There’s a lot to talk about right now. We have a Fed that says they’re data-driven, yet they seem to be looking at the wrong data. The UK’s pension crisis was almost a Lehman brother’s moment. We have an election cycle, and Russia and Ukraine are still at war. And to top it all off, nobody knows whether we’re in a recession right now because they cannot agree on what a recession is.
So despite the Federal Reserve’s attempt to lower inflation, inflation is at a high of 8.2%. It’s a little higher than expected, but it does look like inflation peaked out in September, coming down from 8.3%.
It’s important to note that when the Fed increases interest rates, it’s not like pressing the brakes. Inflation isn’t going to suddenly come to a halt. It’s actually more like warming up the oven; it takes some time to get to the desired temperature. It can take six months to a year for inflation to respond to these rate hikes.
This isn’t a quick fix. It’s also not likely that inflation will return back to 2% anytime soon.
In fact, the Federal Reserve doesn’t believe we’ll return to near 2% until between late 2023 and early 2025
So here’s the agenda. I’m going to start with economic policies: I’ll start with fiscal policy then roll into monetary policy, and then I’ll weave in economics with Fed policy, because the Fed is supposedly data-driven. And there’s a lot of data out there that suggests that the Fed policymakers should not be unanimous in their vote to tighten policy.
Unanimity seems to be the order of the day with the Fed. I don’t know if it’s from Chairman Powell, or what. But we seem to have a Fed that says they’re data dependent, yet the data that their looking at seems to be lagging indicators.
I think the Fed is making some big mistakes here that could possibly throw us into deflation. And there is data out there to show that’s already in the system.
So, starting with fiscal policy, we’re looking at the midterm elections right now. So, basically, nothing new is happening on fiscal policy, which is just as well. In the midterms, we probably, as we usually do in the midterms, have a changeover or a loss of seats for the incumbent party in the house. And that will probably turn the house this time.
And so I think that the policies, looking forward, will be focused on getting spending, taxes regulation down, and maybe opening up the spigots a bit more in terms of energy production here in this country, instead of going to Venezuela or Saudi Arabia.
When we talk about monetary policy, you often hear the term M2 Growth. I don’t want you to feel left out of the party, so let me briefly explain what that is.
M2 is a classification of money supply. It includes assets that are highly liquid but not exclusively cash. M2 is mostly used as a classification for money supply in America, the UK, and eurozone.
So M2 growth peaked at 27% in 2020, and has been slowing ever since. It hit 4.1% in August, we believe it is closing in or might be below 3% on a year-over-year basis in September, which doesn’t leave a lot of room for growth or inflation unless velocity is really picking up, which is the rate at which money turns over.
And we’re in an environment where we do not believe velocity is picking up. If anything, I think individuals and businesses are becoming more concerned and are spending less freely.
So, if you look at M2 also you’ll see that it actually peaked in March. Now, this is very unusual to see sequential declines in money. So, we have not gotten back above that March peak, and we may not get back above it the way that Fed policy is going.
And I think I’d like to build the case a little more here that the Fed is probably making a mistake. I say probably because I have to from a compliance point of view, but I really do believe the Fed is making a mistake. And reflecting a little bit more on the Jackson Hole speech that Chairman Powell gave in late August.
We’ve come to recognize that Chairman Powell really does think he is the reincarnation of Chairman Volcker, that we need him to take a sledgehammer to inflation, much like Volcker did. And history has treated Chairman Volcker very kindly; he did turn the tide on inflation. Now, what he did though, was he turned a tide that had been building for 15 years.
It started in 1964 with the Vietnam War, and with the Great Society. So, many social programs started at that time under President Johnson, and for 15 years fiscal and monetary policy pretty much went rogue as we look at history.
Even after shocks to the system like the oil embargo and the stimulus that came about because of it, both monetary and fiscal policy, we never saw the kind of slowdown in monetary and fiscal policy that we’re seeing right now.
Federal spending is still down 14% on a year-over-year basis, you never saw a decline in fiscal policy spending in the 70s. Monetary policy seemed to be on autopilot back then. The dollar was getting crushed toward the end of the 70s, adding to the inflationary fire.
And so, Chairman Volcker did choke off money supply, and killed inflation. It took quite a long time for people to believe that inflation had peaked. In fact, I don’t think many people believe it peaked as it did in 1981 until 1986 when oil prices crashed. So, the inflation expectations were embedded in the system. And, that was over a 15-year period.
By the time the Fed got around to tackling it this time, it was not a 15-year problem, it was a 15-month problem. And from our point of view, it was caused primarily by shocks, major shocks to the system that we had never seen before.
We had not had, since the Spanish Influenza, a global pandemic. And we did not have the supply chain problems, two years’ worth of them, that we had because of the COVID panic.
And then, of course, we had another shock to top those off, and that was Russia’s invasion of Ukraine. So, these are shocks to the system. This was not a period of embedding inflation expectations. And yet, Chairman Powell is taking a sledgehammer that is actually bigger, much bigger. It’s at least six times bigger right now, and could be eight to 10 times bigger if the Fed does raise the Fed funds rate another 75 basis points on November 2nd.
And what do I mean by that? Well, Chairman Volcker was dealing with double-digit interest rates. He took interest rates from 10% to 20%. Now, by the time he did that, consumers and businesses had gotten used to maneuvering around inflation. So, while that sounds shocking, going from 10 to 20%, and it did have some shock value, it wasn’t the same as what we’re experiencing today with Chairman Powell and the Fed.
Today, we’ve gone from 0.25% on the Fed funds rate to 3.25%, which a 13-fold increase, not a two-fold increase.
So we have this situation where Fed Chairman Powell is behaving as though what’s going on today with inflation is much worse than what Volcker inherited.
Starting from a low base, which is where interest rates where before Covid, is really shocking the system, especially given how long interest rates have been low. It’s been since 2008/9, and here we are in 2022.
So, if they raise the Fed funds rate another 75 basis points, this will be a 16-fold increase compared to Volker’s two-fold increase.
Now, we have been expecting serious ramifications, financial and other ramifications, because of this monetary policy. And we’ve gotten the first one, and it’s starting to be publicized on the news, but maybe you haven’t heard about it.
What I’m talking about is something called Liability Driven Investing or LDI, and it’s where pension funds match their liabilities with the purchase of assets.
So, in its pure form, pensions will match one for one the amount that they have to pay out to pensioners as they retire. Now, it would be great if they did match assets with liabilities completely from a safety to the system point of view, but they don’t. And with banks, and a very low-interest rate environment, they got used to using derivatives and taking shortcuts to try and accomplish the same goal, which is what we saw happen in that October 4th Wall Street Journal post.
And after a very long period of very low-interest rates, we are now talking about this LDI crisis in the UK, that the reason it’s so serious is pension fund sponsors were beginning to think, and banks were beginning to think, that interest rates would stay very low for a very long time for as far as the eye could see.
And that assumption was built into the kind of derivative activity they were doing. No one expected a sharp increase in interest rates. Well, once that happened, pensions began getting margin calls and they couldn’t meet them.
And so, the Bank of England had to step in and basically say pretty much the same thing that Draghi said, the chairman of the European Central Bank in 2011. He basically said, “We’re going to pull out all stops no matter what.”
So while the Bank of England had been almost forced, because of currency depreciation, into following our Fed with higher interest rates, this was going to cause a great deal of harm to its system and so it had to reverse its policy.
So, this is another shift in policy. It’s an outright easing, and they said they will continue until October 15th. So now, all of these pension funds in collaboration with the banks are deleveraging and they have till October 14th.
So, what do you do if you’re deleveraging in an illiquid environment? All markets are experiencing duress today, I think the Fed is a big part of that. So, what do you do?
Well, you sell the most liquid assets in your portfolio. So what are those? Those are government bonds. And so, we’re seeing US government bonds, which are held in pension funds abroad being sold even though deflationary pressures are mounting all over the place.
And so, we think this is a bit of a financial crisis. And we think we’ll see it elsewhere as the Fed continues to raise interest rates, as it seems it wants to do.
Certainly, this week was full of speeches from all the Fed members reminding everyone that they’re going to take interest rates up until we get to 2% inflation.
We’re seeing other changes. We’ve seen China intervene to limit the weakening of the yuan. We’ve seen Japan doing the same. Now, what is that? What are they doing when they do that?
Well, when Japan is trying to support its currency at 145 yen to the dollar, what it does is it sells dollars and buys back yen. Now, that’s good in a way, it’s doing some of what the Fed should be doing here, actually. It’s providing dollar liquidity to the rest of the world.
China’s doing the same thing. And so, we’ll see what happens from here. I think this is getting to be so serious that we are reaching a cathartic moment. And I do think it started with the UK Pension crisis. And the Fed has acknowledged that there are international ramifications to what it is doing, but it is thinking first and foremost about the US.
This reminds me a lot of the early 80s and what happened in the early 80s. There were two accords; the Louvre accord and the Plaza Accord, where the Treasury ministers around the world all agreed to sell dollars to limit the deflationary impact on the rest of the world.
And when I say deflationary impact, there are countries that their currencies are falling apart so they look like they’re in hyperinflation or heading in that direction. But they are being strangled by dollar-denominated debt that they cannot service. And so, this ends up being quite a deflationary situation longer term.
And so, we’re wondering what in the US is the weak link. Is it our pensions? We don’t know. We know there are LDI strategies in the United States. They’re not as leveraged as we understand.
But one never knows. So if it’s not likely that the problem lies with US pensions, what are some of the weak links that we’re seeing?
We’ve been worrying about auto credit for a while now, and now we have more reason to. The Manheim used car index was released last week, effectively, it’s a value index pricing and it dropped another 3% plus, it was at a 4% plus decline last month.
And so, what we have now, it has that the year-over-year increase has gone from 54% in April of 21 to -0.1. So, there you go Fed. There’s some indication that… There’s another indication that deflation is in the system.
That index peaked in January, and is now down 14% just since January. So, it’s declining at more than a 20% rate. Now, why is this important?
Well, a lot of auto paper out there makes assumptions, or the investors make assumptions about the residual values of cars. And those residual values have been going up, maybe not as much as the used car index, but they have been firm.
If we’re right, the used car price index is going to collapse here. Why? Well, many people bought cars during COVID because they wanted to avoid mass transit.
Under normal conditions, they didn’t need that car. Nonetheless, they were quite happy to see used car prices going up with the thought that when the coast is clear, they would sell back into the market, into the used car market. And as I mentioned, used car prices were up 54% on a year-over-year basis at one point, now they’re flat to down.
And now, dealers who were paying too much for used cars are sitting on losses, and they are going to have to disgorge those inventories because inventories cost money to carry, especially as interest rates are going up. So, they’re going to be forced to sell, and we believe that’s already happening.
And there’s about a trillion dollars of auto paper. Now, this won’t be a systemic risk, but because auto paper was the best-performing paper during 08-09, this is going to be quite a surprise to a number of investors.
What’s another weak link in the United States?
Well, corporations have a lot of debt. Why? Well, they’ve been catering to short-term shareholders who want them to buy back shares and don’t mind that they’re leveraging up to do so, or they want them to pay dividends and don’t mind that they’re leveraging up because becoming more indebted.
Well, this is becoming a big problem for certain sectors of the economy that are in the throes of disruption, both cyclical and secular. And I think the retail sector is one of those.
We remain astonished at the inventory buildup taking place out there. And the way we’re looking at this now, from a deflationary point of view — and you know we think that’s the bigger risk now out there — is the pipeline is full of deflationary indicators starting from commodities, and we’ll get into that in a moment.
But at the end of the pipeline, downstream at the consumer level, retailers are awash in inventories. And the latest one is Nike. And Nike is both a retailer but it mostly sells to retail. Nikes inventories. Well, first of all, its global sales were up 3% in this last quarter, its inventories increased 44%, and that’s an August quarter.
There were already telltale signs that the consumer was weakening. Its North American inventories were up 68%. And the inventories in transit, mostly from Asia, were up… So, they’re on ships, were up 85%.
So you know what’s going to happen in order to clear the shelves, Nike is going to have to cut prices and retailers will as well. And we believe this is just a microcosm of a much broader problem out there. And we think we’ll see it in full force this holiday season. So, you should look for and demand bargain basement pricing this holiday season.
Now, November 2nd, they’re going to increase — they’re saying pretty unanimously — 75 basis points. And so, we took a look at the data for the last month because the Fed is saying that it’s data-driven. So, if it’s data-driven, let’s do that.
And so, we looked at all of the indicators for this last month, just the last month, and we found 22 firm or strong indicators suggesting employment and inflation might linger at a higher-than-expected rate. We found 22 weak indicators. Now, pulling out the ones that are specific to employment and inflation, since those are the two variables that the Fed is weighing more than any other, and we find that on the firm side what they didn’t like was core CPI or Consumer Price Index and PCE or Personal Consumption Expenditures at 0.6%, month to month, even though the headline indicators were flat to down.
The PPI core 0.4, and nonfarm payroll which came out today pretty much in line 263,000, but there was a drop in the unemployment rate from 3.7% to 3.5.
Now, the reason for the drop was the labor force, not employment. The labor force shrinking, labor force participation ticked down. So, I don’t take that reason as seriously because we do believe labor force participation will, unbalanced, continue to trend up, especially if we’re in as weak an economy as we believe.
So, on the weak side, again, if the Fed were data-driven, it would be paying attention to employment in the ISM index for September, below 50% means it’s contracting.
The job openings, so JOLTS, they dropped a million in one month. Now, still strong at 10 million, they dropped 1.1 million, that’s a big drop in just one month. So, job openings are declining. We’re also seeing surveys out there, I think of in the US among major employers 300 have announced layoffs. And that’s reflected in something called the challenger layoff survey. And those layoffs, which are broad-based company layoffs, are up 68% year over year.
I would also imagine that they would consider leading indicators, which in every recession and recovery, in my experience, the Fed has paid a lot of mind to. It dropped 0.3% in the month, last month, so September, and that makes for five consecutive months of decline.
And the rule of thumb there is once you’ve got three, you know you’re in a recession. So, the Fed may be saying that it’s data dependent, but it’s looking at the data it wants to look at, it’s not looking at the totality here. It’s also making an assumption that we think is mistaken.
It’s very much a Phillips Curve Fed. The Phillips curve is an economic theory that inflation and unemployment have a stable and inverse relationship. So the Fed is basically saying that rising output in employment causes inflation, or they’re at the very least, highly correlated. And that’s just not true.
If you look at the data; 80s, 90s, 2000s, you’ll see that inflation came down during times when the economy was very strong. Why? It’s because of productivity.
Productivity growth is a critical byproduct, and an anti-inflationary byproduct, of good strong recoveries. So, we shall see.
All right, on to — and I’m going to refer to some numbers here that my colleagues prepared. So, let’s go to the commodity prices again, data-driven Fed. Are you listening?
So, we’ll start from their peaks. We have the gold price down 17%, copper down 30, lumber down 73%, think about that. Housing is collapsing. Iron ore down 45%, infrastructure around the world has run into trouble, especially China. Corn down 17%, Silver down 29%, DRAM prices which are chips, semiconductors down 46%. The Baltic freight index down 48%, that’s an indicator of supply chain issues. The Baltic freight dry index, which is just for dry goods, down 65%, Oil down 29%.
And many people have been dismissing these and saying, “Yeah, but they went to sky-high prices. They’re still not down on a year-over-year basis.” That’s not true anymore.
Let’s look at the year over year numbers.
Gold is down 3%, copper is down 17%. This is as of last week. Lumber is down 28% on a year-over-year basis. Corn is an exception, it is up 27%, again, Ukraine being a big problem there. We have silver down 9%, DRAM prices down 33%. The Baltic dry freight index down 65%. Oil is up 14%. That’s as of last week, it’s had a big pop recently. But we do think having come down from $130 to $90, it is in a downtrend, mostly because of demand destruction.
There’s another kind of esoteric price out there, it’s containerboard prices. And this gives you a sense of how tight the box market is because of a huge amount of trade taking place. So, they are down 29% from their peak, and about 53% from a year ago.
So, just taking the evidence and putting it together like this, there is a lot of data to be driving the Fed, which is what they say is happening. But we don’t think it’s happening. I just rattled off lots of examples.
So, let’s go to the markets, and then, wrap up pretty quickly here. Not much to say. Markets are selling off across the board, and that’s very unusual. It’s associated with crises, and more convincing evidence to us that the Fed is too tight, and that it will pivot. And when it does, it will do so, we think, significantly.
Now first, it might simply be rhetoric, because they always like to tee us up for what the next moves are going to be. And we haven’t heard that rhetoric yet, despite all the evidence I just shared with you.
But that evidence I just shared with you tells us that the Fed is going to get the message loudly and clearly somehow, and it may not be showing through in the numbers they want to see. But it will, they are huge lagging indicators. They’re basing policy on lagging indicators, not what they’re supposed to be doing.
Anyway, in the US alone, if you take equities and bonds and look at what’s happened since the peak, you will see that the loss to investors is more than twice what we saw in 08, 09. That’s how bad this is because bonds are selling off with stocks this time. And one of the reasons for that is a seizing up of liquidity.
As I mentioned, if people are facing margin calls or in financial difficulty, they’re going to sell their most liquid asset, they will have no choice especially with margin calls. Most liquid assets tend to be government bonds, and I think that’s why we’re seeing the backup in government bonds here despite all of the deflationary signals in the pipeline.
Interestingly, one price indicator associated with innovation is holding up, beginning to hold up better than other prices, and that’s Bitcoin. It’s been interesting to see it flatline in the last month while other indicators are reaching for new lows. Now, this is not surprising in the late stages of a bear market. In our experience, innovation starts to outperform in the late stages of a bear market.
Why does that happen? It happens because innovation is the new leadership, innovation solves problems. Innovation solves the kinds of problems we have today; supply chain, food, energy shortages. Think of the genomic revolution, electric vehicles, and so forth. researchers used state-of-the-art genomic sequencers to quickly sequence the SARS COVID virus.
And so, we believe that innovation should outperform if we’re toward the end of this bear market, and if the Fed is close to pivoting, even in its rhetoric
So, with that, I guess I’d like to reassure you that it feels like we’re moving in the right direction. And I think that the 75-basis point increase, if that’s what the Fed is going to do, is going to result in some financial signals that the Fed will have to pay attention to.
We think the pivot is close, if in nothing else but rhetoric in the short term. And we certainly hope that the Fed gets away from this need for unanimity and a united front, when really, we have all of these Fed members, and presidents for a reason; to debate.
And we feel that that debate is being stifled. The debate should be driven by data, but I can’t see how they’re debating the situation. If it were, they would not be unanimous in their thinking right now.
So, let’s hope there are some dissenters, and let’s hope there’s some rhetoric change. There are all kinds of reasons out there, data-driven reasons. And so, we hope the Fed is paying more attention to all of the data instead of just a few pieces of lagging indicators.
So toward the end of 2019, I was preparing for a recession. Equities were overvalued then, and bonds were performing a little irregular in my opinion. Then COVID came, brining stimulus and that’s why we didn’t get a crash then.
I still believe that original recession is baked in the system. Right now, many are saying we’re not in a recession due to the jobs or JOLTS numbers. Job numbers are a lagging indicator, and we have to keep in mind that many employers have been starving for employees. Many service companies still are.
While there are layoffs occurring, I don’t believe employers are going to let employees go without a fight, they might even be willing to suffer to keep them, cutting back in other areas.
But in order for the Fed to taper inflation, we’re going to have to let people go. It’s simple economics. There are reports that we’ll cut about 179,000 jobs per month next year. And when that happens, you’ll know the real recession started.
So I believe the markets are fairly priced right now and that it will take time for all these rate hikes to reflect in the system. Again, 6-12 months. That’s how long it takes. And the risk right now is that the fed will hike rates too far, and that’s going to depress stock prices and possibly push the US into deflation.
If you’re thinking about retiring next year, I recommend to build your cash reserves now, and pay off your mortgage and consumer debts. Don’t carry that into retirement if you can avoid it. Then if you get let go next year, claim unemployment then retire.
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With that, I wish you a happy weekend, or whatever day you’re viewing this, and we’ll see you next month.
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