Return-Free Risk vs. the Economic Truth
With the final March tally now in the books, the S&P 500 was up 3.51%, the 10-year US Treasury note gained 3.37%, commodities were modestly lower by less than a percent, and the US dollar index suffered a pronounced 2.52% drop. Gold and silver shone bright with 8.14% and 14.64% gains, respectively. In fact, gold finished the month of March just a few dollars shy of its highest monthly close on record. While March saw both the S&P 500 and gold move higher together, HAI expects that, beyond short-term noise, the sustainable uptrend is in gold; the yellow metal, not stocks, is telling the economic truth.
Last week, HAI observed that recent interventions from policy makers in response to the bank crisis “could inspire a short-term risk-on bounce. The S&P 500 certainly could trade back to well over 4,000.” With this week’s S&P 500 rally to over 4,100, we’re indeed getting that risk-on bounce. In fact, in a rare occurrence, all but one lonely stock market sub-industry out of the 105 tracked on the MWM dashboard finished the week higher. Watching the price action, the stock market appears as tempting as a beautiful and calm ocean on a hot summer day. Before excitedly throwing on the swim trunks, though, consider the accompanying warning from last week: “if such a bounce develops, it will likely be short lived and quickly followed by a vicious sell-off.” Make no mistake, while the bounce may continue for a time, beneath the surface these waters are treacherous, shark infested, and sport a potentially lethal rip current. Caution is warranted.
To be clear, stock market strength is not about a strong fundamental outlook or compelling value. It’s about expectations for the next stimulative round of Fed-administered easy policy sugar. Still, with inflation still running hot, and the Fed not even in the area code of a credible declaration of victory over inflation, market hopes for the imminent sugar rush it craves may be set for disappointment. As former Treasury Secretary Larry Summers said this week, “We are still a substantially unsustainable-inflation country.”
That substantially unsustainable inflation can be remedied in either of two ways: the banking sector can greatly reduce credit in response to bank sector stress or the Fed can continue to tighten policy. As the Secretary put it, we don’t yet know whether the dynamics of stress in the banking system will manifest in a “non-linear” deflationary fashion in which “constriction of credit leads to declining asset prices, [which] leads to non-performance of loans, [which] leads [circularly back to] more credit constriction.”
If such a credit crunch develops, hunker down. In HAI’s opinion, that scenario leads to a sure-fire doozy of a recessionary hard landing for stocks and the economy. To Summers’ point, while we don’t yet know whether a bank-led disinflationary credit crunch is a certainty, the chances of such an outcome are high. After all, as HAI has mentioned previously, the percentage of banks tightening lending standards had already reached recessionary levels before the recent bank stress and run on deposits erupted. Importantly, lower deposits translate directly to tighter lending, and so far that’s what we’re seeing. According to Bloomberg on Friday, the latest available weekly data reveals that “deposits fell sharply and lending declined by the most in nearly two years.”
Conversely, if substantially tighter credit doesn’t materialize and sustain, we’re still left with what Summers describes as “serious inflation issues.” In that scenario, according to Summers, “the Fed will have to tighten much more than is priced in.” With financial system frailty already resulting in various breakages, and the lagged impact of roughly 250 bps of rate hikes still on the way, one can only imagine how the system would handle the further tightening Summers is alluding to.
The bottom line is that, either way, whether it comes from further bank tightening of credit now in response to current stress or further bank tightening later in response to a Fed that “will have to tighten much more than is priced in,” the cost of victory (at least a short-term victory) over inflation is recession.
JPMorgan Chief Investment Officer Bob Michele sees the writing on the wall as well. While this risk-on rally could continue for a while before “reality catches up,” Michele warned this week that, “recession is inevitable by the end of the year.” Ominously, the JPMorgan CIO told Bloomberg, “You may see it coming, you may not. You don’t know exactly when its going to hit, but once it hits, whatever you own, you own.” His message? Sanitize portfolios to include only assets that can at least weather, and at best thrive in, the turmoil of recession.
