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Friday, March 3, 2023

2023-03-03

*** denotes well-worth reading in full at source (even if excerpted extensively here)


Economic and Market Fare:

2023 so far - a tale of two narratives...from 'soft' landing to 'no' landing...

February's macro theme was the death of The Fed Pivot narrative as expectations for an H2 2023 rate-cut collapsed and the terminal rate outlook priced in rose significantly... .....



I anticipate that inflation will gradually decrease over the next year and a half to an equilibrium rate of approximately 3%. This path will be bumpy, with month-to-month fluctuations. We believe that the markets continue to expect inflation to decrease more quickly than it will. ......

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The primary driver of inflation is money supply. After the 2020/21 printing spree, during which the Fed was calling for transitory inflation despite all signs pointing to inflation, we saw a delayed effect of approximately a year or so. I believe there is now a similarly delayed but inevitable disinflationary process as most inflationary factors are eliminated. We are now facing high-interest rates, falling stock markets, low savings rates, slowing housing markets, decreasing money supply, lower fiscal spending. Commodity inflation is now significantly lower than service inflation. So the primary question this year is what happens to the labor market. .......



The stock market rally so far this year seems based largely on speculation rather than fundamentals. Investors appear hopeful the Federal Reserve will soon return to a policy of cheap and abundant liquidity while ignoring the Fed’s repeated warnings to the contrary.

Speculation and bubbles require significant liquidity. Economic fundamentals do not point to the Fed soon changing course and easing credit conditions or lowering interest rates and have more recently argued the exact opposite: the Fed could stay tighter for longer than investors currently expect.

Accordingly, we continue to be defensively positioned within our portfolios, rather than loading up on those assets most likely to fizzle out. .........



Somebody once described equity pricing to me as a dog that walks on a leash with a man, down a path through the woods.

The path represents the underlying fundamentals of the company or the market, and the dog represents investor sentiment and market valuation about said company or market.

As the man walks down the “fundamentals” path, the dog strays wildly, side-to-side, on the leash. First to the far left side of the path, then back to the right - and in the interim, everywhere in between. It’s distracted, chases woodland creatures, tries to smell items and is just generally excitable. That’s investor behavior.

The one constant is that, at the end of the day, the dog always winds up walking down the path in the same direction as the owner. The point being that no matter how far he temporarily strays from one side to the next, the fundamentals continue to dictate the long-term course.

I found this to be an apt analogy for how I feel about equity markets heading into this week. My longer-term readers know that I still continue to believe equity markets are wildly overpriced and eventually will cripple under the reality of 5% interest rates, persistent inflation, a debt-strapped consumer and depleted savings.

But once again, another week has gone by where my prophecy of a market decline has not been fulfilled - in any meaningful fashion, at least. The market was down about 3% last week, but is still up 3.4% for the year. .......

.......  the uncomfortable and unfortunate reality of things is that the market likely hasn’t yet digested the full effects of the rate hikes we’ve already had, let alone future rate hikes, or even holding the funds rate where it is right now for longer. Again, those economic realities have seen personal savings zapped while debt charges to all-time highs.

.... And then there are other trends that appear to be screaming out that reversion to the mean is coming. .......

The market and the economy become two distinctly separate entities during a period of quantitative easing. When there’s free money flooding the market, the market does whatever it wants regardless of the underlying economy. During a period of tightening, like now, the opposite happens: the market becomes tethered again to the economy.  ......





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Is this Time Different?
The no landing scenario crowd assumes this time is different. Therefore, by default, they argue the graphs and bullet points below are irrelevant.  
  1. A recession occurred every time the 10-year/ 3-month yield curve inverted and then un-inverted.
  2. Fed rate hikes have preceded each of the last ten recessions.
  3. Except once, in 1965, every time the ISM manufacturing index fell below 45, a recession occurred.
  4. A recession occurred each time the Philadelphia Fed Index was at its current level.
  5. A reading of over 50% of Deutsche Bank’s recession probability gauge preceded each recession.
  6. The current level on the 85-factor Chicago Fed National Activity Index (CFNAI) and the OECD leading indicators are commensurate with prior recessions.



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Summary
Maybe UFOs have wealthy aliens onboard wanting to buy a lot of stuff and boost our economy. Most likely, those forecasting a no landing have a false sense of optimism as the economy has thus far proven resilient.

Time is not on the no landing scenario’s side. With every passing day, the effect of yesterday’s interest rate hikes will weigh more on the economy. As we wrote in Janet Yellen Should Focus on Hope, understanding the progression of economic activity deterioration and the time lag between monetary policy changes and full consequences helps us appreciate that a no landing scenario is a pipe dream.

We hope for a soft landing but fear the more typical hard landing is the likely course. We caution those who believe the economy is unaffected by interest rates. It is dangerous to believe this time is different!



Exactly one month ago, we extended our analysis of data fabrication (whether intentional or accidental) at Biden's Department of Labor and Bureau of Labor Services, by looking at layoffs and job openings data, finding that the former was far higher than officially reported when compared to accurate, state level WARN notices...

....... Of course, it's not just job openings where the Labor Department is dead wrong: in fact, virtually every labor market metric, from unemployment to payrolls, has been skewed to represent a stronger economy. 





After finishing the worst year on record for bond performance in 2022, the first month of 2023 saw an about face in the corporate bond market. January was reported to be a record month for investment grade corporate bond ETF (exchange-traded fund) flows. Sure, corporate bond yields are the highest in nearly two decades but the record demand for corporate credit has caused a collapse in the spread that investors receive when buying a corporate bond versus a “risk free” Treasury note. The credit spread is the amount that an investor is being paid to take the corporate credit risk over the “risk free” alternative. In fact, this spread has contracted to levels generally only seen prior to major recessions.

Investors have been starved for yield for so long that the recent rise has lured many to purchase corporate bonds with little to no regard for the additional risk assumed for the extra yield gained. The problem with this rush to buy credit is that if the expected economic slowdown materializes then the companies that back these corporate bonds may find themselves with additional stress to their ability to repay their debts. That’s right, we are likely at the precipice where corporate credit outlooks are just beginning to deteriorate. ….




After Philly's Fed business outlook survey collapsed, the string of regional 'soft data' has continued to weaken.

Chicago's PMI disappointed, printing 43.6 (weakest since Nov), down from 44.3, and below expectations of a rebound to 45.5 with employment falling at a faster rate, new orders contracting, production's slowdown accelerating, and prices still rising.

This is the 6th straight month of contraction (sub-50) for the Chicago PMI.

The Richmond Fed Manufacturing survey notably missed expectations, tumbling from -11 to -16 (vs expectations of a rebound to -5) with shipments tumbling, new orders deep in contraction, number of employees and wages weakened, and capacity utilization weakening. .......



Amid the mounting speculation of a soft landing, and even chatter of a "no landing" (see here and here), one strategist is laughing at the market's renewed sense of optimism and hope, which he counters simply by observing the latest economic and Fed developments and says that "a typical end-cycle environment is coming into place — mixed economic signals with a downward bias combining with a Fed laser-focused on corralling inflation by reducing labor demand."

Yes, for TS Lombard economist Steven Blitz, there is no thesis drift (or rather elevation) and his big picture assessment refuses to budge: "recession will result." Here's why: "Forget the Fed stopping to wait and watch and hope that inflation bends towards 2% without a recession. That horse has left the barn. A key question is where the funds rate is when the Fed realizes recession is already underway."

Blitz's base case is "this summer" with the funds rate around 5.25%, or about 2 more hikes. That said, the TS Lombard analyst hedges and warns that if he is wrong, the funds rate can easily move up to 6.5%, which will make the coming recession that much more brutal. ........

