No Place for Pollyannas

This week, financial markets acted decisively and with rare clarity. Essentially, for this ugly week, it was King Dollar up, virtually everything else down, and in most cases down big. Since the start of 2021, the U.S. dollar has certainly put on a show. It continues to deliver one of its strongest sustained up-legs in 35 years. This week, the dollar index punctuated that move with a fresh 20-year high approaching the 110 level. That strong-dollar wrecking ball, falling asset prices, rising credit default swaps (CDS), and widening credit spreads all conspired on the week to bring global financial conditions to their tightest levels since mid July. There was data that added a few pieces to the mosaic of our unfolding economic landscape, but, overall, the dominant forces this week were the aftershocks of the Jackson Hole earthquake Jay Powell triggered last week.

On the data front, the labor market took center stage. Non-farm payrolls for August beat expectations with a solid 315,000 new jobs vs. the roughly 300,000 expected. Initial unemployment claims ticked lower from the previous week, and the JOLTS data, recording unfilled job openings, unexpectedly increased. The data wasn’t earth shattering, but generally offered further evidence of a resilient, strong, and tight jobs market that needs to cool to help relax 40-year high levels of inflation. Covering the implications of the data, Nomura’s macro guru Charlie McElligott told Bloomberg, “Right now, the thing that’s really upsetting people is…the fact that labor just won’t back off.” He continued saying that, “The market is, frankly, assessing this restrictive for longer framework from the Fed and still seeing hot jobs data… That’s just going to put the Fed in a really awkward position where they’re just going to have to keep leaning in, which, perversely, then creates a situation where we’re probably more likely to crash land.”

Accentuating the Powell quake aftershocks, Fed speakers this week stood in unity behind the Chairman’s hawkish Jackson Hole manifesto. Seemingly every member of the Fed family has been carrying the hawkish policy flag recently. The message is that from the current fed funds rate of 2.25%–2.50%, higher rates for longer will be needed and are forthcoming. This week, it was regional Fed heads Mester, Williams, and Kashkari that grabbed the bullhorn.

Cleveland Federal Reserve Bank President Loretta Mester said, “My current view is that it will be necessary to move the fed funds rate up to somewhat above 4% by early next year and hold it there; I do not anticipate the Fed cutting the fed funds rate target next year.” In reference to a tighter policy trajectory of quantitative tightening (liquidity withdrawal) and a higher Fed funds rate for longer, New York Fed President John Williams reiterated the brand new party line that, “This is not something we’re going to do for a very short period and then change course.” 

Referring to the sharp market declines that have followed Powell’s Jackson Hole speech, Minneapolis Federal Reserve Bank President Neel Kashkari told Bloomberg that, “I was actually happy to see how Chair Powell’s Jackson Hole speech was received.” He added, “People now understand the seriousness of our commitment to getting inflation back down to 2%.” 

Again, the underscored message from this week’s Fedspeak was of a fundamental and consequential Federal Reserve policy regime change. At least for now, the Fed family wants it known that they’re all on board the hawkish policy bandwagon, are aiming at higher rates for longer, and that after suddenly growing the thickest skin since Paul Volker, they’re not only tolerant of financial market losses, they’re “happy” to see them.

HAI sincerely appreciates the Fed’s new stand for responsible monetary management. Failure to prove that they do have a monetary policy break and are willing to use it would run the very real risk of inviting catastrophic systemic breakdown in an Austrian crack-up-boom type dynamic. The Fed’s current course is ultimately almost certainly the lesser of two evils. So, for the often wrong but never in doubt Fed, it’s better late than never for the restrictive policy stance and some newly acquired pain tolerance.

That said, we can’t minimize the risks inherent within the current “least bad” course of action. It’s taking place in the context of a substantial, coordinated global growth slowdown that’s already underway. As Charlie McElligott hinted, the Fed’s new restrictive economic policy “regime change” is powerful poison for our structurally fragile, debt-laden global economy that’s unsustainably dependent on near-zero interest rates and continued credit expansion. Clearly, the least bad option comes nowhere near the criteria for being a good one.

While some pockets of economic data, especially in the labor market (a lagging economic indicator) are still demonstrating strength, the full-force of the cyclical economic downturn has yet to hit. Make no mistake, the leading economic indicators are deeply recessionary. As Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) put it this week, “There’s no ambiguity… There’s a pronounced, pervasive, and persistent decline in the [leading economic] indicators… They’re just clearly recessionary.” That leading economic data describes an incoming storm. When that data is amplified by the increasingly restrictive-for-longer Fed policy, the storm watch becomes a hurricane warning as we head closer to year-end and into 2023.

Putting the pieces together, while the global inflation outbreak has imposed practical, political, and institutional credibility constraints on Fed action in the near-term, the futures market has its eye on the ball, and appears likely to have the dynamics squared up pretty well. By pricing in emergency response rate cuts by the Fed in 2023, the implication, gleaned from futures market pricing, is for a recessionary crisis event first, then a reactive stimulative Fed policy pivot once the now-higher pain threshold to trigger the Fed put has been reached.

There is no doubt that the global economy has been riding a multi-decade credit expansion-fueled boom. That said, recall Austrian economist Ludwig von Mises’s warning that, “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.”

These are the stakes. They’re stark and sobering. The Fed is trying to implement a voluntary pause of further credit expansion—just long enough to knock inflation lower, presumably without popping history’s greatest credit bubble. A soft landing in such an instance would amount to the old trick of yanking away the tablecloth while leaving glasses and dishes unscathed. HAI, however, is anticipating shards of glass and fragments of china—in which expectation we are not alone. This week, former Treasury Secretary Larry Summers told Bloomberg that expectations for a soft-landing “represent the triumph of hope over experience.” Well said, Mr. Treasury Secretary.

In the immediate term, the S&P 500 should attempt to bounce off a confluence of strong technical support factors around the 3,900 level. Whether such a bounce occurs or not, if 3,900 is breached, the door opens for a run to test the June low. If the current bear market lows of June are broken, the risk of panic increases. What has been an orderly retreat from all-time highs may quickly become a rout.

In the commodity sector, micro factors are increasingly being overwhelmed by the larger macro risks affecting all assets. Bank of America chief investment strategist Michael Hartnett currently sees deflation in Asia, stagflation in Europe, and a U.S. transitioning from inflation to recession. According to the strategist, once the U.S. tips from inflation to recession, global growth turns sharply negative by the first quarter of 2023. While the long-term supply side factors remain extremely bullish broadly across the sector, on a shorter time horizon, prices will likely remain extremely volatile. Markets are still attempting to gauge and price the increasing potential demand destruction impact stemming from what may be a deep, coordinated, global recession that hasn’t fully hit yet. Modest positioning in select commodities is certainly warranted, but for patient investors, moving into larger positions over the coming months may be the optimal approach.

Let’s consider for a moment whether this is all overblown. Could it be that the worst is over, the financial asset bubble has already popped, and that by now we’re ready to start a new bull market? As discussed above, that’s not where the data is pointing. But it’s also not where legendary hedge fund manager and first ballot hall-of-fame investor Jeremy Grantham believes we’re headed. This week, Grantham unambiguously dismissed the idea as, “nonsense.” 

According to Grantham, our “super bubble” has yet to pop. In his view, the collapse of a super bubble comes in several stages. First, there’s a setback like the one experienced in the first half of this year, then a bear market rally follows before, finally, fundamentals break down, and the market reaches its low point. “My bet is that we’re going to have a fairly tough time of it economically and financially before this is washed through the system,’’ added Grantham. “What I don’t know is: Does that get out of hand like it did in the ’30s, is it pretty well contained as it was in 2000, or is it somewhere in the middle?” These are some historically brutal comparisons. And while Grantham may not be the go-to for a cheap laugh or cheery market chit-chat, the 83-year-old market vet is one of the all-time best in the business. The market risks he outlines are very real.

Many factors will contribute to determining just where, on the severity spectrum, our unfolding market and economic drama will ultimately land. What’s clear is that the timing, size, scope, and particular composition of a potential Federal Reserve policy pivot will be an enormous factor. Equally clear is this: If the new-found preference for monetary policy responsibility in central banking reverts, and the monetary-maestros return to their activist roots to stimulate and reflate a collapsing credit bubble, it may well be a catastrophe for the currently kingly dollar. Simultaneously it could prove to be the catalyst that touches a match to the powder keg that is gold.

Weekly performance: The S&P 500 lost 3.29%. Gold was off 1.55%, silver dropped by 4.64%, platinum was hit by 4.33%, and palladium was lower by 4.51%. The HUI gold miners index was down 5.16%. The IFRA iShares US Infrastructure ETF was off 4.31%. Energy commodities were lower this week. WTI crude oil lost 6.65% while natural gas was off 5.21%. The CRB Commodity Index was lower by 4.75%, and copper was hit by 7.84%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 3.91% on the week, while the Vanguard Utilities ETF (VPU) was down 1.51%. The dollar ripped higher again by 0.70% to close the week at 109.51. The yield on the 10-yr Treasury gained 16 bps to end the week at 3.20%.

Have a wonderful long weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC