high, in data going back to the 1990s, of 5.3%. That measure was 2.6% pre-pandemic. Prior to Covid, it never surpassed 4%. Furthermore, the narrative of further immaculate disinflation from improved supply chains is beginning to unravel.
As a New York Times article titled “Supply Chain Under Strain as Houthis Intensify Red Sea Strikes” makes clear, inflationary supply chain bottlenecks are, once again, on the comeback. Commenting on the hope that the inflationary global supply chain breakdown post-pandemic was just an unpleasant memory confined to the rear view mirror; the Times says simply, “no such luck.”
According to Stephanie Loomis, head of an international global logistics company, supply chain upheaval is brewing again. In addition to Houthi rebels compromising the use of the Suez Canal, a series of additional logistics hurdles have surfaced in recent weeks. Dockworkers have threatened to strike on the East and Gulf Coasts of the United States, longshore workers at German ports have halted shifts in pursuit of better pay, and rail workers in Canada are poised to walk off the job, imperiling cargo moving across North America and ultimately threatening backups at major ports.
None of that bodes well for pulling inflation down through the last mile of its trip back to 2%. As Loomis put it, “I’m lovingly calling the market now ‘Covid junior’ because in a lot of ways we’re right back to where we were during the pandemic… It’s all happening again.”
Simply put, structurally higher inflation looks to be with us secularly. War, deglobalization, geopolitical fracturing, reshoring/friendshoring production, AI energy demand, the build-out of energy infrastructure, and ongoing supply chain challenges are all inflationary. The great big offset would be a great big recession.
A recession would, at least temporarily, ease price pressures. Problem is, with $35 trillion in debt and deficits running close to $2 trillion before a recession even hits, the U.S. can’t afford a recession without triggering a government debt crisis. It’s a mine field out there. The first risk is recessionary ice with a side of sovereign debt crisis, then the second risk, after a potentially massive stimulative government response, is inflationary fire on a path toward an eventual Austrian crack-up-boom. Ultimately, the question is, how do policymakers exit the path of inflation when they’ve got nowhere else to turn at this point?
While on the topic of eye-popping and consequential US debt and deficits, former New York Federal Reserve Bank president Bill Dudley just offered the latest evidence that the US fiscal problem is rapidly reaching an inflection point as well.
In a Bloomberg op-ed, titled, “The US Budget Deficit Is Huge. Here’s Why to Worry,” Dudley, a Central Bank establishment insider, offers a shot across the bow to anyone who will listen. In perhaps the best evidence yet that the debt “problem” is slowly getting a narrative upgrade to “crisis,” Dudley warned, “The US is taking a big risk by running large and chronic fiscal deficits. The more it borrows, the greater the chance it’ll end up in a vicious cycle, in which government debt and interest rates drive one another inexorably upward. The rising debt burden also increases pressure on the Fed to devalue the debt by allowing inflation to rise.” Dudley continues, “It’s impossible to know when investors will decide that such risks are too much to bear, as the bond vigilantes famously did in the 1990s. When it happens, it tends to be sudden and brutal. This is the concern that should be paramount.” Dudley’s op-ed, the strength of gold despite rising yields, and the record three-year losing streak in bonds are all screaming that “it” is beginning to happen now, and that the “sudden and brutal” part comes next.
Trapped between a rock and a hard place, the Fed would almost certainly fight tooth and nail to avoid the type of vicious cycle described by Dudley. That likely means a bias to significantly cut the fed funds rate, despite inflation, and ultimately the initiation of some form of yield curve control to keep the market (Dudley’s bond vigilantes) from setting interest rates based on fundamentals. Dudley just translated the writing on the wall. The dynamic is unambiguously inflationary. It’s also decidedly good for a higher gold price and overtly bullish hard assets broadly.
Economist Henry Hazlitt observed that “the value of any monetary unit, such as the dollar, depends not merely on the quantity of dollars but on their quality.” Dudley is telling us in no uncertain terms to expect the quantity of dollars to increase while dollar quality simultaneously erodes because, as Von Mises warned long ago and Dudley seemingly confirms now, at this point “inflation is policy.”
Against the dollar, gold shines bright by comparison. Its quantity is scarce, while its quality is never in doubt. Under the circumstances, it’s no surprise gold’s price is ascending. Gold is becoming more valuable because, as Hazlitt put it simply, “people have more faith in gold than they have in the promises or judgement of the government’s monetary managers.” At the inflection point, Hazlitt’s wisdom has never been timelier.
Weekly performance: The S&P 500 popped 1.95%. Gold was up 2.48%, silver surged 7.20%. Platinum was up 3.15%, and palladium gained 6.31%. The HUI gold miners index was up 6.04%. The IFRA iShares US Infrastructure ETF was down 1.19%. Energy commodities were volatile and mixed on the week. WTI crude oil was up 1.99%, while natural gas was off 10.84%. The CRB Commodity Index was nearly flat, off 0.11%. Copper was up big with a 5.93% gain. The Dow Jones US Specialty Real Estate Investment Trust Index was nearly flat, off 0.13%. The Vanguard Utilities ETF was up 0.33%. The dollar index was down 0.94% to close the week at 104.55. The yield on the 10-yr U.S. Treasury was off 12 bps to close at 4.29%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
