No More Talk, Time for Fed Walk

Recent weeks witnessed the development of stunningly divergent trends between the stock and bond markets. Rather than all components of the global market system speaking with a clear and concise unanimity, stocks have rallied fiercely while the global bond market rout has been historic in nature and outright catastrophic of late. Stocks claim the seas are clear. Bonds say batten down the hatches ahead of the tempest. While stocks lure with a tantalizing fiction, the messaging of the bond market fits far more seamlessly into the context of our economic reality.

While stocks may continue to defy bearish expectations in the short-term, consequential internal market dynamics that advise caution in the intermediate timeframe are playing out under the surface. One dominant dynamic continues to be an ongoing large-scale share ownership transfer. Shares are being aggressively offloaded from the books of institutional investors into the hands of a willing and eager army of retail investors buying hand over fist. Institutions have been selling the recent equity rally with unambiguous intention. JPMorgan reports observing institutional “net selling in eight of the past nine days” in which stocks have staged torrid rallies. According to Morgan Stanley’s Prime Brokers, “into every uptick during this latest rally that started in late February, institutional selling has been relentless.”

Goldman Sachs data sings a similar tune and confirms that selling, de-risking, and deleveraging continues from the professional community at an aggressive pace. Goldman reports de-risking activity in 15 of the 21 trading days of March. The cumulative de-risking amounts to the second largest month-over-month dollar amount in the past five years. According to the bank, institutional gross equity exposure is now at its lowest level since the third quarter of 2020, and has receded to a level that’s toward the bottom quartile of the last five years. This constitutes a significant change in character for institutional flows that until recently were determined buyers of equity market strength under almost any circumstances. This institutional character change very likely reflects recognition that a looming hard landing from our post-Covid economic high is a rapidly increasing probability.

At the same time, the net effect of this ownership transfer and bearish strategic repositioning is beginning to manifest in numerous constituent market sectors. Performance trends are beginning to reflect an increasing awareness of both stagflation concerns and recessionary risks. To be sure, broad risk-off was in fashion this week, and defense was the name of the game. That said, the relative performance between different markets segments is becoming the clearer voice.

While all major indexes were lower on the week, the defensive Dow Jones was barely so. On the other hand, the growth-focused, tech-heavy Nasdaq was down a substantial 3.86%, and the higher-risk Russell 2000 small cap index was brutalized by a 4.67% loss. Consumer staples crushed the discretionary sector, all economically sensitive transportation sectors were abandoned, and homebuilders also took it on the chin. Meanwhile, the defensive sectors of utilities and health care were higher, commodities and real assets generally outperformed, and the safe havens of both gold and the dollar rallied.

An additional noteworthy insight into the mind of this market comes courtesy of the financial sector. As interest rates rise, banks stand to benefit from the increased accrual of net interest income feeding into their bottom line. Despite surging rates, however, financials closed lower on the week. The unorthodox reaction to rising rates in the financial sector likely reflects that the benefits of higher rates are being overshadowed by the increasing risk of a recession’s negative hit to loan demand. All in all, the market action this week was not exactly a vote of confidence in the Federal Reserve’s rosy featherbed landing scenario.

Consumer discretionary, consumer staples, transports, homebuilders, and financials are all sensitive sectors that will be important to monitor for ongoing insights into the detailed unfolding of an economic and market down cycle underway and now grinding toward contraction. More than merely reflecting a one-week trend, these critical sectors have now, on a longer time scale, started to broadcast bear market signatures.

Reflecting an important emergent market trend change, even after the recent risk-on rally, consumer discretionary stocks are still off over 16% from peak. By contrast, defensive consumer staples made new all-time highs this week. Similarly telling are the accelerating declines seen in the homebuilders. Selling in this economic bellwether sector has been picking up recently, and the XHB homebuilders ETF is dramatically underperforming the broad market now—down almost 30% from highs. 

Also highly indicative of an economic growth cycle moving toward contraction is the developing divergence between the Dow Jones Transportation sector and the broad Dow Jones Industrial Average. While the Dow industrials sit just 6% below all-time highs, the Dow transports have not participated in the recent market rally. As the broad market has ripped higher, the transports have rolled-over into a more aggressive decline that now lands the index 21% below peak levels. 

Along with weak volume and subdued market breadth measures, the picture painted by institutional de-risking and these developing relative sector performance trends is not consistent with a reinvigorated and reengaged long-term bull market. In contrast, the mounting evidence speaks eloquently of an emerging bear and an equity market that may be catching on to the reality already firmly grasped by bonds.

With myriad storm force market headwinds emanating from a laundry list of unresolved negative economic factors, a sharply slowing economy and a stock market in decline should come as no surprise. Markets have already pulled forward the upside of the unprecedented flood of injected, newly created money and other stimulative policy adrenaline that resuscitated and overly supercharged the post-Covid economy. The explosive boom of this short cycle is now poised to roll toward the bust side of the cycle equation. 

The strongest aspect of our economy, at present, is the labor market. However, broad employment and wages are lagging indicators. Consumer price inflation, however, is a leading indicator of recession. It now rages at 40-year highs. Of fundamentally crucial importance, wages are not keeping up with the rise in consumer prices. As a result, this “hot” economy is far from healthy in any sustainable sense. Negative real wages and a below pre-Covid trend savings rate increasingly drain the consumer. These dynamics are reflected in consumer sentiment readings already at recessionary levels. So what will the Federal Reserve do to save the day?

This week, the Fed sent out an army of no less than nine speakers from the greater Fed family to engage in aggressive market talk therapy. Federal reserve communication was also transmitted via the release of minutes from the last FOMC meeting. Essentially, the FOMC minutes were hawkish on a larger and faster balance sheet unwind than expected of up to $95 billion per month. They were also more aggressive than expected on rates, and expressed the need to reach a neutral rate posture “expeditiously.” To make sure the pill went down smoothly, the endless number of Fed speakers throughout the week ranged from reiterating the hawkish message to tempering any concerns with dovish promises to wait and see what the data instructs. The messaging juggernaut covered all bases. Not surprisingly, the combined outbound Fed message was that they are prepared to be as hawkish or dovish as needed, depending on the data. Regardless, it would seem that they are confidant they will perfectly navigate out of a minefield onto a path of sustainable bliss.

Some, however, received the Fed messaging with a bit of skepticism. Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, responded to the minutes by suggesting that if the Fed was going to swiftly move rates to or through neutral, BMO would be “apprehensive that this cycle’s terminal will persist for a truly extended period before the realities of the recovery will require lower policy rates; fine tuning or otherwise.” To translate, Mr. Lyngen was voicing his obvious doubts and suggesting politely that if the Fed walks this walk, they will quickly send the economy and markets spiraling into decline. At that point, the BMO rates strategist anticipates the “required” dovish policy pivot response.

Former Federal Reserve Bank of New York president Bill Dudley offered views this week seemingly aimed at just the sort of skepticism displayed by Ian Lyngen. In a Bloomberg opinion piece titled, “If Stocks Don’t Fall, the Fed Needs to Force Them,” Dudley made it clear that “tightening financial conditions will be key to getting inflation under control,” but that despite policy implemented so far and the endless promises for imminent further policy tightening, financial conditions have yet to tighten meaningfully.

Dudley says, “This is happening because market participants expect higher short-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025 — but these very expectations are preventing the tightening of financial conditions that would make such an outcome more likely.” In other words, according to Mr. Dudley, markets expect tighter policy to crash the economy and markets. At that point, however, markets fully expect another Fed policy pivot back to a dovish stimulative stance. Dudley’s observation is that markets are anticipating and front-running the eventual dovish policy pivot and implementation of the next Fed “put.” As a result, markets are refusing to sell off. The consequence for markets not falling aggressively is that financial conditions are not tightening. Inflation is not getting remedied, and, increasingly, talk will need to be upgraded to even more aggressive tightening than the market is anticipating.

As Dudley concludes, “Investors should pay closer attention to what Powell has said: Financial conditions need to tighten. If this doesn’t happen on its own (which seems unlikely), the Fed will have to shock markets to achieve the desired response. This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields higher and stock prices lower.”

Lose-lose. Consumer-killing inflation remains unchecked and leads to eventual economic and market catastrophe, or the Fed will be required to painfully shock the system to a level sufficient to snuff out inflation. Either way, the end result is the same. Inflation on Main Street won’t be cured without deflation on Wall Street.

In last week’s HAI, the case was made that, historically, the gold standard naturally infused the monetary system with the necessary embedded checks and balances to ensure a sustainably stable and credible monetary system. The gold standard protected the system from various potential forms of human error. In the aftermath of the gold standard, the responsibility fell to the Federal Reserve to provide sustainable stability to the currency and monetary system.

Essentially, the current tangled mess amounts to a game of chicken between markets and Federal Reserve policy. Fed credibility is on the line now as never before. So, too, is the credibility of the dollar and the dollar-based financial system. Since 2009, the Federal Reserve has printed over $8 trillion to fund the longest and most expensive punchbowl party in history. The Fed has replaced the gold standard with unanchored “whatever it takes” central banking. In doing so, they have undermined the free market and free price system, and created a grand economic experiment. They have greatly destabilized the system. If they do not change course and impose discipline, then the Fed and the entire experiment loses credibility—with devastating consequences.

Given the stakes, the most likely expectation may be for a tightening Fed to accelerate an incoming recession and a painful market decline. The Fed’s policy response at that point will author the next critical chapter in this saga. One thing seems fairly certain, however. As a real asset priced with a strong inverse correlation to Federal Reserve credibility, the insurance of gold may have never been more appealing.

Weekly performance: The S&P 500 was down 1.27%. Gold was up 1.14%, silver was higher by 0.69%, platinum lost 1.31%, and palladium rallied 6.73% on the week. The HUI gold miners index was up 0.36%. The IFRA iShares US Infrastructure ETF was off 1.91%. Energy commodities were mixed. WTI crude oil was down 1.02%. Natural gas was up 9.76%. The CRB Commodity Index was up 0.48%, while copper gained 0.79%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 1.72%, while the Vanguard Utilities ETF (VPU) was up 1.73%. The U.S. Dollar Index was lower by 1.42% to close the week at 99.75. The yield on the 10-year Treasury surged by 34 bps to end the week at 2.72%.

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC