The inflation problem is now well-known to everyone, but the larger looming problem is credit and currency risk, as well as a contracting economy. US government debt now stands at $31 trillion, while global debt is at $360 trillion. While these numbers may seem grotesque, they are the result of a global borrowing spree for over a decade with zero interest rates. Now that central banks are aggressively raising rates, how will that debt get serviced?
There was a near collapse in the British bond market last week. The new Prime Minister, Liz Truss, decided to propose sweeping tax cuts for the wealthy at a time when UK debt is soaring, interest rates are rising sharply, there is a treacherous energy crisis, and inflation is at 10%. This came at a time that the Bank of England has been trying, like the Fed in the US, to reduce its balance sheet by pulling money out of the financial system.
The punishment was swift, and caused a meltdown in the value of UK gilts and the British pound. The largest buyer of long dated UK bonds is the British pension fund system, which 28% of the British public relies on for defined benefit retirement plans. These pension plans are highly leveraged in order to achieve the income they need to meet their liabilities. They began receiving margin calls, and were forced to sell off assets to meet those margin calls. The brutal sell-off was redolent of the emerging market crises we’ve seen before, except that this took place in the world’s fourth largest economy.
The Bank of England was forced to intervene, buying back its own bonds to fend off systemic financial instability.
Back in the US, investors asked two questions:
Could it happen here?
How could the Bank of England “pivot” from being hawkish on inflation to suddenly stimulative toward their market within the span of one week?
With respect to the first question, we need only look at Biden’s student loan forgiveness package, which will cost the US 1.6% of GDP. (Remember that Liz Truss’ tax cut was 1.4% of GDP). While the US economy is more robust than the UK’s, easy fiscal policy does not mix with restrictive monetary policy.
As for the Fed “pivoting “, and easing up on monetary conditions in the US (like the Bank of England just did in the UK), it is not likely to happen anytime soon. Jerome Powell‘s first priority right now is fighting inflation. He insisted recently that his inflation target is 2%, and made it clear last week that there is no Fed “pivot” toward easier money in the near future. We have had two consecutive quarters of negative GDP growth, and a third is likely coming soon. With no monetary policy help from the Fed, investors should prepare for a hard landing.
The bear market and economic contraction of 2022 is truly a global story. The following chart, from the Dallas Federal Reserve, demonstrates the point that world economy is heading into a period of economic weakness:
The direction of financial assets can best be predicted by the following sentence:
“When money flows into the financial system, financial assets all go up. When money is flowing out, they all go down. “
How do we determine if money is flowing in or out of the system? The Financial Conditions index. This is a measure of whether financial conditions are tightening (money out) or loosening (money in). Here is the chart, with the Chicago Fed Financial Conditions represented by the thinner line, and the S&P 500 in bold. Tightening of financial conditions is represented by a downward sloping thin line:
Interestingly, all asset classes went down in the last week of September: stocks, bonds, precious metals, commodity indices, oil, and all other currencies except the dollar. Liquidity in the financial market is waning as these normally disparate asset classes are all trending down together. To elaborate, the corporate bond index is down more in 2022 then the S&P 500 stock index. This is the first time in history that bonds (traditionally perceived as “safe”) are down as much as stocks (perceived as “risky”).
There is no “history” to point to in the current financial markets. There are multiple standard deviation moves going on in stocks, bonds, oil, and silver that points to instability in the financial system and major stress going on behind the scenes.
The US dollar has risen more than 15% relative to all other currencies this year. This is because the Fed has been able to fight inflation more robustly than the more fragile economies of the Eurozone, the UK, Japan, and China:
Source: Yahoo Finance
The Chinese yuan is experiencing its largest loss against the dollar since 1994. Higher interest rates in the US cause flows into the dollar. But the higher dollar has consequences:
To begin with it exacerbates inflation outside the US, which is driving other world economies to their knees. Remember that world commodities are priced in dollars, and when the dollar rises relative to another currency, the price of food and energy rises in that country accordingly.
US exporters suffer, because US goods become more expensive abroad.
The income earned by the US company as abroad decreases in value when translated back to the US.
Dollar denominated debt outside the US ($13 trillion) becomes more difficult to pay back, causing stress in the credit markets.
And the credit markets have a curious way of sniffing out problems before they materialize.
Collateralized loan obligations (CLO’s) are “packages” of loans sold by banks with differing credit qualities.
Below is a chart of normalized year-to-date returns on various CLO indices.
Note the downward trend in all of them, representing a deterioration in their credit qualities
Source: Bloomberg
In the US, the manufacturing sector is weak. The September purchasing managers index (PMI), a gauge of manufacturing health, is still expanding slightly, but is at its lowest level since the pandemic recovery began in May 2020, with the “new order index “and the “new export order index” in contraction. According to the NFIS, the small business outlook for general business conditions is at a 50 year low, demonstrated by the thin line below:
Source: National Federation of Independent Business
Leading economic indicators fell in August for the seventh straight month. In the first quarter of this year productivity saw the worst quarterly decline since 1947 (-7.4%), well that figure fell by 4.1% in the second quarter. Over the past year, labor costs have risen by 9.3%. Falling productivity and rising labor costs bode poorly for corporate profits.
Rising interest rates increase the cost of debt at American companies, which negatively impacts corporate profits, especially considering a large rise in debt at US corporations in the past 10 years:
As mentioned earlier, the ever-stronger dollar will have a negative impact on multinational US corporations.
In the fourth quarter, US corporations will be facing, as headwinds:
A weaker consumer (with oil and gas prices now turning back up).
Higher input costs (which compresses margins).
Higher wage costs
Higher cost of servicing debt
Less profit from goods sold abroad
Less stock buybacks due to higher interest rates
The risk that if Democrats take one Senate seat more in November, Biden’s proposal to raise corporate taxes from 21% to 28% will become reality in 2023.
Corporate earnings across a range of sectors already suggest a slowing economy. The fourth quarter should see a continuation of this.
The chart below represents the New Orders-to-Inventories ratio.
Obviously, when new orders fall and inventories rise, it’s not so good.
This ratio has a decent track record of consistent negative readings prior to economic downturns. The most notable instances were 1973, 1979, 1991, 2001 and 2008:
Home prices in the US are now posting the biggest monthly declines in the US since 2009. The residential housing market is soft due to skyrocketing mortgage rates, which now are offered at 7.12% as opposed to 3% one year ago.
The same weakness can be seen (if not worse) in the commercial real estate market, where high interest rates meet “remote working”, at a time that post Covid leases are up for real. A recent NYU study predicted a severe office real estate downturn, as their research points to a 39% decline in office values, in the long run, representing a $453 billion value destruction.