............ In conclusion, between the upcoming reserve crunch, and the continued Fed hikes, Blitz holds that the coming “asset crunch” will be enough to create a mild recession mid-year. And if it doesn't, "steadily rising real funding costs deliver a “credit crunch” at some point. Recession is inevitable. And once it occurs, the cutting begins."


as many charts as I have included here, way more at the link:




As consumer excess savings run out, the US economy is bound to hit a painful wall

... I believe a similar moment is coming for the US economy - in other words, a sudden, unexpected activity decline that will likely represent a formidable challenge for the nation’s institutions, in particular the Fed

Now, one needs to be very careful with predictions of economic calamities. They often make an intriguing read but occur very seldomly, as it is in everyone’s interest to avoid them, for good reason. Cognizant of that, it is nevertheless what the data tells me, as I lay out in today’s post. It includes some pertinent findings with regards to inequality. I also spell out where I think I could be wrong ..........


***** Kayfabe Capital: That Pip Nonsense
Not-so-great expectations



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While not a new record, this fact provides very little comfort. The only seven-week period when crude stocks rose more was that time when COVID fears had shut down large swaths of economic, civil, and just daily life in the country – from the week of March 13 to and including the week of May 1, 2020, domestic inventories added 78.5 million barrels. To be even in the same general vicinity as then is a huge warning.

................ For those currently occupying those cushy seats at the FOMC, like 2001 this solves their “inflation dilemma” since the oil prices which actually do drive consumer price indices aren’t likely at all to do much more menacing. But what that really means is how this unfortunately opens up the very serious possibility recession has already happened.  

What’s mainly in question today is how long before anyone captured by Greenspan lore realizes it. From the last FOMC meeting minutes released this week, as always officials continue to be wholly concentrated on the “tight” labor market as many see it and what the Phillips theory tells them to expect for subsequent consumer price pressures that are already being set instead by this abrupt glut of oil.

Once they do realize, as inverted curves have been long predicting, what follows will be the usual conference calls and emergency rate cuts.

Then many months further down the road the NBER will come along to confirm what by then will have been obvious to everyone unattached to the mainstream Economics discipline.

There are always those who say this time is different when it comes to curve inversions, for a variety of often disingenuous and occasionally comical “reasons.” This time has been no different in that regard. It’s also near exactly the same in a whole bunch of other ways, too, starting with the Fed’s fixation on misleading labor data, then its unnatural need to disregard the oil market for at least making useful forecasts about the CPI. Consumer prices aren’t the problem, not anymore. ...



Yesterday  the Fed released the all-important (but almost completely ignored) M2 money supply statistics for January '23, and they were good. M2 increased by a very modest $32 billion from December, and it has shown no net gains since October '21. Year over year M2 growth is -1.7%, and 6-mo annualized growth is -3.4%.

M2's huge growth from 2020 through 2021 provided the fuel for the inflation that has rocked the economy for the past year, and it's great news that it's fading away. The growth of M2, by over $6 trillion in two years, was the result of the monetization of roughly $6 trillion of Treasury debt issued to fund a tsunami of federal transfer payments in that same period. Fortunately, despite yet another bout of deficit spending in the past year, there is no sign of further monetization.

It is still mind-boggling to me that the unprecedented growth of M2 has almost completely escaped the public's notice. Most surprising of all: how in the world could the Fed not see it? Why was there only a handful of economists who commented on it, as I noted a year ago? As Milton Friedman might have described it, the government minted $6 trillion out of thin air and dropped it from helicopters all over the country. How could that not have resulted in higher prices?


In any event, here we are; the flood of funny money is receding. That's why there is now plenty of light at the end of the inflation tunnel. ........





We have already seen an inordinate amount of outright fraud this cycle (see this and this) that has, so far, proven to be a terrific indicator of where we stand in the larger market cycle. Today, Bloomberg reports that earnings quality for the S&P 500 Index recently fell to its worst levels in at least three decades and this may be an important sign of where we stand in the larger economic cycle. 

The way they quantify “earnings quality” is to compare the aggregate net income of all companies in the index (ex-financials and energy) to aggregate cash flow. Normally, cash flow should be greater than earnings because it adds back non-cash charges like depreciation and amortization. When that is not the case it can be a red flag that companies are resorting to accounting gimmicks to make earnings look better than they otherwise would. By inference then, companies haven’t employed “financial shenanigans” (to borrow a term from CFRA Founder Howard Schilit) to inflate earnings as aggressively as they are doing today at any point in the past few decades.


Another way to approach this issue is to compare S&P 500 Index earnings to NIPA profits (tracked by the BEA). These two figures are plotted in the chart above. As Gavekal founder Charles Gave recently pointed out (hat tip, David Hay), “When S&P 500 profits diverge dramatically from NIPA profits, it is a sure sign that accounting methods have changed at S&P 500 companies. If S&P 500 profits rise to exceed NIPA profits by 20% or more, it is a signal that companies’ reported profits are being generated largely by their accountants.”

Moreover, there are important economic implications from all of this. Gave continues, “Usually this means that the economy is on the brink of a recession, and that the stock market is about to take a beating.” Last year, we crossed that 20% threshold between S&P 500 earnings and NIPA profits. Perhaps we should add this to the growing list of leading indicators pointing to recession.



....... The thesis is simple: the hawkish Fed is likely to take policy even more restrictive, "increasing the odds of a hard landing", and thus a recession which sends yields across the curve sharply lower. Needless to say, strong data remains the biggest risk for the trade since a higher terminal rate will drag the 10y rate higher as well.

"Monetary policy works with a lag and once the savings buffer has been eliminated we think that consumption will slow" Misra predicts, adding that the long TSY thesis is boosted by "bond fund inflows which have continued."


*** Major: Score-draw 


............... This takes us to the third question, as to whether there is a regime shift afoot, where the peak in rates becomes a plateau. If this is the case, yields will not be returning to the low levels of previous years anytime soon. We would argue that given the 10-year yield is close to 4.0%, it is arguably pricing in a regime shift of sorts. Without getting into the specifics of lower versus higher longer-run rates, our chart at least shows elevated risk premium around the equilibrium.

A simple example will help. Imagine that policy rates averaged approximately 5% for the next five years and then 3.0% for the following five. This is a “hawkish” scenario implying both higher-for-longer rates, and a longer-run equilibrium 50bp above that guided by the 2.50% in the dot plot. In this case, the average for 10-year expected rate would be 4.0%, not far off from where the market is today, calculated by adding together the rate for the two periods and dividing by two. In essence, the debate in bond markets today is whether to buy and hold short-dated bonds at close to 5%, or go for the longer ones which are almost 4.0%.

Those that think the bear market of 2022 has resumed will nonetheless play it safe and stay in
the shorter maturities. Confident in the view that rates will remain at 5%, or even higher, they
will not be worried about having to reinvest at lower yields in the future.

What if the peak for rates is close and the rise in bond market volatility is an indication of a bumpy turning point? Bond investors will consider this to be opportunity cost and know it is not a simple case of taking the highest yield. The bond bulls believe rates will be falling before long, and prefer the longer maturity, locking in yields at 4%.



Key takeaways
  • Monetary policy is tightening globally while private debt levels stand at historical highs. When private debt to GDP is high, aggregate demand may be more sensitive to interest rate hikes.
  • Yet, after a decade of low rates, the maturity of private debt has generally lengthened, the prevalence of variable rates has fallen, and household net worth has increased. This should counteract the higher demand sensitivity stemming from elevated debt.
  • Both the level and composition of private debt are important factors, although not the only ones, for the calibration of monetary policy in the current economic environment.


The US stock market continues to be overvalued on several measures, exposing equities to further downside. ........

The CAPE has fallen, but still remains in the top 90% of all its readings. This is the same for other measures of long-term value, such as Tobin’s Q (the ratio between a firm’s market cap and the replacement cost of its assets), and the price-to-sales ratio. Buffet’s famed, favorite measure – the market cap of US equities versus GDP – also remains elevated.

Even with the equity market down over 17% from its highs, these measures remain in the top 85-90% of all their readings.


hat tip, IW #2:

&#1:



Now that soaring rates have burst the commercial real estate bubble, the carnage is coming fast and furious.





Bubble Fare:



Hussman Funds 2022 Semi-Annual Report and Shareholder Letter

......... The objective of the Hussman Funds is to provide investors with alternatives that pursue a value-conscious, historically-informed, risk-managed, full-cycle investment discipline. The Federal Reserve’s foray into zero-interest rate policy certainly required us to adapt in ways that increase our attention to speculative pressures and limit our reliance on historical “limits” to speculation. These adaptations have restored the strategic flexibility that we enjoyed across decades of complete market cycles, and their benefit has been increasingly evident in recent years – even amid an overall advance in the S&P 500 since 2019. Still, what quantitative easing and zero interest rate policy emphatically did not change is arithmetic, and specifically, the arithmetic that links current price, expected future cash flows, and long-term investment returns. In our view, the greatest risk in the financial markets is the willingness to ignore that arithmetic. Such willingness has never been permanent. .......



Quotes of the Week:

Roberts: The detachment of the stock market from underlying profitability guarantees poor future outcomes for investors. But, as has always been the case, Wall Street is always late in catching up with economic realities.


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(not just) for the ESG crowd:

An independent expert review on Solar Radiation Modification research and deployment









Mariana Mazzucato and Rosie Collington are authors of The Big Con: How the Consulting Industry Weakens our Businesses, Infantilises our Governments and Warps our Economies.  They launched their book with big fanfare in London, charging £30 a person to attend the live event.

Mazzucato has built up a big reputation, scanning from the left in the labour movement through to mainstream governments in Europe and Latin America for espousing the benefits of public investment and the public sector over the private.  As a result, she has been called “the world’s scariest economist”.  Her last book, Mission Impossible, called for public sector-led projects in partnership with the private sector.  This could lead to a better management of the capitalist economy (not its replacement).

Now in this new book, Mazzucato and Rosie Collington expose the scam that the management consultancy business is.  The premise of Mazzucato and Collington is that consulting is really a confidence trick. “A consultant’s job is to convince anxious customers that they have the answers, whether or not that’s true”. With multiple evidence they show that consultancies have weakened businesses and hollowed out state capacity. ......


How conservatives made him their icon and distorted his ideas

........... But by the late twentieth century, Smith’s ideas would become fully adopted by the right—especially by libertarians and free-market conservatives. The full complexity of his thinking was reduced to the catchphrase “the invisible hand,” even though (as intellectual historian Emma Rothschild has noted) the words appeared just a few times in his entire corpus of work, and only once in The Wealth of Nations. Thanks to Milton Friedman—who enjoyed sporting a necktie emblazoned with cameo portraits of Smith—Smith’s ideas became synonymous with free-market capitalism, even though, as many Smith scholars have observed, the thinker himself was much more ambivalent toward laissez-faire than Friedman would suggest.

How did this happen? How did Smith’s ideas become so thoroughly integrated into conservative defenses of the free market against regulation? And are these the only ways of reading his work? These are the questions at the heart of Adam Smith’s America, Glory M. Liu’s intriguing account of Smith’s reception in the United States. Her capacious monograph demonstrates the variety of uses to which Smith’s work has been put since its publication in the late eighteenth century, showing how politically contested readings of Smith always have been. In so doing, she illustrates a broader point still: The vision of the free market that emerged in the late twentieth century is itself highly specific to our historical moment—it was not the way that people (even economists) thought about economic life before and likely not the only way they will conceive of it in the future. ............



Pics of the Week:





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