Storm Watch

The storm stalking global markets is rapidly deepening. As it develops and approaches, more significant impacts are increasingly being felt. The headlining price action this week was the rout in bonds, surging yields, continued strength in the dollar, and very mixed commodity moves. While the weekly decline in major equity markets was relatively minimal, the overall dynamics of this market downtrend are becoming dramatically more intense.

The S&P 500 was off by only 0.21%, with the Dow down only 0.24% on the week. Hardly anything to speak of in itself. For the week, on the whole, tech, growth, and small-caps had a somewhat tougher go of things. The tech- and growth-heavy Nasdaq was off 1.54% while the small cap Russell 2000 shed 1.28%. Shrouded by the aggregate weekly return numbers, however, and of great significance to the overall unfolding of this bear, was the storm surge of intraweek volatility and the ruthless manor in which an aggressive rally attempt was mercilessly body slammed back down to the canvas. Volatility is no friend to sustained uptrends in equity markets, and this week was a price volatility tour de force.

Low volatility is ideal for longer-term fundamental investors. The gears of market motion crank at a deliberate, orderly pace. Cross-market prices, corporate fundamental expectations, and macro considerations can all be assessed, and assets can be allocated within the context of visibility and relative stability. In contrast, periods of elevated volatility create elevated challenges for fundamental investors, even as they attract short-term traders seeking to exploit and harvest the volatility like kids to a candy store.

Traders, bored in stable market environments, love nothing more than repeated high frequency opportunities to “buy the dip, and sell the rip.” However, when “elevated” volatility turns downright violent, volatility junkies especially get kicked in the teeth. When the shiny new grenade purchased yesterday unexpectedly blows up in the hand today, even these dedicated risk-takers revert from fight to flight, and different market strategies devolve into one unified reality—run for your life! We are nearing the point where even risk-tolerant short-term and aggressive traders back away from markets in favor of reassessing things when the dust finally settles.

After over a decade of central bank market backing, “buy the dip” has become the sophisticated guide to profitable trading/investing for a generation of market participants. Dip buying has been all carrot and no stick. Given this backdrop, it’s been extremely difficult for markets to correct and gravitate towards lower, more fundamentally risk-adjusted prices. Of significance, three feisty rally attempts in just the last two weeks have all been brutally rejected. As buying is increasingly dis-incentivized by the painful experience of immediate and heavy losses, buyers are progressively disciplined. The recently chastised back away.

As interest rates rise, equity prices drop, the dollar strengthens, and the Fed QE liquidity spigot turns QT liquidity drain, financial conditions are tightening. The carrot is turning to stick, and dip buyers are learning new lessons. These conditions are changing market dynamics. The buy-the-dip mentality so crucial for a bull market is now under heavy siege. Rather than armies of buyers piling into stocks during bull market corrections, recent market action is ensuring that similar ranks of sellers increasingly emerge to cap bear market rallies. This new dynamic paves the way for lower prices to come despite the inevitable counter-trend bear market rallies that lie ahead. The bear is overtaking the bull, and the weather is turning decidedly nasty as our rapidly intensifying storm approaches.

Of the market’s recent rally efforts, both the most spirited attempt and the most decisively bearish rejection occurred this week, surrounding the all-important events of the latest Federal Reserve FOMC meeting and the Chairman Powell show that followed.

On Wednesday, the Federal Reserve raised its benchmark overnight interest rate by half a percentage point. This was the first time the Fed has raised rates by more than .25% in 22 years. Chairman Powell also suggested that further fed funds rate hikes to increase borrowing costs would likely follow, and could come in the form of additional .50% increments over the next couple of meetings. The FOMC also said it would begin trimming its bloated, nearly $9 trillion balance sheet, by $47.5 billion per month in June, July, and August, and said the reduction would increase to as much as $95 billion per month in September. The FOMC policy statement said, “The Committee is highly attentive to inflation risks,” as inflation “remains elevated.” The Fed pointed to impacts from the war in Ukraine and to the dramatic and ongoing coronavirus lockdowns in China. These, he said, are inflaming supply chain issues that threaten to keep inflationary pressures high.

During the press conference Q&A, Powell responded to questions about the Fed’s ability to deliver a soft landing whereby Fed policy will successfully tame inflation without sending the economy into a downturn. Powell responded by saying, “there is a path.” Essentially, Powell’s path involves imposing tighter financial conditions via policy to moderate economic demand and therefore labor demand. Problematically, Powell’s path assumes that the notoriously blunt instrument of financial-tightening policy can be used for surgical fine-tuning. As Mr. Powell envisions it, “moderating demand” could lead to the record 11.5 million open job vacancies falling without actual unemployment going up. So, just the right degree of tighter policies will kill corporate needs to fill open positions, but stop just shy of hurting economic demand to the point where currently occupied positions are threatened. 

In walking this tightrope, the Fed will cool wage growth, stop the wage price spiral, and reduce consumer price inflation back down toward the Fed’s 2% target. All the while, the Fed will not trigger an increase in the unemployment rate that already resides at the end-of-cycle trough level of 3.6%—a level Powell described as being “just about as low as it’s been in 50 years.’ According to Powell, “that would give us a chance to…get wages down, and get inflation down without having to slow the economy and have a recession and have unemployment rise materially.” 

On a less-than-confidence-inspiring note, Powell went on to say, “So there’s a path to that. Now, I would say I think we have a good chance to have a soft—or softish—landing or outcome, if you will.” Soft-ish, indeed! As highly respected economist David Rosenberg has pointed out, even without a policy tightening to slow economic demand, at this point in the economic cycle, with the unemployment rate already so low, growth naturally slows and jobs are lost from these levels. According to Rosenberg, maintaining the current rock-bottom unemployment for any stretch longer than a year would be a never-before-achieved accomplishment. We are already at levels of unemployment that historically precede recessions.

Perhaps the Fed can pull it off, but the odds seem dramatically stacked against it. As HAI has detailed previously, with negative real, inflation-adjusted wages and a plunging savings rate—below pre-Covid trend levels and now at the lowest level since 2013, the consumer is punching above its weight and headed for at least a standing eight count, if not a coma-inducing knockout. Consumer sentiment over the past three months has remained lower than at any time in the preceding decade, and already hovers around recessionary levels. Additionally, according to Dr. Richard Curtin at the University of Michigan, it is the strong labor market and increasing wages that are keeping the consumer afloat. 

Something in this equation has to give. Unfortunately—and of absolutely crucial importance, a slowing labor market and diminishing wage growth will happen before consumer prices actually fall. As tightening slows the economy, an already stretched and stressed consumer is very likely to significantly reduce spending in a hurry if the jobs market and wages cool, the value of their real estate stops increasing, and their stocks and 401ks are losing value.

At the same time, as the consumer grows ever more vulnerable under current dynamics, weakening business confidence is rapidly spreading. This will increasingly tend to reduce corporate investment spending and act as an additional drag on the economy.

Meanwhile, in a troubling development for a Federal Reserve already facing severe credibility issues, former members of the Fed family are increasingly distancing themselves from Powell and the current FOMC policy trajectory. The criticism from former Fed family members is unprecedented in the modern Fed era. According to Bloomberg, Richard Clarida, who was Powell’s vice chair until January, said this week that, “interest rates will have to go to levels his former boss hasn’t acknowledged.” One of Powell’s other vice chairs for supervision, and a policymaker until December, Randal Quarles broke ranks even more dramatically. This week Quarles said that, “Given the intensity of inflation, the degree to which unemployment has been driven down—to bring that back into an equilibrium, it’s unlikely the Fed is going to be able to manage that to a soft landing… The effect is likely to be a recession.” Quarles went on to say that “For an economy that has accustomed itself to interest rates as low as they have been for as long as they have been, it doesn’t take a very large nominal increase in interest rates to be a very significant percentage of debt service for a number of heavily indebted actors… The effect on the economy could be fairly strong.”

The friendly fire extends beyond Clarita and Quarles. Both former Vice Chair Alan Blinder and former President of the New York Fed William Dudley also see events culminating in a recession.

Outside the Fed family, but no less concerned, ex-IMF chief economist Ken Rogoff also sees the “risk of having a perfect storm” of recession in China, Europe, and the US. Like Larry Summers, Rogoff thinks much higher interest rates will be needed to slow price inflation than the Fed is currently discussing. Given the global, supply-side nature of much of the price pressure, Rogoff believes it’s “really unlikely” that 2% or 3% interest rates will do the job. In his view, 4% to 5% is what would be needed to bring inflation down closer to, but still above, the Fed’s 2% target. 

Nevertheless, Rogoff concedes the lose/lose optionality left for the Fed at this point. On one hand, take your chances with inflation; on the other hand, bring on a recession because the rates needed to subdue inflation will be “too much, too fast.” Rogoff candidly told Bloomberg this week that “There’s just a lot of uncertainty. I’m not going to say I know exactly what needs to be done. But it’s clear that things are way out of control.”

Extreme uncertainty in the context of certain conviction that “things are way out of control” seems an apt description of the market reaction to the Fed’s Wednesday event. Heading into the meeting, the market was positioned for the risk of a Hawkish Fed shock. Given weeks of escalating hawkish rhetoric, the market event risk was weighted towards an even more aggressive event risk than expected. On Wednesday, however, Powell delivered a dovish surprise instead. The Chairman virtually ruled out a three-quarter-percentage-point rate hike in an upcoming meeting, and removed the possibility from the menu of options. The dovish shock caught the market, already vulnerable to a countertrend relief rally, squarely wrong footed. An epic short squeeze ensured what ultimately amounted to the biggest equity rally ever on the day of an FOMC meeting.

As dramatic as the short squeeze/dip-buying frenzy was on Wednesday, markets immediately pivoted into an even more severe body slam on Thursday. In the wake of the market’s round trip to even lower prices, trillions in market value was lost, and billions of ill-timed “buy the dip” bets suffered immediate heavy losses.

The likely trigger of the historic about-face? Inflation. After Powell revealed dovish inclinations by taking the option of a 0.75% rate hike off the table the day before, several events crystalized the nature of the inflation threat. First, the Bank of England offered plain-speak in contrast to Fedspeak, and from across the pond poured cold water on the pleasing image of a US soft landing. In a much more realistic and chilling depiction of the future that could soon await the US, the BOE admitted that it is raising interest rates right into the teeth of a likely incoming recession while inflation is also expected to rise to 10%. 

Additionally, on Thursday China’s politburo reiterated its support for zero-Covid policy and continued hard lockdowns that ensure that the inflationary nightmare of shortages and supply chain chaos will continue to roil markets going forward. Thursday also revealed a surprise US announcement that the government will start to refill the Strategic Petroleum Reserve this autumn. The move will shift the US government from crude sellers to buyers, and underpin expectations for continued high prices in the commodity that is the ultimate inflation force multiplier. Lastly, on Thursday morning, newly released data indicated that US productivity crashed by the most since 1947 as labor costs exploded while business output declined in Q1. The productivity bomb eliminated any hope that inflation could be contained or reduced by increasing productivity.

The inflationary cocktail unleashed on Thursday was the latest confirmation of the rapidly intensifying nature of the powerful storm we face. All told, the events of the week produced another clarifying recognition moment. Hopes for a “softish” landing are slim at best, while decades of untenable and unsustainable monetary policy malpractice suggest a far more realistic outlook: ruinous inflation or devastating policy-induced demand destruction.

First ballot hall of fame investor Paul Tudor Jones described the situation best in an interview this week. The investing legend said, “we are in uncharted territory.” He described the present mess as the “most challenging period ahead for the Fed in it’s history.” He added, “You can’t think of a worse environment than where we are right now for financial assets.” As the storm hits, unique opportunities exist in select hard assets, and the set-up for gold and the precious metals complex remains potentially historic.

Weekly performance: The S&P 500 was down 0.21%. Gold was off by 1.51%, silver was down 3.08%, platinum was up 1.75%, while palladium lost 12.30%. The HUI gold miners index lost 2.94%. The IFRA iShares US Infrastructure ETF was up 0.85% on the week. Energy commodities were up. WTI crude oil rallied 4.85%, while natural gas surged 11.05% on the week. The CRB Commodity Index was up 0.99%, while copper was off 3.17%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.98% on the week, while the Vanguard Utilities ETF (VPU) was up 1.36%. The US Dollar Index was higher by 0.70% to close the week at 103.68. The yield on the 10-year Treasury surged by 23 bps to end the week at 3.12%.

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC