Part III: The Transformity Research Macroeconomic BASE Case 2022-2023--US Recession in first half 2023
Hey Subscriber,
Editors Note: We had some technical problems with our 4-Part Transformity Investing Special Report on "The END of the 2010-2022 Fed TINA Super Cycle Playbook." Thus we are sending out these reports out of order as we recontruct the other reports. Apolgies...its was Mail Chimps fault!
“To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage but provides the greatest profit.”
- John Templeton
Today an investor's bullishness ("we have a bottom at SP 4000") or bearishness ("the Fed has about as good a chance of crushing runaway 9% inflation as I do getting a date with a Kardasian--SP 500 index goes 20%+ lower from here) depends on your confidence in what I have come to describe the Fed's chances to reign in 8.5% inflation without causing a recession "The Immaculate Fed Tightening."
Key Point: Stocks have either a) hit a bottom on this pull back i.e., "I believe in The Immaculate Fed Tightening) or b) SP 500 stocks have at least another 20%+ to go down like the last 10 bear markets that precide/discount a recession within the next 6-12 months.
PS: SP 500 4,000 is now the Bull or Bear "Maginot Line"--if penetrated on big volume, next stop 3600 ish.
Our Recession Case
With the end of the Fed's 12-year induced "New Normal" TINA growth stock mania aka the Fed induced suspension of disbelief about secular growth with unbelieveable valuations for no earnings late stage public venture capital IPOs, SPACs and ARKK "disruptors" (who for many now have turned into retirement money disruptors), there is no dispute that the US Federal Reserve Bank ("The Fed") is entering into economic "No Man's Land" by trying to pull off in gymnastic terms a "quadruple twist, three summersault backflip and stick the landing, too."
History tells us the Fed has NEVER successfully killed runaway price inflation and a wage hike spiral without a real recession.
Key Point: The $46+ trillion question today (i.e. the value of US equities markets) is
1) "Can the Fed drain $6 trillion of monetary stimulus ("quantitative tightening) out of the $26 trillion US economy
2) raise the Prime Lending rate from low 3% to 5.5-6%
3) double mortgage/auto loans/credit card interest rates and
4) crush the already 20% down $46 trillion BOND market
and NOT blow-up the 12 year Fed fueled US business cycle expansion?
According to my favorite market economist Larry Summers (who has been right since last summer on his call that "The Fed is so significantly behind the inflation curve that they will have to crush the 12 year economic expansion in order to save the United States from a new stagflation not seen since the 70s") in an April research report:
"Finally, our paper shows that high levels of wage inflation have historically been associated with a substantial risk of a recession over the next one to two years. We argue that periods that historically have been hailed as successful soft landings have little in common with the present moment . . .
. . .Our results suggest a very low likelihood that the Federal Reserve can reduce inflation without causing a significant slowdown in economic activity."
You don't have to be a Nobel Prize winning economist to connet the inevitable 2023 recession dot plot: just consider the 8 separate $trillion+ financial and inflation shock waves hitting the $23 trillion US economy ALL at the same time in May 2022:
1) We have Historic CPI and PPI Inflation Shocks above 9%
2) We have a Historic Global Energy Price Inflation Shocks similar to 1970's
3) We have a Historic Monetary Liquidity Shock with the reversal of the Fed's $6 trillion of Monetary Quantitative Easing into a historic $6 trillion of Quantitative Tightening (aka taking $6 trillion OUT of financial asset liquidty)
4) We have a Historic Labor Wage Inflation Spiral similar the 70s stagflation era where higher inflation triggers salary increases to keep existing or lure new labor (which cause management to raise service and prices) which then keeps price inflation stickey and ultimately MORE higher wages just to keep up with wage inflation
5) We have a Historic 10-12X higher Fed Funds Rate Hike Super Cycle starting May 4
6) We have a Historic GLOBAL Central Bank Tightening (X China and Japan) already started.
7) We have Historic Food Commodity + Fertilizer Price Hikes which raises the cost of feedstock and wheat/corn/soybeans
8) In much of the American commodity and green veggies and planting regions, we have drought based irrigation water costs skyrocketing while nitrogen basedfertilzer costs have doubled
As we pointed out in Part 1 of these "State of the State the US Economy & Stock Market" Special Reports, unfortunately the Fed can't print commodities nor energy or water, fertizler nor supply chain parts.
More important, the key Fed members know the odds of a successful "soft landing" (defined as breaking the back of 8.5% inflation by taking out excess marginal consumer and business demand for housing, cars, and discretionary products and services wihout causing at least 2-quarters of negative GDP ) at the same time the US is in the middle of a historic wage inflation price spiral, an energy price shock America et al with a historic (like 12X) interest rate hikes are very low.
Key Point: We also know if stocks do not continue to shed value (aka as "the reverse wealth effect" where discretionary spending falls simply because consumers with financial assets don't feel as flush any longer) then the FED KNOWS they will have to raise rates HIGHER until they reverse wealth effect (i.e, your brokerage statement starts to scare you) starts to really BITE.
Really Key Point: In short, one of the Fed's many conundrums in 2022 for stock market investors like you and me--IF stocks don't fall enough to reduce runaway inflation, the FED HAS TO create a recession that will.
Still think the Fed can't stick the "Immaculate Tightening" landing?
The High Hurdles to Soft Landing 2023
Former Fed Governor Bill Dudley makes our 2023 recession case the best:
" In his latest news conference, Jay Powell said that the Fed’s new, more inflation-tolerant monetary policy framework bears no responsibility for the recent sharp surge in consumer prices. Then, the following week, he cited three historical examples — the tightening cycles of 1964, 1984 and 1993 — as evidence that the Fed can achieve a “soft landing,” slowing growth and curbing inflation without precipitating a recession.
I disagree with both. The Fed’s application of its framework has left it to far behind the curve in controlling inflation. This, in turn, has made a hard landing virtually inevitable.
Under the monetary policy framework, introduced in August 2020, the Fed is supposed to target average annual inflation of 2%, which means allowing for occasional overshoots to make up for previous shortfalls. Yet in the current recovery, the central bank translated this into a more specific commitment. It would not start to remove monetary stimulus until three conditions had been met: inflation had reached 2%; inflation was expected to persist for some time; and employment had reached the maximum level consistent with the 2% inflation target.
This was a mistake. As I wrote last June:
This means monetary policy will remain loose until overheating begins – and cooling things off will require the Fed to increase interest rates much faster and further than it would if it started raising rates sooner. […] The delay in lifting off, for example, is likely to push the unemployment rate considerably below the level consistent with stable inflation, increasing the odds that the Fed will need to tighten sufficiently to push the unemployment rate back up by more than 0.5 percentage point. Over the past 75 years, every time the unemployment rate has moved up this much, a full-blown recession has occurred.
This scenario is playing out now. The labor market is “extremely tight” (Powell’s words), inflation is running far above the Fed’s objective and the central bank is only beginning to remove extraordinary monetary accommodation. Powell blames bad luck — surprises such as snarled supply chains that officials could not have anticipated. To some extent he might be right, but the Fed nonetheless bears responsibility for being so slow to recognize the inflation risks and begin to tighten policy.
So can the Fed correct its mistake and engineer a soft landing?
Powell is correct that the central bank tightened monetary policy significantly in 1965, 1984 and 1994 without precipitating a recession.In none of those episodes, though, did the Fed tighten sufficiently to push up the unemployment rate.
1964: The federal funds rates rose from 3.4% in October 1964 to 5.8% in November 1966, while the unemployment rate declined from 5.1% to 3.6%.
1984: The federal funds rate rose from 9.6% in February to 11.6% in August, while the unemployment rate declined from 7.8% to 7.5%.
1993: The federal funds rate rose from 3% in December 1993 to 6% in April 1995, while the unemployment declined from 6.5% to 5.8%.
The current situation is very different.
Consider the starting points: The unemployment rate is much lower (at 3.8%), and inflation is far above the Fed’s 2% target. To create sufficient economic slack to restrain inflation, the Fed will have to tighten enough to push the unemployment rate higher.
