Out of the Gate and Ready to Run – December 1, 2023

Wealth Management • Dec 03 2023
Out of the Gate and Ready to Run – December 1, 2023
Morgan Lewis Posted on December 3, 2023

Out of the Gate and Ready to Run

HAI’s working thesis is that global financial markets are in the late stages of a massive confidence bubble. Amid the insecurity of an incredibly complicated financial market set-up, tucked neatly within an exceptionally complex world of geopolitical fracturing and dramatic secular change, many market participants appear anxious to retreat into the relative comfort of an unquestioned confidence in the efficacy of fiscal and monetary policy status quo.

But that status quo is the unprecedented activist monetary and fiscal policy regime of recent decades. Such deference to that status quo translates to an ultimate bubble of investor confidence in the ability of government policy makers to conjure by hook, crook, or any other means of alchemy, a perpetual Goldilocks environment that will facilitate an endless expansion of the economy and an everlasting increase in financial asset prices.

Certainly, while Jay Powell and the Fed are “navigating by the stars under cloudy skies,” there is no fault laid at the feet of those projecting forward by looking backward. Perhaps unwavering confidence-in-confidence-itself will prove as profitable an approach to markets over the next decade as it has been over the past several. That is, no doubt, a possibility.

Again, the government’s ability to deliver a policy-induced state of perpetual Goldilocks is indeed possible. It is, in fact, the possibility most market participants (those caught in the throes of the confidence bubble) are betting on presently. This week, the latest AAII stock market sentiment survey revealed that the percentage of bearish survey respondents has now dropped to a remarkable six-year low of just 19.6%.

HAI, however, prefers probabilities over possibilities, and projecting forward by looking forward. And with that said, the unsustainability of our monetary and fiscal policy trajectory, is a big problem to the perpetual Goldilocks thesis. Amid our present minefield of a severe fiscal debt and deficit problem, imminent recession risk, and an ongoing secular inflation enigma, the likelihood of achieving a perpetual goldilocks state (one of maintained government fiscal solvency, healthy economic growth, and a stable low-rate of inflation), while possible, remains most improbable. In fact, confidence in perpetual Goldilocks appears little more than what Wells Fargo’s Sameer Samana has called simply, “a pipe dream.”

Nevertheless, at present, financial assets are priced on the assumption that policy makers will produce the “pipe dream” and the reignited financial asset bubble it’s expected to generate. Meanwhile, financial asset prices along with the overarching structure of the ultimate confidence bubble hang precariously in the balance as markets await confirmation that policy makers can and will deliver.

Amid this backdrop, HAI, like Sameer Samana, continues to see a perpetual Goldilocks scenario as only a pipe-dream possibility. In HAI’s view, probabilities dramatically favor a bout with either painful recessionary ice or devastating inflationary fire. This week furthered the case.

Deep and consistent contractions in the leading economic indicators are rare events historically. Every time pronounced and persistent contractions in the leading data have occurred, we’ve experienced a subsequent recession. For over 60 years, every time we’ve had eight months or more of consistent leading economic index weakening, it’s translated into subsequent recession—full stop. It’s been a perfect indicator.

Now at 19 consecutive monthly declines in the Conference Board’s Leading Economic Index, and 13 consecutive months below the -4.5% Conference Board recession threshold, the current weakening streak of the leading economy has been surpassed only two times over the past 60-plus years of data. Those two instances were the run-up into the 1974 recession and the on-ramp to the 2008 Great Recession at 22 months and 24 months respectively of consistent weakening.

All told, the recent performance of the leading economy has already blown past the threshold levels identifying each of the last eight recessions, and the leading data continues to weaken. The deterioration of the leading economy has already been much worse than that of what preceded six of the last eight recessions, and we are rapidly closing in on the worst-ever performances associated with the remaining two historic downturns.

Remember that the leading economic indicators are so named for a reason. Far from just theoretical, the leading economy has a structural, mechanical relationship with the current coincident economy, and it does indeed lead. As EPB Macro’s Eric Basmajian explained recently, “It’s critically important to understand that longer lag times don’t change the mechanism for why the Leading and Cyclical Economy causes changes in the Aggregate Economy. To break the sequence or order of operations, we’d have to see building permits fail to lead construction activity, new orders fail to lead manufacturing production, and the yield curve have no impact on bank lending.” Basmajian continued, “Now we know that the Cyclical Economy has not moved into contraction as a broad basket, but it undoubtedly will under the pressure signaled by the Leading Economy. The long lag time has created a well-fueled ‘this time is different’ narrative, but the explanation for why this time is different fails to explain how the linkage between Leading and Cyclical Indicators will break down.”

