End of the Line? Into the Frying Pan as Markets Anticipate End of Central Bank Tightening
Benjamin M. Lavine, CFA, CAIA, RICP
Chief Investment Officer, 3D/L Capital Management
The U.S. Federal Reserve meets this Wednesday with financial markets pricing in a high probability of a 0.75% rate hike which would bring the benchmark overnight lending rate to 2.25-2.50%. The Fed is also expected to update its economic outlook, dot-plot forecasts for terminal rates, and the status of quantitative tightening or reducing its $8.9 trillion balance sheet (over $4.5 trillion in response to the COVID pandemic).
Challenging Fed policy is accumulating evidence of an economic slowdown, if not recession, that has led to an inverted yield curve (long maturity rates lower than short-term rates) as the fixed income market prices in a lower terminal Fed Funds rate – the peak Fed funds rate before the Fed pivots and starts cutting rates in the face of economic weakness (Figure 1). An increasing percentage of fund managers now see a recession as the likely outcome (Figure 2).
Figure 1 – Market Keeps Lowering Expectations for Fed Funds Terminal Rate (and a Quick Reversal Thereafter)
Source: Wall Street Journal (7/25/2022)
Figure 2 – Recession Now the Consensus Among Fund Managers
Although headline inflation is expected to remain elevated for the rest of the year, there are increasing signs of a slowdown in both input costs and end demand. Oil prices have dropped from a peak level of $115/barrel to around $95 even though natural gas prices remain elevated over fears of constrained Russian supplies and limited LNG export capacity from the U.S. Apart from energy, commodity prices across both industrial metals (Figure 3) and agriculture (Figure 4) have witnessed significant drops, implying an alleviation of supply/demand imbalances (whether increase in the former or destruction in the latter). Much of the recent weakness can be partly attributed to a drop-off in demand from China as the country continues to grapple with COVID infections and ongoing property development collapse.
Figure 3 – Industrial Metal Commodity Returns Have Dropped Precipitously Since 2021-Q1
Figure 4 – As Have Agricultural Goods
What’s driving these sudden price plunges remains unclear, as some point towards systematic trading behavior on the part of leveraged hedge funds (i.e. CTAs) or for more fundamental reasons such as legitimate demand destruction in the face of high prices. U.S. businesses and consumers will likely enjoy some price relief (as evidenced by the drop in gasoline prices), but this relief may prove to be ephemeral due to longer-term structural supply issues resulting from capital underinvestment and the breakdown of trade globalization (as projected by geopolitical strategists such as Peter Zeihan). More on that below.
For now, the concern is that 1) plunging commodity prices, 2) slowing business activity (manufacturing, services), and 3) overtightening by world central banks have produced a sudden economic cliff-drop, first evidenced by warnings from general retailers over slowing consumer discretionary appetite and rising finished goods inventories. If not a cliff-drop, then a sudden braking perhaps (sharp slowdown but not contraction): whether seen in collapsing sales of recreation vehicles and barbecue grills or potential slowdowns across big ticket purchases such as used autos (loan delinquencies and repositions on the rise as many who financed used car prices at a 40% premium over seven years are now underwater) and residential homes (inventories and cuts in asking prices both on the rise). Add on higher financing costs (due to Fed policy) on top of elevated prices (due to inflation) and you end up with a recipe of demand destruction, particularly across income cohorts whose income has not kept pace with inflation.
The challenge for the Fed, not to mention world central banks, is having to implement a ‘typical’ tightening policy response to an ‘atypical’ regime characterized by global pandemic shutdowns/recoveries (thanks in part to a sugar-high injection of fiscal pandemic relief benefits) and geopolitical uncertainty (Russian invasion of Ukraine) that has produced uncomfortably (and non-transitory) high inflation. The concern is that world central banks may not achieve their policy targets of reducing inflation before having to ease (or reverse) policies to address the onset of economic weakness.
This challenge has been exacerbated by structural capital underinvestment in infrastructure and materials sourcing across much of the developed markets, especially in the U.S. As we initially pointed out in our May 2022 blog piece, “The Climbing Cost of Hard Capital,” the U.S. economy has seen a structural decline in the economic share of ‘hard’ capital expenditures, partly explained by the rise in ‘soft’ research & development/technology spending, that has helped propel a new supercycle (perhaps) in commodity prices. Figure 5 displays the structural decline in ‘hard’ U.S. capex.
Figure 5 – Structural Decline in the U.S. Economic Share of ‘Hard’ Capex (Capital Expenditures as a % of U.S. Gross Domestic Product)
Tightening financial conditions and a weaker economic backdrop have also reduced business appetite for future capital spending as indicated by regional Fed surveys (Figures 6a and 6b).
Figure 6a and 6b – Philadelphia and Empire Federal Reserve Surveys of Future Capital Expenditures: a Drop in Capital Spending Appetite
This is not to suggest that capital spending has not produced its fair share of imbalances, as a gorge of overinvestment in technology, housing, and domestic energy resulted in the 2000-2002 dotcom/TMT collapse, 2008 Great Financial Crisis, and 2015-16 oil price collapse – the former two resulting in economic recessions and the latter almost a recession. But structural underinvestment in ‘hard’ cap ex has, more or less, reflected a postwar state of affairs of a globalized/maximally efficient system marked by a finely tuned globalized trading system with key export markets maximizing their competitive advantages and global businesses operating with just-in-time inventories resulting in minimal working capital needs and competitive pricing for the end consumer. Rich developed markets could ‘afford’ to scale back on capital spending as long as the educated populace could keep these markets at the top of the manufacturing food-chain fed by an ever efficient supply chain underneath.
Current state of affairs are not what they were versus the pre-pandemic era. With much of the low value-added raw material inputs sourced out of Russia/Ukraine, South America, and South Africa and intermediate processed goods out of China and pan-Asia (sophisticated components such as semi-conductors), the major developed markets (U.S., Europe, Japan) find themselves in a quandary of either onshoring/reshoring industrial production (see the CHIPS Act being deliberated by Congress to incentivize more semiconductor manufacturing within the U.S.) or reducing industrial output altogether (Europe debating whether or how to reduce energy consumption by 15%). A new capital spending cycle may be upon us, not withstanding geopolitical constraints (costs, resource constraints, opposition from environmental activists), which will likely not produce the disinflationary tailwinds the world enjoyed over the postwar period.
But capital overspending producing an overabundance of supply is not what’s causing the weakening economic backdrop, but rather the recent weakness reflects a hangover of sorts. The 2020-2022 cycle has seen too much inventory on the goods/services side but without the prerequisite overspending on the capital expenditure side. A typical economic downturn involves too much spending producing too many goods/services beyond natural demand as was the proximate cause of prior downturns. The upcoming slowdown of 2022-2023 may not reflect a garden variety cap-ex driven slowdown – a conundrum world central bankers face as they rely on data-driven econometric models to shape rate policies.
After all the COVID revenge spending on goods and services (travel and leisure), the 2nd half of 2022 may be witness to a slowdown not resulting from too much output (inventory) caused by overinvestment as was the case with prior U.S. recessions but by 1) a slowdown in response to high inflation, especially in necessary living expenses (food, energy, housing), and 2) exogenous events outside of policymakers’ control (geopolitics, COVID lockdowns across China). Prior U.S. recessions proved to be deflationary, whether in technology, housing, or domestic energy prices as supply overwhelmed demand, yet we may be witnessed to a sharp economic slowdown/contraction but with stubbornly high inflationary pressures as the normal supply responses incentivized to meet higher demand have not materialized due to capital underinvestment.
Hence, if the U.S. were to enter a recession over the coming year, it will not likely be a result of capital overinvestment producing too many goods relative to natural demand but rather through demand destruction as nominal income cannot (will not) keep pace with higher prices. An upcoming recession may be a result of a ‘revenge spending hangover’ that has produced elevated inventories-to-sales ratios (Figure 7) of the kind warned about by general retailers earlier in the year.
Figure 7 – Elevated Inventory-to-Sales Ratios, But Will 2nd Half GDP Benefit from an Inventory Correction
The good news? The inventory hangover and negative trade balances (a strong U.S. dollar and COVID lockdowns across China has led to a drop-off in U.S. exports relative to imports – Figure 8) that weighed on 1st half GDP could turn into tailwinds during the 2nd half. The U.S. economy needs to work through the imbalances with growth digesting all the excess, whether inventories, fiscal pandemic spending, or money supply (central bank balance sheets). But if U.S. consumer spending merely slows down, rather than contracts, and businesses don’t enact significant layoffs, then the U.S. economy may avert a recession, at least over the near-term.
Figure 8 – Will the U.S. Trade Balance Turn ‘Less Negative’ as the World Moves Past Pandemic Lockdowns? A Depreciating U.S. Dollar Would Help
This leads us back to the Fed and the upcoming July meeting. In a speech to the Little Rock Regional Chamber, Federal Reserve Bank of St. Louis President (and voting Fed board member) James Bullard argued that the focus should be on Gross Domestic Income (GDI) rather than Gross Domestic Product (GDP) as the former “appears to be more consistent with observed labor markets, suggesting the economy continues to grow” while the latter is influenced by factors we referenced above (inventory corrections, negative trade balances). GDI is a broad proxy for U.S. consumer spending as total spending (roughly 70% of total GDP) tends to equate to total income over the long run and also serves as a proxy for the domestic economic conditions.
Positive inflation-adjusted GDI (Figure 9) and a still robust employment backdrop give both the Fed and Biden Administration a positive narrative to counteract the prevailing consensus that the U.S. is about to enter a recession. GDI/consumer spending and a strong labor market remain the two aspects Fed officials keep referring to in justifying the Fed’s policy stance, the shakiness in consumer end markets (autos, housing, durables) from tightening financial conditions notwithstanding. One can argue that GDI was artificially goosed by fiscal pandemic spending, but private income can help make up for the fiscal drag as government benefits expire.
Figure 9 – Gross-Domestic Income Chain-Weighted in 2009 Dollars: Real Gross Domestic Income Remains Positive Even as It Drops from the Post-Pandemic Surge
The last three recessions (2001-02 DotCom Collapse, 2008 GFC, and 2020 COVID Pandemic) all saw real GDI contract, which is why government officials are trying to redirect the recession narrative. If the consumer keeps spending and businesses don’t enact wholesale layoffs in the face of a slowdown, then the U.S. could skate by the current malaise even if we enter 2023 with elevated inflation and slow topline economic growth. Whether this will give enough cover for the Fed to pause its rate hike campaign (which would see leave real (inflation-adjusted) rates in negative territory) remains to be seen, but for now, the Fed is sticking with its outlook of an economic slowdown but not recession narrative as it continues to battle high inflation.
But the capital underinvestment story will likely serve as an overhang for some time to come, especially if the world moves away from globalization, and it will mean elevated inflation levels versus what we’ve enjoyed before the pandemic.
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By: Benjamin Lavine