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Monday, May 29, 2023

2023-05-29

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


Economic and Market Fare:

2% and going back to the old world – I don’t think it stands a snowball’s chance in hell. Low inflation is over and we’re not going back.




The current bounce in equity markets from October continues to outpace historical rallies in bear markets, bolstering the case that the low may be in for this cycle.
It always pays to remember that the path of least resistance for stock markets is up. Bear markets are the exception, not the rule, but they are, as Thomas Hobbes described life without government, “nasty, brutish and short”.
While the current bear market is longer than most, it is still nonetheless a risk for investors wondering whether the current rally is really the beginning of the end of the downturn, or merely the prelude to a nasty sell-off ahead, with new lows plumbed.
No-one knows for sure of course, but the current rally has remained more robust than perhaps most would have expected. ... As the chart below shows, the S&P is diverging further away from historical bear-market rallies.


Firms that use computers to determine buy and sell signals have been loading up while other investors sit back





The US has its market leading "Big 7 Tech" basket (a play on AI hype but really just an excuse to buy the former market leaders Apple, Microsoft, Google, Amazon, Nvidia, Meta, Tesla), which is trading on 30x PE vs 17x for rest of S&P and is single-handedly responsible for all market gains in 2023; Europe on the other hand, has its "Big 7 European Luxury" aspirational basket  (LVMH, L'Oreal, Hermes, Christian Dior, Richemont, Kering, Ferrari) which is trading at an even more ridiculous 36x vs rest of Stoxx 600 trading on 12x PE.
..... As BofA's Michael Hartnett discussed over the weekend, in the past year this high-flying sector had become to European stocks what Big Tech was to the US: a collection of dominant businesses whose explosive growth was unquestioned even as the economy shrank. But the questions are finally starting to emerge as confidence in that view has been dented ...


Despite the stock market rally so far in 2023, the S&P 500 Index has not come close to regaining its all-time high put in early last year.
What has soared to new highs, however, is the stock/bond ratio.
In fact, its ascent has been so strong that, over the past two decades, the SPY-to-TLT ratio has only been as overbought (as measured by quarterly RSI) as it is today at the 2007 top heading into the GFC.


BAML: The Flow Show - Bonds & Bubbles via PDF from The Bond Beat
...Zeitgeist I: “I mean, if you're going to lose your job and be replaced by AI in the next few years, might as well own some AI as a hedge, no?"
Zeitgeist II: “Bubbles not easy, put plenty of investors out of business. But this one you getting paid by fat yields in cash & bonds to ignore for now. Why no FOMO yet.”
Zeitgeist III: “4% real yields popped internet bubble, 3% popped subprime, crypto crashed on real yield rip from -100bps to 150bps. But market telling you real rates may need to rise another 100-150 bps from here to pop ‘baby bubble’ in AI.”

Brean: ...Recession Signal from Profits Building (also from same PDF)
The yield-curve model developed by a former colleague at the New York Fed has been a reliable indicator that a recession was brewing just over the horizon (with that horizon being about one year) but the model is an indicator model not a causal one. A second indicator for us is the share of profits in GDP (we use the nonfinancial corporate sector for both measures) and we view this as a causal model. Declining profitability causes companies to cut back on hiring and investment to restore profitability and conserve cash but this in turn kicks in the Keynesian multiplier from capital spending to GDP growth and disrupts the circular flow of income—eventually leading to a downturn in consumer spending. Every recession has been preceded by a squeeze in profit margins (technically the 1981-82 recession was not but this was because the path of growth was disrupted by the imposition and then removal of credit controls that induced a short recession in 1980). With the revision to first-quarter GDP, yesterday’s data showed a second consecutive quarterly decline in profit margins. Nonfinancial domestic corporate profit margins have now contracted from a peak of 16.3% in the second quarter of 2021 to 14.6% in the first quarter of this year—a decline that is sufficiently large to constitute a solid signal that a recession is likely looming. 
The one caveat that is worth making is that the nonfinancial corporate GDP data, which are derived from incomes and profits, show a very weak picture of the economy already. Real output for this sector has declined in four of the last five quarters which has never occurred with the economy not already in recession. However, private nonfinancial payrolls have risen at an annualized pace of 3.7% over these same five quarters, which has typically suggested that the economy was still in the expansion phase. Why would companies experiencing declining output volumes grow employment at a fairly rapid clip? We believe it is easier to count heads than measure real output and strong job growth in 2022 was just reaffirmed by the latest QCEW data (which is based on state-level unemployment insurance accounting). Nonetheless, with an inverted yield curve and profit margins declining, the probability of a recession beginning later in 2023 or early 2024 has surely increased.


............ It is important not to be Pollyannish about the economy’s near-term prospects. Under almost any scenario, they will be difficult. GDP growth will halt, employment gains will come to a standstill, and unemployment will push higher. However, while history suggests that high inflation and an aggressive Fed mean recession is a serious threat, this time is different enough for the economy that a recession is avoidable. In my more than 30 years as a professional economist, I have never seen such recession pessimism. But I have also never seen such a resilient economy. Something has to give. I suspect it will be the pessimists.


In the FOMC's efforts to bring down inflation, the Committee has not been shy about the need for policy to turn restrictive. Determining the level of interest rates which adequately weighs on activity and thereby inflation without causing untoward damage to the economy is by no means easy, but is important when the effects of policy changes are not immediately felt across the economy. 
One guidepost policymakers use in this endeavor is the natural rate of interest, or r-star. R-star can be thought of as the real short-term interest rate that prevails when the economy is expanding at its potential rate and inflation is stable. In cannot be directly measured, but is rather inferred from how other parts of the economy act in relation to each other. As relationships between real GDP, inflation and the federal funds rate change, so do estimates of r-star. For example, after vacillating from about 2.5%-4.0% from the mid-1980s to early 2000s, the estimated natural rate of interest fell to less than 1% following the 2008 financial crisis (chart). 
The extreme volatility in data following the economy's abrupt shutdowns in 2020 and subsequent reopening made it particularly difficult to extract r-star. The most widely-followed estimates, published by the New York Fed, were temporarily halted while researchers made adjustments to the models after such extraordinary shocks but have resumed this month.
Since the COVID-19 pandemic, r-star seems to have been little changed. Over the past four quarters, the Holston-LaubachWilliams model estimated the U.S. natural rate of interest averaged 0.76%, nearly spot on the pre-pandemic five-year average of 0.77%. In other words, it appears that through all the tumult of the past few years, the era of a low natural rate of interest is ongoing. That may seem surprising given the recent degree of inflation, but comes as potential output is estimated to have been reduced by a whopping 4% relative to its pre-pandemic projection. 
The prevailing low rate of r-star suggests that the FOMC does not have to raise the nominal fed funds rate as far above inflation to rein in price growth as in prior cycles when the natural rate of interest was higher. However, even when accounting for the current environment's low rate of r-star, policy still has yet to clearly become restrictive, given the underlying strength of inflation (chart). That does not necessarily entail that the FOMC hikes further from here, but it does suggest that if Fed officials do indeed believe policy needs to be restrictive for a time, inflation needs to ease very soon.


The economy continues to decelerate, and the most recent data adds significant evidence to the possibility the economy entered a recession last year or at the start of this year. While a recession may already be underway, the deterioration in the labor market has not proven sufficient for the Federal Reserve to soften its continued hawkish policy stance.
In this update, we’ll review the changes and revisions to coincident economic data and zoom in on the initial jobless claims data, which will be our most real-time and reliable labor market measure.
The Bureau of Economic Analysis recently reported the April update for Personal Income and Personal Consumption. The BEA significantly revised the Personal Income data from September 2022 through March 2023.

Real personal income less transfer payments, our preferred income metric, only posted a 0.1% gain since September of last year compared to a previously thought 1.0%. .......

This is extremely common at the start of recessions, which is why the data today looks clear cut like a recession is starting to get underway.
Real retail sales and industrial production hold an average growth rate of 0.1% at recession starts, compared to nonfarm employment and broad personal consumption, which hold an average growth rate of 1.4% at recession starts.
In fact, there has never been a recession in the past where real retail sales and industrial production didn’t have a lower average growth rate than employment and broad personal consumption.
In addition to the six monthly coincident indicators, when dating recessionary periods, the NBER looks at one quarterly series. That quarterly series is actually not real GDP but rather the average of Real GDP and Real GDI, gross domestic income.
Because the income side of the economy is much weaker than previously thought, contrary to the strong wage narrative, real GDI has started to contract, and the average of real GDP and real GDI has been negative in four of the last five quarters. .....
In real-time, the monthly BLS jobs report will offer, at best, a fictitious reading on the current state of labor market gains. This chart shows the 12-month rolling payroll revisions, which clearly demonstrates that the BLS data does not work in real-time as the revisions are completely cyclical.



Key Takeaways:
  • Both longer-term Treasury yields and short-term Treasury yields tend to decline during recessions, but the effect is larger and more consistent with short-term Treasuries.
  • Over the last eight recessions, the median maximum yield decline for the 3-month Treasury was 2.82% and 1.14% for the 10-year Treasury.
  • With an attractive yield compared to recent history and prospects of price appreciation if there were a recession, intermediate maturity Treasuries have a reasonable outlook on top of their potential diversification benefits if we were to see a downturn.
  • The prospect of a decline in yields makes shorter maturity Treasuries less attractive, as investors may need to reinvest at much lower rates when bonds mature.



Bassman: Moral Hazard
...................... I am a UChicago trained monetarist, and I have been an inflation hawk since the start of ZIRP and QE. I will also say that if Bernanke had not chickened out (a technical term) in 2013 during the infamous “Taper Tantrum”, we would not be in this mess at all. But I will confess I too loosened the reins on risk when Powell pounded the table about holding rates at zero until 2023. I would have dialed back on Mortgage REITs if I foresaw ZIRP to 5.25% in barely a year. ...
Not to say “I told you so”, but much of my “Open Letter to the FED” – July 26, 2021 has been prescient. Here I suggested:
1) Reduce MBS and TIPs purchases;
2) Steepen the Yield Curve;
3) Shorten “Forward Guidance” to reduce Moral Hazard.
The most pressing need now is to steepen the Yield Curve, which means we need longer-term rates to be higher than shorter-term rates.
Western civilization, for good or ill, operates on a fractional reserve (leveraged) financial system where banks are the plumbing for the entire system; a steep Yield Curve is paramount for their good health. Perhaps never intended, but banks are now a utility as much as Consolidated Edison; they are a natural monopoly that needs to be more tightly regulated.
.. Finally, the big “surprise” will be sourced from the battle between the Yield Curve and the Stock market; I promise an ugly denouement for one.


Despite decades of research, there remains substantial uncertainty about the quantitative effects of monetary policy. Different models produce conflicting predictions, and these predictions lack precision. This article discusses some reasons for these issues. ....






....... Perhaps the biggest threat to inflation is artificial intelligence (AI)
AI has been predicted to destroy up to 300 million jobs in the coming years. Possibly a doomsday scenario, perhaps not.
.........An employment earthquake could be on the near horizon. Mass unemployment is certainly not a recipe for rampant inflation. There may, however, be unchecked profits for those companies that benefit from AI and a cost-cutting drive. Not a bright outlook for the man on the street. How will we all survive while on the unemployment scrap heap? If such drastic change is upon us, we must rethink everything we know about economics and how society functions









 
Regular readers will know that I have spent quite a lot of time reading the literature in social psychology trying to understand how groups of scholars become crippled with the patterned behaviour that Irving Janis identified as Groupthink in his ground breaking study published in 1972. I feel that my own profession is dominated by this catastrophic syndrome, which has biased the policy scene towards destructive outcomes. However, even after some major calamities, which the mainstream economists were blind too (such as the GFC), the Groupthink is so entrenched and powerful that academic economists actively engage in purges of what they consider to be ‘fringe ideas’, which they dismiss as the equivalent of homeopathy (that is, witchcraft in their eyes). I read an example of this behaviour this week which indicates to me that we are a long way from seeing fundamental change in the academy which might restore the credibility of my profession in the public milieu. My advice to parents – keep your children away from studying economics!

Catastrophic Groupthink

The early Groupthink reference is Janis, I.L. (1972) Victims of Groupthink, New York, Houghton Mifflin.

He found that some communities of scholars develop a dominant culture, which provides its members which a sense of belonging and joint purpose but also renders them oblivious and hostile to new and superior ways of thinking.

