Anatomy of a Yard Sale
This Friday was a festive one at the McAlvany offices in Durango. A holiday decorating competition inspired impressive efforts along with creative, elaborate, and spectacular results. Food, drink, good spirits, and cheer were all in abundance. Additionally on display, and worthy of mention, were some truly outstanding holiday outfits!
While the holiday spirit captivated 166 Turner Drive on Friday, it was a very significant week on Wall Street. Unlike the holiday enthusiasm on display in Durango, December on Wall Street has so far been more coal in the stocking than Santa rally. After recoiling sharply from a failed test of several key overhead resistance levels, the market’s technical backdrop has deteriorated, breadth has turned decidedly negative, economic fundamentals have darkened, and the benchmark S&P 500 has declined nearly 6% month-to-date. The year-end stock market rally that began in October increasingly appears to have run its course. Along with the deeply inverted yield curve, safe-haven bond buying and falling commodity prices also suggest growing concerns over incoming recession.
Further stoking fears of incoming recession, the reality of a rapidly slowing economy was reflected this week in significantly weaker than expected manufacturing data and, crucially, in declining retail sales. HAI has consistently chronicled the precarious state of the consumer. Consumer spending drives roughly 70% of GDP, and since the pandemic consumers have been punching above their weight. However, they’re now running out of savings, easy credit, and time. Data released this week revealed that retail sales for November notably disappointed by contracting the most in 11 months. The results increase the possibility that the long-anticipated consumer-spending pullback may be upon us.
This week also fueled additional concerns over the strength of the economy with a shocking labor market revelation. A group within the Philadelphia Federal Reserve Bank is tasked with assessing the accuracy of the BLS non-farms payroll data. The group necessarily works on a lag, and this week they estimated Q2 payrolls were overstated by over one million jobs. The Philly Fed’s Q2 estimate is more in line with the much weaker Household Survey data that has trailed the Establishment non-farm job numbers by 2.7 million year-to-date. If the Philly Fed data is correct, significant negative job number revisions could be on deck, and could reveal flat job growth in 2022 and a far softer labor market than presently assumed.
The week’s real fireworks began on Tuesday, however, with a softer than expected November Consumer Price Index (CPI) inflation report. Headline CPI increased 7.1% year-over-year (Y/Y) vs. 7.3% expected, and came in significantly lower than October’s 7.7%. On a month-over-month basis, headline prices increased just 0.1% vs. 0.3% expected, and well off October’s 0.4% pace. Core CPI, excluding volatile food and energy, came in at 6% Y/Y vs. 6.1% expected, and down from 6.3% in October.
Not surprisingly, with the fire-breathing inflation dragon presumed slain, the immediate return of easy money assumed, and visions of the next bull-market dancing through their heads, market participants jumped straight out of their sneakers to buy stocks on the CPI news. Short covering and repressed bulls suffering aggressive FOMO sent stocks ripping higher. But the rally soon faded, as rumors of the start of the next mega-bull are greatly exaggerated. As HAI Favorite David Rosenberg put it this week in his always-colorful fashion, “the prospect of a stock market bottom, a real fundamental bottom, as the Fed is still raising rates into an inverted yield curve is…the nuttiest proposition I’ve ever heard.”
Rosenberg’s skepticism is well founded. The CPI report is welcome news on inflation, but not necessarily for the economy. The good news is that inflation is showing real signs of cooling. The bad news is that this inflation progress is being driven by a rapidly slowing economy. Recall that an object in motion stays in motion, and our economic cycle is in motion. It’s trending towards contraction, and heading for danger.
The bull case at this point remains an inconsistent catch-22 that defeats its own premise. Restrictive Fed policy and slowing growth are easing inflation. If the Fed declares victory and reverses policy to avoid the full fury of the incoming recessionary storm, as markets are so eager to see, such actions will re-stoke the economy, markets, and, as a result, inflationary price pressures. In so doing, progress made to date on inflation would be undone. It’s a circular process that goes nowhere and accomplishes nothing.
Tight commodity supply fundamentals remain the key to this catch-22 dilemma. Along with tumbling used car prices, falling energy prices were the biggest contributor to November CPI softness. If the economy reaccelerates, demand will increase into extremely tight commodity supply dynamics. Commodity prices will surge, and energy will likely reverse roles to become the strongest upside inflation driver of hot future CPIs. While bulls with rose-colored glasses see declining inflation numbers as presaging an imminent Fed policy pivot and the resumption of the bull, the reality is that this Fed is trapped. Keeping the policy lid on inflation will drive the economy into a potentially severe recession. Trying to avoid the recession by easing policy can revive the economy and markets for a time—before they eventually break down anyway in an inflationary inferno. At present, Fed Chair Powell is adamant about keeping a lid on inflation.
This week, Jeff Currie and his Goldman Sachs commodity team isolated and illuminated the key issue. Currie and company said that while economic weakness may continue to weigh on commodity prices into the first quarter of 2023, scarcity will begin to boost prices soon thereafter. The inconvenient truth for the Fed and soft-landing enthusiasts is that, “Despite a near doubling year-on-year of many commodity prices by May 2022, capex across the entire commodity complex disappointed… This is the single most important revelation of 2022—even the extraordinarily high prices seen earlier this year cannot create sufficient capital inflows and hence supply response to solve long-term shortages.” In light of their findings, Goldman is now anticipating a 43% surge in commodity prices by the end of 2023. Again, this is key, underpinning the inflation risk and the Fed’s unique predicament is a severe and chronic commodity supply shortage. All the Fed can do is try to tighten financial conditions to sit on demand and wait in hopes that supply will catch up. That means recession.
The Fed is trapped, and the strains are already mounting. This week’s CPI also showed an outsized drop in used car prices. The dramatic slide reflects an industry, like housing, that is now reeling under the strain of higher interest rates and tightening credit. The used car industry is an interest rate-sensitive leading economic indicator. It’s freezing up. The industry is now a ticking time bomb headed rapidly toward defaults, repossessions, and significant credit strains that will feed back into the rest of the financial landscape. It is a similar story to what is already happening in housing, and beginning to happen in commercial real estate, private equity, and private credit. As all these stressors deepen in unison, broad-based deleveraging is likely, and the risks increase for the financial system, credit markets, and the economy.
This is the breach into which the Fed is charging following its front-loaded, unusually large 425-basis-point 2022 rate-hike blitzkrieg. It’s a complex minefield with no easy answers. At present, given two bad options, it’s abundantly clear that for now Chairman Powell aims to lean on demand, and risk recession—even a severe one.
As expected, at this week’s FOMC meeting, the Federal Reserve raised interest rates by 50 basis points. That pushed the federal funds rate to the 4.25%–4.5% range. The last time rates were this high was on the road to the great financial crisis in 2007. But according to Powell and the Fed, they’re not done yet.
In the committee’s latest projections, the average expectation for the terminal rate increased to 5.1%, up significantly from September’s 4.6% projection. In addition, 17 of 19 committee members projected a terminal rate over 5%. During Powell’s press conference Q&A, the Chairman made clear his intentions. He told reporters, “It’s our judgment today that we’re not at a sufficiently restrictive policy stance yet, which is why we say that we would expect that ongoing hikes would be appropriate.” So, while the ultra-aggressive pace of hikes has now slowed to lesser increments, the overall message on rates is “higher for longer.” Powell also made clear, in no uncertain terms, that there will be no rate cuts until the Fed is confident that inflation is moving toward 2% “in a sustained way.”
Powell also addressed the counterproductive disconnect between bullish market behavior and hawkish Fed policy restraint. Markets have repeatedly ignored hawkish Fed messaging and rallied on pivot hopes. Such market action has significantly loosened financial conditions and continues to partially counteract Fed efforts to tighten and battle inflation. In a message to the rally-hungry market, Powell said, “it is important that overall financial conditions continue to reflect the policy restraint that we’re putting in place.”
A day later, an additional hawkish shot was aimed and fired directly at markets. Former Fed Vice Chair Richard Clarita penned an essay that was arguably the most important Fed communiqué of the week, and one that confirms the bogus, catch-22 nature of the stock market’s self-defeating rally thesis. Clarita warned that if markets doubt the Fed, and “if financial conditions ease because markets price in [2023 rate] cuts, a peak policy rate of 5.25% may not be sufficient to put inflation on a path to return to 2% over time.” In other words, if markets keep front-running a supposed Fed pivot, rallying, and continuing to loosen financial conditions, the Fed will just keep raising rates higher for longer until the unhealthy dynamic, financial markets, and likely the economy all break. All in all, amid an ongoing contest between markets and the Fed, this week was just the latest in a string of exuberant premature market pivot parties rudely ended.
In reaction to all the week’s events, former Treasury Secretary Larry Summers reiterated his concern, very much shared by HAI, over a looming Wile E. Coyote moment for consumer spending, corporate earnings, the labor market, the economy, and markets. Referring to an anticipated recession, Summers said that when it “does come, it may prove true the saying about things taking longer to happen than you think they will—and then happening faster than you thought they could.”
Summers also homed in on the labor market specifically. The former secretary suggested that employers have so far been holding onto workers thanks to fears that, given the labor shortages since the pandemic, they won’t be able to fill future openings. That hoarding dynamic, Summers suggested, “could all of a sudden change very dramatically if labor markets start to loosen.” His concerns echo the recent prognostication from Bank of America Chief Investment Officer Michael Hartnett, who two weeks ago ominously predicted, “job losses in 2023 are likely to be as shocking as inflation in 2022.”
Despite this week’s positive inflation data, the truth is that the bearish thesis for the economy and markets is strengthening, and the Fed is trapped between a rock and a hard place. As that bear case is realized, increasingly attractive longer-term opportunities will emerge, but defense is recommended in the near-term.
While on the doorstep of both recession and the start of official meteorological winter, let’s visit an appropriate seasonal analogy. When a skier loses control on the slopes, orderly momentum turns disorderly. The out-of-control skier is an object in motion that, regrettably, remains in motion. Unless a skillful sequence of impressive acrobatics quickly rescues the situation, a very hard and inglorious landing awaits. In skiing parlance, when the brave soul’s chaotic momentum finally comes to an abrupt and painful halt, and skis, poles, hats, gloves, goggles, and dignity all litter the slopes, the crash landing is known as a “yard sale.” As we enter 2023, our economy is just such a troubled object in motion, and Fed acrobatics are significantly handcuffed. In chaos, already tripped up, out of control, and out of balance, the vicious cycle is gaining momentum and the current economic trajectory points to an unseemly yard sale.
Weekly performance: The S&P 500 lost 2.08%. Gold was down 0.58%, silver lost 1.64%, platinum dropped 3.49%, and palladium crashed by 13.32%. The HUI gold miners index was off 2.51%. The IFRA iShares US Infrastructure ETF was down 2.43%. Energy commodities were volatile and higher on the week. WTI crude oil gained 4.84%, while natural gas gained 5.68%. The CRB Commodity Index was higher by 1.92%, while copper lost 3.09%. The Dow Jones US Specialty Real Estate Investment Trust Index was off 2.41% on the week, while the Vanguard Utilities ETF (VPU) was down 0.72%. The dollar was off 0.13% to close the week at 104.66. The yield on the 10-yr Treasury was down 9 bps, ending the week at 3.57%.
Have a wonderful weekend!
Investment Strategist & Co-Portfolio Manager