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#41: Bonds say recession, stocks say growth. Something's got to give.
“This is not a standard business cycle- where you can look at the last 10 times there was a global pandemic and we shut the economy down. And Congress did what it did, and we did what we did. It's just -- It's unique.”
- Jerome Powell, February 1, 2023
Over the past two weeks we have been graced with another FOMC meeting and numerous interviews with Fed governors. Every word is analyzed like a bread crumb guiding investors down the path of monetary policy.
Yet of all the words, open to dovish or hawkish interpretation, Powell’s brief aside quoted above stood out to me as being the most candid and insightful. Current conditions are truly unique. Traditional macroeconomic models and historical precedents have proven ineffective at projecting inflation or economic growth.
Is the labor market historically tight as employment steadily grows, or do payrolls lag the pre-pandemic trend by millions? Yes.
Are consumers sitting on excess savings and debt capacity, or are consumers cutting back on expenditures as the personal savings rate rebounds from historic lows? Yes.
Has inflation declined across many price indexes, or does inflation remain at the highest level in decades? Yes.
Are corporate margins contracting, or do nominal earnings remain near all-time highs? Yes.
Have financial conditions tightened, or are financial conditions loosening? Yes.
This is the challenge of macro analysis in the post-pandemic world - frustrating policymakers and talking-heads alike1. So many data points and cyclical patterns have been thrown into disarray both due to the unique circumstances of COVID and the extraordinary monetary and fiscal policy that followed.
The answer to most economic questions today is contingent on the timeframe you choose, the baseline you deem appropriate, and your interpretation of the data. What matters more, absolute levels, the rate of change, or the rate of the rate of change?
This uncertainty poses a formidable challenge to central bankers who have admitted their struggle in forecasting the future. For investors, whose primary concern is front-running central bank policy, the task is even tougher.
In the absence of confident answers, all we have are best guesses or best wishes. Today, markets seem driven by best wishes.
Back in December, we noted that the stocks were caught in a no-win scenario:
At a 3.5% yield today, the 10-year assumes that inflation will be eradicated in relatively short order, and monetary policy will revert to a near-ZIRP regime for the rest of the decade. In my view, this is too optimistic on inflation and too pessimistic on longer-term economic growth…
[Meanwhile] stocks are caught between a rock and hard place. Strong nominal growth (either via inflation or real gains) will force the Fed to hold rates higher and tighten financial conditions further… A worst scenario is an outright recession, with falling earnings, sentiment, and growth.
While the market did drop in following weeks, the New Year rally has sent indices back above the early December highs. Rather than a “rock and a hard place” the market has decided to “have its cake and eat it too”. Lower long-term rates, a weakening US Dollar, and falling cross-asset volatility have led to a rapid easing of financial conditions over the past several months.
On one hand, long-term interest rates have eased substantially since their peak in October 2022, despite continued rate hikes by central banks and higher expectations for short-term rates over the coming year.
The U.S. Treasury yield curve has only been more inverted during the inflation fights of the late 1970s and early 1980s, when the Federal Funds policy rate was set in the mid-teens. When looking at the current yield curve inversion relative to the absolute level of the Federal Funds rate, the degree of inversion is unprecedented.
Today, long-term rates are highly confident that a dramatic reversal in monetary policy is on the horizon. Such low rates will only hold if our current nominal growth leads to outright contraction.
Meanwhile, equities have rebounded alongside lower long-term rates and easier financial conditions. Stock indices across the globe have rebounded strongly since October2. The New Year surge has transformed a rebound into a true “risk-on” rally as the most speculative and beaten-down (ex-)growth and meme stocks have led the charge (or more likely, speculative fervor and the return of call-buying is merely catching oversold stocks and overly short investors in yet another squeeze3).
The fact that S&P 500 earnings peaked in 2Q 2022 and have contracted consecutively in the last two quarters of the year is of little concern. Implicitly, the equity market believes in continued nominal growth and a reversal of contracting profit margins.
So, which is it?
The bond market is preemptively loosening based on the expectation of hard-landing and central bank pivot. Stocks are taking the benefit of the easing bond market but are assuming nominal growth continues. The net result is an inconsistent and contradictory rebound in financial asset prices across the board.
In our unique post-pandemic world, forecasting growth and inflation has proved to be a unique challenge. The jury is out.
For two years, bearish prognosticators have warned of an exhausted consumer ready to roll over, and yet it has not happened. Real economic growth continues, payrolls are rising, and real wage gains have been positive since gasoline prices rolled over last summer4.
It’s possible that many have simply underestimated the strength of the economy - that due to monetary and fiscal policy, the pandemic was financially beneficial for the majority of Americans who on balance are wealthier than they were before COVID5 and who now enjoy a historically tight labor market. Perhaps the economy is far better equipped to handle rate hikes without dipping into a recession.
But if this proves to be the case, price pressures are likely to remain sticky and volatile and interest rates will likely stay higher for longer6. Long-term rates will have to rise from their current discount to the policy rate, bringing down financial valuations in the process, even if nominal earnings remain resilient.
Or maybe the bearish prognosticators were right all along - just early. Perhaps the strong economic rebound in spending and GDP was driven by pent-up savings, re-stocking and re-levering.
It’s possible that consumers have now drawn down their savings7, loaded their credit cards8, and finally are beginning to cut back on expenditures9. Retailers are left with excess inventory and have slashed new orders, sending manufacturing indices tumbling10. Meanwhile the full impact of rising mortgage rates on the housing sector is still in early innings and will drag on the economy once the massive backlog of new construction is cleared.
If this proves to be the case, real growth will contract and inflation will subside, perhaps leading to a true central bank pivot and rate cuts far sooner than current short-term rates imply. But long-term bonds are already pricing these rate cuts today. Meanwhile the slight decline in corporate earnings we have already witnessed will accelerate downwards.
Either of these scenarios seems plausible.
What seems far less likely to me is the Goldilocks scenario implied by asset prices today - inflation returns to the 2% target while the Fed slashes rates and nominal earnings grow. Goldilocks is a fairy tale (and the bears win).
p.s. in a fourth unlikely but scary scenario, the economy contracts and inflation remains.
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In this column to-date, I have avoided predicting an “impending recession”. A key lesson learned in the early stage of pandemic recovery was that this time is different in many ways. It’s best to follow the data without dogma and so far the data has simply not indicated recession (at least, not yet).
In Germany, the DAX is up 30%, in Hong Kong the HSI Index is up 46%, in the U.S. the S&P 500 is up 15%, and in the UK FTSE 100 has broken to new all-time highs.
Devoid of confounding variables like earnings or growth, Bitcoin or Ethereum are good sentiment and liquidity litmus test. Each experienced a >40% trough-to-peak rally during the month of January.
Real disposable income per capita has risen in five of six months between July - December 2022, only posting a very minor decline in September.
Total U.S. household net worth increased by 27% from 4Q 2019 to 1Q 2022. Net worth gains were unanimous across income brackets.
Already, we see some signs that the loosening of financial conditions in the past several months may be bleeding back into inflation. The housing market has shown a sign of life with mortgage rates falling since November, used car prices are back up two months in a row, and capital market activity such as new asset back securities (ABS) issuance rebounded in January.
The Fed’s analysis shows “excess savings” peaked in mid-2021 and have declined substantially throughout 2022.
A significant portion of outstanding credit card debt was paid down during the pandemic bottoming in 2021. Throughout late 2021 and 2022, those balances have risen back to pre-COVID levels in nominal terms, though remain lower as a percent of disposable income.
Recent personal consumption expenditure (PCE) was negative on a nominal and real basis in November and December 2022.
Broadly speaking, manufacturing indices across the globe are now in contraction. S&P’s ISM manufacturing index shows the deepest level of global contraction since the early days of COVID, and the 2008 global financial crisis prior to that.