“Prudent” Amid FOMO, POMO, and MOMO
This week, in the wild world of markets, fear of missing out (FOMO) has turned into full-on panic of missing out (POMO) as stock market momentum (MOMO) reaches a crescendo. With the Federal Reserve pausing on interest rate hikes this week, market participants are gearing up for the policy pivot party. Meanwhile, what had been called “the most anticipated recession of all time” by many market observers has seemingly been transformed, suddenly, into the most anticipated soft landing/no-landing of all time. Bullish sentiment and investor complacency have taken firm hold, for now, within the market. Market sentiment, a contrarian indicator when at extremes, has flipped from ultra-bearish at the lows in October (a setup for a rally) to extreme-bullish at present (a setup for a decline). Meanwhile market technicals have reached excessively overbought levels on both a short and intermediate timeframe. Just as the majority on Wall Street has finally sounded the all-clear and turbocharged the party, the conditions are now becoming more favorable for a trend change, potentially wrong-footing late comers to the extravaganza.
This week, stocks popped, precious metals dropped, and the dollar flopped, while the yield curve further inverted as front-end yields jumped more than the belly of the curve and long-end yields declined. Commodities experienced a reprieve from recent selling pressure. Everything from energy to copper to other industrial metals basked in the glow of a Chinese rate cut and increased speculation that the Chinese government may step up its stimulus support for the economy—specifically for its flailing, commodity-consuming property development sector.
It remains to be seen whether Chinese stimulus will be pushing on a string or can gain the kind of traction necessary to materially increase commodity demand. While oil and copper were higher on the China news, the pop was muted given the pre-existing oversold conditions, a sharp commodity-supportive dollar decline, and recent bullish supply side developments for each commodity. All in all, despite a strong week in the overall commodity index, most gains have come from agricultural commodity prices benefiting from hot and dry weather across the globe and natural gas prices rising as that same hot weather drives cooling demand. Also stoking European natural gas prices, up 70% in the past five days, are creeping concerns over a renewed energy shortage as the Netherlands prepares to close Europe’s biggest gas field in 2023. Outside of these segments, commodity demand concerns stemming from the fear of a developing global recession and skepticism over the efficacy of China stimulus efforts continue to be reflected in current commodity pricing.
The most impactful data of the week was the release of the Consumer Price Index. Headline CPI in May increased 0.1% month-over-month (M/M) vs. 0.2% expected, and less than the 0.4% increase in April. Year-over-year (Y/Y), headline CPI was 4.0% in May vs. 4.1% expected, and down from 4.9% in April as the trend continues to moderate. While headline inflation continues to cool, core inflation (the primary focus of the Fed), which strips out volatile food and energy prices, remains very sticky and stubbornly elevated. Core CPI increased 0.4% M/M, in line with expectations, while core CPI (Y/Y) rose 5.3%, only marginally below April’s 5.5% level. In addition to ongoing stickiness in the core readings, the added problem for the Fed to sustainably attain their 2% target is that after July, the year-over-year base effect comparisons will become much more challenging. After July, base effects will no longer help to effortlessly send the Y/Y inflation numbers lower.
In other data this week, initial jobless claims significantly outpaced analysts’ expectations for the second week in a row. Initial claims are now starting to accelerate higher against a pre-Covid (undistorted) baseline as the overall deterioration in the labor market picks up. Initial jobless claims are now more than 10% higher than the average of 2018 and 2019, and that’s the historical signal for recession. Also this week, retail sales data came in better than expectations, and was again touted as evidence of consumer strength. However, after adjusting for inflation, smoothed six-month annualized real retail sales are negative by 1.9%. Historically, on average, recessions begin when real retail sales have reached negative 1%.
Data sets aside, the undisputed main event in economic news this week was the Federal Reserve FOMC meeting. After raising interest rates at 10 consecutive meetings since March 2022 by a cumulative 500 basis points—the most rapid series of increases since the 1980s Volker era, this week Jay Powell and the FOMC “paused,” as expected, and opted to leave rates unchanged. According to Powell, “We’ve covered a lot of ground, and the full effects of our tightening have yet to be felt.” While the Fed paused, they also seemed to endorse the idea of a “skip” rather than a sustained pause. Fed officials’ new economic projections released Wednesday showed that 12 of 18 FOMC members expect to raise rates at least two more times this year. That number is up from only four officials in March. Breaking down the Fed’s dot plot estimates further, two FOMC members supported no more hikes for the rest of this year, four expected one more hike, nine said they saw two more hikes, two estimated three hikes, and one supported four additional rate increases. The message from the new economic projections was clearly intended to be hawkish.
So, while the Fed held rates unchanged, they also indicated that the expectation should be that more hikes are on the way. In short, the new game plan is for the Fed to move toward further tightening at a slower pace. Powell did not outright commit to any additional hikes, as the FOMC will remain “data dependent,” but the overall message clearly indicated a bias to hike again. Following the meeting, market-based expectation for a July hike of 25 basis points increased to a 70% probability.
When asked in the Q&A about rate cuts, Powell said, “It will be appropriate to cut rates at such time as inflation is coming down really significantly, and again, we’re talking about a couple years out… Not a single person on the committee wrote down a rate cut this year, nor do I think it is at all likely to be appropriate. If you think about it, inflation has not really moved down. We’re going to have to keep at it.” So, further rate hikes still seem likely. With Fed institutional credibility entirely at stake, it appears as if rate cuts will remain on hold until we see a crash in inflation, a recessionary spike in the unemployment rate, and/or a severe eruption of systemic financial crisis.
Before the fact, markets didn’t think inflation or interest rates would rise in 2022. Today, the market doesn’t think employment will crack or that a recession will arrive in 2023—or even 2024. With rate cuts apparently off the table, however, the market’s hope in the “resilient” economy and no-landing narrative may be misplaced. The CRB Industrials Index, a reliable leading indicator of global growth, has continued to grind lower in recent weeks. It now sits below the October 2022 trough level. The Conference Board’s Leading Economic Index, comprised of 13 key leading economic indicators (with a perfect track record in data back to the 1950s), is deeply recessionary, continues to trend lower, and has yet to bottom. The yield curve, among history’s best leading indicators, is forecasting a recession with a negative 95.5-point 2s10s inversion that’s the deepest since the early 1980s. The breadth of inversions across the curve is also extremely notable. In data back to the 1970s, a recession has never been avoided when yield curve inversion breadth exceeded 70%. The current 76% inversion breadth not only forecasts recession, but also offers one of history’s strongest macro signals to be long gold and short the S&P 500 over a two-year time frame.
At the same time, a credit crunch has started, but has yet to fully mature. A closet-full of shoes is poised and ready to drop in commercial real estate. That will put further stress on already stressed banks and further slow lending growth and, as a result, economic growth and employment. At the same time, far from pricing in these risks, the Buffet indicator (Wilshire 5000 market cap to GDP) paints a portrait of a market significantly more overvalued than at the absolute peak of the tech bubble. With all that said, however, markets couldn’t care less. All that matters is speculation over the return of an everything-bubble 2.0, and the only fear in this market now is the fear of missing out.
This week, amid the recent surge in market sentiment and accompanying swell in hope for a soft-landing/no-landing scenario, Deutsche Bank played party-pooper and rudely rained on the market’s parade. In Deutsche’s latest update, the bank now anticipates a U.S. recession and gauges that risk at a 100% probability. With inflation still sticky-high, lagged impacts of previous rate hikes still working their way through the system, more hikes still expected, and cuts having to wait, David Folkerts-Landau, Deutsche Bank Chief Economist, sees this whole cycle as a compounding series of ongoing policy errors set to end in bust. This week he wrote, “The U.S. is heading for its first genuine policy-led boom-bust cycle in at least four decades.” Echoing similar observations by San Francisco Federal Reserve Bank research highlighted in last week’s HAI, Folkerts-Landau continued, “The inflation we see was induced largely by expansive fiscal and monetary policy, and the aggressive rate hikes needed to tame that have now materialized. Avoiding a hard landing would be historically unprecedented.”
The Deutsche Bank Chief Economist may be on to something. Gross domestic income (GDI) is a measure of the incomes earned and the costs incurred in the production of gross domestic product (GDP). It’s another way of measuring U.S. economic activity. In the latest update from the Bureau of Economic Analysis (BEA), GDI came in at negative 2.3% in Q1 2023. That followed a negative 3.3% contraction in Q4 2022. The sharp contraction in GDI contrasts with still positive GDP, even though they both measure the same economic activity. What’s fascinating is that while both GDI and GDP typically track closely together, we’ve seen this sort of divergence (recessionary GDI while GDP remains positive) before—during the run-up to previous recessions. The same pattern of GDI and GDP divergence into recessionary periods caught the attention of Federal Reserve economist Jeremy Nalewaik, who studied the phenomenon. Nalewaik’s conclusion was that data shows GDI “has done a better job recognizing the start of recessions than has the growth rate of real GDP. This result suggests that placing an increased focus on GDI may be useful in assessing the current state of the economy.”
Michael T. Owyang, an economist and assistant vice president at the Federal Reserve Bank of St. Louis, subsequently expanded on Nalewaik’s work. As with previous recessions, the results found that, in evaluating GDP and GDI by comparing vintages of the unrevised data, “early estimates of GDI captured the downturn in the 2007-09 recession better than GDP, which could have given policymakers advance notice.” Owyang concluded with a suggestion. He said, “For now, GDP remains the prominent measure of output cited by both the media and policymakers. In the end, however, it may be prudent to use both series (or perhaps a measurement combining both) to measure output.”
Well, HAI certainly wished to be “prudent.” According to the BEA’s combined measure of blended GDI and GDP, U.S. economic output has already been negative for two consecutive quarters. Based on the leading indicators, we should expect that contraction to continue and deepen. Unless dangerous early-stage crack-up boom-like dynamics have already terminally hijacked market functioning, odds are very good the stock market will soon take notice.
In the meantime, modern markets are again embracing the idea that it’s a bold “new era” in which old economic laws have been “suspended.” Despite all the headwinds, the market now has the speculative bit in its teeth once again, and that speculation is at fever pitch.
To be sure, markets throw curveballs. Right now, this market is pitching them like Sandy Koufax. Nevertheless, while market participants may continue to chase what they think is a new bull market, the overall market setup ultimately looks like an unfolding bull-trap, “a combo of 2000 and 2008—a big rally before a big collapse,” according to Bank of America Chief Investment Strategist Michael Hartnett this week. While keeping a close eye on the recessionary signal being sent by GDI, HAI suggests it might also be quite “prudent” in our unfolding environment to be long gold as financial insurance. The price of that insurance looks set to spike.
Weekly performance: The S&P 500 was up 2.58%. Gold shed 0.30%, silver dropped by 1.15%, platinum lost 2.52%, and palladium recovered last week’s losses with an 8.54% rebound. The HUI gold miners index was nearly flat, up 0.06%. The IFRA iShares US Infrastructure ETF was up 0.84%. Energy commodities were volatile and higher on the week. WTI crude oil gained 2.51%, and natural gas surged 16.68%. The CRB Commodity Index was up 3.98%, and copper gained 2.67%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.68% on the week. The Vanguard Utilities ETF was up 1.16%. The dollar was down 1.63% to close at 101.84. The yield on the 10-yr Treasury was higher by 2 bps, ending the week at 3.77%
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