These communities develop what Irving Janis identified in 1972 to be ‘Groupthink’, which drives the ‘mob-rule’ that maintains discipline within paradigms.

Groupthink is a “mode of thinking people engage in when they are deeply involved in a cohesive in-group, when the members striving for unanimity override their motivation to realistically appraise alternative courses of action” (Janus, 1982: 9) and “requires each member to avoid raising controversial issues” (Janis, 1982: 12).

It has also been defined as “a pattern of thought characterized by self-deception, forced manufacture of consent, and conformity to group values and ethics” (Merriam-Webster on-line dictionary).

Groupthink becomes apparent to the outside world when there is a crisis or in Janis’s words a ‘fiasco’.

In this blog post – Fake surveys and Groupthink in the economics profession (March 19, 2019) – I considered how the mainstream profession reinforce their mob rule through the misuse of survey data.

An academic discipline that falls into Groupthink becomes degenerative (in the terminology of Imre Lakatos) in that it systematically fails to match its theoretical and predictive framework with the reality around us.

It systematically fails to provide meaningful knowledge but hangs onto dominance through control of the narrative, through the power of the senior professors, through the control of research funding, control of publication editorial positions, control of promotion processes within the academy and control of who enters the academic hierarchy. That control is insidious and powerful and mostly filters out aberrant voices. .......



Quotes of the Week:

Furman: New data out indicates that the economy contracted at a -0.5% annual rate in Q1, the fourth quarter of the last five with negative growth. This is based on average of GDP (+1.3% in Q1) and GDI (-2.3%) which is generally more reliable than either one individually.


Smith: Just like the Internet bubble in 2000, from an investment standpoint, we the think biggest threat from AI is to investors in the abundance of hyped-up overvalued technology businesses that are all perceived to be big future winners.




Charts:
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(not just) for the ESG crowd:

A US$20 billion case over Quebec’s cancelled liquefied natural gas facility is just one example of foreign investors suing governments for ‘lost future profits’ from fossil fuels













.......... The optics at the G7 meeting couldn’t be more stark. Meeting in the one city that is the ultimate symbol of Western madness, Hiroshima, the symbolism was very clear. We are united in our self-righteousness and if you don’t like it, remember what happened to Japan.

We will destroy the planet in order to save it. Indivisible European/Asian security is a euphemism for global war.

No amount of failure seems to dissuade these people. Because failure is simply not an option.

........... It is exactly what I expected them to do at the outset of the war (here, here, and here) failing a swift victory over Ukraine; continue their war of attrition across all theaters against the West until they either 1) sue for peace or 2) collapse under the weight of their own hubris.

Former British Prime Minister Boris Johnson (Who else?), put the kibosh on any early negotiated settlement between Russia and Ukraine.

To Crooke’s point, the West’s investment in Ukraine was simply too big to give up that easily. Believing the ultimate sanctions package would overthrow Putin and destabilize Russia, both Davos and the Anglo-neocons bet too heavily on this working. As my dad used to say about pro athletes, “he spends too much time reading his press clippings…”



Other Fare:

When most people in the English-speaking world hear the word “propaganda”, they tend to think of something that’s done by foreign nations who have governments that are so totalitarian they won’t even let people know what’s true or think for themselves.

Others understand that propaganda is something that happens in their own nation, but think it only happens to other people in other political parties. If they think of themselves as left-leaning they see those to their right as propagandized by right wing media, and if they think of themselves as right-leaning they see those to their left as propagandized by left wing media.

A few understand that propaganda is administered in their own nation by their own media, and understand that it’s administered across partisan lines, but they think of it in terms of really egregious lies like weapons of mass destruction in Iraq or babies being taken from incubators in Kuwait.

In reality, all are inaccurate understandings of what propaganda is and how it works in western society. Propaganda is administered in western nations, by western nations, across the political spectrum — and the really blatant and well-known examples of its existence make up only a small sliver of the propaganda that our civilization is continuously marinating in.

The most common articles of propaganda — and by far the most consequential — are not the glaring, memorable instances that live in infamy among the critically minded. They’re the mundane messages, distortions and lies-by-omission that people are fed day in and day out to normalize the status quo and lay the foundation for more propaganda to be administered in the future. ....


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