The Heat is On – February 24, 2023

The Heat is On – February 24, 2023
Morgan Lewis Posted on February 25, 2023

The Heat is On

Last week, HAI observed that the S&P 500 had broken below the rising trend channel that defined the rally off December lows. The implication was that the trend break would set up a possible back-test of clustered S&P breakout levels and support zones in the $3,900 to $4,000 range. This week, the S&P 500 closed below the even larger-degree trend channel that has defined the entire countertrend rally off the October bear market low to date. In so doing, the S&P broke below the all-important falling 50-week moving average, and, by closing the week at $3,970, it entered the zone of key clustered support discussed last week. Breaking below the rising October rally trend channel, losing the 50-week moving average, and a weekly close below $4,000 are all dubious developments for stocks. For market participants daydreaming of an ongoing market rally, it’s crucial that the S&P 500 holds its present support zone and bounces significantly. A failed test that breaks below support on a weekly close will be a strong indication that the stock market’s Goldilocks moment is over.

This week, the market price dashboard reflected a resumption of the nasty trends of 2022, trends the market hoped to forget. Major stock indexes were hit across the board, precious metals were down, commodities were mostly lower, while volatility jumped along with the dollar and yields. Meanwhile, the 2s10s yield curve inversion deepened and remains at its most inverted level since 1981, three months before the infamous “double dip” recession began.

On Wednesday, the minutes from the February 1st Fed FOMC meeting were released. According to the minutes, inflation remains the primary concern for the Federal Reserve. While conceding that inflation remains “well above” the 2% target, however, “participants noted that inflation data received over the past three months showed a welcome reduction in the monthly pace of price increases but stressed that substantially more evidence of progress…would be required to be confident that inflation was on a sustained downward path.” Well, since those remarks were recorded at the start of the month, “substantially more evidence” is in. CPI, PPI, and now PCE unanimously testify that inflation is certainly not on a “sustained downward path.”

Friday offered the latest in a string of indications that inflation pressures remain sticky-high and are defying the will and wishes of those banking on the efficacy of magic disinflation theory. On Friday, the release of core Personal Consumption Expenditures (PCE), the Fed’s preferred inflation gauge, confirmed that rather than playing nice and heading neatly to the Fed’s 2% target, inflation is reaccelerating in the wrong direction and distancing itself from target all over again. Year-over-year (Y/Y) January core PCE registered at 4.7%, unexpectedly surpassing December’s 4.6% and far outpacing the 4.3% estimate. Month-over-month, core prices increased 0.6%, exceeding estimates, and were up from December’s upwardly revised reading of 0.4%. Headline PCE also came in much hotter than expected, and increased to 5.4% (Y/Y), up from 5% last month. In other words, as Glenn Frey’s hit single from the 1984 film “Beverly Hills Cop” put it, “The Heat Is On,” and life continues to get significantly more complicated for Powell, the Fed, and markets.

So, what does it all mean? Real time “coincident” growth, as defined by the National Bureau of Economic Research (NBER) is a measure of income, consumption, production, and employment. It has been trending lower for some time. The best chance for a soft landing was that inflation would magically disappear. That would, in theory, free the Fed to support the slowing economy with a return to an “accommodative” policy setting before recession took hold. With the recent inflation data, however, that already remote possibility is rapidly diminishing. Given the lag factor, the full effects of the monetary tightening already administered haven’t been felt yet, and the recent data greatly enhances the odds of more policy tightening to come over an even longer period of time. With coincident trend growth already slowing to a pre-recessionary pace, leading economic indicators outright recessionary and still down-trending, the residual monetary tightening “pig” still in the “python,” and more rate hikes likely, the recession risk ahead is extremely high.

On a smoothed trend basis, coincident economic growth started 2022 at roughly 3%. Leading indicators were pointing lower at the time, and coincident growth cooled to a 2% trend over the summer. At that point, with leading indicators pointing lower still, we saw coincident data subsequently follow through lower again with another drop to 1% trending growth towards the end of last year. Coincident trend growth cooling into the 1% range is significant because, as EPB Research points out, when smoothed trend growth is in decline, “the average recession begins at roughly 1%.”

Most recently, December and January have presented a wrinkle. At this point, it looks clear that seasonal adjustments made December data appear too weak and January data too strong. There’s little doubt that the fog of war surrounding the official economic data battlefront of late is as thick as ever. Across official data sets, seasonal adjustments to recent data have been among the highest ever applied by statisticians, and even banks such as JPMorgan, Goldman Sachs, and UBS have all been up in arms over the level of recent adjustments and distortions.

That said, peering through the fog of seasonal adjustments, the dramatic loosening of financial conditions from October through early February does appear to have clearly sent a short-term growth impulse into the economy. As stock prices rose, mortgage rates eased lower, and corporate and consumer sentiment improved from all time lows, some increased demand entered the economy. Just this week, University of Michigan’s Surveys of Consumers Director Joanne Hsu highlighted the phenomenon by capturing an important aspect of the feedback loop. Hsu observed that, “After lifting for the third consecutive month, sentiment is now 17 index points above the all-time low from June 2022 but remains almost 20 points below its historical average. Consumers with larger stock holdings exhibited particularly large increases in sentiment.” So, as stocks rise, consumers feel better and loosen the purse strings a bit. In so doing, they send a demand impulse that reverberates throughout the 70%-of-GDP consumer economy. When the consumer feels better, everyone feels better, and throughout the economy, everything looks better.

However, unless the micro dynamics feeding this loosening of financial conditions and mini wealth effect can continue indefinitely, the phenomenon will fade.

Why should the current demand impulse fade? As HAI has repeatedly discussed since last summer, a market rally and a loosening of financial conditions predicated on front-running expectations for an imminent end of both inflation and Fed tightening is a catch-22 that undermines the foundation of its own premise. It is self-defeating. As we are now clearly seeing in the re-stoked inflation data, given the underlying inflationary dynamics firmly in place, any significant loosening of financial conditions triggering any associated economic growth impulse feeds right back into reaccelerating inflationary heat. In so doing, it brings further Fed policy tightening for longer right back onto the table. At a bare minimum, it removes the possibility of the Fed easing policy anytime soon without the excuse of either a clear descent into recession or some other economic and/or market crisis dynamic erupting.

So, as inflation data heats up again, expectations for more Fed tightening increase in lockstep. As the market increasingly accepts this cause-and-effect feedback loop, financial conditions should tighten again and the current economic demand impulse from recent loosening of financial conditions will fade. In fact, this sequence is already playing out. Once inflation data started to surprise higher over recent weeks, the futures market began pricing future fed funds rate expectations significantly higher for longer and pushed back the timeline for expected eventual rate cuts.

As the policy outlook gets tighter, market-based financial conditions are indeed tightening again. Stocks have begun to show renewed weakness, yields have moved sharply higher, mortgage rates have turned up again, and the dollar index has strengthened from under 101 at the start of February to over 105 now.

Importantly, short-term distortions aside, the direction of coincident “real time” economic growth is forecast by the leading indicators. So, when the current short-term small-scale growth impulse fades, the unsettling reality is that we’ll find ourselves, once again, running headfirst into the larger-degree recessionary economic cycle downturn already clearly apparent in the declining leading economic data.

If the current short-term growth impulse from the recent easing in financial conditions was a sudden and sustainable reacceleration in the economic cycle, the growth impulse would have been preceded by a sustained upturn in earlier leading indicator data. That hasn’t happened at all. The leading data is recessionary, has not bottomed, and continues to drop with force. The sharp downturn in the long-lead and even short-lead economic data is reflected in the recession warnings being broadcast by countless forward indicators such as the yield curve, the Conference Board’s Leading Economic Index, and, as HAI covered last week, ECRI’s long-lead economic indicator. So, with the “catch-22” thesis (described above) beginning to play out as inflation data strengthens again, a tighter for longer policy narrative is starting to work into tighter market-based financial conditions. If financial conditions continue to tighten, the current short-term growth impulse will be snuffed out, and we may all soon get acquainted, suddenly and surprisingly, with the looming recession clearly flagged by the leading data.

