Recession Can’t Come Soon Enough, from Gary Phillips

The market has always been a discursive struggle between the bulls and the bears. A system of oppositions that one might think, would logically or functionally negate each other. Of course, the relationship never stays linear for long and the inevitable convexity leads to a Hegelian resolution of thesis and antithesis.

The dialectical tension between an "impending" (but reluctant to manifest) recession (inverted yield curve) and a resilient economy (Q3 GDP +3.2) and labor market (unemployment 3.7%) underscores the struggle between the "higher for longer" bears, and the bulls who believe in the equivocation of "pause" with "pivot."

A reactive Fed will continue to focus on a strong jobs market and keep its tightening bias, which WILL inevitably cause a deep recession; however, the recession won't come "soon enough" for the Fed to save the day. And, the seemingly gradual descent into negative growth, will allow the recession trade to dominate its opposition.

Larry Williams responds:

The actual economy down but not out or negative:

Gary Phillips replies:

i get what you're saying. (perhaps the economy is strong enough we never have to endure a recession in 2023.)

but, methinks you're missing MY point: the longer the economy "holds on", and the longer it takes for a recession to rear its ugly head, the longer the Fed continues QT ( good news is very bad news). on the other hand, if there was an impulsive and deep, drop in growth, (bad news would be welcomed with open arms) the Fed would be more inclined to pause or pivot sooner (de facto put).

Humbert H. writes:

The Micron news that rattled the markets is actually a good indication that the economy isn't strong enough. Micron is as close to an economic barometer as you can have in the chip business because of its wide range of end markets. I've been reading some notable value investors (and I try to be a value investor although not a notable one) claim that it's a part of an oligopoly that is now living in a stable oligopolistic Nirvana. Oligopoly (or even better monopoly) is a dream come true for value investors because it results in long runs of high returns on invested capital which in the long term leads to a steady climb in stock prices. Well, it got wacked by the economy all the same because there is nowhere to hide. Servers, PCs, game consoles, cars are getting wacked and will only deteriorate. Sooner or later even the phones will start feeling it. Separately, new constriction is getting killed. Seen the prices of lumber lately? This is a slowly unfolding catastrophe, with the job market the only good part and that's what the Fed is most focused on destroying! Just like the chip shortage and the lumber boom, everything else will go to hell. Yes, a year from now we'll probably be witnessing the Fed trying to revive the economy, but it has to die first for that to happen.

Gary Phillips responds:

i would imagine that's one of the reasons why the bonds aren't puking.

William Huggins writes:

I'm quite surprised that few have been willing to say this but: "recession is the medicine for inflation". the idea that inflation will subside without job or enterprise losses is praying that Sully lands the plane without anyone being hurt (as opposed to Uruguay's soccer team in 1972 where cannibalism is all that kept the survivors going).

yesterday's news was full of "santa rally" headlines, which suggests to me that people are desperately trying to see what they want in the markets. retailers have continued to pile in as baby boomers save the last gasp of cash flow before mass retirement but institutions are cutting their equity positions suggesting that in our game of musical chairs, its main street that will be left without a seat.

overall, interest rates will keep rising as long as the real rate is negative. imo, there is a generational unwinding of negative real rates that has created housing market distortions, which has fed back into demands for pay to afford those more expensive houses. the medicine is positive real rates. that increase in the cost of capital is taking the wind out of the sails of P/E 50+ companies. i think a whole generation has entered the market since 2008 and their expectations are that real rates will be (and stay forever) negative. this mistaken belief continues to fuel aspirational bottom fishers who have claimed every bounce down the stairs is a turning point (like this week).

we are still not at the "pain" point where defaults start piling up but its coming in 2023 as household savings shrink in response to higher rates.

Larry Williams writes:

The fed says GDP to be firm and steady:

Humbert H. responds:

They also said inflation was transitory.

William Huggins corrects himself:

(i should have said savings are responding to the negative real rate - people are consuming because savings are a loss at this point)

Zubin Al Genubi writes:

My theory is the process will take years. Powell says 2025. Why not take him at his word. While the market will rejoice at any dip, but its going to take more to get core cpi below 3%. They ran trillions and trillions through. Its not going to flush out in 3 months like some think.

Humbert H. comments:

Well there is more and more talk that 2% is just a number, and it is. They need the number higher otherwise they won't be able to inflate their way out of the debt. Nobody can explain the 2% anyway other than some foreign central bank started using it at some point. If the world wasn't as screwed up as it is they would use 0%. My feeling is he will crash the economy and then "will not have any choice" but to pivot. But he has to crash it otherwise his damn "legacy" will be that of a weak man, and we can't have that, can we?

Larry Williams suggests:

Study the past to see how long it takes these high levels of inflation to decline….usually about 18 months.

Boris Simonder adds:

Past inflation duration vs. current (white curve).

Stefan Jovanovich points to lumber:

NASDAQ: lumber prices

Bud Conrad responds:

Boris, Great Chart! I was going to work up this chart, and you gave it to us. Thanks. According to this, inflation dropped to about 2% after 24 months from the Peak. The overlay so far looks convincing.

But I would argue that we have a much more difficult situation now with total Federal Debt at about 110% of GDP when it was only 30+% at the 1980 peak. The problem is that the government with $31 Trillion debt, can't cover the interest on debt, at say 10% cost of borrowing, because the $3T interest payment takes up most of the tax receipts. Interest was $400B a year ago and jumped to $800B), So the Fed can't hike to the level of the 1980 peak of 20% - ever.

The market sees the "pivot" coming much earlier than Powell now asserts. I have no reason to have confidence in what the Fed says, from their previous mis leading pronouncements. They are required to act as proponents of economic prosperity as part of their assumed responsibility to manage the economy. Jawboning does work for a little while, but is bad investment advice.

My expectation is more aligned with rates in the forward market that are predicting the Fed capitulates to the government, the big bankers and general investors and errs on the side of continuing inflation by dropping both rates and asset purchases. (They are really the same thing as one causes the other.) That means that if the Fed pivots as early as first half 2023, the predicted spike in assets from lower rates will drive the actual inflation of asset prices much higher by 2024 and the bulls (like Larry) will be proven right. But I think the potential fear from Fed capitulation (and the readjustment in foreign trade not using dollars from Saudi, Russian and Chinese trades) will also drive dedollarization even faster, so we will get international dollar collapse. So your higher house and stock prices in dollars will not buy you more oil, Chinese manufactured goods, or vacations in the Emirates). Inflation will climb also with the government deficit and foreign repatriation of Treasuries as foreigners won't want to hold Treasuries they accumulated with their trade surpluses.

The only buyer of last resort of the $4T (?!) Federal deficit (Treasuries) will be the Fed. They will "create" the money from thin air. And that will be very inflationary. The only respite will be from other Central Bankers and the IMF and BIS and… all doing the same hat trick of money printing themselves. So world currencies will inflate. In that environment, commodity prices are the winners. (gold, oil, copper tin, steel, coal, houses, military equipment….

)

The authorities will attempt to ham-handedly manage the crisis with currency controls, forced Treasury buying by pension is and banks, price controls and even confiscation, all to little avail for the big trend.: Higher inflation than anyone expects will be obvious by the mid decade.

Gary Phillips responds:

I tend to agree with Larry, sooner, rather than later. It's happening as we speak. Stefan brings up a very salient point. Gas prices are falling Durable goods prices are falling (they led the way up, and are now leading the way down). (Food) commodity prices are falling. Rents are falling. Savings rates rates are plummeting. Credit impulse making new lows. M2 money supply contracting. if the Fed keeps this up, we may blow right through 2% and see a full blown deflationary bust.

as Bill Huggins said, spending can only be maintained via drawing down savings & incurring more debt. Individuals are spending every last penny to maintain their standard of living and postpone personal deflation that will certainly not end well, and will only serve to hasten the decline.

Humbert H. responds:

Somehow the discussion has shifted to how long it will take for inflation to come down. Of course it will come down as the economy is destroyed, savings run out, new construction is decimated due to higher mortgage rates, and close to 20,000 illegal aliens enter the country per day, many of whom need to work immediately to pay off the cost of getting here. Slightly longer term the trends aren’t so good as deficit spending goes on, investment in new carbon fuel extraction just isn’t likely to increase, and de-globalization is starting to happen. But sure, 18 months sounds pretty good. My initial point was that I disagree with Larry that we’re in a bull market. We’ll be lower 3 months from now unless the Uke war suddenly ends.

Larry Williams adds:

The 12 month rate of change of CPI, down for 4 months, gives nice stock signals:

Humbert H. comments:

The hardest thing about using the past to predict the future is deciding how similar the past is to the present. Was the Fed fighting inflation in the same determined way as they are now during this time frame? We have to go back to 1982 to see the same low-to-high excursion in interest rates as we’ll see by the time this cycle is over. When the Fed is on a warpath, it’s better not to fight it until 6 months before the end of the recession, so to me that’s the question: how close are we to the end of the recession that has not yet been officially called?

John Floyd comments:

One of the lessons I learned and have heeded is “recession” is rather arbitrary, and in the technical sense not known until 2 quarters hence and subject to revisions. in my view a better way to look at it is "it may not be a “recession”, but it will feel like it."

I think history lessons for the model of the current environment needs to go back well beyond the 70’s. Debt levels, productivity, demographics, globalization, deglobalization, to name a few.

And then the same person who gave me the lesson on recessions had a funny line at a recent dinner: ”the only reason generation Z and the millennials will wake up is to quit their jobs!” at 42% of the population I am pretty sure that is not good for productivity.

William Huggins writes:

the recession is coming in 2023 as a result of monetary policy to bring inflation in check - people are dancing as the boat sinks. it will not just be american, its going to eat up canada, germany, and the uk too. people have been blaming the local politicians for inflation but there is (also) a significant contribution from global supply side issues - how else to explain a systematic issue afflicting so many nations simultaneously?

my basic macro play for the year was to buy north american commodity producers (once the war broke out) and to focus on cash flow generators that pay dividends. all my speculative plays (ewz, gold, ntr) all lost money on bad timing but a basic macro orientation gave me a 11% gain on the year. keeping it simple.

Bud Conrad adds:

The longer term view of savings shows just how big thee Stimulus checks that were directly deposited into bank accounts were.

The government immediately halted the recession that was caused by the government in shutting every small business and forcing people to stay home. The low level now of saving is partly because everybody found some extra money, and it is not really reflective of sensible saving values. The government exercised its power and found a new cover in the MMT. There should be no surprise that this $6 T in stimulus ($4T shown above for households) goosed the economy and spiked inflation, (even as under reported by the official CPI).

H. Humbert comments:

Bud, Larry has been bullish since March. "Buy now" is always good advice if your time frame is measured in years. We're just arguing about how many months the market will continue to go down before turning up. I've mentioned in this exchange that inflation isn't likely to go to 2% because they need it to be higher to inflate the debt away, and as you correctly point out they need the interest rates to be low to afford to pay the interest. The question is really this: is there somebody around who will make Powell an offer he can't refuse he'll pivot sooner than he wants to? Like someone casually showing him a picture of JFK or Epstein, or something. Nominally, there is no leverage to make him do anything at all. His mandate is to keep the wolves well fed and the sheep safe, that's a fantasy. So how long before the market downdraft ends?

Bud Conrad responds:

Inflation will never go to 2% with the intractable government deficits that require money printing. (We agree.) To your question, The stock market downdraft ends with a credible Fed pivot (not just say quarter point hikes but when they actually make the first (of many) cuts in rates and start new Treasury purchases.).

And then the question is when the Fed cuts. Your image is a great one and you are on to something, about who actually runs things, but I think Powell already knows that he has to "Do what is expected". In this case, he has been accommodating higher inflation up to March 2022 as expected, and will return pretty soon to that plan. The powers want inflation even as they make pronouncements that they will control it, to keep dupes buying long term Treasuries. There are so many fallacies of understanding how market works, that I have to get them on the table:

1. Price Increases (called Inflation) comes from too much money chasing too few goods. It is not driven by the current interest rate.

2. Interest rates are driven by the inflation rate (expectations). Potential Treasury buyers will buy oil, gold or real estate rather than guaranteed losses on Treasuries, if they know inflation will take away their principal. SO Inflation drives rates (not the reverse. Plot the CPI against deficits, interest rates and money supply, and you will see the correlation and the order in time, as to the causal relationship. History says rising inflation goes with rising rates.

So my interpretation is that the Fed will not really fix inflation, by raising rates, despite everybody from Bernanke on saying that it can. The Fed is raising rates because the market says they have to (look at the 2 year Treasury). The market is driving the Fed. If they don't raise rates, nobody will buy Treasuries. The only way they kept rates low was by buying Treasuries and MBS in the market. That is the way they control rates, not by asserting Fed Funds rate. Fed funds is irrelevant since we cancelled the Fraction of reserve requirement that banks have to have on deposit at the Fed, during the pandemic. We no longer have a Fractional Reserve System, if you didn't notice. Buying and selling Treasuries counts on setting rates. (So my base assertion is in direct opposition to all the Fed proclaims.

3. There is no hope of the Fed lowering rates to 2% by raising rates, even by completely destroying the economy. Rates in Argentina are close to the inflation rate there of both at about 100% (per year!). I'm repeating: Raising rates only accommodates the market. It does not fix inflation. Fixing inflation requires the Federal government to match taxation and spending. That is not happening (and won't happen as those with power to make those decisions benefit from more spending and not raising taxes. The incentives are for more deficits which lead to money inflation that leads to prices rising. It isn't supply chains, unemployment, wage gains, or Putin's fault. To some extent it isn't even the Fed, although everybody parses Powell's every nuanced word. It is the Federal government deficit. And I have to add that the deficit is actually improperly under calculated with trillions not accounted for. (Another opaque long story).

4. Summary: The Fed has to pivot before PCE gets to 2%. The new printing will drive inflation much higher than any one expects, (above the 1980 peak), asset prices will rise despite only modest economic growth. Then the dollar and the economy crash, as the reserve currency stature of the dollar also loses its authority, and we have something more like the depression. This is hard to pin to a time frame because it is two inflection points:

A. Rates up a little more: Assets crash and then rates are slashed: (1H 2023).

B. Then markets and commodities take off: (2H 2023 to 2024)

C. Which then necessitates another response to inflation like balancing the budget to defend the dollar at a time when tax revenues decline from the economic slowdown, and demands for spending for unemployment or price shocks make that impossible to achieve. Fed action at this time will not help inflation but it will help the government and banks by buying $20 Trillion of Treasuries and other assets. (To end of Decade)

Zubin Al Genubi adds:

Bud's view is similar to Ray Dalio's decline of the US empire.

Stefan Jovanovich comments:

The British Empire did not end with the massive increase in debt; it began with the explosion in borrowing and the City of London's discovering that they, not Amsterdam, had to be the guarantor of the "money" needed for the FX exchanges of international trade and the subsidies needed to defeat Napoleon's Empire and the pound did not need to be coin in order to be as good as gold.

Bud Conrad responds:

It is interesting that some think I was predicting the end of US Empire. I only talked about the specifics of financial structure: Deficits driving money creation, driving inflation, and the effects of the Fed on our economy. Thanks to Gary Phillips for kicking off the discussion (as he used to do with Tax Receipts that will play a part on future deficits), and comments from others.

But I left out: The possibility of the war spreading (some evoke WWIII with Nukes), the effects of money creation and asset inflation that exacerbate the social conflict from the wealth disparity, and the ongoing control and corruption of the continuing mismanagement of the World health crisis. If you add those to my more myopic financial collapse, you would come to the society changing conclusion of a Thucydides Trap.

Larry Williams clarifies:

Larry has been bullish since our bull market signal issued as shown –and discussed—here:

Gary Phillips writes:

Powell went from no tightening is necessary, to overtightening. He's like a trader that buys the top, and sells the bottom. So there's no reason to believe that he is capable of learning from the past, either in its totality or that his preferred 70's analog is relevant today. It is impossible to predict his moves, the timing of his moves, or the motives for his moves. The goalposts are constantly being relocated, which means that one must trade the market, and not Fed.

Personally, I would be reluctant to categorize the June and October lows as anything other than bear market bounces. The October rally started out as an OPEX related technical bounce, that was further fueled by the perception that inflation was easing, a Fed pivot (and a soft landing) was in the near future, lower interest rates would return, and a recession would be averted. For a brief moment, risk aversion was summarily dismissed, and FOMO became the prevalent emotion. The rallies were all about flows, positioning, and sentiment, that were predicated on an anachronistic assessment of where the market is today.

What we should learn from the past is that it is not the present. The post-GFC environment dating back to 2009 has been "terminated," and it may or may not "be back". We are no longer in a highly stimulative, risk-on, ZIRP environment, where the only fear is missing out on the next "inevitable" move higher. A secular change has occurred, and we are now in a period of high inflation, a tightening Fed, more normal interest rates, rising risk aversion, and tight credit. Fear of missing out has been replaced with fear of losing money, and BTFD has been proven to be a less than enduring strategy.

The market's underlying structure is complex, unknown, and changes over time. And, there is little in the way of objective certain truth. Any historical analysis understates the uncertainty of forward looking forecasts; but, accurately assessing the present is certainly a prerequisite for any attempt. Nevertheless, we are often left with spontaneous observations and probability based assumptions. We trade the market as it evolves using lessons learned; and, the intended result is the application of a well defined process that generates prompt, deliberate, and hopefully correct decisions.

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