In addition to the hot January PCE print, the other surprise of last week was the upbeat flash PMI from
S&P Global Market Intelligence (formerly IHS Markit) showing upside surprises from the G4 industrialized countries. Increasingly, the market narrative is shifting from a growth slowdown to no recession and continued growth. The markets are behaving the same way, as they turn to discounting a growth revival, led by a successful China reopening.
At the same time, last week’s release of the
February FOMC minutes warned, “Participants observed that a restrictive policy stance would need to be maintained until the incoming data provided confidence that inflation was on a sustained downward path to 2%, which was likely to take some time.”
What should you do? Fight the tape, or fight the Fed?
Hard, soft, or no landing?
Ever since the Federal Reserve began to tighten monetary policy and show its determination to bring inflation back to its 2% target, economists and strategists have debated whether the US economy would experience a hard landing, soft landing, or, more recently, no landing.
First, let’s define some terms. The chart below shows the history of the US unemployment rate with peaks and valleys labelled (blue line), core inflation (red line), and recession periods shaded. We would define a hard landing as a recessionary period when the unemployment rate rose more than 3% and soft landings otherwise. The 1990 and the 2000-2002 periods qualify as soft landings, though unemployment rose further after the recession ended. The 2022 COVID Crash would have been the hardest landing comparable to the Great Depression were it not for the unprecedented level of fiscal and monetary response by Congress and the Federal Reserve.
A no-landing scenario implies that unemployment doesn’t rise much, growth doesn’t decline much, but inflation remains elevated. Increasingly, market action is shifting towards that view as cyclical industries with the exception of oil and gas are outperforming the market. The recent results of the BoA Global Fund Manager Survey showed recession fears peaked in November 2022 and have fallen sharply.
The current economic cycle is somewhat unusual compared to past cycles. Manufacturing and goods inflation have weakened, but services inflation remains strong. In particular, the labor market is tight and unemployment is low, as Fed Chair Powell pointed out in his
February post-FOMC press conference.
However, US economic growth is beating expectations. The January Jobs Report saw half a million new jobs, retail sales grow a whopping 3%, and the January stronger-than-expected PCE report are all supportive of the no-landing narrative. However, a no-landing growth pattern where inflation remains elevated will force the Fed to raise rates even further, which risks an eventual hard landing.
Current market expectations calls for three more consecutive quarter-point rate hikes, followed by a plateau and no rate cut in late 2023. With the caveat that the last FOMC occurred before the blockbuster January Jobs Report and strong retail sales print, the minutes showed that “almost all” participants agreed to a 25 basis point rate hike, and only “a few participants stated that they favored raising the target range for the federal funds rate 50 basis points at this meeting or that they could have supported raising the target by that amount”. In a victory for the doves, it seems that Cleveland Fed President Loretta Mester and St. Louis Fed President James Bullard, who called for a 50 basis point hike at the next meeting, have little support within the FOMC.
Recession to the left, recession to the right
Despite the rosy numbers, forward looking indicators point to a recession ahead.
New Deal democrat, who maintains a set of coincident, short-leading, and long-leading economic indicators with zero, six, and 12 month time horizons respectively, believes the economy is on the verge of entering a recession, but positive developments in leading indicators point to better times ahead.
There are two trends percolating under the surface. One trend is the continued slow decaying of growth in the coincident indicators. The other is the slow move towards turning neutral or positive among some of the long and even short leading indicators.
No forecast at this point, but I am beginning to suspect that, while there will be a recession, it will be relatively short and relatively mild.
Unrelated to any of New Deal democrat’s analysis, the results of the quarterly loan officer’s survey is disturbing inasmuch as it’s signaling a credit crunch. A net 44.8% of banks are tightening credit for large and middle-market firms and the results for small-market firms, which are not shown, are similar. While the history for this series is limited, readings above 40% have either led to, or coincided, with a recession.
Even if the economy were to avoid a recession, continued growth and elevated inflation are likely to see the Fed react with even a tighter monetary policy and higher interest rates. Such a scenario is reminiscent of the double-dip recession of 1980-1982, when the Volcker Fed initially cut rates in 1980, only to raise them again to very painful levels until something broke. In this case, it was the Mexican Peso Crisis that threatened the solvency of the US banking system.
What’s holding up the market?
In light of the dubious macro outlook, what’s holding up the market.
Marketwatch reported that Morgan Stanley’s Mike Wilson pointed to rising liquidity as an explanation for the risk-on character of the market, and compared the current situation to climbers on Mount Everest.
Either by choice or out of necessity investors have followed stock prices to dizzying heights once again as liquidity (bottled oxygen) allows them to climb into a region where they know they shouldn’t go and cannot live very long. They climb in pursuit of the ultimate topping out of greed, assuming they will be able to descend without catastrophic consequences. But the oxygen eventually runs out and those who ignore the risks get hurt.
Wilson went on to warn about the elevated valuation of the stock market. Indeed, the S&P 500 forward P/E is exhibiting a strong negative divergence compared to the 10-year real rate.
On the other hand, Fed liquidity has been fairly stable despite the Fed’s quantitative tightening program. That’s because the Treasury Department is drawing down the Treasury General Account (TGA) held at the Fed and supplying the banking system with liquidity as part of its “extraordinary measures” to mitigate the effects of the debt ceiling. Treasury Secretary Janet Yellen has estimated that the government will run out of money in June, while the Congressional Budget Office’s estimate is between July and September.
From a global perspective,
FT Alphaville reported that Apollo chief economist Torsten Sløk pointed out that the BoJ’s liquidity injections as part of its yield curve control program is overwhelming the Fed’s QT.
That’s not all. The PBoC is another major supplier of liquidity to the global financial system (see Fed paper
What Happens in China Does Not Stay in China). Recent evidence shows that the PBoC has been ramping up liquidity, which has the effect of holding up the price of risky assets.
Investment conclusions
In light of these cross-currents, what should investors do? Should they fight the tape, or fight the Fed, along with elevated valuation risk?
I believe that the answer lies with investment time horizon. In the short run, liquidity controls the tape. In the long run, valuation and interest rates matter to returns. For now, European stock and cyclical industries are the leadership. Enjoy the ride and take shelter if their leadership falters.
Party now, pay later.
It’s notable that every time unemployment gets to really low levels, a recession follows. This is especially true if the CPI is rising.
So the chance of a recession is high, especially with the yield curves and what I read about leading indicators.
The problem is not the Fed but congress. It’s congress that passed stimulus bills and has spent more money than they should over the last 50 years .
Maybe “bad news is good news” will scale new heights
and a recession is bad news, however if congress decides to stimulate (the Fed doesn’t have to pivot) then where will equities go? In a historical context, 5% is not high, mortgage rates of 7% are not high compared to the 70s, 80s, 90s
For me the big question is what congress will do. Covid has enabled government stimulus. Does anyone think that is a one time deal? It’s a bit like “I’m gonna do crack but just once” Yeah, maybe.
Once upon a time the narrative was balancing the budget. The budget issues became a real problem in the 60s which led to Nixon closing the gold window which opened the door for federal deficits, but for many years there has been a pretense that this is something congress needs to pay attention to (then ignore) until we got the pandemic. Now we are waiting for another excuse. If we can forgive student loans, why not zombie companies loans they can’t roll over, another crisis is like a bad day making you go back to the crack pipe oh for the 2nd time only, and that’s it! No more.
Remember that for us, bad news is bad news (maybe a silver lining) and in a healthy economy it should be the same but it is not always the case in this economy.
Moral of the story….Follow the prices.
In the near future, Congress is unlikely to provide stimulus as they did during pandemic. There is likely to be programs providing extended unemployment benefits, nutritional assistance etc. Fed will be fighting this battle and Chair Powell must get a strong backbone to withstand the vicious attacks sure to follow.
I pray everyday for his health and well being!!
Well, maybe we don’t get helicopter money like last time, but if we get a recession, what happens to all the zombie companies, and the ones that show their zombie nature in a recession? Sure the bondholders pick up the pieces, but what happens to the workers when these companies are being reorganized? Unemployment falls onto the states if I’m not mistaken, so we could get some troubles at the state level. There can always be transfer payments of course. So more government spending. But we are not alone, the largest economies are all heavily in debt and likely they will print more. The USD may be the best of the lot of depreciating in purchasing power currencies, but they are all going down. Maybe this is why the market will go up, because you can’t print I-phones, or gold, or oil. Real things are real, you can’t make them by hitting a key in the Eccles building. Then money may be migrating to equities and we are in a secular bond bear market.
Or maybe we get a bad landing and lots of babies in bathwater tossed onto the street. I think that depends on how much forced selling we get.
Not a time to be complacent.
Most economists, policymakers and businesses know that higher inflation is corrosive to long term growth of a healthy economy and society. Chair Powell understands that and has clearly communicated it. The idea of a ‘no landing’ is a non starter with the Fed, I believe. Other possibility is a Goldilocks economy – an outcome with very low probability. The Fed is focused on getting inflation down to 2%. All of their actions will be towards that goal(a crisis notwithstanding). The amount and duration of higher rates will depend on the inflation data ( affected by geo political and macro developments). No one can accurately predict it. I believe that the actions that Fed has taken and likely to take should lead the economy into a recession. How does it help to talk about shallow or a hard recession? History tells us that earnings decline roughly 20% in a recession. If multiple also contracts, the market is at risk of falling 20%. Probability is fairly high.
The performance of cyclical sectors was a result of a market narrative of rate cut in second half. It was not fundamentally driven outperform imo.
A game of musical chairs. Who loses when the music stops? In the meantime, 3 months Treasury yields 4.8%. Zero risk. Even a Ten year treasury bond is attractive at almost 4%. A growth recession will provide juicy capital gains of 5-10%.
A couple of thoughts:
1) For what it’s worth, BlackRock’s weekly commentary has been positing for a while that they see the Fed living with inflation at 3-3 1/2 or so once the economic damage becomes apparent. Always a grain of salt with BlackRocks marketing, sorry I mean economic, publications.
2) Bondholders picking up the pieces – that means pensions and life insurers, and their beneficiaries – you and me, probably.
3) Europe leading? Dunno, looks to me like VGK, EZU, and EWG are rolling over. And SCHD and AIA.
4) Short Treasuries – zero risk, debt ceiling charade notwithstanding…. Maybe buy short maturity Apple bonds instead.
5) Thank you to all who post frequently, I appreciate your insights and perspectives.
Yeah, pensions and life insurers, I think about them and worry. The biggest problem is the lag between when they are in trouble and when it actually matters.
While rates went down, the bonds appreciated, but you have to take a 30+ year view.
Just look at a 20 year chart of TLT. Admittedly they don’t sell their bonds to capture capital appreciation, or at least I think mostly they hold to maturity, so they did not capture the capital appreciation that peaked in 2020.
Now they have a ton of bonds yielding minuscule amounts that have been bought since the GFC when inflation and COLA is way higher. What will happen if inflation stays sticky or heads higher?
I took SS at 62 for 2 reasons, first because I worried that means testing would happen and I would not be getting by the time I was 80, and also because I was not sure I would get to 80. Well if I’m wrong and I live past 80, what’s not to like? If means testing doesn’t happen is ok because I keep getting it.
But the pensions and life insurance companies, they will default one way or another unless there is bailouts for everyone….sounds inflationary huh?
I see a lot of reference here to eventual Fed pivot. I have been accumulating GLD and GDX and also have longer running positions in oil and commodities.
Congress is going to spawn bubbles by sops, spending packages etc. Budget battle in June is not that far.