The 3-month/10-year U.S. Treasury yield curve has been inverted for 216 consecutive trading days, the longest streak since at least 1960. In bond lingo, a yield curve inversion coupled with increasing bond yields is called a bear flattener. Bear, denoting the direction of bond prices, and flattener describing the shape of the yield curve. Yield curve inversions lead to recessions. However, they are poor timing signals. Further, as shown below, courtesy of NDR, the stock market tends to do well during bear flatteners despite a coming recession. A bull steepener (uninversion) is the more imminent recession signal and warning for stock investors. Monday’s Commentary cautions a steepener may be close (see Tweet of the Day below).

A bull steepener occurs when bond prices rise (yields decline) and short-term yields fall more than long-term yields. Bull steepeners usually result from the Fed lowering interest rates or the market anticipating such actions. As shown in orange below, the last three bull steepener trades coincided with significant stock market declines and recessions. Recently, the yield curve entered a bear-steepening trade- long-term yields are rising while short-term yields remain relatively stable. Until we see a bull steepener with yields falling across the bond maturity spectrum and the market anticipating Fed rate cuts, the stock market should be on safe ground.

What To Watch Today

Earnings

Economy

Market Trading Update

As we enter the last week of the month and the quarter, we are starting to see a lot of positioning for quarter-end reporting. September also marks the fiscal year-end for many fund managers, adding to the sloppy trading in stocks and bonds. While bonds took a hit yesterday, stocks rallied at the close, which is a good sign for the bulls. I would discount most of the action over the course of this week and pay attention to how markets react in October once we start seeing earnings reports and we get the revisions to GDP, which will likely be negative. For now, the market held support at the June lows, which keeps markets on a bullish footing for now.

More On The Labor Market

Yesterday’s Commentary shared data from the ECRI highlighting some leading labor market indicators pointing to weakness. In the Commentary, we asked if it was simply a normalization of labor conditions or the beginning of a more concerning trend. The following graph from Tavi Costa sheds more light on the question.

The rate of annual change of permanent job losses is positive for six months running. Further, it aligns with the early warnings from the last three recessions. Permanent job losses, as defined by the BLS, are shown below. While the recent increase in year-over-year terms is low, it is starting to become consistent. Other than two months in 2016, sustained positive readings in this indicator precede and accompany recessions.

We caution the pandemic-related volatility in economic activity makes comparing historical data to current data difficult. That said, this is a reason for caution but not yet outright concern.

Gamma Dynamics And JP Morgan

Every Monday, SimpleVisor subscribers get access to the latest Viking Analytics report. Viking Analytics uses options market activity to assign equity allocations. This week’s report shares a dynamic in the options market that might be volatility-inducing.

Next Friday’s end of quarter option expiration includes the now-famous end of quarter structural collar from JP Morgan. Not surprisingly, put gamma bottoms near 4,200 which is near the put leg of JPM’s collar, which is at 4215. We could see amplified moves where dips get sold and rallies get bought due to the large open interest in expiring puts.

JP Morgan runs a $15 billion hedged equity fund. It uses options, which reset at the end of each quarter, to limit the fund’s exposure to declines. Because of the size of the fund, the options it owns, and the proximity of recent prices to their option strikes, dealers exposed to JP Morgan’s options trades may need to buy or sell to hedge their positions. As Viking notes, such hedging activity could lead to pronounced volatility.

Don’t Bet Against A Fourth Quarter S&P 500 Rally

The table below from Carson and ISABEL.NET.com speaks for itself. When year-to-date S&P 500 returns through September are similar to current levels, the rest of the year promises a 5.1% return on average, with only three of nineteen instances producing a negative return. In all cases, they were small.

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“Compound market returns.” During bullish markets, there is inevitably a regurgitation of this myth that was contrived to extract capital from retail investors and place it in the hands of Wall Street.

However, the compound market returns myth was contrived from the myth that “markets always go up,” therefore, it is ALWAYS a good time to invest. How often have you seen the following chart presented by an advisor suggesting if you had invested 120 years ago, you would have obtained a 10% annualized return?

It is a true statement that over the very long term, stocks have returned roughly 6% from capital appreciation and 4% from dividends on a nominal basis. However, since inflation has averaged approximately 2.3% over the same period, real returns averaged roughly 8% annually.

The obvious problem with that statement is that you don’t have 123 years to invest, that is, unless you have discovered the secret to eternal life or are a vampire.

For the rest of us, mere mortals, time matters.

Let’s revisit the chart above, add valuations, and review the market’s various “life-cycle” periods. As you will notice, when valuations were previously elevated, the future price action of the markets was negative until that overvaluation was reversed.

Unfortunately, individuals only have a finite investing time horizon until they retire. Therefore, as opposed to studies discussing “long-term investing” without defining what the “long term” actually is – it is “TIME” that we should be focusing on.

When I give lectures and seminars, I always take the same poll:

“How long do you have until retirement?”

The results are always the same. The majority of attendees responded that they have about 15 years until retirement. Wait…what happened to the 30 or 40 years always discussed by advisors?

Think about it for a moment. Most investors don’t start seriously saving for retirement until their mid-40s. This is because by the time they graduate college, land a job, get married, have kids, and send them off to college, a real push toward saving for retirement is tough to do as incomes haven’t reached their peak. This leaves most individuals with 20 to 25 productive work years before retirement age to achieve investment goals. 

Let’s review the chart above concerning starting valuations. As shown below, market returns approached zero during periods throughout market history. Those periods were the result of the reversion of previous overvaluation.

What should be evident is that “WHEN” you start your investing journey is incredibly important to future outcomes.

This analysis leads us to the second market myth, “Compound Market Returns.”

The Eighth Wonder Of The World

Albert Einstein once stated:

“Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays it.”

Notice that Einstein said “interest,” not “stock market returns.”

Financial advisors and the media latched on that quote to promote the idea of dollar-cost averaging into the stock market. Of course, this is good for those charging a fee on assets they hold for you. Here is a good example.

“Let’s say you invest $500 a month in a brokerage account over a 20-year period. All told, you’re sinking $120,000 into your account, which is a lot of money. But if your investments during that time generate an average annual 8% return, which is below the stock market’s average, you’ll end up with about $275,000. All told, that’s a gain of $155,000. And compounding is what helps make that possible.” – Motley Fool

Here is the problem. Compound Interest and Compound Market Returns are two different things.

Einstein was correct. If I buy an investment, like a bond or a CD, that pays INTEREST, my money compounds over time. This is because the interest payment is fixed, and the principal is returned at maturity.

However, as shown above, the stock market does NOT provide a fixed annual rate of return over time. It is variable, and that variability impacts the ending return of the investment over time. The chart below shows an investment in the stock market over time versus a compound market rate of return of 8%, as suggested by Motley Fool.

As you can see, there is a vast difference between an actual return over time and an AVERAGE or COMPOUND market return.

The difference has everything to do with the math.

Compound Market Returns Are A Myth

This past week, Visual Capitalist produced a chart on “The Rule Of 72.” As they note, the rule of 72 is a classic shortcut that estimates how long it takes to double your investment. The math is simple. Take any rate of return you desire, say 8%, and divide that into 72, which tells your money will double in 9 years.

This is a true statement, as shown below. If we invest $10,000 into an investment that yields 8% annually, the value of my investment will double in 9 years.

However, the math changes drastically when introducing negative return years. The chart below shows the impact of a single loss, two losses, and a singular market crash (like the Dot.com crash or the Financial Crisis) on the time to double my return.

The investment community’s promotion of “buy and hold” strategies is understandable. It is easy. It makes them money on the fees they charge, and, given that markets go up more often than they fall, it is an easy story to sell.

However, what should be clear is that compound market returns do not exist.

The real-world damage that market declines inflict on investors hoping to garner annualized 8% returns to compensate for the lack of savings is all too real and virtually impossible to recover from. When investors lose money in the market, it is possible to regain the lost principal given enough time. However, and most importantly, what can never be recovered is the lost “time” between today and retirement. “Time” is exceptionally finite and the most precious commodity investors have.

With valuations currently elevated along with high-interest rates, the risk of another market and economic downturn is too real. As such, investors should consider what that means to future market returns and the time horizon required to meet financial goals.

But one thing is for sure.

Assuming the market will go up every year by 8% is not, and has never been a reliable investment thesis.

Wouldn’t everyone who ever invested in the markets be fabulously wealthy if it was?

Conclusion

For investors, understanding potential returns from any given valuation point is crucial when considering putting their “savings” at risk. Risk is an important concept as it is a function of “loss.” 

The more risk an investor takes within a portfolio, the greater the destruction of capital will be when reversions occur.

The analysis above reveals the important points that individuals should OF ANY AGE should consider:

• Investors should adjust expectations for future returns and withdrawal rates downward due to current valuation levels.
• The potential for front-loaded returns in the future is unlikely.
• Your life expectancy plays a huge role in future outcomes. 
• Investors must consider the impact of taxation.
• Investment allocations must carefully consider future inflation expectations.
• Drawdowns from portfolios during declining market environments accelerate the principal bleed. Plans should be made during up years to harbor capital for reduced portfolio withdrawals during adverse market conditions.
• Investors MUST dismiss expectations for compounded annual return rates instead of variable return rates based on current valuation levels.

Over the last two decades, two massive bear markets have left many individuals further away from retirement than they ever imagined.

The myth of “compound market returns” is dangerous to individuals trying to save and invest their way to retirement.

Bear markets matter, and they matter much more than you think.

The Treasury bond yield curve has a near-perfect track record for predicting recessions. Inverted yield curves, when the yields on short-maturity bonds are greater than long-maturity bonds, are precursors to recessions. Yield curve inversions, however, are poor timing tools. The last four recessions started after an inverted yield curve un-inverted back to its normal positive slope. Yield curve inversions and uninversions are the bond markets’ way of pricing in lag effects. The task we face in predicting when the lag effects will result in a weaker economy or recession is predicting when the yield curve will uninvert.

To help us, we present a technical analysis of the 3-month/10-year yield curve. The graphs below are from an astute client of ours. The graph on the left is the yield curve with its 50, 100, and 200 dmas. The second is the recent two-year period blown up to see the curve and its averages better. Before focusing on the moving averages, notice how yield curve inversions and uninversions occur before each recession. It’s hard to see, but the turning point of those pre-recession yield curve inversions was signaled by the 50dma crossing above the 100 and 200 dmas. The graph on the right shows the 50dma is now above the 100dma and is quickly approaching the 200dma. Such a crossing, called a “golden cross,” is bullish, meaning the yield curve universion may be upon us shortly. If so, a recession may not be far behind.

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

The market took a hit this week as the Fed projections of “higher for longer” killed the “rate cut hopes.” However, while there was much handwringing and teeth-gnashing over the decline, it was quite normal within any given year. As we noted in June:

“Notably, in any given year, bullish or bearish, a 5-10% correction is entirely normal and healthy. Such corrective actions are opportunities to increase portfolio equity risk.”

It took a bit longer than expected for the correction to begin, but in late July, the market peaked and has continued to correct through September. With the market still in a broader uptrend, the bullish backdrop remains, but there is a risk of a decline to 4200. However, the market is oversold on many levels, so a reflexive rally next week to the 50-DMA would be unsurprising.

Not only is the current correction normal, but it is also well aligned with the seasonal tendencies of market returns, as we noted on Tuesday in “October Weakness.”

“While September has been a bit sloppy so far, will further weakness in October weigh on investor sentiment before the seasonally strong period begins? The S&P 500 index seasonality chart below shows weakness in the last two weeks of September and the first two weeks of October is common.”

Nonetheless, the weakness following the FOMC this weakness certainly raises concerns. However, a history review suggests that while the Fed is currently “talking a tough game,” reality tends to be very different. The reason is that the Fed projections are useless because they are always late and wrong. There is no reason to suspect this time will be different.

The Week Ahead

Jerome Powell made it clear the Fed is data-dependent as it weighs whether or not to raise rates at the coming November and December meetings. With that, the next round of employment and inflation data will be of primary importance and help the markets better assess what the Fed may do at coming meetings.

The PCE price index gets less fanfare than CPI, but the Fed prefers it to measure prices. On Friday, the core PCE is expected to increase by 0.2%, in line with last month’s reading, and decline from 4.2% to 3.8% on a year-over-year basis. The all-inclusive (non-core) number is expected to increase from 0.2% to 0.4%. Also on the inflation front will be the University of Michigan consumer sentiment survey. Inflation expectations, in the survey, fell unexpectedly from 3% to 2.7% in the last report. The Fed puts a lot of stock in the relationship between expectations and future inflation readings. The Chicago, Dallas, Richmond, and Kansas City Fed surveys will provide close to real-time sentiment of business leaders on prices and employment in the manufacturing and service sectors.

With the Fed meeting past, Fed members will be back on the speaking circuit. We suspect some will lean toward hiking rates by another 25bps, while others will want to refrain. Based on Powell’s press conference last week, it appears the Fed wants to keep the threat of 25bps out there but not necessarily use it as they are concerned about the lag effect of the prior hikes.

Friday marks the last trading day of the quarter, so expect some volatility throughout the week as investment managers “window dress” their portfolios.

Labor Weakness or Normalization?

The number of job openings is falling rapidly. At the same time, ADP and the BLS are reporting that job growth is slowing to more normal levels. The recent slowing of the labor market begs the question- is the labor market simply getting back to pre-pandemic levels, or will the recent weakness continue?

To help us consider the question, we lean on ECRI’s latest report on the job market. The Economic Cycle Research Institute (ECRI) has a long and distinguished track record of forecasting business cycles. Presidents, Fed Chairmen, and business leaders have used their information to make more informed decisions.

With that, let’s look at their recent report. Their broad labor conditions index shows that the labor market is always expanding or contracting. It rarely consolidates. Over the last year, the index has been declining, indicating a weakening of the labor market. Such always occurs before a recession. But, even with the decline, the index is still above the 30+ year peak. Instead of falling precipitously as it has done in the past, might it level out once the pandemic-related stimulus is fully exited from the economy? The following two graphs show some of the subcomponents of the index. In both cases, these leading indicators are declining but still at or above pre-pandemic levels.

ECRI sums up its report as follows:

Beyond the debate of a soft or hard landing, our forward-looking indicators offer little sign of a sustained revival. However, at least some of the non-cyclical forces still boosting the economy are liable to subside while the cyclical drag remains. The outcome of this tug-of-war will determine the hardness of the landing.

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In a $28 billion all-cash deal, Cisco (CSCO) is acquiring Splunk (SPLK). Splunk helps companies monitor and reduce cybersecurity risks. They also help companies resolve hack-related technical issues quickly. Cisco has acquired four other cybersecurity firms this year as they grow their footprint in the high-demand cybersecurity industry. Cybersecurity products complement Cisco’s software business lines and telecommunications and networking equipment products. Some analysts offer caution, thinking Cisco paid too high a price for Splunk. Regulatory hurdles must also be dealt with before the purchase can occur.

As is typical with buyouts, the market’s initial reaction was negative, with Cisco shares opening about 4% lower. Splunk traded almost 20% higher. While the market may initially frown on the deal, Cisco thinks Splunk offers significant synergies, leading to more growth. Per CNBC: “Cisco expects the deal to be cash flow positive and gross margin accretive in the first year following the closing of the acquisition; it will be accretive to Cisco’s non-GAAP earnings per share by the second year. Robbins (Cisco’s CEO) expected organizational synergies to become clear and impactful within 12 to 18 months.”

What To Watch Today

Earnings

• No notable earnings releases today.

Economy

Market Trading Update

The September weakness remains as the market took out support at the 100-DMA yesterday. The market is oversold on a short-term basis and is testing minor support from June. A break below that support will bring the 200-DMA into focus and stretch the current decline to more extreme measures. Continue to manage exposures for now, but with September coming to a close and most of the data behind us before earnings season starts, a rally attempt today or Monday will not be surprising.

Putting The Market Decline Into Perspective

The recent market decline elicits fear-mongering on Twitter and generates concerning headlines in traditional media outlets. To help analyze the recent downdraft, we share the graph below of the S&P 500. The graph charts the rally starting at the mid-October 2022 lows. As highlighted, the recent correction is the fourth one since the rally began almost a year ago. The current decline of about 6% from recent highs aligns with the prior sell-offs ranging from 5.3% to 9.3%. Thus far, the decline appears to be a natural and healthy pause in an upward trend. Additionally, there is currently a positive divergence in the MACD. As shown below the graph, the MACD is higher than the early August low despite the price being about the same level.

While we are optimistic this recent weakness is a consolidation before another leg higher, we are cognizant that the S&P 500 is below its 50dma and just broke its 100dma. That said, it is still about 5% above its 200dma. Further caution is warranted if the index breaks the 200dma. In addition to technical levels, we are also monitoring interest rates and oil prices, which are weighing on investors sentiment.

Bank Of England Increases QT

Last week, we discussed how the ECB unexpectedly increased rates by 0.25% but effectively said their rate hiking cycle is likely done. The Fed followed on Wednesday and did not hike rates, but it maintains a bias toward hiking. The Bank of England (BOE) surprised markets by not hiking rates as was largely expected, but they did increase their pace of QT.

Three central banks and three distinct actions. Europe and England are dealing with high inflation and poor economic growth. As such, they are both reluctant to keep hiking rates. Conversely, the U.S. has seen its inflation rate fall quicker than Europe and England, while its economic activity has been more robust. As their monetary policies start to diverge, the volatility in the currency markets is likely to increase. The U.S. dollar index, as shown below, is up to six-month highs. A stronger dollar results domestically in deflationary price pressures from imports. At the same time, it raises the cost of dollar borrowing for foreign companies. Given the heavy reliance on said dollar funding, the stronger dollar will, in addition to prior rate hikes, act as a further headwind for foreign economic growth.

Wednesday’s Fed Day Mirrored Prior Fed Days

Another FOMC meeting and the same market results as prior meetings. It is stunning how Wednesday’s price action tracked the average from the prior eight meetings. The graph below is courtesy of Bespoke. As it shows, the market sells off as the Fed releases its statement at 2 p.m. ET. It then rallies back during the Chairman’s press conference, only to sell off more deeply following his statements.

In the ten days following the prior eight meetings, the S&P was up 1% on average. The maximum gain was 5%, and the largest loss was 4%. Five instances produced positive results, leaving three with negative returns.

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The hit TV series “That 70s Show” aired from 1998 to 2006 and focused on six teenage friends living in Wisconsin in the late 70s. The irony was that the actors playing the teenagers were not born in the late 70s and had never experienced life during that period. Many alive today cannot fathom a lifestyle devoid of the internet, cable television, mobile phones, and social media. Oh…the horrors.

Yet, today, almost 50 years later, financial commentators, many of whom were not alive at the time, suggest that inflation and yields will repeat “That 70s Show.” Understandably, the increase in inflation and interest rates from their historic lows is cause for concern. As James Bullard noted, “Inflation is a pernicious problem,” which is why the Federal Reserve lept into action.

“When the US Federal Reserve embarked on an aggressive campaign to quash inflation last year, it did so with the goal of avoiding a painful repeat of the 1970s, when inflation spun out of control and economic malaise set in.” – CNN

That concern of “spiraling inflation” remains the key concern of the Federal Reserve in its current monetary policy decisions. It has also pushed many economists to point back at history, using “That 70s Show” period as the yardstick for justifying their concerns about a resurgence of inflation.

“The chair of the Federal Reserve at the time, Arthur Burns, hiked interest rates dramatically between 1972 and 1974. Then, as the economy contracted, he changed course and started cutting rates.

Inflation later roared back, forcing the hand of Paul Volcker, who took over at the Fed in 1979, Richardson said. Volcker brought double-digit inflation to heel — but only by raising borrowing costs high enough to trigger back-to-back recessions in the early 1980s that at one point pushed unemployment above 10%.

‘If they don’t stop inflation now, the historical analogy [indicates] it’s not going to stop, and it’s going to get worse,’ said Richardson, an economics professor at the University of California, Irvine.”

However, such may be an oversimplification to suggest Burns was wrong and Volker was right. The reason is the economy today is vastly different than during “That 70s Show.”

Today Is Very Different Than The 1970s

During the 70s, the Federal Reserve was entrenched in an inflation fight. The end of the Bretton Woods and the failure of wage/price controls combined with an oil embargo sent inflation surging. That surge sent markets crumbling under the weight of rising interest rates. Ongoing oil price shocks, spiking food costs, wages, and budgetary pressures led to stagflation through the end of that decade.

What was most notable was the Fed’s inflation fight. Like today, the Fed is hiking rates to quell inflationary pressures from exogenous factors. In the late 70s, the oil crisis led to inflationary pressures as oil prices fed through a manufacturing-intensive economy. Today, inflation resulted from monetary interventions that created demand against a supply-constrained economy.

Such is a critical point. During “That 70s Show,” the economy was primarily manufacturing-based, providing a high multiplier effect on economic growth. Today, the mix has reversed, with services making up the bulk of economic activity. While services are essential, they have a very low multiplier effect on economic activity.

One of the primary reasons is that services require lower wage growth than manufacturing.

While wages did rise sharply over the last couple of years, such was a function of the economic shutdown, which created a supply/demand gap in the employment matrix. As shown, full-time employment as a percentage of the population fell sharply during the pandemic lockdown. However, with full employment back to pre-pandemic levels, wage growth declines as employers regain control over the labor balance.

Furthermore, the economic composite of wages, interest rates, and economic growth remain highly correlated between “That 70s Show” and today. Such suggests that while inflation rose with the supply/demand imbalance created by the shutdown, the return to normalcy will lower inflation as economic activity slows.

With a correlation of 85%, the inflationary decline will be coincident with economic growth, interest rates, and wages.

Unlike “That 70s Show,” where economic growth and wages were rising steadily, which allowed for higher levels of interest rates and inflation, There is a singular reason why a repeat of that period is quite impossible.

The Debt Burden And Economic Weakness

What is notable about “That 70s Show” is that it was the culmination of events following World War II.

Following World War II, America became the “last man standing.” France, England, Russia, Germany, Poland, Japan, and others were devastated, with little ability to produce for themselves. America found its most substantial economic growth as the “boys of war” returned home to start rebuilding a war-ravaged globe.

But that was just the start of it.

In the late ’50s, America stepped into the abyss as humankind took its first steps into space. The space race, which lasted nearly two decades, led to leaps in innovation and technology that paved the wave for the future of America.

These advances, combined with the industrial and manufacturing backdrop, fostered high levels of economic growth, increased savings rates, and capital investment, which supported higher interest rates.

Furthermore, the Government ran no deficit, and household debt to net worth was about 60%. So, while inflation increased and interest rates rose in tandem, the average household could sustain its living standard. The chart shows the difference between household debt versus incomes in the pre- and post-financialization eras.

With the Government running a deep deficit with debt exceeding $32 trillion, consumer debt at record levels, and economic growth rates fragile, consumers’ ability to withstand higher inflation and interest rates is limited. As noted previously, the “gap” between income and savings to sustain the standard of living is at record levels. The chart shows the gap between the inflation-adjusted cost of living and the spread between incomes and savings. It currently requires more than $6500 of debt annually to fill the “gap.“

It Is Not The Same

While the Fed is currently engaged “in the fight of its life,” trying to quell inflation, The economic differences are vastly different today. Due to the heavy debt burden, the economy requires lower interest rates to sustain even meager economic growth rates of 2%. Such levels were historically seen as “pre-recessionary,” but today, they are something economists hope to maintain.

This is one of the primary reasons why economic growth will continue to run at lower levels. Such suggests we will witness an economy:

• Subject to more frequent recessionary spats,
• Lower equity market returns, and
• A stagflationary environment as wage growth remains suppressed while the cost of living rises.

Changes in structural employment, demographics, and deflationary pressures derived from changes in productivity will magnify these problems.

While many want to suggest that the Federal Reserve is worried about “That 70s Show,” we would be lucky to have the economic strength to support such a concern.

The Fed’s bigger worry should be when the impact of higher rates causes a financial break in a debt-dependent financial system.

Jerome Powell and the Fed have been pounding the “higher for longer” table to prepare the markets for a sustained period of high interest rates. Powell did not waiver from the stance at yesterday’s post-FOMC press conference. Until the last few months, the Fed Funds futures market didn’t agree with the Fed’s higher-for-longer mantra. However, the Fed’s consistent messaging, sticky inflation, and robust economic growth have the market rethinking its stance. For example, with Fed Funds at 4.25-4.50% last January, the odds of the Fed raising rates to its current level (5.25-5.50%) by year-end were only 1.5%. The odds greatly favored a 1% rate cut by year-end. Simply, the market did not believe in higher or longer.

The graphs below quantify how the market has adjusted to the Fed’s persistence since June. The left graphs show the odds of a rate increase at the next 3 Fed meetings and the following 7. The odds of another hike by January are clustered around 35% but have been slightly declining recently. Conversely, the odds of another hike between March and December 2024 are rising. The graphs on the right show the odds of rate cuts. The top chart shows the odds of a rate cut by January 2024 are now zero. They were nearing 50% in June. The odds of a Fed rate cut in March or May 2024 are falling. From July 2024 and out, the odds of a cut have been increasing. The bottom line is the market is estimating higher for longer until July 2024 but not ruling out higher for longer for the entire year.

What To Watch Today

Earnings

Economy

Market Trading Update

The market traded off yesterday following the Fed’s statement, which, unsurprisingly, was virtually no different than what was said last time. However, the projections seemed to startle the markets, with the central bank’s benchmark overnight interest rate peaking this year in the 5.50%-5.75% range, just a quarter of a percentage point above the current range.

“But from there, the Fed’s updated quarterly projections show rates falling only half a percentage point in 2024 compared to the full percentage point of cuts anticipated at the meeting in June.

With the federal funds rate falling to 5.1% by the end of 2024 and 3.9% by the end of 2025, the central bank’s main measure of inflation is projected to drop to 3.3% by the end of this year, to 2.5% next year and to 2.2% by the end of 2025. The Fed expects to get inflation back to its 2% target in 2026, which is a later date than some officials had thought possible.”

The trouble for the markets, of course, is that they have been banking on rate cuts sooner rather than later. As such, the “later” upset market participants, and duration-sensitive stocks, read Technology, came under pressure. Nonetheless, the market remains bullish for now, and the short-term sell signal suggests some continued sloppy action over the next week or so before earnings season can lift the bulls.

The Fed Statement and Jerome Powell

The Fed did not hike interest rates as was widely expected. The FOMC statement, redlined below by ZeroHedge, shows the Fed made minimal edits to the statement from the July 26 meeting. They acknowledge some slowing of job growth but that the labor market remains strong.

Powell’s comments were similar to his prior post-meeting press conference. Here are key takeaways:

• The full effect of rate hikes “remains to be felt.”
• He is determined to get inflation back to 2% as quickly as possible.
• There was unanimous support for no rate hike, but there seems to be less agreement about whether to hike at the next two meetings. Incoming economic data and perceived risks will determine upcoming decisions.
• “We are fairly close to where we need to get.”
• Jerome Powell says a soft landing is NOT his baseline expectation, but he didn’t expand on whether that implies a recession or a continuation of strong economic growth. That said, he stressed that a soft landing is the Fed’s primary objective.
• On numerous occasions, Powell mentions the lag effects and the risk they pose to the economy and Fed forecasts.
• Is stronger than historical GDP growth an impediment to getting inflation back to 2%? That question appears to be a primary Fed concern.
• The Fed is looking through recent increases in oil prices, but they will reconsider the risks if oil prices remain at current levels or higher. He reiterates core inflation, excluding food and energy, is their preferred method for assessing inflation.
• “The worst thing we can do is fail to restore price stability.” Their primary goal is to get inflation to 2%, and he stressed multiple times it will take precedence over economic weakness and higher unemployment.

Federal Reserve Economic and Rate Projection Revisions

Every quarter, the Fed releases its summary of economic projections, aka Fed dot plots. Investors compare the most recent release versus the prior one to help assess how the Fed’s collective mindset is changing. The four categories the Fed projects are GDP, unemployment rate, inflation, and Fed Funds.

The table below shows the latest projections and the changes from June. As we led with, “higher for longer” is the theme of the projections. To wit, the Fed Funds rate projection for 2024 and 2025 rose by .50%. Further, the 5.60% ending rate for 2023 implies they are forecasting one more rate hike this year. Of the projections of the 19 Fed members, 12 see one more rate hike, while seven think the Fed is done hiking for this cycle.

The reason for the higher for longer Fed Funds forecast is an increase in their GDP expectations for 2023 and 2024 and lower unemployment forecasts for 2023, 2024, and 2025. However, their inflation projections were largely unchanged. They reduced their core PCE forecast for year-end 2023 to 3.7% from 3.9% but increased the broader PCE forecast by a tenth of a percent. They do not appear worried about a resurgence in inflation, but their projections lead us to believe they are concerned they will linger above their 2% target.

Foreign Holdings of U.S. Treasurys Continue to Rise

For those claiming the world is moving away from the dollar as the world’s reserve currency, evidence of such action is hard to find. We have discussed de-dollarization numerous times and provided proof that even the loudest de-dollarization advocates are taking pro-dollar actions. The graph below furthers our claim that foreigners continue to require dollars. It shows that foreign holdings of U.S. Treasuries rose to $7.655 trillion in July, which is 2% higher over the last year, and sits just below all-time highs. If de-dollarization were the goal for some countries, they would have to sell U.S. Treasury securities to convert their reserves to another currency.

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In Our Elevator Pitch For Bonds, we ask, “is this time different.” 

Our view of the attractiveness of bonds can be honed into an elevator pitch. It essentially boils down to a straightforward question – Is this time different?

Have the forty-year pre-pandemic economic trends reversed, and the economy’s inner workings changed permanently over the last three years? expectations

More specifically, are slowing productivity growth, weakening demographics, and rising debt levels about to reverse their prior trends and become a tailwind for economic growth?

NO, this time is not different. Yesterday’s economic headwinds have not vanished. They will eventually overcome the massive pandemic-related stimulus that continues to prop up the economy.

This article employs a classic bond model that allows us to solve for the expected economic growth as implied by bond yields. As you will see, the bond market believes economic growth will be significantly higher than expectations for the last 20 years. If they are correct and this time is different, current bond yields may be fair or even too low. However, if this time is not different, the market is grossly offside in its growth expectations, and bond yields are too high.

Decomposing Bond Yields

U.S. Treasury bond yields are a function of three factors: term premium, inflation, and economic growth expectations. Because Treasury securities are considered risk-free, credit risk is not a factor. For more on that, please read our recent article, Risk Free Government Debt- Fact Or Fiction.

Term Premia

Term premium, also called term premia, is the amount by which the yield of a long-term bond exceeds the expected yields of short-term bonds. It quantifies the amount investors expect to be compensated for committing to one long-term interest rate versus a series of shorter-term interest rates.  

Term premia is not an exact science, but there are many models that calculate it, including the Fed’s Three-Factor Nominal Term Structure Model. We use this model to decompose yields later in this article.

The Fed model, graphed below, shows a steady decline in the term premium for the last 30+ years. Since rates have been reliably trending lower, long-term bond investors have been increasingly willing to accept less of a term premium because they expect short-term yields to continue to trend lower. As shown, the premium has primarily morphed into a discount since 2018. Such indicates that a series of short-term rates over the next ten years will average less than current long-term rates.

Inflation Expectations

Gauging inflation expectations is done via numerous surveys of consumers and business leaders. They can also be calculated through the difference between TIP and nominal bond yields. Further, the Fed updates its outlook for longer-term inflation rates quarterly.

This analysis uses the difference between TIPs and nominal bonds, known as the breakeven inflation rate. Unlike surveys and Fed estimates, the breakeven rate is based on investors and traders putting their money where their mouths are. Thus, we might claim it to be a little more credible.

The following graph shows the long-term trend in 10-year inflation expectations and the actual rate of inflation that followed in the subsequent ten years. Other than during recessions, the market tends to overestimate future inflation rates by a quarter to half a percent. The chart ends in 2013, as we do not have ten full years of future inflation data after that year. 

Economic Growth Expectations

The third factor is economic growth expectations. Like inflation expectations, there are many sources for this data.

To put context to our opening question, “Is this time different?” we solve for economic growth expectations using the Fed term premia model and ten-year breakeven inflation rates.

Before we look at expectations, let’s look at the historical economic growth trend.

As shown, real GDP has been trending lower since 1990. Assuming the trend holds, real GDP will average 1.65% over the next ten years. The trend currently resides at 1.90%.

Decomposing Bond Yields

The following graph uses the current ten-year yield and decomposes the rate based on term premia, inflation expectations, and the implied economic growth rate we solve for.

The following chart singles out real growth expectations (green above), which we solved for.

Bond yields imply the highest economic growth rate in the last 20 years!

The next graph allows us to compare growth expectations, as shown above, to the trend growth rate over the 20-year period.

The last time the bond market implied such a high forecast for economic growth was around the financial crisis and recession of 2008-2009. However, real GDP was trending 0.5% higher during that period than today. On a relative basis, the current expectation is .75% higher.

Our analysis assumes the Fed’s term premia and the market’s 10-year breakeven inflation estimates are correct. They are not, nor will they be accurate in the future. As a result, growth expectations, as we solve for, have been about 1.50% short of reality.

However, context is essential. While the growth estimate will likely be too low, the current deviation versus prior readings is what matters. Currently, yields imply almost 2.50% more growth than its average forecast for the last 20 years.

Summary

The bond market implies something has changed in the last couple of years to reverse the nation’s downward economic growth trajectory. There is nothing that leads us to that conclusion.

The pandemic only aggravated the debt burden, which reduces future growth rates. Demographics continue to worsen slowly, detracting from economic growth. Given debt, demographics, and other social and political factors, we see no reason productivity growth won’t continue to decline, which also weighs on economic growth.

Can AI be a productivity game changer and rationale for higher economic growth rates? Maybe, but productivity growth has declined over the last 25 years despite the internet, robotics, and numerous other productivity-enhancing inventions.

Can the economy grow 2.0% to 2.5% faster per year over the next ten years than the last 30 years? We don’t think so. Therefore, the graphs suggest ten-year yields are about 2.0% to 2.5% too high.

This time is not different, and bond yields are too high. 

Higher mortgage rates are resulting in a shortage of inventory of used homes and a surge in new homebuilding. Recent data shows a third of all homes for sale are new homes. That is almost three times the average ratio. While homebuilders have been taking advantage of the low inventory situation by offering home buyers reduced mortgage rates and other discounts, it appears they are starting to have concerns. The most recent NAHB builder confidence survey fell to 45. A reading below 50 means there are more homebuilders with negative sentiment than positive sentiment. Further, housing starts fell to their lowest level since June 2020, when the pandemic wreaked havoc on the economy. August annualized housing starts were 1.283 million on a seasonally adjusted basis. That is -11.3% below the downwardly revised 1.45 million from the previous month and expectations for 1.43 million.

The recent decline in homebuilder confidence and reduction in housing starts bodes poorly for the industry. From a macroeconomic perspective, housing is an excellent leading indicator of economic activity. As we outlined in Janet Yellen Should Focus On HOPE, “HOPE is an acronym describing the lags and the sequence in which economic activity typically weakens before a recession.” The “H” or leading indicator is housing. If existing home sales, housing starts, and homebuilder confidence continue to weaken while mortgage rates preclude buyers and sellers from transacting, the housing sector may suffer. Until mortgage rates decline, the problems are likely to continue.

What To Watch Today

Economics

Earnings

Market Trading Update

Yesterday’s market action was diametrically opposed to Monday’s as the market sold off early in the day only to stage a comeback rally by the end. Traders remain unwilling to take on any big bets ahead of the Federal Reserve’s interest rate decision this afternoon. The sloppy action continues for now, and while the market did trigger a short-term sell-signal, that signal is occurring from lower levels, suggesting downside risk is likely limited. Such continues to look like a market treading water until the Q3 earnings season begins in October. For now, continue to monitor risk and use current market weakness as an opportunity to rebalance portfolios as needed.

Bank Bailout- Six Months In and Six Months To Go

In March, the Fed was dealing with a banking crisis of its own making. The surge in interest rates caught many banks off guard. With deposits fleeing the banks for higher yields, banks were forced to sell assets. Most banking assets, be they loans or securities, were trading at discounts to their purchase prices. As a result, banks like Silvergate and Silicon Valley had to take bankruptcy-inducing losses to offset lost deposits.

Seeing the potential trouble of underwater bank assets, the Fed created the Bank Term Funding Program (BTFP). The facility allows banks to pledge Treasury bonds trading at discounts to par as collateral for loans based on the par value of the collateral. Three months into the program, the balances continue to grow, albeit slowly. The program ends in March. As such, we suspect the Fed will start to discuss their options. They can extend the program and roll over existing loans or terminate it. The program is a form of QE, so the Fed may perceive rolling over existing loans as inflation-inducing. However, terminating the program could lead to more bankruptcies.

Housing Update

Redfin puts out great commentary and statistics on the housing markets to help us navigate how high mortgage rates affect the sale and rental markets. As we have noted, 40% of CPI is tied to rents and rental prices imputed from home prices. As such, we thought it would be helpful to share a handful of charts and commentary from Redfin’s website.

Home prices are slightly higher year over year despite a substantial 14.5% drop in the number of homes sold. Home sales are seasonal. Therefore, comparing the recent peak in June to the prior June peaks is essential.

In regards to the supply of houses, Redfin says the following:

In August 2023, there were 1,514,235 homes for sale in the United States, down 18.6% year over year. The number of newly listed homes was 536,703 and down 13.3% year over year.The median days on the market was 30 days, up 4 year over year. The average months of supply is 2 months, down year over year.

Essentially, the housing market is at a standstill. Existing homeowners are finding it tough to sell houses despite high prices because they do not want to give up their very low mortgage rates. On the flip side, home buyers are finding homeownership expensive due to high prices, limited supply, and high mortgage rates.

In regards to the recent migration trends, we continue to see movement from the northeast, California, and upper midwest to the south. The data is from the last three months but replicates recent longer-term trends.

Politics, taxes, cost of living, and weather are leading factors in the migrations. However, some that have moved may be trading those issues for new ones, as we share below.

The final graph shows rental prices. The good news is that rents are flat year over year. As such, the contribution to annual CPI inflation is zero. However, recently, rents have been increasing and remain significantly elevated from pre-pandemic levels. The CPI data on rents lags significantly from the graph. Therefore, the next four to six CPI reports will show rental prices declining despite the evidence below that they are rising again.

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While September has been a bit sloppy so far, will further weakness in October weigh on investor sentiment before the seasonally strong period begins? As shown by the S&P 500 index seasonality chart below, weakness in the last two weeks of September and the first two weeks of October is common. However, we must also understand that the big down move in the market during that period came from historical crashes such as the “Financial Crisis” in 2008. Excluding those periods, the market still tends to be weak but more flat in nature.

Just as a reminder, the historical analysis suggests summer months of the market tend to be the weakest of the year. The mathematical statistics prove this as $10,000 invested in the market from November to April vastly outperformed the same amount invested from May through October. Interestingly, the max drawdowns are significantly larger during the “Sell In May” periods. Previous important dates of major market declines occurred in October 1929, 1987, and 2008.

So far this year, the May through October period remains about average, with a return through last Friday of 6.74%. Even if there is some additional weakness, the overall period should still be a “win” for investors. However, as noted, the weakness came a bit late this year, with a 5%ish correction starting in August.

However, this is a bit deceiving. As we noted previously, much of the gain in the market this year has come from essentially ten stocks that have the largest concentration, in terms of market capitalization, in the index. The surge in those stocks has skewed the performance of the broad market index. The performance of the bottom 490 stocks remains markedly different.

Looking at the performance of the equal-weighted index from May to the present, we see the seasonal market weakness more clearly. While still positive, the return so far is about 200 basis points weaker.

So, as we begin to wrap up the seasonally weak period for stocks, what will potentially be the market drivers into year-end as the seasonally strong period begins?

Driving Ms. Daisy

Three primary drivers will likely drive markets from the middle of October through year-end.

The first is earnings season, which kicks off in two weeks. As is always the case, analysts have significantly lowered the “earnings bar” heading into reporting season. As noted in “Trojan Horses,” analysts are always wrong, and by a large degree.

“This is why we call it ‘Millennial Earnings Season.’ Wall Street continuously lowers estimates as the reporting period approaches so ‘everyone gets a trophy.’” 

The chart below shows the changes in Q3 earnings estimates from February 2022, when analysts provided their first estimates.

Of course, with the bar lowered, such will generate a high “beat rate” by companies, which will help fuel stock prices in the short term. Notably, those “high beat rates” get support from the more negative short-term sentiment and reduced equity allocations by professional managers during the summer. As stocks start to move higher, professional managers will begin to chase performance, pushing prices higher.

Given the large divergence between the market and equal-weighted indices this year, there is additional pressure on managers to “catch up” with performance moving into year-end reporting. Given the “career risk” to managers of significant underperformance, additional buying pressure could manifest.

Lastly, corporate share buyback windows will reopen in November and December as companies exit their earnings “blackout period.” Notably, as shown in the table below, the last two months of the year represent the best two-month period of the year for corporate executions. Such is because corporations have a clear picture of their current financial positions and can use stored cash to execute buybacks. As noted by Goldman Sachs:

“The VWAP machines will be lining up to buy $5bn worth of equities daily during November and December.”

Yes, that is $5 billion each trading day, which provides sufficient buying power to lift asset prices into year-end.

Don’t Forget About The Risks

A reasonable backdrop between the summer selloff, sentiment, positioning, and buybacks suggests a push higher by year-end. Add to that the performance chase by portfolio managers as they buy stocks for year-end reporting purposes. As Goldman’s flow guru Scott Rubner points out:

“Since 1900, the average Q4 return for SPX when the market returns for the first three quarters of the year were greater than 10%, fourth quarter returns were stronger than average coming in at 4.6%.”

While the backdrop certainly supports a rally into year-end, such is not guaranteed. However, the potential risk of elevated interest rates, slowing economic data, and tighter financial conditions should not be dismissed.

One of the things we continue to keep a very close watch on is the extremely suppressed level of market volatility. While the markets are indeed acting bullishly, extremely low levels of volatility are a warning. As shown below, previous periods of low volatility eventually led to periods of higher volatility.

While such low levels of volatility can certainly last longer than many expect, it is inevitable that, eventually, we will have a reversal. When that will happen, or what will cause it, is always unknown, but such a reversal is almost assured.

For now, an ongoing bullish bias continues to support the market near-term. Bull markets built on “momentum” are very hard to kill. Warning signs can last longer than logic would predict. The risk comes when investors begin to “discount” the warnings and assume they are wrong by suggesting “this time is different.”

There is little to lose by paying attention to “risk.”

If warning signs prove incorrect, removing hedges and reallocating into equity risk is simple.

However, if warning signs come to fruition, a more conservative stance in portfolios will protect capital in the short term. Reducing volatility allows for a logical approach to making further adjustments as the correction becomes more apparent. (The goal is not to be forced into a “panic selling” situation.)

It also allows you the opportunity to follow the “Golden Investment Rule:” 

 “Buy low and sell high.” 

Nick Timiraos of the Wall Street Journal published an article entitled Why A Soft Landing Could Prove Elusive. His lead sentence and the graph below speak volumes about the accuracy of headlines about soft landings. He starts: “On the eve of recessions in 1990, 2001, and 2007, many Wall Street economists proclaimed the U.S. was on the cusp of achieving a soft landing, in which interest-rate increases corralled inflation without causing a recession.” The graph below shows that headlines referencing a soft landing are most common before recessions. Of the four increases in soft landing headlines, 1995 was the only one that proved accurate. There have been 144 headlines about a soft landing between last year and this year. That exceeds the prior instances going back to 1985.

Nick offers caution that the surge in soft landing headlines may be a precursor for a hard landing. In his opinion, “Here is what could go wrong this time”:

• The Fed has already raised rates too aggressively and will pause longer than needed.
• The economy stays hot, forcing the Fed to raise rates more.
• Energy prices continue higher, both hurting economic growth and pushing inflation higher. Thus, the Fed would be less likely to ease if need be.
• Financial Crisis. The U.S. financial system is more leveraged now than at any other time. Higher rates will eventually force a deleveraging and likely financial crisis.

What To Watch Today

Earnings

Economy

Market Trading Update

Unsurprisingly, the market traded sloppily yesterday, with stocks rallying in the morning but selling off into the afternoon to end up virtually flat for the day. Small and Mid-Cap stocks were the worst performers, with Apple (AAPL) and Google (GOOG) holding up the large-cap indices. With the Federal Reserve’s FOMC policy meeting this week, traders will be unwilling to take on large bets ahead of that announcement. While it is widely anticipated the Fed will do nothing and mostly reiterate prior statements of being data-dependent and higher-for-longer, there is still a risk of an unanticipated statement or action. Expect further weak trading action today ahead of the policy announcement tomorrow.

Buyers Strike For Treasury Bonds?

Some claim there is a buyer’s strike for Treasury bonds. One way to check the veracity of such claims is to observe the bid-to-cover ratio for Treasury auctions. As shown below, the bid-to-cover ratio for 10-year notes and its moving average has been stable and in line with the ratio of the last ten years. The ratio measures the number of bids at the Treasury auctions versus the amount of bonds being auctioned. Further evidence is found in our Tweet of the Day. As it shows, the inflows into Treasury bond ETFs dwarf anything experienced in the last fifteen years. We caution, however, how much of the inflows are going to very short-term bond ETFs, which act as money market surrogates.

Consumer Inflation Expectations Fall As Oil Rises

Despite $4+ gasoline at the pumps and the price of crude oil rising above $90 a barrel, consumer expectations for inflation are falling. We are a little surprised as there tends to be a decent correlation between gasoline prices and consumer inflation expectations. The most recent University of Michigan five-year inflation forecast fell from 3.0% to 2.7%. The Fed considers inflation expectations an important guide to future inflation rates. As such, the latest Michigan reading may help ease some nerves at the Fed that inflation has started to rise again.

The following graphs provide context for the relationship between the Michigan 5-year inflation survey and actual 5-year inflation rates. The scatter plot shows a decent correlation (R-squared =.55) between expectations and actual inflation readings. However, the period we offer saw little volatility in inflation rates. The second graph shows that the survey tends to overestimate inflation by .50% to 1.00%.

UAW Strike Update

The United Autoworkers Union (UAW) rejected the latest proposal from Stellantis (STLA- aka Chrysler), which means the strike against the Big 3 continues. Stellantis offered a 21% pay increase, in line with Ford’s (F) +21% and General Motors (GM) +20%. The UAW has come down from 40% to 36%, but a wide gap still exists. Fortunately, the UAW is only calling for small strikes at certain plants. If the number of strikes escalates, more employees join the picket line, and the situation persists, we will see a more noticeable economic impact. It will be interesting to see if Jerome Powell opines on the situation on Wednesday.

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The travel and leisure sector is one of the hottest industries driving job growth. Since the pandemic, the travel and leisure industry added one million jobs, equating to 6% growth, about double the labor market’s growth over the same period. While the industry has greatly benefited from the resumption of regular travel and leisure activities, the airlines have yet to recover. TSA reports that the number of air travelers in the U.S. for 2023 to date is up less than half a percent versus the same period in 2019. Per the Department of Transportation, average airline fares in the first quarter of 2023 are up about 10% versus the same quarter in 2019. However, on an inflation-adjusted basis, they are down 8%. The graph below shows the major airlines are still down 30-60% from the pre-pandemic peak. Over the same period, the S&P 500 is about 40%.

Labor and fuel account for over 50% of airline expenses. Per the BLS, the number of workers employed in the airline industry is up by less than 10% since the pandemic. However, the median wages for pilots and engineers are up over 30%. Also problematic, jet fuel prices are up over 80% since January 2020, despite crude oil only rising 11%. The bottom line is profit margins for the airline industry are getting squeezed. Before the pandemic, the aggregate margin (net income to sales) for the four stocks graphed hovered between 7% and 8%. Over the last 12 months, it is a mere 2.25%, which compares favorably to the previous two years. While the travel industry has recovered, airlines continue to struggle.

What To Watch Today

Earnings

• No notable earnings releases

Economics

Market Trading Update

As we noted last week,

“The more extreme overbought condition is about halfway through a corrective cycle, suggesting we could see further “sloppy” trading next week. With the market holding within a consolidation range, a breakout to the upside should confirm the start of the seasonal strong trading period into year-end.”

Such remained the case this past week. Friday was particularly choppy as one of the largest options expiration days on record. With nearly $3.2 Trillion in options expiring, stocks traded negatively for the day.

Unsurprisingly, given the recent performance of the mega-cap stocks, which has recently attracted most of the liquidity flows, the selling pressure was primarily contained within those names, with value stocks outperforming for the day. However, the market held support at the 50-DMA on Friday, with the overall price conditions remaining neutral. Like a groundhog that sees its shadow, the MACD signal is close to registering a “sell signal.” If the signal triggers it could signal a couple of additional weeks of sloppy trading action heading into October. Such would be consistent with seasonal weakness before heading into the last trading quarter of the year.

For now, there is no change to the bullish backdrop of the market, and nothing suggests a need to become more cautious near term. It is always possible that analysis could change over the next couple of weeks, and if it does, we will suggest reducing equity exposure and becoming more cautious.

The Week Ahead

This week’s highlight will be Wednesday’s FOMC meeting statement and Powell press conference. Despite relatively strong economic data and inflation data slightly above expectations, the market continues to assign a near-zero chance they hike rates. The Fed will also update its projections for GDP, unemployment, inflation, and the Fed Funds rate. The table below shows the projections from June. Any changes to their inflation and Fed Funds forecasts are likely to have a market impact. Fed members will be open to speaking following the meeting. Accordingly, we suspect their thoughts will help better assess the odds of a November rate hike. Currently, it stands around 50%.

Volatility Is Back To Pre-Pandemic Levels

Volatility (VIX) has fallen to its lowest level since the pandemic started. While low volatility is a sign of complacency and is typically followed by periods of high volatility, it can remain suppressed for long periods. As shown below, the current VIX level preceded surges in the VIX. Yet it is also the norm for the better part of 2013 to 2019 and the two years leading up to the financial crisis.

The second graph shows the continuous ninth VIX futures contract. This contract covers the implied volatility for nine months forward. This contract is a key factor driving costs for longer-term option protection.

Treasury Return Scenarios

A reader asked us if we could quantify the potential performance of Treasury bonds given changes in yield levels. The table below shows the potential performance is skewed to the upside. This occurs because the high current yields cushion price declines if rates rise. The formula to approximate the one-year expected total return is the yield plus the change in rate times the bond’s duration.

As we show, two-year note yields can rise 2%, and the 5.01% yield offsets the potential decline in its price. At the other end of the maturity spectrum, a 2% decline in 10-year rates will result in a 20% gain, nearly double the potential loss if rates rise by the same amount.

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The term “Bond Vigilantes” is a nostalgic twist on an old-west theme. In the nineteenth century, the American West formed self-appointed groups, or committees, to seize the duties of law enforcement and judicial authority in situations when citizens found law enforcement lacking or inadequate.

In the bond market, the term “Bond Vigilante” was first coined by Ed Yardeni in 1980 when bond traders sold Treasurys in response to the growing power of the Federal Reserve and its policies on the U.S. economy. (Sound familiar?) According to Investopedia:

“A bond vigilante is a bond trader who threatens to sell, or actually sells, a large number of bonds to protest or signal distaste with policies of the issuer. Selling bonds depress their prices, pushing interest rates up and making it more costly for the issuer to borrow.”

If the “Sheriff” in town isn’t doing their job, the premise is that holders will become “Bond Vigilantes” and “take the law into their own hands.”

Over the last couple of years, the fear of “Bond Vigilantes” has returned with the surge of inflation since 2022. Even Ed Yardeni, the economist who coined the term “Bond Vigilantes” and has regularly predicted their return to the investment landscape ever since, says they’re “saddling up.”

The problem is that the expected return of the “Bond Vigilantes” is flawed as it is based on the premise that those vigilantes have the power to “take the law of monetary policy into their own hands.”

“Shorting government bonds when the central bank is politically aligned with the Treasury is a sure-fire way to lose lots of money. The consolidated government’s balance sheet consists of IOU liabilities that it can manufacture in infinite quantities. Why would anyone think they can win that game? It’s like my writing  IOUs for blog points. Maybe I write more than I can ever cover for. But I create the points. I can always create more. if I write too many, their value depreciates.” – Credit Writedowns, circa 2011.

As shown in the chart below, since 1980, betting on the return of the vigilantes has been a losing bet. (It is worth noting that previous spikes in the annual rates of change in rates preceded either financial events or recessions. The current episode is magnitudes more significant than any prior event since 1954)

Lastly, if you are betting on the return of the vigilantes, the track record of betting against the bond market since 1787 remains quite dismal.

The biggest flaw in the “return of the Bond Vigilantes” theory remains the “Town Sheriff.”

The Central Bank Sheriffs

As noted above, since 1980, the Federal Reserve has been a critical player in the bond market. Either through monetary policy changes, raising or lowering interest rates, or, as seen since 2008, directly intervening in the bond market. Those actions by the Federal Reserve were always in response to a financial event, crisis, or recession.

While Central Banks have always been the “Sheriff” in town, the “Bond Vigilantes” can run amok for a while before finding themselves on the wrong end of the hangman’s noose. Such has mainly been the case following the Financial Crisis in 2008.

“Earlier this year, the world’s most famous bond investor, Bill Gross, was short U.S. government debt. He was hailed as THE VIGILANTE by Megan McArdle at The Atlantic. At long last, it seemed, the long-dormant bond vigilantes had arrived on horseback, ready to force the U.S. government into austerity.” – Business Insider, 2011

Of course, that venture by Bill Gross backfired as Central Banks repeatedly stepped in. To quote the President of the European Central Bank, Mario Draghi.

“We will do whatever it takes to preserve the continent’s common currency.”

Doing “whatever it takes” has not been just the stance of the ECB “Sheriff,” but every major Central Bank since 2008. As discussed in “Deficit Surge:”

“Many ‘bond bears’ suggest that rates must rise as deficits increase and more debt is issued. The theory is that at some point, buyers will require a higher yield to buy more debt from the U.S. Such is perfectly logical in a normally functioning bond market where the only players are the individual and institutional bond market players. In other words, as long as ‘all else is equal,’ rates should rise in such an environment.“

All Else Is Not Equal

However, all else is not equal in a global economy where government debt yields are controlled by Central Banks colluding with Governments to maintain economic growth, control inflation, and avoid financial crises.

This monetization of debt issuance to support anemic economic growth, suppress inflationary forces, and depress borrowing costs will not change in the future. The biggest problem with the “Bond Vigilante” thesis is the inability of the economy to sustain higher rates due to mounting debt issuance and rising deficits. The chart below models the CBO analysis using the growth trend of debt but also includes the need for the Federal Reserve to monetize nearly 30% of the issuance.

At the current growth rate, the Federal debt load will climb from $32 trillion to roughly $140 trillion by 2050. Concurrently, assuming the Fed continues monetizing 30% of debt issuance, its balance sheet will swell to more than $40 trillion.

While you may think such is unsustainable, there is a clear example of why “Bond Vigilantes” keep getting arrested.

Japan Is A Good Example

Since 2008, Japan has run a massive “quantitative easing” program. That program, on a relative basis, is 3-times more extensive than in the U.S. Not surprisingly, economic prosperity is only marginally higher since the turn of the century. Nonetheless, if the thesis of “Bond Vigilantes” is valid, and if they exist, then Japan should be fighting significantly higher interest rates and inflation, given a debt-GDP ratio of more than 210%.

Surprisingly, there is no evidence of such. Maybe the situation would be markedly different if the Bank of Japan (BOJ) didn’t own most ETF, corporate, and government debt markets. However, such is also why Japan continues to be plagued by rolling recessions, low inflation, and low-interest rates. (Japan’s 10-year Treasury rate fell into negative territory for the second time recently.) 

While many argue the U.S. economy will eventually “grow” its way out of debt, there is no evidence such a capability exists. We know that interest rates in the U.S. and globally are telling us economic growth will remain weak in the future. While the recent surge in U.S. interest rates resulted from massive one-time liquidity injections, the similarities between the U.S. and Japan remain a stark reminder of where interest rates will ultimately be.

The reality is that each time interest rates tick higher, the rumors of the return of the “Bond Vigilante” surface. In the short term, it may seem like they are moving markets. However, eventually, the “Sheriff” will arrive to reassert its force on the markets. This isn’t a good thing, as noted by my colleague Doug Kass:

“The fact is that financial engineering does not help an economy, it probably hurts it. If it helped, after mega-doses of the stuff in every imaginable form, the Japanese economy would be humming. But the Japanese economy is doing the opposite. Japan tried to substitute monetary policy for sound fiscal and economic policy. And the result is terrible.”

Japan is a microcosm of what the U.S. will face in the coming years.

As in the play by Samuel Beckett, those waiting for the “Bond Vigilantes” to arrive may just as well be waiting on Godot.

“Based on its current assessment, the Governing Council considers that the key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to target.” And with that statement, the European Central Bank (ECB) appears to have halted its rate hiking cycle. The announcement followed a surprise rate hike from 4.25% to 4.50%. Unlike the U.S. economy, Europe has witnessed sluggish economic growth. To wit, the ECB reduced their economic growth forecasts, cutting this year to +0.7% and reducing next year from +1.5% to +1.0%. The underlying message in today’s announcement is that they appear comfortable that weak economic growth coupled with high-interest rates will, in time, reduce inflation back to normal levels.

So, what might this mean for the Fed? For starters, central banks often coordinate their actions. With next week’s Fed meeting, some Fed watchers must now think the Fed takes a similar step. However, based on everything Powell has said, he will likely maintain the threat of higher interest rates until inflation is back to 2%. Letting up on his inflation vigilance could prove troublesome. If he follows the ECB, he risks roiling the bond markets and reigniting the regional banking crisis. We think they keep its “higher for longer” messaging until inflation reaches its target, the economy falters, or a financial crisis erupts. The Fed Funds futures market doesn’t expect the Fed to hike rates next week. The odds (orange) of a rate hike are 6%. The November odds are also the same as before the ECB, meaning the market doesn’t expect the hiking cycle to end.

What To Watch Today

Earnings

• No notable releases today

Economy

Market Trading Update

Despite two stronger-than-expected inflation reports, the market traded strongly higher on bets the Federal Reserve is done hiking rates. The market held support at the 50-DMA, and the rally kept the “buy signal” intact. With the market not overbought, there is further room for the market to rally into the end of the month. With volatility suppressed and volume light, there is certainly a risk of something cracking the market. Therefore, we continue to suggest remaining somewhat cautious on allocations but continue to maintain target weight exposures for now.

ARM IPO- The Next Nvidia?

SoftBank took ARM private seven years ago and is now selling some of its shares back to the public market via an IPO. The ARM IPO was priced at $51 per share, valuing the company at $54 billion. ARM’s IPO is well followed as their technology is used in almost 100% of mobile phone processors. Further, they are moving to design more chips for data centers and AI applications. Per Reuters:

Arm has told potential investors that the cloud computing market, of which it has only a 10% share and therefore more room to expand, could grow at an annual rate of 17% through 2025, mainly due to advances in artificial intelligence.

Given the recent hype around AI, its valuation is similar to Nvidia’s. Accordingly, per CNBC, ARM’s P/E based on the IPO price is approximately 104, just slightly below Nvidia’s 108. Apple, Google, Nvidia, and Samsung are among ARM’s largest clients, and all have said they will buy shares. While it may be tempting to buy the IPO and ride the AI wave, one should ask why, with such excellent prospects, SoftBank sold some of its stake in the company. As shown below, ARM shares rose by about 25% above the IPO price. Such a premium is common, but often, it is erased in the following weeks and months.

The Stimulus That Keeps Stimulating

The following joke helps us appreciate why the pandemic-related stimulus from 2020 and 2021 continues to buoy the economy.

Two economists are walking in the woods and come across a pile of bear poop. The first economist offers the second economist $100 to eat it. The second economist eats the pile of poop and collects his $100. They walk a little further and stumble upon another pile of poop. This time the second economist offers the first economist $100 to eat it. The first economist eats it and takes the $100.

They walk a little more and one economist turns to the other and says “I gave you $100 to eat poop and then you gave me back $100 to eat poop. I can’t help but feel like we both ate poop for nothing.” That’s not true, says the first economist, “we increased GDP by $200.”

The point of the joke is that monetary velocity matters. Velocity measures how often dollars circulate in the economy. For example, if the government paid every citizen a million dollars and they all kept the money in their sock drawers, the monetary velocity of the stimulus would be zero, as would the economic benefit. Conversely, if everyone immediately went out and bought something, and then those they purchased from spent the money, and on and on, GDP would skyrocket. We have written about the importance of monetary velocity (HERE and HERE). These articles and others show how the combination of the money supply and monetary velocity determines inflation.

As the joke alludes, velocity also significantly affects GDP. It also helps further explain why we see such a lag between higher interest rates and economic weakness. Overconsumption is a well-known behavior resulting from the pandemic. Therefore, the stimulus dollars keep circulating and likely will until behaviors normalize.

As we show, two measures of the annual change in monetary velocity are at 60+ year highs.

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Ford, GM, and Stellantis (Chrysler), aka the “Big 3,” are in around-the-clock negotiations with the UAW as they approach a deadline at midnight tonight. Without an agreement by midnight, the UAW will order its members to strike. At risk, potentially 100,000 fewer cars would be produced per week, and nearly 150k workers would be temporarily unemployed. Earlier this week, the UAW turned down a 10% increase in wages. Further, they called the offer from the Big 3 “insulting.” That said, the UAW admits they are making headway with the auto companies.

If a strike occurs and lasts over a few weeks, the economy will undoubtedly feel the adverse effects. Consequently, Goldman Sachs forecasts a strike would reduce GDP by 0.05% to 0.10% per week on an annualized basis. A prolonged strike puts the Fed in a bind. A production setback would reduce the supply of cars on the market. In turn, this results in new and used car inflation and also weighs on economic activity. The graph below shows investors in Ford and GM have discounted share prices sharply from early July highs, but they have stabilized recently. Stellantis (STLA) has held up better in the face of a UAW strike. Specific terms of an agreement will likely determine the path for the stocks once the situation is resolved.

What To Watch Today

Earnings

Economy

Market Trading Update

Despite the CPI rise yesterday, the bond and stock market responded positively. Stocks traded mostly higher during the day, and bonds, which started off weak, rallied into the close. Yesterday’s action did nothing to change our outlook short-term, and the data suggests the Fed will likely remain on hold for now. Today is the PPI reading, which, like CPI, the Fed will look at the core reading. If PPI comes in hotter than expected, we could see pressure on both stocks and bonds. Trading volumes remain light, so a pick-up in volatility is certainly likely short-term. For now, keep a watch on the bullish trend line as an indicator for a change from the current bullish outlook to more bearish.

CPI Rising, But Core CPI Is Falling

The bad news in yesterday’s CPI report is that the monthly rate of CPI for August rose 0.6%, which equates to 7.2% on an annualized basis. A sharp increase was expected. Year over year, CPI rose to 3.7%. The good news is that core inflation (excluding food and energy), the Fed’s preferred gauge, was only up 0.3% monthly, and it continues to fall on a year-over-year basis, from 4.7% to 4.3%.

Gasoline and food prices were primarily responsible for the jump from the prior month. In fact, gasoline accounted for over 50% of the increase. Interestingly, commodities less food and energy fell for the third month in a row. The second graph below shows fuel prices may continue to rise in the next couple of CPI reports as they lag actual fuel prices.

Most investors and economists focus on monthly and yearly data. However, we feel the best gauge is annualizing the most recent three months of data. Such a calculation captures current inflation trends but is not overly impacted by single-month anomalies or events from a year ago. As shown below in orange, this method highlights that the annualized three-month rate of CPI inflation is 2.41% and back within the pre-pandemic range.

Despite the increase in CPI, the market still assigns a meager 5% chance the Fed will hike rates next week. Following the inflation data, the odds of a rate hike in November increased slightly from 40% to 44%. Further, the stock and bond markets didn’t seem concerned with the data.

Oil Supply Squeeze

Given supply-demand dynamics, the rising oil prices, as documented above, should not be surprising. The Saudi and Russian production cuts, the limited ability of the administration to release more oil from the strategic reserves (SPR), and reduced investments in new production due to tighter regulations and the push for alternatives are resulting in a lack of supply. Per the Bloomberg graph below, global oil markets face a supply shortfall of more than 3 million barrels a day next quarter. They claim it is potentially the biggest deficit in more than a decade.

The second graph shows that the SPR, America’s oil piggy bank, only has 760 million barrels of oil, equating to about 45 days worth.

Small Business Point to Slowing Job Market

The latest NFIB survey shows a weakening labor market among small businesses. Small businesses account for almost 50% of the workforce. The percentage of those surveyed with at least one unfilled job opening is down to 40%, slightly above where it stood on the eve of the pandemic. Recently, labor productivity has been declining. The NFIB report helps explain why. Per the report, 24% of firms report labor quality as their number one problem, and 8% say labor costs are their biggest problem. Both reside very close to 50-year highs.

The second graph, Courtest of Ed Yardeni, shows the strong inverse correlation between NFIB job openings and unemployment. Assuming it holds, unemployment should rise, and a recession is likely to follow. Further supporting evidence for a weaker job market, the third graph shows that job creation plans are at eight-year lows.

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Tesla (TSLA) shares jumped 10% on Monday, gaining over $50 billion in market cap in one day. For perspective, Ford has a market cap of $48 billion. Fueling investor optimism was a Morgan Stanley research report upgrading Tesla’s share price to $400. Such is a nearly 50% increase over where TSLA shares currently trade. In late 2021, TSLA shares peaked at $400. Because of its valuation at the time, TSLA stock was priced at multiples of its competitors, surpassing every other automaker’s aggregate market cap. Prior investor expectations for tremendous growth and industry dominance were mainly based on EV auto sales.

Morgan Stanley thinks TSLA will have a distinct advantage in autonomous cars, specifically in artificial intelligence (AI). Per the article’s opening: “The autonomous car has been described as the mother of all AI projects. In its quest to solve for autonomy, Tesla has developed an advanced supercomputing architecture that pushes new boundaries in custom silicon and may put Tesla at an asymmetric advantage in a $10 trillion TAM.” TAM stands for the total addressable market. The auto industry makes about $2.5 trillion in revenue annually. Companies like Tesla, involved in AI, have seen their shares surge. The question facing Tesla, Nvidia, and other AI leaders is, can profits ultimately catch up with such massive valuations? Also, consider if AI companies meet their grand expectations; competing companies that cannot innovate quickly enough will fail.

What To Watch Today

Market Trading Update

Credit Availability Adds To The Lag Effect

When most people talk about the lag effect, they are primarily concerned with higher interest rates and how they dampen economic growth and dissuade spending. There is a second component that is important but not often appreciated enough. The shape of the yield curve plays a significant role in bank profits. Bank profitability and perceived credit risk are big factors driving a bank’s desire to lend money.

Inverted yield curves make borrowing short and lending long less profitable and sometimes unprofitable for banks. Further, inverted yield curves always lead to recessions. Consequently, not only are profits limited, but credit risk will increase on loans made during these periods when the recession does occur.

The graph below from the Daily Shot shows credit availability is harder today than at any point in the last ten years. So, while higher interest rates disincentivize borrowing and spending, some borrowers are also finding it more difficult to borrow.

A Unique Perspective On Unemployment

The graph below, courtesy of Trading View, presents the unemployment rate in a unique format. Instead of showing the actual rate, the unemployment rate is subtracted from 100, which inverts the line from what we are used to seeing. The graph is a mirror image of the traditional unemployment rate presentation, but one thing becomes more noticeable in this format. The unemployment rate is always rising or falling. It spends very little time consolidating at the same level.

Economic prognosticators with a soft or no landing consensus must believe, by default, that unemployment will consolidate at 50-year lows. History thus far proves that doesn’t happen. Might this time be different?

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Despite surging interest rates, there are few signs they are impeding economic activity or causing distress amongst borrowers. It may seem strange that higher rates are not proving troublesome for an economy with such a high amount of leverage. Don’t breathe a sigh of relief quite yet. There is often a delay, called the lag effect, between higher interest rates and economic weakness.   

Changes in interest rates only impact new borrowers, including those with maturing debt who must reissue debt to pay back investors of the maturing bonds. Accordingly, higher rates do not impact those with fixed-rate debt that is not maturing. The lag effect occurs due to the time it takes for the new debt issuance to bear enough weight on the economy to slow it down.

The graph below shows the Fed Funds rate and the time, as measured in months, from the last in a series of rate hikes preceding each recession since 1981. The average delay between the final rate increase and recession has been 11 months. The last Fed hike was in July 2023. Assuming that was the Fed’s final rate increase for this cycle, it may not be until June 2024 before a recession occurs.

This so-called lag effect is even more pronounced when rates were very low for extended periods before the rate hikes.

We examine government, corporate, and consumer debt to appreciate the current lag effect and better gauge when it will rear its ugly head.

Government

There is over $32 trillion of U.S. Treasury debt outstanding. Simple math asserts that each 1% increase in interest rates pushes the government’s interest expense up by $320 billion. That math is wrong.

The reality is only a small portion of the federal debt matures in any given month and must be reissued. Further complicating matters, some maturing debt was issued when interest rates were similar to or higher than current levels. For instance, the 30-year bond issued on August 16, 1993, with a coupon of 6.25%, just matured in August. Reissuing debt to replace the bond saved the government about 2% on $11.50 billion, or $230 million.

In our article, The Government Can’t Afford Higher For Longer, we quantified how rising interest rates affect and will affect the government’s interest expense. As we share below, its interest expense will increase more between 2022 and 2024 than in the 51 years prior!

Higher interest rates are unsustainable for the government. A $2 trillion deficit, as we have now, during a robust and peace-time economy with high-interest rates will force the government to cut its spending. While that is good in the long run, it hurts the economy in the short run. Ergo, as each month passes and interest expenses consume more of the deficit, government spending in other areas is likely to slow.

Rather than reduce spending, the easier, albeit fiscally irresponsible, way to keep running massive deficits is to ensure inflation normalizes so rates can drop significantly and interest costs are not burdensome. That has been the Fed and Treasury playbook for the last 30 years and will continue.

Corporate Debt

In aggregate, higher interest rates are currently helping corporate borrowers. As the graph below from Albert Edwards shows, net interest payments for U.S. corporations have fallen while Fed Funds have risen significantly. We touched on this graph in a recent Commentary titled Albert Edwards Ask What On Earth Is Going On?

To help explain why higher interest rates are currently helping corporations, consider the following quote per our article:

Albert surmises that many companies borrowed heavily in 2020-2021 at very low-interest rates, and the proceeds remain in deposit accounts earning more than the interest on the debt. Consequently, net interest is reduced.

The following graph, also from our Commentary, shows that such a circumstance is common when the Fed raises rates. The red circles highlight four instances in which interest costs as a percentage of profits fell while the Fed was hiking rates. The yellow circles show that interest expenses lagged but rose after the Fed stopped raising rates.

Such is the lag effect. Most companies spread out their debt, so only a small amount matures in any year. Therefore, it can take time until more expensive debt replaces cheaper maturing debt

The tweet below shows a wall of maturing debt is approaching quickly.

The following graph, courtesy of Game of Trades, shows what will happen to corporate interest expenses over time if rates stay at current levels. As it shows, corporate interest expenses will triple!

Individuals

The impact on individuals is similar to corporations and the government. Marginal purchases on credit result in the financial recognition of higher interest rates.

The graph below shows the weighted average mortgage rate. Currently, mortgage rates are well over 7%, about 4% higher than the lowest mortgage rates set in early 2022. Despite the sharp increase, the weighted average rate has barely ticked up. Only those buying houses are affected by the new mortgage rates, and there aren’t many home buyers. Existing home sales are at levels last seen during the depth of the financial crisis.

Unlike houses, cars do not have as long a shelf life. Per a recent study by ISH Markit, the average length of car ownership is 79 months or just over 6.5 years. As such, about 15% of car owners will have to pay cash or borrow at high auto loan interest rates.

Interest rates on credit cards float monthly. Therefore, cardholders who do not pay their entire balance monthly are immediately impacted by higher rates. According to the Fed and shown below, the average credit card interest rate is 21%, up over 6% since the Fed started raising rates. Credit card rates have risen significantly more than U.S. Treasury rates and Fed Funds.

Record Low Rates Before 2022 Increase the Lag

When contemplating how corporations and individuals have thus far insulated themselves from higher interest rates, consider that when interest rates are held low for long periods, the weighted average rate for every type of loan is lowered. The longer, the more borrowers benefit. And, the less borrowers are immediately impacted by higher interest rates.

As we showed, sub 3% mortgages in 2020 and 2021 and meager rates before the pandemic allowed a large majority of borrowers to extend their debt and avoid, for a period, the wrath of higher interest rates.

Over time, however, corporate and government debt matures, people need new cars or houses, and the reality of higher interest rates hits.

Summary

The lag effect is a ticking time bomb. Each day that passes, another borrower feels the impact of higher interest rates. The financial impact is slow but steadily increasing. Also, remember that the various types of pandemic-related stimulus are quickly exiting the economy. Normalizing economic activity and the slow but steadily growing lag effect will likely result in a recession.  

Given the leverage the economy depends upon, “higher for longer” is not possible without breaking something.  

“(Market) Predictions Are Difficult…Especially When They Are About The Future” – Niels Bohr

Okay, I took a little poetic license, but the point is that while we try, predictions of the future are difficult at best and impossible at worst. If we could accurately predict the future, fortune tellers would win all the lotteries, psychics would be richer than Elon Musk, and portfolio managers would always beat the index.

However, we can analyze what occurred previously, weed through the noise of the present, and discern the possible outcomes of the future. The biggest problem with Wall Street, both today and in the past, is the consistent disregard of the unexpected and random events they inevitability occur.

We have seen plenty, from trade wars to Brexit, to Fed policy and a global pandemic in recent years. Yet, before each of those events caused a market downturn, Wall Street analysts were wildly bullish that wouldn’t happen.

For example, on December 7th, 2021, we wrote an article about the predictions for 2022.

“There is one thing about Goldman Sachs that is always consistent; they are ‘bullish.’ Of course, given that the market is positive more often than negative, it ‘pays’ to be bullish when your company sells products to hungry investors.

It is important to remember that Goldman Sachs was wrong when it was most important, particularly in 2000 and 2008.

However, in keeping with its traditional bullishness, Goldman’s chief equity strategist David Kostin forecasted the S&P 500 will climb by 9% to 5100 at year-end 2022. As he notes, such will “reflect a prospective total return of 10% including dividends.”

The problem, of course, is that the S&P 500 did NOT end the year at 5100.

It isn’t just Goldman Sachs always making bullish and erroneous forecasts but the vast majority of Wall Street analysts. Such errors in predictions are most evident in expectations for forward earnings. Ed Yardeni tracks the historical earnings forecast and changes for each year. Analysts’ expectations are clearly wrong by about 30% on average.

Despite increasing signs of recessionary risk, analysts are once again becoming increasingly optimistic about earnings growth into 2024. Of course, such would require substantially stronger economic growth to generate those earnings.

So, the question becomes how much faith should we have in Wall Street estimates when it comes to our investing?

Predictions Of The Future Have An Expiration

In the late 90s, there was a study on the accuracy of “predictions.” The study took predictions from various professions, including psychics and meteorologists. The study came to two conclusions.

1. “Meteorologists” are the MOST accurate predictors of the future, and,
2. The predictive ability was accurate to just 3-days.

Most importantly, once predictions stretch beyond 3-days, the accuracy is no better than a coin flip.

A quarter of a century later, the Economist magazine analyzed computer models and their weather-forecasting accuracy. Surprisingly, despite the massive increases in computer analysis capabilities, increased data collection, and improved models, the accuracy has failed to improve. Now, as it was then, the accuracy of weather forecasts is roughly 100% for 3-days into the future. However, at ten days, the accuracy is still no better than a coin flip.

Here is the critical point. When analyzing weather patterns, there is a tremendous amount of observable data. From surface temperatures to high and low-pressure zones, humidity, air quality, and numerous data points. That data, collected by Doppler radar, radiosondes, weather satellites, buoys, and other instruments, is fed into computerized NWS supercomputers where numerical forecast models go to work.

Still, with all that data, the predictions’ accuracy is only good for three to ten days.

Given the markets are affected by a broad spectrum of extremely variable inputs from economics to geopolitics, monetary policy, interest rates, financial events, and most importantly, human psychology, how accurate are predictions 12 months into the future?

As investors, how much weight should give to any prediction that extends for more than a week?

Navigating From Here

In the short term, all that really matters to investors is short-term market psychology. That psychology is easily seen in the technical analysis of market price data. This is why we spend each week discussing with you the technical support and resistance levels and the market’s overall trend – bullish or bearish.

In the long term, meaning over the course of the next decade, it is fundamentals and valuations that will determine the return on your investments.

With that in mind, my job as a portfolio manager is to navigate market risks as we see them. Making a “one-sided” bet on a potential outcome harbors an outsized risk of being wrong. Such would potentially impact client capital and damage financial outcomes.

Therefore, we approach risk management in the market by choosing to hedge risk and reduce potential liabilities. As such, given the market’s current structure, we have three options currently:

1. Do Nothing – If the markets do correct, we destroy capital and time waiting for the portfolio to recover.
2. Take Profits – Taking profits, raising cash, and reducing equity exposure before a correction helps mitigate the damage of a decline. However, if wrong, we can repurchase positions, add new ones, or resize portfolio holdings as needed.
3. Hedge – We have also opted to hedge by adding a position to the portfolio that is the “inverse” of the market. Such allows us to keep existing positions intact. By “shorting against the portfolio,” we effectively reduce our equity risk (and related capital destruction) during a market correction.

As noted, we continued to use a combination of both #2 and #3 in the past. Doing nothing leaves us overly exposed to an unexpected “volatility shock” in the market or the reversal of bullish psychology.

In our view, we can either manage risk or ignore it.

The only problem with “ignoring risk” is that such has a long history of not working out well.

Investment Guidelines

When it comes to investing, we tend to repeat our mistakes by forgetting the past. Therefore, it is worth repeating investing guidelines to return your focus to what truly matters.

• Investing is not a competition. There are no prizes for winning but severe penalties for losing.
• Emotions have no place in investing. You are generally better off doing the opposite of what you “feel.”
• The ONLY investments that you can “buy and hold” are those providing an income stream and return of principal.
• Market valuations are very poor market timing devices.
• Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short-term trading.
• “Market timing” is impossible– managing exposure to risk is both logical and possible.
• Investment is about discipline and patience. Lacking either one can be destructive to your investment goals.
• There is no value in daily media commentary– turn off the television and save yourself the mental capital.
• Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities.  The winner is the one who knows when to “fold” and when to go “all in.”
• No investment strategy works all the time. The trick is knowing the difference between a bad investment strategy and one that is temporarily out of favor.

“The investor’s chief problem – and even his worst enemy – is likely to be himself.” – Benjamin Graham.

Three Fed branches put out economic forecasts of economic activity throughout the current quarter. These Fed GDP forecasts are called Nowcasts because the Fed branches use current economic data points and not estimates of future data to quantify how GDP is running. The Fed GDP NowCasts tend to be volatile as data and data revisions can significantly impact their predictions. With only a few weeks left in the quarter, three well-followed Fed GDP NowCasts are painting three different economic pictures.

The most followed, the Atlanta Fed’s GDPNow, is shown in the graphic on the right. Currently, it forecasts real GDP is running at +5.6% for the quarter. As shown, its expectation has been in the mid to upper +5% range for over a month. Below their forecast, it shows the Wall Street GDP consensus forecast is below +2.50%. While the Atlanta Fed thinks we are experiencing explosive growth, the St. Louis Fed expects third-quarter GDP growth to be slightly negative. Take theirs with a grain of salt, as they have consistently underappreciated economic growth for the last year. Lastly, the New York Fed expects +2.2% lukewarm GDP growth. We think GDP, barring any economic surprises between now and month’s end, will likely fall somewhere between the Atlanta and New York Fed’s predictions.

What To Watch Today

Earnings

• No notable releases today

Economics

Market Trading Update

While the bulls are certainly prevalent in the financial media, a bit of perspective is needed. Since the beginning of 2022, the S&P 500 Market-Cap Weighted Index is still 6% lower, while the Equal Weighted Index is 9% lower. Given that the S&P 500 has been driven by the advances in the Top-10 Mega-Cap weighted names, the performance is a bit suspect, given the underlying economic strength. That is likely better represented by the Small- and Mid-Cap stocks (we are using the Russell 2000 as a proxy), which remain 18% lower.

Importantly, while the bulls are thumping their chest about this year’s performance, there is an important takeaway that is overlooked.

If you were planning on 6% annualized rates of return to meet your financial planning needs, the problem with making up losses is magnified. While the S&P 500 Market-Cap Weighted Index is down 6% from its peak, your portfolio needs to recover that 6%, plus the 6% you didn’t earn in 2022 AND the 6% for 2023.

This is the problem with most of the analysis that suggests markets AVERAGE 6, 7, or 8% annually. They don’t, and the time lost trying to get back to even is regained.

Be careful about financial projections. They are rarely accurate and explains why 80% or more of the population remains woefully undersaved for retirement.

Investor Allocations Bode Poorly For Future Returns

The graphs below from Jim Colquitt’s latest Weekly Chart Review warn that equity returns over the next ten years may be poor. His forecast is based on the robust relationship between investor allocations to equities and the ten-year forward annualized returns for each corresponding allocation reading. Currently, investors are highly allocated to equities. Often, when investors are this bullish, equity market returns tend to suffer. Therefore, if the two lines in the graph below maintain their relationship, we should expect ten-year equity returns to be slightly negative. The scatter plot below the graph shows the strength of the relationship and the return expectations.

With risk-free yields north of 4% for ten years, it may be tempting to sell equities and buy bonds.

However, as Jim cautions:

It is important to remind readers that this does not mean that we should expect a return of approximately -0.73% every year for the next 10 years. Instead, what it means is that over the next decade, we will likely see a market that has very dramatic sell-offs followed by very dramatic rallies which will net out to effectively a return of -0.73% over the next 10 years.

Prospects For Rent Deflation Are Strengthening

Per ApartmentList, rental prices are down 1.2% annually after reaching 18% in November 2021. The second chart below shows similar rental price disinflation according to RealPage. Both actual and imputed rental prices account for about 40% of CPI. Therefore, assessing rental prices is crucial to getting CPI forecasts correct. Therefore, as we have written, CPI rental prices tend to lag real rental prices by half a year or even longer. Ergo, the actual rent disinflation/deflation may not show up in CPI until 2024.

The recent price trends may continue based on the coming supply of apartment buildings. The first graph below shows that multi-family housing construction is at an all-time high. This should continue to put a lid on rent prices and possibly be outright deflationary. So, if almost half of CPI is flat to negative, the remaining 60% has to run at 4% to get inflation to the Fed’s 2% target. The third graph shows CPI less shelter is running at 1% annually. Consequently, even if other prices rise a little, as we are seeing, it’s hard to imagine that CPI inflation won’t fall as CPI-computed rent prices catch up with reality.

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The FDIC graph shows that banks are sitting on over $500 billion of losses on their investment securities. This doesn’t include bank loans and other assets with significant unrealized losses. The graph may look scary, but thanks to a rule passed during the financial crisis, it may not be. In 2008, banks were taking tremendous losses as their loan and security prices plummeted. Banks were failing in large numbers. To halt the crisis, FASB changed accounting rules to shelter banks from taking losses unless they sell the assets. Before the new rule, banks had to report the fair value, aka mark to market, of all assets. Now, they can elect to classify assets such that they mark them at par instead of current prices. With some long-term bank assets trading at 50-60 cents on the dollar, the 2008 rule is saving many banks from reporting large losses and potentially bankruptcy.

We can debate the rule change, but what’s important to grasp is the bank losses shown below, while not realized are real and there are situations in which the losses might be realized in the futre. Since the Fed started raising rates, bank depositors began withdrawing money from banks and moving it to higher-yielding options. Deposits are a bank’s primary source of funding for its assets. When a deposit leaves the bank, the bank can either replace the funding or sell assets. Selling an asset turns an unrealized loss into a realized loss. Such actions played a primary role in bankrupting Silicon Valley Bank, Silvergate, and others. The graph below represents the possibility for the future realization of losses and possibly more bankruptcies. Therefore, as we consider Fed policy going forward, a big challenge the Fed faces with its “higher for longer” campaign is the possibility banks must realize losses.

What To Watch Today

Economics

• No notable economic releases

Earnings

Market Trading Update

The market sold off decently over the last week, retesting the rising trend line and holding the 50-DMA. The more extreme overbought condition is about halfway through a corrective cycle, suggesting we could see some further “sloppy” trading next week. With the market holding within a consolidation range, a breakout to the upside should confirm the start of the seasonal strong trading period into year-end.

As shown, the July through October periods tend to trade sideways in pre-election years with a stronger year-end push as portfolio managers window-dress portfolios into year-end. This year, the market has tracked fairly closely to the historical norms and should continue into year-end, given no major financial or economic upheaval.

We continue to suggest remaining allocated to the equity market for now. However, we also suggest using short-term rallies to rebalance equity risks and overall allocations accordingly. While there is no evidence of a more severe market correction on the near-term horizon, such does not mean that it can’t happen. As we get into 2024, the odds of a more meaningful contraction rise as the risk of economic grows. Continue to manage risk accordingly.

The Week Ahead

After a sleepy economic data week, this will week be more lively and help us better assess what the Fed may do at next week’s FOMC meeting. CPI is expected to increase by 0.4%, 0.2% more than last month. However, the core rate is only expected to rise by 0.2%. monthly and fall from 4.7% to 4.5% annually. PPI and Retail Sales follow on Thursday.

The Fed will enter their pre-meeting media blackout period this week. Consequently, we have likely already heard the last thinking of the Fed members. The table below shows that Fed Funds market assigns a 94% chance they keep rates the same on September 20 and a 40.6% chance they hike rates by .25% at the November 1 meeting.

The Treasury will auction 10 year notes on Tuesday and 30 year bonds on Wednesday. The combination of important inflation data and the auctions will likely create a good amount of volatility in the bond markets.

The Fed Is Buying Bonds, Not Selling Them

The first graph below from Jim Bianco shows the Fed has reduced its balance sheet by about $1 trillion since QT started in April 2022. However, the graph, because it’s a stacked area graph, does a poor job of showing which maturity ranges and security types have been most affected.  A client of ours did some great work producing the second chart to better clarify how QT effects the Fed’s holdings by maturity ranges. The orange line represents securities ten years and longer. As the graph shows, these longer assets have been steadily rising since the Fed enacted QE in 2019. As he highlights, they continue to increase despite the Fed’s policy reversal to QT in 2022. QT aims to remove $95 billion of assets a month from its balance sheet.

We bring this up because we have heard incorrect statements claiming that QT adds to the supply of long term bonds in the market. The fact is the Fed conducts QT by allowing bonds to mature. By default, the maturing bonds are all very short-term. Importantly, when the monthly amount of maturing bonds exceeds the Fed’s $95 billion target, they need to buy bonds. Again, despite QT, the Fed has been buying long-term bonds as there have been more bonds maturing than their stated monthly objective.

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Since the beginning of the year, economic data has continued to defy the recession calls of 2022. Therefore, it is unsurprising that economic data surprised analysts’ more dire predictions last year. Of course, given the underestimation of the economy previously, the risk of overestimation is now a real possibility.

The upgrading of estimates also contributed to the discussion of the Federal Reserve’s need to raise the “neutral rate.”

The neutral interest rate is:

“The real rate (net of inflation) that supports the economy at full employment and maximum output while keeping inflation constant.“

(Note: There is no accurate measure of the neutral rate, and it cannot be observed directly. In other words, it is a guess.)

The issue, as always, is that economists are looking at lagging economic data to make assumptions about the future. However, after over 40 years of rising debt levels, economic growth remains slowing. As shown, as debt issuance increased after each economic crisis since the turn of the century, economic growth rates declined. (I have projected the increase in debt based on the average quarterly debt growth since 2018.)

Naturally, if the economy grows at a slower natural rate, inflation and interest rates will ultimately match that growth rate. Furthermore, and most importantly, in the context of this discussion, avoiding a recession becomes increasingly challenging at lower growth rates.

While analysts become more optimistic about economic growth, the divergence of the economic data suggests increased risk to that outlook.

Production Comes First

As is always the case, predicting a recession is incredibly difficult. The influence of monetary and fiscal policy, corporate actions, and other events can increase or delay the recessionary onset. Nonetheless, restrictive policies, such as higher interest rates and tighter lending standards, will curtail the consumption that drives economic growth. The chart below is a composite index of bank lending standards and interest rates versus GDP. The financial conditions composite is inverted to compare declines in economic activity better. Unsurprisingly, tight financial conditions always precede weaker economic growth rates and recessions.

Critically, what drives the economic cycle must be understood. We often speak of the consumption side of the economic equation; however, consumers can not consume without producing something first. Production must come first to generate the income needed for that consumption. As analysts increase earnings estimates, the earnings derived from corporate revenues are a function of consumer spending. Such is a crucial part of the cycle.

The Invisible Hand

Of course, if you bypass the production phase of the cycle by sending checks directly to households, you will get a strong surge in economic growth. As shown in the chart below, the massive spike in economic growth in the second quarter of 2021 directly resulted from those fiscal policies.

However, once individuals spent that stimulus, the economic activity subsided as the production side of the equation was still lagging. Here is the crucial point. For a household to consume at an economically sustainable rate, such requires full-time employment. While the media touts the “strong employment reports,” such is mostly the recovery of jobs lost during the economic shutdown. As shown, full-time employment as a percentage of the working-age population has only recovered to pre-pandemic levels.

In other words, we have NOT created millions of new jobs, as touted by the current administration, but rather only recovered the jobs lost and the increase in the working-age population since the economic shutdown. However, higher inflation and interest rates require more income to maintain the same growth rates.

The production side of the equation is now ringing a loud alarm.

The GDP & GDI Relationship

Let’s review the economic cycle equation once again.

Production => Incomes => Consumption => Demand => Increased Employment => Increased Wages

It is a relatively simple economic concept that seems to elude the vast majority of mainstream analysts and, seemingly, the Federal Reserve itself. However, there are two measures of economic activity. The most common measure is GDP, which is simply the sum of Personal Consumption Expenditures (PCE), Business Investment, Government Spending, and Net Exports (Exports Less Imports)

The other less observed measure is Gross Domestic Income (GDI). The calculation of GDI is as follows:

GDI = Wages + Profits + Interest Income + Rental Income + Taxes – Production/Import Subsidies + Statistical Adjustments. 

Therefore, given that GDI measures the income side of the equation (derived from production), it is logical that GDI should track pretty closely to GDP over time. Furthermore, it should be logical that deviations between production and consumption should indicate a shift in the economic underpinnings.

As shown below, in 2021 and 2022, real (inflation-adjusted) GDI supported economic growth. With $5 Trillion in stimulus supporting incomes, the consumption side of the equation rose. However, beginning in the 4th quarter of 2022 and persisting through the 2nd quarter of 2023, GDI has turned negative as all of the stimulative monetary measures have become exhausted. Yet, economic growth has increased sharply over that time frame.

The following chart is a bit clearer. I rebased both GDP and GDI to 100 in 2016. Again, logically, GDI and GDP should track closely to each other given the economic relationship. However, the deviation is apparent starting last year.

The question is whether this Is an anomaly or has it occurred previously.

GDI Sends A Recession Warning

The short answer is YES.

The chart below looks at real GDP and GDI back to 1947 and measures the deviation between the 3-quarter growth rates of each. With only the expectation being in the late 70’s, a recession followed each time GDP deviated from GDI. In other words, the economic activity eventually catches down to the primary driver of consumption: production. Currently, the deviation of GDP from GDI is the largest on record.

In past articles, we reviewed many indicators that typically preceded recessionary onsets. Falling tax receipts, inverted yield curves, student loan payments, leading economic indicators, and even our economic composite confirm that recessionary risks remain elevated. As shown, based solely on the inverted yield curve alone, the probability of a recession is at one of the highest levels since the 1980s.

Given the wide range of other confirming indicators previously discussed, betting on the “avoidance” of a recession, particularly given such tight financial conditions, seems risky. Such was a point made in “Financial Conditions Are Tighter Than You Think.” To wit:

“As shown below, financial conditions, measured by the difference between the 10-year Treasury yield and the “neutral rate,” clearly reside in restrictive territory. Such has previously always preceded an economic downturn since 1980.”

However, even if you want to dismiss all of the other indicators discussed previously under the guise of “it’s different this time,” the recessionary warning sign sent by the spread between GDP and GDI should likely not be.

Sure, this “time could be different.” The problem is that, historically, such has not been the case. While we must weigh the possibility that analysts are correct in their more optimistic predictions, the probabilities still lie with the indicators.

GDI is increasing those probabilities.

Our Daily Commentary from August 25 summarizes a SimpleVisor stock scan, highlighting companies with high sales exposure to China. The article states: “Once again, trade tensions are heating up with China as President Biden signed an executive order to limit U.S. investments in Chinese technology companies for national security concerns. China says a response is coming.” It appears China’s retaliation is to go after America’s largest company, Apple. On September 6, China ordered its central government agencies to ban the use of iPhones. Per the WSJ, The directive is the latest step in Beijing’s campaign to cut reliance on foreign technology and enhance cybersecurity.” China expanded its retaliation on Thursday morning to include state companies and other agencies from using iPhones.

China must balance trade retaliation with what is best for its struggling economy. Recently, China lowered home down payment requirements, encouraged second property purchases, and told banks to lower mortgage rates. They also cut rates twice this year, cut taxes on stock market transactions, and told banks to buy stock shares. The Apple trade retaliation works against China’s economic goals. Ergo, it will be interesting to see how China responds if Biden takes additional retaliation actions. China must consider the U.S. has more trade leverage. The U.S., as shown below courtesy of Trading Economics, is China’s largest customer, accounting for 15% of its exports, almost four times that of the next non-China customer, Japan. But, the U.S. is only China’s third largest importer (7.2%) behind South Korea and Japan.

What To Watch Today

Earnings

Economics

The Big Bond Swap

We have recently discussed in our newsletter, radio show, and podcasts that we were looking to make a swap in our bond portfolios. The following video, with Michael Lebowitz and me, explains why we swapped out of the iShares Treasury Bond ETF (TLT) and into a U.S. Treasury Bond.

Be sure and subscribe to our YouTube channel.

Payroll Growth Sliding Downward

The graphs below from Alpha Beta Soup show that the decline in the growth rate of jobs is following a similar pattern as all recessions since 1968. To line up start dates, allowing for a better comparison, the graph uses the number of months from when the yield curve first inverted. As we have shared in the past, all yield curve inversions have ultimately resulted in recessions. However, in most cases, the recession does not begin until the yield curve uninverts. Based on the graph, we might expect negative job growth in early 2024. In that case, market anticipation of Fed rate cuts would lower short-term rates, likely causing the yield curve to uninvert.

The next graph goes back further in time but anchors the historical data to the start of recessions. While the start date for the recent data in the graph is arbitrary, you can see payroll growth is in line with prior instances. This graph forecasts a recession in eight months.

Low Volatility Continues

Per the Bespoke graph below, it has been 136 trading days without a daily change, up or down, of 2% or more in the S&P 500. That marks the longest streak of less than 2% daily volatility in over five years.

Jobless Claims Remain Low

Initial Jobless Claims remain relatively low despite other signs the labor market may be weakening. Yesterday’s 216K in new claims was below the 230K expected and the upwardly revised 229K from the previous week. It is the lowest print since February. A higher number of Baby Boomers are retiring, which may alleviate the need for some companies to let go of employees. Further, if those let go find work quickly, they may not file for unemployment claims. Regardless of the reason, jobless claims, a leading labor market indicator, remain strong. As shown, they are slightly higher than the 2022 lows but well below the historical average of 260k

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The top graph below charts stock prices and bond yields. The smaller graph below shows the rolling ten-day correlation of stocks (SPY) and bond yields (10-yr UST). The higher the correlation, the stronger the relationship between stock prices and bond yields. Conversely, the weaker the correlation, the more stocks and bond yields move in opposite directions. As we highlight in blue, it is common for the relationship to be negative. But, as we highlight in yellow, there are periods where stocks and bonds have a positive correlation. For instance, the S&P 500 was up nearly 10% from May through July, while the ten-year yield rose by 0.70%. Such a strong correlation with already high and rising bond yields is not sustainable. Higher interest rates raise borrowing costs and impede on economic growth. Both negatively affect earnings.

Recently, the stock bond correlation has shifted back to its more normal negative relationship. The spurt in bond yields approaching the 2022 peak is weighing on the stock market. Our take is that the stock market doesn’t care about bond yields until they do. Stock gains going forward will become increasingly more difficult unless bond yields start to fall. Given this likelihood, stocks will probably become more sensitive to economic and inflation data, as well as Fed speak and monetary policy actions. If so, the stock market mantra going forward will likely be to sell stocks on good economic news and buy on bad economic news.

What To Watch Today

Economics

Earnings

Market Trading Update

Despite the selloff in the market over the last couple of trading days, market volatility remains extremely compressed. While declining volatility is bullish for equities in the short-term, as there is a lack of fear about a correction, such is also a concern. Going back 20 years, whenever volatility was as suppressed as it is currently, such has previously led to short-term corrections in risk assets or worse. Given the deep oversold condition of the index, investors should expect a reversal sooner rather than later. Historically, the unwinding of compressed volatility tends to be a rather sudden event with a sharp negative move in asset prices. I would eventually expect the same this time.

Avoiding The Volatility Tax

Buy and hold is a very popular strategy, but is it the most effective for compounding wealth? The upside to buy and hold is it’s incredibly simple and can be easily accomplished by DIY investors. But, while paying management fees or putting your own time and effort into portfolio management may be avoided, the volatility tax on buy and hold is a notable cost. The graph below, courtesy of Hi Mount, shows that avoiding both the best and worst performance days leads to higher returns and a lower risk profile. We put the data from the graph into the table below it. It shows the Sharpe ratio. The ratio measures the ratio of returns versus the risk taken. It allows for an easy comparison of different strategies. Not surprisingly, avoiding more of the highest volatility best and worst days, improves the Sharpe ratio.

Service Sector is Heating Up

The service sector continues to drive economic growth. Additionally, Jerome Powell has mentioned the strength in the sector is feeding his inflation concerns.

As we share in the graph below, the ISM services survey has recently flirted with an economic contraction reading (sub 50) but remains resilient above 50. In yesterday’s latest release, new orders, employment, and prices rose. The only blemish on the survey is that inventories are rising and order backlogs are falling. The report will do nothing to ease Powell’s worries. However, the PMI services survey, a lesser-followed gauge of the service sector, fell from 52.3 to 50.5. The PMI report shared the following insight.

Although only fractional, the fall in new orders was the first in six months and signalled a marked turnaround from the sharp upturn seen in the second quarter of 2023. Muted demand conditions reportedly stemmed from the impact of higher interest rates and inflation on customer spending.

The odds of a Fed hike at the September 20 meeting remain below 10%, but implied Fed Funds futures saw a slight uptick to nearly a 50% chance of a hike at the November meeting. Next week’s CPI and Retail Sales will play a large role in helping the Fed decide what they will do at the two upcoming meetings.

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Most investors believe that U.S. government debt is risk free. Why shouldn’t they, every economic and financial textbook, media outlet, and bond guru say so?

Did you know it used to be a fact that the earth was flat and “health cigars” were a thing? Obviously, those facts and myths have been disproven, as have many others that seem equally preposterous today. 

Facts, even if we are not 100% confident that they are factual, provide stability in an otherwise chaotic world. Our need for stability allows unproven “facts” to perpetuate.

In this article, we challenge a “fact” that serves as the foundation for pricing all financial assets. However, our concern for the risk-free status of government debt may be very different from where you think we might be going with this article.

Fitch Downgrades U.S. Government Debt

On August 1, 2023, Fitch downgraded U.S. government debt from AAA to AA+. The event occurred almost twelve years to the day that S&P took the same action. The recent downgrade was ridiculous for two reasons.

First, why does the U.S. government have a debt rating? The Treasury and or Fed can print money to ensure its debt never defaults.

Second, if you were to apply traditional credit metrics to the federal government, its rating should have been well below the AAA rating that it had before the downgrade.

Treating the government as we would a company, we find that it has incurred a loss in all but four of the last 40 years. It’s hard to imagine a company could lose so much money consistently, remain in business, be AA+-rated, and be globally considered risk free.

Rating The Government With Traditional Measures

When Fitch calculates the credit rating for a company, it uses the debt service coverage ratio (DSCR), among other fundamental measures of debt, assets, and liquidity. DSCR measures corporate cash flows as compared to debt obligations. Basically, it’s a rough calculation of a company’s ability to pay down its debt.

The government’s DSCR is just under 10. As of 2022, it had debt outstanding of $30.8 billion and $3.1 billion in tax receipts. Remember that tax receipts are like sales for a company and not net profit. The government will spend the $3.1 billion of tax receipts plus a couple more billion to keep the government running. Just the cost of the interest on the debt will eat into a third of the tax receipts.

The graph below shows the growth of the government’s DSCR from 3.0 to 10.0 over the last fifty years. The horizontal lines are NYU Stern School estimates of the appropriate credit rating based on the DSCR for non-financial corporations. As shown, the government’s DSCR would land it firmly in junk bond territory between a B and CCC rating.

A Different Kind of Default Risk

If the government’s debt rating resembles a CCC-rated bond, why do we consider it risk free? The simple answer is that the government and the Fed own the money printing press. If need be, they will print money to fund its debt.

As such, the odds of a government bond investor not receiving their interest and principal in its entirety are zero percent. However, the risks for domestic bondholders and the American people are plentiful when the government and Fed ignore their fiscal and monetary responsibilities.

Government debt has risen significantly, but government interest rate expenses have increased by far less, as shown below.

To accomplish this feat, the Fed has administered near-zero interest rates and, since 2008, has bought nearly $9 trillion, or about a quarter of the total public debt outstanding. Historically, low-interest rates have allowed the Treasury to increase its debt outstanding since 2000 sixfold, while its interest expense has slightly more than doubled over the same period.

The cost of continual deficits, or the risk, is weaker economic growth. While our prosperity is less than it otherwise would be, weaker economic growth contributes to lower interest rates.

Government debt has a negative multiplier. Each dollar of debt the government issues results in negative economic growth and weaker inflation over the long run. Government spending initially boosts economic activity. But over time, the aggregate costs of the debt in terms of interest expenses outstrip the benefits. Further, the capital used by the government likely would have been invested in more productive uses by the private sector.

Hoisington Investment Management On The Negative Multiplier

For more on the topic, we lean on Hoisington Investment Management’s latest quarterly update:

Estimates from econometric studies of highly indebted industrialized economies indicate that the government expenditure multiplier is positive for the first four to six quarters after the initial deficit financing, then turns negative after three years. This implies that a dollar of debt financed federal expenditures will, ‘at the end of the day,’ reduce private GDP.

Regarding how recent surges in deficits will affect economic growth, they have this to say:

After taking into consideration the benefits of the deficit spending, the lagged negative multiplier effects and the way in which debt is being financed, the upcoming deficits are likely to have a negligible, if not contractionary, impact on economic growth this year and next.

Simply, more deficit spending reduces economic growth and inflation, pushing bond yields lower. Instead of punishing fiscal abuse, the government is rewarded with lower yields, albeit at the cost of less economic activity and, therefore, lower tax receipts. 

Such is the magic of exceedingly low interest rates generated by the Fed and the government’s fiscal irresponsibility.

Wicksell Warned Us

As we said, the risk of holding Treasury bonds is not a technical default. The risk is that the methods used to manipulate the interest rate markets to help keep debt affordable harm the nation’s prosperity.

A few years back, we wrote Wicksell’s Elegant Model. The article summarizes Knut Wicksell’s theories concerning the level of interest rates versus the natural economic growth rate.

The following quotes from the article help us appreciate his concepts and why the necessity for lower interest rates presents a significant risk to the populace.

On the other hand, if market rates of interest are held abnormally below the natural rate then capital allocation decisions are not made on the basis of marginal efficiency but according to the average return on invested capital. This explains why, in those periods, more speculative assets such as stocks and real estate boom.

But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow-driven investments with riskier prospects languish. The bottom line: existing assets rise in value, but few new assets are added to the capital stock, which is decidedly bad for productivity and the economy’s structural growth.

Summary

Risk free Treasury securities will always pay its investors in full. But the means and schemes used to pay them will detract from economic activity and, ultimately, the prosperity of the nation’s citizens. We think that is quite a risk and one grossly underappreciated!

Three months ago, Congress and the President avoided a shutdown and default on government debt when they agreed to increase the Treasury’s spending cap. Unbeknownst to many, another potential government shutdown may come in less than a month. Lawmakers need to agree on the fiscal budget for 2024, which starts on October 1, 2023. A government shutdown is not nearly as problematic as the debt ceiling. Unlike the debt ceiling, the Treasury can still issue debt, so a default is not in the cards. However, hundreds of thousands of federal workers could be temporarily suspended from their jobs without pay. Consequently, many government services, some of which are critical, could be shut down.

Currently, both parties are confident they will reach an agreement. To avoid a government shutdown, Congress needs to pass twelve appropriations bills. Each bill funds a different part of the government. Or, they can pass an omnibus deal combining the twelve bills into one. Recently, Congress has gone with the omnibus approach. While both parties are hopeful, there are significant differences in their preferred spending targets. Further complicating matters, a large group of Republicans were not happy with the debt ceiling deal and may use this opportunity to push for much more aggressive cuts. Heading into an election year, the Democrats are likely to fight cuts. In 2018, Donald Trump and the House-led Democrats could not agree on funding. As a result, they shut down the government for 34 days in 2018. Despite the government shutdown, the market rallied over 10% during the fiasco.

What To Watch Today

Earnings

Economy

Market Trading Update

Are oil prices about to go surging higher? It’s possible with the technical backdrop improving after the recent decline. However, oil prices are getting fairly extended in the short term, with more extreme overbought readings, so a pullback should be expected. However, with the MACD “buy signal” triggered, we could see higher prices heading into October. xl

However, energy stock prices, as represented by XLE, did not fall with the decline in oil prices. The divergence from the long-term historical correlation will likely be filled at some point.

For now, energy stocks are also extremely extended after the recent move higher, so a correction in those stocks should be expected when oil prices eventually revert. The trend and the overall backdrop remains positive for both oil and energy stocks near term, however, the onset of a recessionary environment will ultimately realign energy stock and oil prices.

People Do Not Feel Like Buying Homes

As a result of house price inflation and the highest mortgage rates in 15-year highs, buying conditions for home buyers have deteriorated. Per the chart below, courtesy of Game of Trades, buying conditions are at levels only seen twice since 1960. While the existing home sale market is essentially frozen, as most buyers are unwilling to take on a high mortgage rate for a relatively expensive house, new home builders are doing well. For one, the inventory of new homes is comparatively robust versus existing homes. Second, and more importantly, new home builders can offer discounts in the form of lower mortgage rates. We suspect that as long as “people don’t feel like buying homes,” the homebuilders will continue to take an above-average percentage of total house sales.

Higher Crude Prices Dragging Bond Yields Higher

Since July, crude oil prices have risen from $70 a barrel to over $85. Prices at the pumps are now approaching $4 in many locations. At the same time, bond yields are rising as bond traders are concerned that higher oil and gas prices will generate more inflation. While such a correlation between crude and inflation expectations is the norm, the correlation between CPI and crude is less robust. As we show below, crude oil prices have much less of an impact on inflation than traders expect. That said, markets run on expectations, so higher crude may temporarily push yields higher.

The first graph below shows the strong relationship between crude oil and 5-year inflation expectations. The second graph shows the relationship is strong when inflation is low, but it vanishes when CPI is above the Fed’s 2% target, as we have today.

It’s worth adding the Fed prefers to gauge inflation with core measures that strip out food and energy prices. As such, the recent rise in crude prices may not overly concern the Fed as much as the bond market.

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Mega-cap stocks continue to dominate the market in 2023. The question is, why? After all, many other great companies have arguably much better valuations and fundamentals. Yet, those companies continue to lag the market’s overall returns as the bifurcation between the Mega-cap companies and everything else widens. The chat below clarifies the problem, which compares the market-capitalization weighted index to the equal-weight.

The bifurcation between the top 10 companies, as measured by market capitalization, and the other 490 stocks in the index has created an illusion of market bullishness. As we discussed just recently in “Investing In 2024:”

“The surge in the most hated sectors last year has been the main driver of this year’s broad market performance. If we strip out the performance of those three sectors, the market would be near flat on a year-to-date basis.”

Despite the extremely crowded trade into the three sectors comprised of those ten stocks, we continue to see professional investors crowd into those shares at a record clip.

The question is, why are professional managers seemingly chasing these stocks with reckless abandon?

The answer is more simplistic than you may think.

Career Risk And The Passive Effect

For investment managers, generating performance is necessary to limit “career risk.” If a manager underperforms their relative benchmark index for very long, they most likely won’t have a “career” in the investment management business. Currently, there are two drivers for the mega-capitalization stock chase. First, these stocks are highly liquid, and managers can quickly move money into and out without significant price movements.

The second is the passive indexing effect.

As investors change their investing habits from buying individual stocks to the ease of buying a broad index, the inflows of capital unequally shift into the largest capitalization stocks in the index. Over the last decade, the inflows into exchange-traded funds (ETFs) have exploded.

That ETF issuance surge and the assets’ growth under management fuel the performance of the top 10 stocks. As we discussed previously:

“In other words, out of roughly 1750 ETF’s, the top-10 stocks in the index comprise approximately 25% of all issued ETFs. Such makes sense, given that for an ETF issuer to “sell” you a product, they need good performance. Moreover, in a late-stage market cycle driven by momentum, it is not uncommon to find the same “best performing” stocks proliferating many ETFs.”

Therefore, as investors buy shares of a passive ETF, the shares of all the underlying companies must be purchased. Given the massive inflows into ETFs over the last year and subsequent inflows into the top-10 stocks, the mirage of market stability is not surprising.

As shown, for each $1 invested in the S&P 500 index, $0.32 flows directly into the top 10 stocks. The remaining $0.68 is divided between the remaining 490 stocks. This “passive indexing effect” has changed the market dynamics over the last decade.

However, the “passive effect” is only one reason portfolio managers hide in these massive companies.

The other reason is “safety.”

Safety In Liquidity

If and when the economy slips into a recession, earnings and revenue will decline for companies. Given the current level of interest rates, inflation, and reversal of monetary liquidity post-pandemic, the risk of recession is higher than normal. Higher interest rates, in particular, currently pose the largest threat to small and medium-sized companies. As Andrew Lapthorne of Societe General recently noted:

“The largest 10% of companies represent 62% of the overall non-financial market cap of the S&P 1500, so from a market perspective, it would appear that interest rates are not yet affecting the balance-sheet stress of the market overall. But lower down the size scale, things are tough and getting tougher. Interest coverage at the bottom 50% of S&P 1500 companies and the smallest quoted companies (as listed in the Russell 2000 index) falling sharply from low levels.”

These smaller companies do not have access to the capital markets as easily as larger capitalization companies and do not have the massive cash balances the mega-cap companies hold.

“It stands to reason that smaller quoted companies in the Russell 2000 index, as well as unquoted companies, don’t have as much access to corporate bond issuance so have been unable to lock into the near-zero long-dated fixed borrowings that the larger companies have.”

As that debt wall of term loans hits over the next few years, higher borrowing costs are going to raise the risk of defaults and bankruptcies. While we may not be in a recession yet, doesn’t mean it can’t happen. As noted by Simon White via Bloomberg, tightening financial conditions have seen corporate bankruptcies rise by 71% since last year. If financial conditions are still elevated over the next few years, that bankruptcy risk increases markedly.

As Albert concludes:

“Contrary to what the mega-cap valuations might suggest, smaller companies remain the beating heart of the US economy – maybe the mega-caps are more like vampires sucking the lifeblood out of other companies. It seems the lights are going out all over the US smaller-cap corporate sector.

They weren’t able to lock into long-term loans at almost zero interest rates and pile it high in the money markets at variable rates. Ultimately the pain for US small- and mid-cap companies will trigger the recession most economists are now giving up on, and hey, guess what? I think we’ll soon find out that even the large- and mega-cap stocks might not be immune to the indirect recessionary impact of higher interest rates after all.“

Portfolio managers must chase the market higher or potentially suffer career risk. Therefore, the easiest place to allocate cash is the mega-capitalization companies with low risk of bankruptcy or default and extremely high liquidity.

I agree with Albert that current exuberance in the markets and the belief of a “no landing” scenario are likely largely overblown. Substantially tighter financial conditions remain the biggest risk to the markets. Therefore, when the Fed begins cutting rates to fix what it broke, we will see the rotation to safety occurring simultaneously.

Mega-Cap Will Dominate Until It Doesn’t

For now, there is little to deter portfolio managers from chasing the mega-cap stocks for performance reporting purposes. As noted, a big divergence between the manager’s performance and the benchmark index will lead to “career risk.” However, the problem is compounded by retail investors piling money into passive ETFs.

There is a basic belief by investors that “for every buyer, there is a seller.”

However, the correct statement is:

“For every buyer, there is a seller….at a specific price.”

In other words, when the selling begins, those wanting to “sell” overrun those willing to “buy.” Therefore, prices drop until a “buyer” is willing to step in.

That surge in selling pressure creates a “liquidity vacuum” between the current price and a “buyer” willing to execute. In other words, just as professional managers are trying to sell their shares of Apple (AAPL), the other 343 ETFs that own Apple are vying for the same scarce pool of buyers in a declining market.

Furthermore, advisors are also actively migrating portfolio management to passive ETFs for some, if not all, of the asset allocation equation. The rise of index funds has turned everyone into “asset class pickers” instead of stock pickers. However, just because individuals are choosing to “buy baskets” of stocks rather than individual securities, it is not a “passive” choice but rather “active management” in a different form.  

With the concentration of risk in a handful of stocks, the markets are set for a rather vicious cycle. The concentration of holdings and the subsequent lack of liquidity suggest reversals will not be a slow and methodical process. Rather, it will be a stampede with little regard for price, valuation, or fundamental measures as the exit narrows.

I suspect that March 2020 was just a “sampling” of what will happen when the next “real” bear market begins.

Starting last Friday, interest began accruing on student loans, and on October 1, payments will be due. Over three years ago, the CARES Act allowed student loan forbearance until September 2020. It was ultimately extended multiple times. As payments begin, the weight of student loan payments will dampen consumption and economic activity. The question is- how much? To help us assess the economic effect, Distill put out an excellent research paper. It starts as follows: “Student loan repayments will sting far more than most folks believe.” Given its economic importance, we summarize a few of their main points.

There are $1.8 trillion of student loans, of which $1.4 are federal and have been in forbearance. 62% of borrowers are under the age of 40 and have an average balance of $32k. Distill estimates that those who will now be making payments will reduce discretionary spending by 9% to 15%. Per their calculations, the payments could impact retail sales by .60% to 1.00%. It’s likely that 20-somethings, which account for about a fifth of the new payees, will pare back on discretionary spending to make their payments. The 30-somethings, the largest cohort, will likely reduce spending on household formation. Distil’s warning: “Consumers don’t spend when they are angry or afraid.”

What To Watch Today

Earnings

Economy

Market Trading Update

On Friday, the much-anticipated employment report printed a 187,000 job increase, but notably, the unemployment rate rose to 3.8%. The increase in the unemployment rate encouraged the bulls as the goal of the Federal Reserve tightening the financial conditions in the economy was to slow employment and reduce economic demand. Notably, previous months showed fairly significant downward revisions.

From a market perspective, that “weaker-than-expected” economic data adds to the “hope” that the Fed has tightened financial conditions enough. As we noted last week.

“A correction was needed, given the market was up more than 15% in the year’s first half. Nonetheless, the market continues to trade within its bullish trend and tested and rallied off that level on Friday for a second time. It also remains above critical support levels for now. With the MACD “sell signal” beginning to turn and the RSI index improving, we could see a further rally next week.“

This past week, the market did rally fairly strongly, taking out resistance levels at the downtrend from the July peak and the 50-DMA. The market is now in a technical position to retest the July peak and potentially set new highs for the year. Unsurprisingly, the advance is still dominated by “Mega-7” capitalization stocks.

This all aligns with our analysis over the last couple of weeks wherein:

“As long as nothing ‘breaks,’ when this corrective cycle completes, we expect a rally into year-end. Such will be a function of performance chasing as portfolio managers play catch up into year-end.”

That scenario is still playing out for now. While we could certainly see a pickup in volatility during September, pullbacks to support should still be used to add to equity exposure as needed. Use the current rally to rebalance portfolios, take profits, and neutralize risks accordingly.

With that said, there are certainly risks to remain mindful of. The risk of a recession from tighter financial conditions is one of them.

The Week Ahead

This holiday-shortened week should be quiet, with few earnings reports and little economic data. We will closely monitor the ISM service sector survey on Wednesday and jobless claims on Thursday. We suspect Fed members will start prepping us for the coming meeting on September 20th. The odds of a rate hike at the meeting are currently only 7%.

The BLS Employment Report

Payrolls grew by 187k, slightly above expectations. However, the unemployment rate jumped from 3.5% to 3.8%. That is primarily a function of 525k people who entered the workforce, so it is not overly concerning. Further, August tends to see larger increases due to recently graduated students. Also of note, hourly earnings fell short of expectations at 0.2%. As we saw in the JOLTS report, with the declining quit and job opening rates, employees appear to be losing leverage with their employers.

As shown in the second table below, payrolls have been revised lower by 355k jobs this year. June, for instance, was initially reported as +209k and has since been cut in half to +105k. The third graph shows temporary employment continues to decline. Businesses often reduce temporary staff before taking more drastic actions with full-time workers. Consequently, a decline in temporary workers precedes most recessions.

In summary, there are clear signs the labor markets are weakening. But, thus far, we would characterize the recent data as a normalization to pre-pandemic trends. If employment data continues to degrade, our concerns about a recession will rise.

More Auto Loan Delinquencies Are Coming

In Friday’s Commentary, we wrote about the uptick in delinquencies on consumer loans. The repayment of student loans may cause even more delinquencies. Per the Distill report in our lede, almost a third of student loans outstanding are held by those in their 30s. The graph below shows these borrowers have an estimated $3 billion of other consumer debt. Consumer debt can be defaulted on and extinguished. Student loan debt cannot. Therefore, when push comes to shove for struggling borrowers, not paying a consumer loan, as opposed to a student loan, might be the optimal choice.

According to TransUnion, more than a third of consumers with student loans took on new auto loans during the pandemic. To put the debt load on some borrowers in context, the Wall Street Journal writes: “With the average price of a new General Motors vehicle at $52,000 and new car loans with an interest rate of 9.5%, many consumers are struggling to keep up with their payments.” Not only will consumer delinquencies which are at ten-year highs, likely rise, but spending on autos and houses will decline by those now saddled with student loan payments.

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Powell’s recent Jackson Hole Summit speech was mainly as expected. Well, except for the part where Powell obfuscated the truth behind the surge in inflation. More telling was the misunderstanding of the impact of fiscal and monetary policies on long-term outcomes.

Let’s begin with Powell’s assessment of the cause of inflation.

“The ongoing episode of high inflation initially emerged from a collision between very strong demand and pandemic-constrained supply. By the time the Federal Open Market Committee raised the policy rate in March 2022, it was clear that bringing down inflation would depend on both the unwinding of the unprecedented pandemic-related demand and supply distortions and on our tightening of monetary policy, which would slow the growth of aggregate demand, allowing supply time to catch up. While these two forces are now working together to bring down inflation, the process still has a long way to go, even with the more favorable recent readings.”

It’s crucial to note the complete dismissal of the causes behind the “collision between very strong demand and pandemic-constrained supply.” I suspect this was intentional to avoid placing blame at the feet of the current or previous administrations or themselves. However, it muddies the impact of their actions that created the problem.

While the Fed, the Government, and the media repeatedly blame everyone but themselves for inflation, from greedy corporations to individuals, the issue is, and always has been, basic economics.

Basic Economics

As Milton Friedman once stated, corporations don’t cause inflation; governments create inflation by printing money. There was no better example of this than the massive Government interventions in 2020 and 2021. Those policy decisions sent subsequent rounds of checks to households. Those funds created demand concurrently with an economic shutdown constraining the supply of goods.

The following economic illustration is taught in every “Econ 101” class. Unsurprisingly, inflation is the consequence if supply is restricted and demand increases by providing “stimulus” checks.

• Who had the power to shut down the entire economy and force everyone into their homes using a fear-driven campaign? Was it the war, corporations, or the Government?
• Who then supplied trillions in stimulus checks directly to households to spend when no supply could be produced? Was that corporations? Russia? Or was it the Government?
• Who supported the issuance of trillions in debt issuance to fund those stimulus checks and keep interest rates suppressed? Was that the Federal Reserve, Russia, or corporations?
• Was it corporations who put a moratorium on student loan, rent, and mortgage payments giving individuals a source of additional funds to spend? Or was it the Government?

The inflation surge had much less to do with the war or giant corporations taking advantage of consumers and more about the Federal Reserve’s and the Government’s actions. The cause of inflation was the economic consequence of “too much money chasing too few goods.”

Unfortunately, Powell is blaming the wrong culprit.

War With Ukraine Is Not The Issue

“The effects of Russia’s war against Ukraine have been a primary driver of the changes in headline inflation around the world since early 2022. Headline inflation is what households and businesses experience most directly, so this decline is very good news. But food and energy prices are influenced by global factors that remain volatile, and can provide a misleading signal of where inflation is headed.”

While the war between Russia and Ukraine certainly did not help matters, it wasn’t as much of a factor of inflationary pressures as Mr. Powell makes it.

First, as Mr. Powell states, “I will focus on core PCE inflation, which omits the food and energy components.” Secondly, while the surge in energy prices was partially due to the war and restricted supply of Russian oil, prices were already well on the rise from the Covid collapse as the world began to open back up.

In fact, since the peak of backwardation in 2022, oil prices have steadily declined, lowering the inflationary impact on U.S. households. Such is also a function of the extraction of the $5 Trillion in deficit spending used to send checks to families, creating an outsized demand for oil during a production shutdown.

Mr. Powell is correct that declining inflation is a benefit to households. However, the excuse of using the war between Russia and Ukraine as a basis for inflationary pressures is disingenuous. Given that oil prices significantly correlate to the overall rise and fall of inflation, despite being a relatively small component of the overall calculation, it suggests it is far more of a reflection of the actions of both the Federal Reserve and the Government since 2020.

The most significant contributor to the decline of inflation is the reversal of the massive amount of monetary stimulus and support forced into the economy. As Powell noted:

“Turning to the outlook, although further unwinding of pandemic-related distortions should continue to put some downward pressure on inflation, restrictive monetary policy will likely play an increasingly important role. Getting inflation sustainably back down to 2 percent is expected to require a period of below-trend economic growth and some softening in labor market conditions.”

The problem with that statement is that if Powell does not acknowledge the actual cause of inflation, the Federal Reserve will likely be behind the curve when something eventually breaks.

A Day Late And A Dollar Short

As Powell noted in his speech:

“Beyond these traditional sources of policy uncertainty, the supply and demand dislocations unique to this cycle raise further complications through their effects on inflation and labor market dynamics.

These uncertainties, both old and new, complicate our task of balancing the risk of tightening monetary policy too much against the risk of tightening too little. Doing too little could allow above-target inflation to become entrenched and ultimately require monetary policy to wring more persistent inflation from the economy at a high cost to employment. Doing too much could also do unnecessary harm to the economy.

Without correctly identifying the true culprits of the current bout of inflation, the risk of doing too much or too little becomes elevated. In simpler terms, if you aim at the wrong target, the odds of success fall dramatically.

The problem is that monetary policy is already very restrictive. From inflation, surging short and long-term interest rates, and the “bullwhip effect,” economic growth will slow as the “lag effect” catches up. Such is already showing up in many of the economic reports. Our real-time composite economic index and the 6-month rate of change in the Leading Economic Index confirm the same.

While Powell most likely understands the true causes of inflation, he can’t undermine the current Administration. As Ian Shepherdson previously noted, this is more about controlling sentiment.

“Policymakers know very well the path of inflation, especially the core rate, over the remainder of this year is impervious to interest rate decisions. Monetary policy works with long lags. ‌But the Fed has constituencies other than monetary economists; they have to calm the inflation fears of the public, the markets, and politicians. That means they have no choice but to sound as tough as possible because part of their job is to rein in inflation expectations.”

As we discussed in “Stability/Instability Paradox:”

“The ‘stability/instability paradox‘ assumes that all players are rational, and such rationality implies an avoidance of complete destruction. In other words, all players will act rationally, and no one will push ‘the big red button.’”

With consumers under pressure from higher interest rates, tighter lending standards, and slowing economic growth rates, the risk of doing too much is rising. Since 1980, the financial landscape has been littered with the carcasses of monetary policy miscalculations.

Could the Fed engineer a “soft landing” in the economy? Such is always possible. However, even Jerome Powell admits that sticking such a landing may be more challenging than many expect.

“As is often the case, we are navigating by the stars under cloudy skies.”

The problem for “Powell & Co.” is that intentionally obfuscating the truth about the cause of inflation is one thing. However, if he genuinely believes that inflation is the function of organic economic activities, he will most likely be the architect of the next recession.

Gross Domestic Product (GDP) and Gross Domestic Income (GDI) are two very similar measures of economic activity. The difference is that GDP measures output, while GDI assesses income. In both theory and history, these two measures should tell the same economic story. Historically, GDI has proven to be more reliable but is less followed as it is released a month later than GDP.

It’s hard to see in the graph below, but GDI growth has been negative for the last three quarters while GDP has grown. The Tweet of the Day at the bottom shows a close-up chart of the recent divergence. We are concerned that significant differences between GDP and GDI tend to occur before recessions. In addition to showing the strong correlation between GDP and GDI, the graph also shows the standard deviation (sigma) between changes in the two figures. Currently, at 3.72 sigmas, the difference is the largest going back to WWII. The circles highlight similar albeit smaller differences that occurred before the recession of 2000 and 2008.

What To Watch Today

Economics

Earnings

Market Trading Update

After four straight days of gains, the market traded mostly in positive territory yesterday but ultimately succumbed to a bout of selling pressure ahead of the much-anticipated employment report this morning. An employment number that is too strong will be a negative for the markets as it will keep the Fed on the rate-hiking path to slow economic activity. A soft number could send stocks higher to start the first trading day of the new month.

Once again, we have slipped back into the “bad news is good news” for stocks in hopes of the Fed returning to more accommodative monetary policies to push asset prices higher. A soft employment report this morning will not be unsurprising, given that much of the data as of late was weaker than expected. The market remains in a bullish rally following the August sell-off, with Technology, Communications, and Discretionary continuing to lead the charge so far. Will 2024 be the year that the laggards again become the leaders?

Delinquencies On The Rise

We have recently posited that the excess savings from the two massive stimulus checks and other financial benefits have largely been used. The graph below from the Washington Post adds further credence to our logic. As it shows, delinquencies for the three major consumer credit types fell during 2020 and 2021. The combination of stimulus and reduced spending made paying credit bills easier than usual for consumers. The beneficial financial situation lasted until 2022. At that time, excess savings were declining, and the interest rates on said credit started to rise, making the debt payments more onerous. Also, inflation outpaced wages in many cases. Such led some consumers to borrow more than they otherwise would have.

The unwind of the stimulus, the increased use of credit, inflation, and higher interest rates are finally resulting in delinquencies. They are now at their highest levels in ten years and likely increasing further. As long as the labor market remains healthy, this will likely remain a problem for lower-income earners. However, if unemployment upticks, weak consumption will become a much broader economic concern.

PCE Prices Update

The PCE price index, the Fed’s preferred inflation gauge, was in line with expectations, rising 0.2% for July. The year-over-year PCE ticked up 0.1% to 3.3%. While PCE, like CPI, appears to be sticky around 3.0-3.5%, inflation is much closer to 2% than the number portrays.

In Is Inflation Already At The Fed’s Target, we explained how CPI is likely already at the Fed’s 2% target if you factor in that reporting for shelter prices lags the real world significantly. Per the article:

The last three months of CPI- excluding shelter, have averaged +0.001%. The year-over-year data show CPI, excluding shelter prices, is +1.19%. Compare that to the +3.1% reported last week. Also, note that shelter prices lagged when inflation was heating up. Not surprisingly, they are now lagging with inflation rates normalizing.

We revisit the analysis because PCE is telling us the same story. As we highlight below, the market-based PCE measure, which excludes imputed rents (about 25% of CPI), is running at 0.1% a month and 1.8% on a three-month annualized basis.

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Tuesday’s JOLTS report and Wednesday’s ADP point to a sudden weakening of the labor markets. The JOLTS report (Job Openings and Labor Turnover Survey) produced by the BLS showed the number of job openings fell by 338k to 8.8 million. As shown below, job openings are falling almost as rapidly as they rose in 2020 and 2021. Per ZeroHedge: “The 3-month drop in job openings was 1.5 million, the 2nd highest on record surpassed only by the total economic shutdown during the covid crash.” Also, within the JOLTS report was another decline in the quit rate. This measures how many employees, as a percentage of the workforce, voluntarily quit jobs. The quit rate increases when employees are confident they can attain higher wages or a better job. Confidence appears to be waning as the quits rate, at 2.3%, is back to pre-pandemic levels.

ADP, like JOLTS, provided the markets with negative surprises. ADP reported the economy added 177k new private-sector jobs last month. While still a decent number, it is well off the prior two months, which averaged about 400k new jobs each month. Per ADP’s chief economist: “This month’s numbers are consistent with the pace of job creation before the pandemic. After two years of exceptional gains tied to the recovery, we’re moving toward more sustainable growth in pay and employment as the economic effects of the pandemic recede.” Both JOLTS and ADP show a sharp slowdown in the pace of hiring. While neither indicates declining job growth, the strong employment trend is finally normalizing. Jobless Claims this morning and the BLS report on Friday will provide more data on the labor market.

What To Watch Today

Economics

Earnings

Market Trading Update

More bad news was good news for the market yesterday, as investors hope the Fed will stop hiking rates. A weak ADP number suggests further weakness in Friday’s much-anticipated employment report, a down revision to Q2 GDP, and a trade deficit surge all contributed to the “bad news = buy stocks” meme.

Setting all of the media-driven narrative aside, after a 5% decline from the recent peak, the market was sufficiently oversold for a bounce. As noted yesterday, with the “buy signal” now registered, the market rallied yesterday, and investors put capital back to work. The market is starting to move back to more overbought short-term territory, so use pullbacks to the 50-DMA as an opportunity to add trading positions as needed. While we could see a rally that lasts for a few days, September is certainly a month that typically brings some volatility. So, if you are overweight equities and need to rebalance some risk, this rally is likely a good opportunity to do so. Once we get into October, we will have a better sense of what the end of the year will look like, and we can allocate accordingly.

More On The Quits Rate

As noted, the quits rate is a good measure of employee confidence. When confidence is high, employees feel more emboldened to ask for raises or quit and seek higher-paying jobs. The recently high quits rate concerned the Fed as they feared it could fuel a price wage spiral. Such occurs when higher wages drive prices higher, which drives wages higher, and so on. With the quits rate back to more normal levels, the Fed can breathe a sigh of relief that wage pressures are likely behind us. The graph below, from Liz Young at SOFI, shows the quits rate tends to lead the Atlanta Fed Wage Growth Tracker by about nine months.

Retailers In Trouble Part 2

Yesterday’s Commentary led with a discussion on slowing personal consumption and its effect on retailers. The graph below shows the market is concerned for the retailers’ financial viability. CDS, or credit default swaps, are insurance contracts for bondholders. As shown, CDS on the retail sector has spiked, while non-retailers show no such change. Keep in mind CDS for retailers tend to be much more volatile than the broader market. The second graph further confirms investors are wary of the retail industry. It shows that since the lows last October, the retail ETF (XRT) has underperformed the S&P 500 by about 15%.

Hedge Funds Love MegaCap Stocks

Hedge funds now allocate about a third of their stock exposure to mega-cap stocks (>200 billion market cap). Such an increase in their exposure over the year helps explain the strong outperformance of the magnificent seven and a few other very large-cap stocks. With such a high allocation, the odds of hedge funds adding more exposure to mega-cap stocks are low. If those stocks falter, the hedge funds will likely trip over each other to sell. For now, mega caps are the right place to position. But, the imbalance raises concern that such positioning may not be a good long-term position.

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Part one of this article discusses the potential ramifications related to policy actions that China and Japan might take. These large U.S. Treasury bondholders could temporarily upset the Treasury market, but as we opined, we do not think they threaten our forecast for lower yields. Like China and Japan, inflation, deficits, and QT are stories bond bears are telling themselves to justify higher yields in the future.

Part 2 focuses on the inflation outlook, burgeoning fiscal deficits, and QT. Like China and Japan, any of the three factors we discuss in this article can briefly upset the bond market. But we do not see inflation, deficits, or QT as a cause of concern for longer-term bond bulls. 

Inflation Expectations

Some are starting to worry that inflation is beginning to rise again. For example, Lawrence Summers shares the graph below, implying that prices will ramp back up.

Given the symbiotic relationship between bond yields and inflation, bearish bond traders are taking notice of new inflation worries. Gasoline, home prices, and some other goods and services are again on the uptick.

While some may be concerned about higher prices, implied inflation, as determined by the bond markets, displays no such fear. As we share below, five- and ten-year inflation expectations continue declining despite bond yields rising sharply.

CPI will likely continue lower as lagged inflation reporting on shelter costs will catch up to reality. As we wrote in Is Inflation Already At The Fed’s Target? :

CPI with realistic OER and rent prices would be lower than the CPI excluding shelter numbers graphed above. Ask yourself:” What would Fed monetary policy be if inflation was at the Fed’s target?”

The quote references the following graph showing that CPI excluding shelter is 1.019%.

Bottom line:

We think inflation readings will be lower in six months, albeit may bounce around current levels for a few months before declining. While some think inflation will rise, the markets, in aggregate, have no such concern as we share with implied inflation rates. Therefore, it’s tough to pin the recent yield increases on inflation expectations.

Debt and Deficits

Do federal deficits and associated debt issuance correlate with bond yields?

While many fear sharply increasing deficits will push yields higher, history argues the opposite. Since 1980, yields have fallen precipitously while debt to GDP has increased. Why?

Per Hoisington Investment Management’s latest quarterly update:

Estimates from econometric studies of highly indebted industrialized economies indicate that the government expenditure multiplier is positive for the first four to six quarters after the initial deficit financing, then turns negative after three years. This implies that a dollar of debt financed federal expenditures will, ‘at the end of the day,’ reduce private GDP.

In other words, today’s stimulus is tomorrow’s burden.

Government debt is onerous. Since it is growing much quicker than tax revenue, lower interest rates are required to keep interest expenses affordable for the Government. Further, the burgeoning debt will reduce economic growth and inflation in time. As we show, debt has grown much faster than GDP, tax revenues, and federal interest expenses. However, due to higher interest rates, interest expense has grown more in the last three years than in the fifty years prior. The recent trend is unsustainable!

Bottom Line:

The market may rightly fret that more debt will increase yields. However, history argues the opposite. The Fed and Treasury know that issuing new debt and rolling over existing debt can’t be done much longer at higher rates. In early August, The Treasury Department announced that it was comfortable letting the share of bills outstanding increase above the recommended level to 22.4%. In other words, they are trying to avoid locking in higher rates for longer.

QT

The Fed is likely to continue QT even after they pause rate hikes. This means that bonds on the Fed’s balance sheet today must find a new home. While that may appear to be a bearish factor for bonds, it’s worth noting the Fed is not selling long-term bonds. They are only letting maturing bonds roll off their balance sheet. In fact, each month, they are a net buyer of long-term bonds. The Fed needs to buy bonds when the amount of their maturing bonds exceeds the $95 billion monthly objective.

The regional bank crisis resulted from banks having to realize losses on long-term bonds and loans. Those assets and their unrealized losses are still on bank balance sheets. The Fed is aware that higher yields risk reigniting the bank crisis. Do not be surprised if the Fed or Treasury initiates some yield control if rates increase. As we said in the deficits section, neither the Government nor the economy can afford higher rates. For more, read our article- The Government Can’t Afford Higher for Longer.

Bottom Line:

QT is a short-term measure employed to normalize the Fed’s balance sheet. We have little doubt that when the time comes, the Fed will again aggressively buy bonds to reduce interest rates and limit the financial fallout of higher rates.

They will do whatever it takes when the time comes!

Summary

Like any other financial asset, bond yields trade up and down minute by minute. The media and investors tell stories explaining each move. But often, gyrations are simply a temporary imbalance of buyers and sellers. China, Japan, inflation, deficits, and QT are frightening stories and headlines. But as we share in this article and its predecessor, they should not worry bond bulls willing to endure short-term yield volatility for significant long-term reward.

No doubt, the bearish factors in this article are concerning. That said, we think they dwarf compared to the opportunity that bonds present. Currently, 10-year notes yield 3% more than the long-term trend economic growth rate and trend inflation. The graph shows the natural economic growth rate is likely around 1%. Earning 4% or more in a 1% economy is the best yield premium bond investors have been paid in well over 20 years. The real question bond holders need to ask themselves is, are the 60-year economic trends in the graph reversing higher? If yes, rethink bonds. If not, get them while they are cheap!