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The Stimulus Pig In The Economic Python

Twelve insights on Fed interest rate cut “pivot mania”.

The lag effect of monetary policy changes will surprise the Fed as the fiscal “pig” of stimulus begins to exit the economic “python.””
Lance Roberts

“When I look back at the bull market that we’ve had in financial assets really starting in 1982. All the factors that created that boom not only have stopped, they’ve reversed…We are in deep trouble.”
Stan Druckenmiller

While it is hard to know precisely when the persistent red ink will be viewed as big enough to matter, a fiscal crunch and bond market turbulence seem inevitable at some point.
Bill Dudley

Ever since 2008 US economic policy intervention has become increasingly active and influential. The S&P 500 greatly benefited, both in terms of sales, and particularly in terms of asset values. Nevertheless growth remained chronically weak, measured in GDP terms. Rarely, if ever, have equity asset values diverged to this extent from GDP. The stimulus of 2020/21 took intervention to a whole new level. Too far, in fact, as it has revealed the limits of post 2008 policy.

This intervention distortion will have to find a way to unwind just as policy becomes increasingly compromised by the declining effectiveness of monetary and fiscal policy support following historic excesses.

Investor thinking and behavior about how to invest has been conditioned to times of neverending and excessive stimulus, but the game has changed in important ways. Investors need to carefully consider the link between declining growth and inflation, rate cuts and asset values. The current rate cut pivot mania, where immediate rate cuts and higher asset values follow in short order, seems to be out of line with current policy statements and longer term historical experience. Twelve points will explain the conflict.

For the last several months the markets have rallied hard on weak inflation or growth readings. There is a hurry to expect a sustained stock market rally based on a near term Fed rate cut. Here’s why that could be a dangerous assumption.

1. The 2020/21 stimulus experience did not produce a good outcome.

2023: You Wanted Endless Stimulus, You Got Stagflation. Daniel Lacalle

Now we face a 2023 with even more disappointing estimates. According to Bloomberg economics, global growth will decline from a poor 3.2 percent in 2022 to a worrying 2.4 percent in 2023, significantly below the pre-covid-19 trend but with higher global debt. Total global debt rose by $3.3 trillion in Q1 2022 to a new record of over $305 trillion—mostly due to China and the US, according to the Institute of International Finance.

However, consensus estimates show an even worse outlook. Global growth should stall at +1.8 percent, with the euro area at zero growth and the United States at just 0.3 percent, with inflation reaching 6 percent globally, 6.1 percent in the euro area, and 4.1 percent in the United States.

2. The latest data suggests we are on the verge of a recession.

The 6-month rate of change of the Leading Economic Index has a perfect track record of forecasting recessions. It is now at that point.

A similar meassage comes from last week’s ISM Services PMI.

3. Earnings typically fall in a recession. Or at least mean revert from all time highs.

EPS appears to be far above its long-term trend, and due to revert down toward the mean. This chart from the Bloomberg terminal shows that any sensible trend line suggests that recent earnings are unsustainable.’

4. Powell’s statements, and FOMC members, have been consistent since Jackson Hole in August 2022. There is no Fed rush to cut interest rates. Powell’s guidance is no rate cut until 2024.

It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against
prematurely loosening policy. And I’ll close by saying that we will stay the course until the job is done
Powell at the Brookings Institute 2022

Any near term cut would collapse confidence in the Fed, not just from inconsistency but also historical precedent as can be seen below.

5. The Fed has never started rate cuts below inflation. 250 bps to go!

6. The huge scale of stimulus has taken time to work through the system.

It is still positive and taking time to decline back to 2019 levels. Real interest rates are still negative, there has been additional fiscal support and there is lagged support from previous measures. This can delay the pivot, or even lead to further tightening.

7. Fiscal spending boosts can also extended the boom and also delay the pivot.

economic growth could prove more persistent than expected. Not only did the economy expand much faster during the second half of 2022 than the first, but also the economy will receive additional support next year as federal government outlays surge. The $1.7 trillion government funding bill for 2023 increases defense spending by 10% and domestic discretionary spending by 6%. At the same time, the monthly social security and disability benefit checks to 70 million recipients will rise by 8.7% starting this month. In fact, the increase in recipients’ disposable income will be even larger because Medicare insurance premiums, which are deducted from these checks, will decline this year because the hikes implemented in 2022 turned out to be considerably higher than needed.”  

8. History shows that stock market exuberance based solely on an interest rate cut is usually badly misplaced.

9. A premature rate cut could be a longer term policy disaster.

Powell has indicated that he is aware that in the 1970s it took positive real rates to bring down inflation. Even then inflation reemerged as soon as real rates declined to zero. The interest rate relationship with inflation has fundamentally changed in a high inflation environment.

10. Buybacks may be in decline.

The scale of buybacks reached new records in 2022, well over $1 Trillion. However this has become much less attractive for two reasons. First issuing debt to buyback stock has become much less attractive as the gap between low yielding debt and high yielding bonds has closed, as shown below. Also, buybacks are now being taxed for the first time in 2023.

11. Geopolitics.

Increasingly the world is operating in a different way. Becoming more regional and nationalist and less fluid globally. Furthermore, Dollar reserves are now in decline.

My sense is that the market is starting to realize that the world is going from
unipolar to multipolar politically, but the market has yet to make the leap that
in the emerging multipolar world order, cross-currency bases will be smaller,
commodity bases will be greater, and inflation rates in the West will be higher…

Here are the key parts from President Xi’s speech at the China-GCC Summit
(all emphasis with orange underlines are mine):

“In the next three to five years,
China is ready to work with GCC countries in the following priority areas:
first, setting up a new paradigm of all-dimensional energy cooperation, where
China will continue to import large quantities of crude oil on a long-term basis
from GCCcountries, and purchase more LNG. We will strengthen our cooperation
in the upstream sector, engineering services, as well as [downstream] storage,
transportation, and refinery. The Shanghai Petroleum and Natural Gas Exchange
platform will be fully utilized for RMB settlement in oil and gas trade, […] and we
could start currency swap cooperation and advance the m-CBDC Bridge project
Zoltan Pozsar

12. Fiscal fragility.

The scale of debt outstanding is becoming alarming. Any further slippage in Inflation or fiscal policy could add to financing costs.

Bill Dudley explains:

“The budget deficit is likely to be around 5% of gross domestic product in 2023. That is an abject performance when the economy is operating beyond full employment. Moreover, it is a horrible jumping off point for what lies ahead — much higher debt service costs and soaring social security and Medicare spending as the baby boom generation retires. The squeeze on government finances will be exacerbated by a sharp rise in the cost of the Fed’s liabilities (mainly bank reserves) relative to the earnings the Fed realizes from its holdings of Treasury and agency mortgage-backed securities. The rise in short-term rates will cause the central bank’s income to fall from a profit of more than $100 billion in 2021 to a loss of more than $100 billion in 2023. As Everett Dirksen is reputed to have put it when he was Senate Minority Leader, “A billion here, a billion there, and pretty soon you’re talking about real money.” 

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The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs Best Investor metrics and techniques as never before.

Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.

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