Model Portfolio Update – December 2022

Global Liquidity Growth in October (the latest available month) of (6%) was far below the trend growth of 7% and may be close to bottoming in the next few months. Global Liquidity has 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 growth. Long Duration Equity/Bonds Returns tend to be positively correlated with Liquidity Growth. With weak general liquidity/funding conditions, allocation to the Safety portfolio is prudent. Gold has replaced the US dollar in the safety portfolio this month. As we cover in the previous post, Historically, Bear markets lasting > 1 year and subsequent recessions have resulted in significant drawdowns (~45% for S&P 500) and last 18 months on average. The current bear market has been about 11 months, so we may be only halfway through the bottom and start of a new bull market. Generally, a bottom is formed when global liquidity turns positive and the yield curve slope has positive momentum.  


Looking at the Fed Funds Rate and comparing it against historical levels of the Fed Funds Rate and inflation may understate the tightening of monetary conditions we have seen in 2022. A proxy rate or a shadow interest rate can be interpreted as indicating what the federal funds rate would typically be associated with prevailing financial market conditions (including the impact of Quantitative Tightening and altering of Forward Guidance, the strength of US dollar, and energy prices) if the fed funds rate were the only monetary policy tool being used and would peg the rate closer to 6.6% rather than current rate of 4.0%, which is much closer to where core inflation rate is running.     

We use cyclical indicators of the business cycle including Long-leading indicators and Short-leading indicators to help determine the forward-looking economic outlook. Long-leading indicators tend to turn 15 months ahead of the recession and Short-leading indicators are 7 months ahead of a recession. So we use short-leading indicators to confirm our long-leading indicators. As of the latest month, all Long-leading indicators are negative and Short-leading indicators (excluding labor market indicators) are negative as well. Labor markets have remained strong, though high-frequency data (daily treasury/tax data, initial claims, contractors) on the labor market appears to show continuing slowing of growth into 2023. Both the yield curve and long-leading indicators suggest that the probability of recession to above historically recession triggers (50-80%) over the next 12 months. 

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Mapping out the Boom-Bust cycle and  Yield Curve Inversion…Did we miss a Market bottom in October 2022?

In this post, we cover the recent yield curve inversion of the 10-year less 3-mth spread and this has historically preceded a recession and has yet to give a false signal.

We review the Austrian Business Cycle Theory (Boom/Bust cycle of monetary accelerations leading to Bust/monetary decelerations) and how tracking the True Money Supply may explain the “predictability” of recession via the yield curve slope.  

Changing growth rates in the Austrian “true money supply” (TMS) monetary aggregate correspond quite well with the spread in the yield curve… when the banking system contracts and money supply growth decelerates, then the yield curve flattens or even inverts. It is not surprising that when the banks “slam on the brakes” with money creation, the economy soon goes into recession. The unsustainable boom is associated with “easy money” and artificially low-interest rates. When the banks (led by the central bank, in modern times) change course and tighten money growth, interest rates rise and trigger the inevitable bust. The True Money Supply measure strips out savings elements from M2 money supply such as money market mutual funds and time deposits.

An Inverted Yield Curve and slowing Money Supply growth have been associated with Bear markets that last beyond a year and which are followed by a subsequent recession.

We are seeing a similar setup now, given the tightness of money growth to respond to current high consumer price inflation. Before the equity market forms a bottom, the yield curve must steepen and we should see positive momentum in money growth (which we have not seen quite yet).

We spend a fair amount of time reviewing the past 22 significant S&P 500 equity market drawdowns since 1929 and try to determine if there is an analytical framework with measure to track to help identify market troughs that are safe for investors to buy into. We have asked ourselves the question – did we miss the bottom on October 12th?

Based on our research and analytical framework, we believe we did not, if a recession occurs next year and a recession/growth downturn is expected in 2023.

Equity market drawdowns have been ~45% when bear markets are subsequently followed by a recession. Based on the long-leading indicators, we believe that a growth downturn will occur in 2023. Highly inflationary pre-recession conditions tend to have longer Bear Markets/Recessions (lasting up to 3 years) and recessions tend to slow inflationary pressures.

At its current price, of $3,992, the S&P 500 trades at a forward P/E multiple of 17x. We have reviewed the current consensus S&P 500 Operating EPS estimates for 2023 of $228/share, which have been revised down in recent months and expect to see YoY growth of 2% in 2023 vs 2022, down from 5% earlier in the year. However, given the pace and severity of tightening of financial conditions (US dollar, rates and energy prices) our leading indicators for S&P 500 EPS are pointing to a decline of between 10 to 25% in 2023. The current price declines in the S&P 500 has largely been due to P/E multiple compression due to higher rates, and have not considered the potential drop in earnings into 2023. This represents further downside risk to equities at this point.

Equity markets tend to peak about 10 months before a recession when the pre-conditions are highly inflationary and it appears that we may be heading in this direction in early 2023 based on our long-leading indicators.

