The Rocket’s Red Glare
With America’s 4th of July birthday upon us, we’re not just seeing fireworks decorate the nation’s skies, markets are putting on a firework extravaganza of their own. The markets’ show, however, is likely to continue well beyond the long Independence Day weekend. If you monitored markets this week, HAI recommends Advil and acupuncture as an assist for the nasty bout of whiplash you’re likely suffering. Volatility wasn’t just extreme day to day and intraday throughout this week, volatility was extreme intra-hour and minute by minute.
The post-Covid economic impact of trillions in monetary and fiscal stimulus, near-zero interest rate policy, a rapid mass reopening from lockdowns, and a historic flash-crashing unemployment rate was to send a grounded economy into flight in an epic supercharged rocket launch. However, this was a hot-not-healthy and unsustainable economy. Like the 30% year-over-year price-inflated firecrackers Americans are about to enjoy en masse, the Covid economic recovery burned hot and bright, but all too quickly. While the violent economic resurgence posted an impressive initial flight trajectory, the engines have recently sputtered. Nevertheless, the strong economic momentum has been sufficient to keep the plane flying in glide mode up to present. At this point, however, as Americans enjoy an estimated 150 million 4th of July hot dogs this long holiday weekend, the gliding economy risks slowing to the point of nosing down into an accelerated decent.
Assisting in that decent, for now, is the newly non-accommodative Federal Reserve. While unprecedented government stimulus efforts got this raging, raucous party started, an 8.6% 41-year high in consumer price inflation and a shocking new 70-year record low in American consumer sentiment have forced a policy re-think. For the moment, the new policy setting is aimed at forging an “unconditional” fight against inflation. Markets are increasingly reacting, and quite poorly, to the growing recognition that the Fed is tightening policy and financial conditions right into the teeth of an already down-turning economy. We are witnessing the “growth shock” transitioning into “recession shock” predicted by Bank of America Chief Investment Strategist Michael Hartnett.
This week’s price action accentuated that old unsettling recessionary feeling. Equities slipped lower, consumer staples outperformed discretionary, and defensive utilities surged. Most commodities got hit on demand destruction concerns. The traditional economic indicator that is “Dr. Copper” flashed more warning signs as it continued to break down from a higher trading range it held for well over a year. Gold was under pressure, but managed to close the week above $1,800. Bonds surged, yields collapsed, and the dollar managed its highest weekly close in nearly 20 years.
Also hitting the depressing blue notes in the downturn orchestra were a slew of macro indicators. In the debt markets, credit default swaps were notably higher and credit spreads widened for both high yield and investment grade debt. Meanwhile, inflation expectations, as gauged by both 5-and 10-year inflation breakevens, dropped even as expectations for the terminal rate of the Fed’s rate hike cycle declined. The missing variable in an equation involving both lower inflation expectation and reduced expectation for the extent of Fed tightening is a souring outlook on economic growth.
At the same time, markets increasingly priced in expectations for a Fed pivot this week. Various futures markets moved towards suggesting that, after ending rate hikes, the Fed will pivot to cutting rates sooner and more vigorously than previously expected. Again, the implication is that markets view something, perhaps a recession or some other market accident, as an increasingly likely catalyst for an eventual Fed policy pivot and that markets are increasingly pulling that “event” forward in timing.
As economist Murray Rothbard explained, without the continuing inflation of money, “the distortions and misallocations of production, the overinvestment in uneconomic capital projects, and the excessively high prices and wages in those capital goods industries become evident and obvious. It is then that the inevitable recession sets in, the recession being the reaction by which the market economy readjusts itself, liquidates unsound investments, and realigns prices and outputs of the economy so as to eliminate the unsound consequences of the boom. The recovery arrives when the readjustment has been completed.”
While the “adjustment” has started, it is far from complete. Last week, HAI observed, that “with first quarter U.S. 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.” To illustrate just how fast things are starting to move, and not in the right direction, let’s update those figures. After a second revision to Q1 GDP and two updates from the Atlanta Fed on their Q2 GDP estimate, the numbers this week now stand at an official -1.6% Q1 GDP contraction and a now alarming -2.1% Atlanta Fed estimate for a Q2 GDP drop. That’s a whopping 4.6% wrong way swing in estimates for Q2 GDP growth in a little over a month and a half!
The island of strong economic data is indeed eroding away. The labor market, so far, has shown the least cracks to its strength. That said, it is a lagging indicator, so weakness in other areas should eventually manifest in the labor market. The most notable data developments this week were hammer blows aimed at the narrative of a “kevlar” consumer. The argument, to which HAI does not subscribe, has been that with excess aggregate savings the consumer might talk their way to a 70-year all-time low in consumer sentiment, but when it comes to action, will still hold up this economy with robust spending.
This week, however, the most alarming aspect of the previously mentioned Q1 GDP revision was the fact that consumption was significantly revised down from 3.1% to 1.8%. That’s a massive revision. At the same time, the Q1 GDP revision also revealed that Final Sales of Domestic Product declined 1.2% and that Real Disposal Personal Income tumbled 12% for Q1. Also released this week was that Real Personal Spending declined 0.4% in May for the first contraction this year. The decline was more than estimated, and, significantly, spending data for each of the prior four months was revised lower. All in all, the data painted the picture of a significantly softer consumer than previously assumed.
To date, manufacturing data has also been a resident on the island of economic strength. While manufacturing remains in expansion, more recently the trend has been toward accelerating weakness. Chris Williamson, Chief Business Economist at S&P Global said this week’s manufacturing PMI survey, “has fallen in June to a level indicative of the manufacturing sector acting as a drag on GDP, with that drag set to intensify as we move through the summer. Forward-looking indicators…have all deteriorated markedly to suggest an increased risk of an industrial downturn.”
Also adding to growth concerns this week, fresh reports emerged of a significant slowdown in semiconductor demand, along with inventory builds. The implication is that demand for all sorts of electronic products is fading. New cars are a hefty source of semiconductor demand. One point of supporting evidence, amid many, for a chip demand slowdown can be seen in slumping auto sales. This week, estimates for the seasonally adjusted annual sales rate for new cars in June anticipate a huge 20% year-over-year sales drop. Estimates are for a 13.2 million unit seasonally adjusted June sales rate. Prior to the pandemic, for five straight years, unit sales toped 17 million.
Reacting to the cumulative impact of the recent economic data, former Treasury Secretary Larry Summers expressed what many others are feeling as well. According to Summers, the risk is increasing that the looming recession he’s anticipating will start in 2022, sooner than he had anticipated. He told Bloomberg, “The risks of a 2022 recession are significantly higher than I would have judged six or nine weeks ago.”
This week, economist Mohamad El-Erian voiced his concern over another aspect of the threat now facing the economy. In an interview with Bloomberg, El-Erian flagged increasingly scarce liquidity as a big risk to markets and to accentuating economic slowdown dynamics. As evidence mounts that capital is becoming more expensive and difficult to acquire, El-Erian said, “We’re starting to see markets locked out of funding. Issuance in June was very low. Companies either were unwilling or unable to refinance themselves.” If companies in need face increasing difficulties acquiring new capital, spending will be cut. If corporate spending drops, the economy will slow further.
In commodity land, tension is rising along with growth concerns. Last week HAI touched upon the fact that demand concerns have recently edged out extremely tight, record-low inventory levels in dictating prices for the group of major industrial metals. In energy markets, the same battle rages. In recent weeks, persistent and serious energy supply concerns have been countered by growing demand risks. So far the energy sector has fared better than the industrial metals, which are even more sensitive to pure economic demand dynamics. This week, demand pressure on energy markets resulted from indications that U.S. gasoline demand is beginning to falter in the face of tightening consumer purse strings amid record high prices at the pump. On a four-week rolling basis, outside of the 2020 pandemic lockdown, implied U.S. gas demand fell to the lowest seasonal level since 2014. We are only beginning the summer driving season. Demand from U.S. drivers usually doesn’t peak until September. Demand weakness showing up so early in the driving season is a strong indication of demand destruction. The data was supported by separate survey data this week that indicated Americans planning to take a holiday by motor vehicle in the next six months fell to a seasonally adjusted four-year low.
On the flip side, U.S. EIA inventory data showed that even with huge ongoing Strategic Petroleum Reserve injections, crude and WTI inventory stockpiles are at seasonal low levels not seen since 2014. In addition to price supportive inventory data, fresh supply concerns emerged this week from both Libya and Norway. OPEC+ is already trailing its own production target by 2.7 million barrels per day. The added supply scare comes amid existing speculation that OPEC+ spare capacity is almost nonexistent.
The net result of the escalating supply/demand battle is that oil prices gained marginally in a volatile week, partially offsetting more substantial losses over previous weeks. For now, prices remain range bound between $100 and $125. In energy, as with the industrial metals, price dynamics are likely skewed toward elevated near-term downside risks, while persistently constrained supply fundamentals offer powerful upside support to the price outlook for the longer-term.
Now, this is a very special and important holiday weekend as the United States celebrates its 246th birthday of Independence. This 4th of July, amidst many grave concerns, let us take comfort in the fact that our nation has faced and surmounted the challenges of crisis many times in the past. HAI hopes that the wise and good, both in and outside of Government, as they have in the past, will strive gallantly to navigate the impending storm with sufficient skill to avert the worst potential economic, political, and social outcomes. Gazing beyond the tumultuous immediate horizon, there is an inspiring potential future of the brightest prospects to be realized if Americans tap the noble strength within them, restore and refresh the nation’s best core values and principles, and resolutely aim at nursing that bright future into fruition. HAI sincerely wishes that, rather than succumb to cynicism, Americans are instead inspired by George Washington’s appeal in his Newberg Address, that those facing challenge rise to meet it through exploring the bounds of that “last stage of perfection to which human nature is capable of attaining.”
In so doing we can all contribute toward generating legitimate hope that We the People of the United States can earn and secure anew the Blessings of Liberty to ourselves and our Posterity and get back to the mission of always striving to establish an ever more perfect Union.
Amid gloomy times in our nation, let’s remember that there is an intersection of wisdom, effort, inspiration, ingenuity, noble principles, and values within all of us where authentic hope is reliably borne. I believe that intersection is also part of the American character. May we find it now. Best wishes for a wonderful Independence Day to all!
Through the perilous fight, the rocket’s red glare, bombs bursting in air, our flag was still there, in the land of the free, and the home of the brave!
Weekly performance: The S&P 500 lost 2.21%. Gold was down 1.57%, silver was clubbed by 6.87% on the week, platinum was off 3.59%, and palladium bucked the precious metals trend by gaining 4.52%. The HUI gold miners index was down by 4.60%. The IFRA iShares US Infrastructure ETF was up 0.96%. Energy commodities were volatile and mixed. WTI crude oil was up 0.75%, while natural gas plunged by 14.49%. The CRB Commodity Index was lower by 2.25%, while copper lost 3.74%. The Dow Jones US Specialty Real Estate Investment Trust Index was off by 0.64% on the week, while the Vanguard Utilities ETF (VPU) was up by 4.08%. The dollar was stronger by 0.91% to close the week at 104.91. The yield on the 10-yr Treasury plunged by 25 bps to end the week at 2.88%
Have a wonderful holiday weekend!
Equity Analyst & Investment Strategist