Risky Business – December 2, 2022

Risky Business – December 2, 2022
Morgan Lewis Posted on December 3, 2022

Risky Business

This week marked the latest in a consecutive streak of fascinating weeks for markets throughout the remarkable year of 2022. The risk-on rally continued, and inflation data, labor market data, and a gaggle of Fed speakers dominated the headlines.

No less than seven Fed speakers took to the microphone this week, including Chairman Powell himself. To avoid imposing a headache and dizziness upon you, dear reader, this author will sum up the Fed-speak chorus in one coherent message. The Fed will continue to raise rates for “some time,” albeit at a slower pace, until they deem policy to be “sufficiently restrictive.” They then plan to pause and keep rates at that level until they’re confident in bringing inflation back down to their 2% target. In HAI translation, they plan to keep rates higher for longer, in the service of the inflation fight, until something significant breaks—likely including an economy that spirals into recession in 2023.

In remarks this week at the Brookings Institute, Chairman Powell was far more nuanced. Despite the higher-for-longer message, he added, “I don’t want to over-tighten. Cutting rates is not something we want to do soon. So that’s why we’re slowing down and we are going to try to find our way to what that right level is.” However, as HAI has said before, given the lagging impact of rates and the pending impact of what the Fed has already done, by the time Powell and company are confidant they’ve done enough, it will be increasingly clear they’ve done too much.

This week offered more inflation-relevant data for the Fed to consider. Despite some signs of an initial turn lower in the labor cycle from the ADP private jobs report, the household jobs survey, and recent unemployment claims data, the nonfarm payroll Establishment Survey continues to outperform expectations. In Friday’s Establishment Survey, the Labor Department reported that employers added more jobs than forecast, and that monthly wages jumped by more than expected. Nonfarm payrolls increased 263,000 in November after an upwardly revised 284,000 gain in October. The median estimates in a Bloomberg survey of economists called for a 200,000 advance in payrolls. The unemployment rate held at 3.7% as participation actually dropped slightly. The report points to enduring inflation pressures emanating from a tight labor market, and is certain to be viewed by Fed officials as an argument to continue on the path toward a more restrictive policy.

Meanwhile, the Fed’s favorite inflation indicator, the Personal Consumption Expenditures Price Index (PCE) was also released. Both the headline and core PCE Deflator declined as expected. Headline year-over-year PCE was 6.0% vs. 6.3% the prior month. Core PCE was 5.0% vs. 5.2% the month prior.

Before we get the pom-poms out and start cheering too enthusiastically, however, consider that the current numbers still represent the highest inflation readings since a boyish 21-year-old Tom Cruise (now 60) famously danced in nothing but a collared-shirt and “tighty-whitey” underwear in 1983’s hit Risky Business. This data certainly isn’t altering any Fed policy plans, so it’s clear that rallying stock markets are currently engaged in some “risky business” of their own.

The heartbeat of the US’s economy is consumer spending. It represents 70% of GDP, and many stock market bulls tether their enthusiasm to a narrative based on expectations for a continuously resilient consumer. So far, that narrative has held up fairly well, but American consumers are punching above their weight. At present, the odds increasingly favor an unseemly TKO of this “resilient-consumer.”

A typical poison cocktail for the consumer includes the ingredients of high inflation, historically low savings rates, negative real wages, accelerated debt accumulation at higher borrowing costs, weak equity and housing markets, and time. All of these ingredients are currently in place. As the stated conditions persist over time, the various tentacles of this negative wealth effect start to exert pressure. As they do, the consumer spending spigot tends to shift away from the discretionary and refocus toward the category of items more closely associated with the necessary. The combination of such a spending shift, in the context of significantly increasing borrowing costs, translates to certain consumer discretionary-based businesses particularly feeling the pinch. Consequently, job losses enter the equation and become the great accelerator of this vicious cycle. As job losses begin, they significantly weaken the consumer at a dramatically increased clip. In response, spending dries up further, more jobs are cut, and again, further damage is inflicted on an already weakened consumer. So goes the merry-go-round of the vicious recessionary spiral. Again, these financial stressors over a long and ever-extending timeline are currently in place, at work, and diligently eroding the foundations of the American consumer.

This week, the Commerce Department updated the personal savings rate. Along with revising previous monthly data significantly lower, the latest figure was reported at 2.3%. That is the lowest monthly personal savings rate reported by the government in data stretching back to 1959 outside of one lonely month preceding the great financial crisis. That’s a problematic statistic and it compares very unfavorably to the 9.3% pre-pandemic rate. The results are no surprise. Amid relentless high inflation and 19 straight months of negative real “inflation adjusted” wages, the American financial cushion is thinning at a record rate.

At the same time, Americans are temporarily compensating by using their first, and last, line of defense. In the third quarter, US consumers increased their credit card balances at the fastest rate in 20 years, and record household debt is bloating at the fastest annual pace since 2008. Turning to debt as an answer is never sustainable, but this mass debt binge is doubly unsustainable as borrowing costs have risen sharply.

The bearish reality rapidly impinging on the “strong” consumer narrative is reflected already in deeply recessionary consumer sentiment, recessionary future economic expectation readings, and in the University of Michigan’s index of current economic conditions. What is nothing short of remarkable is that these recessionary “soft data” prints are all being reached before the real recession has hit and before the unemployment rate has spiked.

The University of Michigan’s current economic conditions index has data back to 1960. Several observations from the data series are worth considering. The first is that every single sharp and significant drop in the index since 1960 has culminated in recession. It’s a 100% hit rate. The second is that when the index starts to drop as the economy hits the runway to recession, it has never bottomed until after job losses mount and after the unemployment rate has started a recessionary spike. In our present miraculous moment, the current economic conditions index has not only undergone the sort of sharp and significant drop always consistent with imminent recession, it has utterly collapsed in record fashion. From near all-time high current conditions index readings during the pre-pandemic years, the index has since dropped right through the top-floor trapdoor, down the elevator shaft, and straight through the sub-basement to the lowest readings ever recorded. The total collapse of the current conditions index significantly exceeds that which preceded the 2008 great recession and is historically unparalleled in both magnitude and speed. Even more remarkable, the historical conditions 100% correlated with a bottom in the current conditions index have not at all been met yet. Job losses have not significantly mounted, and the unemployment rate has not yet started to spike.

Despite this week’s better than expected nonfarm payroll report, however, the condition of the labor market, and that unemployment rate, may be about to change. As previously mentioned, fledgling signs of a downturn in the labor cycle are popping up in ADP data, the household employment survey, and in unemployment claims data. In addition, HAI’s tally of publicly announced job cuts continues to accelerate. With final results now in for November, a trend is clear. October job cuts outpaced September’s by over 133%, while November’s cuts outpaced October’s by over 181%. In fact, November’s one-month total also exceeded the two-month combined total for September and October by 97%. Consequently, the great accelerator (job losses) of the decline of both the consumer and the broad economy into next year’s recessionary nastiness may be about ready to swing its wrecking ball. As Bank of America chief investment officer, Michael Hartnett, ominously predicted this week, “job losses in 2023 are likely to be as shocking as inflation in 2022.” Ominous, indeed, considering the 2022 inflation shock was of the 40-year high variety.

In addition, recent HAIs have chronicled numerous additional indications of imminent recession. Those include the absolutely blaring warning siren emanating from the yield curve, recessionary housing market data, severe auto industry trouble, a dramatic and unprecedented sharp swing from record-loose to recessionary-tight bank lending standards for both commercial loans and consumer credit—just to name a few.

While the basket of recessionary indicators is already rather full, lets add a few more. This week, the ISM manufacturing index slid into outright contraction for the first time since Covid. At the same time, the reputable Conference Board Leading Economic Index (LEI) was the latest alarm to trigger. The Conference Board’s LEI is a collection of 10 vital economic variables. The latest reading of the LEI, which has been plunging, revealed that for the ninth time in its 60+ year history, the index surpassed the negative level that has accompanied eight of the last eight recessions. It’s another indicator with a 100% track record now screaming recession. In addition, the current negative reading has surpassed the level that marks the historical average start time of recession. In other words, the LEI and its spotless track record say the ninth recession of its lifespan is assured, and it starts now.

What does all this mean for financial assets in the equity market currently rallying aggressively in hopes that the bear-market bottom is already in? In short, “risky business.” For a more comprehensive answer, however, let’s turn to comments made this week by two HAI favorites, former treasury secretary Larry Summers and economist David Rosenberg.

What may appear to hopeful eyes as relative calm and a bear market bottom may merely be the calm before the storm. Larry Summers cautioned this week that looks can be deceiving, and that change tends to occur suddenly.

Voicing a sentiment very similar to HAI’s view of a vicious economic cycle currently in progress, the former Treasury Secretary said, “There are all these mechanisms that kick in…at a certain point, consumers run out of their savings and then you have a Wile E. Coyote kind of moment… Once you get into a negative situation, there’s an avalanche aspect—and I think we have a real risk that that’s going to happen” for the US economy. He added that, “when it kicks in, I suspect it’ll be fairly forceful.” Summers added a final warning, saying that “this is going to be a relatively high-interest-rate recession, not like the low-interest-rate recessions we’ve seen in the past.” If accurate, Summers’ prediction is a factor that could complicate recovery efforts.