Equity markets typically do not bottom before unemployment begins to tick up. 65% of Peak-to-Trough losses occur after the unemployment rate exceeds the 12-mth moving of the unemployment rate with a median loss of 24%, so we still have downside risk here. We have yet to see the unemployment rate cross over its 12-month moving average.

Equity market troughs tend to occur within 4-6 months of the official recession or first 20% of the recession (before unemployment rate peaks) and when long-leading indicators point upward. We have yet to see our long-leading indicators pick up (i.e. yield curve steepening, positive momentum in money growth etc.) and they continue to deteriorate. Buying in at market troughs tend to be where investors make a lot of money with 5-year annualized returns in the S&P 500 being about 10% per year.    

We also reviewed our inflation gauge based on leading indicators and note that inflation is expected to decelerate over the next 6-12 months. We also note that unit labor costs grew YoY at ~6% and remain well above trend growth of 1.1%, though growth is starting to dissipate which should reduce any further concerns around a wage/price spiral. As we have discussed before, wage gains if offset by productivity gains may not be highly inflationary, however, we have noted that much of the wage gains in the last 12-18 months have not been offset by higher productivity, resulting in higher than anticipated inflation.

The US dollar momentum has waned in recent weeks and traders have reduced their speculative positions in the US dollar. Historically, when the US dollar momentum begins to weaken in this part of the cycle, safe havens such as bonds/gold tend to start to rally as they start to anticipate increases in monetary inflation in the next 6-12 months to offset the expected disinflation we may start to see into Q1/23. We expect to see these assets play a larger role in our trend-following portfolio allocations.  


Follow the Money – Understanding Policy Lags…

This post tries to map out how liquidity is supplied into the real economy.

When a commercial bank makes a loan, the borrowers’ bank accounts are credited by the amount of the loan credited (i.e. money is created). A lot of money was created in 2020/21 as a result of COVID-19 and has caused price levels to rise across goods, services, and assets. Money can also be created via central bank debt monetization.

Money growth in 2020/21 grew at over 3 times the amount of trend growth of money – no wonder we see consumer price inflation at 4 times the amount of the inflation target. As you will see, trend growth of money tends to grow at a constant rate over time to help ensure aggregate demand meets supply across the business cycle.

The outcome of the supplied liquidity including Real GDP growth, corporate profits, employment and consumer prices, is the focus for most investors, which are all key measures of the health of an economy, rather than money/credit growth.

Very few people focus on monetary aggregates and credit growth and we believe that newly supplied liquidity drives the economy forward and helps to refinance old debts to maintain the stability of the existing system. Most of the inflation we see in 2022 is a result of policy decisions from 2020/21 as there is a long lag to see the outcome of the initial policy decision.

Many forecasters may suffer from an availability bias and extrapolate the recent past such as interest rates and inflation will continue to rise indefinitely without considering debt levels and growth in credit and money.

But what if we looked closer at how money flows through the economy, would this give us some perspective on which potential assets may thrive more in a high consumer price inflation/below trend monetary inflation paradigm such as the U.S. dollar trade-weighted index?

So rather than using the current inflation reports and extrapolating the past into the future, should we try to determine the cause/effect relationships and potential lead/lags between money/credit growth and price changes across consumer goods and assets?

This is why Global Liquidity trend (with a 6-mth lead) are incorporated into our investment process through the Global Risk Indicator to signal whether we should invest in the Risk-on portfolios or Risk-off/Safety portfolio.

Current consensus estimates for the S&P 500 Operating Earnings per Share are $239 for 2023. This appears at odds with declining liquidity growth over the past 9-mths and we expect this trend to continue as rate hikes are expected to continue as consumer price remains elevated. As a result, it does not appear that the market has discounted an earnings recession yet, which may mean more downside from where we are today, given that we have yet to see the outcome of the tighter money from 2022 into 2023 to 2025. There are many indications of slower growth ahead, but central banks do not want to repeat the stop-and-go policies of the 1970s and ensure that the inflation dragon is slayed and are expected to stay the course. However, given that debt-to-income levels are far greater now then in the 1970s, financial stability may come to the forefront as the most important concern and rate hiking abandoned.

September 2022: Comparing Mortgage Rates/Housing Prices In Canada across Time…..

The increased value of housing and stock prices on paper makes consumers feel more confident in the economy’s prospects. Feeling more confident, they spend more and become more willing to buy goods and services by taking out more credit increasing their risk appetite. We have covered these concepts in a previous post.

Our financial system supports asset values by increasing credit creation over time. Each time a bank creates a loan, a corresponding deposit is created through the banking system, which adds to the money supply. Money is used to purchase goods and services and accumulate and save for a property. As the money supply grows, cash is devalued against assets (financial assets, real estate, commodities, art, etc.), causing nominal prices to rise. As a result, households feel like they have more wealth and believe as they are richer they may be able to spend more on luxuries such as new computers, the latest technology gadgets, vacations, additional cars, and homes increasing private demand through consumption and investment.

As home values rise, homeowners find it easier to borrow using their home value as security for either home renovations or consumption spending. If this ‘wealth effect’ is strong, it could leave the economy more vulnerable to adverse events, such as a large decline in house prices. We saw in the run-up to the 2007-2008 recession home equity extraction was potentially being used by households to finance spending in the U.S. The combination of the pullback in house prices and job loss reduced consumption significantly in 2007-2008. We saw in 2020-2021 a similar trend of housing/consumption moving together – well above trend. Historically, large price increases well above trend have resulted, in large declines, including a reduction in household spending. Hence too much reliance on residential real estate and the wealth effect/consumption could have issues for some countries’ financial sustainability going forward.

As a request from a subscriber, we have reviewed the Canadian housing/mortgage market below which complements our previous post.

The window for a soft landing is closing…. Deep Dive into the US LABOUR MARKET, INFLATION,  and Bear Markets

At Beowulf’s Treasury we focus on Leading Indicators and market sentiment to help supplement our trend-following portfolio strategy, along with fundamental research.

The Labour Market is strongest right before a recession (Unemployment rate tends to be lowest/Wage growth highest). The payroll report in early August surprised to the upside with 2x jobs added versus consensus expectations. We note however, Inflation and unemployment are lagging indicators. The loosening of Financial conditions (lower interest rates, lower US dollar, low energy prices) in 2020/2021 (from 18 months before) gave rise to increased aggregate demand (goods/services), along with significant changes in consumptions patterns (goods favoured to services when we were sheltering in place/working from home during COVID-19) that created supply disruptions and in turn increased the demand for labor.

Following leading indicators such as the credit cycle/peaking in home prices may provide keys to when the unemployment rate (follows a home price top historically 12-15 mths) may start moving up. We note that Home Prices for most jurisdictions peaked around January/February 2022 and continued to decrease as Financial conditions have tightened. We have noticed that Job Openings have declined by 1.2 million roles since April 2022, though the ratio to Unemployed workers remains elevated. Wage growth has decelerated by about 50 bps since March 2022. We note its more important to follow the Rate of Change in the Job Openings-to-Unemployment ratio against Wage growth, rather than focusing on the absolute number of the ratio. Initial jobless claims have increased since March 2022 and a number of companies have recently announced layoffs which are potentially not counted in the statistics yet. Generally speaking work hours, job openings will start to decline about 6 months before we see a move in the unemployment rate and we are seeing this now.

On the Inflation front, Global supply chain pressure has eased (partially due to remix of consumption to services from goods), however, higher acceleration in labor and shelter costs, impacting core inflation, have not been considered. As we have noted before, with tightening financial conditions, world trade declines and therefore global supply chain pressure reduces.

Loosening of Financial condition from June-August 2022 (lower real rates based on lower inflation momentum) has resulted in additional risk-taking/high-beta equities up in the last couple of weeks. There has been much discussion of a Central Bank pivot now that inflation momentum has slowed in July. However, it is expected that Central Banks will remain restrictive from a policy perspective going forward until inflation momentum significantly slows (i.e. a number of months of flat or declining inflation prints before pivoting from hawkish stance) and inflation is much closer to the inflation objective of 2%.

Changes in Financial condition (i.e. tightening of rates, higher US dollar, and higher energy prices) take about 18 months to see the results and flow through the economy and impact consumer and corporate behavior. Current tightening is expected to result in a 15-20% S&P 500 EPS decline in 2023 based on historical correlations holding. This is much lower than the current consensus growth of 5% for 2023.  If corporate earnings growth is lower as implied by the relationship with financial conditions, labor markets are expected to continue to weaken into 2023.  Q2/2022 EPS report may mark peak cyclical earnings growth.

Recessions have followed Bear markets ~70% of the time. Bear markets along with recessions tend to be long/drawn out before new equity market highs tend to be associated with tightening of financial conditions in the preceding 18 mths (1981/82 (471 days before new high), 2000-2002 (999 days), 2008-2009 (525 days). There were numerous bear market rallies. A market trough or bottom tends to occur when evidence of loosening financial conditions and significantly lower equity market allocations in investor portfolios (lower by ~10% to 15% from original position). Bear markets with no recession, tend to be associated with loosening financial conditions (weaker dollar, lower rates, etc.)  (1987/1997/1998) in the preceding 18-mths. As a rule of thumb, deviation from the 13612W3 Moving Average of -3.0 Z-Score or Lower has historically provided a margin of Safety and a higher probability of success in the next 12 months. Given the current macro setup and history, investors proceed with caution if capital is deployed into equities in current markets. Please enjoy our research in the attached pdf.

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