Eyes Ahead: Looking for the Fat Pitch

It was a captivating week in the wild world of markets, with fascinating, high-impact dynamics in play. Strong labor market data in the non-farm payrolls release Friday offered a positive economic surprise, the dollar broke out significantly to another set of fresh multi-decade highs, commodities were mixed but still generally weak, yields rebounded as bonds dropped, and yield curves ominously re-inverted. Major market equity indexes rallied this holiday-shortened week, but three out of the four trading days were attended by a negative NYSE advance/decline ratio, indicating weak breadth. Likewise, three of the four trading days had more down volume than up volume. So, while oversold stock indexes tacked some positive points on the board this week, underneath the hood, the rally was suspiciously weak.

The most energetic participants in the equity rally have come from the most speculative, high risk, and oversold portions of the market. The flash of speculative risk-on sentiment coincided with escalating futures-market expectations. Specifically, investors anticipate a more aggressive eventual Federal Reserve policy pivot to rate cuts following the expected eventual end of the current Fed rate-hiking cycle. Again, tepid rallies based on the idea that eventual rate cuts should raise valuation multiples overlook a crucial fact: Future rate cuts will likely be possible only after an “event” that is negative enough to inspire a politically saleable Fed pivot.

Overall, some stronger-than-expected economic data, most notably the non-farms payroll release, provided clutter to muddle the market narrative sketch. Let’s see if we can re-sharpen the picture.

First off, the Fed released the minutes of its June 14-15 policy meeting this week. The minutes revealed that ongoing 40-year high inflation is stoking concerns over institutional credibility and lost public faith in the Federal Reserve’s ability to remedy relentless price increases. The concerns have prompted Fed officials to rally around a path of outsized interest rate hikes and reaffirm its now primary intent to get prices under control unconditionally. According to the minutes, “Most agreed that risks to inflation were skewed to the upside and cited several such risks, including those associated with ongoing supply bottlenecks and rising energy and commodity prices.” 

At the same time, the Committee also acknowledged growing risks to the economy, stating that, “Participants judged that uncertainty about economic growth over the next couple of years was elevated.” The minutes continued, “Downside risks included the possibility that a further tightening in financial conditions would have a larger negative effect on economic activity than anticipated.” The minutes also highlighted the potential for another outsized rate hike at the next meeting later this month. The minutes stated that, “Participants judged that an increase of 50 or 75 basis points would likely be appropriate at the next meeting. Participants concurred that the economic outlook warranted moving to a restrictive stance of policy, and they recognized the possibility that an even more restrictive stance could be appropriate if elevated inflation pressures were to persist.”

Not much new in these minutes, but their consistency underscores a point. The overarching message, underscored by several hawkish Fed officials also speaking up this week, is that the Fed is locked into inflation-fighting, interest rate-raising hawk-mode. This institution, rightly worried about its credibility, is very unlikely to pivot until it convincingly reduces inflation or a significant market/economic accident provides cover for a policy pivot. Until recently, many market strategists assumed central banks would prefer to live with high inflation rather than put economic growth at risk. The Fed continues to force at least a partial rethink of that view. As Matthew Joyce at Barclays put it, “More hawkish central banks…reminded us that inflation is their prime concern, while activity/growth and markets are lesser considerations.”

Higher interest rates, the Fed’s primary tool to bring down inflation, are murder on this debt-laden economy. Over years of near-zero interest rate policy and low inflation, our economy has necessarily evolved structurally into a much more frail and fragile entity far more dependent on easy money than in the past. So the hawkish Fed is locked in. We can check that box for now.

As a result, the Fed, the economy, and markets are in a race against time. The higher rates rise and the longer they stick around at high levels, the greater the damage. There are two scenarios: the “soft-landing” or varying degrees of “hard.” For the relatively benign softish-landing scenario, where the Fed can eventually moderate its policy before breaking functioning markets and killing the economy, inflation will need to plunge meaningfully lower—and immediately.

That’s unlikely to happen. As we all know, last month CPI notched a new 40-year high water mark at 8.6%. Bloomberg estimates for next Wednesday’s June CPI reading are for a dizzying 8.8% print—another high. Even a monumental miss versus estimates next week will still almost certainly keeps CPI well north of 8% and miles away from any plausible face-saving Fed pivot point. At the same time, the huge housing and rent contributions to inflation statistics, by far the largest statistical influence, lag real-time data by many months. At present, we still have an ample amount of lagged inflationary heat from housing statistics to flow through the next several months of inflation measures.

Theoretically, a soft-landing via a sudden break in inflation could be achieved from a significant further drop in commodity prices. Such a drop, if immediate, could help temporarily cool off economic price pressures. The Fed could plausibly claim some sort of victory over inflation and begin a soft-landing policy pivot. 

The problem with this scenario, however, is that extremely low supply from both severe inventory shortages and production constraints are rampant across the commodity sector. With the supply side so tight, the only way commodity prices materially fall is if markets price in demand destruction. The recent commodity price correction was largely the result of markets pricing in the demand destruction of a mild recession. The catch-22 is that for a significant further commodity price correction that could more meaningfully ease inflationary price pressures in the economy, the market would have to price in the demand destruction of a much more serious recession. Such an outcome negates the possibility of a soft landing.

Now, the FOMC has made it abundantly clear that its focus on price stability (inflation) currently trumps the usual dual focus on price stability and employment. As such, another path to an early Fed pivot and what we might call a less hard landing in a mildish recession could come from an immediate material slowdown in the labor market. That would represent a factor that would work towards reducing future price pressure, but also, crucially, a deteriorating labor market would allow the Fed to credibly reassert the “dual mandate” focus and temper hawkish policy for sake of the labor market.

Well, as mentioned, this week the labor market threw a bit of a curveball. Job openings, as measured by the Job Openings and Labor Turnover Survey (JOLTS), appear to have peaked, but came in stronger than expected and remain near record-high levels. The JOLTS series comes with an extra one-month lag in reporting. Nevertheless, the Fed will need to see a very substantial drop in job openings before it can use weak labor markets as a justification for a dovish policy pivot. On Friday, the June non-farm payroll jobs report also depicted a much stronger labor market than expected. Payrolls grew by 372,000 according to the Bureau of Labor Statistics, while analysts had expected a rise of only between 250,000 and 268,000. The number blew beyond the reported Wall Street “whisper number” of 245,000, and trounced Goldman Sachs’ preferred payrolls range of 175,000 – 250,000. 

So, taken together, could the JOLTS and non-farm payroll data mean that the Fed’s got this all squared away? Does it suggest that the economy is actually more than strong enough to withstand higher rates? Does a gloriously soft, feather-bed landing await us after all? Perhaps. Anything is possible. However, it’s very unlikely. Much more likely is that the events of this week have significantly increased the risk of a worst-case scenario. With this headline strength in the lagging labor market data, the Fed is now more boxed-in than ever. It has no choice but to execute an aggressive tightening cycle right into the teeth of an already down-turning economy that has a kryptonite-like sensitivity to higher interest rates. Friday’s payroll data may have just pushed us further down the scale toward the hard end of the landing spectrum.

As HAI has detailed recently, a number of leading economic indicators are already rolling over into a decidedly negative trajectory. In addition to the all-time lows in consumer sentiment, small business sentiment, and Fund Manager Survey global growth expectations, leading ISM data, regional Fed manufacturing surveys, slowing housing, auto, and semiconductor sales, along with building inventories, are all starting to tell a convincing story. Evidence is also mounting that actual consumer spending is on its last leg. The negative wealth effect of falling stocks and a cooling housing market is hitting the higher income brackets where all of the excess savings reside. At lower income levels, consumers are using surging levels of revolving credit and even pay-as-you-go schemes in an unsustainable bid to keep up with everyday expenses. In addition, recent declines in commodity prices, outsized losses in economically sensitive bellwether equity sectors, and significantly tightened corporate debt finance markets all sing a similar tune of an economy on the brink of accelerated downturn.

While the leading indicators speak of what’s to come by peering out the front windshield, JOLTS and official payroll data in the labor market are lagging indicators chronicling the view in the rearview mirror. As Charles Schwab Chief Investment Strategist Liz Ann Sonders put it Friday on Bloomberg, this is when you need to look “not just at the leading indicators…but the leading-leading indicators, and that’s where you’re starting to stack up more than just anecdotal evidence…that suggests we may be in this, sort of, final window of pretty strong payroll numbers.”

Senior portfolio manager at Federated Hermes Steve Chiavarone summed up the take on the jobs number with a tight and tidy bow. “There is a feeling of Wile E. Coyote running over the cliff. The economy is slowing, Fed hikes will almost certainly lead to a hard landing, but with employment remaining this strong and next week’s CPI likely to stay high, the risk that the Fed will hike higher and further than they should increases.” Again, the consequence is that so, too, increases the risk of a harder, nastier landing than might otherwise be expected.

In addition to the Wile E. Coyote image, I’ll add shades of the band that continued to play on the decks of the sinking Titanic. One of Mr. Chiavarone’s Federated Hermes colleagues also described the current predicament succinctly, saying, “We are looking at the largest Fed policy mistake since the 1930s.”

Even factions within the Fed’s own data analytics network agree that the landing we’re headed for is hard. A widely followed New York Fed economic model now puts the chances of a “soft landing” at 10%. Conversely the model rates recession risk at 80% and now expects outright negative annual GDP economic growth in both 2022 and 2023.

Over the last two weeks, HAI discussed energy and industrial metals. The sectors offer extremely attractive long-term investment opportunities with elevated near-term downside risk due to the potential for recessionary demand destruction. At present, in this complex macro environment, the same can be said of gold—but for different primary reasons. The break below $1,800 in gold and the recent pronounced weakness in the precious metals mining stocks indicates that price action is responding to the breakout higher in the dollar, a hawkish Fed defending its institutional credibility by resolutely implementing inflation fighting policy, and the broad risk to all assets of liquidations in the event of a larger market panic. Further sizeable declines are a risk, but are by no means assured. Technicals are oversold, sector sentiment is overly pessimistic, and internal futures market positioning in the Commitment of Traders (COT) data is supportive of a substantial rally. That said, the unique, extremely elevated, broad macro risk opens the door to the possibility of further declines until the gold market sniffs out initial signs of an impending Fed policy pivot.

Referencing that very same eventual Fed pivot, legendary investor Stanley Druckenmiller recently said he’s currently “waiting for a fat pitch,” and that “the currency market is incredibly interesting to me… I will be surprised if sometime in the next six months I’m not short the dollar.” Conversely, in anticipation of the Fed pivot, and even before a top in the dollar, a “fat pitch” upside opportunity is likely developing in the gold market. Rather than an end of the up-cycle in gold, the current weakness fits more with a larger macro set-up that resembles the mid-cycle gold bull-market corrections seen in the previous mid-1970s and 2008-2009 corrections. Those corrections, ultimately, acted as the springboards for the next leg higher in those respective bull markets. They resulted in very strong sustained trending moves to substantial new highs. So, as with other select commodities, near-term risk remains, but a “fat pitch’ opportunity appears to be brewing. For the patient ready swinger, it could go the distance.

Weekly performance: The S&P 500 gained 1.94%. Gold was down 3.29%, silver was off by 2.19% on the week, platinum was up 1.32%, and palladium popped 11.27%. The HUI gold miners index was down by 4.54%. The IFRA iShares US Infrastructure ETF was off 1.24%. Energy commodities were volatile and mixed again. WTI crude oil was down 3.36%, while natural gas rebounded by 5.31%. The CRB Commodity Index was lower by 1.40%, while copper lost another 2.22%. The Dow Jones US Specialty Real Estate Investment Trust Index was off by 1.16% on the week, while the Vanguard Utilities ETF (VPU) was down 2.81%. The U.S. Dollar Index surged by 1.82% to close the week at 106.82. The yield on the 10-yr Treasury jumped by 21 bps to end the week at 3.09%

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist