Friday Highlight Reel - Edition #5

A sampling of interesting observations from the Haymaker's network of market experts and favorite resources.

“There is a lot going on in financial markets, none of it particularly good. The January rally based on premature hopes that the inflation fight was done has collapsed. Cracks are appearing n the financial system - some in unexpected places - as higher rates start to set in.” -Michael Lewitt, The Credit Strategist Blog

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Editor’s Note

Hello, Readers:

Leading us off in this edition is an excerpt from the recent work of Gerard Minack, author of the Down Under Daily and a high-finance thinker whose market insights Dave values to an extraordinary degree. You’ll also see some pertinent material from the Quill Intelligence team, DoubleLine, AIER, and, to round out the week’s reel, Crescat Capital. We are also excited to bring you, for our final entry, a ~22-minute podcast featuring Evergreen Gavekal CEO Tyler Hay, as interviewed by the firm’s Director of Private Wealth, Jeff Otis. We hope you’ll find time for a listen after making your way through the main reel entries.

As always, be sure to share/like today’s edition before you go, and if you’re not subscribed…

We hope this edition leads you into a wonderful weekend ahead.

Enjoy the reel.

-MJM

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#1: Minack on Equities & Markets

“There are a few points to note about equities and recessions. First, recessions always cause equity markets to fall.  Equities fall for the obvious reason that recessions are always bad for earnings.  Even in high-inflation cycles – such as the 1970s – reported EPS fell in nominal terms.  More to the point, earnings have become increasingly sensitive to cycle downturns over the past 35 years (Exhibit 2).  EPS would likely fall 20-30% in even a moderate recession.”

“… equity markets are not particularly far-sighted.  Since 1950, the S&P500 was within 2% of its cycle peak on average 4 months before a recession starts (Exhibit 3).  Excluding the two oil-shock bear markets of the 1970s, the median gap between the market peak and the recession start was 2 months.  (In contrast, equities bottom on average 5 months before a recession ends.  Equity investors are quicker to price recovery than recession.  Bond investors do the reverse.)”

“Third, equities typically assume the Fed can pull off a soft landing – until it becomes clear it hasn’t.  This is a triumph of hope over experience: 9 of 12 Fed tightening cycles since the mid-1950s have ended with a hard landing.  Over the past 30 years the gap between the end of Fed tightening and the onset of recession has been unusually large, and that has provided a window for tradeable rallies even when the cycle ended in a recession (Exhibit 4).”

Haymaker Take: While I admit I have a number of favorite research sources, Gerard Minack is definitely near the top of the list. His thinking is always rational and he does an excellent job of not letting his biases overly influence his conclusions. Presently, I believe too many Wall Street strategists and commentators are doing just that by ignoring repeatedly proven indicators. Their desire to see a soft landing and a resumption of the bull market is, in my view, leading them to some false conclusions. Gerard refers to this most aptly as the triumph of hope over experience, a common human flaw. It’s interesting that Google searches for “soft landing” have spiked recently. This happened right before the last two recessions, as well. In fact, the term “soft-landing” was coined in 1973 when it was hoped a shallow slowdown would ensue. Instead, what followed was the worst recession, up to that point, since WWII.

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#2: Andrew Sinclair on Debt Spreads

“Something Danielle [DiMartino-Booth] taught me to watch very closely, the spread between BBB 2-yr & 10-yr debt, is on the edge of breaking. If this is negative, it signals lending to corporations BBB-rated & lower is dead. This evening it closed at a record low +1.11bps. Bloomberg only carries the data back to June 2009. Here’s the chart. We’re on the cusp of a systemic break in corporate refinancing. Bankruptcies will likely gain momentum.“

Haymaker Take: When Andrew refers to 1.11 basis points, he means a bit over a hundredth of a percent. That’s truly miniscule. The theory behind why this matters is that when the return on lending to Corporate America is so low, relative to banks simply putting money into treasuries, they will eschew business loans. BBB-rated companies are considered high-quality borrowers, by the way. With a torrent of corporate debt needing to be refinanced this year and next, that’s more than a little problematic.

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#3: DoubleLine on Housing Affordability

Haymaker Take: The above image was pulled from a recent 80-page slide deck the reigning King of Bonds, Jeff Gundlach, put out this week. It speaks — powerfully — for itself. The only way for homes to sell briskly with interest rates this elevated, and heading higher, is for prices to fall. Of course, real estate is highly localized and some regions are much more vulnerable than others. For example, in the Seattle area’s Eastside market (mostly Bellevue, Kirkland, Issaquah and Redmond), prices appear to have fallen over 20%. This is admittedly from a crazy-high peak last year. However, home purchases back then were happening at frenetic pace. Accordingly, I don’t believe it was a case of just a few isolated transactions. Personally, I think affordability is the ultimate leading indicator for the future path of home prices. 

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#4: AIER on ESG

Headline: AIER

“Wherever it began, ESG clearly hit its stride within the last five to ten years. Those were heady times, at least economically speaking, first characterized by zero interest rate policies (ZIRP) and then, during the pandemic, by massively expansionary monetary and fiscal programs. Yet in the last two years or so, the prevailing economic circumstances have changed considerably. Inflation at four-decade highs is battering firms by raising the cost of doing business. It is also negatively impacting corporate revenues, as consumers retrench by cutting back on expenditures. 

Nowhere are these effects more evident than in shareholder land, where the fourth-quarter 2022 S&P 500 earnings season is just about over. ‘Earnings quality’ is an evaluation of the soundness of current corporate earnings and, consequently, how well they are likely to predict future earnings. For the past year, and certainly for the last quarter, the quality of earnings has been abysmal. One particular element – ‘accruals,’ or cashless earnings – are their highest reported level ever, according to UBS. In that same report, we find the somewhat shocking revelation that nearly one in three Russell 3000 index constituents is unprofitable.”

Haymaker Take: Regular readers are aware that one of my highest-conviction anticipations of the last year was of an earnings recession for S&P 500 companies.  This now looks to be virtually fait accompli. The final quarter of 2022 is nearly certain to be down and the first quarter of this year is, as well. (Two consecutive down quarters is considered to constitute an earnings recession.) In fact, Canada’s star economist, David Rosenberg, believes the profits downturn started a year ago. As the AIER notes above, earnings quality has been sub-par. In the past, this has been an excellent leading indicator of future disappointments. Mike Wilson, Morgan Stanley’s Chief Investment Officer, has long been warning of profit problems, as often relayed in Haymaker editions. He further points out they remain well above their long-term trend. This implies considerable further downside, particularly if those of us expecting a recession are proven right.

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To learn more about Evergreen Gavekal, where the Haymaker himself serves as Co-CIO, click below.

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#5: Crescat on Negative Stocks

“Since 1900, there have been only five decades that the total real return for US stock was negative. In fact, they we were all deeply negative. Three of these periods happened during inflationary eras. The other two occurred at a time when valuations of US equity markets were at historical levels.  Today, we have both set ups at the same time.”

Haymaker Take: Note the key word above “real” in the first sentence. This means stock returns were seriously in the red on an after-inflation basis in those desultory decades. It wasn’t a lost cause, however, as the shares of companies producing real assets (like energy, agriculture and metals) generally fared quite well. That has been the case thus far this decade. However, many of these have experienced sharp declines over the last year. This has been mostly due to the Fed’s aggressive tightening campaign which, in turn, has led to a strong dollar. That’s unlikely to change anytime soon, but it’s my belief at some point over the next year, perhaps less, the Fed will need to cut rates, likely dramatically. This presupposes that both the economy and financial markets buckle between now and then. It’s also my anticipation that Powell & Co will need to restart its Magical Money Machine, officially known as Large Scale Asset Purchases, or QE. For now, though, QT, the opposite of QE, is the order of the day. This is going to make the U.S. government’s ability to finance its vaulting deficits extremely daunting.

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#6: Bonus Entry — Evergreen’s Tyler Hay & Jeff Otis, “Looking Ahead”

Click below for Evergreen CEO Tyler Hay’s thoughts on inflation, the employment landscape, real estate, and several more topics of immediate economic consequence. At just over 20 minutes, it’s a quick listen.

Image linked to podcast.

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P.S. Brace yourselves for an MHM edition next week on the U.S. banking crisis, underscored by the FDIC’s shocking seizure today of SVB Financial.

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