“Nowcasting” the Storm Track – May 13, 2022

“Nowcasting” the Storm Track – May 13, 2022
Morgan Lewis Posted on May 15, 2022

“Nowcasting” the Storm Track

This past week was another wild one in markets. Broad-based cross-asset selling pressure remained intense. Notable exceptions were found in relative strength from the crude oil market, bonds held up, and the dollar index continued to surge, breaking to 20-year highs. Headlining the market weakness was a breakdown into panic mode for the cryptocurrency sector which, by weeks end, was nursing a sector-wide market capitalization less than half of the levels held as recently as November. 

Precious metals and a number of commodities took a hit, and equities experienced continued broad-based weakness. Markets have firmly rolled over into a bear market slide, and, over time, significant further downside very likely looms for many asset classes. That said, bear market rallies are a certainty, and can be fierce. We could see one take shape at any point here. 

Recent rally attempts have been quickly turned lower, but this week a late week upside reversal for stocks pivoted higher from strong technical trendline support. The sound technical footing could offer more juice and follow-through potential for this latest counter-trend rally attempt. On the other hand, if equity markets fail to sustain a bounce in the coming week, the risk for another bearish cascade will significantly increase. At this point in the unfolding market storm, we will be “nowcasting” the increasingly turbulent volatility in real time.

The big-ticket data released this week was updated inflation numbers. On Wednesday, the U.S. Bureau of Labor Statistics reported that April’s Consumer Price Index (CPI) inflation data came in at 8.3%. The figure was slightly below the March reading of 8.5%, but came in hotter than the 8.1% expectations. A day later, on Thursday, the U.S. wholesale Producer Price Index (PPI) for April was released. The year-over-year increase registered at 11%, also besting the 10.7% consensus estimate. Taken together, the reports reinforced what has become obvious. Broad inflation pressures will persist at ruinously high levels for longer than expected, and there is no easing in the data to plausibly relieve the Federal Reserve from their commitment to a path of aggressive monetary policy tightening aimed at subduing inflation.

Such severe and unrelenting inflation is creating an unacceptable and unsustainable consumer problem. Further, this is a hot, not healthy economy that is fundamentally far weaker and more vulnerable than it may presently appear on the surface. As a result of these dynamic factors, the Fed is trapped in a lose-lose situation. They must fight this severe inflation on behalf of the consumer, but to do so their only tool is to slow the economy via a tightening of financial conditions that will restrict demand. With the precarious underlying weakness and fragility of our economy and markets, policy-induced demand destruction is an extremely likely trigger for an imminent recession. It is this stormy reality that has been roiling markets, and has transformed our market bull into a bear.

Reviewing where we’ve been informs an understanding of where we are; understanding where we are at present provides insights as to where we might be headed. Central bank policy for over a decade has incentivized investments in Fed-backed financial assets at the expense of suitable levels of investment in needed real asset production. As a result, we have chronic underinvestment in real assets that has now resulted in structural supply constraints that will persist until the necessary levels of new productive investments are made. There now exists an underlying inflationary mismatch between the size of the real economy vs. that of the financial economy. The real economy is too small for the size and scope of the financial bubble economy the Fed has blown. Over time, these policy-induced dynamics have fed a secular economic shift toward inflation.

The modern monetary era’s inflationary policies, chronic underinvestment in the real economy, and the offshoring of fragile supply chains created a fuel-soaked tinderbox extremely vulnerable to an inflationary spark. The monetary, fiscal, and near-zero interest rate policy response to Covid provided just such a spark. Way too much money chasing way too few goods comically understates the post Covid dynamics. In addition, deglobalization, the impact of war and related sanctions, and unyielding shortages and supply chain disruptions have all added fuel to the inflationary fire.

Inflation is now fully entrenched. It’s running at a 40-year record pace on a global scale. Of essential consequence, the consumer is being crushed under a heavy inflation burden that’s outstripping the pace of wage gains and killing consumer savings rates. Unsustainable consumer dynamics are in play, and, as such, an unsustainable economy logically follows.

This week, the new Director of the University of Michigan Surveys of Consumers, Joanne Hsu, provided an update on the health of the all-important consumer. Director Hsu reported that consumer sentiment, already at recessionary levels, has declined by an additional 9.4% so far in May. Hsu added that, “These declines were broad based—for current economic conditions as well as consumer expectations, and visible across income, age, education, geography, and political affiliation—continuing the general downward trend in sentiment over the past year.” Radically underscoring the scope of the price problem, Hsu observed that “Buying conditions for durables reached its lowest reading since the question began appearing on the monthly surveys in 1978, again primarily due to high prices.” These findings dramatically punctuate the vulnerable and tenuous position of consumer spending.

While the bullish argument for strong ongoing consumer spending rests upon the roughly $2 trillion of excess savings on the aggregate consumer balance sheet, those savings are heavily skewed towards a much smaller pool of the wealthy and above-average earners. In addition, among those with the outsized share of aggregate savings, the vast majority of increases, rather than coming from a robust labor market, are overwhelmingly the result of massive gains on investment assets. So bloated savings are held by a relative few, and are primarily the result of a central bank-sponsored post-pandemic parabolic rise in home values and stocks. By contrast, to date, the labor market has not fully added back all the jobs lost in the pandemic, and it certainly has not yet expanded. At the same time, while wages have been increasing, wage growth adjusted for inflation is negative. Moreover, the savings rate is well below pre-Covid trend and down to 2013 levels.

From a consumer spending perspective, it matters where the savings come from. A consumer with savings resulting from a secure, stable, high-paying job is much more likely to remain resilient in the face of a deteriorating economy and high consumer price inflation. A consumer sitting on savings that are the result of exceptional asset price gains on investment may rightly be expected to tighten the belt in a big hurry when bear market conditions hit. For the investor, a bear market is the equivalent of a job loss for the consumer whose savings come primarily from wages. These dynamics are also greatly accentuated when consumer sentiment is already recessionary and buying conditions are the worst in University of Michigan data history. 

In short, the consumer economy appears extremely vulnerable to an unexpectedly rapid drop-off in spending when interest rates rise, asset prices fall, job and wage growth cool, all before consumer prices can respond with a meaningful drop. To bring down inflation, the Fed will need to overtly target all of these recession trigger factors, and the results are likely to quickly remove any illusions of a “soft landing” in the process.

Now that the inflation genie is truly out of the bottle, the choice must be made. Take your chances with inflation or attack demand and the easy money environment our fragile modern economy now requires in order to function.

We’ve examined how consumer weakness might play into the recession threat. Lets also examine the other side of this equation. Lets see how the dynamics of Fed tightening may directly affect the labor market and pose a related and compounding risk to the overall recession threat.

Online used car retailer Carvana (not an MWM company) is a relevant long story that we’ll make short. Their story reflects the profound shift from the broad corporate operating environment during the pandemic aftermath era to the environment we are presently entering. We can expect to hear a form of the Carvana story echoed many times over in the days, weeks, and months ahead. 

In the aftermath of the pandemic, with ultra-low interest rates, unprecedented amounts of stimulus flooding the consumer, and online businesses booming from lockdown tailwinds, the company saw an opportunity to grow. The company chased that opportunity, grew substantially, and funded that growth with record low-cost borrowing. Fortune doesn’t always favor the bold, however, and this week the firm announced that it is laying off 2,500 staff members in an attempt to better align staffing numbers with sales volumes. 

With tighter financial conditions just starting to negatively impact both its borrowing costs and sales volume, this round of layoffs is not likely to be the last. As borrowing costs become increasingly prohibitive and economic demand comes under increasingly heavy pressure, staff numbers will likely continue to be cut in order to maintain that balance with ever shrinking sales volume. In an explanatory email to employees, this week, the CEO remarked that, “It has always been the right move to start building for growth well ahead of when we expect it to show up.” As supporting evidence for this assertion, CEO Ernie Garcia stated that, “This strategy worked for us every year until this one.” 

