Transitory Goldilocks
The National Bureau of Economic Research (NBER) is the research organization known for marking the official start and end dates for U.S. recessions. In April, the NBER released a working paper that examined the history of significant contractionary and expansionary changes in monetary policy since 1946. The study aimed to answer a question: does monetary policy matter?
In short, according to the NBER, the answer is emphatically, yes. According to the group charged with official recession diagnosis, “we find that such monetary shocks have large and significant effects on unemployment, output, and inflation in the expected directions.” The working paper continued, “Analysis of available policy records suggests that a contractionary monetary shock likely occurred in 2022. Based on the empirical estimates of the effect of previous shocks, one would expect substantial negative impacts on real GDP and inflation in 2023 and 2024.”
In other words, according to the NBER, just as the hen was in the egg, the flower in the seed, so, too, is 2023-2024’s expected substantial negative growth shock contained in 2022-2023’s ongoing “contractionary monetary shock.” While the eventual outcome is far more predictable than the timing as a result of “long and variable lags,” HAI, like the NBER, continues to see a preponderance of evidence pointing to the glaring risk that, once again, history will repeat and deliver an ultimate Wile-E-Coyote moment for markets and the economy over the next year.
If given enough time before the wheels fall off, however, markets appear determined to push a FOMO-driven short squeeze back toward highs and potentially beyond. This is a dangerous set-up. It’s an echo-bubble into a very high probability bull-trap, complete with an unmerciful trap-door likely to swing open from the lofty heights of unjustifiable bubble valuations.
Further underscoring the point, Stanley Druckenmiller notes that, “When I look back at the bull market that we’ve had in financial assets…all the factors that created that not only have stopped, they’ve reversed.” Nevertheless, the current upside momentum in this market is now an undeniable force. From a technical perspective, the previous all-time highs are in sight and acting as something of a red cape to draw in bulls.
The market narrative has certainly shifted bullish, and goldilocks is the name of the game. Recession fears for most market participants have waned, and market confidence that inflation will fall neatly to target without issue has surged. For the most part, data this week furthered the goldilocks narrative.
The week was highlighted by softer-than-expected inflation data from the Consumer Price Index (CPI) and by an update on jobless claims. The latter continues to paint a picture of weakening labor market trends, though not yet a recessionary decline.
On Wednesday, the Bureau of Labor Statistics announced that U.S. consumer prices rose modestly in June and registered their smallest annual increase in more than two years. Headline CPI gained 0.2% in June after edging up 0.1% in May. Expectations had been for a 0.3% month-over-month (M/M) increase. Year-over-year (Y/Y) headline CPI came in at 3.0% vs. 4.0% last month, and less than the 3.1% expected. Core CPI (less volatile food and energy) increased 0.2% M/M vs. 0.3% expected, and the Y/Y core reading was 4.8% vs. 5.0% expected. Good progress, but, as HAI discussed last week, the “easy” part of falling inflation statistics is likely nearing an end.
Oil prices are the great inflation force multiplier. So far, oil’s massive decline from over $130/barrel has been the largest driver of lower headline CPI and, to a lesser extent, even lower core CPI through secondary cost pressures. That said, going forward, unless we get the full demand destruction hit of a hard landing soon, OPEC+ production cuts, lower rig counts, and increasing decline rates for U.S. shale production are all signaling a stabilization, if not an increase in oil prices likely in the months ahead.
At the same time, base effect calculations become a headwind for lower CPI after July. As a result, M/M inflation will now have to average below 0.2% from now on. If it isn’t, Y/Y CPI will be higher again by 2024. A sub-0.2% M/M average will be an incredibly tough bar, especially if oil prices stop falling and start to increase again, as they have already started to do over the last two weeks. So, despite market enthusiasm over weaker-than-expected CPI this week, higher interest rates for longer continues to be the likely policy path. A continuation of higher for longer means that the ultimate likelihood of a hard landing increases.
On the labor market data this week, the most effective way to measure the jobless claims data is to look at the change in jobless claims compared to a pre-Covid baseline. This removes any effects of new seasonal adjustments and post-Covid labor distortions. Right now, initial jobless claims are running about 10% above the baseline of earlier years. That’s a level historically consistent with the typical start of recession, but we’re not yet seeing initial claims aggressively accelerate above the 10% level.
Continuing jobless claims are a more reliable recessionary labor market indicator, and continuing claims are now running about 7% above the pre-Covid baseline trend—up very significantly this year, but still shy of the 10% recession indication level. At the start of the year, both initial and continuing claims were actually below the pre-Covid baseline levels, so a very significant and material weakening has certainly transpired year-to-date, particularly since March. So far, we have initial cracks, but not the heavy pressure consistent with a full recessionary breakdown of the labor market.
HAI believes that the situation will continue to develop this year or perhaps early in 2024 as the credit cycle crunch worsens. Contraction is unambiguously the path forecasted by the leading indicators. The Conference Board’s leading Employment Trends Index has continued to post negative growth rates for eight consecutive months, providing a very strong indication that the forward direction of travel for the labor market is decidedly down and into contraction.
F. Scott Fitzgerald famously wrote: “The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.” For now, when analyzing markets, we must all aspire to pass this test. We must hold the risk of both a blow-off-boom and a violent bust in our minds simultaneously, and retain the ability to function and allocate resources accordingly. As Société Générale put it this week, upside risk remains in the market at present, while at the same time, “We believe the profit margin reversal, credit weakness, and sharply rising recession risk will most likely be visible in 1H24, bringing the S&P 500 back down.”
In the short run, the psychology of the market has clearly turned speculative. We’re reverting toward the market psychology observed by Dr. Benjamin Anderson back in the roaring 1920s. As Anderson described, “Every era of speculation brings forth a crop of theories designed to justify the speculation, and the speculative slogans are easily seized upon. The term ‘new era’ was the slogan for the 1927–1929 period. We were in a new era in which old economic laws were suspended.” We’re there again. Speculation reigns, and it’s a “new era” where it is increasingly said that old economic laws, such as those described by the NBER, have been suspended.
The challenge in such environments is that when there is widespread market psychology buy-in to the idea of a “new era where old economic laws have been suspended,” the imagination runs wild throughout the collective mind of the market, fear of missing out (FOMO) turns into a pathological panic of missing out (POMO), and irrational exuberance can surge while markets put on an upside fireworks show that seemingly confirms, for a time, the “crop of theories designed to justify the speculation.” Such speculative bouts are actually a common feature of late economic growth cycles and market tops leading into recessions. In fact, on a median basis, the S&P 500 is typically up 16% in the year that precedes a market peak heading into recession. In a sample size of 12, the S&P in such periods has always posted at least a double-digit gain. This is a dangerous set-up indeed.
Adding even further complexity is the reality that, of course, it is always at least somewhat different and sometimes significantly so. Highlighting this point last week was IMF deputy head Gita Gopinath. Gopinath warned that, “central banks must accept the uncomfortable truth that they may have to tolerate a longer period of inflation above their 2% target in order to avert a financial crisis.” She went on to point out that “policy makers risk being faced with a stark choice between solving a future financial crash among heavily indebted countries and raising borrowing costs enough to tame stubborn inflation… Central banks may need to adjust their monetary policy reaction function to account for financial stress.”
In HAI’s view, when prominent establishment voices say the quiet part out loud, it pays to listen. Gopinath appears to be flagging the concern that this global rate-hike cycle is different this time because it is occurring at record sovereign debt levels. This is an extremely important observation from a top IMF official warning that if a rate hike cycle were to lead to a financial crisis and crash, the sort of government monetary and fiscal response necessary to bail out such a crisis, given the record sovereign debt, could risk popping the sovereign debt bubble.
To HAI, it appears Gopinath is outright suggesting that policy makers should overweight that risk by tolerating higher inflation for longer. In other words, HAI interprets the IMF Deputy Managing Director as suggesting that record levels of sovereign debt have compromised monetary policy and specifically the inflation fighting rate-hike monetary policy brake. If the practical use of interest rates as an inflation fighting monetary policy brake is no longer tenable—meaning, if rates cannot be taken as high as necessary for as long as necessary to consistently tame inflation for fear that trying to do so will result in a sovereign debt collapse (and subsequently in what Dr. Lacy Hunt describes as “a recession without recovery” i.e. a depression) —then the very real risk implied is that the terminal phase of inflation-as-policy may be upon us.
Gopinath’s suggestion said as much. Despite suggesting policy makers moderate their inflation fighting in light of “financial stress” concerns, she simultaneously acknowledges that, “such a shift in the [central bank] reaction function could leave the central bank behind the curve in fighting inflation.” In other words, Gopinath is saying that risk of financial stress, and by extension risk of sovereign debt stress, are now at a point where they override inflation concerns. That’s a perfectly painted portrait of broken monetary policy.
There is no way to tell for certain, at this point, if we have already crossed this Rubicon on the ability to control inflation. If, however, we are at the point where over-indebtedness has already ended the era of effective monetary policy, and markets are now waking up to this reality, then we have to consider the possibility that, as famed Austrian economist Ludwig Von Mises warned, “the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system flounders.” If in fact we are already at the point where the boom turns not into bust, but into the crack-up-boom, then we need to consider a very different interpretation of the recent surge in stock prices.
Returning to Fitzgerald’s observation, we are indeed charged with holding a wide distribution of potential opposing outcomes in mind at the same time. The probability is that this time is not yet materially different, and that after a convincing momentum-driven bull trap, markets face a bruising decline ahead in late 2023 into 2024 as the hard landing hits. After that decline, inflationary concerns would likely resurface as central bankers shift policy back to a stimulative easy monetary policy setting. At the same time, a chance, but a smaller one, remains that this time is distinctly different, and that markets are already adjusting toward inflationary crack-up-boom dynamics in response to broken monetary policy that will see depreciating cash continue to chase asset prices higher—especially assets that offer the characteristic of scarcity, despite the reality of a deteriorating underlying economy.
How do we hold two opposing ideas in mind at the same time and still retain the ability to function? How do we navigate this environment and allocate assets? HAI believes the best approach is a cautious one, with a portfolio thoughtfully constructed to survive and thrive in the event of either recessionary ice or inflationary fire. A barbell approach comprised of hard-landing protection from elevated levels of cash-like short term Treasurys with attractive yield on one side, and on the other side, inflation protection in the form of scarce hard assets and their producers. More specifically, on the inflation protection side of the portfolio, a higher allocation to precious metals and related equities is advised before the hard landing risk has cleared. In the event of a recessionary hard larding and lower asset prices in economically sensitive hard assets, the cash-like portion of the portfolio offers the dry powder needed to increase exposure to economically sensitive commodities and producers with strong yields at better prices. Such a portfolio will perform, and eventually thrive, in either macro scenario we face.
At the same time, avoiding much exposure to the major market indexes will likely be wise. 2023’s stock market performance has been disproportionately driven by a piling into the “magnificent seven” mega-cap tech stocks. If current risk-on turns suddenly into decided risk-off, the magnificent seven unwind may be dramatic, as might be their negative impact on the indexes. Many of the current market darlings are seeing their valuation multiples expand into ever more unsustainably bloated levels, even as sales and earnings are dropping. Of the magnificent seven, Alphabet trades at the most “modest” P/E multiple of 27x (modest only within its incredibly warped micro-universe). Apple trades at a 32x P/E multiple, while Meta is pushing a cool 40x multiple. Unfortunately, those names represent your magnificent-seven “relative value” plays. From there, we push P/E multiples to 67x for Microsoft, 80x for Tesla, 228x for Nvidia, and (a perhaps slightly stretched?) 317x for Amazon.
These seven “magnificent” stocks that currently define major market indexes and have driven almost all of the year-to-date S&P 500 gains are priced for a future that’s even better than perfection from both a company-specific and macroeconomic fundamental standpoint. Furthermore, these stocks are priced for, and are dependent upon, a return to the market regimes that dominated for the last 40-years. HAI, however, believes that comprehensive regime change is upon us, and that hard assets are the regime change assets that will lead all assets in the new secular market cycle to come.
Uncertainty over recessionary ice or inflationary fire absolutely challenges us all, as Fitzgerald suggested, to hold two opposing ideas in mind at the same time and still retain the ability to function. As long as uncertainty reigns, both outcomes must be prepared for. What appears much more certain, however, is that, one way or another, our “new era” of hoped for perpetual goldilocks is, in reality, almost surely transitory.
Weekly performance: The S&P 500 gained 2.42%. Gold was up 1.65%, silver surged 8.16%, platinum was up 7.16%, and palladium gained 1.71%. The HUI gold miners index jumped 8.01%. The IFRA iShares US Infrastructure ETF was up 2.62%. Energy commodities were volatile and mixed on the week. WTI crude oil was up 2.11%, while natural gas lost 1.67%. The CRB Commodity Index was up 2.39%. Copper was up sharply, gaining 3.99%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 2.17%, and the Vanguard Utilities ETF was up 2.31%. The dollar was crushed, down 2.30% to close at 99.61. The yield on the 10-yr Treasury crashed by 23 bps, ending the week at 3.83%.
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