David Rosenberg offered a similarly discouraging view on the fate of the economy and financial assets. This week, the Wall Street legend said, “We’re heading into a recession. It wasn’t the first half of this year with the back-to-back quarters of negative growth… The real enchilada is going to come next year as we get the full brunt of all the lags of what the Fed has already done.” As he sees it, “it’s only now just starting, or will start in the opening months of next year… This was the year of financial turbulence because of what the Fed did, next year is going to be the year of the economic turbulence as…the peak impact of what the Fed has already done hits home in the economy (along with) all the spillover impacts it has on asset prices, home prices, credit defaults, so on and so forth.”

As to the ongoing stock market rally, Rosenberg said, “we’re supposed to believe that a bottom in the market is at hand as the Fed is still raising interest rates into an inverted yield curve, it boggles the mind.”

Rosenberg’s skepticism is valid. The Fed is still hiking interest rates into a yield curve inversion, now the deepest 2’s10’s inversion since 1981. That is indeed a condition in which the stock market has never bottomed. In addition, HAI will also point out that no historical bear market has ever ended before the associated recession has begun.

For those who think the market has bottomed and frantically want to FOMO and Santa-rally their way to market glory, Rosenberg has a final thought. He suggests that such an attitude requires cognitive dissonance in the face of historical facts, and necessitates the notoriously dangerous “this time it’s different” rationale. HAI always appreciates Rosenberg’s color, and he didn’t disappoint this week. Of the attitude held by rabid stock bulls already trying to pick a bear-market bottom in financial asset equities, he says “it reminds me of Harry Callahan…in the famous Dirty Harry films with Clint Eastwood saying, ‘do you feel lucky…punk?’”

While the same can’t be said for financial asset equities, HAI believes it’s becoming increasingly likely that the lows for gold have been established. Not a certainty by any stretch, but increasingly likely. That doesn’t necessarily mean, however, that the market is ready, just yet, to break out to new all-time highs and run to the upside on its next major trending move. That may have to wait for the real Fed policy pivot and subsequent easing cycle to begin. In the meantime, gold is short-term overbought, and is facing significant technical resistance levels. In addition, as the expected incoming recession hits in full, we will need to watch out for a potential severe credit crisis/freeze/event that could cause another round of heavy selling if it occurs and triggers a collateral squeeze. In such an instance, gold is the most pristine and liquid collateral available, and it will be sold heavily at an institutional level as major market participants are forced to scramble to raise liquidity and deleverage. The dollar would also likely spike higher again in a credit freeze, further pressuring gold. Expectations are, however, that a gold selloff would be relatively brief, as such a severe credit event would likely trigger a Fed policy response.

That said, the future looks increasingly bright for the yellow metal at this point. If gold can hold above $1,700 before an eventual breakout to new highs, the prime beneficiaries may be the mining stocks. While their performance, like gold, will likely remain volatile until a more definitive upside breakout occurs, the best companies in the sector, both producers and royalty/streaming names will be profitable and continuing to build financial health with gold prices north of $1,700. If gold prices then breakout to new highs with the catalyst of the next easing cycle, these already healthy companies will be perfectly set up to spit out the most substantial free cash flow streams and dividend yields in industry history.

HAI respects the truth in hedge fund legend Ray Dalio’s observation that “he who lives by the crystal ball will eat shattered glass.” So, no crystal balls here, but if these stars align, if gold can hold it’s lows before eventually breaking out, Mr. Market will surely embrace the mining sector’s top names—those holding top assets, run by top management teams. Such a scenario sketches an image of a trip along the yellow brick road very much worth taking.

Weekly performance: The S&P 500 gained 1.13%. Gold was higher by 3.17%, silver popped 8.49%, platinum added 3.93%, and palladium gained 4.40%. The HUI gold miners index was up 4.79%. The IFRA iShares US Infrastructure ETF was higher by 0.21%. Energy commodities were volatile and mixed on the week. WTI crude oil jumped 4.85%, while natural gas plunged 14.31%. The CRB Commodity Index was little changed, down 0.07%, while copper popped 6.06%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.73% on the week, while the Vanguard Utilities ETF (VPU) was little changed, down 0.14%. The dollar lost 1.34% to close the week at 104.5. The yield on the 10-yr Treasury was lower by 17 bps, ending the week at 3.51%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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