Seeing Through the Fog of War
HAI has long viewed the outbreak of consumer price inflation to 40-year highs as a consequential game changer for the economy and financial system. White-hot consumer price inflation is a death sentence for the consumer. Inflation, over time, eventually achieves its lethal execution of the consumer and the 70%-of-GDP consumer economy. Left to fester, inflation wreaks widespread havoc all across the economy. To quote Fed Chair Powell, “Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone.”
The 2021-2022 explosive bout of consumer price inflation was a falling domino that set a dangerous sequence in motion. After initially dismissing the problem of rapidly escalating prices, central bank policymakers were forced to flip from record accommodative stimulus and near-zero interest rates to significant quantitative tightening and a rate-hiking blitzkrieg that would have made Paul Volker proud.
The catch? The current crop of central bank monetary maestros was forced to tighten policy into such a heavily debt-laden, structurally fragile, interest rate-sensitive economy and financial system that Volker himself would have cringed at the prospect. Given the dynamic set-up, HAI has long expected the interacting variables in this equation to eventually result in recession and a hard landing for the economy and markets. As long as central bankers are serious about bringing consumer price inflation back down to their 2% target “unconditionally,” the expectation for just such a hard landing remains firm.
Alternatively, if the Fed prematurely declares victory over inflation, pauses rate hikes too early, or even cuts rates and expands dollar liquidity into still elevated levels of inflation, we’re talking about what ex-Treasury Secretary Larry Summers warns could be a prolonged stagflationary “1970s-style economic crisis.” In the later scenario, if central bankers don’t re-engage meaningfully and aggressively in the inflation fight, the stagflationary scenario could take on dangerous inflationary crack-up-boom characteristics.
Probably the least likely possibility is a sustained Goldilocks era of immaculate disinflation accompanied by healthy economic growth. Regardless, HAI expects numerous pitfalls and surprises along our perilous path.
Well, this week the surprises were wild and everywhere. The most prominent shockers came via a jaw-dropping Bureau of Labor Statistics’ non-farm payrolls report, a complete reversal in January of December’s ISM services PMI elevator drop into contraction, and, most significantly, Fed Chairman Powell’s decision not to push back against surging animal spirits and the ongoing dramatic loosening of financial conditions. It’s a tremendous mess out there right now on the financial market battlefield, and this week was one of the more confusing and strange weeks in terms of data and developments in some time. Let’s try to see through the fog of war.
Since the tightening cycle began, this market has repeatedly acted like a gaggle of naughty school children on the playground, while the Fed has tried to be the disciplinarian teacher supervising with a watchful eye. Children on the playground have an irrepressible urge to play. Absent fear, a disciplinarian demanding responsible “risk-off” behavior has an uphill battle on their hands and can only hope to contain animal spirits temporarily.
When central bankers eventually had to tighten policy to curb inflation, the Fed needed markets to take them seriously and to assist Fed efforts by adopting broad risk-off sentiment and behavior. A risk-off market taking its cue from hawkish Fed policy is the necessary transmission mechanism for Fed policy to actually tighten financial conditions sufficiently to ultimately squash inflation.
Once the rate hiking cycle picked up steam, Jay Powell and the Fed talked tough and demanded that markets respect the Fed’s inflation fight with risk-off behavior befitting a serious policy tightening cycle. Despite the presence of a watchful disciplinarian, however, markets, like rowdy playground kids, get excited, turn playful, and aim to let the good times roll at every possible opportunity. Throughout this tightening cycle, the still irrepressible bullish instinct of the bubble-market has staged repeated rally attempts to front-run an end of inflation and an end of the tightening cycle. Each ensuing rally attempt has loosened financial conditions and has directly undermined the efficacy of the inflation fight. None, however, has loosened financial conditions and threatened to undermine the inflation fight more than the current market rally that began in October. Different measures of financial conditions vary on the extent of the loosening, but all record dramatic loosening since October, and Bloomberg’s financial conditions index, astonishingly, suggests that financial conditions are more relaxed now than before the Fed’s very first rate hike last March.
So far in 2023, with inflation falling and the Fed already slowing the pace of tightening and nearing a rate hike pause, fear of recession and of hawkish Fed policy have been happily discarded in the waste bucket of 2022 by markets now looking forward to a soft landing. Fear is out, and it’s now party time on the playground again.
Previously, every time markets misbehaved, got overly frisky, and started front-running an end of inflation and a hoped-for Fed easing cycle, Powell and company turned disciplinarian, pushed back, and scared the market lower with renewed hawkish intentions. Wednesday’s Federal Reserve FOMC meeting changed all that. This time, Powell the disciplinarian turned a blind eye and looked the other way. HAI expected this Fed FOMC meeting to arguably be the most significant of the hiking cycle to date. Arguably, it was.
Powell and the Fed did raise interest rates by 25 basis points (bps) in another step down from 50 bps last time and 75 bps before that. Additionally, the FOMC statement indicated that a couple of additional rate hikes are still likely in the future. The Committee anticipates that “ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to two percent over time.” During his press conference, Powell also said, “the job is not done,” and emphasized that, “It would be very premature to declare victory, or to think that we’ve really got this.”
