Soft Landing May be Elusive, moving to Credit cycle downturn

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Global Liquidity Growth is positive though may be close to peaking, signs of economic deflation and weakening demand are broadening….

The Global Liquidity Growth in April (the latest available month) of +3.9% (6-month smoothed growth) was below the trend growth of 7% and bottomed in November. The large increase month-over-month is related to the stimulus provided by China, which offsets the declines in liquidity from the rest of the world. Also weakening of demand in end clients (U.S., Europe) via higher interest rates and inflation does not support cyclical uplift in the global manufacturing cycle. This is evident in the slowing of manufacturing PMI including in China.  U.S. Liquidity has continued to decline close to 5% per annum and the “banking crisis” is expected to tighten credit conditions more. Looking ahead we expect global liquidity to move from a tailwind to a headwind (without a significant change in policy), putting pressure on asset prices moving forward.

Central Bank Policy Rates: The liquidity cycle (central bank raising/reducing overnight rate) is used to re-inflate the business/manufacturing cycle due to recession or credit event (i.e. large bankruptcies/insolvency) and usage of the Central Bank balance sheet to manage long-end of the yield curve to meet the policy objective. The impact of rate hikes takes between 12-18 months to have full effect. We saw maximum policy tightness in September 2022. Most central banks appear to be close to ending the hiking cycle. Inflation has been controlled via rate hikes and lower money growth in the real economy. Our central bank diffusion index leads the ISM Manufacturing PMI by 12 months and points to the continued declining ISM Index. Private Sector Global Liquidity and ISM Manufacturing New Order Index tends to lead S&P Operating EPS by 12 months and 10 months, respectively.

Central Bank Balance Sheets: Since October 2022, Global Central Bank liquidity has risen, which has increased valuations (Price-to-earnings ratio) to reduce risk/maintain financial stability, and real interest rates have fallen. Equity markets have appeared to bottom as a result. Equity markets have not tended to bottom before an actual recession. Historically, private sector money growth and re-steepening of the yield curve have been associated with equity market bottoms to re-inflate the business cycle and earnings through the flow of credit into the economy. We have yet to see an inflection of private sector liquidity or a re-steepening of the yield curve.

U.S. Fiscal Dominance, Trying to Outrun a Recession: The Fiscal cliff (lower spending coming out of COVID-19) put a damper on growth in 2022, but this has been reversing as growth in spending has accelerated due to spending down of Treasury General Account to reduce the amount of time on fiscal gridlock on the debt ceiling limit, which had a positive impact on Q1/23 GDP and potentially kept inflation elevated longer.

However, the U.S. Fiscal position relies on US dollar reserve status and continue asset price growth (as capital is favored vs labor) to continue to maintain the current level of spending. The current interest rate/spending level does not appear to be sustainable in the long run, without asset appreciation or significant change in policies capital vs labor. The amount of debt (U.S. Treasuries) to raise in the next 12 months is significant to fund the projected spending and roll existing maturities. As foreign buyers have reduced their exposure to U.S. Treasuries since 2014, given the level of funding to support the fiscal mandate, this points to liquidity conditions tightening and volatility in asset markets, without re-instating quantitative easing (QE) or yield curve control (YCC). This leaves government authorities stuck between a rock (expanding fiscal deficit, given declining tax payments) or a hard place (tightening interest rates in the face of a slowing economy to bring down inflation for good).   

We expect that we are entering the next phase of the credit cycle downturn and lowering employment in the coming months, as credit tightens.

Global Liquidity growth and G-20 OECD Composite Leading Indicator (CLI) growth have been below trend since November 2021 and the trend-following portfolios have been allocated to the Safety portfolio since January 2022 generally as a result of lower-than-trend Global Liquidity and G-20 OECD CLI growth. Quality and Low beta equities have been favored.

This month’s allocation is within the trend following safety portfolio (Gold, Investment Grade Bonds (LQD), Intermediate-term Treasuries (7-10-years) (IEF). For April 2023, the Trend-following strategy and investment in the Wave Runner/Safety Portfolio have generated 0.2% and are up 5.6% YTD (underperformed ACWI by 3.6% YTD so far).

As we cover in the previous posts, historically, bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500 on average) and last 18 months on average as first earnings multiples are repriced, then earnings expectations repriced. The current bear market has been about 16 months, so we may be only halfway through the bottoming process and start of a new bull market. Highly Inflationary pre-Recession conditions tend to have longer Bear Markets/Recessions and recessions tend to slow inflationary pressures. Generally, a bottom is formed when global liquidity turns positive and the yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows and have bottomed. We are starting to see indications of a bottoming process but do not appear to have had the final capitulation.  

Aggregate U.S. Commercial Bank Balance Sheet/Credit Crunch Ahead: A deposit drawdown of >3% has preceded each equity market drawdown of > 20% (ex-COVID-19). Banks are highly levered (10-25x), and instability of funding profile, causes a pullback in the flow of credit into the economy through deleveraging (i.e. tightening of credit standards). Credit availability appears to have declined post-U.S. regional bank failures in the last month, as credit drawdown is ~1% and credit is only growing at 3% (3-month annualized), which is lower than the trend growth of 7%. This is significant as the economy relies on the continuous flow of credit/money to real economic growth over and above population growth. When credit growth declines significantly, bankruptcies/higher credit losses, and higher unemployment have followed.

U.S. housing has yet to bottom. Usually, for the economy to bottom, the housing sector will need to bottom. We have seen activity slow and broaden across industry from housing, manufacturing, retail and transportation.   Jobless claims tend to follow the housing cycle on a 10-15 month lag. Housing and Manufacturing sectors appear to be in recession (industrial production -2% on 6-month smoothed change). Retail sales appear to have taken another leg down in March/April(The last two weeks of Redbook sales have fallen to 1.5% YoY (Apr 11) and 1.1% (Apr 18) relative to March 2023 of 2.9%) and credit tightening tends to weaken retail sales. 

Bear markets are about uncertain earnings outlooks. Current U.S. corporate operating earnings estimates in for FY2023 of $219/share or up 12% YoY and earnings recession in H1/23 of (3%), appears to price a soft landing.  We have seen signs of higher costs reducing profit margins that cannot be recouped via higher prices. Revenues have held up given the monetary illusion of inflation. Based on our models, we believe consensus EPS may be optimistic based on the tightening of credit standards and suggests a hard landing.  

China’s re-opening stalls on weak factory demand: China’s economic recovery is real, but largely in services, so the recovery has not supportive of most commodities, which is why we have seen the continued weakness in industrial commodities. China’s Manufacturing PMI dropped below 50 in April. China’s Producer Price Index continued to fall in March (down 2.5% YoY), as a result of weak demand (lower exports) amid worsening economic conditions across the globe. Services have remained elevated in domestic consumption. Households continue to have excess deposits, and we are seeing higher expectations for tourism but no significant changes in Big Ticket/Home Purchases. Restoring confidence remains crucial for the consumption outlook.  Households’ confidence is closely linked to property prices, food price inflation, and stock market performance and we have seen some uplift, though consumption is a much smaller part of GDP  (40% of GDP) relative to the West (60% of GDP). Beijing’s new common prosperity policies focus on redistributing income from the wealthy to the poor and the middle class is expected to support this, but may not be enough to stop the global slowdown.

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