The Markets Open One Eye to Danger – April 22, 2022

The Markets Open One Eye to Danger – April 22, 2022
Morgan Lewis Posted on April 23, 2022

The Markets Open One Eye to Danger

Last week’s HAI pointed out that a storm is brewing. We are facing a complicated set of interrelated problems. Some of these problems are already present. Some are incubating and maturing. They are well on their way to joining the gathering storm shortly, just as surely as “the flower is in the seed.”

The world of weather forecasting (meteorology) has a term known as “bombogenesis.” The curious word describes the process of a weather disturbance that, under certain “ideal” conditions, rapidly intensifies into an extremely powerful storm—or a meteorological “bomb.” When all the ingredients are present and synchronize in just the right terrifying atmospheric harmony, a monster is born. The whirlwind is unleashed.

As with the weather, economies and financial markets experience powerful storms as well. The question is whether the potent ingredients in play and their coordinated interaction amount to a mere disturbance or coalesce into a full-blown tempest. What is known at present is that far more than enough highly potent ingredients exist in today’s social, economic, political, and financial environment to facilitate a market “bomb.” What is being monitored and analyzed intensely is how those ingredients are coming together.

So far in 2022, markets have only been reacting to a “disturbance,” not yet something more ominous. Market reactions to mounting risks, however, are a process—a process BofA’s Michael Hartnett recently likened to a multi-course meal. So far, he says, we have experienced only the “appetizer, not the main course.” It takes time and plenty of convincing for a market accustomed to the good times of a bull market bubble and easy money to abandon the dream and face a new reality. Below the surface of major market indexes, however, reality has been setting in.

As HAI chronicled last week, the existence of a number of these potent negative market relevant factors is becoming widely known. It is reflected in deeply recessionary sentiment—at all-time low levels in many instances, showing up in consumer sentiment, fund manager surveys, and small business expectation measures. This week, AAII market sentiment readings added a 30-year low in the number of “bullish” market participants to the expanding list of evidence that the market is waking up.

This week, the action in financial markets seemed to suggest something of a recognition moment. Indeed, participants seemed to realize that the market “disturbance” is intensifying into a larger storm. Such sentiment has, historically—and ironically, been associated with contrarian bullish market reactions. True to form, early in the week, the bullish market narrative took over: The overwhelmingly negative market sentiment was excessive, it proclaimed, and presaged a rally. 

The week started encouragingly enough with a market rally lasting into Thursday. In fact, Tuesday was the best day for stocks in more than a month. JPMorgan’s committed perma-bull Marko Kolanovic, who almost always advises long positioning in stocks, was out trumpeting the contrarian-sentiment rally narrative. According to Kolanovic, he remained “constructive on equities,” arguing that both sentiment and positioning in stocks was too bearish and that a near-term rally was a green-light go. But while sharp and convincing bear market rallies are certain to unfold as our market drama progresses, Kolanovic’s commentary did not age well this week.

Reality hit the silver-lining narrative hard and fast late in the day on Thursday as Fed Chair Powell spoke at an IMF panel. With markets facing the bearish reality of a serious looming economic growth problem, severe inflation, a suffering consumer, war, dramatically accelerating deglobalization, excessive debt, currency issues, high stock valuations, a pending corporate earnings and margin problem, and a trapped hawkish Fed, Mr. Powell grabbed the microphone.

Powell’s remarks were important, and triggered a rapid and unambiguously negative response from the market. Significantly, Powell embraced the idea of front-loading interest rate hikes. The Chairman said he would like to move “a little more quickly” on increasing rates, and that “there’s something to the idea of front-end loading.” He went on to state that his views now point “in the direction of 50 basis points being on the table.” Powell also said that, “the US labor market is too hot…unsustainably hot,” and he now believes a steeper hike trajectory is “essential to restore price stability.”

The market’s negative reaction may be rooted in several aspects of Powell’s remarks. First, Powell’s comments threw a wrench into one of the more benign—in the near-term—scenarios for how the Fed rate hike cycle could play out. If the Fed were to proceed slowly and cautiously on a tightening of financial conditions, it would buy time for either inflation to possibly ease on its own, or for consumer demand destruction to kick in and assert downward pressure on prices. In either case, this would, at least arguably, open up the possibility of a soft landing. The Fed would then have justification to back away from any legitimate policy-induced tightening of financial conditions—tightening that would be almost certain to overburden the economy and pave a speedy path into recession. By front loading, the Fed will significantly increase the chances that a meaningful tightening of financial conditions occurs right into the teeth of an economic slowdown that’s already in progress. The combined impact would ensure a hard flop rather than the promised featherbed landing.

In addition, Powell’s mention of the labor market is crucial. As long as the labor market is deemed strong and healthy, it can be used as the backbone of hopes for a soft, tightrope-walk landing where the strength of the economy withstands the tighter financial conditions that manage to kill inflation. Powell describing the labor market as “too hot” and “unsustainably hot” is an admission of the “hot, not healthy,” view of this economy. It changes the narrative. The labor market is no longer the savior of this economy, but is instead a patient on the doctor’s table. The labor market is now identified as an intended target of Fed policy constraints. Taken together, the views expressed by the top dog at the Fed represent a big hit to bullish market hopes for avoiding recession.

While the more sober and candid tone from the Chairman is sincerely appreciated, it’s understandable that the market may be questioning the Fed’s own conviction regarding their prospects of soft-landing success. Recently, even the inspirational rallying cries have trended more cautious. On Thursday Powell said, “Our goal is to use our tools to get demand and supply back in synch, so that inflation moves down and does so without a slowdown that amounts to a recession.” 

In that demand/supply equation, the Fed’s only lever to bring things back in synch and reduce surging prices is to attack demand and accentuate an economic downturn. Referring to the intention of delivering the goldilocks soft landing, Powell continued, saying, “I don’t think you’ll hear anyone at the Fed say that that’s going to be straightforward or easy. It’s going to be very challenging. We’re going to do our best to accomplish that.”

As Powell spoke late Thursday, the market sold off. The bearish intensity of the selling was powerful, and it accelerated right into the Friday close. On Friday, nearly six stocks closed lower for every one that closed up on the New York Stock Exchange, and 90.2% of the volume on the NYSE was down volume. That was the highest percentage of down volume seen in seven months. Not a single stock on the Dow Jones Industrial Average closed the day higher, and just 3% of the stocks in the S&P 500 finished Friday with gains. The hefty declines were indiscriminate across asset classes, with the exception of the dollar and the VIX volatility index, which surged nearly 25%. The timing and characteristics of the late-week declines suggest that a new wave of determined selling is kicking off to the downside, and selling pressure and volatility may well increase as stocks again aim lower.

According to Bank of America data recorded just through Wednesday, before the major selloff even ensued, broad US equity fund outflows were the largest since December. Even more striking, through mid-week investors pulled $19.6 billion from US large cap stocks. That represents the largest exodus since February of 2018. Commenting on the data, BofA strategists noted that, while bearishness is pervasive, the “extreme inflation” shock and higher rates shock is just setting in. BofA also noted that, in regard to the evolution of Fed policy, “75 basis points is the new 25 basis points.” As a result, the bank expects that the massive outflows from equity funds are “just getting started.”

Another significant development this week, with notably bearish implications, is the fact that forward inflation expectations continued to rise this week. Despite all of the escalating hawkish rhetoric in recent months and days, this week 10-year inflation expectations made new multi-decade highs. With long-term inflation expectations starting to break anchor despite the best efforts of hawkish Fedspeak, the troubling dynamic is likely stoking an ever-more determined hawkish policy pivot. At the same time, the ineffectiveness of talk is likely increasing the market’s expectations that the Fed will have no choice but to follow through on increased front-loading of hawkish policy actions. Again, the implication is for the increasing likelihood of a meaningful tightening of financial conditions that will fast track this economy into recession.

Two weeks ago, Deutsche Bank became the first major Wall Street bank to officially adopt a US recession as its house view base-case call. What is now playing out with inflation expectations is accentuating the bank’s recession call. Not only does the bank see an incoming recession, but this week added that the dynamics now in place mean inflation expectations “will likely move significantly higher, ultimately leading to an even more aggressive tightening and a deeper recession with a larger rise in unemployment.” The inflation momentum threatening to unanchor expectations translates to the “need to move aggressively to retain their credibility.” The bank goes on to add that with the necessarily aggressive expected tightening, “The Fed’s record shows that achieving soft landings while reining in inflation with rate hikes this large is next to impossible.”

Amid all this turmoil, the hard asset commodity sector is wedged between conflicting factors. On the one hand, extended Covid lockdowns in China and significant recession risks in the US and elsewhere are causing bearish growth fears and resulting commodity demand concerns. On the other hand, equally powerful bullish support for many hard asset commodities is a reality. It’s being driven by a greatly challenged supply side extending into the future, chronic underinvestment, and an emerging shift within financial markets away from financial assets toward a preference for real hard assets. 

Copper is a great example. Its price has been range-bound as growth concerns stoke demand concerns, while at the same time the war in Ukraine is accelerating the desire to push away from Russian fossil fuels toward copper-intensive electrification. While gold may be the hard asset with attributes best suited for the present environment, it is not without challenges. The rising dollar, surging interest rates, and the hawkish policy trajectory of the Fed are all powerful headwinds that will surely score some occasional blows. 

That said, gold’s strength has been impressive, and its attributes have been overpowering the headwinds. Among the many potent factors supporting gold, its insurance characteristics against Fed policy error are particularly relevant at present. As the risk of further consequential policy errors increase and Fed credibility concerns mount, a new type of Fed “put” is in play. This time it’s a powerful free-market insurance bid underneath the yellow metal that’s buying aggressively the more the Fed flirts with disaster.

The theoretical foundations of our modern monetary economic framework are fundamentally untenable and inherently unsustainable. So, too, are the overly used and abused “prescriptive” policies derived therefrom. While certain “tools” in the modern monetary toolkit may for a time produce the short-term effect desired by central banks, we are presently witnessing that our modern monetary framework does not work over time. It doesn’t sustainably solve problems, but rather produces and compounds them en masse. Our modern economics are little more than what economist Henry Hazlitt described as “an intricate network of fallacies that mutually support each other.” We now face the risk of harvesting the unwanted fruit of many decades of monetary malpractice. The market is slowly figuring this out. Until we remedy the faulty foundations of our underlying economic framework, the demand for a true store of value and the insurance bid under gold will remain strong.

A market storm is brewing. This week offered some compelling evidence that the market is waking up to that fact. It is beginning to see that all the factors are in place, and the gathering storm is rapidly intensifying.

Weekly performance: The S&P 500 was down 2.75%. Gold was off by 2.06%, silver was down by 5.60%, platinum lost 6.72%, and palladium gained 0.89%. The HUI gold miners index took it on the chin, down 9.32%. The IFRA iShares US Infrastructure ETF was down 1.74% on the week. Energy commodities were down. WTI crude oil fell by 4.56%, while natural gas gave back half of last week’s surge, down 8.73% on the week. The CRB Commodity Index was lower by 2.47%, while copper was off 2.99%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 0.75% on the week, while the Vanguard Utilities ETF (VPU) was off 2.16%. The US Dollar Index was higher by 0.88% to close the week at 101.21. The yield on the 10-year Treasury jumped by 7 bps to end the week at 2.90%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist

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