Tuesday 2 January 2024

Outlook into 2025 - a recession scare going into Q2

So in the last blog I noted how a US recession did not seem imminent and many aspects of inflation were rolling over, while positioning had been pressured lower since mid-July, which I thought may be setting up an inflection point.

An abridged summary on comments:

"Heading into Q4 headline inflation will likely fall heavily due to YoY factors and the economy should continue to slow. So the market will start looking more seriously at rate cuts next year...we could get a soft landing in the US, i.e. the US economy slows but does not go into a real recession...because the US consumer remains fairly strong... and the US fiscal deficit is around 6% of GDP...

...so that argues towards a period of rebalancing and slower growth similar to 2000-2003."


Soft landing all but priced in in Q1

So markets have rallied on a soft landing/ rate cuts outlook. So far that looks to be the right call. But that doesn't anticipate investor positioning around what actually happens. If markets rally further during Q1, with say the S&P pushing for 5000 give or take, positioning will likely have swung full pendulum to stretched and the bears fully wrung out.

The FOMC has its next meetings on the 1st Feb, 22nd March, 3rd May. Then four more into the elections. 

I'm not a Fed watcher, but with 3-6 month inflation readings via several measures around 2% +/-50bps, the current Fed funds rate over 5.25% is excessive in real terms in a slowing economy. Per Nickileaks below:

So in an election year the Fed will be under immense pressure to signal in Jan and then start a cutting cycle in March. 

But given the Fed's stated concerns about service wage growth being high and service PMIs still being slightly expansionary and the Atlanta Fed still showing relatively high YoY wage growth of circa 5% (down from almost 7% - so wages are slowing and it is a heavily lagging indicator, but is probably not slowing as fast as they would like to 3-3.5%), so the Fed is likely to highlight the recent easing of financing conditions and is unlikely to cut aggressive, instead emphasising caution and a 'measured normalisation pace, whilst remaining vigilant' or something like that. 

So assuming they even do 50bps cuts at the March, May and June, the Fed funds rate would only drop to 3.75%-4%, and higher rates if they do 25bps or cut slower into the summer. 

Yet 3.75-4% is still fairly tight (contractionary) in a slowing economy with little real inflation problem to talk about...


Slowing inflation and growth dynamics, leading to a market scare

The Atlanta Fed has Q3 GDP of 4.9% slowing to around 2.3% in Q4, with the consumer being most of the growth and inventories back to dragging. 

I dont see the Federal deficit either being expanded or contracted a lot into the election - although I am not an expert on executive powers in this area. According to the White House docs they forecast a $2.1Tn increase in Treasury debt in 2024, which equates to almost 8% of 2023 GDP, at a time of full employment. 

The consumer savings rate is low, as they run down excess savings from Covid. Yet a sudden rise in savings or liquidation of inventories are the two most likely triggers for a standard recession. Also weakness starting in cyclical areas covered by the Manufacturing PMIs tends to spread out into private sector service areas, despite the massive Fiscal deficit dominating a large part of the service economy. 

So by the end of Q1, going into Q2, we could have a situation where inflation is going under the Fed's 2% level, but high rates are biting, GDP slowing, job losses broadening and savings rising while final demand starts to weaken and businesses are starting to cut back on inventories, investment and employment. 

That would be a fairly classical set up for an inflation/ growth downside scare or recession. For sometime in Q2 by the data and the markets positioning for it maybe in March or April.


Lets assume a growth scare/ market mini-crash happens going into Q2

And sometime in Q2 the S&P is down meaningfully and 10yr Tsy bonds have a 2% handle yield on them. 

The Fed will then have to accelerate rate cuts into the election to try and head off a broader recession and get a new growth cycle going into year end. 

-50bps at every meeting from March to November would bring rates down to 2.25-2.5% and a flat/ contango curve should help banks lend. 


Back to hiking in 2025?

Question is what happens then. Equities will be rallying into the election and probably year end. 

Per the chart below, in the first two recessions wage growth fell at least 2% YoY (orange lines) before the cycle restarted, in 2020 it was a minimal slowdown and we entered the cycle with more or less full employment and still high wage growth that then started rising and was accelerated by the effects of Russia's invasion of Ukraine.


The Fed then scrambled from a behind the curve position to try and get restrictive to get inflation and wage growth down. 

One could argue that as the cost of living crisis passed wage growth naturally slowed and the Fed hiking cycle impact has been significantly blunted by other factors (fixed rate debt, $6Tn Fiscal deficit etc).

If YoY wage growth bottoms out in mid-24 at around 4% YoY (yellow line) and the economy starts to recover from either a growth scare or only a shallow recession, then we might expect wage growth to also start moving up again, but from a quite high starting base. 

Food and energy prices

I don't have a strong view on food and expect oil broadly to trade with the S&P, so bounce now, sell off in Q2. 

Coming out of that though I'm a structural bull on resources in general, which I think have seen undersupply investment levels and demand grows with GDP or government instructed policies such as electrification. 

So if energy prices rise in 2025 it might point towards wage growth also rising as the cost of living starts to upshift again - given energy costs filter through everything in the economy, at which point the Fed will be back to hiking, having been caught behind the curve again. 

What happens in the election, fiscal deficits, real yields is not so clear to me, but I dont see anything dramatic happening before the election. A Trump re-election is likely to casue a bit of a market/ economic shock same as in 2016. 


So in summary the outlook seems fairly analogous to 2000-2003, where depending on the size of sell off and bounce you look at, we had 5-10 major sell offs and bounces, or as I would call them pathways and inflection points, and the market fell overall in nominal terms.

This blog has always focused on more strategic (3, 6, 12-month) time horizons and mostly on the main asset markets. 

If you like the blogs, perhaps follow me on Twitter where I also focus on shorter time horizons and other areas including the political economy and emerging markets. Thanks.












Monday 25 September 2023

Will JPow take credit for Yellen delivering an immaculate soft landing?

In my last post I posited that the liquidity reduction could cause a market sell off and USD rally. 

Well a fairly mild one has happened; bonds and equities sold off and the USD rallied, while credit spreads remained fairly stable and VIX is still in the teens.

So is there more to come? What's next? 

Many think the Fed is finished hiking so that, in itself, is an inflection point. Heading into Q4 headline inflation will likely fall heavily due to YoY factors and the economy should continue to slow. So the market will start looking more seriously at rate cuts next year, which should be positive for duration. As of right now with the 10yr at 4.53% I think it is a buy for real money investors with a 1-2 year time horizon, not sure if it will sell off more this week but technically it is oversold I think and fundamentally is high yielding vs where inflation and growth is likely to average vs growth over the next few years. 

On the economy and equities, we could get a soft landing in the US, i.e. the US economy slows but does not go into a real recession. That is because the US consumer remains fairly strong (strong employment, two/ three years of strong wage growth versus many fixed costs like mortgages and car leases leading to strong growth in effectively disposable income for people who have skilled jobs https://www.atlantafed.org/chcs/wage-growth-tracker?panel=1)  and the US fiscal deficit is around 6% of GDP. So the consumer which is around 70% of the economy is likely to remain fairly strong.

In terms of the more cyclical parts of the economy, housing is likely to drag, autos will likely see falling average prices and some volume reductions, so a drag but no implosion. Energy is still strong and if the consumer is strong there is no obvious reason for a big inventory liquidation. 

So that argues towards a period of rebalancing and slower growth similar to 2000-2003.

So the economy, particularly when the Federal deficit is so big, is not that immediately sensitive to the Fed hikes and in a slowdown by definition some industry sectors will shrink while the others and total overall economy still grows.

As the economy slows, manufacturing PMIs are likely to remain slightly negative and service PMIs should also slow, may even be negative for a few months. This slowing is part of the soft landing and is not in itself a warning of an imminent crash.

As headline inflation falls and core slows, but core is underpinned by a robust service sector and service sector wages, with government employment and spending directly and indirectly being a large part of the service sector wage bill, the Fed might cut rates next year but not go to zero. So it might cut to say 3% or something in time. 

So at that point without a large recession/ any real GDP recession and inflation down and the Fed cutting, JPow will be hailed by the media as the Maestro II. 

Even though the Powell Fed was late to tighten policy pre-Covid and has had almost no effect on the reversion of inflation back to long term trend levels, which has mostly been due to the global commodity price/ PPI wash out plus the large fiscal deficit blunting a lot of the pro-cyclical effects of his hiking cycle.

Overall this should be a reasonably positive environment for duration and for solvent/ cash generating risky assets, but probably not for loss making/ concept risky assets (sorry Cathie).

I guess the downside risk is that companies panic and cut investment/ inventories quickly, then cut jobs and that weaker jobs market leads to a rise in the savings rate and a more rapid slowdown, which then self-reinforces into a typical hard landing. That would still be positive for duration but not for risky assets.

So that is a 3-6 month US outlook. 

The EU I am more negative on (could even see an EU deflationary recession), UK cautiously optimistic and EM selectively positive on.

Longer term I guess the US question is how big is the trade off between credit growth, corporate margins, inflation, rates, credit demand/ deleveraging and Federal fiscal deficits. If we are in for an extended 2000-2003 type deleveraging environment, corporate margins should steadily fall, the CA deficit shrink and USD fall as investors look for growth and returns elsewhere. But that is probably a 2024 consideration.

Friday 16 June 2023

Jerome and Janet's impending liquidity rug pull


If the last 3 months have mainly been about circa $700bn being injected into banks and $500bn being pulled from bank deposits and some of that deposit pull going into various financial markets, the coming summer period looks set to be more or less the opposite. 

Consider the following:

  • Yellen will raise up to $1tn TGA and is issuing net about $250bn/ qtr.
  • Powell is doing about $300bn QT/ qtr
  • And he wants to run off the funding expansion this year, they have run off $200bn SOFR based funding MTD
  • And have another $400bn SOFR based funding YTD to go
  • There is about $3.3tn excess reserves at the Fed
So they could drop excess reserves to about $1.4tn by the end of September
There is about $2Tn sitting in reverse repo, which is effectively QE sterilisation, but it may be the case that if the Fed encourages/ forces some of that out, the released money goes into excess reserves and not into Treasuries. Although some is likely to go into Tsys and soften the impact of the above. 
Minimum excess reserves in the system is probably around $1tn, as bank finance needs and deposits are not evenly spread, with Treasury primary dealers being the main net wholesale borrowers from banks.
A more workable minimum level is probably $1.25-1.5Tn
So setting aside any reverse repo reverse sterilisation, essentially the Fed and Treasury could drain all functional excess reserves from the system by end the of September, certainly by year end with another 3 months of fiscal deficit and QT.
Now if they are selling that many Treasuries and dont want real rates to rise, other USD holding investors need to buy Treasuries.
And to buy Treasuries they need to sell something else.
Most probably they will sell the assets that have risen the most this year and which would be most exposed to a recession. Namely US equities and US HY and we see a leg higher in the USD.
As such we are more or less at a liquidity inflection point.
We have another month for real money to adjust their portfolios before going into the summer period and reduced market liquidity.



Friday 9 September 2022

Foreign Treasury holdings, QT and the Euro bounce

The chart below shows that a UK/ EU or Japanese financial can buy US Treasuries (2yr here) and XCCY asset swap them back to local Libor and lose money vs RFR, 20-35bps in Europe and 70bps in Japan. Or they can hold local assets, which in the case of the UK and EZ now have a positive and rising yield given rate hikes coming, and have no counterparty capital charge. 

For example, UK 2yr Gilt yields about 3% right now where as SONIA -25bps yields about 1.45%. 3m Gilt about 2.4% yield.


There are a couple of charts below from the Treasury report that is produced annually. You can see foreign holdings, which are dominated by European/ UK/ Japanese investors rose by Trillions as ZIRP/ QE policies were implemented after 2008. Since pre-Covid foreign holdings of Treasuries have increased from circa $4Tn to almost $8Tn. These flows along with equity flows have covered the US current account deficit since 2008.


But this is now a negative carry/ unattractive trade for the previous buyers. 

So there are a few implications, as foreign financial buyers reduce/ disappear and in some cases sell existing holdings, at the same time as the Fed is unwinding its balance sheet, either domestic buyers come in, or yields rise.

Both scenarios are negative for US asset prices as it either increases the discount rate or increases the discount rate and causes US domestic portfolio rotation away from risky assets and into Treasuries.

So this is the portfolio channelling, with a leverage factor, of QT into US asset markets is happening in coming months. Its also broadly USD negative, and along with the fading energy narrative I think may have put a floor under the Euro and Sterling this week. When the BoJ starts to hike rates the effect will be amplified, but Yen likely to remain weak until then.  

Going forwards capital will have a cost and govt bond issuance risks crowing out other borrowers.

It will also affect private markets. If LBOs have been financed at 5.5x senior debt/ EBITDA and Lev loans pay about L+5.5%, then with the Fed hiking to 4% the leveraged loans will yield 9.5%, which at 5.5 debt/ EBITDA is going to use up over half the EBITDA for interest service. EBITDA margins are also going to fall as credit slows and the economy slows and in a recession, EBITDA will fall a lot. So there are going to be a few zombie LBOs out there.

I think this is quite important from an asset allocation standpoint over the next six months.