This is actually a perfect storm for risk assets, and I don’t think we’ve ever seen such a smorgasbord of downside risks all taking hold at the same time.
The spread of the pandemic in China that cuts both ways with demand and supply; the escalating war in Ukraine, which also is a demand and supply crusher; and we have the U.S. dollar surging and the Japanese yen sharply slumping in 2015-16 style. As you may recall, that was when we saw the Chinese devaluation and capital flight – with a domino effect on equities and credit that forced the Federal Reserve to the sidelines for almost a year, even though it had originally penned in three rate hikes. But that wasn’t a Fed facing 8.5 per cent inflation, a 3.6 per cent unemployment rate, or a fear that its credibility was under attack.
We are going to see a first quarter U.S. GDP number this Thursday around 1 per cent, and historically when the Fed begins a tightening cycle it’s traditionally more than 3 per cent.
I should add that the only time historically when the Fed embarked on its first series of rate hikes in a cycle without all the major averages above the 200-day trend lines was back in 1987. Meanwhile, if you look now at what the futures market is pricing in for the funds rate and the planned balance sheet reduction by the Fed, we are talking about a combined 450 basis points of de facto rate hikes this year.
We haven’t seen that since the Paul Volcker era, but that is indeed who current Fed chairman Jerome Powell now compares himself to.
We traced through what this would mean for the economy. In 2022, this would amount to roughly a 2.5 to three percentage point drag on GDP growth and that accelerates to a 5.5 percentage point drag in 2023. From baseline growth, that implies a flat GDP growth profile for this year and then negative 3 per cent for next year – so yes, recession under this policy outlook is as close to a certainty as anything can be.
That means a U.S. unemployment rate approaching 5 per cent by the end of this year and 6.5 per cent by the end of next year, which would be a big surprise to a Fed thinking we remain close to 3.5 per cent for each of the next three years. Keep in mind that in these past 10 years since the Fed began publishing its forecasts, it has been dead wrong on the jobless rate fully 76 per cent of the time.
Meanwhile, what I suggest we do here is focus on the internals of the stock market and heed the message for both growth and inflation. While the financials and consumer discretionary sectors are bleeding from the surge in market interest rates, we now have the capital-spending stocks taking it on the chin in a material way, with industrial machinery and electrical equipment sectors well in bear markets of their own. The same for software and telecom services – both slicing below the March lows as last week ended.
So, the consumer-sensitive sectors have a consumer recession all over them, and now, even with apparent large cash loads on the corporate side to put at work, the sectors geared toward business-to-business are predicting a turndown in capital expenditure.
It must be emphasized that there is no bottom in the overall stock market until the asset-gathering stocks, as in the wealth management sector, finds a trough, and the group just took out the prior March low. We find ourselves now in a dangerous phase where the major averages hit and failed at key resistance levels to only then go and break below critical support points – and on higher volume.
And now, suddenly, the bond market is beginning to shift its focus, which had exclusively been on inflation, to recession. And on inflation, the question has been “who has the story right, stocks or bonds?” Just as the 10-year Treasury Inflation-Protected Security “breakevens” – a gauge of investors’ inflation expectations – top 3 per cent for the first time since inception in 2003, we have the stock market saying “chill.”
The materials stocks, the poster child for “inflation” in the equity space, are down 5.6 per cent from their high and are lower now than they were in May, 2021. Meanwhile, S&P 500 energy stocks closed Friday below where they were on March 8. Best cure for high prices is high prices, as they say. Living proof to that adage right here.
So, when does the Treasury market wake up and see what the stock market sees? We surely cannot be that far off at this point, and what tells the tale on this front is what is happening to the rates-sensitive housing and mortgage markets. The bond sell-off has taken the 30-year fixed rate mortgage in the U.S. up 190 basis points so far in 2022 to an 11-year high of 5.2 per cent. This is biting so hard that mortgage applications have tanked for six weeks in a row and are down an epic 48 per cent on a year-over-year basis. The key thing here is the refinancing component because its decline has become excessive; it’s down 68 per cent from a year ago and at a depressed level that we saw previously in January, 2019, August, 2008, and January, 2001 (there is an 80 per cent inverse correlation between bond yields and the refinancing index).
It wasn’t apparent then, any more than is the case today, that these were most assuredly terrific opportunities to start adding back duration to the portfolio and going long “the bond.”
The poster children for the Treasury market within the S&P 500 are signalling a turn lower in Treasury yields and, inversely, higher Treasury prices. Rare has been the time that we have been in such a pernicious cyclical bear market in Treasuries, with the likes of utilities, real estate investment trusts and consumer staples hitting or approaching record highs, and when you look at the relative strength of each one of these yield-centric sectors, they are back to where they were in the summer and fall of 2020 – and that was when the 10-year Treasury was sitting below 1 per cent.
I’m not saying the 10-year Treasury yield is going to 1 per cent, but I am saying that the gap between the spot 10-year T-note yield, at 2.79 per cent, and the 200-day moving average, at below 1.7 per cent, represents a two-standard-deviation event, and you always want to invest in such an event – in any asset class. Indeed, if you had invested in that two-standard deviation move from the trendline in the S&P 500 in the fall of 2008 after Lehman Brothers failed, you would have ended up doing well even though the market lows didn’t get established until March, 2009. (A standard deviation is the average amount of variability in the dataset relative to its mean. A higher deviation would indicate the current level is further from the long-run norm, and therefore has further to fall – or rise – should a reversion to the mean take place.)
If you could ride out the 26 per cent plunge that year to the March lows, you were ultimately rewarded with a 23 per cent positive price return for the entire year. The very same oversold condition was evident in the Commodity Research Bureau Index back in April, 2020, when the mantra was all about COVID-19 instead of today’s narrative of secular inflation, and if you bought into that two-standard-deviation event and shunned the consensus chatter, you made 45 per cent in your long commodity trade a year out.
That’s how I view today’s bond market, with that lens of a dramatically oversold condition, and where prices go from here.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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