While sanitizing portfolios, remember that this is a market in which to be extremely selective on an asset-specific and company-specific basis. A passive index approach to market exposure is likely to compound misery. On aggregate, stocks aren’t cheap. S&P 500 earnings estimates have fallen from peak levels, but are still frothy and far from pricing in the earnings hit of a recession.
In fact, a glaring disconnect has developed between what companies are now saying and what analysts expect. For the upcoming quarter, actual guidance released by companies has missed Bloomberg analyst estimates for earnings per share (EPS) at a 68.4% clip. That said, even on top of still-overinflated earnings estimates that are likely to fall significantly, the S&P 500’s 12-month forward price-to-earnings (P/E) multiple of 18x ranks in the 82nd percentile since 1980. In other words, these are still bull-market valuations investors are typically willing to pay only when risks are low and the economic and policy winds are firmly at the back of risk assets. That is decidedly not the case in today’s environment as a full-blown tempest threatens hurricane-force headwinds.
At the same time, with the 2-year Treasury yield still over 4% despite the recent drop in Treasury yields, the relatively “risk-free rate” towers over the S&P 500’s 1.7% dividend yield (which is a shadow of its 3.7% historical norm). These yield spreads, in place since late 2022, haven’t favored Treasurys over stocks this much in over 15 years.
In short, whether based on earnings or on yield relative to competing assets, this stock market is in no way a value proposition overall. It is currently a speculation on Fed policy, not an investment—at least not by Benjamin Graham’s definition as an entity “that, upon thorough analysis, promises safety of principal and an adequate return.” To the contrary, from a fundamental standpoint, this market, on the index level, is a perfect example of what Jim Grant describes as “return-free risk.”
Meanwhile, signs are increasing that consumers are opening their eyes to the portrait of recession painted by Summers and Michele. As a self-fulfilling prophecy, consumer sentiment is a critical ingredient in the making of the recessionary stew. Already at recessionary levels for well over a year, but having stabilized slightly off lows recently, University of Michigan consumer sentiment for March fell for the first time in four months this week, dropping a substantial 8% below February’s level.
Interestingly, survey director Joanne Hsu indicated that this month’s drop in sentiment wasn’t primarily attributable to a knee-jerk reaction to the turmoil in the banking sector. Instead, Hsu said consumer sentiment “was already exhibiting downward momentum prior to the collapse of Silicon Valley Bank.” Sentiment fell across all demographic groups, and all five index components declined, led by “a notably sharp weakening in one-year business conditions.” As Hsu concluded, “Overall, our data revealed multiple signs that consumers increasingly expect a recession ahead.”
So here’s the tally: already recessionary and declining consumer sentiment, an inverted yield curve, deeply recessionary leading economic indicators, 250 bps of lagged rate hike impacts yet to be felt, bank failures, deposit runs, and tightening lending standards—all while, according to EPB Research, four-month average economic growth is already down-trending to the 1% pre-recessionary state that is the typical starting point for historical recessions. In other words, today’s broad stock market is far from the investment opportunity of a lifetime.
That said, as John Hussman puts it, “The single difference between the most recent market cycle and other cycles across history is that in every other cycle speculation always had a well-defined limit.” In an economy where for years the Fed loosed every tether to common sense and discipline, it’s no surprise that the market has now loosed every tether to fundamentals. At present, the market has been reduced to little more than a speculative frenzy over expected Fed policy.
Of course, the alternative to recession would be an immediate and aggressive Fed policy pivot to stimulative easy policy. This is the speculation fueling the current rally. As past HAIs have pointed out, however, hot inflation remains the sticky pair of shackles binding the hands of policy makers. The stimulative policy pivot needed to postpone our recessionary economic trajectory would be a full can of gas on an already burning inflation fire—full stop. In times past, such a policy maneuver would simply be unthinkable. In our modern moment, though, nothing can be ruled out. Our policy crisis threatens catastrophic trade-offs on any path officials dare to tread. Cornered policy makers must rely mightily on luck while attempting to divine the least devastating policy option.
