Good News/Bad News—But Not In Equal Measure

This was another eventful week in markets. Overall, stocks continued to push higher in an ongoing bear market rally. Market sentiment is a powerful contrarian indicator. Currently, both extremely depressed stock market sentiment and supportive market technicals are sending screaming buy signals. As a result, this rally certainly has the potential to continue higher in major indexes. In the dot-com bear market, there were six significant countertrend rallies before the bottom was in. In the great financial crisis, markets staged five major countertrend moves along the journey to a March 2009 bottom. Since the start of our current decline from all-time highs, the major indexes have completed three bear market rallies, each exceptionally weak by historical standards. The current rally attempt is the fourth, and historical precedent suggests it has every potential to develop into a more substantial short squeeze. With that said, however, a broad sell-off on Friday cast some doubt on the sustainability of equity strength.

On the week, bonds surged, while yields collapsed throughout the curve. Ominously, in warning of recession, the deepest yield curve inversions since the great financial crisis remained intact. The dollar backed off from its recent unstoppable ascent, and commodities were mixed. Oil remained under pressure, while copper received a modest reprieve from its recent bludgeoning. Gold was extremely volatile, but managed a modestly positive weekly close.

The most recent consumer price inflation statistics, as we all know, have been scalding hot. They demonstrate that price pressures are rampant and incredibly widespread throughout the economy. Price increases outstripping wage gains and negative real disposable incomes are sapping consumer purchasing power, and in turn dramatically undermining the economic trajectory as well as both consumer and corporate confidence.

In our credit-based financial system under the “Fed standard,” responsibility falls to the Central Bank to right the ship. The Federal Reserve is truly under immense political pressure. Institutional credibility is on the line like never before, and the modern monetary maestros simply must be seen as waging a fierce battle against the flame-throwing inflation dragon. In response this past month, the Fed has repeatedly committed and recommitted to fighting inflation “unconditionally” until they bring consumer prices down to their 2% target.

Powell & the gang are now firmly on an aggressive policy course to use the “tools” of interest rate hikes and quantitative tightening (balance sheet reduction/liquidity withdrawal) to rein in economic demand and slow soaring prices. A restrictive policy setting is, however, powerful poison for this structurally fragile debt-based economy. Such policy runs the serious risk of not just subduing inflation, but also killing the economy.

To declare victory, one in which the Fed doesn’t tank the economy and can credibly justify a policy pivot back to an accommodative setting, they will need hard evidence that consumer price inflation is moving lower and that the tight labor market is easing. To accomplish such a feat, the Fed will need a little pixy dust and a whole lot of luck. This is, to be sure, an extremely dangerous set-up because inflation and employment are both lagging indicators. By the time consumer price inflation stats and non-farm payrolls justify a Fed policy pivot, the economy may already be on fire and sinking like the Lusitania.

A “mild” recession is already nearly a consensus view. However, the consequence of continuing to tighten financial conditions aggressively while a recession is already in the offing is the increased risk of a severe recession. It could be the pin that pops what investing legend Jeremy Grantham has called a “super-bubble.”

This dangerous set-up is already starting to play out. This week, leading economic data deteriorated notably. Housing data was broadly problematic. The National Association of Home Builders (NAHB)/Wells Fargo Housing Market Index (HMI) found that homebuilder sentiment rerated to a new post-pandemic low in the steepest monthly decline since the heart of the pandemic. The survey also reported significant declines in overall housing sentiment, sales condition sentiment, expectations for future sales, and traffic sentiment. In addition, the Mortgage Bankers Association reported that mortgage applications and refinancing hit a 22-year low last week after applications for mortgages fell 7% on the week. Rounding out the sector doldrums, the National Association of Realtors reported that home sales in June fell 5.4% from the prior month, and declined 14.2% year-over-year. The number of homes listed increased by 2.4% for the first year-over-year gain in three years.

Initial weekly jobless claims nudged higher again. The increase over the previous week was 11,000 claims over estimates, and continues a trend higher off lows established last spring. Unemployment filing has now reached the highest weekly level since November 2021. Meanwhile, a number of companies announced layoffs and hiring freezes throughout the week. Social media platform SNAP also delivered disastrous earnings and made clear that corporate advertising spending is being dramatically cut due to expectations of reduced broad consumer demand. AT&T also warned that their customers are having trouble paying their bills on time. The company said that the problem has emerged and accelerated, specifically in just the last six weeks.

On Thursday, the Philly Fed Business Index plummeted to a negative 12.3 reading vs. expectations for a 0.0 print. Significantly, the measure of business capital expenditure plans for the next six months cratered to a nine-year low while new orders tanked. To top things off, the future activity measure for factories in the region fell to the lowest reading since 1979. Not a pretty picture.

On Friday, it was the S&P Global flash composite purchasing managers output index that was singing the blues. Any reading below 50 indicates contraction. The preliminary July measure shocked markets by falling 4.8 points to 47.5. The reading is the weakest since the early pandemic plunge. Removing the pandemic-distorted numbers, 47.5 is the lowest reading since 2009. Commenting on the data, S&P Global Chief Business Economist Chris Williamson said, “the preliminary PMI data for July point to a worrying deterioration in the economy… Manufacturing has stalled and the service sector’s rebound from the pandemic has gone into reverse.”

The incendiary consumer price inflation data of late, along with recent strong non-farm payroll statistics, has offered the Fed no escape from the minefield they’re in the middle of. Despite the fact that other leading economic data is beginning to rapidly deteriorate, the lagging consumer price and labor market data has escorted the world’s dominant central bank to the far reaches of the perilous plank. Just another step or two may confirm a nasty impending accident. Next Wednesday’s Federal Reserve FOMC meeting promises to be just such a step in the direction of trouble. In an economy already showing signs of an initial rapid weakening, for which higher interest rates are kryptonite, market expectations are for another jumbo 0.75% rate-hike next week.

Despite the notable deterioration in leading economic data, the stock market appears uncertain how to react. Some market participants subscribe to a perverse “bad news is good news” rationale. The counterintuitive logic, a unique byproduct of our current upside-down era of monetary mania, is centered on expectations that poor economic data will limit Federal Reserve rate hikes and quicken an eventual “accommodative” policy pivot. Fair enough, but given the bind the Fed is in, a painful crisis “event” is likely a necessary precondition for any defensible policy pivot justification on the part of a credibility-challenged Fed.

Next week, in addition to the FOMC meeting, 50% of all S&P 500 companies will report for the climax of earnings season. Even if results are relatively better than expected, and stoke a continuation of the recent market rally, caution is warranted. The odds of an eventual crisis event continue to rise.

In commodity markets, needless to say, the ongoing tug-of-war between historically tight stockpiles, long-term chronic underinvestment, geopolitical supply constraint dynamics, and potential near-term demand destruction continue to supercharge volatility throughout the sector.

In the gold market, this week price briefly broke below $1,700 to test 2021 lows in the $1,670s. Recent weakness in the yellow metal is due to the strong dollar and Fed interest rate hikes. Most importantly, however, recent price action strongly suggests that gold is suffering from market illiquidity stress. As illiquidity stress has increased, investors have unwound market leverage in response to margin calls, or are front-running an even larger potential liquidity panic that may yet unfold. In such environments—as we saw in 2008 and 2020—gold, as a form of prime collateral, is sold to meet margin calls and as market participants scramble to get liquid.

Further sizeable declines are still a risk given the macro environment and liquidity dynamics, but we are rapidly approaching selling extremes that should soon trigger a bounce, if not the final bottom, of the multi-year correction. Technicals are deeply oversold, sector sentiment is excessively pessimistic, and internal futures market positioning in the Commitment of Traders (COT) data suggests a washout is nearly complete and that internal market positioning is increasingly supportive of a substantial rally. Presently the liquidity issue holds sway, but as events play out, and eventually the Fed pivots policy, the dynamics will shift. Economist Henry Hazlitt observed that, “the value of any monetary unit, such as the dollar, depends not merely on the quantity of dollars but on their quality.” In the event of a Federal Reserve pivot and a renewed attempt to reflate the system by old means, dollar quantity will increase, while simultaneously, quality erodes. In such an instance, gold’s quality is never in doubt. As insurance and a store of value, it will ascend because, as Hazlitt put it, “people have more faith in gold than they have in the promises or judgment of the government’s monetary managers.” Depending on how events unfold, Hazlitt’s wisdom may never be truer than over the years to come.

Weekly performance: The S&P 500 gained 2.55%. Gold was up 1.40%, silver was up 0.12%, platinum was higher by 4.37%, and palladium rebounded by 10.35%. The HUI gold miners index fell by 1.15%. The IFRA iShares US Infrastructure ETF was up 2.08%. Energy commodities were incredibly volatile and mixed again. WTI crude oil was down 2.96%, while natural gas surged by 16.80%. The CRB Commodity Index was up 1.27%. Copper rebounded by 3.57%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 2.22% on the week, while the Vanguard Utilities ETF (VPU) was down 0.42%. The US Dollar Index declined by 1.20% to close the week at 106.62. The yield on the 10-yr Treasury lost 16 bps to end the week at 2.77%

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC