Signs: What’s Here Today and What’s Coming Tomorrow
Stock markets started 2023 under pressure, but finished the new year’s first trading week on a strong note. A release of hawkish Fed minutes and weak economic data kept financial markets subdued until Friday. At that point, non-farm payroll data sparked the latest round of Fed pivot mania, soft landing dreams, and speculation that markets and the economy will soon return to the comfort zone of low inflation, low-interest rates, and gobs of excess liquidity.
Stocks closed the week higher, gold rallied to a new recovery high, approaching $1,880, and while many commodities were positive, energy was crushed again. Oil has certainly taken a beating since its March peak, as WTI prices are now down 43%, but it’s natural gas prices that have really dropped like a sack of potatoes. U.S. nat gas prices have now crashed 63% just since September. The dollar was higher on the week, but lost most of its gains on Friday. Bonds soared as yields crashed, but the 2s10s yield curve maintained a deep 70 bps inversion, and continues to broadcast a public service announcement warning investors of incoming recession.
As mentioned, it was the non-farms payroll data on Friday that really excited the market and got the latest iteration of the pivot party started. The U.S. Bureau of Labor Statistics reported a better than expected increase of 223,000 jobs for the month of December vs. estimates for a 203,000 print. The unemployment rate decreased by 0.1% to 3.5%, a level matching five-decade lows. Meanwhile, the labor participation rate inched higher. The portion of the release greeted most enthusiastically by markets, however, was a cooling of the pace of wage inflation. The increase in average hourly earnings decelerated to 0.3% from 0.4%, and, of course, the market declared an end to wage inflation, a victory over consumer price inflation, and started blaring the dance music while spinning the disco ball.
Outside of the lagging labor market, however, the week’s economic data was less than inspiring. The Purchasing Managers Index (PMI) and Institute for Supply Management (ISM) gauges are among the best and broadest regularly reported economic data points available. They measure the strength of activity on both the services and manufacturing sides of the economy. In an ominous indication of the economic growth trajectory, all of the latest December PMI and ISM data for services and manufacturing now signal outright contraction. Any reading below 50 marks contraction. As of December, the PMI came in at 46.2 for manufacturing and 44.7 for services. The ISM reading sagged to 48.4 for manufacturing and 49.6 for services.
In November, the ISM services reading had surprised to the upside at 56.5, and was highlighted, like the labor market, as an example of U.S. economic resilience. While December’s ISM services number was expected to show a cooling trend (estimates were for a 55 print), the actual reading of 49.6 plunged the measure into contraction territory with the largest month-over-month drop since Covid lockdowns shuttered the economy.
In addition to the uniform headline contractions, other key subcomponents showed contraction as well. Services PMI business new orders dropped to 45.2, business new export orders were 47.7, and business employment—in contrast to the headline non-farm jobs data—was also in contraction at 49.8. U.S. manufacturing new orders posted their largest month-over-month drop since the March 2020 lockdown.
This is the first time that the key ISM and PMI headline readings for both services and manufacturing have been in outright contraction at the same time since the Covid recession. The economy is slowing significantly. Historically, when all these indicators are contracting in unison, the Fed is almost always actively easing policy to stave off recession. This time is indeed different. The Fed is still hiking interest rates, performing quantitative tightening to withdraw liquidity, and telling anyone who will listen that it won’t cut rates in 2023.
There are two primary reasons for the Fed’s stubborn hawkish persistence despite a weakening economy, progress on inflation, and now initial indications of cooling wage growth. The first is that, while inflationary pressures are easing, inflation is still much too vulnerable to reacceleration. The second is increasingly a credibility story.
The ISM data illustrates part one of the two-part story, explaining why Powell and company continue to press firmly on the monetary policy brake. While inflation is indeed slowing, thanks in large part to that weakening economy, in stark contrast to the contraction theme seen elsewhere across the services and manufacturing data, the ISM business prices measure came in at a still-hot 67.6. The pace of price inflation is off the sultry highs of last summer, but prices remain an item significantly out of balance and very much in expansion territory.
On a practical level, as Rabobank global strategist Michael Every has pointed out, despite a weakening economy, “nobody ever got fired for hiking rates when inflation is at 7%,” and chairman Powell insists that, even after eventually pausing on hikes, the Fed has learned history’s unambiguous lesson: Don’t ease monetary policy prematurely in an inflation fight. If you reignite the economy too soon, you reignite inflation. Policymakers then, like confused clowns, swiftly arrive right back where they started, but with a bigger inflation problem and even less credibility.
While history is clear on that point, the risk is now more elevated and less appreciated because of powerful factors indicating that a persistent secular shift toward higher levels of inflation has already occurred.
To a historically unprecedented degree, the financial economy has grown too large for the real economy to effectively service. Central bank policy of recent decades essentially created a backing of financial assets that incentivized a funneling of massive investment flows into the financial economy. Those flows came at the direct expense of sufficient investment into the real economy. For better or worse, environmental regulations and social pressures exacerbated the phenomenon. As HAI has pointed out in the past, these are critical factors contributing to the now chronic and structural commodity supply shortages—shortages that on balance will keep commodity prices relatively high.
Natural resource supply shortages, however, are not the only contributors to a secular shift toward higher underlying inflation rates. As opposed to geopolitical cooperation, increased hostility and conflict is inherently inflationary. Resulting resource nationalism adds significant price pressures to preexisting resource shortages. It argues that, for now, we are past peak cheap natural resources.
