Q4 2022: What Lies Beneath

Mark's Favorite Tweet of Q3 2022:

MacroAlf (@Alf) Tweeted: ''The government [screwed] up with a humongous 5+ trillion fiscal stimulus and we were sleeping at the wheel in H221, so we are going to get you unemployed to repair that. Thank you very much'' ~ Jerome Powell

Ok, so I doubt Jpow actually said that, and maybe he didn’t even think it, but is not far off from what the Fed is seeking to accomplish. More on that below.

WHAT RECESSION??

GDP grew at a 0.65% pace in Q3, or 2.6% annually, erasing two slightly negative quarters. Is the recession watch officially off?? Looking closer, it looks like GDP was positive due to cyclical factors that may not hold—trade and government spending, not consumption and investment which make up 89% of US GDP. Don’t mistake this for a favorable growth environment until rates normalize, inflation cools, and leading indicators pick up. And that might be a while.

Here's a neat chart from Enterprise Bank’s Capital Markets Playbook, which points to the main indicators that the National Bureau of Economic Research (NBER) looks at when determining recessions. Note, there are distinctly less “green” indicators heading into Q4 2022. That’s bad.

In my opinion, a real recession is a foregone conclusion in 2023. Yield curve inversions (when short term debt yields more than long term debt, indicating deep pessimism from investors about the short term) are typically reliable indicators of recessions, and are uniformly negative. Employment is strong, but that’s a lagging indicator. I have been told the consumer is strong…. let’s check on that. Is it good when consumer credit card debt goes up really fast? (note, I have been indirectly reprimanded on Twitter by Darius Dale (@42macroDDale) for suggesting this chart means that the average consumer is tanking...feel free to check that out as Darius is very knowledgeable. I still struggle with argument that the average consumer is strong right now, but his point is fair, this is just one cherry-picked data point).

The pertinent question on recession is: how severe? Housing will point the way and is almost a proxy for economic health due to importance to the US economy. And home sales are now below pre-covid levels and showing signs of falling further. And with mortgage rates on 30-year fixed debt in the 7s, no wonder.

Speaking of rates….

A 0.75% rate hike in November and 0.50% rate hike in December are currently priced in for the Fed Funds target rate, bringing the upper bound to 4.50%.

The Fed rate hikes are aimed at bringing down inflation. Will they work? And how hard will they let employment get hit?

I wrote in the Q3 note:

My money is on one more hike in September, followed by several months of steady rates, followed by rate cuts in Q1 2023. Possibly sooner. (Anyone who wants to take the opposite of that wager, shoot me an email—if I am wrong, I’ll buy you lunch). The Fed has 2 jobs 1) price stability and 2) max employment. #1 is the priority, until #2 starts to hurt. We’re a long way off right now but continue to watch for signs of softness in the labor market (keep in mind employment figures are a lagging indicator).

I look to be wrong here. Unemployment remains very low for the time being, and inflation has barely cooled. But pivot language is starting to become present in Fed messaging, indicating that the Fed is reaching the point where it will pause and see just what effects its actions have had. The economy has been resilient thus far, but the Fed is running out of runway.

Take a step back to understand the Fed approach: the Fed can’t increase supply of goods or energy. But it can decrease demand for said goods by making it prohibitively expensive to borrow to acquire goods and energy. Additionally, the inverse wealth effect—if people feel poorer because 401ks are shrinking, people will spend less--will take a bite out of spending.

The Fed’s job isn’t easy, and I wouldn’t want it. Credit risk or inflation risk – which is more serious? The US may be getting close to the event horizon, the point of no return, where it can’t service debt from its main source of revenue—taxes. If this happens, taxes are likely to go higher, and if the government is limited in its ability to tax (typically not a popular issue amongst voters), it will resort to creating money to pay off debt. And that means inflation, which is what the Fed wanted to squelch in the first place.

I don’t mean to pick on the US. I just spend more time thinking about it since I live here. It’s worth noting that the rest of the world is in worse straights. To what extent the Fed needs to pay attention to global financial stress remains to be seen, but it is telling that the ECB and WEF are calling for the Fed to stop hiking rates.

?Interest payments on US debt are approaching the $800B mark, the amount the US spends on military, and are set to cross $1T shortly. This limits the ability to keep rates high over the long term.

Rate Implications

If you have floating rate debt, it’s gotten more expensive over the past year. SOFR, the new index most floating rate debt is moving to, is 3.03% as of 10/28/22, up from 1.09% at 6/30/22. Prime, another index often used for floating rate debt, is at 6.25%, up from 4.75% at 6/30/22.

5-year US Treasury rate is at 4.18% as of 10/28/22, up from 2.88% at 6/30/22. This rate is often very important for banks pricing out fixed rate term debt.

Parting Thoughts

What you can expect for the remainder of the year:

-?????????I think inflation is going to be higher for a longer period…multiple years above 4%. While the past isn’t always a reliable guide for the future, per Patrick Saner of Credit Suisse, data since 1920 shows that once CPI is greater than 8%, it takes around 2 years to fall beneath 6%. Current market consensus indicates we’ll be below 3% in 2 years.

-?????????Expect growth in 2023 to be anemic or negative. Still room for successful businesses to thrive, just more headwinds in doing so. Entrepreneurs will still find ways to create value.

-?????????Cash is king. Buying opportunities will start to emerge as weaker businesses more reliant on expensive debt start to struggle.

-?????????Deleverage: I am a banker. I like debt as a tool for my clients—when used judiciously. It helps boost returns but can also make you more fragile in a downturn. If we do really slow down, it may be good to consider paying down debt and cleaning up the lines of credit, if you haven’t already.

-?????????Strengthen the supply chain: this is particularly important if you are dependent on parts from China or Europe. Both areas of geo-political instability. Add in a looming energy crisis in Europe…

-?????????Re-invest: if your liquidity position is solid, a downturn may be a good time to re-invest in technology, inventory and top-notch personnel and emerge faster and stronger. Hopefully getting shipments will be less of a problem in a downturn—suppliers might be even eager to talk!

-?????????If your inventory/raw materials have run up in value, you may benefit from switching from first-in-first-out (FIFO) to last-in-first-out (LIFO) inventory accounting. Talk to someone more qualified than me!

-?????????You all have heard of Earnings Retention Credits (ERC) at this point, and maybe have received some ERC funds. If your business is in Kansas, check out the Promoting Employment Across Kansas (PEAK) program, and you may be eligible for refunds on payroll withholding tax.

If you find this at all helpful or insightful, or have a question, let me know! Would love your feedback as I hope to make this genuinely interesting and useful.

And a reminder: Please note, these are my personal opinions and not the opinions of my esteemed employer. This is not investment advice, but hopefully helpful grist for your decision-making mill.

Best,

Mark