Volker or Burns? – October 28, 2022

Volker or Burns? – October 28, 2022
Morgan Lewis Posted on October 31, 2022

Volker or Burns?

On the eve of another crucial Federal Reserve FOMC meeting next Wednesday, expectations are a near lock that amid the Fed’s ongoing rate hike barrage, a fourth straight 75-basis point jumbo hike is incoming. Market uncertainty swirls around the ultimate terminal rate of the hiking cycle and the exact size of subsequent future hikes, but the near-term trajectory for rates remains higher. 

In a zombie economy borne of and acclimated to a near-zero interest rate universe, the new financial physics of interest rate gravity set the stage for an incoming wave of economic pain and a near-certain future recession. In fact, after every other segment of the yield curve inverted in 2022, red flagging the elevated risk of future recession, the last remaining holdout finally went negative to join the inversion pack this week. Notably, however, this latest inversion comes in the Fed’s preferred recession signal, the 3-month/10-year spread. The 3M10Y has inverted just prior to every recession since 1968, and none other than the Federal Reserve Bank of New York has blessed the signal as a “valid” indicator.

As interest rate borrowing costs rise sharply; oven-hot 8.2% consumer-crippling price inflation bites; and stocks, bonds, and now the housing market all head lower; the negative-wealth-effect builds. With the revolver’s chamber now fully loaded with negative-wealth-effect bullets, consumer spending is increasingly in the sights. For the corporate economy, along with inflation pressures and a higher cost of capital, reduced consumer spending will further exacerbate developing margin compression and weigh on earnings. 

This sequence is currently unfolding, and was most prominently on display this week in the rate-sensitive tech sector. The latest quarterly reports from Microsoft, Texas Instruments, and Amazon were various shades of disastrous. So, too, were updates from Snap, Meta (Facebook), and Alphabet (Google). Importantly for the latter cohort, the underlying problem is a broad pullback in corporate advertising spending. As PIMCO’s Erin Browne pointed out on Bloomberg this week, corporate belt tightening on marketing budgets historically anticipates and precedes significant contractions in consumer spending. Reduced ad spending is also a leading indicator that strongly correlates with a subsequent pullback in corporate capital expenditures broadly. Moreover, a pullback in corporate cap-ex correlates with subsequent higher unemployment and lower GDP. It’s an evolving vicious cycle, and once significant layoffs begin to manifest, they greatly exacerbate the negative wealth effect and prompt further reductions in consumer spending.

So, while government data on Thursday revealed that US GDP was up 2.6% in the third quarter, that headline gain merely made up for the economy’s contraction during the first half of the year. It will likely prove to be a fleeting one-quarter phenomenon. Most of the positive GDP number was attributable to trade exports—mostly commodities, specifically oil and gas—sent to European nations mired in an acute energy crisis. Stripping trade and inventory adjustments out, final sales to domestic buyers posted growth of just 0.5%—considerably less than the average of almost 2.6% over the five years before the pandemic. Sal Guatieri, a senior economist at BMO Capital Markets, referring to the final-demand indicator, said, “It’s very unusual to see that indicator basically stall outside of a recession period. That’s telling. That means the US economy beneath the surface is losing steam.”

The foreboding signs for the economy included a 26.4% annualized plunge in residential investment, and a 15.3% annualized decline in business investment. Real “inflation adjusted” GDP was further boosted by an outsized decline in the Bureau of Economic Analysis’ GDP Price Index. Adjustments stemming from the BEA’s price index calculation rather remarkably meant that while inflation adjusted GDP increased, Q3 nominal GDP actually declined by $552.4 billion. So again, taken together, the U.S. economy has been stalling out for the first three quarters of the year. However, given the negative wealth effect dynamics that have become entrenched over the period, the contraction lies ahead.

Last week, HAI mentioned that when the rug is set to be pulled out from under economic growth, and when demand destruction must be taken into account, patience is typically a virtue from an investment perspective. The possible exceptions were gold, as insurance, and other “special situation” commodities. This week’s boost in energy exports in Q3 GDP highlights why the odds are increasing that energy may be gaining “special situation” status.

Tight energy supplies are by no means entirely the result of the West cutting off Russia as a meaningful source of supply. The pig was in this python long before a hot war in Ukraine catalyzed and accelerated global geopolitical fracturing.

Increasingly over the last decade, Western consensus has been that the future is one of alternative energy. That said, alternative energy is not yet ready to supply the bulk of global energy demand, and global energy demand continues to grow. According to Reuters, in 2021, energy demand exceeded pre-pandemic levels by 1.3%. Fossil fuels accounted for 82% of that 2021 energy use. That compares with 83% in 2019 and 85% five years ago.

So global energy demand is growing, and fossil fuels still represent the backbone of global energy supply. Regardless of right or wrong, the reality is that, for years, political and environmental pressures have increased structural uncertainty regarding the long-term demand outlook for fossil fuels. The acute problem is that the elevated structural uncertainty regarding the demand outlook translates to a massive disincentive for the long lead-time capital expenditure outlays necessary to secure ample future supply. The cap-ex drought and chronic underinvestment of yesteryear now translate to the supply crunch of today. Overlay onto these underlying dynamics the geopolitical fracturing and newly emergent multipolar world, and you arrive at the energy crisis we now face.

Last week, HAI pointed out that crude oil was wedged between significant competing price determining factors. On one side is the negative price threat of an increased hit from incoming global recessionary demand destruction, and, on the other, price-supportive impacts from both OPEC+ production cuts starting next month along with a U.S. government that will soon turn from substantial seller to oil buyer in order to replenish the depleted Strategic Petroleum Reserve (SPR).

This week, the building energy market stress made headlines. JPMorgan CEO Jamie Dimon minced no words in a CNBC interview. Dimon said, “We are getting energy completely wrong… We have a longer-term problem now, which is the world is not producing enough oil and gas to reduce coal, make the transition, [and] create security for people, so I would put it in a critical category. This should be treated almost as a matter of war at this point, nothing short of that.”

With OECD oil stocks 243m barrels below the five-year average as of the end of August according to the International Energy Agency, OPEC+ spare capacity in serious question, and stocks in the US SPR at their lowest level since 1984, the supply side risk in the energy market is increasingly apparent. The supply side tightness may provide enough counterbalance to the demand side risk to upgrade the near-term price outlook more towards neutral as the longer-term outlook remains positive.

Highlighting the elevated geopolitical vulnerabilities now firmly attached to the energy outlook, the Saudi Energy Minister, Prince Abdulaziz, said this week that, “People are depleting their emergency stocks…[using them] as a mechanism to manipulate markets when it’s profound purpose is to mitigate shortages of supply.” Ominously, he added, “Relying on emergency stocks for oil supply may become painful in months to come.”

Even former Treasury Secretary Larry Summers offered words of caution on the energy front this week. Referring to his worries over the growing “confrontation” between the U.S. and what he described as a “Russian-Saudi axis,” Summers told Fortune that inflation is at risk of getting a fresh impetus from a spike in oil prices. “This is going to be a very complex time, and I hope that we get through it while avoiding oil price spikes,” he said. But “my guess is that that’s going to happen.”

So, all Fed Chair Powell and the FOMC can do to fight inflation is attack aggregate economic demand by clamping down on activity with aggressively tight monetary policy. Mr. Powell knows this, as he said in his Jackson Hole manifesto, “the current high inflation in the United States is the product of strong demand and constrained supply, and that the Fed’s tools work principally on aggregate demand… There is clearly a job to do in moderating demand to better align with supply. We are committed to doing that job.” 

To sufficiently align demand with supply when commodity market supply is so tight implies the need for aggressive demand destruction. Powell and the policy tool-kit must work overtime to force the tight commodity supply beach ball under water and keep it from exploding upwards. To this point, Powell seems committed to doing just that. The consequences, as previously stated, are an almost certain recession—likely a very serious one, and possibly one that puts the pin to the larger overarching credit super-bubble. Powell’s job is tough and unenviable.

So far, Powell has accomplished only the “easy” part of his stated mission to bring inflation back to the 2% target “unconditionally.” It’s relatively easy to stand up as the tough and dedicated inflation fighter when the world is crying out in unison over inflation’s menace. But as another former Treasury Secretary, William E. Simon, reminds us, “the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it.” Now comes Powell’s true test. Will he stand strong on the inflation fight when the applause stops, the pain starts, and everyone’s clamoring anew for “everything that causes it?”

After the United Nations asked the Fed and other central banks to halt interest rate increases because they “would reverse the pandemic pledges to build a more sustainable, resilient and inclusive world,” two U.S. senators and a congressman joined the chorus this week. At the same time, a growing number of the formerly unified Fed governors appears to be subtly shifting dovish. What’s more, this week two credible sources (former senior White House aid Harald Malmgren and HAI favorite BofA Wall Street strategist Michael Hartnett) suggested the Fed will try to find a “technical” escape from its minefield trap by raising the inflation target. So, essentially, if inflation isn’t at the 2% target, just jack up the target. Brilliant! Problem solved! Memo to the Fed: while politicians and policymakers can always engage in a Potomac two-step, the real economy doesn’t dance. Hopefully Powell is made of more substance than that, but at this week’s FOMC meeting the Chairman’s resolve will be challenged. Will he maintain Jackson Hole form? Will he fight inflation come what may and, like Volker, defeat it, or will he be timid, falter, and fail like Arthur Burns? Time will tell, and we will soon get our answer. One thing is certain: If the Fed does pull the lever on raising the inflation target, it’s best to own gold in advance.

Weekly performance: The S&P 500 was up 3.95%. Gold was lower by 0.69%, silver was up 0.42%, platinum gained by 1.63%, and palladium lost 5.40%. The HUI gold miners index outperformed physical again, up 1.44%. The IFRA iShares US Infrastructure ETF gained 5.89%. Energy commodities were higher on the week. WTI crude oil was up 3.35%, while natural gas regained some of last week’s outsized losses, gaining 14.62%. The CRB Commodity Index was nearly flat, up 0.10%, while copper was lower by 1.15%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 7.10% on the week, while the Vanguard Utilities ETF (VPU) was higher by 6.47%. The dollar dropped by 1.37% to close the week at 110.45. The yield on the 10-yr Treasury declined sharply by 19 bps to end the week at 4.02%

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist

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