The Good, The Bad, and The Ugly

“May you live in interesting times” is said to be an ancient Chinese curse. We’ll, I don’t know if it’s actually a curse, but interesting times are certainly upon us. We have a historic financial asset bubble threatening to deflate; an inflation problem of 40-year-high proportions; a schizophrenic, credibility-hemorrhaging Fed caught between a rock and a hard place; a dysfunctional global supply chain; an energy crisis; a brewing food crisis; economic ripples from China’s stop-and-go Covid disruptions; a global geopolitical debacle; a hot war; and perhaps an intensifying east-west cold one as well. It’s an exhausting list of items up there on the threat-board, and I’m sure I’ve left some out. Like I said, I don’t know if it’s a curse, but we live in interesting times to be sure. It is a truly tragic and unfortunate mess on our hands. This week, in markets, the mess muddled on.

Since the end of the gold standard and the start of the “Fed standard,” central bank economic and market interventions have increased at an ever-accelerating pace and on an ever-expanding scale. When fundamentals weaken and markets drop, the Fed intervenes with the stimulative tonic necessary to revive the failing patient and send markets higher again. As a consequence, the structural fragility of the economy and markets has increased. As the process has unfolded, a perverse relationship has also developed between markets, fundamentals, and the Fed. In this particular transmission system, bad fundamentals, via the resulting Fed interventions, have been the trigger for higher market prices. In other words, bad news has become good news, and good news, bad. This perverse dynamic has been present and escalating for well over a decade, but it defined market action this week.

After Fedspeakers Bullard and Bostic floated dovish talk that sent rate hike expectations lower and markets surging higher last week, this week was the opposite. This week’s version of Fedspeak was back to Volker-esque determined hawkishness. Fedspeakers Mester and Brainerd led the Hawkish revival, while Bostic walked back his “September pause” remarks. For all of the renewed hawkish Fed saber rattling, however, markets essentially remained fairly resilient. Equity markets shook-off Fed threats and actually put in new highs for the recent bear-market rally on Thursday.

Overall, stocks seemed inversely reactive to economic data throughout the week. Strong data prompted selling; weak data triggered rallies. No data better illustrated the dynamic than labor market news.

Thursday’s market strength came on the heels of a weaker-than-expected ADP private payrolls report that came in with 128,000 May jobs—a number about half of expectations. Notably, the ADP data reported that construction jobs, a particularly housing market-sensitive sector, contracted for the first time in 15 months. Also on Thursday, Challenger, in its job cuts report, said that the construction sector and other particularly interest rate-sensitive sectors saw more job cut announcements in May than in the previous four months combined. Markets rallied because the bad data suggested that the Fed might soon have an out to relieve it from hawkish policy follow-though.

On the other hand, Thursday’s highs reversed to a lower weekly close because of a stronger-than-expected nonfarm payrolls report Friday morning. According to the Labor Department, May nonfarm payrolls in the U.S. rose by 390,000 vs. the 320,000 expected. The non-farm payroll data is the most dominant and influential labor market report, and the good news soured the mood of equity markets. The combined impact of strong nonfarm payrolls with surging oil and gas prices counteracted the dovish implications of the ADP report and implied that the Fed needs to remain hawkish.

As a result, after rate hike expectations dropped in the prior week, hawkish Fed-hike expectations were back on the upswing by this Friday’s close. Stocks dropped, most commodities were higher, the dollar rebounded, and bonds took a hit as yields popped.

It is quite clear that due to inflation the Fed is boxed into tightening policy in the face of a brewing economic slowdown. The writing is on the wall. The Fed is in a real jam. The economic data will deteriorate. If the slowing data and easing inflation happen quickly, then the Fed will have the option to pivot toward the softer policy path. That outcome points toward a protracted period of painful stagflation. 

On the other hand, if the data is slower to deteriorate, the Fed will be under much more pressure to pursue legitimately hawkish policy. Such a policy would in time very likely produce a recession that would be sharp and painful, but shorter in duration. In addition, on the other side of the turmoil, this outcome will deal a heavier blow to inflation. Consider it the “rip the Band-Aid off” solution.

Neither of these lose/lose outcomes is particularly appealing. At this point, the endless streams of inconsistent and erratic Fedspeak appear to be an attempt to manage an orderly decline in markets. Structurally, markets are so fragile and sensitive to de-risking & deleveraging, illiquidity, and falling prices that panics and crashes are a huge risk if declines turn disorderly.

But more important than Fedspeak, from here the real-time data watch takes center stage. With inflation and inflationary factors where they are now, almost any strong economic data can be expected to perpetuate inflation. As described, that’s likely to trigger stock market selling, while weak economic data could catalyze a speculative bounce. With game changing inflation already over 8%, however, this dance between markets and the Fed is a riskier game than ever before.

Last week, HAI highlighted the essential importance and appeal of gold and related assets in this unprecedented environment. In the stagflation scenario, other areas of the commodity complex offer diversification, value, and attractive upside if supply constraints overpower demand constraints.

This week, Goldman Sachs Global Head of Commodities Research Jeff Currie spoke of a new and budding TINA (there-is-no-alternative) trade. This time it’s in the commodities sector. Outside of precious metals and other real assets, there are few reliable and tested alternatives for hedging the myriad current macro risks. Currie observed that, “As central bankers can drain liquidity faster than the economy can generate new production capacity, financial assets will continue to underperform physical assets like commodities.” According to Currie, heightened investor uncertainty about the economy has kept inflows to the sector relatively subdued to date, but he sees that changing. 

Currie’s latest read on the sector is significantly informed by the recent China Covid lockdowns. He rightly observes that the effect was a massive demand hit to many commodities. The fact that prices remained strong throughout lockdowns, according to Currie, suggests that the next leg higher for sector prices is set to commence now that Chinese demand is back online. His interpretation is that supply constraint factors are overwhelming demand factors in pricing dynamics. From these foundations, any upside surprise on demand translates to upside surprises on pricing. 

On the demand side, in addition to consumer and investor demand, Russia’s invasion of Ukraine is contributing an additional factor. The invasion and sanctions shock has driven policymakers and upstream manufacturers to compete to build precautionary stocks of everything from agricultural commodities to crude.

Morgan Stanley agrees with Currie’s bullish take on commodities. This week the bank also argued that tailwinds outweigh headwinds in the sector. So far this year, the commodities rally has defied GDP downgrades, a strengthening dollar, and aggressive sell-offs in other markets. According to Morgan Stanley, the resilience has been driven by key tailwinds that are still intact and, in some cases, set to strengthen. Demand for inflation hedges, demand for geopolitical risk hedges, the impact of the green energy transition, and an extended period of underinvestment are all supporting prices. Now, with the re-opening of China and the de-Russification of energy both accelerating this week, the bank sees renewed strength ahead for the sector.

At this point, the commodity argument is best suited if current macro dynamics resolve in the stagflationary scenario. The commodity liability is more exposed, in the near-term, in a straight recessionary environment where economic demand drops to the minimum and market volatility spikes to the maximum.

While the Fed still peddles the “soft, or softish landing” narrative, this week offered signs of increasing recognition that the future reality to prepare for is either a prolonged stagflation or devastating recession. A chorus of voices could be heard from a staggering number of prominent members of corporate America, all warning that we are absolutely not in economic Kansas anymore. No less than a dozen of the world’s most prominent corporate executives publicly sounded the alarm over either stagflation or an incoming recession. 

One voice in the choir was JPMorgan’s CEO, Jamie Dimon. Just a month ago, Dimon cautioned investors of “storm clouds” looming over the economy that, while present, could still dissipate. This week, however, Dimon offered a disturbing update to the forecast. Speaking at an investor conference on Wednesday, Dimon dramatically upgraded the storm watch to a hurricane warning. Rather than “storm clouds,” he now said, “It’s a hurricane. That hurricane is right there, down the road, and coming our way.” He added, “We don’t know if it’s a minor one or Superstorm Sandy. You better brace yourself.”

This week, aside from the corporate executive canary chorus, highly respected economist David Rosenberg put himself in the Superstorm Sandy camp. According to Rosenberg, even if we only suffer a relatively mild economic recession, the associated bear market in stocks is almost certain to be anything but mild. The reason is that a signature of recessionary bear markets is that they correct excess market valuation multiples. Sometimes valuations are more stretched than others, and our current bear market started with the highest excess multiple since at least the dot.com bubble. According to Rosenberg, so far, at the May lows, we had still corrected only halfway to the target low multiple. “So, here’s the rub, we haven’t even fully ‘mean reverted’ the multiple yet, and we haven’t even seen the earnings contraction. That’s coming next.” He added, “I think this is going to be very serious.”

Beyond the bear market math of multiple and earnings contractions, Rosenberg isolated a crucial piece of the larger threat we currently face. After over a decade of surging asset prices and a largely accepted mantra that the Fed “always has your back,” American households are dramatically overexposed to the risk of devastating losses. “That’s a very dangerous game to have people believe that the Fed always has your back. So the number that actually has me most unnerved is $45 trillion.” Forty-five trillion is the dollar amount of the long equities position held on American household balance sheets. To put that in perspective, the number equates to 40% of the household asset mix. Historically, that asset mix is almost always below 10%. Ten years ago, the long equities portion of American household balance sheets was a relatively miniscule $14 trillion. 

Doubling the trouble, Rosenberg also points out that another $40 trillion of household assets reside in the extremely vulnerable housing market. The obvious concern is that American household balance sheets could be wiped out in a hurry. How exactly these excesses unwind and dynamics resolve is uncertain, but Rosenberg stated that in “a full-fledged bear market, I’m concerned that it could create the conditions for a panic.” While both the Fed and markets are still playing a dangerous game, Rosenberg ominously concludes, “the game is over.”

The storm is coming. MWM will be watching the unfolding data intently to track the particular manifestation of the tempest. The different potential unfolding environments will offer unique risks and opportunities. We will act accordingly.

Weekly performance: The S&P 500 dropped 1.20%. Gold was off 0.38%, silver lost 0.86%, platinum was up 7.78%, and palladium lost 3.35%. The HUI gold miners index was higher by 0.73%. The IFRA I Shares US Infrastructure ETF was lower by 0.55%. Energy commodities were mixed. WTI crude oil was up another 3.30%, while natural gas was down 2.34%. The CRB Commodity Index was higher by 0.86%, while copper gained 3.71%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 2.15% on the week, while the Vanguard Utilities ETF (VPU) was up 3.65%. The dollar was higher by 0.51% to close the week at 102.22. The yield on the 10-yr Treasury surged by 22 bps to end the week at 2.96%

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC