As the number of people crazy enough to subscribe to read my ramblings continues to increase, I will periodically revisit the analytical process which undergirds this Substack to provide context. The first post from late last November, Welcome to Kayfabe - whatever the hell that is, offers a summary of the important components of the process. The last post of 2021, Where are We in ‘The Process’, offered a sort of preview for 2022 through the lens of the various components. Today will be dedicated to revisiting the macroeconomic backdrop.
As expressed in this Substack’s first post, I have found Lacy Hunt’s macro framework to be the most cogent for analyzing macroeconomics that I have come across. He shares a quarterly analysis at Hoisington Investment Management’s website, with the latest iteration posted yesterday.
Hoisington has had a VERY rough time during the last two years, with the mutual fund they sub-advise for Wasatch down almost 5% for calendar year 2021 and another 23%+ so far this year as of yesterday. Here was the opening paragraph from Lacy’s Q4 2020 letter:
Investing in a 30-year U.S. Treasury bond at a paltry yield of 2.4% on December 31, 2019 appeared to be a poor investment choice, particularly since it was the lowest year-end yield since the inception of the 30-year bond in 1977. However, in a short 12 months the 30-year U.S. Treasury realized a 20% return compared with a 18.4% return in the S&P 500 and a 7.5% return for the Bloomberg Barclays Aggregate Bond Index. A similar context existed at the end of 2020 as the yield stood 75 basis points lower at 1.65%, another record year end low. Presently, the overwhelming judgment of market forecasters is that interest rates will rise throughout 2021 owing to the expectation that additional fiscal stimulus coupled with an easy monetary policy will create an inflationary cocktail as pandemic related shutdowns lessen. The essence of the decision at Hoisington Management to maintain a bullish stance on long U.S. Treasury yields is not whether rates can rise, since it happens transitorily every year, but whether they can stay elevated. Provided there are no major changes by Congress to the Federal Reserve Act, we believe it is prudent to expect that long dated U.S. Treasury rates will eventually gravitate to lower levels as inflation continues to recede.
One could reasonably ask why in the heck someone would place a high degree of importance on Lacy’s analysis given the terrible recent performance, but I believe it is vitally important to delineate between the macroeconomic analytical framework and the portfolio management decision-making. As the paragraph above declared, they made the decision to ride out the upturn in inflation and interest rates.
But despite those decisions and related performance, Lacy’s analytical framework has offered a clear and accurate way to analyze a period that has confused many, including the Federal Reserve. To ignore the efficacy of this framework due to the portfolio management decision to ride out the ‘storm’ would be unwise, in my opinion.
Part of the value I try to offer is to incorporate the various elements of my own process to those in my ‘Circle of Trust.’
From a complex systems perspective, Lacy may have underestimated the supply chain issues and how severe and durable they would be. The complexity of modern global supply chains was/is extreme, suggesting that issues caused by the pandemic and invasion of Ukraine would be difficult to ‘fix'. Underestimating the extent of the issue does not invalidate the analytical framework as to the drivers of the upturn in consumer prices.
Many have been understandably mocked for using the term ‘transitory’ relative to the dynamics which have fueled the dramatic upturn in consumer prices over the past two years. The duration of the upturn relative to the word ‘transitory’ has resulted in many people misattributing the underlying drivers of the causes.
‘Money printing’ relative to the huge expansion in monetary aggregates during the pandemic has once again become a common factor referenced relative to the upswing in consumer prices. While it very likely did contribute to the acceleration and blow-off tops in the everything bubble, consumer prices have largely been driven higher by supply and demand curve shifts.
The stimmy checks fueled elevated consumption, with that consumption being funneled into goods, and resulted in huge shifts in these curves. In addition, the decision by the Fed to keep the interest rates they control near zero, despite the dramatic increase in consumer inflation, further stimulated demand for various durable goods, housing, automobiles, etc. This is from Hunt’s latest:
Remarkably, Fed's low rate policy was very slow to change even though the actual increase in their preferred inflation measure surged to more than triple the upper limit of their target. Thus, the Fed continued to create demand, i.e., to shift the Aggregate Demand curve outward, while doing nothing to lift the Aggregate Supply (AS) curve upward. Indeed, supply chain disruptions from the pandemic, aggravated by the Russian invasion of Ukraine, shifted the AS curve inward, exacerbating the monetary induced price surge. This mountain of liquidity, the largest except for possibly an isolated event related to the end of WWII, played a major role in allowing price hikes from various supply chain disruptions to be passed on to beleaguered consumers who suffered from a Quarterly Review and Outlook Second Quarter 2022 much faster rise in prices than wages.
If we revisit the missive referenced in my December 29, 2021, post from Hunt’s Q3 2021 letter:
The U.S. economy has clearly experienced an unprecedented set of supply side disruptions, which serve to shift the upward sloping aggregate supply curve inward. In a graph, with aggregate prices on the vertical axis and real GDP on the horizontal axis, this causes the aggregate supply and demand curves to intersect at a higher price level and lower level of real GDP. This drop in real GDP, often referred to as a supply side recession, increases what is known as the deflationary gap, which means that the level of real GDP falls further from the level of potential GDP. This deflationary gap in turn leads to demand destruction setting in motion a process that will eventually reverse the rise in inflation.
The deflationary gap and demand destruction appear to be in full swing, with inventories at retailers having exploded. Even demand for things like gasoline appears to be rolling over. Again - the timing of these mechanisms transpiring, along with Hoisington’s decision to stay in long-term US treasury bonds during this period, should not distract from the analytical framework.
Why is all this important? With the recent CPI report coming in at over 9%, the Fed appears to be on a path to try and regain credibility due to the mistakes of the prior 2 years. Just as they were derelict in keeping rates low for way too long, and hence compounded issues created by supply and demand curves shifting, they appear poised to continue floundering incoherently into the teeth of a burgeoning global recession.
Hunt lays out why the Fed’s pivot, whenever it inevitably occurs, is unlikely to have the economic impact many expect:
Two additional monetary indicators supplement this list of economic indicators. First, portions of the Treasury yield curve have flattened significantly and inverted at times. Second, ODL (other deposit liabilities) is linked to monetary policy by the deposit multiplier, which is defined as ODL divided by total reserves, which is referred to as 'd'. The deposit multiplier has turned down again (Chart 3), indicating the Fed’s ability to stimulate economic activity under the 'lender of last resort' regime is diminishing and monetary policy’s capabilities are becoming increasingly asymmetric. Recently, d was 4.3, close to its record low, and dramatically lower than the 64.8 average from 1959 to date. A low d indicates the demand for money is weak and that the banks are having difficulty pricing all their costs, including the risk premium that is most likely rising alongside the deterioration in business prospects.
As we consider how events may unfold over the next year or two, markets will surely respond whenever the Fed does pivot, but ending the tightening and then reverting back to near-zero rates and renewed QE is unlikely to stimulate economic activity significantly. However, as I laid out in Regime Change, the Fed reverting back to those policies in conjunction with renewed fiscal stimulus targeting consumers could open a pathway to the end of this era.
This has become my base case, as a setup for the Bizarro Recession is likely to create conditions that incentivize such policy prescriptions as election-year politics transition into 2023. Hunt appears to share this concern, as this is how he concludes the most recent letter:
Monetary considerations coupled with these real side indicators point to recession and a reduction in inflation and long-term Treasury bond yields. If the Fed stays within the scope of the Federal Reserve Acts, they will have difficulty in containing the recession and fostering a recovery. But that situation puts us on alert to the possibility that the Fed returns to a Pandemic type of response that generated an inflation rate far above their target, as the experience of the past two years has so painfully taught. The economy might recover temporarily, but the expansion would be interrupted by another cost-of-living crisis and the Fed would not achieve either of its mandates for employment or inflation.
With forward rate markets already beginning to price in Fed rate cuts next year, my personal bias is towards exposure which should benefit from a steepening yield curve rather than pure duration such as that which Hoisington deploys. I mentioned one related idea on Twitter early last month and believe such exposure offers a better risk-reward profile. While Hunt appears worried about the potential, I believe it is likely inevitable.
Regardless, the Fed looks to be entering a period of policy whipsawing amidst widespread doubt and confusion. Hopefully seeing the world through the prism of ‘kayfabe’ can help us navigate it, with Hunt’s macroeconomic framework retaining its standing within the Circle of Trust.