As it is said, patience is a virtue. Given the depth, breadth, and consistency of the ongoing recessionary signaling of the leading economy, and its mechanical relationship to the aggregate coincident economy over time, throwing caution to the wind, now, is a historically bad bet.

Furthermore, we are now beginning to see increased evidence that the cyclical economy is beginning to buckle. Given the sequence of transmission from leading economy to cyclical economy to the aggregate coincident economy, a newly pronounced weakening now percolating in the cyclical economy is a critical development and a recessionary warning flag.

This week’s ISM manufacturing Purchasing Managers Index (PMI) data showed the cyclical manufacturing sector continues in a deep state of contraction with a 46.7 reading (anything under 50 is contraction) and that came in well shy of the 47.2 expected. November was the 13th straight month of contraction. At this point, all five manufacturing sub-indexes are now in contraction, up from four last month. Importantly, ISM survey chief Timothy Fiore said, “the share of sector GDP registering a composite PMI calculation at or below 45 percent—a good barometer of overall manufacturing weakness—was 54 percent in November, compared to 35 percent in October and 6 percent in September.” That trend reveals a very sharp weakening in the cyclical economy. It’s exactly the sort of cyclical weakening we should expect given the current state of extremely recessionary leading indicators.

In addition, the sub-index for supplier deliveries also contracted at a notably faster pace than in October, indicating a substantial drop-off in demand.

Even more notable, however, in the context of HAI’s recession watch, the ISM employment index registered a very significant 45.8 contraction vs. estimates for a 47.2 reading. According to ISM, over the latest period, companies “took more actions to reduce head counts, primarily using layoffs and attrition.” Furthermore, the latest Conference Board release of its Leading Employment Index also registered its sharpest decline yet of this current cycle.

To be clear, Friday’s ISM data dump wasn’t in any way a positive indicator for the trend in the leading and cyclical economies. Nevertheless, Goldman Sachs offered a lame attempt to spin it that way. Goldman claimed that “from a forward-looking basis, this is encouraging given the positive change in new orders.” After all, Goldman is correct that new orders are among the most important leading economic variables, and while remaining in the third-longest stretch of contraction in over 60 years, the rate of contraction did slow slightly. That said, Goldman failed to note that the modest easing of the rate of decline for new orders had nothing to do with either the leading or cyclical economy. It came entirely from the non-cyclical Food, Beverage, & Tobacco Products segment. Needless to say, non-cyclical food, drink, and smoke aren’t the crucial area of focus when monitoring what looks to be the road toward recession. In fact, as ISM laid out, “of the six largest manufacturing sectors, only Food, Beverage & Tobacco Products reported increased new orders.” Frankly, that’s not bullish, it’s bearish.

The intensified deterioration of the cyclical economy that appears to be developing is a strong indication that the transmission sequence of weakness from the leading economy toward the current economy is, on a long and variable lag, progressing. Again, this week’s data was a warning flag.

When considering the implications of the recessionary signaling from the leading economic indicators and increasingly the cyclical economy, it’s important to also consider that current monetary policy isn’t stimulating any recovery. Despite the fact that the Fed has paused interest rate hikes, real interest rates (the fed funds rate minus trending inflation) are now generally well over 2% depending on which inflation number you use. At the same time, the trend rate of real aggregate economic growth is now running closer to 1.5%. A trending real fed funds rate higher than the real aggregate trend rate of economic growth is typically considered a restrictive policy setting. You can certainly argue, and many do, that we are not really “restrictive” at present, but in HAI’s view, from a monetary policy standpoint, we are, at minimum, about as restrictive as (or perhaps better stated—the least stimulative) we’ve been in over a decade. Such a conclusion is supported by ISM chief economist Rubeela Farooqi’s claim this week that, in the real economy, we continue to “face challenges from higher borrowing costs and tighter credit conditions.”

That’s significant. It suggests further weakening for the leading economy and implies further sequential associated recessionary impacts heading downstream toward the aggregate coincident economy—on a lag.

Now, as past HAI’s have detailed, recessions blow-out government deficit spending levels because tax receipts plunge as government stimulus spending soars. But, with deficits already over $2 trillion, interest expense alone north of $1 trillion (now, amazingly, larger than defense spending), and total debt pushing towards $34 trillion, the federal government can’t further blow out deficits in a recession without major negative consequences to the currency, the Treasury market, and risking a government solvency crisis. Remember that this fiscal problem is what Stanley Druckenmiller calls the “200-foot tsunami just 10-miles out.” Any attempt to add to the deficit with a massive stimulatory deficit spending bonanza to recover out of recession would fast-track an insolvency crisis and send the fiscal tsunami crashing ashore. In other words, it’s fair to say that the government can’t afford the incoming recession.

Should policy makers try, as it appears they may already be doing, to preemptively deficit-spend their way out of imminent recession risk and then preemptively cut interest rates to stimulate growth next year, they will still run into severe trouble. First, even without a recession, a continuation of current levels of deficit spending will eventually trigger the acute fiscal crisis anyway. Again, it’s just “10-miles out.”

Second, such spending and preemptive rate cuts, even if successful in thwarting recession, will also retard further progress on inflation and eventually cause a sharp reacceleration of inflation rates.

Last, but by no means least, as legendary economist Lacy Hunt suggests, government spending to avoid recession may backfire spectacularly. As Dr. Hunt explains, “the current widely held view that fiscal policy can remain stimulative… is not supported by scholarly research.” Research of indebted economies is clear that, “the fiscal multiplier is positive [stimulative of growth] for the first four to six quarters after an action.” The catch, however—and it is a big one, is that the fiscal “multiplier is negative [depresses growth] after three years.” In a warning that should send chills right up the spines of all policy makers, Dr. Hunt states, unambiguously, “this means that increasing ‘negative multiplier’ government spending to reverse poor economic conditions will be counterproductive.”

When considering the implications of Dr. Hunt’s argument, keep in mind that we are just now three years removed from the Covid fiscal response—the largest “negative multiplier” government spending binge in history. As Dr. Hunt concludes, “the economy is currently far more susceptible to a downturn than is generally recognized.” Or, in other words, “the economy is headed into a hard landing.”

Dr. Hunt’s findings are further supported by a recent Bank for International Settlements (BIS) paper. According to the BIS, “When does debt go from good to bad?… Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP.” Well, we are already north of 120%. According to the Congressional Budget Office, we’re only heading higher from here.

Needless to say, the stunning implication if the BIS, Dr. Hunt, and exhaustive scholarly research prove correct, is that if we aggressively deficit-spend to avoid recession, we may inadvertently contribute to its manifestation as well as the recession’s ultimate fury. We’d arrive at the worst of all possible scenarios: we’d arrive at a dystopian combination of full-blown insolvency crisis amid recession without recovery—otherwise known as depression. That’s about as far from “perpetual Goldilocks” as Dorothy found herself from Kansas. Let us hope, with every fiber of our being, that outcome is avoided.

In short, the closer one looks into the perpetual Goldilocks thesis, the more it crumbles. We have increasing evidence of compromised monetary policy, similar evidence of compromised Treasury functioning, and major risks to growth, government solvency, and inflation. Like the game Whac-A-Mole, policy makers can try to apply their diminishing “tool-kit” to address one area of concern, but only by exacerbating other key problems. Far from a plausible outlook for perpetual Goldilocks, realistically it appears instead that the sand in the hourglass is running out as the walls close in on a thesis that was never much more than a pipe dream.

Economic growth is slowing notably, and while the timing remains variable, recession risk is very high. Right now, to thwart the risk, policy makers appear to be on a path towards looser financial conditions with ongoing deficit spending and a monetary policy easing cycle teed-up for 2024. In the short term, that could be positive for asset prices including financial assets—that is, until inflation likely re-accelerates in a few months or quarters, or until Lacy Hunt’s “negative multiplier” hard-landing bomb arrives.

If policy makers do not ease or actually tighten financial conditions into slowing growth, the government fiscal problem will likely explode into full-blown crisis as recession hits. That’s a scenario in which asset prices start to tumble much sooner as yields rise again and the dollar spikes.

As the only time-tested, counterparty-risk-free pristine collateral in the system, HAI likes gold best in either scenario. Ultimately, the days of the perpetual Goldilocks thesis look seriously numbered, and the collapse of the confidence bubble appears imminent. Clearly, with gold’s continuous contract managing the trifecta of a monthly, weekly, and daily record all-time high closing price this week, for some market participants, the secret is already out. Gold is ahead of the game, out of the gate, and ready to run.

Weekly performance: The S&P 500 gained 0.77%. Gold was higher by 4.33%. Silver was up 6.23%, platinum was lower by 0.09%, and palladium was crushed by 6.03%. The HUI gold miners index surged 8.09%. The IFRA iShares US Infrastructure ETF was up 2.45%. Energy commodities were volatile and lower on the week. WTI crude oil was down 1.95%, while natural gas was off 6.17%. The CRB Commodity Index was lower by 0.45%, and copper was up 3.76%. The Dow Jones US Specialty Real Estate Investment Trust Index gained 4.82%. The Vanguard Utilities ETF was up 1.53%. The dollar index was down 0.10% to close the week at 103.2. The yield on the 10-yr U.S. Treasury lost 25 bps to end the week at 4.22%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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