Winter 2023 - Roaring 20s, bear trap?

Introduction

Are we headed into a roaring 20s, or will we end up in a bear trap with ‘no landing’, no pivot and a long journey to eventual investment returns and regrowth?

Today, as we move towards what commentators argue are the dying embers of the interest rate tightening cycle and as Nvidia has a blow off top earnings announcement, we’re going to explore and hopefully answer (or at least better understand) the question above.

We’re also going to look at why equities have been on a tear until recently. Is rising global indebtedness an issue? Why are bond yields spiking? And what does all this BS mean for us here in Australia, going forward?

If you’ve been following my weekly blogs, you’ll know that the view I’ve held for quite some time is that the rise in equities from the depths of the pandemic has been a result of market participants ‘frontrunning’ an end to the interest rate hiking cycle.

It’s had nothing to do with fundamentals, other than fundamentally crazy PE ratios.

Rather, this frontrunning, or ‘fading the hawk’ as I like to call it has been based on one overarching assumption.

And that is that inflation, and/or the Fed’s response in trying to tame it would cause a recession and/or something to break after which the Fed would need to step in, cut interest rates, refill the liquidity punchbowl, and equities would moon - a literal Roaring 20s powered by GPUs!

Whether that bullish end-state eventuates will depend on whether there is a U.S. recession, or a major ‘breakage’ in the financial plumbing/collateral base, and how deep it is.

Having laid out that backdrop, let’s drill down into U.S. markets, the epicentre for risk assets and the world’s reserve currency, and we’ll then circle the wagons back to see what all this means for those of us who are lucky enough to live in this lucky country.

The first half of 2023…

For most companies and investors, 2023 started with a few simple wishes.

An end to Russian war crimes, supply side blockages, high energy prices, high inflation, and China lockdowns.

But as the year progressed, those simple wishes became too much to ask.

Regrettably, the Russian war machine grinded on, China opened to a whimper, not all supply chains healed, and access to critical minerals/circuit boards was further disrupted.

While energy prices moderated, OPEC cut production, and demand for fossil fuels increased as the green transition stalled due to a strong USD and a nothing burger of a commodity supply response.

Then, duration mismatches caused by fintech-powered bank runs and sinking bond values, sunk tech/crypto concentrated SVB, Signature Bank, Silvergate, and First Republic. Markets started to work out that commercial real estate asset valuations had cratered as work from home had become entrenched, and that certain centralised crypto exchanges had been writing tokens their bodies couldn’t quite cash.

Not quite the first half of the new year that everyone was hoping for, right?

But in spite of all of that, stocks went on a tear and ripped higher in a shorter period than ever before. It’s been called the most hated rally in history.

Why was that?

The expectation of new liquidity (more currency debasement) drove risk assets…

Those who say the answer is simple, say it was a resilient economy expressing itself in the form of an extended bull market rally.

But I’m calling BS on that. Perhaps it was a narrow one in artificial intelligence (AI) with Nvidia, MSFT and others catching second, third and fourth breaths, and there’s no doubt the impetus has been ‘risk on’, but it didn’t look and quack like a wide bull market to me.

It was concentrated in less than 10 stocks that on a combined basis can move NASDAQ and the S&P.

Others have described the first six months of 2023 as a bear market rally. And while that makes more sense as we found ourselves in a late phase of the business cycle, it still doesn’t explain why equities mooned to the extent they did in the first half of 2023.

I don’t think it has anything to do with productivity and fundamentals. Rather, I believe the reason is structural and has everything to do with bond yields and the following potent cocktail:

Since COVID, a fast and furious $6.1 trillion in reserves was created by the U.S. Federal Reserve (the Fed) with ~$2.5 trillion of that total entering financial markets/the economy via QE/helicopter money - thus providing sustainable rocket fuel for risk assets and consumption; and
Over the past 12 months, a fast and furious interest rate hike program of 525 basis points has made it more attractive to divert that liquidity into equities, given bond prices declined as higher rates/yields made existing fixed coupons on bonds comparatively unattractive.

Don't believe the bit about liquidity?

Well, let's compare the pre-COVID and post-COVID levels of liquidity injected into the monetary system by the Fed’s quantitative easing (QE) program as well as its direct bond purchases from the Treasury.

At the time of writing, the Fed's balance sheet stands at $8.145 trillion, down $850 billion from its peak.

But that’s not the full story.

Firstly, the $8.145 trillion includes firepower held in general reserve by the Treasury. Secondly, it includes reserves in commercial bank/lender accounts ‘parked up’ with the Fed, and not yet ‘printed’ into the money supply.

Remember, under QE, the Fed purchases securities (such as government bonds) from the secondary market, typically from primary dealers like commercial and investment banks. The aim is to influence interest rates, inject liquidity into financial markets, and stimulate economic activity. Whereas, Helicopter money involves the central bank creating new money to directly finance government spending, often by buying newly issued government securities directly from the Treasury. The central bank effectively "monetises" the government's debt by creating money to fund it.

The Fed does not use existing money from its reserves to do any of this. Rather, it creates reserves on its balance sheet and credits the account of the selling institution which can then print that money by lending; or it credits the Treasury, which then spends the money.

But in the case of a lender that does not want to lend or buy assets, it parks those ‘delayed loans and investments’ with the Fed, effectively earning interest (less risky than lending) and as a secondary outcome, those reserves are held back from the money supply.

So, if we deduct those unavailable reserves from the $8.145 trillion gross, the net amount available to the financial system/economy is ~$5.9 trillion.

Let’s call that liquidity. And a few weeks ago, it was $6.2 trillion, so let’s use $6.1 trillion as the average.

But in January 2020, the calculation only returned $3.6 trillion.

The difference of ~$2.5 trillion is my estimate of ‘incremental’ liquidity added since COVID.

Essentially ~$0.83 trillion of ‘new money’ each year for the last three years found its way into risk assets/consumption, courtesy of the Fed’s QE and Treasury debt monetisation activities.

In total, we’ve experienced an extraordinarily fast and intoxicating addition of trillions in incremental liquidity that had to go somewhere, and a lot went into risk assets (asset inflation) and consumption (consumer price inflation).

But why the rotation specifically into equities (and cash money market accounts) and not bonds? Why stonks?

Inflation pushed up rates, making bonds relatively unattractive

Approximately 12 months after Fed Chair Powell’s over-ample COVID response, i.e., March/April 2021, inflation flipped from assets into consumer prices.

There were at least three contributors:

COVID lockdowns and COVID/Russia supply blockages - this was predominantly transitory, with some exceptions like Russian gas, China rare earths and certain critical minerals.
High disposable income feeding the demand side - while perhaps the pent-up and ‘reopening’ demand for goods was transitory, services have proved resilient and the main fuel stoking this extended period of demand has been the trillions in incremental liquidity mentioned in the previous section. If it’s there and incremental - why not spend it or invest it?
QE consequences - while it might not create it, it is not true to say that QE does not contribute to inflation. QE produces reserves, some of which are lent out by banks. It also sidecars with low interest rates which cause asset inflation, trickle down wealth effects, and an impetus to borrow and invest in speculative/risky assets to create bigger and longer wealth effects; in turn leading to profit taking and incremental consumption. That transmission mechanism might be indirect, but it is a contributor.

This high table of inflationary actors resulted in inflation of >5% and that’s something we haven’t seen (there or here) since 1991, prior to the hard recession we had to have.

But fast forward back to 2022, and once the Fed admitted post-COVID supply chains would take too long to heal, unemployment was sufficiently low, and President Biden labelled inflation as public enemy number one - the Fed started to tighten.

In March 2022 (one year after 3% inflation appeared) the Fed announced interest rate lift-off. But it was late to the party. It had let inflation run too hot for too long.

It then attempted to destroy aggregate demand quickly, with large step-ups in interest rates because it knew it had no control over supply-effects (or fiscal levers).

Even as Russia invaded Ukraine, choking off critical minerals and food, the Fed kept raising rates to cool the economy’s primary boiler, and for good measure dialled down the steam further by not replacing some of the spent coal in the secondary boiler, thus restarting QT (quantitative tightening).

QT is when the Fed withdraws reserves from markets by running down its balance sheet and only reinvesting some of the proceeds it receives from maturing investments.

Still, Fed Chair Powell’s guidance was crystal clear - rates would go into restrictive territory and stay there until inflation returned to the Fed’s long-term target rate of 2%, over time. And QT would remain on autopilot.

Despite this guidance, risk markets ignored the Fed. In response, the Fed stuck to its guns, and has kept its policy consistent since that time.

The most recent rate hike on 27 July 2023 was another 25-basis point rise and it took the Federal Funds Rate (FFR) to a range of 5.25% to 5.5%.

We’ve only been in what the Powell Fed might call ‘restrictive territory’ for a few months.

And there’s likely to be at least one more hike this year. Maybe it will be September or November, or both?

Below you can see how the entire curve has shifted up over the last 6 months.

Now, if you cast your mind back a few years you might recall that the short end of the yield curve was 0%, while the 30 year was yielding a mere 1.92%.

Back then the yield curve was not inverted. Yields on all maturities shorter than 10-years were yielding less than the 10-year.

That’s because bond buyers as a whole perceived little risk in the short-term and as a result did not require large premia to hold short-term fixed income products.

Now they do. It’s a different regime and a different world, but it’s not 👾👾👾

And so, money will eventually go to where it’s treated best

The point we finally come to answers the question of ‘why equities?’

And the answer is that while interest rates rose and made the lower coupon rates on existing bonds look unattractive, the demand for/prices of those bonds collapsed.

Investor money flowed into equities because relatively speaking, it was treated better there. Some also went into cash money market accounts given the solid yield with zero risk of a capital loss if rates keep rising.

And there it remained because the consensus view was that a crisis/recession would result from a Fed over tightening, and that would in turn require the Fed to step in and cuts rates to zero. And hey presto, equities go up!

And that consensus narrative was supported by the assumption that if the Fed did not step in, it would cause a ‘game over 1929 style asset barbeque 🔥🔥🔥’ that would cause the sovereign debt bubble to burst.

I would say that it was those beliefs and the belief that mounting debts to fund government deficits would replace growth (and service the next load of debt) that kept equities on a tear in the first half of the year.

There’s one caveat though, and that’s been the bond vigilantes that have continually faded the Fed and bought bonds on the expectation of a 2023 pivot/rate cut, prematurely, and only to see rates go up further 🤮

But is that view still the consensus case? Can debt replace growth? When is it repaid?

Good questions, and let’s consider what the lasting effects of too much debt are.

The lasting effects of using too much debt to fuel growth

One of the lasting effects of relying on too much debt to wallpaper over the cracks (versus strong fiscal policy) is that the National debt gets diverted into speculative pursuits/investments and becomes unproductive.

It jumps out of the primary market (Main Street) into secondary markets (Wall Street).

And the total debt stack keeps on rising because Main Street does not create sufficient GDP to repay its debts. It just gets bigger. So do Wall Street bonuses.

The fact it no longer materialises into real GDP is not a new thing, as I’ve previously written and demonstrated in actual numbers.

Take this piece from my 2019 article: “The World’s forgotten how to fly, without $243 trillion of debt”:

So how much debt are we talking about?
Excluding all forms of unregulated/unreported/shadow debt and certain derivative products, about US$243 trillion, or just under one quarter of a quadrillion!
Assuming about US$76 trillion in global GDP, this tells us that the world is about 318% leveraged before taking shadowy/derivative debt into account.
Whilst total debt to GDP has slowed from its peak in 2018, it has not slowed since the collapse of Lehman in 2008.
In fact, it has expanded by around US$70 trillion (or an eye popping 40%) and debt to GDP has increased by about 38 absolute percentage points.
What’s really worth noting is that incremental debt plus all other forms of investment has only produced an additional US$14 trillion in GDP, i.e., representing 10 year growth of 20% (or about 2% compounding annual growth).
This means that only 20c in each dollar (or US$14 trillion) of the US$70 trillion in incremental debt has so far been represented by incremental global goods and services.
Let me use a very loose term ‘20c in the debt dollar of productivity gains’.

Well, today it’s closer to 15c in the debt dollar.

That is to say that global debt is now over $300 trillion and in the U.S alone, the annual growth in GDP is less than the annual interest bill on the $32.7 trillion National debt stack.

Don’t believe it? U.S. GDP growth was $1.8 trillion in the last 12 months; but the annual interest bill on the National debt sits at a hard to imagine ~$3.8 trillion (private and public sectors added). You can do the math.

And up until a few weeks ago the market was fully pricing in a ‘hard landing’ and a restart of the ‘QE Infinity train to nowhere, somewhere off the coast of Japan’ which in turn would enable wobbly borrowers to refinance their portion of this $32.7 trillion debt stack with ample collateral/low interest rates.

So, what are the lasting effects of too much debt?

Well, it depends.

When the Fed and other central banks have an ability to restart the QE train to nowhere, sustainably spew out liquidity and cut interest rates, the debt colossus can be easily managed. Nothing to see there.
But when the Fed and other central banks can no longer do that, that is exactly when the level and cost of debt matters, and we get corrections, defaults and crises and runs on the USD, making the problem even worse.

With that debt equation in mind, let’s get back to the question of the day - bull market or bear trap?

The depth of recession or crisis, if there is one, will dictate whether we’re heading for a roaring 20s, or stuck in a bear trap…

I believe that a bull market rally fuelled by abundant liquidity after a pivot/rate cut might only eventuate if a contraction/recession is deep enough.

That, or a major breakage of the monetary infrastructure/debt market plumbing is about to occur.

I’m suggesting that a crisis would need to be deep enough to not only choke off sticky inflation, but it would need to threaten the efficient working of money and credit markets.

If the collateral base (property, bonds, equities, commodities) that secures the sovereign debt stack is at risk of crashing, any Fed not asleep at the wheel would step in to ensure debt markets (aka the sovereign debt bubble🎈) doesn’t burst 🧨

Otherwise, if it’s not that serious, the Fed might simply see a 10% or 20% pull back in risk markets as ‘not in our wheelhouse’, i.e., a nothing 🍔

Asset inflation was not in Chair Powell’s wheelhouse on the way up. so why would asset deflation be in his wheelhouse now? Unless of course it starts to undermine the collateralised debt stack.

Result? Rates higher and a no-pivot for longer, which would cause bond yields to increase and turn bulls into bears for longer.

To summarise, I see two main scenarios at play:

Scenario 1 is a ‘When bad news is good’ Bull Market: If it’s a meaningful recession (the Fed overtightens to force recession and asphyxiate inflation) and/or debt and collateral defaults come into in play, the Fed will cut rates, the market will ‘Put’ crumbling paper to the Fed, the QE Infinity train to nowhere somewhere off the coast of Japan will gather speed, the bulls will embark and head straight for the saloon carriage to snort as much financial Rohypnol as possible so that equities, crypto and other risk assets will moon and the business cycle will reset and start all over again.
Scenario 2 is a Bear Trap: If the result of monetary policy is a soft or ‘no’ landing and if the resulting contraction is shallow and resembles a downdraft or air-pocket (even under a ‘higher rates for longer’ policy) and inflation reoffends due to economic resilience - then, restrictive policy for longer and ‘big and fast’ monetary and fiscal stimulus may not eventuate; meaning that the equity bulls might end up in a bear trap pedalling hard to backfill bubble territory valuations from their nose bleed seats on top of the debt stack. Treasury yields could spike, again.

As of the end of the first half of calendar 2023 and even by the end of July, I believe investors favoured equities not because fundamentals were bullish, but rather from a structural perspective they assigned a far higher probability to Scenario 1.

Their consistent argument being that there have only been two soft landings in U.S. history.

But over the last three weeks, equities have come off and bond yields have spiked. And ‘spiked’ is probably an understatement 😲

I’ve noticed 1, 2 and 3-month duration Treasuries steepen by 40 basis points over the past few weeks.

Maybe, just maybe, Scenario 2 might be gathering more of a following 🤔

In support of that, bond yields are screaming ‘risk’ at the short end, but at the middle and longer end of the curve, yields are skyrocketing, and the curve is steepening (refer the chart above) and that’s even more interesting.

At the time of writing this, the 10-year Treasury is yielding 4.33% and the 20-year is up 60 basis points to nearly 4.6%.

This steepening might be explained by less buying from Japan and China; and/or long bond holders doubting the Fed’s ability to tame inflation - thus demanding significantly higher yields in expectation of higher inflation for longer.

It’s this selling at the long end of the curve that makes me think that a higher probability is now being assigned to Scenario 2. That is to say, the bull’s Arcadian pivot is being crowded out by bears and an expectation of a longer hibernation without stimulus.

On the other hand, any of the following could happen to cause a flip back to a hard landing, pivot, cut and a consensus return to Scenario 1:

The cost of money might become too expensive to facilitate affordable refinancing.
Affordable short-term capital in the form of Repurchase Agreements (Repos) might become scarce/unavailable.
Chinese property developers/lenders might fail.
The PBOC might step in to defend a falling Yuan (or stimulate).
More Japanese funds might exit U.S. Treasuries and return to JGBs as the yield curve control collar is further relaxed.
Important U.S. Treasury bill auctions might fail.
More U.S. banks might fail as investment portfolio valuations fall and depositors get nervous.
U.S. corporate earnings might miss.
Other events of similar importance might occur to destabilise the collateral base.

And what if a couple of those events happen at the same time? Well, we flip back to Scenario 1, where bad news eventually becomes good news, and we get rate cuts and fiscal welfare.

The reality is that both bulls and bears have massive opposing positions, but I’m seeing more evidence of a bear trap for longer, but for a few exceptions.

Summary

Equities were on a tear in the first half of 2023 because of the speed at which the Fed transmitted $2.5 trillion of incremental liquidity into the money supply/economy, since COVID.

Bond prices cratered as they do in a rising interest rate environment (nice yields, but if they go up, the bond price comes down) and money flowed into equities.

In short, QE and COVID cash found its way to where it was treated the best.

More recently, equities bulls look more like bears as they push out their hopes for a policy pivot and rate cuts in the short term.

While short term bond yields are rising on risks of more tightening (and in expectation of more Treasury issuance), long-term bond investors are selling bonds and pushing up yields to decade highs as they demand significantly higher yields to compensate for expected ongoing inflation.

This bearish steepening of yields in long term bonds should be telling Chair Powell that his fight against inflation is not over, and it might encourage him to hike rates further, or risk a repeat of the 1970s.

And while mounting debts are not a problem if the Fed has an ability/headroom to cut rates and allow affordable servicing of debts, that might not happen for quite some time and in the meantime, there’s still a risk that those debts can become a bubble if they cannot be serviced. But we don’t currently have that predicament.

Conclusion - the answer to today’s question?

I would say that right at the minute, no broad based Roaring 20s on the near-term horizon. It feels like equities and bonds have entered bear trap territory (Scenario 2) despite some narrow exceptions. No crash, some specific hot stocks and bond dislocations to get interested in, plus maybe precious metals, but on balance a slow grind to the right as we wait to see the data and the Fed’s demeanour.

But if the Fed’s tightening or a geopolitical event causes a sharp recession or a breakage that’s systemic enough to force the Fed to pivot and cut, we might flip back to Scenario 1. Less likely IMHO. Not because it won’t happen, it might, but if it does the question becomes whether there will be solid returns to be had in equities.

The jury’s out on that, but in the meantime, a Bear trap, but for limited exceptions.

Circling the wagons here in Oz

The ASX200 has performed admirably, although nowhere near as spectacularly as U.S. markets.

Mostly, this is because we don’t have the same weighting of long duration technology companies as do the NASDAQ100 and S&P500, and there’s been trillions more of liquidity tipped in there, than here.

But in the first half of the year, high inflation/interest rates, higher input costs, a strong USD and a non-stimulated China have stopped the 'commodities super-cycle that was supposed to be’ in its tracks.

All eyes are watching for real estate/construction friendly China stimulus to happen, but will it?

The above macro factors have made Australian imports more expensive and exports less valuable. High payroll and input costs have also been a problem, and the margin squeeze we’ve been expecting from this is finally showing up in corporate earnings.

BHP is a good example of a company that’s being squeezed by higher costs and lower commodity prices. Last week it reported a 37% decrease in earnings and an expected cut in dividend.

Iluka also served up a not so appetising 🥪 that was expected, although based on the price action last week after the announcement it was not expected by all. The mineral sand miner that wants to value add all the way to magnets reported decreases in revenue and EBITDA of 10% and 22% respectively, paired with a 26% rise in its cost of sales. Overall, a ~45% BOHICA Bear fall in profit with negative free cash flow. The dividend is likely to be snipped to nearly nothing. Shares were down 9% plus after the announcement.

Even ASX tech posterchild Wisetech Global was brutalised with ~19.6% shaved off its value after announcing higher profits for the year but accompanying that historical result was a warning that average profit margins would decrease until 2026. This margin dilution is expected to result from three recent margin-dilutive acquisitions.

So, what do the next 6-9 months hold for business conditions here in our China-dependent, commodity-laden and USD/AUD sensitive economy? How will the macro factors discussed above effect your business, and your personal investment portfolio? Where are the opportunities?

If you’d like the answer to those and other questions, you can subscribe to our exclusive content quarterly newsletter, NextPerspective by tapping the button below and following the prompts. NextPerspective will return at the end of Spring.

See you in the market 👋

Mike

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Michael GanonAugust 29, 2023