Like I said, this is a long story made short, and Mr. Garcia’s observation is accurate. His experience will be widely shared across the corporate universe. Simply put, 2022 is an entirely different animal than yesteryear. It’s a severe storm in the midst of rapid intensification. Carvana provides an example of how the changing environment may conspire to unravel the strong labor market in a surprising hurry.

Carvana’s experience is illustrative of how tighter financial conditions may erode the labor market, especially impacting companies build upon expectations of a permanent easy money world. Carvana’s borrow-cheap-to-grow-big strategy, like the endless ranks of similar “growth” companies, is no longer working because the strategy, perfectly suited for yesterday’s environment, is a complete disaster in tighter, eventually recessionary conditions. 

Similarly affected are the swollen ranks of another class of companies more appropriately described as the borrow-cheap-just-to-stay-alive cohort. Perpetually loose financial conditions erode economic health over time, and have facilitated the construct of a fundamentally fragile and unsustainable economy. As the Fed marches forward on its tightening path, we may all soon find out just how sensitive both markets and the economy have become to tighter financial conditions. It may not be pretty.

As far as the Fed’s ultimate policy path, commitment to fully follow through on its hawkish rhetoric, and its ability to stay the hawkish policy course even if and when markets and the economy start to break, many questions remain unanswered. The Fed suffered a massive credibility hit with the debacle of its “transitory inflation” insistence and the policy errors that went with it. At present, the stakes for the Fed are as high as they have ever been, and it can ill afford another credibility-crushing policy error. After insisting that the strength of the economy will support its tightening cycle and asserting its ability to orchestrate a “softish” landing, the Fed appears vulnerable to another devastating policy error.

The Fed is tightening into an already existing economic downturn. This week, highly respected economist David Rosenberg described the current circumstances in stark, unvarnished terms. Referring to the Fed’s out-of-control inflation problem and the complicated minefield surrounding the issue of how to deal with it, Rosenberg said matter-of-factly, “They actually need…you understand what I’m saying, they need a bear market in equities. They need home prices to go down.” The risk, given current dynamics, however, is that they get more than they bargained for. Rosenberg warned, “I don’t think people realize how weak the economy is. And yet the Fed is not just tightening… They’re getting super-duper aggressive here.” He added, “I think the recession is starting right now…you have people out there saying it’s not till 2023. I just roll my eyes at that. It’s staring us in the face.” 

If economic “strength” evaporates more suddenly, completely, and decisively than expected, the Federal Reserve will be under immense pressure to execute a policy pivot. If the economy and markets break down into a disorderly, destabilizing, and damaging unraveling, the Fed may have no choice but to once again ease and stimulate. How the Fed conducts itself and executes in such a crucible is a major point of focus from here. The spectrum of possible outcomes is wide, and the resulting risks and opportunities are many.

Given the risk of a near-term economic demand hit, the outlook for the commodity sector remains exceptionally attractive in the long-term, with significant caution advised at present. The battle lines have been drawn. For all the risks to near-term demand, the supply side is equally challenged and provides significant price support across key commodities sectors such as energy, industrial metals, and agriculture products. For overall global price pressures to ease significantly, prices in these key commodity sectors need to drop. For that to happen, given the firm supply-side price support, aggregate economic demand would need to fall sharply. So caution in the near-term is advised, and if a demand vortex develops significantly enough to hammer prices, a strong long-term buying opportunity may present itself.

Weekly performance: The S&P 500 was down 2.41%. Gold was off by 3.96%, silver was down 6.12%, platinum was off 2.65%, and palladium lost 5.21%. The HUI gold miners index was crushed by 9.68%. The IFRA iShares US Infrastructure ETF was down 1.98%. Energy commodities were mixed. WTI crude oil was higher by 0.66%, while natural gas was down 4.73% on the week. The CRB Commodity Index was lower by 0.88%, and copper was off 2.11%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 3.81%. The Vanguard Utilities ETF (VPU) was down 1.12%. The dollar was higher by 0.91% to close the week at 104.62. The yield on the 10-year Treasury dropped by 19 bps to end the week at 2.93%.

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist

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