The first post on this substack covered the broader picture of the analytical underpinnings for this newsletter. After the spending the past few weeks highlighting some of the aspects of the process, using specific examples, this week will be focused upon pulling it all together for a current assessment.
Business Cycle
The US economy, along with most of the world, experienced a brief but severe recession as a result of pandemic-related lockdowns in the spring of 2020. Subsequently, a new recovery and expansion emerged. By late summer and early autumn 2020, the recovery became reinforced by an upturn in the global industrial cycle.
As Economic Cycle Research Institute has stated, this is important due to the ‘bullwhip effect,’ where the impact on growth from an industrial upturn is far more pronounced, and particularly so in emerging economies more leveraged to manufacturing and commodity prices. The relative boost to economic growth in the US can be as much as six times greater than the service economy, though obviously the size and scale which are now leveraged to the industrial cycle is far smaller.
That upturn kicked into high gear in Q4 2020 and through the first half of 2021, which also coincided with more cyclical and industrial-related market industries assuming relative momentum. For example, here is a 3 year weekly chart of the S&P Oil and Gas Exploration ETF (XOP), where it successfully retraced to test the panic lows in spring 2020:
Next is the Metals and Mining ETF (XME):
Both showing outsized gains over that six to eight month period from autumn 2020 through late spring 2021. However, leading indicators began to point towards the global industrial cycle rolling over and entering a growth rate cycle slowdown. Here is a 1 year daily chart for the price of continuous copper futures - note the consolidation which commenced following the high reached in early May 2021:
The US economy then followed suit, with a growth rate cycle downturn emerging late in the summer, with leading indicators not yet suggesting an end to the slowdown is on the horizon. Leading indicators have some visibility out around 3 to 6 months, so a continued slowdown appears to be baked into the cake for at least most of the first half of 2022.
The picture looks worse outside of the US, with growth rate cycle downturns also unfolding now in a global synchronized fashion, with China and Europe having rolled over prior to the US.
By definition, with the exception of outlier issues like war or pandemic-related lockdowns, growth rate cycle downturns precede recessions. However, not all slowdowns manifest in recession, as ‘soft landings’ can result in a fresh growth rate cycle upturn which prolongs the expansion. It is simply too early to have conviction on whether or not this cycle will culminate in a new recession emerging next year, or whether a soft landing will occur.
Macro Economy
The macro backdrop has not changed materially relative to the macro framework to which I apply. The nexus of over-indebtedness, bad demographics, low monetary velocity, and below trend growth remain intact. The cyclical factors which have fueled a large uptick in consumer prices have been significant, with pandemic-fueled disruptions to global supply chains and massive deficit financed household spending resulting in shifts in supply and demand curves.
That graph is courtesy of Jeff Snider of Alhambra Investments and shows the impact of government transfer payments in supporting personal incomes- particularly in ‘real’ terms. I say ‘real', as this incorporates the phoney baloney government inflation calculations. Regardless, those support programs are now rolling off and will largely end heading into the first half of 2022.
Lacy Hunt wrote in his Q3 investor letter about an emerging “deflation gap”:
“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 entire letter is always worth multiple readings, and that one was no exception.
ECRI’s future inflation gauge (FIG) began to flatten in the summer and has begun to soften a bit, but price increases tend to be sticky and inflation is often a lagging issue - i.e. it tends to follow the business cycle with a delay: as we saw in 2008, when crude oil hit its all time high 6 months into the recession!
This mix of weakening real incomes with less support from government programs, all while higher prices are likely to remain sticky through much of 2022, is likely to result in demand destruction, as Lacy states. This is an important concept, as we see huge spikes in energy prices in Europe, for example. Rather than a sign of broad monetary inflation, it is likely to result in a reshuffling of spending away from other areas of the economy. As economies decelerate into growth rate cycle downturns, they get increasingly more vulnerable to shocks which can trigger the recessionary feedback loop of declining incomes, employment, sales and production.
Many emerging market economies have already been engaged in monetary tightening for much of 2021, with some like Brazil already seeing their forward rate curves beginning to invert. Risks of misguided policy errors appear to be front and center for 2022. The global Eurodollar market is flashing huge warning signs, as the interbank funding market of US dollar deposits in international banks suggests that the global slowdown is already resulting in growing funding issues.
Complex Systems
As covered in last week’s letter, the underlying criticality within the financial system, as well as the broader economy, may be the most hyper in history. Growth rate cycle downturns like the one we are currently experiencing have been correlated with ‘financial accidents', or deleveraging events. For example, the crash of 1987 and the significant correction into autumn 1998 both occurred during slowdowns. More recently, the sharp decline in risk assets into the December holiday period in 2018 occurred about 1 year into a growth rate cycle downturn, and relatively early in the Federal Reserve attempting to normalize policy. Sound familiar?
But financial markets are just a reflection of the broader complex system which is humanity. Other related pressures can contribute to the relative criticality of the overall system - geopolitical tensions (hello Taiwan and Ukraine), domestic political volatility amidst societal acrimony, pandemic-related mental health and trauma, etc. As someone who is married to a healthcare professional, I have seen the heavy toll the last 20 months has had - the trauma is likely to be long lasting, including amongst the horrifically impacted youth population.
As the societal pendulum swings more towards emotional volatility, criticality increases, in my view. So the overall system is hypercritical and vulnerable to the outsized and nonlinear risk cascading which is inherent to such system dynamics. The analytical tools I have used to try and determine when an ‘avalanche’ have started high up the mountain has already triggered.
Many markets around the world have already started to cascade and display price behavior which follows power law scaling and in a fractal way. The major US indexes have not yet joined that process, as a relatively small number of mega cap stocks have held them up on a relative basis. Many markets reached declines of 15%-20% at their recent lows, even as the S&P 500 only corrected by about 5% over the two weeks from November 22nd to December 3rd. It is possible that the ‘mountain’ will stabilize and resume its growth to ever higher levels of mania, but such a path would simply make the inevitable even more explosive.
Traditional Investment Analysis and Ideas
This section is likely to remain relative modest for the time being, as there just are not a lot of market segments which offer absolute value which is attractive enough to take on the systemic and market-related risks currently present. Generally speaking, the investment landscape for ‘dirty’ is increasingly attractive on a 5 to 7 year time horizon. The combination of a prolonged bear market in most commodity markets since 2012 resulted in a sharp decline in investment into future production, and the pandemic and ESG movement have compounded these issues. This is likely to setup prolonged periods of profitability for those companies with stable production assets, with those pipelined to grow production even more appealing. Specific areas I am looking to consider into future market dislocations are oil, North American natural gas, coal, and uranium, with base metals and more diversified resource companies potentially entering the equation if a recessionary bear market emerges.
One industry for which I have a long love/hate relationship has been precious metals mining companies. Generally speaking, it is a terrible industry filled with difficult operating conditions, political risks, and promotional management teams. However, the past decade has imposed a lot of market-driven discipline on resource allocation. It’s been a long bear market, with the AMEX Gold Bugs Index (HUI) still about 60% below its peak in September 2011. Absolute valuations of the industry are now compelling, with increasing M&A activity beginning to rationalize things further.
In the era of explosive growth in passive indexing, gold stocks comprise just 0.20% of the S&P 500, with a Newmont Mining (NEM) currently trading at less than half the market price to earnings multiple with a 3.70% dividend yield. I am not current on the specifics of Newmont, and it is in no way a recommendation on the stock. Along with Newmont, Barrick (GOLD) and Agnico (AEM) are in similar area on price to earnings with about 2% and 2.70% yields, all with relative strong balance sheets. The three are currently around 30% of the major industry ETF’s. Those dividend yields compare with the current dividend yield on the S&P 500 of about 1.30% and interest yield on the 10 year US Treasury of about 1.48%.
Rolling down the US yield curve as the slowdown becomes more broadly priced in and common knowledge, with the Fed likely to terminate their latest flirtation with ‘normalizing’ in 2022, is another focus for me heading into 2022.
Lastly, I am monitoring whether the recent rally to new highs in mega cap US indexes, along with retracements in other markets, exhaust over the coming weeks and through Q1. Given the extreme criticality within the system, it will be of particular note if a top in the SPX is followed by an impulsive initial decline which displays power law and fractal scaling.