The Eye of the Storm

Will Powell pivot? And if so, when?

Bear market rallies can engender even more superlatives than those that accompanied stocks to their bull market peaks. “All is well! We have had the correction, and this is the start of the next bull market.”

Is all well? Having argued that inflation was transitory and failed ignominiously in the attempt, a motley assortment, including a Fed chairman, a Treasury Secretary, a cardboard cut-out at the White House and many practitioners in “Old Wall Street”, are trying to tell us that there is no sign of a recession despite 2 consecutive quarters of negative GDP growth. The current argument goes that unemployment is very low and consumer spending is still strong. Add in the rosy scenarios provided by the CEOs of the big tech stocks and you have recipe for a market melt up which is exactly what we are experiencing.

The market seems to be anticipating a Fed pivot ie ceasing rate rises and / or reinstating QE. Why would that be?

This week, Powell said further hikes would “depend on the data”, noting further that the Fed is “watching for a slowdown in economic activity”:

FED'S POWELL: ANOTHER UNUSUALLY LARGE INCREASE IN RATES COULD BE APPROPRIATE, DEPENDS ON DATA – Bloomberg, 27/7/22

POWELL: WE ARE WATCHING FOR SLOW DOWN IN ECONOMIC ACTIVITY – Bloomberg, 27/7/22

Critically, the weakening data we have seen over the past 1-2 months likely reflects the “US economy slamming on the brakes. The results from Amazon and Apple would seem to disprove this, but both are consumer dependent and until the latest inflation number and gas going over $5 a gallon consumers continued to consume. Both companies’ statements confirmed that the outlook in terms of hiring and spending is deteriorating and the business outlook in general is indicating much lower growth.

AMAZON CFO SAYS COMPANY IS QUESTIONING ITS HIRING PLANS AND LIKELY WON'T HIRE AT SAME PACE AS IN PREVIOUS YEARS – Bloomberg, 28/7/22

Amazon aims to sublet, end warehouse leases as online sales cool – 21/5/22/

US Services PMI sub 50 – July 2022 Source TradingEconomics.com

The long-term trajectory of the Conference Board US Leading Indicator slowed sharply in June

For the 264 S&P500 companies that have reported for Q2 so far, the average earnings growth number is minus 1.5%. Sectors such as Energy +355%, Industrials +40% and Health Care +19% skew the data somewhat. Given the 20% decline in oil prices since the peak in mid-June the energy sector is unlikely to repeat this feat. Perhaps even more concerning is that the companies in the technology sector have reported the first overall negative earnings growth figure since the early 2000s.

That could end up being useful timing for Powell, who is expected to speak at Jackson Hole in late August. If the economic data comes through in August much weaker as anticipated, we expect Powell to be much more dovish than he was earlier this week in the Fed meeting press conference. When Powell takes the podium, the US midterm elections will be just over two months away, with the White House pushing for a pivot to a more accommodative stance. In case you still believe the Fed is “independent” remember who appoints the chairman and also note the revolving door through which Yellen passed on the way to her role as Secretary to the US Treasury.

The ever insightful Luke Gromen (fftt.com) highlighted this point made by Larry Summers (US Treasury Secretary under Clinton) offering a less than enthusiastic review of Jerome Powell’s post-meeting press conference on Wednesday. The key point of contention was the Fed chair’s assertion that the newly established funds rate is “right in the range of what we think is neutral.”

Jay Powell said things that, to be blunt, were analytically indefensible. There is no conceivable way that a 2.5% interest rate, in an economy inflating like this, is anywhere near neutral.

Summers is correct, but the problem both Powell and Yellen, have is that by raising rates in Volckerish fashion to properly combat inflation is that they would bankrupt the US government. Not something they are inclined to do, nor that the government would allow.

As an example, of the $23 trillion in outstanding US Treasuries (February 2022) 30% will mature in less than 12 months. After raising rates by 75 basis points on Wednesday, the Fed has raised rates by 2.25% since March 15, 2022, an annual rate of increase of 6.75% (2.25% over 4 months x 3). Here’s where this creates an additional problem for the Fed and Treasury. Assuming a 6.75% annual rate (modest compared with the policy Volcker carried through in the late70s – early 80s) = $465 billion more in interest expense, 12 months from now. $465 billion is ~12% of all-time record tax receipts from 2021; assuming the same 20% decline in tax receipts in a plain vanilla recession would make $465 billion = 14% of forward tax receipts.

That would take entitlement spending plus interest rate expense towards 90% of US tax receipts. Assuming a 20% decrease in tax receipts, which Yellen has flagged by observing that they are now slowing down having said three months ago that they were going up, could raise that 90% estimate to 135% of tax receipts. Arguably the US is already bankrupt ex the fact that they have a money printing press.

A brief aside into some weather forecasting, but bear with me there is point to this.

A hurricane, according to the National Oceanic and Atmospheric Administration, is “a rotating, organized system of clouds and thunderstorms. At the centre of each hurricane is what scientists call the “eye” of the storm; the eye is surrounded by the “eyewall” which is subsequently wrapped with massive “rain bands”. Warm, moist ocean air flows up through the eye is met with cooler air flowing down from the atmosphere, creating a very powerful counterclockwise rotating storm or cyclone (in the northern hemisphere; these storms rotate clockwise in the southern hemisphere). The eyewall is a massively concentrated band of thunderstorms featuring the heaviest, most damaging of winds; the rain bands which wrap the eyewall are vast in size, yet typically weaken the further from the eye you get.”

Amidst all the chaos, devastation, and destruction these storms leave in their wake, at the eye of each hurricane is in fact, nothingness, often a calm light breeze, most frequently under blue skies. For as destructive as the eyewall is, the eye is the complete antithesis until the storm moves on and the other side of the eye moves back into the eyewall.

Whilst we find that we are not always in agreement with much of what the CEO of JP Morgan has to say, his hurricane analogy hits the spot.

“I said there are storm clouds, they’re big storm clouds; now it's a hurricane … right now, it's kind of sunny, things are doing fine … you know everyone thinks the Fed can handle this, (but) that hurricane is right out there down the road coming our way we just don't know if it's a minor one or Superstorm Sandy or Andrew or something like that; you better brace yourself.” Jamie Dimon NY Financial Conference 6th June 2022.

Despite the bullish rhetoric it feels very much as if we are in the eye of the storm. If Powell pivots soon, the end of August at the latest, we may avoid the worst. If he doesn’t then mind your “eye”.