That said, this was in no way the hawkish Jay “Volker” Powell of Jackson Hole or subsequent FOMC press conferences. Far more Burns than Volker, Powell dismissed practically every opportunity he was presented with during his press conference Q&A to deliver a pointedly hawkish message to markets. To the contrary, there were even faint whiffs of some celebratory victory lapping. The Chairman declared, “We can now say, I think for the first time, that the disinflationary process has started. We can see that, and we see it really in goods prices so far.”
True, and fair enough, but in the context of a market undoing Fed tightening and drastically loosening financial conditions, Powell’s comment represented a seemingly dramatic relaxation of his inflation fighting posture. In addition, rather than emphasize “there will be pain,” as he has done previously, Powell continued to insist that there is a path for the central bank to bring price inflation down to 2% without causing a significant economic slowdown.
Again, fair enough, but by doing so he was throwing gasoline on the market rally, the loosening of financial conditions, and the rampant animal spirits that are all inconsistent with the inflation fight. As Neil Dutta, head of economics at Renaissance Macro Research, said, the Fed’s “flirtation with the soft landing today increases the risk of a harder landing later.”
The real tell indicating that Powell is backing away from his Volker impersonation came in his response to the first question of the presser. An AP reporter said to Powell matter-of-factly, “As you know, financial conditions have loosened since the fall…” The reporter then proceeded to ask, “Does that make your job of combating inflation harder?” This was a softball lobbed gently to Powell, addressing the question on everyone’s minds. Powell absolutely knew it would be coming, and he absolutely could have crushed it if he wanted.
Instead, rather than take the opportunity to warn markets to “knock it off,” Powell responded with the following: “So, it is important that overall financial conditions continue to reflect the policy restraint that we’re putting in place… And of course, financial conditions have tightened very significantly over the past year. I would say that our focus is not on short-term moves but on sustained changes to broader financial conditions.” Not only did Powell not take the opportunity to warn markets off current bullish behavior, shockingly, he denied altogether that financial conditions had even loosened.
Economist Mohammed El-Erian pointed out that markets, down on the day, reversed sharply higher on “Powell characterizing financial conditions as having tightened quite a bit in the last year.” El-Erian went on to offer, “Not sure which index he is using. The most widely cited ones show overall financial conditions as loose as they were a year ago.”
A couple of thoughts on what may be causing Powell to significantly ratchet down the hawkish rhetoric: I don’t think it’s because he’s suddenly certain we’re comfortably on a glide path to the 2% target. He may have recognized that he’s reached his rate-hiking limit. Recall that when Volker did whatever it took to kill inflation in the early 1980s, US government debt-to-GDP was just above 30%. It’s now 125%. North of 100% debt-to-GDP is historically the danger zone for sovereign debt levels. As Powell raises rates and slows the economy, government tax receipts fall and interest paid on debt increases. This means the government is facing a rapidly deteriorating fiscal situation with widening debt and deficits.
Reflecting the growing fiscal strain, on Monday the Treasury department announced that it expects to borrow a record $932 billion in the first quarter of 2023. That is a 60% increase from the amount estimated as recently as October. Further fiscal deterioration from current levels could threaten a balance-of-payment crisis that ultimately destabilizes and threatens US Treasury market functioning. If concerns on that front are growing, Powell and the Fed likely want to steer very clear of testing those limits. If these concerns have captured policymakers’ attention, Powell’s Volker act may be definitively over. He may be nearly out of runway on further rate hikes. He may no longer be able to use aggressive hikes to fight back against loose financial conditions. He may now be relegated to merely hoping he’s already done enough.
Another possibility is that, in spite of the partially offsetting force of loosening financial conditions, perhaps Powell sees a recession as already in the pipeline and calculates that after another small rate hike or two he can pause and let the lagging impact of rate hikes into an already slowing economy and deeply inverted yield curve trigger the recession that will, for a time, finish the job on inflation. Perhaps he is worried enough about the economy that he is tolerant of loose financial conditions as a factor working to soften the blow of a hard landing. Certainly, HAI has offered numerous examples of recent weak economic data pointing toward recession, and has also highlighted a laundry list of historically extremely accurate recession indicators now sounding alarm bells.
As to the latest economic data, this week it offered a number of the surprises and conflicting crosswinds referred to earlier. In a truly wild week for data, the consumer, the labor market, and services and manufacturing sectors took center stage.
Along with surging credit card debt that is paradoxically occurring as consumer spending is beginning to sputter (a sign strapped consumers are being forced to borrow to pay for necessities), this week Bloomberg reported that Americans are falling behind on car payments at a higher rate than in 2009. Sixty-day delinquencies on auto loans are now nearing an all-time high, and car repossessions are suddenly spiking at the fastest rate since 2009, with further acceleration expected.
In addition, the weakening consumer is now showing up in soft demand for electronics. According to Bloomberg, after overproduction, weak consumer demand for electronics is triggering a “historic crash” in the chip sector. The industry is “suffering one of its worst routs ever.” There’s now “a glut of chips sitting in warehouses, customers are cutting back orders, and product prices have plunged.”
On the manufacturing front, the ISM manufacturing PMI data missed estimates and deteriorated into even deeper recessionary territory than last month. Output is now at its lowest level since 2009. Orders and production were the weakest since the Covid lockdown aftermath, and construction spending had a big drop, missed estimates, and turned negative month-over-month.
On the other hand, singing a completely different tune, after plunging below 50 into contraction for December with a huge drop to 49.2, ISM services for January completely flipped the script and surged back to 55.2—almost back to its November level. The series has recently been volatile, and now conflicts with the S&P Global services PMI, which remains in contraction. The ISM services number was a curious surprise, but it paled in comparison to the stunner delivered by the Bureau of Labor Statistics (BLS) in its update on January non-farm payrolls.
Against an upwardly revised 260,000 new jobs in December and a January estimate of 185,000 new jobs added, the BLS completely blew the doors off with an absolutely astonishing beat of 517,000 new jobs in January. Before getting too excited about the strength of the labor market, consider Bloomberg economist Anna Wong’s take, “If it seems too good to be true, that’s because it is too good to be true—the gain is mostly due to seasonal factors and revisions to past data.” Indeed, amazingly enough, the non-seasonally adjusted jobs number was not only negative, but the most negative since the pandemic.
Causing further skepticism on the headline BLS jobs report, earlier in the week the ADP private employment number came in at 106,000 jobs in January, significantly missing estimates. Furthermore, this week’s Challenger, Gray and Christmas job cuts data was concerning. January 2023 saw the most job cuts to start a year since 2009’s great financial crisis. Furthermore, the year-over-year (y/y) percent change was up 440%. That’s higher than the great financial crisis peak y/y percent increase of 261%.
So, for weekly data and monetary policy purposes, surprises and conflicting crosswinds were the name of the game in this week’s fog of war. What can be said is that economic data and trends remain troubling, and the Fed now looks much less likely than previously expected to push back meaningfully on markets and loosening financial conditions.
As recent HAIs have pointed out, loosening financial conditions are only one aspect of the risk picture. The possibility that inflation will remain elevated or reaccelerate is increasing as the US prepares to restock the Strategic Petroleum Reserve—changing from oil seller to oil buyer on a very large scale. In addition, better-than-expected European growth translates into more commodity demand, and China’s reopening looks to add even more substantial demand to critically tight global supply dynamics. For many key commodities, added demand on top of tight supply means higher prices and added inflation pressures. China’s reopening is potentially of particular significance, as its 1.4 billion people represent twice the population of Europe and the US combined.
As BofA’s Michael Hartnett wrote this week, the “most painful trade” is always the “apocalypse postponed.” As the market rallies on a fleeting moment of hope, Hartnett said that stocks have already gone too far, and that investors face brutal declines if US growth crumbles. The BofA strategist warns that, “the risk is that inflation flares up again over the next few months, and that the US economy faces a deeper recession in the second half of 2023.” Without question, keep helmets on and seatbelts securely fastened. This remains a complex, volatile, and high-risk environment across assets.
Gold, however, continues to be uniquely favored in the current macro backdrop. At present, gold is overextended and technically overbought at the same time as the dollar is due for a bounce. In the near term, the yellow metal is highly vulnerable to a correction, with initial support levels at $1,838, $1,796, and $1,753. On a longer time horizon, however, gold appears to be setting up to test highs, with ultimate sights set on a significant breakout, trending into new all-time high territory.
Supporting this view on the demand side is what the Financial Times described this week as “colossal” global central bank buying that reached a 55-year high in 2022 and accelerated to “a historic rate” in the second half. Aggressive central bank purchases drove overall 2022 demand to a decade high. Of additional interest is that the People’s Bank of China started buying gold again at the end of last year. Publicly reported “official” PBOC gold purchases are a fairly rare occurrence. Prior purchases were made in the early 2000s, at the start of 2009, the summer of 2015, and at the start of 2019. The common denominator in all PBOC “official” purchases is that they all occurred ahead of significant advances in the gold price. Given the macro, fundamental, and technical set-ups for the yellow metal, history may be poised to repeat over the next two years.
It’s also worth considering that gold may have special appeal at a time when nation states and central banks around the world risk discovering the wisdom of Friedrich Hayek’s observation that, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
Weekly performance: The S&P 500 was up 1.62%. Gold was down 2.74%, silver lost 5.12%, platinum was lower by 3.59%, and palladium gained 1.17%. The HUI gold miners index lost 5.71%. The IFRA iShares US Infrastructure ETF was up 2.60%. Energy commodities were volatile and lower on the week. WTI crude oil lost 7.89%, while natural gas was hit again, down another 15.41%. The CRB Commodity Index was down 4.13%, while copper was down 3.79%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.43% on the week, while the Vanguard Utilities ETF (VPU) was down 1.01%. The dollar was up 1.01% to close at 102.75. The yield on the 10-yr Treasury was up 1 bp to end the week at 3.53%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager