The Going Gets Tough

Next week, the MWM team will be hosting its annual client conference live in Durango. On behalf of the team, this author would like to thank all clients attending. After several Covid-inspired remote conferences, the MWM team is excited and looking forward to seeing all of you in person!

Since Fed Chairman Powell’s hawkish Jackson Hole manifesto in August, it’s been abundantly clear that the Fed’s credibility chips are all-in on the inflation war. Our central bank monetary magicians are committed, with singular focus, to aggressively leaning into a hawkish policy stance. They will use jumbo rate hikes and substantial balance sheet run-off known as quantitative tightening to bring soaring inflation back down to the Fed’s 2% target “unconditionally.” For the Fed’s well-advertised warpath, it’s whip inflation or bust. Unfortunately, markets are increasingly signaling the latter. In our debt-laden, credit expansion-based “super-bubble,” the hawkish policy crusade always came with the disclaimer that it might well break markets before inflation. Evidence is now rapidly mounting that the breakage has begun.

The S&P 500 was down this week by another 2.91%. The global benchmark has now closed the month at a definitive new bear market low under 3,600, and all major market indexes are now below their 200-week moving averages for the first time since the Covid panic lows. The incredibly rapid housing market reversal is deepening as mortgage rates reach 15-year highs and affordability plummets. Bonds are delivering their worst drawdown in history, yields are surging, and the dollar index continues to wreak havoc on the global economy. Deep inversions throughout the yield curve persist and continue to forecast what is no longer a surprise to anyone: A global recession is knocking on the door like an unwanted houseguest. While the recessionary forces are still building and will take time to fully manifest, crisis dynamics are already gripping markets. These are unprecedented times, conjuring a level of fright fully befitting the upcoming Halloween month of October.

Indicators of financial stress are surging across markets and throughout the globe. Corporate credit default swaps (CDS) for both investment grade and high yield markets are surging to levels not seen since the peak of the Covid crisis, and high yield and investment grade credit spreads are blowing out. Bank CDS for JPMorgan, Bank of America, Citibank, Morgan Stanley, Goldman Sachs, and Deutsche Bank have all similarly surged to their highest levels since the Covid panic. SocGen has actually surpassed Covid stress CDS highs, while Credit Suisse has rocketed past theirs by nearly 65%. The story is the same for global sovereign CDS in both developed and emerging markets. The clear implication is that the combined impact of the “unconditionally” hawkish Fed, surging global interest rates, a strong dollar hammer, and extremely thin market liquidity is already starting to break global credit-bubble markets. In a sign of just how dire things are starting to become, a measure of credit stress tracked by Bank of America jumped to a “borderline critical zone” this week. BofA strategists added in a note Friday, “Credit market dysfunction starts beyond this point.”

Like the massive boulder rolling toward Indiana Jones, rapidly tightening global financial conditions are now gaining momentum, and market participants are scurrying to get clear. Spiraling losses on Wall Street are now snowballing into forced asset liquidation. As losses mount, the de-risking & deleveraging doom loop in which selling begets more selling becomes a growing concern threatening to accelerate the ongoing rout in global markets.

Crisis events and instances of market breakdowns are now also triggering the first wave of significant government and central bank market interventions. Over the last two weeks, both the Peoples’ Bank of China and the Bank of Japan were forced to intervene in their respective currencies. This week, it was the Bank of England in crisis mode. The BOE was forced to suspend plans previously in place to sell down its bond holdings (quantitative tightening). In a complete 180-degree policy reversal, the BOE was instead pressed into a brand new bond buying intervention due to “material risks to UK financial stability.” So, a plan for QT turned into a brand new round of QE. Turns out that aggressive UK tax cuts aimed at fiscal stimulus announced the previous Friday triggered a UK bond market rout leading to widespread margin calls that systemically threatened the UK’s pension fund industry. Kerrin Rosenberg, CEO of Cardano Investment, told the Financial Times on Wednesday that, “If there was no intervention today, gilt yields could have gone up to 7–8% from 4.5% this morning, and in that situation around 90% of UK pension funds would have run out of collateral… They would have been wiped out.”

These building global crisis dynamics will likely continue to intensify over the coming weeks and months until such time as the Fed and other global central banks, despite still elevated inflation, begin to pivot away from their policy wrecking-ball of tight financial conditions and inflation fighting.

As BofA’s rates specialist Marc Cabana observed in reference to the critical factor of tight global financial conditions, “this crisis could have been avoided had the same set of proposals been made in times of supportive financial conditions. This is not one of those times however.” He went on to warn, “Thin US Treasury liquidity & limited demand may make the US market vulnerable to a market functioning breakdown, similar to the UK…. (The) Fed could follow the BoE in the event of an extreme UST market functioning breakdown.”

In the world of weather forecasting, when the forecasted storm begins to hit, meteorologists turn from forecasting to “nowcasting” as the real-time events unfold. In our analogous market-moment “weather event,” the die has been cast. Events are now in motion, and nowcasting is the name of the game.

Market stress is rapidly increasing and spreading. We may be approaching panic, and as Bank of America chief investment strategist Michael Hartnett observed this week, “Markets stop panicking when central banks start panicking.” All told, the events of the last two weeks appear to be accelerating the advent of a global central bank panic that could bring about a more coordinated policy pivot. Its time to nowcast events and monitor the Fed and other central bank responses. Whether the U.S. Fed sticks to its guns as it has done in impressive fashion to date, or begins to show signs of a pivot, the certainty is that pressures on Powell and the Fed are beginning to multiply.

Make no mistake, the overall implications of such a premature policy pivot while inflation remains elevated are truly frightening. As Mohammed El-Erian warns those hoping for a pivot, “be careful what you wish for…” That said, hard assets would be expected to benefit relative to financial assets. Nevertheless, with a global recession seemingly imminent, and plenty of resulting economic fall-out to come, economically sensitive commodities may remain volatile and temperamental for some time. Economically insensitive gold, however, will quickly become the asset to watch. If the yellow metal can buck the selling pressure caused by market liquidity constraints and collateral shortages, and diverge from other assets with a sustained rally, it may signal that the hawkish Fed is nearing the end of its rope and that some sort of pivot is in sight.

This week, the always colorful Albert Edwards squared up the unfolding market drama with his usual flair. The SocGen legend stated, “The bottom line is, after decades of central bank stimulus inflating bubbles and financial leverage to grotesque heights, the markets are still in charge… I keep citing Mike Tyson’s famous quote, ‘everyone has a plan till they get punched in the face.’” The Fed has a plan. After the fists start flying, however, all bets are off.

Weekly performance: The S&P 500 was down 2.91%. Gold was up 0.99%, silver gained 0.69%, platinum was nearly flat, up 0.05%, and palladium jumped 5.39%. The HUI gold miners index rebounded by 8.10%. The IFRA iShares US Infrastructure ETF dropped by 4.46%. Energy commodities were mixed on the week. WTI crude oil gained by 0.95%, while natural gas lost another 3.23%. The CRB Commodity Index was up by 1.00% and copper gained 2.10%. The Dow Jones US Specialty Real Estate Investment Trust Index was lower by 4.00% on the week. The Vanguard Utilities ETF (VPU) was down 8.49%. The dollar backed off by 0.78% to close a volatile week at 112.08. The yield on the 10-yr Treasury was higher by 14 bps to end the week at 3.83%

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC