The Fitzgerald Test
A recent HAI cited F. Scott Fitzgerald’s famous quote that, “The test of a first-rate intelligence is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function.” When analyzing current financial markets, we must all aspire to pass this “Fitzgerald test.” We must hold two opposing risks for the market outlook in mind at the very same time, and retain the ability to function. The current economic and market environment is far from healthy. That’s not the question. The tricky question is not whether unhealth will manifest—rather, in what form will it manifest?
HAI has repeatedly expressed the view that markets and the economy are on a trajectory toward either recessionary ice (base case probability), or inflationary fire (lower chance scenario). Back to the Fitzgerald test, these are two opposing ideas with very different expressions in terms of expectations for asset price responses. This is an incredibly complicated, challenging, and even dangerous environment for asset allocation. Nevertheless, we must relish the challenge and aim at high functioning.
Past HAI’s have detailed the more probable recessionary ice scenario extensively. Below, this author will again recapitulate and update the ice scenario. However, given this week’s downgrade of the U.S. government credit rating by Fitch, we have a most timely opportunity to discuss in greater detail the alternative inflationary fire scenario as well. So, for those interested, this HAI is an attempt to help us all ace the always-difficult Fitzgerald test.
The expectation has long been, and remains, that the “ice” scenario is the very likely next stop for our financial market train ride. The recessionary ice scenario is unambiguously supported by historical precedent, the lagged effects of the Fed’s monetary policy tightening cycle, the extremely inverted yield curve, 15 straight months of deeply recessionary leading economic indicators, and by what famed economist Dr. Lacy Hunt just described as a confluence of factors setting-up a “classic” “old fashioned credit crunch.” With the new financial physics of interest rate gravity now firmly in place after a decade of zero-G, the recessionary ice scenario (incoming recession and a potentially violent market downturn), despite taking longer to develop than HAI anticipated, is still very much expected—it remains the high probability base case outcome.
Furthering the ice scenario, this week offered an update on the latest Senior Loan Officer Opinion Survey (SLOOS) Report. The SLOOS is one of the most reliable predictors of US recessions. The latest report indicated a further tightening of commercial bank lending standards as well as lower demand for loans. Both lending standards and loan demand are now at levels consistent with past recessions, and, as with Federal Reserve interest rate hikes, the negative impact to the economy bites on a lag. The latest SLOOS represents another strong indicator of incoming recession likely beginning toward the end of the year. While the most potent impacts of the lagged effects will take more time to bite, impacts are already beginning to surface. Bond and leveraged-loan defaults are rising, charge-off and delinquency rates for loans are climbing, and corporate bankruptcy filings have increased sharply.
Also furthering the case for ice, on Wednesday the Brookings Institution released a detailed report warning of “deteriorating household finances” that will no longer support strong spending. The report found that “the extraordinary wealth that households accumulated in 2020 and 2021 had dissipated by the first quarter of 2023.” Brookings added that, “the current state of household finances does not support continued strong consumer spending, and leaves households at a crossroads…they can either moderate their spending or become more indebted.” So, according to Brookings, consumers must either cut spending or, conversely, up their borrowing even more. If consumers choose the latter option, the highly respected think tank spelled out the consequences in plain terms—“financial health could deteriorate in a worrying way.”
The dynamics highlighted by Brookings will only be exacerbated after the amnesty in student debt repayments ends and repayments resume in October. The payments will affect roughly 40 million Americans, specifically a younger and lower income cohort, a group least able to afford the added expense. As of the end of May, the research group Education Data Initiative estimated the average student loan repayment burden to be a decidedly chunky $503 per month of effectively anti-stimulus. That’s going to hurt. It’s also going to dramatically compound and accelerate the “crossroads” spoken of by Brookings. Household finances already dictate that consumers must cut spending. For 40 million of those consumers, they must “discover” an additional $503 per month or increase their indebtedness “in a worrying way.”
Confirming the Brookings report findings and validating concerns over the impact of resumed student debt payments, this week a Bloomberg poll found that a disturbingly low (and falling) number of Americans can afford to foot a $400 emergency bill. The share of US adults who said they could handle such an emergency expense dropped to a 46% minority last quarter. Over a third of respondents said they’d need to use some sort of debt, such as borrowing on credit cards, while one in five said they simply wouldn’t be able to pay at all. Taken together, the figures highlight just how vulnerable the U.S. consumer has become. The current consumer equation paints a portrait of a decidedly up-hill battle for an economy in which consumer spending drives 70% of GDP.
For now, the dominant services sector of the economy is still expanding, but activity in the U.S. continues to slow. According to the latest data from the Institute for Supply Management (ISM), the Services Purchasing Managers Index (PMI) fell to a reading of 52.7 last month, down from June’s reading of 53.9. The result was below the consensus estimates for a drop to 53.1. Readings over 50 signify expansion, but the month-over-month drop to 52.7 indicates a slowing of that expansion.
Also out this week, the latest data on the U.S. manufacturing sector showed it contracted for the ninth consecutive month. The ISM manufacturing PMI came in at 46.4 (below 50 is contraction). The reading was slightly below expectations for a 46.9 print. The ongoing weakness in manufacturing is significant. Despite being a much smaller part of an economy increasingly dominated by the larger service sector, manufacturing is far more cyclical and economically sensitive. As such, manufacturing weakness leads weakness in services. Also of important note, the report revealed that the manufacturing employment index dropped a full 3.7 points to a very weak 44.4 in July.
This week, the labor market news was somewhat mixed. Labor data certainly wasn’t bad. It did, however, show some subtle but important signs of cooling. The Job Openings and Labor Turnover Survey (JOLTS) report from the Labor Department Tuesday showed that job openings in June decreased more than expected to 10.4 million, down from 10.9 million in May. On the better-than-expected side, the ADP National Employment Report issued on Wednesday reported that the U.S. private sector added 324,000 jobs in July—well above expectations. The report also showed that job gains were concentrated in the service sector. Again, services are far less cyclical and therefore far more lagging. As the economy sours, the weakness shows first in manufacturing and later in services, and that’s exactly what we’re seeing.
Lastly, on Friday, the U.S. Bureau of Labor Statistics reported that Nonfarm Payrolls increased by 187,000 in July, slightly below expectations for 200,000. Also, June’s increase of 209,000 was revised lower to 185,000. Again, not bad numbers, but below the surface there were some signs of cracks in the foundation. Temp jobs, always a cyclical and leading indicator of a turn in the labor market, dropped significantly. Similarly, cyclical labor market leading indicators manufacturing and transportation were notably weak. In addition, hours worked, the first place employers look to cut labor costs, also declined, signaling reduced demand from employers. So even as the economy added jobs, the average hours worked fell. That portrays a labor market that’s not nearly as strong as the headline job numbers. As chief economist at Pantheon Macroeconomics Ian Shepherdson said, we’re now seeing “softish payroll numbers” that show a clear cooling in the labor market. The last leg of the stool for the consumer is employment. If employment cracks, the consumer breaks, and if the consumer breaks, the recessionary ice arrives.
Historically there has been a close primary relationship between the economy, corporate earnings, valuations, and stock market prices over time. If that close historical tether remains intact, when the full force of the expected economic contraction accelerates, then we will see the “recessionary ice” scenario play out in a painful, potentially violent, drop in equity prices.
Still, it is different this time in some important ways. The U.S. debt and fiscal position has never been as bad as it is now, and it’s rapidly worsening. For a number of reasons we will discuss, the $32.7 trillion and growing mountain of U.S. debt could ultimately threaten to sever that close primary historical tether between stock market prices and the economy, corporate earnings, and valuations. Under certain circumstances, at such high levels of debt, market pricing could establish a new primary relationship tethered instead to inflation expectations. That would be the potential path to early stage crack-up-boom dynamics and the inflationary fire scenario. Let’s examine.
As HAI reported back in May, Stanley Druckenmiller juxtaposed the market’s concerns over the relative insignificance of a possible technical default surrounding the debt ceiling debate against the underappreciated but much larger looming threat of the overall U.S. government debt, deficit, and fiscal problem. As Druckenmiller put it, “all this focus on the debt ceiling instead of the future fiscal issue is like sitting on the beach at Santa Monica worrying about whether a 30-foot wave will damage the pier when you know there’s a 200-foot tsunami just 10 miles out.” Druckenmiller added that, “The fiscal recklessness of the last decade has been like watching a horror movie unfold.” Indeed it certainly has. This week even the typically mute credit rating agency Fitch took note.
As the fiscal “horrors” of the past decade have rapidly intensified in both the present and expected future, in a first since 2011 and for only the second time ever, a major U.S. credit rating agency has now downgraded the U.S. sovereign credit rating. On Tuesday, Fitch downgraded the U.S.’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘AA+’ from ‘AAA.’
According to Fitch, the rating downgrade of the United States reflects a high and growing general government debt burden, expected further future fiscal deterioration, and the “erosion of governance” relative to peers over the last two decades.
Among the many reasons Fitch cited for the downgrade, an obvious factor is that the U.S. national debt-to-GDP ratio is now “over two-and-a-half times higher than the ‘AAA’ median of 39.3% of GDP and ‘AA’ median of 44.7%.” New spending initiatives, weaker federal tax revenues, and a higher interest burden were, combined, projected to further drive a continually higher debt-to-GDP ratio. Crucially, Fitch’s longer-term projections forecast additional debt/GDP rises, “increasing the vulnerability of the U.S. fiscal position to future economic shocks.” This last line may be Fitch’s key statement. It helps explain how the excessive national debt could sever asset market pricing’s tie to the economy, corporate earnings, and valuations, and tether it instead to inflation expectations.
At a certain point, at high enough debt levels, the government fiscal situation becomes so fragile as to be at constant imminent risk of insolvency and sovereign debt default. In such a fragile state, a government attempting to avoid a nominal debt default becomes unable to fight inflation by any traditional means. Instead, it is forced to embrace inflation. When debt levels are lower and healthier, Federal Reserve interest rate hikes serve to slow the economy and, by extension, slow inflation. Often a recession and the negative wealth effect of falling stock and real estate values are needed to reset consumer price inflation to lower levels. This is the history of rate hiking cycles. The Fed raises rates, higher rates trigger an economic shock, we enter recession, and inflation resets lower.
If, however, debt levels and deficits are high enough, then the use of interest rate hikes to tame inflation can initiate a terminal debt spiral that rapidly races toward insolvency and default. When enough debt has accumulated, interest rate hikes blow out the interest expense cost of the debt. At the same time, as interest rate hikes slow the economy, government tax receipts fall as slowing GDP causes lower income tax revenue, and falling asset prices cause lower capital gains tax revenue. In other words, on enough debt, interest rate hikes lead to surging expenses on top of falling revenue. If tax receipts are insufficient to fund government expenditures, you get a deficit that feeds right back into a further increase in the already problematic level of total government debt. Hence, a debt doom-loop can take hold.
True interest expense (TIE) is interest plus entitlements. Right now, TIE is over 100% of tax receipts. Government tax revenue is already spent before the government has even paid a dollar of its operating outlays on items such as defense, education, transportation, labor, agriculture, homeland security, and more. While it gets precious little attention, we are currently blowing out the deficit and already flirting with serious debt doom-loop dynamics that could threaten to accelerate future default risk. Its no wonder Fitch downgraded the U.S. credit rating. The wonder is that they still left it as high as ‘AA+’.
At present, the government is in a tight spot, constantly getting tighter. Interest expenses are skyrocketing, and tax receipts are falling sharply. With interest rates at current higher levels, neither side of the government funding equation is cooperating to reduce funding stress. Average tax receipts, on a trailing 12-month basis, are now running at negative 11%. Interest expense on the now $32.7 trillion of debt is now looking to push close to $1 trillion annualized. As the CEO of the Peterson Foundation, an organization promoting fiscal responsibility, recently stated, “Unfortunately, interest is now the government’s fastest growing ‘program.’ ” As a result, the annualized 2023 deficit is now projected by some, including Piper Sandler, to be as high as $1.9 trillion, with some estimates as high as $2.1 trillion. If we sustain the trend of muted tax receipts along with ramped-up interest expenses, then the risk of government insolvency will be pulled forward dramatically. In light of the math, Maya MacGuineas, president of the Committee for a Responsible Federal Budget (a depressingly tough job at present, to say the least) recently asked a good question, “How can anyone possibly think this trend is sustainable?”
The apparent unsustainability of this fiscal situation—Druckenmiller’s 200-foot tsunami just 10 miles out—prompts a key question. With debt and deficits this high, can the government afford high enough interest rates to fight inflation, a slowing economy, and a falling stock market? It’s a real question swirling throughout the investment community. If the answer is a “hard no,” and we’ve already crossed that point of no return, then the implication is that we’re headed back to zero percent interest rates ASAP, and the Fed will be similarly forced to intervene with massive stimulus to prevent any further slowdown in the economy as well as any renewed declines in the stock market. In other words, if we’ve already crossed the debt and deficit Rubicon, it would imply we’ve entered a perpetually high inflation regime. It would imply that monetary policy, as we’ve known it, is effectively broken. The Fed can no longer combat inflation with higher interest rates. It would also reaffirm the “Fed put” backstopping financial markets and ensuring that stock markets move only higher.
In addition, if we have already entered the terminal doom-loop phase of massive debt and deficits, a further implication involves the concept of “fiscal dominance.” Fiscal dominance essentially describes a condition in which the government must print money outright in order to finance deficits. Other than tax receipts, the printing press is the only means of non-interest-bearing government funding. It’s the “inflation tax.” It’s the only way for a terminally indebted government to finance itself without furthering the debt and deficit doom-loop with ever-higher levels of debt and interest expenses. This is obviously an incredibly inflationary road for a government to take, and one where the release valve would be a rapidly depreciating currency.
The thought of the U.S. entering into fiscal dominance may seem like a far-fetched dystopian nightmare, but there is good reason to think otherwise. Early in June, Columbia Business School Professor Charles Calomiris wrote a St. Louis Fed white paper. In it he said that at 2% global real yields, “the U.S. would likely face an imminent fiscal dominance problem” and would need to print money to finance deficits. Well, we are now near the highest real yields since 2009 and currently pushing close to that 2% real yield threshold without any clear assurance that we won’t cross the line.
If indeed we have arrived at this point, or nearly so, and markets recognize it, then it could sow the seeds of a devastating Austrian crack-up-boom and the inflationary fire scenario. If market participants recognize an implied ironclad government “put” backing the stock market, along with a currency facing accelerated depreciation due to fiscal dominance dynamics, heavy capital flows could funnel into the real values of finite assets deemed to possess the key characteristic of scarcity. In such a scenario, markets would tend to gravitate away from the historical tether between prices and the underlying economy, and towards a new dynamic, one in which market prices are increasingly driven only by expectations for government sanctioned inflation and severe perpetual currency debasement.
Back to the “Fitzgerald test”; recessionary ice and inflationary fire are most certainly two very opposing ideas to be held in mind simultaneously, with very different expressions in terms of expectations for asset price responses. So how do we function amid such a mess? HAI believes that while on a longer time frame we might be on a path to inflationary fire, we are likely not quite at full fiscal dominance just yet. As a result, the greater risk over the near-term remains recessionary ice. Given the uncertainty, however, HAI advises a defensive portfolio fit to pass the Fitzgerald test and built to survive and thrive in two opposing outcomes. Build a portfolio based on expectations for a downturn with optionality in the form of cash-like short-term Treasurys paying a solid interest kicker, while hedging the crack-up inflation risk with moderate position sizes in scarcity-rich, top-quality hard asset themes favoring larger allocation to precious metals and related best-in-class precious metals producers. As our market saga unfolds, and greater clarity emerges with regard to recessionary ice or inflationary fire, tweak asset allocation and press bets accordingly.
As to gold’s increasing scarcity, recall the recent S&P Global findings HAI highlighted weeks ago. S&P confirmed that there were roughly 180 major gold discoveries of over one million ounces in reserves in the 1990s, 120 in the 2000s, 40 in the 2010s, and none since 2019. Less future product in the face of higher demand amid a potential flood into real values births higher prices. As a portfolio inflation hedge anchor in the current environment, with economic insensitivity, matchless intrinsic quality, and increasing scarcity, nothing beats gold.
Weekly performance: The S&P 500 dropped 2.27%. Gold was off 1.19%, silver lost 3.18%, platinum was down 1.61%, and palladium was up 2.02%. The HUI gold miners index was off 3.46%. The IFRA iShares US Infrastructure ETF was down 1.75%. Energy commodities were volatile and mixed on the week. WTI crude oil kept rising, up further by 2.78%, while natural gas lost 2.31%. The CRB Commodity Index was slightly lower, off 0.36%, while copper was down 1.53%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 2.90%, while the Vanguard Utilities ETF was down 4.36%. The dollar gained 0.43% to close at 101.84. The yield on the 10-yr Treasury was up 9 bps, ending the week at 4.05%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager