Image Credit: Marco Verch (Flickr)

Will Investors Rework their Positions in Response to Fed Statements?

Will the Fed send any new signals after its May FOMC meeting?

Federal Reserve members have set investor expectations for a 50bp increase in overnight rates after the May 4 meeting. It’s a pretty safe bet. Anything different would severely spook the markets. However, where the surprise may come is in what Chairman Jay Powell says related to the future after the two-day meeting. This could adjust expectations which would cause investors to adjust their portfolios.

A New Wrinkle to Watch

 While the markets believe that at the following meeting in June the FOMC will also serve up a 50bp hike, last week’s negative first-quarter GDP report may cause the Chairman to speak more cautiously.  And no one has clarity on what the Fed may do after June. One new wrinkle Fed-watchers are aware of is that the negative Q1 GDP, by definition, places us halfway to a recession. If the current quarter also shows negative growth, we are, by definition, already in a recession.

Tightening monetary policy to stop inflation while the economy is shrinking is stagflation.

Investors will be placing every word in the Fed Chairman’s post-meeting statement under a microscope. Inflation is still running at 40-year highs. Interest rates are well below inflation rates creating negative real yields (interest rate minus inflation). Investors prefer to earn above future inflation expectations.

So what are the Fed’s expectations? We should know tomorrow afternoon.

Current Market Expectations

The half a percentage point increase expected is considered aggressive. The Fed typically acts in 25 bp moves and then measures the results. Fed Funds are currently targeted at 0.25%-0.50%, so doubling the level truly is unusual. Many economists, based on previous Fed-speak, expect that a similar move will be made in June before the policymakers sit back and let the market absorb their moves.

The Fed has a number of accommodative stances in place that it discussed unwinding beginning this year – market participants want to know if anything has changed. One of them is to begin shrinking its $9 trillion asset portfolio, starting in the first half and at a much faster pace than its sidetracked attempt at passively reducing its holdings went five years ago.

Since Last Tightening

In March, Fed officials lifted their benchmark federal-funds rate to a range between 0.25% and 0.50%, from near zero. They also projected they could lower inflation back to their 2% target without raising the fed-funds rate higher than 3%. They have considered 2% their neutral range where the economy would avoid getting too heated and avoid slumping.

Economic reports released since the Fed’s last 2022 meeting suggest price pressures could remain more persistent as employers continue to give in to higher wage pressures along with price inputs. On Friday, a Labor Department measure of worker pay that is closely watched by central-bank officials showed wages and benefits for private-sector workers continued to rise at its highest rate since 2000.

Fed communication with the public is especially important now because the central bank is relying on market expectations about its future policy intentions to play a major role in removing stimulus without undue costs to the economy.

Take-Away

Bond traders who watch the Fed most closely are expecting a 50bp increase. Not 25bp and not 75bp. The Fed would disrupt the market if they did anything different. It’s future expectations that will be managed both for the overnight lending rate and the more entrenched stimulus that has been in the system as the Fed purchased longer-term bonds. “Mopping” up this stimulus, which has had a very positive impact on economic growth, is tricky.

Chairman Powell’s audience will be listening intently to know what the future holds. In reality, not even the Fed Chair himself knows what is coming in the next year or two. But, the market will at least hear what the top banker is expecting. 

The FOMC announcement should come at 2pm on May 4.

Paul Hoffman

Managing Editor, Channelchek

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Sources

https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

https://www.usnews.com/news/business/articles/2022-05-03/asian-shares-mixed-in-light-golden-week-trading

https://www.wsj.com/articles/feds-message-on-interest-rate-path-destination-will-be-scrutinized-11651570200?mod=hp_lead_pos4

 

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What Will the Fed Choose: Recession or an Economic Crisis?

Last week was all about earnings, as some of Wall Street’s heavyweights released their quarterly reports. Moreover, while mixed results caused sentiment to swing from one extreme to the other, inflation remains front and center, and the outlook for Fed policy is bullish.

For example, whether it’s PepsiCo, Mondelez, or Whirlpool, companies have warned that inflation remains extremely problematic. Moreover, with American Express and Visa highlighting consumers’ eagerness to spend, the pricing pressures show no signs of slowing down. Likewise, S&P Global released its U.S. Composite PMI on Apr. 22, and I wrote on Apr. 25 that it was another all-time high for inflation.

Services:

Source: S&P Global

Manufacturing:

Source: S&P Global

With growth, employment and inflation supporting several rate hikes over the next several months, there is little in the release that implies a dovish U-turn. To that point, please remember that the survey was conducted from Apr. 11 to Apr. 21. Therefore, while investors hope that decelerating growth and inflation will allow the Fed to back off, the PMI data suggests otherwise. As such, the Fed’s conundrum continues to intensify.

Furthermore, with more appetizing earnings reports released on Apr. 28, the results were even more bullish for Fed policy. Likewise, with the precious metals (PMs’) force fields wearing off, they should suffer profoundly as rate hike volatility increases. For example, McDonald’s released its first-quarter earnings on Apr. 28. CFO Kevin Ozan said during the Q1 earnings call:

“In the U.S., I think last quarter, I mentioned that we thought commodities were going to be up roughly 8% or so for the U.S. That number is now more like 12% to 14% for the year. So U.S. commodities clearly have risen (…).”

“On the labor side, in the U.S., it’s probably over 10% right now. Part of that is because, you’ll recall that we made adjustments to our wages in our company-owned restaurants mid-year last year, so we haven’t lapped that. So part of it is due to that and part of it is due to just continued wage inflation.”

As a result, the Fed is losing control of the inflation situation, and the largest restaurant chain in the world is still sounding the alarm. Therefore, with the pricing pressures unwilling to abate on their own (which I’ve warned about for some time), killing demand is the only way to reduce the wage-price spiral.

Please see below:

Source: McDonald’s/Seeking Alpha

On top of that, Caterpillar released its first-quarter earnings on Apr. 28. For context, the company is the world’s largest construction equipment manufacturer. CFO Andrew Bonfield said during the Q1 earnings call:

“We remain encouraged by the strong demand for our products and services. The first quarter of 2022 marked the fifth consecutive quarter of higher end user demand compared to the prior year. Services remained strong in the quarter. We continue to make progress on our service initiatives, including customer value agreements, e-commerce, connected assets and prioritized service events.”

CEO Jim Umpleby added:

“Absent the supply chain constraints, our top line would have been even stronger. When the supply chain conditions ease, we expect to be well positioned to fully meet demand and gain operating leverage from higher volumes.”

Thus, with each new earnings season, companies note that demand remains resilient. As a result, why not raise prices and capitalize on too much stimulus?

Source: Caterpillar/Seeking Alpha

As expected, the “transitory” camp waved the white flag in 2022. However, the merry-go-round of input/output inflation was visible from a mile away. For example, remember what I wrote on Mar. 30, 2021?

Didn’t Powell insist that near-term inflation was only “one-time” and “transient”? Well, despite government-issued CPI data failing to capture the effect of the Fed’s liquidity circus, pricing pressures are popping up everywhere. And with corporations’ decision tree left to raising prices or accepting lower margins, which one do you think they’ll choose?

Continuing the theme, Domino’s Pizza reported its first-quarter earnings on Apr. 28. For context, the company is the largest pizza chain in the U.S. Moreover, when contrasting the quarterly results of Microsoft and Alphabet on Apr. 28, I wrote that investors fail to realize that some companies have succumbed to the medium-term realities sooner than others. Therefore, Domino’s Pizza is another example. CEO Ritch Allison said during the Q1 earnings call:

“Consistent with our communications during our prior earnings call, we faced significant inflationary cost increases across the business in Q1. Those cost pressures combined with the deleveraging from the decline in U.S. same-store sales resulted in earnings falling short of our high expectations for the business (…).”

“We believe that we will continue to face pressure both on the top line for our U.S. business and on our bottom line earnings over the next few quarters. While we remain very optimistic about our ability to drive long-term profitable growth in the near-term 2022 is shaping up to be a challenging year.”

 

CFO Sandeep Reddy added:

“In addition, we would like to update the guidance we provided in March for 2022. Based on the continuously evolving inflationary environment, we now expect the increase in the store food basket within our U.S. system to range from 10% to 12% as compared to 2021 levels.”

If that wasn’t enough, with unprecedented handouts reducing U.S. citizens’ incentive to work, staffing shortages materially impacted Domino’s Q1 results. Moreover, the development is extremely inflationary and only increases the chances of future interest rate hikes.

Please see below:

Source: Domino’s Pizza/Seeking Alpha

Therefore, while I’ve warned on numerous occasions that the Fed is in a lose-lose situation, investors still hold out hope for a dovish pivot. However, they fail to understand the consequences. For example, a dovish 180 is extremely unlikely in this environment; but even if officials completely reversed course, the long-term economic damage would be even more paramount.

When companies are saddled with input pressures, even value-oriented chains like Domino’s Pizza can only endure margin erosion for so long. Thus, with management searching for new ways to appease investors, Fed officials’ patience will only cause an even bigger long-term collapse once inflationary demand destruction unfolds.

Please see below:

Source: Domino’s Pizza/Seeking Alpha

Turning to the macroeconomic front, some interesting data also hit the wire on Apr. 28. For example, the Kansas City Fed released its Tenth District Manufacturing Survey. The headline index declined from 37 in March to 25 in April. Chad Wilkerson, Vice President and Economist at the KC Fed, said:

“The pace of regional factory growth eased somewhat but remained strong. Firms continued to report issues with higher input prices, increased supply chain disruptions, and labor shortages. However, firms were optimistic about future activity and reported little impact from higher interest rates.”

To that point, both the prices paid and received indexes increased month-over-month (MoM).

 

Please see below:

Source: KC Fed

Finally, the major surprise on Apr. 28 was that U.S. real GDP contracted by 1.4% (advance estimate) in Q1. The report stated: “The decrease in real GDP reflected decreases in private inventory investment, exports, federal government spending, and state and local government spending, while imports, which are a subtraction in the calculation of GDP, increased.”

However: “Personal consumption expenditures (PCE), nonresidential fixed investment, and residential fixed investment increased.”

Therefore, with supply chain disruptions leading to import stockpiling (which hurts GDP), net trade was the weak link. However, the dynamic should reverse in Q2 and Q3, and if so, shouldn’t impact the Fed’s rate hike cycle.

The bottom line? The Fed is stuck between a rock and a hard place: deal with inflation now and (likely) push the U.S. into a recession later or ignore inflation and watch an even bigger crisis unfold down the road. As such, the first option is the most likely outcome. Remember, while Fed officials may seem out of touch, they’re not stupid, and history shows the devastating consequences of letting unabated inflation fester. Therefore, interest rate hikes should dominate the headlines over the next several months, and the PMs and the S&P 500 should suffer mightily along the way.

In conclusion, the PMs were mixed on Apr. 28, as silver was the daily underperformer. Moreover, while mining stocks were boosted by the S&P 500, the ‘buy the dip’ crowd is fighting a losing battle. With Amazon and Apple down after the bell on Apr. 28, weak earnings guidance should also dominate the headlines in the months to come. As a result, with the USD Index on fire and real yields poised to continue their ascent, the PMs’ medium-term outlooks are extremely treacherous.

What to Watch for Next Week

With more U.S. economic data releases next week, the most important are as follows:

May 2: ISM Manufacturing PMI

Like this week’s S&P Global Report, ISM’s report is one of the most important data points because it covers growth, inflation, and employment across the entire U.S. Therefore, the results are more relevant than regional surveys.

May 3: JOLTS job openings

Since the lagged data covers March’s figures, it’s less relevant than leading data like the PMIs. However, it’s still important to monitor how government-tallied results are shaping up.

May 4: ADP private payrolls, ISM Services PMI, FOMC statement and press conference

With the FOMC poised to hike interest rates by 50 basis points on May 4, the results and Powell’s comments are the most important fundamental developments of the week. However, ADP’s private payrolls will also provide insight into the health of the U.S. labor market, while the ISM’s Services PMI will have similar implications as the manufacturing PMI. Moreover, both will provide clues about future Fed policy.

May 5: Challenger jobs cuts

With the data showcasing how many employees were fired in April, it’s another indicator of the health of the U.S. labor market.

May 6: Nonfarm payrolls, unemployment rate, average hourly earnings

Half of the Fed’s dual mandate is maximum employment, so continued strength in nonfarm payrolls is bullish for Fed policy. In addition, a low unemployment rate is also helpful, while average hourly earnings will showcase the current state of wage inflation.

All in all, economic data releases impact precious metals because they impact monetary policy. Moreover, if we continue to see higher employment and inflation, the Fed should keep its foot on the hawkish accelerator. If that occurs, the outcome is profoundly bearish for the PMs.

About the Author: Przemyslaw Radomski, CFA (PR) writes for and publishes articles that underscore his disposition of being passionately curious about markets behavior. He uses his statistical and financial background to question the common views and profit on the misconceptions.

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Image Credit: Yuki kawagishi (Flickr)

‘Great Resignation’ Appears to be Hastening the Exodus of US and Other Western Companies from Russia

 

Companies across the globe are fleeing Russia in an unprecedented display of corporate solidarity with their governments, appalled over the invasion of Ukraine. Over 750 multinational businesses so far have said they’re curtailing, suspending or severing ties to Russia, more than triple the number that abandoned South Africa over apartheid in the 1980s.

Many corporate statements announcing the decisions have emphasized humanitarian aspects and unity with the Ukrainian people. For example, Pepsi suspended soda sales in Russia, describing events in Ukraine as “horrific”; Ford Motor Co. cited Russia’s “threats to peace and stability” in pausing operations at its three plants in the country; and Ikea closed its stores there and called the war a “human tragedy.”

 

This article was republished with permission from The Conversation, a news site dedicated to sharing ideas from academic experts. It was written by and represents the research-based opinions of Steven Kreft, Clinical Professor of Business Economics and Public Policy, Indiana University, Elham Mafi-Kreft, Clinical Associate Professor of Business Economics, Indiana University.

 

Detractors of this type of corporate do-goodery have dismissed it as “virtue signaling,” implying there is an ulterior motive to the grandstanding. As scholars of corporate social responsibility, we believe altruism can play a role in corporate decisions like these, but – as virtual signaling suggests – other more profit-focused drivers are usually at work, especially given the stakes when deciding to abandon an entire country.

In this case, the common theme we see for many companies is the “great resignation” – and the fight to attract increasingly picky, younger Gen Z and millennial workers, who say they want to work for socially responsible brands.

Pepsi, which has been in Russia for over 60 years, suspended soda sales, calling the invasion ‘horrific.’  Image Credit: Alexander Zemlianichenko

A Weighty Decision

A company’s decision to entirely sever its operations in a country is seldom taken lightly.

In leaving Russia, companies will incur significant costs from abandoning equipment, stores and factories, or even an entire workforce. For example, Exxon said it expected to lose US$4 billion in assets over its decision to exit Russia, while McDonald’s restaurant closures will cost the company $50 million per month.

And there’s no knowing when the companies leaving Russia will be able to return – if ever.

Yet that isn’t stopping hundreds of companies from making the difficult decision to back away. Amid their condemnations of the invasion and expressions of solidarity with the Ukrainian people, many companies have also acknowledged clear business-related reasons. Appliance maker Whirlpool cited the security of its workers, Japanese automaker Toyota blamed logistical and supply-chain hurdles, and video streaming company Netflix said troubles with payment processing will strain operations.

Growing Power of Workers

While these practical reasons, along with the moral concerns, could be enough to drive the exodus, we believe the great resignation, in which record numbers of workers are quitting their jobs, is amplifying all these other risks of staying in Russia.

Roughly 47 million U.S. workers voluntarily left their jobs in 2021, accounting for well over a quarter of the civilian labor force, according to the Bureau of Labor Statistics. Over 4.5 million quit in November alone, a single-month record, and nearly that many continued to hand in their notices in early 2022.

It’s not just a U.S. phenomenon. Many other countries are experiencing similarly high rates of workers voluntarily quitting their jobs.

This trend has shifted bargaining power to employees, and companies are struggling to acquire skilled workers to fill vacant positions. Employees are demanding higher pay and more benefits, and some are rethinking their careers so that their work is more aligned with their values.

Another sign of the shift in power is the recent success of youth-led labor organizing efforts. A growing number of Starbucks locations are becoming unionized, while Amazon got its first U.S.-based union after workers on Staten Island in New York City voted to form one in April 2022. Starbucks and Amazon have both suspended operations in Russia.

Some industries are experiencing especially high employee attrition rates, including management consulting and oil and gas, according to a recent article in MIT Sloan Management Review. The attrition rate measures how many workers are lost and not replaced over a period of time.

Management consulting, in which a talented workforce is vital, for example, saw an attrition rate of 16% over the six-month period researchers looked at, or over five times the national average.

Employees Demand Solidarity with Ukraine

This is why it wasn’t a surprise to us that companies in these labor-strained industries either were among those that severed ties with Russia or quickly did so after facing criticism from employees.

IT consultant Accenture, with nearly 700,000 employees, seemed to set the tone for what would be expected of companies in its industry when on March 3, 2022, it said it was discontinuing all business in Russia.

“Accenture stands with the people of Ukraine and the governments, companies and individuals around the world calling for the immediate end to the unlawful and horrific attack on the people of Ukraine and their freedom,” it wrote.

Competitors McKinsey and Boston Consulting Group initially planned more timid withdrawals by cutting ties with the Russian government but continuing to honor existing private contracts. But after current and former employees of both companies took to social media to call out their perceived soft stance and even cowardice on Russia, the companies quickly reversed course by announcing they were pulling out completely. All the other consulting giants have done the same, including Bain, Deloitte, EY, KPMG and PwC.

The big Western oil companies have similarly faced employee pressure to exit Russia, with workers going so far as to refuse to offload Russian oil and gas onto their docks. This comes on top of governments pushing companies to take steps that go beyond the sanctions. In severing ties, companies such as BP, Shell and Exxon have abandoned significant assets in Russia, which will result in huge losses on their balance sheets.

 

Short-Term Costs for Long-term Gains

But accepting these short-term losses appear to be worth it to avoid larger ones down the road.

Recruiting and retaining a talented workforce is an important driver of a company’s long-term profitability.

Training new workers is costly, and the best talent is always hard to recruit – a challenge made worse by the great resignation. Survey after survey has shown workers are increasingly driven by a sense of purpose and expect their companies to reinforce their values.

No company that we know of explicitly cited issues related to the great resignation as a driver of its decision to leave Russia. And industries with high attrition rates and vocal workforces such as Big Tech haven’t seen complete withdrawals. In some cases, such as with Apple, Alphabet and Meta, they’ve suspended some operations but are trying to keep doing business in part because they play important roles in providing free information to Russian citizens to counter Kremlin propaganda.

Every company and every industry has its own unique analysis to go through based on exposure to business and reputational risk in Russia. We believe the great resignation compounds this risk, in some cases significantly. And employees are increasingly reporting feeling stressed out over Ukraine.

Russia’s aggression against Ukraine has been condemned almost universally in the West. Given that, many of the companies that severed ties – while sacrificing short-term profits – likely knew that staying would have been far more harmful for their brand, not only with customers but their employees as well.

 

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Image Credit: Can Pac Swire (Flickr)

Challenges to the US Dollar as a Reserve Currency and Market Impact

 

The percentage of US dollars used by foreign central banks as their reserve currency, has fallen dramatically in the past seven years. During this same period, a greater share of global reserves are being held in Chinese yuan. Could this shift impact US investments, including stocks and interest-bearing securities? Will US living standards suffer?

When any reserve currency, including gold, the Euro, the yuan and others, experiences increased demand, its value is enhanced. Fading demand has the impact of decreasing value which pushes upward on inflation for goods transacted in that currency. A weakening currency also demands higher interest rates to attract use. Valuations across all dollar-denominated markets may get dragged down with a declining dollar as well.

 

Background

The United States dollar has been the world’s primary reserve currency for over 60 years. Before the early 1970s, the dollar had been pegged to gold and most other currencies were then valued off the dollar. Since dollars are easier to work with than gold, greenbacks were used as the main intervention currency for monetary policy adjustments outside (and inside) of the US.

The establishment of the European monetary union and the euro in 1999 led to predictions of the dollar weakening. These fears were not realized. The use of the dollar as the primary reserve currency is based on the US maintaining a position as the world’s dominant economy. US dollars did not reach the position of reserve currency by world leaders somehow meeting and deciding to use dollars. Instead, it was based on trust and size of the US economy and debt market.

It does however make international transactions easier if currencies are priced to one currency.

Recent Trend

Using measurements from just before the Russian sanctions from the West, the percentage of dollars used as a currency dropped below 59% (Q4 2021).  This is down from 62% at the beginning of 2020, and 65% five years earlier in 2015. The trend toward using other currencies has recently accelerated.

The declining use of the dollar is even more dramatic when currency values are factored in. The recent strengthening of the dollar is masking a steeper drop in its “per unit” reserve status; the increase in momentum may have begun in 2018 when the US imposed tariffs on specific goods from China and a few other nations.

The euro is the second most widely-held reserve currency. It had experienced a net reduction over the last decade, but so far this decade has ticked higher. The trend seems to show that central banks are diversifying their reserve holdings.  It would not be surprising if future data shows that the war in Europe has caused a lower level of use of euros as reserves.

Rising bond yields are likely to drive flows to dollars as long as competing currency, real yields (after inflation) aren’t rising more rapidly.

Very recently the Yuan has lost value as Beijing has re-imposed strict lockdowns related to coronavirus activity.  Coupled with rising rates in the US and Europe, the Yuan should be under downward pressure.

Impact on Markets

Ordinarily, a softening yuan against US dollars would add to the two countries’ trade imbalances. Strong dollars make imports cheap. However, if production does not keep up with demand because of new lockdowns, the Chinese may not benefit from increased exports.

Inflation would be dampened somewhat on goods produced in China, but again if there is only a modest increase in imported goods from the US the inflation numbers reported will be barely impacted.

Strengthening dollars drive currency into US markets and could help support price levels during a period, like now, when there is a bearish tone due to a more hawkish monetary policy.

Take-Away

The US economy is experiencing its challenges for many different reasons. So are the other economies of the world. For this reason, central banks are diversifying. However, the US dollar is still considered to be the “risk-free” exchange medium against which others are measured. The size and scope of the US economy is likely to help the greenback retain its position, even as outside central banks decide to spread their risk around more than they have in the past.

 

Paul Hoffman

Managing Editor, Channelchek

 

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Sources

https://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4

https://www.chinabankingnews.com/2022/04/25/chinese-renminbi-rises-as-share-of-global-reserves-as-greenback-drops-to-record-low/

https://www.bis.org/publ/qtrpdf/r_qt1812b.pdf

 

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Why the Beige Book Takes on Added Importance in Times of Growing Economic Uncertainty

 

The Beige Book, more technically known as the Summary of Commentary on Current Economic Conditions, is a report compiled by the United States Federal Reserve Board (The Fed) eight times each year. The information a review of economic conditions within the Feds 12 banking districts. The information discusses the business activity in the area, the trends, and how tight labor markets are.

