Recent changes in Fed language coupled with signs of economic deceleration are notable and promising.
Data is suggesting that economic contraction should reveal itself quickly. Taking interest rates beyond a certain point of restriction carries significant risks.
Stock market bottoms are hard to time but historically have led to a change in category leadership.
The November 2, 2022, Fed meeting delivered no surprises in terms of Fed policy. The Fed raised its short-term Funds rate by 75 basis points for a fourth consecutive meeting to 4.0% and made it clear that an additional raise will occur at their December meeting. The Fed added a new term to their statement, “cumulative effect” to assign some weight to the impact of what is now nearly 400 basis points of rate increases in a span of seven months, among the fastest on record. This is suggestive of a slower pace of rate increases going forward.
Markets declined on the day as Fed chair Jerome Powell dismissed any notions of ceasing the rate increases and suggested that the “terminal rate” or ultimate destination for the Fed Funds rate, could be as high as 5%. However, we believe the addition of the new language and abundant signs of economic deceleration are important to note. Inflation is a lagging variable that evidences after the economy experiences supply/demand imbalances and excess money creation. The supply/demand imbalances are trending in the other direction right now – there is reduced demand for improving the supply of goods, and money supply growth is poised to go negative in the coming months. All of this is incompatible with further increases in inflation and inflation expectations. This can be seen in numerous recent earnings reports, growing inventories, reduced cargo container demand, and in high-frequency surveys such as the ISM manufacturing PMI index. The ISM has declined to just a hair over 50 (readings below 50 = contraction).
It is reasonable to assume these variables will show further weakness as private sector financing terms have become onerous.
By a simple measurement, viewing the BBB corporate bond yield spread versus 10-year Treasuries – the cost of corporate debt has risen to levels consistent with prior market-stress episodes, such as the European financial crisis in 2011-12 and the commodity crash in 2016. By more absolute yield levels, corporate debt costs have risen to levels not seen since the 2008-09 financial crisis – coupon rates are some 50-80% higher than these prior stress periods.
Anecdotally, we are hearing more draconian terms, such as…
“debt markets are frozen”
“money is not available at any price”
“A-rated borrowers are having a tough time”
…to name a few memorable phrases that have cropped up recently in conversations with fixed income traders and real estate developers. Collateralized repo markets, the so-called “plumbing of the financial system”, reflect these liquidity and valuation issues currently. Repo funding requires considerable excess collateral to be deposited – meaning that to get a dollar (of near-term funding) the borrower needs to pledge more than a dollar of (longer maturity) collateral. In a manner of speaking, a dollar is not equal to a dollar because the Fed has introduced so much day-to-day uncertainty. We have not heard of debt markets so-characterized since 2008.
That is not a prediction that anything like the 2008 financial crisis is imminent. That economically disastrous episode was caused by years of systematically poor credit standards, misrated and misleading co-mingled credit structures, and, most critically, very high leverage at major financial institutions. The leverage issue would be difficult to repeat, given vastly higher capital requirements at banks and far stricter risk scores for most categories of lending. However, rapidly freezing credit availability means that as current under-construction projects burn off, a significant downdraft in economic activity awaits. This is already priced into financial markets, with the 2-10 year yield curve inversion reaching a fresh 40-year high.
Looking at it differently, given far higher absolute yields the last time the curve inverted by over 55 basis points (in the early 1980s when the Fed Funds rate was 20%!), the current inversion, as compared to the actual 10 year yield, is arguably the highest on record. Markets seldom flash stronger signals than this.
Last, we believe money supply growth is a critical variable to watch, but with some unique complexities. M2 growth is poised to go negative in the coming months, a development not seen since the Great Depression. M2 growth or deceleration consistently leads to inflation growth or deceleration by about a year. An economy growing at a high single-digit percentage rate (in nominal terms) cannot sustain this rate without a corresponding level of money supply growth – it’s like a person who needs to eat 3,000 calories a day eating only 2,000 a day – weight loss is assured if this endures.
The important offset to this scary-sounding data point is that the Fed created so much money in 2020-21 (M2 grew by 41% or $6.4 trillion, or 25% of current $GDP, since 2019) that there are at least $2 trillion in excess reserves parked at the Fed by various banks, essentially not entering the real economy or the financial economy for that matter. Thus, bleeding some or most of this excess off (via the Fed Balance sheet contracting) may not have nearly the negative impact as it would if there were no excess reserves in the system. That said, the Fed does plan to drain most of these off over the next two years.
WHAT DOES ALL THIS MEAN?
There is a mix of positive and negative news if you add all this up.
On the negative side, our concern, as highlighted in last month’s Bear Market Ruminations piece, is that the extremely rapid change in financial conditions, interest rate expectations, and a reactionary Fed focused on a backward-looking variable (the inflation rate), all following many years of low rates and generally low fixed income market volatility, means the risk of a financial accident is not small.
On the positive side, if a rising cost of capital and an uncertain Fed path are the primary movers of credit market stress and stock valuation pressure in 2022, the fast-approaching economic weakness ought to discourage the Fed from continuing much further into restrictive territory. The change in Fed statement verbiage is notable; there are governors at the Fed that recognize the dangers, and possibly counter-productive elements, of the current path. Put differently, if the risks of a financial accident, and the risks of a long and deep recession decrease, fair-value stock multiples should improve. Markets are, in their uniquely forward-looking way, beginning to sniff this out. Yields at the very long end of the curve (10-30 years) have not moved very much since the end of the 3rd quarter, currency volatility has declined, and volatility rates in swap markets have also declined from recent peaks near the end of the 3rd quarter. The key word in the above is “ought,” an auxiliary verb conditioned around advisability and logical consequences. People, governments, and institutions ought to do all kinds of things that they fail to do or fail to do on a timely basis. So we will see.
Stock market bottoms are notoriously hard to call, and we are not in the business of calling them (just the stocks). However, changes in stock market leadership tend to be more evident to the eyes. Historically, most bear markets are accompanied by distinct changes in category leadership. Value stocks led the market from 2000 to 2007 but sorely underperformed growthier names into and exiting the 2008-09 financial crisis. Today the tables seem to have turned. The “high multiple, digital economy, future is so bright I need sunglasses” stock market of the late 2010s and early 2020s has very decisively turned into an old/physical economy-dominated market. Rational if not capacity-constrained, shortages remain in the physical economy that may persist, recession or no recession. Should the 0% cost of capital regime that predominated from 2008-2022 not recur, we suspect the duration of this leadership change to be more than just a year or two.
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