Blain’s Morning Porridge – July 27th 2023: Fed Hikes, but how big is the recession risk?
“It’s very easy to miss the speculative froth when you are a part of it….”
The market has chosen to read the Fed 25pb hike as a positive sign we’re on the glide path to a soft landing – but what does the market know? The charts and common sense increasingly scream recession. Take your pick: deflationary bust or stagflationary crisis?
Some mornings the Morning Porridge just writes itself… thus it is today.
For weeks now I’ve been struggling with a deep sense the global economic picture is nowhere near as rosy as the market seems to think. Overly exuberant markets misjudging the economic reality is hardly unusual.. but it happens time and time again. As I keep reminding readers – markets are not intelligent. They are simply voting machines reflecting the expectations of participants, who, individually may be very, very wrong.
Yesterday the Fed raised rates by the expected 25 bp. From a market perspective it all felt a bit Job Done. Fed Head Jerome Powell left listeners very aware further hikes are on the table if the data suggests the current resiliency of the US economy looks like overheating – but the market read the hike as a positive signal the Fed is on the glidepath to economic nirvana: a soft-landing. Stocks bounced higher as bond yields fell. (And in thin summer markets went back again..)
As I wrote earlier this week, you can’t trade against the market’s mood. But, you can hedge it by investing smartly. (Contrarians are much lauded for the very few days they are right!) Such is the confidence in the Fed’s landing skills and the current upside narrative, I reckon it would barely stumble if the Fed applies the brakes more violently in September with a further hike. The market will remain positive… just as long as there are no major surprises..
A 5.5% Fed Funds rate is something I remember from about a billion years ago when the big number on my age was still less than 4. The data over the next 2 months (the Fed gets a break for August) will be critical – jobs, wage pressure and inflation will be in the headlines… Yet, it’s the other stuff the market should be watching… what’s happening to earnings, corporate debt and defaults, and how much consumers are spending. Lest we forget… any economy is ultimately based on what consumers consume (which includes how much they are paying in taxes to fund government).
While the direction of markets suggests everything is fine, a significant number of market participants are not convinced we’re out the woods. They point to deflationary recession risks. Among these is my good friend Paul Horvath, CEO of Orchard who published a note on Linked-In yesterday called… Winter is Coming. It’s well worth a read – he highlights 11 Charts Predicting a Recession is Coming.
(I tend not to use charts in the Morning Porridge – partly because I always find myself having to explain them. Too many strategists present squiggly lines and earnestly expect intellectual deadbeats like myself to immediately grasp the insights they contain.. I prefer to understand the logic behind them.)
Paul takes the current thinking behind why a recession is unlikely and debunks it. The pandemic spending surge is done. Labour conditions remain tight, but businesses can’t keep paying up for labour if earnings are under pressure. Oil and energy prices may have fallen, but could equally climb again. Inflation is not done – and the Fed can’t relax and assume its beaten.
However, his core argument is US Consumers (and by extension, elsewhere) are under serious financial stress. That seems a no-brainer to me! Here in the UK consumers face high inflation, record high taxes, higher mortgage and rental costs, food price rises, massive increases in energy and utility bills, increases in all other costs, and wage constraints. You don’t need to be a genius to figure folk are struggling with discretionary spending – meaning every corporate should be on notice of falling demand.
The 11 charts Paul has compiled for the US show the following:
- Over 50% of US adults say they are financially worse off. The only time that’s been higher was during the Global Financial Crisis (“GFC”) of 2008.
- US Corporate defaults have doubled since last year.
- Car loan payment defaults are rising faster than during the 2008-2009 GFC. Over 6% of subprime auto loans are delinquent.
- The rejection rate on auto loans has risen to 14% (from less than 9% 3 months ago, reflecting tighter credit conditions.
- US Household debt is over $17 trillion, up $2.9 trillion since 2019.
- Credit Delinquency rates for adults under 30 is 4 times the national average, a 7%, reflecting the pain of high borrowing is particularly concentrated on younger workers.
- Credit Card balances have risen 22% to an average of $6000 since 2021, reflecting increased borrowings post pandemic.
- US Household personal savings peaked at $1.7 trillion in 2021, but have now fallen to negative $0.6 trillion. The Covid money is gone.
- US bankruptcies (Chapter 11) jumped 69% in H1 2023 from last year.
- Demand for new homes has crashed by 20% reflecting the unaffordability of mortgage rates.
- The US Leading Economic Index spots turning points in the business cycle – it’s been in decline for 15 months, the longest since 2007-08 as the GFC developed!
I could add a stack of other data points to the above list – notably the inversion in the yield curve, but I’ll leave it to Janet Yellen, US Treasury Secretary to comment: “People stop buying things, and that is how you turn a slowdown into a recession.”
I could also cite the extraordinarily high valuation and PE levels as evidence the market is “missing the point” even when its right in its face. I think there are many reasons why valuations/speculation is so out of whack with common sense… it’s all about the behaviour of crowds, historical bubbles and the fact most participants in the market today think the GFC that began just 15 years ago is as irrelevant as the Punic Wars are to modern geopolitics. Er, no… markets and the way markets think remain profoundly distorted by the monetary experimentation than followed 2008.
All the evidence of potential recession are in clear sight, yet its apparently a new stock bull market. Valuations look daft.
There are a number of reasons to think spending may become even tighter. A whole series of US government supports and subsidies are under spending pressure. At the moment Bidenomics spending programmes like green energy, the Inflation Reduction Act and the Infrastructure Investment programme support the economy with nearly $1.8 trillion of stimulus, propping up spending and jobs. (Kind of funny: the issue in the US is the strength of the jobs markets, and its government subsidy that’s partially supported it.)
There is also a shock to come. The US Supreme Court, now captured by the extreme Republic Right, has opined that Student Loan Forgiveness is “unconstitutional”. Thus 36 million Americans will have to restart paying their student loans (on hold since March 2020), taking another $18 billion of discretionary spending out the economy every month from September 2023.
Take the same issues Paul has identified in the US and apply them across Europe, and even China… and the outlook for a massive correction becomes clear. What’s the right investment course in a time like this? Current market valuations look unsustainable in the face of this kind of pressure, but there are areas which could provide steady, dull, boring, predictable utility like income streams – like private secured credit. The unknown is what would a deflationary bust (as predicted above) do to economies if it morphed into a stagflationary bust? Ouch….
Five Things To Read This Morning
Out of time, and back to the day job…
Strategist – Shard Capital