In 2022, Dartmouth economist Danny Blanchflower described the modern Fed policy circus as “clownkookooland.” He wasn’t kidding. For now, however, HAI’s baseline assumption is that policy makers will choose to keep policy restraint in place until the recession hits sufficiently to knock inflation (temporarily) as low as possible, at which point the Fed as firefighter will pivot to inflationary emergency response measures.
Given the present dynamics at play, however, some market participants are not content to merely speculate on Fed policy in financial assets that, from an investment perspective at current levels, offer more return-free risk than genuine opportunity. Some investors are making a different bet, a bet that a cornered Fed with nothing but lose/lose options promises to be a much more likely, powerful, and sustainable catalyst for higher gold prices than for higher financial asset prices.
In short, it’s a bet that financial assets at current levels are, in fact, return-free risk, and that when assessing the recent strength in both markets, it’s the rally in gold that’s telling the economic truth. These investors pumped $1.26 billion into gold mutual funds and exchange-traded funds (ETF) during the week ended March 22, for the largest weekly net inflow in a year. While global central banks have been massive buyers of gold over the last year, mutual fund and ETF buying was absent the market. If motivated buyers persist and recent fund inflows sustain, it will introduce a powerful new bullish dynamic into precious metals prices for 2023.
All the while, global multi-currency commodity pricing continues to progress. This week, according to Reuters, Chinese national oil company CNOOC and France’s TotalEnergies completed China’s first yuan-settled LNG trade of approximately 65,000 tonnes of LNG through the Shanghai Petroleum and Natural Gas Exchange. Reuters also noted that, “China has placed an emphasis on settling oil and gas trades in yuan in recent years in a bid to establish its currency internationally and to weaken the dollar’s grip on world trade.”
Prior to this week’s developments, Russia had already increasingly embraced multi-currency commodity pricing amid punitive Western sanctions that have weaponized the dollar. In addition, during a visit to the Saudi capital of Riyadh in December, China President Xi Jinping announced that China would “make full use” of the Shanghai exchange as a platform to carry out yuan settlements of oil and gas trades.
These developments highlight two important points. The first is that global players are increasingly interested in securing critical commodities and real assets in currencies other than the dollar. The second is that multi-currency commodity pricing with net settlement in gold opens the door for gold to compete with US Treasurys as a global reserve asset.
Such a development—one that Credit Suisse analyst Zoltan Pozsar sees as likely and underway—would be extremely positive for the physical gold price, and, by extension, for gold miners. While the issue of gold emerging as a global reserve asset is ultimately of massive importance, it’s likely a slower burn catalyst. No doubt the gold market is watching developments closely. In the meantime, with the yellow metal poised just below all-time highs awaiting a major upside break-out, the gold market will be closely watching the Federal Reserve for cues on policy. The timing of that breakout may depend primarily on which unfortunate path policy makers decide to venture down. If they pivot and prematurely abandon the inflation fight, gold’s breakout may come sooner. If they maintain policy restraint all the way into recession, the breakout may come a bit later. Either way, odds are increasing that the yellow brick road gets paved well into new all-time high territory.
Weekly performance: The S&P 500 was up 3.48%. Gold was nearly flat, up 0.12%. Silver gained 3.51%, platinum was up 1.95%, and palladium added 3.79%. The HUI gold miners index was up 3.24%. The IFRA iShares US Infrastructure ETF gained 3.93%. Energy commodities were volatile and mixed on the week. WTI crude oil surged 9.25%. Natural gas lost 6.14%. The CRB Commodity Index was up 3.57%, and copper gained 0.49%. The Dow Jones US Specialty Real Estate Investment Trust Index gained 4.30% on the week, while the Vanguard Utilities ETF was up 3.06%. The dollar was down 0.55% to close at 102.19. The yield on the 10-yr Treasury added 10 bps to end the week at 3.48%.
Investment Strategist & Co-Portfolio Manager