Information in the Beige Book is divided by industry, including real estate, tourism, agriculture, financial services, manufacturing, and high-tech. Trends in employment, prices, and wages for each of the 12 districts is also a regular part of the reporting.

Additionally, the districts comment on how the businesses of their region are impacted by national and international trends. The Beige Book will also examine how local businesses are affected by changes in exchange rates, oil prices, and inflation.

Common Beige Book Usage

If the district overall reports show economic activity is slowing, the FOMC may begin to lean toward easing monetary policy, to stimulate economic strength.

The FOMC may also discern from the districts an overheating national economy inflationary risks headed higher than the Fed target. In this case they will discuss at the FOMC meeting hitting the economic brakes with a contractionary strategy. This could include pulling money out of the economy and raising interest rates. 

The Beige Book allows investors and analysts to see a report that the FOMC will use to help guide their hand. Many view it as a lagging indicator as the information is looking in the rearview mirror. Other Fed watchers consider the Beige Book contents a leading economic indicator because it influences the FOMC’s decisions.

The most critical change the Fed may take after reviewing economic detail of the entire country and the business is adjustments to the Fed Funds rate. Surprises in the report has the ability to cause the markets (bond and stock) to suddenly turn.

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Image: Marco Verch (Flickr)

Allianz Economist Explains His Thoughts on Gold and Crypto’s Future

 

Muhamed A. El-Arian is the Chief Economic Advisor at Allianz, (Allianz owns PIMCO). He said in an interview on CNBC he believes the Fed may have to raise its inflation target to 3%. The Fed’s current and ongoing inflation target is 2%. Recent inflation reports show YOY inflation at 8.5%. The Allianz economist sees prices increasing within the various asset classes that are generally seen as inflation hedges. This is why he is bullish on gold and cryptocurrencies.

Gold and cryptocurrency prices would increase if the Federal Reserve were to lift its inflation target as it engages in a prolonged fight to bring down consumer prices, economist Mohamed El-Erian told CNBC on Monday (April 18).  “They both go higher in a world like that,” he said, referring to the notion that the Fed may need to increase its long-term inflation target to 3% from 2%.

“What will force them to change their target is the recognition that by being so late, they can’t get to that target and their credibility is threatened,” said El-Erian. “They will also worry that by hitting the brakes too hard, they may push this economy not just into a short-term recession, but into a longer term recession.” Controlling inflation and calming markets while orchestrating price stability is tricky. El-Arian believes that the markets will view the Fed as being more credible if they set and attain a 3% target rather than fail at a 2% target while crippling the economy longer term. 

Currently, the FOMC Fed Chair Jay Powell is working to tamp down the rise in prices which is due to tight labor markets, supply chain issues, higher fuel demand with less fuel production, an increase in money supply, and an overall expectation of higher prices. Inflation in March beat a 40-year high at 8.5% year-over-year. The last time price increases were so rampant, Ronald Reagan had just begun occupying the oval office.

Last month the FOMC began what is being viewed as an interest rate-hike cycle when it raised the Fed Funds rate 25 basis points from a range of 0% to 0.25%. It has also begun tapering and will soon shrink its balance sheet which has the impact of taking cash out of the market which makes money more expensive (interest rates).

Impact on Gold and Crypto

Gold is considered a safe haven when there is uncertain global stability or a risk of higher prices. With the accelerated money creation attributed to the pandemic and the Russian invasion of Ukraine, gold prices have risen about 9% this year, trading at $1,960 per ounce. In contrast, bitcoin has decreased in value by 16% to $41,300 and ether has lost 21% to trade at $2,900.

Is crypto as good of a diversifier as precious metals? The Allianz economist said, “The concern for the crypto people is that this decline is happening at a time when gold is up and hitting almost $2,000,” He continued, “The big argument for crypto is it’s a diversifier — at a time of inflation, it is attractive.” But crypto hasn’t worked as a cushion recently, he said. “And that’s because crypto, unlike gold, benefited enormously from all the liquidity injections.

The way El-Arian reads the increase in gold and decline in crypto prices is there is a tug of war between the recognition that liquidity is going out from the system as a whole and attractiveness as a diversifier. He explained the liquidity element is winning out.

The Fed’s Inflation Target

El-Arian, as mentioned earlier believes that a credible target will comfort the markets compared to one that the Fed is less likely to attain soon. “What will force them to change their target is the recognition that by being so late, they can’t get to that target and their credibility is threatened,” said El-Erian. 

El-Arian told CNBC he would expect gold and crypto prices to rise if the Federal Reserve were to raise its inflation target to 3%.  

 

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Sources

https://twitter.com/elerianm/status/1516319290605154309?ref_src=twsrc%5Etfw

https://www.cnbc.com/video/2022/04/18/we-are-nowhere-near-the-end-of-our-inflation-challenge-says-mohamed-el-erian.html

 

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Image Credit Marco Verch (Flickr)

We Still Haven’t Reached the Inflation Finale

 

Inflations have an inbuilt mechanism that works to burn them out.

Government (including the central bank) can thwart the mechanism if they resort to further monetary injections of sufficient power.

Hence inflations can run for a long time and in virulent form. This occurs where the money issuers see net benefit from making new monetary injections even though likely to be less than for the initial one which took so many people by surprise.

Ultimately at some point the cost-benefit calculus shifts in favor of government not blocking the operation of the burn-out mechanism.

Let’s try to work out which model of burnout the Great Pandemic inflation in the US will follow.

 

About the Author: Brendan Brown is a founding partner of Macro Hedge Advisors (www.macrohedgeadvisors.com) and senior fellow at Hudson Institute. He is an international monetary and financial economist, consultant, and author. He is also a Senior Fellow of the Mises Institute. Brendan is the author of Europe’s Century of Crises under Dollar Hegemony: A Dialogue on the Global Tyranny of Unsound Money with Philippe Simonnot, among other books.

 

Our process of discovery starts with Milton Friedman’s observation about the nature of the “inflation gap.” Paraphrasing this we can say that monetary inflation is where the supply of money is persistently veering ahead of demand for money. Ideally this comparison is for base money (rather than broad money).

This gap between supply and demand is always in the future. Like the mirage on a hot road, when we get to the place where we saw the gap it is no longer there. Prices have adjusted upwards (and maybe other economic variables have shifted) so as to lift the demand for money in nominal terms into line with the initial increase in supply.

Meanwhile, however, the issuer has injected a new supply of money. And so the gap is still out there when we look into the future (along the inflation highway).

We can think of the burn-out mechanism as a rise of prices (and possible swing in other variables) which keeps lifting demand for money (in nominal terms) into line with increased supply. The essence of the burn-out mechanism is the destruction of real wealth in the form of money (and government bonds) by the rise in prices. These wealth losses and the need to replenish money holdings in real terms to some extent bear down on demand in goods and services markets.

 

The laboratory of monetary history provides some insights here.

Take first the extreme case of the German hyperinflation. The government in Berlin, desperate for funds, kept making monetary injections even as the burn-out mechanism functioned. In real terms the revenue gains for government got smaller and smaller as individuals switched out of mark money into dollars instead. Eventually the gains were so tiny from new injections and the social political costs so great that these halted.

Fast-forward to the monetary inflation of World War II. From 1946–48 the Fed made no new monetary injection (monetary base constant) despite prices galloping ahead as driven by the excess of money created during the war. A very mild recession in 1948 and the vast run down in military spending which had occurred meant there was no incentive for the government/Fed to make new injections as consumer prices reached a plateau after their sharp jump. Nominal yields on long Treasury bonds remained close to 2 percent throughout.

It was quite different in the “greatest US peacetime inflation” from the early/mid 1960s to the end of the 1970s. Then the Fed responded multiple times to inflation burnout by new injections; think of 1967–68; 1970–72; 1975–77; and yes, 1980.

Each injection during the Greatest Monetary Inflation had its own distinct cost-benefit analysis. In 67/8 a priority was to hold down the cost of government borrowing in the midst of the Vietnam war; in 70/72 Chair Burns was a top member of the Richard Nixon reelection campaign; later in 75/7 his aim was promoting recovery in the context of challenging elections ahead for the Republicans (1976); in 1980 there was a looming election and recession fright.

Two overriding comments apply to these continued injections through the Greatest Peacetime Inflation.

First, the injectors (the Fed and more broadly the Administration economic team) persistently overestimated the severity of the economic downturn which seemed to be emerging. Given all the revisions in the data since the analyst today would be hard-pressed to use the term severe recession or indeed recession at all in some cases with respect to the episodes of economic weakness in 1970, 1974–75, or 1980s. Yet at the time the injectors saw the current data as justification for interfering with the burn-out mechanism.

Second, a whole Keynesian/neo-Keynesian mythology has developed about how high and rising inflation expectations were the challenge which prevented the monetary authority from allowing a “natural” burnout to take place. It is difficult, however, to substantiate such a claim. In the counterfactual of the Fed resolutely refusing to reinject, expectations would surely have fallen.

Jumping forward to today, Spring 2020, is the Fed at last allowing the burn-out mechanism to work, having consummated its “hawkish turn?”

A key problem in answering this question is how to estimate in a non-anchored monetary system what burnout is occurring. How to measure demand for money in a system which has become so distorted?

Examples of such distortion include bank reserves, a large component of monetary base, paying interest and at a rate above market. Base money has lost much of its special qualities in an environment where banks or individuals are confident of liquidity provision, whether in form of “too big to fail,” “lender of last resort,” or “deposit insurance.”

Without any precision we can say that substantial monetary inflation has emerged during the pandemic with prices of goods and services surely rising by more than what could be explained by supply shortages and dislocations such as would occur under sound money regimes. But by how much?

Whatever the unmeasurable inflation gap has been the near 8 percent rise in consumer prices in the past year has surely helped narrow it the nearer we get to the point in the highway of inflation where we initially saw it.

Chief Powell is now telling us that he has no intention of accommodating inflation. For this top monetary bureaucrat and his colleagues this means projecting a series of rises for the fed funds rate which seems to be impressive both whether measured by frequency or cumulative size. No one, of course, has a clue about how interest rates would be moving in the counterfactual case of just allowing the burnout to take place and no new monetary injections.

So, it is far too early for any sober-rational commentator to announce that the burn-out mechanism is now healthily at work and will accomplish its purpose. And yes, it is possible that the Fed will at some point constrain (by mistake amidst the general fog) the money supply such that this lags behind demand for money, meaning a period of monetary deflation.

It is hard to form a diagnosis of the monetary inflation gap based just on contemporaneous readings of CPI inflation or taking the speculative temperature in asset markets.

Notably the distortions of price signals in asset market as caused by monetary inflation can persist well beyond the closing of the inflation gap—as was the case with both the crash of 1929 and of 2008.

The central scenario of this writer is that the pandemic monetary inflation theatre still has several acts before its finale.

One of these would feature the apparent onset of recession and asset deflation to which the Fed responds ultimately by further inflationary injections of money. And even though there is an inflation curse on all fiat monies, one act entitled flight from the dollar will most likely come into the schedule before this monetary theater season is over.

 

Suggested Reading

How the Cost of Owning a New EV Could Also Climb Quickly

Nancy Pelosi’s Coattail Investors Get an Update

Since 2008, Monetary Policy Has Cost American Savers about $4 Trillion

Lessons from How the Back of Inflation Finally Broke in 1982

 

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Why a Growing or Shrinking Fed Balance Sheet Can Impact Your Investments

 

From an accounting standpoint, a balance sheet is a list of those things owed and those things owned. In a household, one may own what’s in their bank account, their car, and possibly a percentage of the dwelling’s value; those are counted as a person’s assets. What one may have in student loan debt, or mortgage or other debt balances, are liabilities. A list of the two that includes subtraction of one total from the other is the household’s “balance sheet.”

For the Federal Reserve, the list of liabilities includes, money in the economy held by individuals or companies, and cash at commercial banks (that then hold reserves at the Fed). Treasuries and other securities, on the other hand, are counted as the Fed’s assets. 

Federal Reserve Assets

Securities (primarily bonds) held outright account for most of the Fed’s total balance sheet. Nearly two-thirds of these assets are Treasury securities, (Bills, Notes, Bonds). Mortgage-related securities account for almost 25% of the assets on the Feds balance sheet. Through special “lending facilities” during the first year of the coronavirus, the Fed also purchased corporate bonds, municipal bonds, and ETFs that invest in debt.

Federal Reserve Liabilities

The liability side of the balance sheet, used primarily to conduct monetary policy, can be resized as needed. That is to say, the central bank can decide to expand its balance sheet by electronically “printing” money and simultaneously purchasing securities from primary Treasury broker/dealers. This new money used to buy bonds injects money into the economy as the sellers then have money in their hands that didn’t exist before the purchase. This pushes rates downward as there is more of a supply of money to be lent and more demand for bonds. More available money usually pushes asset prices higher.

Similarly, the Fed can shrink its balance sheet by selling its bonds.

Investment Impact

When the Fed either buys bonds (adds money) or sells bonds, including letting them mature (pulls out money) asset prices can be impacted because the availability of funds is reduced and becomes more expensive. The impact may be felt in everything from real estate prices, stocks, bonds, and goods and services.

Explore More:

What
is the PCE Index?

What is
the Yield Curve?

Orchestrating a Soft Economic Landing

 

The Fed’s “easy” monetary policy has been compared to a substance addiction since at least Y2K. Those that have used this analogy compare the 2008 economic problems to an individual that is addicted who crashes. They complain the treatment should not be more of what has caused the addiction in the first place. That is, easier monetary policy, including even stronger “medicine” in the form of quantitative easing.

Following 2008 the markets had the longest rally in history. For pandemic-related reasons the Fed stopped unwinding the previous stimulus in 2020 and instead increased the dosage to include buying a broader array of assets during the pandemic. This week the Fed announced it has more aggressive plans than even before the pandemic to pull the massive amount of stimulants out of the economy.

FOMC Plans

The March FOMC minutes suggest the Fed plans to shrink its balance
sheet sooner than expected and may start selling some of the $3 trillion in mortgage-backed securities it has accumulated since the early days of the pandemic. It plans to reduce the balance sheet by no more than $95 billion a month, phasing this in over the coming months (beginning after the May FOMC meeting). That could add up to more than $1 trillion a year. This would be much more rapid than the last time the Fed tried to shrink its balance sheet and added to it instead.

Can the Fed orchestrate a soft landing while raising overnight rates and reducing its bond holdings?

The minutes showed little discussion of how much a huge reduction will impact the economy. It was not too long ago the Fed was concerned about tapering or reducing how much it added to bond purchases. This new tact is even more extreme. The discussions may not have been had at the meeting or included in the minutes because there is no experience to pull from. It has never been done before. So anything contributed would be an educated guess, economists like empirical data…there is none. In January Chairman Powell openly admitted that it was much clearer how rate increases worked than quantitative tightening.

The educated guess seems to be that letting inflation run rampant is not part of their mandate, so the way forward is to begin and adjust. Attacking the longer end of the yield curve may be like using more leverage than increasing overnight lending rates; quantitative tightening (QT) might cause more pronounced negative reactions in consumer demand.

Will weaning the economy off up to $1 trillion a year be disastrous for investors? The minutes say that the Committee is “prepared to adjust the details of its approach.” This can be read as “IDK.”

 

Paul Hoffman

Managing Editor, Channelchek

 

Fed Governor Lael Brainard (April 5, 2022)

 

They’re early which says they are concerned. Many Fed watchers and market participants thought QT would begin in July, which would have been considerably earlier than the last time the Fed reversed quantitative policies, (2017-19, from 2009). Over the past two years the Federal Reserve has doubled its balance sheet to $9 trillion. The meeting minutes show officials debated how they would begin to reduce the trillions of dollars in bond purchases it agreed to over in the previous two years. The minutes, barring any unforeseen calamities, suggest the beginning will be after the next two day meeting which ends May 4. It was indicated in the minutes that they would have raised the overnight rates 50 bp last meeting if not for uncertainty of the war in Europe. Chairman Powell recently indicated that expectations should be for 50 bp after the May meeting.

The 95 million per month sales should be considered a cap, $60 billion for Treasuries, securities and $35 billion for mortgage bonds. The actual sales may start out much smaller and let the Fed step back and weigh the impact. Either way, the US is on track for less accommodative policy from the Fed.

 

Suggested Reading

What is the Fed’s Balance Sheet?

The Detrimental Impact of Fed Policy on Savers

New Economic Variables Confound Fed’s Future Path

Michael Burry Says Covid19 Cure Worse Than Disease (March 2020)

 

Sources

https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

https://www.federalreserve.gov/monetarypolicy/fomcminutes20220316.htm

https://www.cnbc.com/video/2021/06/29/growth-will-see-a-tailwind-in-the-coming-months-veritas-financial-groups-branch.html

https://www.marketwatch.com/investing/barrons

 

Stay up to date. Follow us:

Orchestrating a Soft Economic Landing

 

The Fed’s “easy” monetary policy has been compared to a substance addiction since at least Y2K. Those that have used this analogy compare the 2008 economic problems to an individual that is addicted who crashes. They complain the treatment should not be more of what has caused the addiction in the first place. That is, easier monetary policy, including even stronger “medicine” in the form of quantitative easing.

Following 2008 the markets had the longest rally in history. For pandemic-related reasons the Fed stopped unwinding the previous stimulus in 2020 and instead increased the dosage to include buying a broader array of assets during the pandemic. This week the Fed announced it has more aggressive plans than even before the pandemic to pull the massive amount of stimulants out of the economy.

FOMC Plans

The March FOMC minutes suggest the Fed plans to shrink its balance
sheet sooner than expected and may start selling some of the $3 trillion in mortgage-backed securities it has accumulated since the early days of the pandemic. It plans to reduce the balance sheet by no more than $95 billion a month, phasing this in over the coming months (beginning after the May FOMC meeting). That could add up to more than $1 trillion a year. This would be much more rapid than the last time the Fed tried to shrink its balance sheet and added to it instead.

Can the Fed orchestrate a soft landing while raising overnight rates and reducing its bond holdings?

The minutes showed little discussion of how much a huge reduction will impact the economy. It was not too long ago the Fed was concerned about tapering or reducing how much it added to bond purchases. This new tact is even more extreme. The discussions may not have been had at the meeting or included in the minutes because there is no experience to pull from. It has never been done before. So anything contributed would be an educated guess, economists like empirical data…there is none. In January Chairman Powell openly admitted that it was much clearer how rate increases worked than quantitative tightening.

The educated guess seems to be that letting inflation run rampant is not part of their mandate, so the way forward is to begin and adjust. Attacking the longer end of the yield curve may be like using more leverage than increasing overnight lending rates; quantitative tightening (QT) might cause more pronounced negative reactions in consumer demand.

Will weaning the economy off up to $1 trillion a year be disastrous for investors? The minutes say that the Committee is “prepared to adjust the details of its approach.” This can be read as “IDK.”

 

Paul Hoffman

Managing Editor, Channelchek

 

Fed Governor Lael Brainard (April 5, 2022)

 

They’re early which says they are concerned. Many Fed watchers and market participants thought QT would begin in July, which would have been considerably earlier than the last time the Fed reversed quantitative policies, (2017-19, from 2009). Over the past two years the Federal Reserve has doubled its balance sheet to $9 trillion. The meeting minutes show officials debated how they would begin to reduce the trillions of dollars in bond purchases it agreed to over in the previous two years. The minutes, barring any unforeseen calamities, suggest the beginning will be after the next two day meeting which ends May 4. It was indicated in the minutes that they would have raised the overnight rates 50 bp last meeting if not for uncertainty of the war in Europe. Chairman Powell recently indicated that expectations should be for 50 bp after the May meeting.

The 95 million per month sales should be considered a cap, $60 billion for Treasuries, securities and $35 billion for mortgage bonds. The actual sales may start out much smaller and let the Fed step back and weigh the impact. Either way, the US is on track for less accommodative policy from the Fed.

 

Suggested Reading

What is the Fed’s Balance Sheet?

The Detrimental Impact of Fed Policy on Savers

New Economic Variables Confound Fed’s Future Path

Michael Burry Says Covid19 Cure Worse Than Disease (March 2020)

 

Sources

https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

https://www.federalreserve.gov/monetarypolicy/fomcminutes20220316.htm

https://www.cnbc.com/video/2021/06/29/growth-will-see-a-tailwind-in-the-coming-months-veritas-financial-groups-branch.html

https://www.marketwatch.com/investing/barrons

 

Stay up to date. Follow us:

Why a Growing or Shrinking Fed Balance Sheet Can Impact Your Investments

 

From an accounting standpoint, a balance sheet is a list of those things owed and those things owned. In a household, one may own what’s in their bank account, their car, and possibly a percentage of the dwelling’s value; those are counted as a person’s assets. What one may have in student loan debt, or mortgage or other debt balances, are liabilities. A list of the two that includes subtraction of one total from the other is the household’s “balance sheet.”

For the Federal Reserve, the list of liabilities includes, money in the economy held by individuals or companies, and cash at commercial banks (that then hold reserves at the Fed). Treasuries and other securities, on the other hand, are counted as the Fed’s assets. 

Federal Reserve Assets

Securities (primarily bonds) held outright account for most of the Fed’s total balance sheet. Nearly two-thirds of these assets are Treasury securities, (Bills, Notes, Bonds). Mortgage-related securities account for almost 25% of the assets on the Feds balance sheet. Through special “lending facilities” during the first year of the coronavirus, the Fed also purchased corporate bonds, municipal bonds, and ETFs that invest in debt.

Federal Reserve Liabilities

The liability side of the balance sheet, used primarily to conduct monetary policy, can be resized as needed. That is to say, the central bank can decide to expand its balance sheet by electronically “printing” money and simultaneously purchasing securities from primary Treasury broker/dealers. This new money used to buy bonds injects money into the economy as the sellers then have money in their hands that didn’t exist before the purchase. This pushes rates downward as there is more of a supply of money to be lent and more demand for bonds. More available money usually pushes asset prices higher.

Similarly, the Fed can shrink its balance sheet by selling its bonds.

Investment Impact

When the Fed either buys bonds (adds money) or sells bonds, including letting them mature (pulls out money) asset prices can be impacted because the availability of funds is reduced and becomes more expensive. The impact may be felt in everything from real estate prices, stocks, bonds, and goods and services.

Explore More:

What
is the PCE Index?

What is
the Yield Curve?

Image Credit: Monstera (Pexels)

Tilt Confidently – A Perspective on Financial Markets and the Economy

 

Tilt Confidently

Economic excesses often create potential investment opportunities. When a key economic factor reaches a ridiculous level, it frequently proves profitable to expect a reversal: Recall the 10-year bond yield at 0.5% in mid-2020 (those who tilted investment bets toward rising-yield beneficiaries have since profited)—or the early-1981 extreme of 16%? Another example was 1995, when the U.S. dollar spiked to levels never seen before—nor since. In the 1990s, the labor participation rate peaked near 68% after having never risen above 60% prior to 1970. And, in the mid-1990s, following a decline of nearly 20% from its 1973 post-war high, the real-wage rate finally bottomed.

Although short-term timing on any economic trend is always a challenge, when something gets severely out of bounds, the favored odds are that it is apt to soon adjust. Today, there are several matters that could be considered remarkably out of the norm, including economic policies, inflation, various commodity prices, and geopolitical turmoil. However, in our view, the greatest economic extreme, at this time, is “confidence.”

 

Extreme Main-Street Pessimism?

Chart 1 shows a measure of U.S. consumer confidence from the 1950s to date. At present, confidence is lower than 98.5% of the time since 1952! Obviously, pessimism is at an extreme—there have been only a handful of readings as low as today. But what makes this extraordinarily uncommon is, for the last two years, confidence has plummeted while stocks have been in a strong bull market driven by a robust economic recovery. Yes, inflation is currently very high, and there is a war in Ukraine. All the same, inflation was even higher, for longer, in the 1970s when the Vietnam War was ongoing, and, yet, outside of recessions, consumer confidence sustained at much higher levels.

Nearly every significant decay in confidence occurred when the U.S. was in a recession. While an imminent recession is always possible, the likelihood that the U.S. is now in a recession—or even headed for one this year—seems rather remote. Outside of recessions, there was only one other time that confidence was as low as it is today: After a solid recovery in confidence at the start of the 2009 expansion, there was a brief confidence breakdown in mid-2011. Then, renewed fears that the expansion would fail is probably why confidence again declined. Those fears, however, proved unfounded; confidence quickly revived and embarked on a multi-year advance until the 2020 pandemic.

Is confidence about the contemporary expansion following a similar path? It bounced from about 70 to 90 during the first year of this recovery, but since last April, it has again collapsed (like in 2011). Despite strong economic growth and the S&P 500 within 5% of its all-time high, Main Street confidence remains depressed due to a combination of Federal Reserve and interest-rate fears, the highest inflation rate in decades, and Putin’s war.

In our view, even if some or all of these fears continue to fester, confidence will not likely fall much further. Indeed, it would truly be “extreme” if it did. Rather, some of the current nightmares facing the recovery will probably turn out better than feared, causing Main Street sentiment to soon lift, as it did after its 2011 break- down.

According to a Bloomberg survey of private-sector economists, the consensus for U.S. real-GDP growth in 2022 is a robust 3.5%. With Main Street characterized by excessive pessimism and solid real growth, in our view, an opportunity exists for investors to exploit the likelihood that confidence is poised to rise.

Portfolio Tilts For “Rising Confidence?”

Confidence as subdued as today’s is reminiscent of being in a recession that is nearing the start of a new economic expansion. Consequently, many of the investment options highlighted here are typically favored in the infancy of a new economic expansion. It is very odd for conviction to be so low when starting the third year of a recovery.

Nonetheless, if confidence does perk up from today’s extraordinarily low level—whether it is the start of a new expansion or the third year of an ongoing recovery—greater enthusiasm will likely run through both the economy and the stock market in a fashion similar to how it has traditionally done in a fresh recovery.

The following charts illustrate six distinct investments whose relative performance corresponds closely with consumer confidence. Investors may want to consider some of these as possible portfolio tilts.

1. Cyclicals Need Some Confidence! Chart 2 overlays the relative return of the S&P 500’s major cyclical sectors with the Consumer Confidence Index. At least since 2002, there has been a close relationship between cyclical stock leadership and Main Street confidence. Indeed, cyclicals led after the March 2020 bear-market bottom until May 2021, when confidence rolled over. Could cyclical stocks be nearing a “mini-replay” of 2020, driven by a renewed spike in consumer confidence?

 

2. Low Quality? With the S&P 500 Index still trying to recover from a recent correction, and yields rising at an aggressive pace, most are advocating to boost the “quality” in portfolios. However, as illustrated in Chart 3, not only is the relative price of low-quality stocks nearly the same today as at the bottom of the 2009 bear market, but a trend of improved confidence could prompt a period of leadership for low-quality stocks.

 

3. High-Beta’s Run To Continue? High-beta stocks have led the stock market throughout most of this bull run (Chart 4) and may continue to be superior investments should Main Street confidence finally improve. Most recently, after confidence peaked last May, high-beta has slightly underperformed but has not suffered as aggressively as other confidence-sensitive investments. Nevertheless, since at least 1990, it has paid to be overweight high-beta stocks during periods of improving confidence.

 

4. An IPO Leadership Replay? IPOs and SPACs had a massive run earlier in this bull market, followed by an epic collapse (Chart 5). The pattern is similar to the surge and plunge of Main Street confidence. While far from a perfect relationship, since at least 2009, when confidence improved, IPOs directionally outpaced. Likewise, periods of rising pessimism on Main Street have been associated with underperforming IPOs. Many perceive the IPO run as a speculative frenzy that has now been left for dead. Is it possible, though, if confidence again turns up, IPOs could have another “curtain call” in the balance of this bull market?

 

5. Smaller Cap For A Confidence Run! Not surprisingly, as illustrated by Chart 6, smaller-cap stocks do best when consumer confidence rises. The blue line represents the price return of micro-cap stocks relative to mega-caps. The notable periods when consumer confidence surged (2009, 2011, and 2020) were all associated with solid leadership by microcap stocks. As confidence collapsed over the last year, versus the largest stocks, micro caps have relinquished about two-thirds of their cumulative outperformance since this bull market began in March 2020. If consumer confidence is poised for another revival, it may be time to tilt away from your mega-cap winners toward smaller stocks!

 

6. Tilting Toward EM Debt? It is not obvious why EM debt tends to outpace when U.S. consumers are confident. As shown in Chart 7, since 2008, EM debt has significantly rewarded investors whenever Main Street sentiment was improving. Currently, the price of EM debt relative to Treasuries is nearly as low as it was at the stock-market bottoms of 2009 and 2020. It is not a coincidence these were periods when consumer confidence had also declined substantially. This chart is a good reminder that if Main Street confidence does soon improve, investors may need to adjust exposure to bonds as well as stocks.

---

Final Comments

 

Consumer confidence is now as low—or lower— than it has been in any recession in the post-war era. Considering that economic growth looks healthy and the stock market is near record highs, today’s excessive level of Main Street pessimism is odd.

Understandably, many investments that typically do poorly as pessimism rises have been severe underperformers in the last year. Even if a recession is imminent, neither consumer confidence nor sentiment-sensitive investments are likely to do much worse because both are already priced for a recession. But should today’s economic fears prove overblown, Main Street confidence is likely headed for a substantial recovery that should boost the relative results of a number of investments, including cyclicals, low-quality, high-beta, IPOs, small caps, and EM debt.

If you, too, believe there is simply too much pessimism today, get your shopping list ready and “Tilt Confidently.”

---

The above was reprinted with permission from Paulsen’s Perspective an institutional newsletter published by THE LEUTHOLD GROUP.

Authored by James W Paulsen, Ph.D.  Chief Investment Strategist of The Leuthold Group, LLC. Jim is a member of the investment committee, authors market and economic commentary, and works with the Leuthold investment team in serving institutional, financial advisor, and investment professional clients.

The Leuthold Group has been producing original analysis for the institutional marketplace for nearly half a century. Driven by the research, its investment management arm is centered on tactical asset allocation and disciplined quantitative methodologies.

 

 

Stay up to date. Follow us:

Image Credit: Monstera (Pexels)

Tilt Confidently – A Perspective on Financial Markets and the Economy

 

Tilt Confidently

Economic excesses often create potential investment opportunities. When a key economic factor reaches a ridiculous level, it frequently proves profitable to expect a reversal: Recall the 10-year bond yield at 0.5% in mid-2020 (those who tilted investment bets toward rising-yield beneficiaries have since profited)—or the early-1981 extreme of 16%? Another example was 1995, when the U.S. dollar spiked to levels never seen before—nor since. In the 1990s, the labor participation rate peaked near 68% after having never risen above 60% prior to 1970. And, in the mid-1990s, following a decline of nearly 20% from its 1973 post-war high, the real-wage rate finally bottomed.

Although short-term timing on any economic trend is always a challenge, when something gets severely out of bounds, the favored odds are that it is apt to soon adjust. Today, there are several matters that could be considered remarkably out of the norm, including economic policies, inflation, various commodity prices, and geopolitical turmoil. However, in our view, the greatest economic extreme, at this time, is “confidence.”

 

Extreme Main-Street Pessimism?

Chart 1 shows a measure of U.S. consumer confidence from the 1950s to date. At present, confidence is lower than 98.5% of the time since 1952! Obviously, pessimism is at an extreme—there have been only a handful of readings as low as today. But what makes this extraordinarily uncommon is, for the last two years, confidence has plummeted while stocks have been in a strong bull market driven by a robust economic recovery. Yes, inflation is currently very high, and there is a war in Ukraine. All the same, inflation was even higher, for longer, in the 1970s when the Vietnam War was ongoing, and, yet, outside of recessions, consumer confidence sustained at much higher levels.

Nearly every significant decay in confidence occurred when the U.S. was in a recession. While an imminent recession is always possible, the likelihood that the U.S. is now in a recession—or even headed for one this year—seems rather remote. Outside of recessions, there was only one other time that confidence was as low as it is today: After a solid recovery in confidence at the start of the 2009 expansion, there was a brief confidence breakdown in mid-2011. Then, renewed fears that the expansion would fail is probably why confidence again declined. Those fears, however, proved unfounded; confidence quickly revived and embarked on a multi-year advance until the 2020 pandemic.

Is confidence about the contemporary expansion following a similar path? It bounced from about 70 to 90 during the first year of this recovery, but since last April, it has again collapsed (like in 2011). Despite strong economic growth and the S&P 500 within 5% of its all-time high, Main Street confidence remains depressed due to a combination of Federal Reserve and interest-rate fears, the highest inflation rate in decades, and Putin’s war.

In our view, even if some or all of these fears continue to fester, confidence will not likely fall much further. Indeed, it would truly be “extreme” if it did. Rather, some of the current nightmares facing the recovery will probably turn out better than feared, causing Main Street sentiment to soon lift, as it did after its 2011 break- down.

According to a Bloomberg survey of private-sector economists, the consensus for U.S. real-GDP growth in 2022 is a robust 3.5%. With Main Street characterized by excessive pessimism and solid real growth, in our view, an opportunity exists for investors to exploit the likelihood that confidence is poised to rise.

Portfolio Tilts For “Rising Confidence?”

Confidence as subdued as today’s is reminiscent of being in a recession that is nearing the start of a new economic expansion. Consequently, many of the investment options highlighted here are typically favored in the infancy of a new economic expansion. It is very odd for conviction to be so low when starting the third year of a recovery.

Nonetheless, if confidence does perk up from today’s extraordinarily low level—whether it is the start of a new expansion or the third year of an ongoing recovery—greater enthusiasm will likely run through both the economy and the stock market in a fashion similar to how it has traditionally done in a fresh recovery.

The following charts illustrate six distinct investments whose relative performance corresponds closely with consumer confidence. Investors may want to consider some of these as possible portfolio tilts.

1. Cyclicals Need Some Confidence! Chart 2 overlays the relative return of the S&P 500’s major cyclical sectors with the Consumer Confidence Index. At least since 2002, there has been a close relationship between cyclical stock leadership and Main Street confidence. Indeed, cyclicals led after the March 2020 bear-market bottom until May 2021, when confidence rolled over. Could cyclical stocks be nearing a “mini-replay” of 2020, driven by a renewed spike in consumer confidence?

 

2. Low Quality? With the S&P 500 Index still trying to recover from a recent correction, and yields rising at an aggressive pace, most are advocating to boost the “quality” in portfolios. However, as illustrated in Chart 3, not only is the relative price of low-quality stocks nearly the same today as at the bottom of the 2009 bear market, but a trend of improved confidence could prompt a period of leadership for low-quality stocks.

 

3. High-Beta’s Run To Continue? High-beta stocks have led the stock market throughout most of this bull run (Chart 4) and may continue to be superior investments should Main Street confidence finally improve. Most recently, after confidence peaked last May, high-beta has slightly underperformed but has not suffered as aggressively as other confidence-sensitive investments. Nevertheless, since at least 1990, it has paid to be overweight high-beta stocks during periods of improving confidence.

 

4. An IPO Leadership Replay? IPOs and SPACs had a massive run earlier in this bull market, followed by an epic collapse (Chart 5). The pattern is similar to the surge and plunge of Main Street confidence. While far from a perfect relationship, since at least 2009, when confidence improved, IPOs directionally outpaced. Likewise, periods of rising pessimism on Main Street have been associated with underperforming IPOs. Many perceive the IPO run as a speculative frenzy that has now been left for dead. Is it possible, though, if confidence again turns up, IPOs could have another “curtain call” in the balance of this bull market?

 

5. Smaller Cap For A Confidence Run! Not surprisingly, as illustrated by Chart 6, smaller-cap stocks do best when consumer confidence rises. The blue line represents the price return of micro-cap stocks relative to mega-caps. The notable periods when consumer confidence surged (2009, 2011, and 2020) were all associated with solid leadership by microcap stocks. As confidence collapsed over the last year, versus the largest stocks, micro caps have relinquished about two-thirds of their cumulative outperformance since this bull market began in March 2020. If consumer confidence is poised for another revival, it may be time to tilt away from your mega-cap winners toward smaller stocks!

 

6. Tilting Toward EM Debt? It is not obvious why EM debt tends to outpace when U.S. consumers are confident. As shown in Chart 7, since 2008, EM debt has significantly rewarded investors whenever Main Street sentiment was improving. Currently, the price of EM debt relative to Treasuries is nearly as low as it was at the stock-market bottoms of 2009 and 2020. It is not a coincidence these were periods when consumer confidence had also declined substantially. This chart is a good reminder that if Main Street confidence does soon improve, investors may need to adjust exposure to bonds as well as stocks.

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Final Comments

 

Consumer confidence is now as low—or lower— than it has been in any recession in the post-war era. Considering that economic growth looks healthy and the stock market is near record highs, today’s excessive level of Main Street pessimism is odd.

Understandably, many investments that typically do poorly as pessimism rises have been severe underperformers in the last year. Even if a recession is imminent, neither consumer confidence nor sentiment-sensitive investments are likely to do much worse because both are already priced for a recession. But should today’s economic fears prove overblown, Main Street confidence is likely headed for a substantial recovery that should boost the relative results of a number of investments, including cyclicals, low-quality, high-beta, IPOs, small caps, and EM debt.

If you, too, believe there is simply too much pessimism today, get your shopping list ready and “Tilt Confidently.”

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The above was reprinted with permission from Paulsen’s Perspective an institutional newsletter published by THE LEUTHOLD GROUP.

Authored by James W Paulsen, Ph.D.  Chief Investment Strategist of The Leuthold Group, LLC. Jim is a member of the investment committee, authors market and economic commentary, and works with the Leuthold investment team in serving institutional, financial advisor, and investment professional clients.

The Leuthold Group has been producing original analysis for the institutional marketplace for nearly half a century. Driven by the research, its investment management arm is centered on tactical asset allocation and disciplined quantitative methodologies.

 

 

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