Former Treasury Secretary Larry Summers sees the potentially developing accident as well, and this week highlighted worrying signals of a potential sharp drop-off in economic activity. The former Secretary told Bloomberg, “We’ve got an extremely difficult economy to read… People may be reading a bit too much into the moment in terms of economic strength—relative to the way things could look very differently in a quarter or two.”

Summers said that while coincident indicators look strong right now, “there are a variety of leading indicators that are more troubling.” Summers said that inventories “look to be building up relative to sales,” companies are “reporting concerns about their order books,” employee head-counts are too high relative to “the level of output they’re producing,” and that “consumer savings are being depleted with a low savings rate.” In reference to the cartoon character that speeds right off a cliff before the unceremonious plunge, Summers concluded, “There is stuff, when you look down the road a bit, that has to be substantially concerning about a Wile-E-Coyote kind of moment.”

This setup takes us right back to 2021 and the beginning of our story, when inflation first began to accelerate. In the context of a credit bubble dependent on an unending river of liquidity and zero interest rates, inflation is the problem that stands between the market and the easy, stimulative policy setting it craves. With magic disinflation theory debunked, reality underscores the inconvenient truth—either accept a recession (one that could be the hardest of hard landings if it definitively pops the credit bubble) or live with inflation. If policymakers try to avoid recession rather than fight inflation, they can only delay recession by adjusting policy in ways that will further feed inflation. Walk down that plank, and we could get a prolonged stagflationary crisis potentially far more devastating than that seen in the 1970s.

As Schwab chief investment officer Liz Ann Sonders said this week, echoing HAI’s skepticism over the prospects of a perfect disinflationary soft landing, “I think something would have to give either broadly in the economy, or more specifically in the labor market, to bring the immaculate disappearance of inflation… Without that commensurate hit to the economy or the labor market, I think [a soft landing] is a stretch.” In other words, the truth, so devastating to the magic disinflation soft-landing crowd, is that the choice is binary: recession or inflation. Both end badly. Ultimately, policymakers will choose.

For gold, the key question is whether the Fed is up to the tightening challenge. If the answer is no, then the Fed is choosing to tolerate higher levels of consumer price inflation, likely in an attempt to temporarily stave off recession, keep the credit bubble from bursting, and buy time for the government’s rapidly deteriorating fiscal balance of payments crisis.

If the Fed shies away from the path of sufficient tightening, if it chooses to live with inflation over the alternative, then gold’s current correction could be short-lived. The yellow metal would be poised to break out from its exceptionally bullish decade-long sideways consolidation, take out remaining overhead resistance, and make a run deep into new all-time high territory.

Conversely, if the Fed is up to the challenge of sufficient further tightening and is willing to ride the economy into recession, then we can expect the current correction in the gold price off January’s peak to extend, and for gold to remain capped underneath the $1,950–$2,000/oz. resistance zone. While a breakout may have to wait in this scenario, it may not be for long. Once the recession bites, gold will soon sniff out the start of a crisis-response Fed easing cycle. That’s an energetic catalyst also likely to pave the yellow brick road to significant new all-time highs.

While nothing is ever certain, plenty of risks remain, and the short-term path and timing, as ever, remain in doubt, HAI sees the odds that the yellow metal is approaching a major breakout to substantial new all-time highs as an increasingly loaded bet.

Weekly performance: The S&P 500 was down 2.67%. Gold was down 1.79%, silver lost 3.59%, platinum was lower by 1.47%, and palladium got smacked lower by 7.64%. The HUI gold miners index lost 4.68%. The IFRA iShares US Infrastructure ETF was down 2.30. Energy commodities were volatile and mixed on the week. WTI crude oil dipped modestly by 0.30%, while natural gas finally bounced, jumping 12%. The CRB Commodity Index was nearly flat, down 0.16%, while copper lost 3.89%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 4.50% on the week, while the Vanguard Utilities ETF (VPU) was down 2.82%. The dollar was up 1.33% to close at 105.16. The yield on the 10-yr Treasury gained 13 bps to end the week at 3.95%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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