Which leads us to the key point: The Fed has never achieved a soft landing when it has had to push up unemployment significantly.
This is memorialized in the Sahm Rule, which holds that a recession is inevitable when the 3-month moving average of the unemployment rate increases by 0.5 percentage point or more. Worse, full-blown recessions have always been accompanied by much larger increases: specifically, over the past 75 years, no less than 2 percentage points."
Thank you Fed Governor Dudley.
Now here's Larry Summers analysis in a recent paper on the Fed's likelihood of achieving The Immaculate Tightening.
"This paper uses historical labor market data to assess the plausibility that the Federal Reserve can engineer a soft landing for the economy. We first show that the labor market today is significantly tighter than implied by the unemployment rate: the vacancy and quit rates currently experienced in the United States correspond to a degree of labor market tightness previously associated with sub-2 percent unemployment rates.
We highlight that the super-tight labor market coincides with current wage inflation of 6.5 percent – the highest level experienced in the past 40 years – and that firm-side slack measures predict further increases in wage inflation over the coming year.
Finally, we show that high levels of wage inflation have historically been associated with a substantial risk of a recession over the next one to two years. We argue that periods that historically have been hailed as successful soft landings have little in common with the present moment.
Our results suggest a very low likelihood that the Federal Reserve can reduce inflation without causing a significant slowdown in economic activity."
Back to the gymnastics metaphor, the Fed is trying to convince bond and stocks markets they can land a quintuple backflip with a triple twist off the high bar without a wobble.
Oh Yea--The US Consumer Economy (70% of US GDP) Is Already Slowing in 2022!
Higher prices’ negative effect on unit sales can be gleaned from trucking and inventory data says Piper Sandler’s macroeconomic research unit, led by Nancy Lazar. Trucking activity has plunged 50% in the past 10 weeks on flat unit retail sales and already excessive inventories, according to a research note.
That’s the reversal of the trucking surge during the worst of the pandemic, when retailers struggled to keep up with demand swelled by government stimulus. Trucking and railroad and delivery stocks’ pronounced underperformance (From Fed-X to Amazon) recently attest to the effects of sales slowing and warehouses bulging, the report adds.
Indeed, the relative performance of an array of economically sensitive stocks points to outright recession, says my friend David Rosenberg, the founder and eponym of Rosenberg Research. Charting the sum of S& P 500 banks, home builders, home furnishing companies, retailers, auto parts firms, and transports, divided by the sum of S& P consumer staples, utilities, and healthcare, the line goes from upper left to lower right, a 24% decline from the high almost a year ago.
This ratio of cyclicals to defensive stocks also rolled over in 1998-2001, 2004-08, and 2018-20, ahead of the past three recessions.
What’s missing from the recession scenario is tight money, necessary to wring inflation from the economy. St. Louis Fed President James Bullard said in an interview with the Financial Times this past week that it is “fantasy” to think that inflation will back off without interest rates high enough to constrain the economy.
Or as Komal Sri-Kumar, president of Sri- Kumar Global Strategies, observed following the release of the Fed’s latest projections, which see relatively mild rate hikes bringing down inflation without raising unemployment or denting growth: “They might as well attach a bridge for sale” sign to them.
That might be the best line on the Fed's chances to hit the Immaculate Tightning landing ever.
Transformity Research's Base Case on a 2023 Recession (and at least a full -32% retracement of the SP 500 "New Normal" bull market): 95% (5% chance that Putin is removed from running Russia soon).
PS: The Latest Atlanta Fed Q2 2022 GDP estimate: 1.6 percent — May 2, 2022
The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2022 is 1.6 percent on May 2, down from 1.9 percent on April 29.
After this morning's releases from the US Census Bureau and the Institute for Supply Management, the nowcasts for second-quarter real personal consumption expenditures and second-quarter real gross private domestic investment growth declined from 3.8 percent and -1.3 percent, respectively, to 3.6 percent and -2.1 percent, respectively.
More Special Reports to come!
Toby