Guest Haymaker - Vincent Deluard

In The Ring - December 9th, 2022

Dec 09, 2022

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“I don’t see a recession coming. Everyone’s too negative.” -CNBC’s Jim Cramer earlier this week

Deluard vs. Delusions

Regular Haymaker readers are aware of the high regard in which I hold Vincent Deluard. We have become good friends over the last six years and, frankly, when I first met him he wasn’t that well known. But the investment world has woken up to his prodigious intellect and his first-class communication skills.

The formidable Louis Gave, whom so many of you admire, has become one of Vincent’s most ardent fans. Bloomberg recently had him on their show What Goes Up and he knocked the cover off the verbal ball. Barron’s is increasingly and extensively quoting him. But the most important aspect for Haymaker readers is the accuracy of his forecasts.

Like all of us in the business of making predictions about the future, he gets a few things wrong… but not many. He was very early to recognize that inflation was the polar opposite of transitory. He also studies the surging gig economy closer than any big-picture strategist I follow. That unique insight is a key reason as to why he’s not in the recession camp (admittedly, unlike yours truly), though he does expect a nasty earnings downturn.

Vincent has kindly allowed us to share with you his most recent note, which was just published this past Wednesday. It’s particularly timely because Vincent and I will be doing a joint podcast next week. Naturally, we’ll be sharing it with you all shortly thereafter. In his latest missive, he’s addressing the ongoing strength of the jobs market which has caught many economic pundits off guard. While I’m sympathetic to the arguments they make about the birth-death model (which flatters the unemployment numbers when the economy is cracking) and the much weaker Household Survey (historically better at catching inflection points from expansion to contraction), Vincent’s counterarguments are compelling.

One of this most intriguing insights is that there are now more Social Security recipients than there were unionized workers back in the 1970s. This is a rebuff to those experts who say you can’t have persistent inflation with such a diminished card-carrying union labor force. A nearly 9% bump to around 60 million Social Security recipients (including disability benefits) is a massive jolt of spending power to the economy. This is despite that, after inflation, it’s actually just a push. But what drives overall economic activity is nominal, not real, spending.

Like me, he believes the market made a serious mistake last week by pricing in a looming Fed policy reversal to an easing mode soon. We both see interest rates going higher and staying up for far longer than the bulls hope. He believes the Fed will ultimately be forced to accept a higher base-level of inflation — more like 4% to 5% than their usual 2% optimal level. Again, I’m sympatico with that view.

While I continue to expect a broad recession — partially because Jim Cramer doesn’t, but more importantly due to the severely inverted yield curve — I do appreciate Vincent’s reasoning. This actually relates to last week’s Haymaker by Gavekal’s Anatole Kaletsky in which he stated the Fed needs to choose between a painful recession and higher than preferred inflation. Clearly, Vincent sees Powell & Co. opting for the second scenario. As 2023 unfolds, that’s a view I feel will be validated, particularly later in the year. Yet, as both Vincent and Anatole observe, that’s not good for either stocks or bonds.

Accordingly, for the legions of stock-market bulls yearning for an easy Fed, be careful what you wish for; you may get it good and hard. Perhaps make that bad and hard.

-David Hay

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

Private Wealth Management

GROUNDHOG DAY - Vincent Deluard

(December 2022 Global Macro Edition - minor formatting and text adjustments applied here as necessary)

“"Well, what if there is no tomorrow? There wasn't one today."

B. Murray, Groundhog Day, 1993

1 – This past month’s rally resembles the 17% bear market rally of this past summer

2 – Investors keep underestimating the strength of consumption and the tightness of the labor market

3 – Higher prices incentivize workers to take on gigs, rather than slash consumption

4 – Banks should benefit from steeper curves, higher rates, and strong demand for credit

5 – Gold’s recent breakout may anticipate the real Fed pivot: accepting that 4-5% inflation is the solution

Einstein’s definition of insanity, doing the same thing over and over and expecting different results, seems to apply to the many strategists who clung to these three core beliefs all year long:

High inflation is a freak accident caused by Russia / COVID / Chinese lockdowns / supply chains / used cars / lumber prices / plane tickets / the shift to goods / the shift to services / [insert excuse there]
The economy will collapse if the Fed Funds rate rises above 3%
The Fed will eventually realize its mistake, cut rates to zero, and bail out markets once again.

The persistence of inflation, the resilience of the labor market, and the buoyancy of consumption have disproved this thesis many times. So has the fact that rates have risen to 4% to without breaking anything major – other than what the Federal Reserve wanted to break: meme stocks, out-of-control housing prices, and crypto scams.

But deflationists have not lost hope, and they can always find the odd data point, such as October’s CPI print, to support their views. If the data does not cooperate, then they usually blame the data (the birth/death adjustment, the low response rate in the establishment survey, flaws in the JOLTS) or promise that the inevitable economic collapse is simply delayed. Psychoanalytically, investors’ stubborn delusions could come from an Oedipean complex: if we cry hard enough, the Fed will embrace us again and make all our problems go away with an endless supply of liquidity.

The first part of this report will discuss the similarities between the recent rebound in stock prices and the 17% bear market rally of this past summer.

The second part will reinforce the case I made in “it’s the labor market, stupid”! Instead of discouraging consumers, higher prices incentivize workers to take a second job in the booming gig economy. Consumption is supported by a historical 8.7% increase in social security benefits, steady gains in average hourly earnings, a soaring gig economy, flush deposit accounts, low household leverage , and double-digit growth in bank credit.

The third part will draw the four investment implications of my macro view.

The bear market is not over! J. Powell will rain on the bulls’ parade again.
The yield curve should steepen in 2023, mostly because of higher long-term rates
Banks should be the best-performing part of my Holy Trinity portfolio.
Gold’s recent rally may anticipate the Fed’s acceptance that inflation is the solution. Do not fade it.

Déjà Vu All Over Again

The S&P 500 index gained about 13% since Jay Powell’s hawkish speech in Jackson Hole, with monster one-day rallies following the release of a slightly less-hot-than-expected inflation print for October and Powell’s promise to slow the pace of rate hikes at his Brookings Institute speech. Real rates, as measured by 5-year-TIPS yields, dropped by about 80 basis points.

Five months ago, a slightly less-hot-than-expected inflation print for July also triggered a 17% rally in stock prices and a 76 basis points drop in real rates. Then, as seems to be the case in the past week, the 200-day moving average acted as a ceiling for the stock market rally.

These monster bear market rallies ultimately reflect the prevalence of the “transitory” narrative and investors’ stubborn hope that the inflation shock of 2022 was a one-time freak accident which will soon be forgotten. The chart below, created by Jim Bianco, shows that economists have consistently underestimated inflation since COVID and that they always expect inflation to revert to 2% over the medium term.

The monthly survey of consumer expectations, which is based on 1,200 consumers who measure inflation at the grocery store rather than in Stata, tells a different and more interesting story. Consumers expect inflation to average 5.9% in the next twelve months, up from 5.4% in October. Consumers’ expectations have been quicker to adjust to higher prices than economists’ surveys or breakeven rates. The gap between consumers’ expectations and inflation breakevens is almost at a 3-year high of 3.2%.

An unwanted easing of financial condition is another common point with this summer’s bear market rally. The Chicago Fed National Financial Condition Index eased to -.27, versus -.21 in the summer. Spreads on junk bonds fell by about 120 basis points in these two rallies. This is not what the fed wants to see: all prior easing cycles started after a significant tightening of financial conditions. Once again, investors are rushing to the (happy) end of the story and forgetting the middle part, when J. Powell rains on the bulls’ parade, as he did in Jackson Hole after the last rally.

Last, both rallies were characterized by a lucky soft patch in commodity prices. In both cases, hopes for an end to China-zero COVID policies were crushed by new variants. I have no idea when China will relax its policies, but four things are certain:

China will eventually re-open, so lockdowns simply postpone the demand shock
Lockdowns and mass protests put more strains on global supply chains, a major driver of long-term inflation
Europe’s unusually warm fall and extraordinary energy saving measures will not last forever
249 million barrels have left the Strategic

Petroleum Reserve (only 389 million are left).The fact that oil and iron prices stabilized and copper prices soared in November against that backdrop should instill hope in commodity bulls’ hearts, and fear for the deflationist crowd.

Stop Underestimating the Strength of the US Consumer!

Another month, another miss. US non-farm payrolls increased by 263,000 in November, versus expectations of 200,000. Consensus expectations underestimated job creations by an insane 1.6 million in the past year. Average hourly earnings rose by 0.6% month over month, the highest pace since December 2020, and twice the consensus estimate of 0.3%. The unemployment rate held steady at 3.7%, and the participation rate dropped slightly to 62.1%.

Last week’s release confirmed the analysis I presented in “It’s the Labor Market, Stupid”: instead of discouraging consumers, higher prices incentivize workers to take a second job in the booming gig economy. Because the Bureau of Labor Statistics relies on outdated surveys of old-economy firms, the Federal Reserve has consistently overestimated the slack in the labor market and underestimated the strength of consumption.

Predicting the change in monthly inflation is almost impossible, but I would guess that December’s release will come higher than expected. The Cleveland Fed inflation Nowcast is significantly above the consensus estimate for CPI (7.3%) and core CPI (6%). The preliminary report on productivity and costs also supports my stagflationary view: nonfarm business sector labor productivity decreased 1.4 % year-over-year in the third quarter, the first instance of three consecutive declines in this measure since 1982. If productivity keeps dropping(1), even a slowing economy will not ease wage pressures as it takes more workers to produce the same output.

(1) I do not believe productivity is dropping: in reality, workers are switching to the gig economy, whose output is not properly measured. I will write more on this in an upcoming report.

Last but not least, consumption should be supported by a historical 8.7% Cost-of-Living Adjustment for social security beneficiaries. The COLA will go into effect with December 2022 benefits and will be credited on about 60 million checks going out in January 2023.

Economists generally do not believe that 70s-style wage/price spirals are possible due to the de-unionization of the US labor force, but there are a lot more social security beneficiaries today than there were union members in the 70s.

Retirees get an 8.7% benefit increase, average hourly earnings are growing by 5-6%, the gig economy is soaring, credit balances are rising fast from historically low level, checking accounts are still flush with the savings accumulated during COVID, and bank credit is growing by double digit: the 2022 consumption boom continue in 2023.

The Fed’s real pivot will not be to cut rates because consumption is weak, but it will be to accept that 4-5% inflation rate is a small price to pay for a long-postponed pay raise for blue-collar workers and give Millennials and GenZ-ers a chance to buy homes and start families.

Inflation is the solution to Western countries’ debt and generational crisis.

Investment Implications

The bearish consensus on the economy is likely a subconscious result of investors’ desires for a return to the zerorate and easy money policies of the past decade. What is good for the stock market is bad for the economy, and vice versa.

My bullishness on the economy means that I remain bearish on financial assets: long rates must increase to adjust to structurally higher inflation, which will reduce the value of the duration-heavy S&P 500 index. The continued rise in wages will pressure corporate margins. The only recession I see in the current data is a profit recession.

Withheld income and employment tax collections grew by 5.1% in the past two months (which is consistent with average hourly earnings) and other individual income tax collections soared by 26% (which is consistent with my view that workers are turning to gigs to adjust to higher prices), but corporate income tax collections have dropped by 11%.

The Bureau of Economic Analysis confirms that corporate profits after tax shrank by 5.9% in the third quarter and are essentially flat on a year-over-year basis. Consensus expectations for S&P 500 index EPS to rise to $220 next year from $206 in the past twelve months will need to be revised down.

Curve-steepening trades are the second obvious investment implication of my economic bullishness. 10-year yields are 78 basis points below 2-year yields, the largest gap in 40 years. Past inversions lasted between six and twelve months, so the curve should start steepening in in early 2023. This could happen as a result of lower short-term rates because of the widely-desired Fed pivot, or because of higher long-term rates as the Fed would accept a higher rate of inflation for longer, following to my bearish steepener scenario.

Equity investors can use banks to bet on steeper curves. As shown in the chart below, banks have outperformed by more than 40 percentage points in the twelve months following deep inversions of the yield curve.

Finally, gold should be the long-term beneficiary of the Fed’s pivot on inflation. Gold prices have suffered from he relentless rise in real yields in 2022 but the relation broke down this past month: after its recent breakout, gold decoupled from 2-year note prices. I pay a lot of attention to these divergences because gold prices have been prescient in recent years: gold’s monster rally between August 2018 and August 2020 correctly anticipated the Fed’s pivot on Christmas 2018, the explosion of its balance sheet, and the spike in inflation. Its disappointing performance after August 2020 also anticipated the Fed’s hawkish pivot and the rise of real rates in 2022. If the next two years resemble 2001-2004 (steepening yield curve, negative real yields, meltdown of the tech bubble, rebound of value, and reflation), investors should consider adding a sliver of precious metals to my Holy Trinity portfolio.

Disclaimer

This commentary is intended for Institutional and Investment Professional Use Only and may not be distributed to the investing public. The views expressed are those of the author and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and StoneX Group Inc. disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, should be construed as market commentary, merely observing economic, political and/or market conditions, and not intended to refer to any particular trading strategy, promotional element or quality of service provided by StoneX Group Inc. or its affiliates. There is no guarantee as to its accuracy or

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The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value.

The Consumer Price Index (CPI) is a measure of inflation compiled by the US Bureau of Labor Studies. Consumer Price Index for All Urban Consumers (CPI-U): U. S. city average, by detailed expenditure category including food, energy, appliances, apparel, transportation, shelter, recreation, medical, education, etc.

The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets and the traditional and “shadow” banking systems.

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