Just as globalization was disinflationary, the newly unfolding deglobalization dynamic is inflationary on a number of additional levels. Deglobalization likely means we are past peak cheap labor, and also means that the low-cost “just in time” inventory model will necessarily transition to a costlier but more resilient “just in case” model. All of these factors are likely to keep price inflation in a higher secular range than in the recent past.
Consequently, higher interest rates and interest rate volatility are likely to be a secular reality as well. Within the context of this new backdrop of relatively higher inflation and interest rates, any false step into a premature easy policy pivot could be a devastating mistake with particularly incendiary consequences. Any increase in economic demand could have outsized upward price pressures.
As mentioned, a credibility-related policy constraint is the second part of the Fed’s hawkish story. The credibility crisis is on acute display at present in market pricing. Despite the Fed’s adamant, persistent, and consistent reiterations of hawkish guidance, the market isn’t cooperating and isn’t pricing it in. The market is ignoring the Fed, and is instead pricing in expectations for a lower-than-guided fed funds terminal rate and an anticipated pivot to interest rate cuts in 2023.
As a consequence of the market’s more dovish policy outlook that effectively calls the Fed’s bluff, the Morgan Stanley Financial Conditions Index has eased by roughly 35% since late October. So, while the Fed keeps trying to tighten the monetary policy noose, the market keeps loosening it. Since October, the market is winning.
In this week’s FOMC meeting minutes, the Fed directly addressed this intensifying dynamic in the most direct manner yet. The Fed warned against “unwarranted” loosening of financial conditions, stating that such loosening would impede its inflation fighting efforts. The meeting minutes also revealed that Fed officials were worried about any “misperception” by financial markets of their actions. “Participants noted that, because monetary policy worked importantly through financial markets, an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee’s reaction function, would complicate the committee’s effort to restore price stability.”
As HAI pointed out last week, in addition to looser financial conditions directly undermining the inflation fight, the market’s disregard of Fed guidance essentially forces the Fed to push rates higher and leave them high for longer than markets expect. If the Fed were to lose this arm-wrestling match with markets, it would effectively amount to an irreparable shattering of credibility and loss of any effective monetary policy brake. Such a development would unhinge markets and inflation. A financial system once governed by the gold standard, then subsequently the Fed standard, would be governed by no standard. The likely outcome would be an inflationary Austrian crack-up-boom and calamity.
So, while the Fed struggles to fight inflation, rebuild credibility, and maintain relevance, the market is pushing it into a tighter-for-longer policy path. It’s a dangerous game. Importantly, by the time the Fed can confidently determine that it has done enough on both the inflation and credibility fronts, it will almost certainly have done too much damage on the economic front. This reality, in the context of the slowing economy, keeps the risk of an accident and consequent recession extremely high.
Reacting to the events of the week and the interplay between weak manufacturing and services data on one hand, and better-than-expected headline jobs data and cooling wage growth on the other, was, as always, former Treasury Secretary Larry Summers. The Secretary told Bloomberg on Friday, “I think the judgment that soft landings are the triumph of hope over experience continues to be the right best guess,” adding that, “I’m not sure that continued [labor market] strength points to a softer landing rather than pointing to an even harder landing when things re-equilibrate.”
At present, markets still appear to be analyzing inflation, Fed policy maneuvers, and both recession risks and subsequent policy responses through a presumed static, but in fact now outdated, prism of yesteryear’s secular era of low inflation and low interest rates.
Beyond the immediate distraction of Fed policy speculation and recession risk, a large-scale market repricing will likely be necessary to account for higher-than-expected inflation and interest rates on a secular level. A mispricing means both risk and opportunity. One of the most certain beneficiaries in a secular repricing looks to be scarce natural resources. Higher prices will be necessary to incentivize the increased supply needed for the expansion of the real economy, and the expansion of the real economy will ultimately be needed to defeat a secular trend of higher inflation.
In addition, as Credit Suisse guru Zoltan Pozsar has detailed recently, there are growing indications that much of the world is in favor of maintaining—but altering—the dollar reserve system. Rather than maintaining a pure petrodollar, momentum is reportedly building toward a transition to multi-currency energy pricing with gold as net settlement. As described, the U.S. dollar would remain the global reserve currency, but gold priced at a floating rate would evolve to replace U.S. Treasurys as the primary global reserve asset.
While still speculative and unconfirmed, Pozsar is insightful and well informed. The current petrodollar system is increasingly problematic for an increasing number of interested parties, including the U.S. If the dollar reserve system evolves in the way proposed, over time it would offer an improvement. It would also likely be extremely bullish for gold prices, as the yellow metal would once again take on a recognized key role in the global financial system, not via the gold standard, but as the primary global reserve asset. MWM will be watching developments closely.
Weekly performance: The S&P 500 was up 1.45%. Gold was up 2.38%, silver was down slightly by 0.25%, platinum was higher by 1.98%, and palladium gained 0.45%%. The HUI gold miners index surged 9.59%. The IFRA iShares U.S. Infrastructure ETF was higher by 2.37%. Energy commodities were volatile and crushed on the week. WTI crude oil was off 8.09%, while natural gas crashed again, down another 17.09%. The CRB Commodity Index was hit (mostly due to energy), and closed down 4.66%, while copper was up 2.62%. The Dow Jones U.S. Specialty Real Estate Investment Trust Index was up 2.80% on the week, while the Vanguard Utilities ETF (VPU) was little changed, up 0.16%. The dollar was up on a very volatile week by 0.37% to close at 103.65. The yield on the 10-yr Treasury was hammered, losing 33 bps to end the week at 3.55%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager