The Fed’s Dilemma: Pyrrhic Victory Against Inflation or Worldwide Flood of Liquidity – June 24, 2022

The Fed’s Dilemma: Pyrrhic Victory Against Inflation or Worldwide Flood of Liquidity – June 24, 2022
Morgan Lewis Posted on June 25, 2022

The Fed’s Dilemma: Pyrrhic Victory Against Inflation or Worldwide Flood of Liquidity

Extremely depressed market sentiment readings and oversold underlying market technicals have been storing up fuel for a bear market relief rally for months. With the high impact Federal Reserve FOMC meeting in the rearview mirror, and a relatively light week for data and critical market-relevant events, equity indexes received an engraved invitation to rally. They graciously accepted this week. All major market stock indexes surged well over 5% for the week. The Nasdaq, however, like an underwater beachball released from its tether, led the pack with an explosive 7.49% upside surge. While the rally has already helped ease oversold technicals and taken the edge off dreadful sentiment, we’ve been expecting one at some point, and it could certainly continue to run a bit further.

Counterintuitively, this week’s aggressive equity rally occurred amid widespread growing expectations for recession. Seemingly every analyst on Wall Street increased their estimation of the odds of recession this week, including those at Deutsche Bank, Citi, Goldman Sachs, Morgan Stanley, and Nomura.

Beyond surging stock indexes, bonds caught a bid as yields backed off, the dollar weakened, and gold prices eased modestly. Increased recession fears and concern for accompanying demand destruction continued to exert pressure on energy, copper, and most commodities.

For now, at least, along with supportive sentiment and technicals, stock markets are rallying on the logic that rate hike expectations fall as recession risks rise. Subsequent expectations anticipate a quicker Fed pivot back to stimulative rate cuts. Bear market relief rallies need an excuse, and the math of lower-than-feared interest rates justifying higher valuation multiples for stocks will do for now. The blissful times are unlikely to last too long, however. Those valuation multiples are not likely to fare well as the “E” in “PE” (price-to-earnings) multiples gets crushed when stubbornly high corporate input costs meet a recessionary collapse in demand.

While most analysts recognized increasing recession risks, one prominent optimist this week was the President of the United States. Following a call with former Treasury Secretary Larry Summers, President Biden announced to the press, triumphantly, that a recession is avoidable and “isn’t inevitable.” Following his discussion with Biden, however, Summers revealed later in the week that he viewed a recession as “almost inevitable.” In light of hearing Summers’ position straight from the horse’s mouth, it appears Biden was peddling a bit of hopeful “so you’re saying there’s a chance?” spin in his account of the high-profile encounter. Meanwhile, outside the spin zone, Bloomberg Economics’ 24-month recession probability measure reached the high levels that preceded the recession, the Great Recession, and the Covid recession at 98.5%. With all due respect to the President, HAI’s views on an incoming recession fall decidedly in line with with Summers and Bloomberg Economics.

With first quarter US GDP growth already having contracted at a revised 1.5% rate, and the Atlanta Fed Q2 2022 GDP estimate in freefall from positive 2.5% in May to 0% at present, economic growth is already pulling up lame. Adding color and dimension to the slowdown picture is a Federal Reserve aggressively raising interest rates to quell 40-year-high inflation, a pending corporate profit recession, building credit stress, initial signs of cracks in the labor market, an unaffordable housing market, a buckling consumer, and deteriorating economic data. Given the factors piling on the growth outlook, HAI also takes the front end of the Bloomberg Economics 24-month recession timing window.

On the economic front, significant deterioration in data this week underscored that recession may already be knocking at the door. The US PMI Composite Output Index declined month-over-month (M/M) to a 5-month low. The US Services Business Activity Index also declined M/M to a five-month low. US Manufacturing PMI declined sharply M/M to its lowest level in 23 months, while the US Manufacturing Output Index declined sharply into outright contraction with its lowest reading in 24 months. In addition, business confidence slumped to one of the greatest extents since comparable data was available in 2012.

In the latest scream from the collective voice of the American consumer, University of Michigan Surveys of Consumers data offered no signs of relief on Friday from deeply recessionary, historically low levels of consumer sentiment. According to survey Director Joanne Hsu, “The final June reading confirmed the early-June decline in consumer sentiment, settling…14.4% below May for the lowest reading on record” since the agency began collecting data in November of 1952. The participant pool in the choir of consumer cries is diverse. Consumer sentiment “across income, age, education, geographic region, political affiliation, stockholding, and homeownership status all posted large declines.”

The report also revealed that, “79% of consumers expected bad times in the year ahead for business conditions.” That marks the highest reading since the Great Financial Crisis. In addition, inflation continued to be of paramount concern to consumers. Forty-seven percent blamed inflation for eroding their living standards, a level just one point shy of the all-time high. Of crucial importance, “consumers also expressed the highest level of uncertainty over long-run inflation since 1991, continuing a sharp increase that began in 2021.”

The data confirms that the Fed is hostage to incoming inflation data and “uncertain” consumer perceptions that the Fed will effectively fight the good inflation fight. People must clearly see the Fed aggressively attacking inflation or that 31-year high in long-term inflation expectations and uncertainty risks becoming certainty that the Fed won’t solve the problem. Such a development would dramatically un-anchor inflation expectations, sending them to dangerously high levels. If consumers begin to suspect high inflation as far as the eye can see, inflation psychology will become behavioral. In a vicious cycle, consumers and businesses will fuel turbo-charged inflation by making present decisions based on expectations that prices will only rise aggressively over time. Inflation expectations therefore mark the Fed’s final fallback position in the inflation fight. 

Meanwhile, the market is catching on to the sequence of events: 

  • Inflation is causing a consumer crisis that risks becoming a calamity. 
  • The Fed must be seen as waging a credible inflation fight. 
  • A credible Fed fight amounts to a policy that intentionally slows an already down-turning economy. 
  • Recession will be the result. 
  • If the Fed doesn’t pivot back to an accommodative and stimulative policy stance quickly, this recession will, very likely, be as nasty as the Fed is willing to allow. 
  • Without quickly reinitiated Fed support, this would likely not just be a recession, but a recession that pops the biggest financial asset bubble in history.

To complicate matters dramatically, we do not live in the under-30% government debt-to-GDP Volker era. We live in the post-Covid era of over 120% debt to GDP, in which the federal government has run a deficit and added to its debt in every fiscal year since 2002. With such high debt-to-GDP levels and ongoing annual budget deficits, one must consider whether the US can handle a prolonged period of higher interest rates and/or a lengthy and damaging recession.

The Comptroller General of the United States and head of the US Government Accountability Office (GAO) recently wrote that the “GAO’s latest report on the nation’s fiscal health paints a sobering picture.” The GAO Comptroller points out that burgeoning federal debt is “a trend that is unsustainable.” This trend has been feasible only because of historically low and consistently falling interest rates throughout the last 20 years. The unsustainable increase in debt has most recently been accommodated by the extreme measure of central bank-implemented, near-zero interest rate policy. According to the Congressional Budget Office (CBO), higher interest rates mean “newly issued debt would cost the government more, and maturing debt would have to be refinanced at the prevailing (potentially higher) interest rate.” In recent years, the federal government’s spending on net interest has represented a relatively small share of total federal spending, but only due to near-zero interest rate policy. If interest rates rise, according to the GAO, “net interest spending is projected to increase, presenting additional challenges to fiscal sustainability.”

So, higher interest rates will significantly increase government interest payments on massive debt. Further, a recession will severely limit revenue to a government already running deficits as income, sales, capital gains, and other tax receipts drop. In short order, the combination of higher interest rates and lower government tax receipts will provoke a serious solvency problem. In such a state, options are reduced to two unfortunates: default on government payment obligations or cut interest rates to the bone and inflate the debt away over time. Historically, sovereign governments with debt-to-GDP levels over 100% have disproportionately chosen to inflate away the debt rather than default.

This is all to say that the Federal Reserve and US government are very likely in a much bigger bind than most are aware. Given the larger sovereign debt context, a very strong argument can be made that the current rate hike cycle and nasty incoming downturn will soon be met, once again, with an energetic policy pivot back to aggressive rate cuts, deeply negative real interest rates, and an economically stimulative accommodative monetary policy setting—in short, the reinstatement of the infamous “Fed put.”

In the meantime, before the Fed can pivot, recession is the first order of business. Commodities are starting to feel the pressure of demand destruction concerns. The worries about global growth helped push the Bloomberg Commodity Index to a four-month low this past week, with all sectors suffering setbacks. Since reaching a record peak on June 9, the index has fallen by around 12%. The energy correction of recent weeks has been the most dramatic display of growing demand concerns, but industrial metals are flashing the same warnings.

After a very strong start, industrial metals are now down 6% on the year, while copper, after its worst week in a year, is currently down 15% in 2022. Copper’s poor weekly performance was exacerbated by a large Chilean mining company agreeing to end a worker strike that appeared set to trigger a price-supportive reduction in supply. Nevertheless, demand destruction worries apply to all economically sensitive commodities at present. 

That said, the longer-term value and return potential in the space is only growing. As prices fall, a dramatic disconnect is emerging between sharply lower prices and depleted stock levels held at warehouses monitored by exchanges in London and Shanghai. This past week, despite falling prices, inventory stocks of the four major industrial metals dropped to a fresh combined record low at 1.1 million tons, down 60% from a year ago. As events unfold, amazing opportunities are slowly forming for the patient and attentive.

In last week’s HAI, we discussed the arguments suggesting that the global economy has shifted into a new era defined by an underlying secular inflation bias. With an inflationary secular tailwind in place, the next Fed pivot stands to stoke inflation anew and be extremely supportive of hard assets such as supply-constrained commodities in high demand, precious metals, and the companies that produce them all. The risk resides in the current downturn that precipitates the eventual policy pivot. MWM is working diligently to manage the interim market risk while watching for opportunities to position optimally in some of the best unfolding investments, setting up for the years ahead.

Weekly performance: The S&P 500 surged 6.45%. Gold was down 0.56%, silver was lower by 2.18% on the week, platinum was off 2.85%, and palladium gained 3.09%. The HUI gold miners index was down by 1.46%. The IFRA I Shares US Infrastructure ETF was up 4.29%. Energy commodities were lower again. WTI crude oil was off by 0.34%, while natural gas plunged by 9.56%. The CRB Commodity Index was lower by 3.41%, while copper lost 6.73%. The Dow Jones US Specialty Real Estate Investment Trust Index was up big by 8.30% on the week, while the Vanguard Utilities ETF (VPU) was up by 6.12%. The US Dollar Index was lower by 0.51% to close the week at 103.96. The yield on the 10-yr Treasury dropped by 12 bps to end the week at 3.13%

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist

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