Global Liquidity and better-than-anticipated January data (inflation, payroll, ISM surveys) have supported markets this year so far…Will higher global liquidity offset cyclical weakness via Central/Commercial Bank tightening?

Global Liquidity/Monetary Policy: Central Bank balance sheets (reduced Quantitative Tightening pace since October/22 in the U.S.) appear to be expanding and used to maintain financial stability while slowly withdrawing support without creating significant bond market volatility/sovereign issuers and strongly rated corporates. Supporting equity markets appears to be a by-product of supporting financial stability and credit markets. Earnings multiples (P/E) are altered by liquidity/interest rates/monetary policy, which is largely what we have seen so far. Earnings expectations are coming down.

Does China’s liquidity impulse kick off restarting the global manufacturing cycle that would support corporate earnings and further global consumption and/or another wave of global inflation via higher commodity prices?

Overnight rates/tight monetary policy is being used to manage demand/inflation. The 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. U.S. Liquidity has continued to decline close to 3% per annum. Coupled with higher interest rates, Commercial banks are also tightening credit standards, which has reduced demand as well historically as liquidity becomes scarce and some customers are not able to roll their debts and eventually default.

Leading indicators have continued to decline and have bottomed and point to a recession in H2/2023. Coincident indicators are still marginally positive, though growth is slowing. The labor market has yet to see significant stress, though there have been lower hours, less temporary staff, part-time and less job openings. These trends tend to occur before full-scale layoffs. Corporate profits expectations will need to deteriorate further before higher layoffs. An uncertain macro environment is supportive of a trend-following strategy (floating rate bonds (TFLO), Chinese Bonds (CBON) and gold (PHYS or GLD) for the current month).

The U.S. housing has yet to bottom. Home prices continue to fall and appear to have more room to fall. Usually for the economy to bottom, the housing sector will need to bottom. Jobless claims tend to follow the housing market on a 10-12 month lag. At this point, the labor market has remained tight and there may be evidence of labor hoarding, which may be partially related to the monetary illusion related to revenue in high inflationary environments. As margins erode due to higher costs and/or sales volumes decline, eventually businesses will cut labor. At this point based on leading indicators, housing and manufacturing sectors appear to be in recession (industrial production -2% on 6-mth smoothed change). We note that inventory-to-sales ratio (tends to spike during recessionary conditions) have continued to climb, which point to more disinflationary trends in forms of price discounting and lower expected future manufacturing activity.

Current corporate operating earnings for FY2022 (92% reported Q4/22) of $196/share, down 6% YoY. FY2023 earnings expectations have been lowered from $225 to $220/share, representing 12% YoY growth and projecting an earnings recession in H1/23 of (4%).  We have seen signs of higher costs reducing profit margins that cannot be recouped via higher prices. Nominal revenues have held up given the monetary illusion of inflation. Inflation-adjusted revenues have remained flat since the middle of 2022. Corporate profit margins are expected to deteriorate further (with 4x companies providing negative outlooks vs positive in Q1/23). Historically, this has led to employer driven-layoffs outstripping employee-driven quits, leading to wage growth coming back closer to the trend. Current consensus 2023 S&P EPS is about 30% above the long-term trend line (earnings growth of 6%) which goes back to the 1880s. Our leading earnings indicator (1-year lead) has us back to the trend line by the end of 2023. Recessions tend to get us back to trend.

Disinflationary trends remain, but appears some service categories remain sticky into H1/23 keeping core inflation elevated at 3.5-4.0%:

Above-trend wage growth due to tightness in the labor market may keep inflation elevated above 2% target in 2023/into 2024 without a recession. Job-switchers have earned a premium of 1.5% higher than job-stayers, which is well above the long-term trend of 0.5%. Employees continue to have bargaining power, though expected to decline over the next 12 months, with wages closer to pre-COVID trend of 3.3%.

Given the pace of the rate hikes in 2022 and lagged impact on the economy, we likely have not seen the full impact of the tightening yet. Monthly coincident data (based on Jan/23) data, growth appears to be re-accelerating employment and personal income growth (though a number of restatements/seasonal adjustments), however, high-frequency data and leading data point to further deterioration. We expect that January data may be revised at a later date.

Global Liquidity growth is almost back to positive in December,  but signs of economic deflation and weakening demand…

Global Liquidity Growth in December (the latest available month) of (0.3%) was far below the trend growth of 7% but 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. U.S. Liquidity has continued to decline close to 4% per annum.

China’s recent reopening by abandoning zero-COVID and policy support of the property sector via easing the “three-red-lines” policy through more liquidity has enhanced market sentiment across all markets (equities, bonds, and commodities).

The reopening of China and related policy easing may provide an additional deflationary impulse from supply chains, partially offset by potentially higher commodity price inflation later in 2023. Also weakening of demand in end clients (U.S., Europe) via higher interest rates and inflation may not support cyclical uplift in the global manufacturing cycle as we have seen in past cycles (2011, 2016). We have covered the China reopening and its potential implications in more detail in the second part of this document.  This catalyst supported risk assets during January 2023, with the MSCI All Country World Index (ACWI) up 7.5% during the month.

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. Month-over-month liquidity growth momentum has increased as China has increased liquidity and long-duration assets have reacted positively (equities, REITs, and Bonds). Long Duration Equity/Bonds Returns tend to be positively correlated with Global Liquidity growth. With weak general liquidity/funding conditions, allocation to the Safety portfolio is prudent.

This month’s allocation within the safety portfolio (Gold, Chinese Bonds, US Investment-grade bonds)  reflects the market’s anticipation of the continuation of deflationary conditions into 2023 and further global liquidity growth momentum coming back to trend, which may kick off the next cyclical upswing. For January 2023, the Trend-following strategy and investment in the Wave Runner/Safety Portfolio have generated 5.9%. We are starting to see positive momentum in many of the factors in our global risk indicator that may switch at some point to “risk-on” in early 2023 such as improving the Copper-to-Gold ratio, and risk-on sentiment (Discretionary vs Staples). However, we have yet to see Housing Starts bottom yet.

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 13 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 yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows. We are starting to see indications of a bottoming process. The S&P 500 2023 Consensus EPS is expected to come down in the near term. 

Cyclical growth from China may be lower than in previous cycles as credit growth appears to be ~50% of the previous cycles (2011, 2014, 2016, 2020). Policymakers are not constrained by too-high inflation, and the economy is operating below potential. However, policymakers are also exercising self-restraint against the excesses of “flooding” the system with liquidity and overleveraging. Policymakers must walk a fine line between supporting housing rather than importing commodities, building, and increasing the housing supply for the sake of simply growing GDP. Speculation has made Chinese homes the most expensive in the world on a price-to-income basis.

The property sector is the largest single sector in China’s economy and its ups and downs usually have a meaningful impact on headline GDP growth. About 70% of homes sold since 2018 have been bought by people who already own at least one property. Higher household “excess” deposits appear due to lower housing sales and potentially residing in the upper end of the wealth distribution and consumer confidence is low in China. Much attention has been paid to U$2T domestic deposits available for deployment, however, current sentiment may not be supportive of ‘excessive consumption’ to offset the rest of the world slow down.

Achieving a 3-5% trend GDP growth will require more focus on driving private consumption in China. Household consumption is less than 40% of China’s GDP as of 2020, versus a global average in other countries of roughly 60%. 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 objective.

Restoring confidence remains crucial for the consumption outlook. Consumer confidence has appeared quite dampened in 2022, and we expect some improvement in 2023. Households’ confidence is closely linked to property prices, food price inflation, and stock market performance – we expect almost all drivers to argue for stronger consumers into 2023, but may not be able to offset weakened demand from the rest of the world. We will continue to track how this story plays out.

This week we have reviewed cyclical and secular trends as it relates to growth and inflation and how these trends may impact asset markets.

But first, an analogy to help us work through the current environment. For those of us that have driven in winter conditions and snowy roads (similar to the picture above), the first rule is to drive slowly (even with snow tires). It’s harder to control or stop your vehicle on a slick or snow-covered road. Increase your following distance enough so that you’ll have plenty of time to stop for vehicles ahead of you. Take the time to learn how a vehicle handles under winter weather driving conditions.

We use this analogy for the challenge that lies ahead for the central banks as they are driving on a snow-covered road (a slowing economy) and have several potential options: 1) keep increasing rates and cause a significant economic downturn (going over the cliff as you round the curve in the picture above) 2) pause and wait for the lagged impact of existing rate hikes/potential economic damage, and 3) start easing off too quickly and have inflationary pressures re-emerge quickly.  

1) Cyclical Trends

Stock markets have been positive 2023YTD and trading close to the 200-day moving average: this appears to be a technical reversal given the bearish sentiment coming into 2023 (weak H1/23, followed by H2/23 recovery). With inflation momentum slowing, a soft landing has become a potential market narrative and financial conditions have loosened since November, however, leading indicators point to further economic pressure and lower EPS in 2023. China’s re-opening and liquidity impulse is expected to be positive and may offset weakness from the rest of the globe. 

Current corporate earnings trajectory may be unsustainable (S&P 500 EPS for 2023F at $225/share represents 13% growth over 2022F) and profit margins are elevated – well above historical trend and margins have reverted to the mean. Consensus EPS have not considered an Earnings recession in 2023. Recessions tend to have (23%) declines in Earnings during recessions since 1949. Based on survey data, pricing power has been diminished and increased labor/input costs are outstripping price increases which compress operating margins. This behavior has lead to layoffs in the past.   Q4/22 Earnings season has kicked off this past week and we expect a lowering of future 2023 guidance over the next few weeks.

Disinflationary trends: Despite the headlines, wages and inflation momentum are falling in lock step back to pre-COVID-19 trend lines. Slowing energy prices have reduced inflation momentum as well. The Fed and administration need to keep inflation expectations anchored to keep interest rates manageable and avoid a similar sovereign debt crisis as we saw with UK in 2022. Bringing down energy prices has been major help in alleviating a surge in inflation, which then influences inflation expectations. A big driver behind the fall in Energy prices has been the Strategic Petroleum Reserve (SPR)  – a reduction of 50% during 2022. Given the pace of the rate hikes in 2022 and lagged impact on the economy, we likely have not seen the full impact of the tightening yet.

Leading indicators continue to decline and have yet to bottom and point to a recession in H2/2023. Coincident indicators are still positive, though growth is slowing. The labor market has yet to see significant stress, though lower hours, less temporary staff, part-time and less job openings. These trends tend to occur before full-scale layoffs. 

An uncertain macro environment is supportive of a trend-following strategy (long-term bonds, gold, and IG Bonds for the current month)

2) Secular Trends

Corporate Earnings and Stock Price (going back to 1881) are well above long-term trends. Recession tends to bring back EPS/prices to historical trend line.

Shiller’s Cyclically Adjusted Price-to-Earnings Ratio (CAPE) (10-year Price-to-earnings) ratio can be modeled using a macro multifactor model of long-term growth and inflation, cyclical deviations, and volatility of growth/inflation.

1)Multifactor Model based on CAPE (dependent variable) and independent variables (average growth (industrial production) over trailing 10-years, average inflation over trailing 10-years, macro uncertainty (standard deviation of growth and inflation over last 10 years), 3-year growth as % of 10-year growth, 3-year inflation as % of 10-year inflation and macro uncertainty (3-year standard deviation of growth and inflation as % of 10-year standard deviation of growth and inflation. )

Higher long-term inflation above 4% and associated inflation/macro uncertainty have historically compressed CAPE below the average of 22x. Historically, valuations/wealth are maximized in low, stable interest rate environments (1960-1970, 1992-2022).

Less globalization/war/pandemic increases macro uncertainty.  Macro uncertainty leads to equity market volatility and reduces valuations/wealth.

Secular forces that have been sped up as a result of COVID-19 (de-globalization/war/multi-polar, larger wage share of GDP/populism, increased wealth/income equality, de-carbonization) point to higher trend inflation (beyond the target of 2%) and more inflation uncertainty. This points to trend inflation between 2.5% and 3.5% going forward and may compress the CAPE ratio closer to the average of 22x from current 29x.

1)Based on the multifactor model Core PCE (dependent variable) and independent variables (Income/Wealth Distribution), Globalization (imports as % of GDI), Employment-to-Pop (25-55 years), Commodity prices, Technology adoption, and Federal Debt as % of GDI. Trained on the 2010-2019 period. 

Happy New year to everyone! We wish you a happy and prosperous 2023.

Review of 2022 and 2023 Outlook

1)In 2022, the Buy & Hold Balanced Benchmark of 60% US Equities and 40% US Bonds had the 6^th worst year since 1871. Portfolio diversification was non-existent as Inflation uncertainty dominated growth uncertainty causing bonds and equities to be positively correlated.  About 65% of the time, the balanced portfolio is back to positive returns the next calendar year after falling the previous year.

2)Equity markets have yet to reprice for potential earnings recession and the current market has repriced earnings multiples due to higher discount rates.  The current EPS Projection for 2023 is well above the trend line (25% above) and tends to mean revert over time (i.e. recessions) due to lags of monetary policy.

3) Current recession probability in the U.S. for the next 12 months is 61% based on the yield curve (10y3m) regression, model. Fed Funds Rate (FFR) (overnight rate) has been higher than the 2-year Treasury rate towards the end of December. Usually, the 2-year rate falling below the FFR has historically been a sign of lower FFR in foreseeable future (within 6 months). 

4)Gold prices are starting to anticipate deflationary conditions and potential responses by central banks through global liquidity increases, yield curves re-steepening, and real yields declining. Central Banks have also be increasing their share of gold as a % of their overall reserves in recent months (China/Russia) as the world trade moves away from globalization/US dollar financial system to a on a multi-polar as the US and China look to decouple their interests due to strategic competition. Re-opening of China also supports demand for gold in the near-term.  Also, the potential for decline of investor trust in the financial system is supportive of gold outperformance relative to equities as liquidity growth increases in an environment of higher than average geopolitical risk. 

5)Credit Standards appear to be tightening along side increases in interest rates. Reduced Credit Availability tends to precede prior recessions and widening of credit spreads/increased equity market volatility.  An important metric to track going forward – High Yield Credit Spreads. High Yield Spreads have widened this year but does not seem to reflect the trajectory of tightening of credit standards and interest rates expected ahead to counter inflation. 

Model Portfolio Summary (January 2023)

1) Global Liquidity Growth in November (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. Month-over-month liquidity growth momentum has increased as China has increased liquidity and long-duration assets have reacted positively (equities, REITs, and Bonds). 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. Commodities’ momentum (Natural Gas, Gasoline, Oil, Wheat) has waned in the current month suggesting slowing demand growth.

2) This month’s allocation within the safety portfolio (Gold, Long-term US Treasuries, Investment-grade bonds)  reflects the market’s anticipation of deflationary conditions into 2023 and further global liquidity growth momentum coming back to trend. For FY2022, the Trend-following strategy and investment in the Wave Runner/Safety Portfolio have generated 3.2% in FY2022, which is far superior to the balanced portfolio benchmark of (18%) (all model portfolios beat the benchmark in 2022).   

3) 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 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 12 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 yield curve slope starts to steepen and has positive momentum, and Coppock curves are at their lows.    

4) We have begun to publish Coppock curves (which we covered in previous posts) for each model portfolio to track the bottoming process.

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In this post, we cover the recent data regarding the state of the global economy focusing on recent employment and inflation reports (lagging indicators) and trying to glean if we can see the light at the end of the tunnel of the rate hiking cycle/reduction of liquidity.

We have noted in the past the importance of including liquidity trends and market risk appetite and have included this in our global risk indicator to determine when to take additional equity market risk.

The following are the key themes we are tracking:

1)Global Liquidity Trends: Liquidity growth is still well below trend growth, but may have bottomed in September, as in October China’s Liquidity increased, US Liquidity Index continues to tighten overall. Lagging indicators (Employment and Inflation) continue to be at late-cycle levels. Liquidity trends are expected to drive equity markets going forward, so we are going to continue to pay attention to shifts in momentum. As liquidity increases, we expect the $US dollar to continue to weaken, potentially increasing future US corporate profits.

2)Employment growth in November remained positive, though growth trend starting to follow interest rates on a lagged basis (~18-mths historically). There are long variable lags of monetary policy which take time to flow through economy and have only been in the rate hiking cycle for last 9 months. We are seeing deterioration across rate-sensitive industries in which layoffs have tracked the uplift in rates and tend to lead over all employment trends. Most leading indicators of employment have declined and high frequency data such as increasing initial jobless claims/ layoffs, and daily tax withholdings, and contractors have slowed/declined year-over-year pointing to future wage growth slowing.

3)Transportation, Supply Chain and Consumer: Transportation/freight trends have recently weakened and supply chain pressures have subsided. Consumer has remained strong, though credit availability tightens at the same time as interest rates flow through the economy putting pressure on future retail sales and continues to increase inventory levels relative to sales.

4)Inflation remains elevated but has peaked and momentum is slowing given that demand for goods appears to be declining. Momentum across most inflation-leading indicators has continued to decline throughout 2022…The implied shadow Fed Funds rate appeared to peak in October/November and remains above inflation. We are watching the yield curve slope to see if the yield curve starts to steepen (i.e. 2-year rate declines more than the 10-year rate) as central banks start to consider cutting overnight rates, given that the yield curve first inverts, then steepens right before the recession. Based on our research, we note that equity markets tend to bottom when the yield curve troughs and steepens and continues to steepen.

5)US Equities – Valuation/Earnings:

Valuation multiples have recently expanded slightly potentially due to higher net central bank liquidity month-over-month in November – we continue to track this trend. If the Fed sticks to Quantitative Tightening plan of ~$90B per month, we could see S&P 500, re-test October 2022 lows of 3500 if prior correlation holds.

We do not believe a recession has been considered in consensus earnings as consensus EPS of 2% compares with earnings recession of average (23%) from prior recession since 1949 and (25%) estimate from tightening financial conditions from 18-mths before.

6)China Update: China’s growth has been slower when US Dollar has been strong. Industrial Profits declined 2% in October. Credit and money growth in 2022 has been below trend and appears to have bottomed.  Appears that China may gradually turn back on the liquidity taps to support economic growth which could partially offset recession conditions in the rest of the world. Generally, recent global slowdowns when liquidity was tightening, have been offset by liquidity growth in China (2008-2009, 2016-2018). Though given the debt levels/real estate market and potential for higher inflation of imported goods and services, the liquidity provision is expected to be less than prior liquidity injections, so may not offset the potential global recession. Emerging from COVID lockdowns may increase liquidity and commodities prices as well, driving inflation higher.

7)OECD Composite Leading Indicators (CLI): Most countries’ OECD CLI point to slowing economic growth in coming months, however, there appears to be a turn in trend change in OECD CLI momentum as 43% of countries have increased month-over-month….Is there light at end of the tunnel? Could China’s reopening and economic support via liquidity avert the global recession?

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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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.  

  

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.