Inspired Heat and the Recessionary Gorilla

Decades ago economist Hyman Minsky described our credit-based, Keynes-inspired, post gold-standard economic model as one that would evolve over time in stages. The system started with what he called “hedge finance,” but would progress into “speculative finance” before culminating in “Ponzi finance.” These stages would necessarily develop as ever more credit growth was needed to keep the gears of the system turning and the economy expanding. Over time the model pointed to a structurally fragile, debt-saturated, highly leveraged economy—one that would become systemically dependent on ever-lower interest rates, ultra-loose financial conditions, and yet more credit expansion. As this debt-saturated financial system evolved, higher interest rates and tighter financial conditions would increasingly act as its kryptonite.

A tip of the hat to Hyman Minsky! He certainly nailed the trajectory of our Keynesian financial framework under the dedicated stewardship of the “Fed standard.” At present we have a massive, debt-saturated, highly levered, global financial bubble. One of the biggest risks to this system, particularly in its later stages, is a sticky breakout of runaway consumer price inflation. In our 70% consumer driven economy, if price inflation breaks out and runs at a rate that eventually severely impairs the health of the consumer, the economic outlook is grim indeed.

Unfortunately, this is exactly what we are presently facing. We currently have raging consumer price inflation, and it’s running too fast for the consumer to keep up over time. As a result, the Fed is being forced to aggressively raise interest rates and tighten financial conditions to subdue prices. Worse, it’s having to do so in an economy that is less capable of dealing with such a policy than at any prior point in history. Dr. Powell and the FOMC now run the serious risk of curing the disease by killing the patient.

Testifying to the developing consumer conundrum, the Bureau of Labor Statistics (BLS) reported this week that “real,” inflation adjusted, average hourly earnings in June decreased 3.6% year-over-year. When the BLS calculates the inconvenient fact that the average number of paid work hours has dropped over the same time period, the end result is a very troubling 4.4% decrease in “real” average weekly earnings over the last year. This represents the biggest slide in real earnings data since immediately prior to the great financial crisis. If you want to understand why University of Michigan consumer sentiment is at 70-year all-time survey lows, consider that Americans’ inflation adjusted wages have now fallen for 15 straight months. Just imagine millions of Americans locked into jobs that “offer” an ongoing structural 4.4% pay cut, the math of which gets worse month after month as relentless inflation continues to accelerate.

In addition, the personal savings rate continues to plummet to the lowest level in years, and is now well below the pre-Covid trend. It’s not just low-income Americans that are affected by surging prices, many more will have to downsize and scale back spending. A survey by Pymnts.com and LendingClub Corp. reported an eye-opening finding. More than a third of Americans earning at least $250,000 annually—almost four times the median US salary—say they are now living paycheck to paycheck.

The situation is unsustainable, and points to a ticking time bomb for future consumer spending—the very same consumer spending that is the engine of the economy.

Dramatically compounding the problem, on Wednesday, the Bureau of Labor Statistics (BLS) needed inch-thick oven mitts to handle the release of June’s sizzling Consumer Price Index (CPI) inflation report. After May’s CPI number offered markets 8.6% shock and awe, estimates for the June number were set at a blistering 8.8%. When the actual report was taken out of the oven, however, the charred remains indicated a fresh 40+ year high 9.1% consumer price inflation rate.

Simply put, the fearsome price pressures were undeniable. What’s worse, the inflationary heat was broad based throughout almost every category. Adding insult to injury, a day later, producer prices (PPI) also regained upside momentum and reported a far-hotter-than-estimated 11.3% year-over-year (Y/Y) reading. Reacting to the inflation data, ING economist James Knightley observed, “It’s the breadth of the price pressures that is really concerning for the Federal Reserve… With supply conditions showing little sign of improvement, the onus is on the Fed to hit the brakes via higher rates to allow demand to better match supply conditions. The recession threat is rising.”

The report was a shock, and a very consequential one. Along with the recent stronger-than-expected jobs report, the CPI and PPI data are all sending inflation warnings that the Fed can’t easily ignore without bleeding more credibility. Barring a sudden and dramatic offsetting development, the Fed now appears all but boxed into delivering another outsized dose of interest rate kryptonite when it hikes rates again at the end of the month. 

The bigger problem developing is that despite this current inflationary data, the leading economic data has already turned decidedly negative and recessionary in the U.S. Leading indicators of real economic growth imply that a sharp downturn is already in the pipeline. Over the coming months, the real-time U.S. economic data will very likely deteriorate sharply across all corners of the economy, including income, consumption, production, and lastly, employment. The effect of another outsized interest rate hike, at this point, is extremely likely to dramatically increase the odds of a very hard landing recession, and significantly add to its severity.

To make matters worse, multiple severe financial market pressure points appear to be rapidly unraveling across the globe. From China to Europe, to Russia, to Japan, to emerging markets, events are unfolding that could trigger various manifestations of global financial turmoil. Furthermore, another supersized Fed rate hike will exacerbate rather than alleviate the myriad offshore threats.

All of these dynamics are wreaking havoc in commodity markets. The sector remains under intense pressure from a whole host of negative developments. Most importantly, all commodity sub-sectors are reacting to wildly increased speculation suggesting an imminent potential global recession, as well as risks that a crisis could erupt that spreads financial contagion throughout global markets. These concerns are triggering large-scale volatile liquidations and the unwinding of positions held by leveraged speculators. 

At the same time, the dollar has been on a parabolic tear, and has strengthened to levels not seen in decades. The violence of the dollar’s surge has added broad-based pressure across the entire commodity complex. China, the world’s top commodity consumer, continues to struggle, with resurgent Covid cases once again threatening to curb a massive source of demand. Even more impactful, China’s challenged property development sector is beginning to show signs of imploding beyond the PBOC’s ability to repair it. Such a development would drastically alter the fundamental demand outlook for a number of commodities—most notably the industrial metals, including copper and iron ore, both of which continue to freefall.

On the recent price action of economically sensitive Dr. Copper and its potential implications on the broader macro set-up, Société Générale’s highly respected Albert Edwards has some colorful commentary this week. He remarked that, “This is not so much a canary in the coalmine as a rout. Just as in mid-2008, I now see the recessionary gorilla charging towards us out of the mist… Soft-landing advocates must now face the overwhelming evidence of economic collapse and extricate their heads from the sand.”

Austrian economist Ludwig von Mises provided a description for what he expected to be the likely ultimate outcome for the sort of credit-based Keynesian financial system described by Hyman Minsky. Mises observed, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

At present, the Fed is temporarily engaged in raising rates, implementing tighter financial conditions, and the “voluntary abandonment of further credit expansion.” As Mises predicted, global markets do indeed appear to be drifting towards crisis. The question is, at what pain point will Powell and company pivot back to rate cuts, loose financial conditions, and aggressive credit expansion? It could be sooner than most expect, but until the tell is spotted, caution, discipline, and patience are advised while waiting for a pivot and the fat pitch that will accompany it.

Weekly performance: The S&P 500 lost 0.80%. Gold was down 2.22%, silver was off by 3.38% on the week, platinum was down 5.88%, and palladium was smoked by a 15.17% drop. The HUI gold miners index was hit hard by 6.10%. The IFRA iShares US Infrastructure ETF was off 0.09%. Energy commodities were incredibly volatile and mixed again. WTI crude oil was down 6.87%, while natural gas rebounded by 17.60%. The CRB Commodity Index was lower by 3.51%, and copper continued the slaughter with another 8.24% plunge. The Dow Jones US Specialty Real Estate Investment Trust Index was off by 0.68% on the week, while the Vanguard Utilities ETF (VPU) was up 0.01%. The dollar surged again by 1.02% to close the week at 107.91. The yield on the 10-yr Treasury lost 16 bps to end the week at 2.93%.

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC