Global Macro: Has the Fed Abandoned Its Inflation Target? ft. Andreas Steno & Darius Dale

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0:54hi everyone and welcome back to real vision and this macro deep dive my name is andrea steno and I always look forward to host a true gentleman, but also one of the best macro watchers out there, Darius Dale of 42 Macro. It's great to see you again, mate. Great to see you, brother. And thanks for the super kind introduction. I don't know if I deserve that, but I'm great to be here, man. Thanks. It's always good to be here with the Real Vision gang as well. So hope all is well and you're in. Darius, we had a tumultuous last week in US macro markets. We had the CPI report out and we also had the retail sales report out.

1:31And it seems like we're kind of standing at crossroads here with inflation softening a little bit, but also some signs in some of the reports that we get from the U.S. economy of cracks appearing. So how do you view the U.S. economy after this week of data? Yeah, that's a great question. So I agree with the characterization that we are at a crossroads from a fundamental standpoint. We are sort of cresting off the top of what has been a very positive, uninterrupted string of accelerating growth dating back to the second half of 2022. I recall that we were on the right side of that when we offered our resilient U.S.

2:08economy theme back in the summer of that year. And we're sort of kind of getting towards the end of that process, albeit we don't necessarily agree with a lot of the bear porn out there that the U.S. economy is in or near a recession. We do expect growth to slow, but we expect growth to We anticipate that growth will generally surprise consensus expectations to the upside throughout the duration of our next 12-month forecasting horizon. And at some point, that'll change. Either consensus expectations will catch up to ours or, you know, we'll eventually kind of merge towards the end of that process.

2:41But for now, we are seeing growth with a negative delta. But again, that delta is not as bad as what consensus is currently expecting. On the inflation side, we have been appropriately calling for inflation to slow and surprise consensus expectations to the downside. We got that, obviously, with some elements of the DBI and CBI reports this week, and those are confirming of our expectation. We are starting to, at least according to our models, get towards the end of the inflation decelerating process. Currently, we are expecting inflation to sort of meander lower over the next couple of months before kind of bottoming.

3:16And once we get into the first half of next year, our projections show that inflation will really start to accelerate again. And that's consistent with how inflation has historically behaved in the business cycle. There's really no time series history of inflation breaking sustainably below trend in the absence of a recession. And so in the context of our deep dive on the business cycle, we are going to stick with that view and our current model projections for inflation to start to really accelerate again in the first half of next year. that's wildly divergent from consensus, which is essentially calling for a very durable and sort of a perfect return to 2 % inflation.

3:53We take offense to those projections, but again, we don't think there's really any market risk to deal with now as a function of that. We think that's more of a first half of 2025 trade. So we can unpack any of that as you like and kind of drill down from there. So Darius, one question related to the inflation cycle. We're currently, say, between 2.5 % and 3 % inflation. And it seems like we're a couple of weeks away from the Federal Reserve commencing a cutting cycle. Does that mean that the Federal Reserve is no longer truly committed to 2 % inflation? And how do you read that cocktail of inflation above target and the cutting cycle commencing?

4:29Yeah, no, it's in our opinion, we think the Fed is kowtowing to fiscal dominance here in this poor turning regime, which is exactly what the Fed has done historically in poor turning regimes. I recall that one of the key dynamics that investors should anticipate in a fourth turning is an explosive growth of public debts and deficits and the Fed and how those debts and deficits contribute to above trend inflation. And as a function of that, the Fed has to use its balance sheet, use its monetary policy toolkit to engineer sort of excess demand for treasuries relative to where the actual market demand for those securities might be.

5:07And so as a function of that sort of foreturning style monetary policy, we do not believe the Fed actually wants the Fed, the U.S. economy to return to durably to 2 percent inflation. We ultimately understand that in order to get a durable trend of 2 percent inflation, you would obviously have to slow past 2 percent from these levels so that the mean of the time series goes to 2 percent. And in order to do that, you would obviously have to push the U.S. economy into a downturn, and we do not believe there is any political will on the Federal Reserve Board to push the U.S. economy into a downturn.

5:40So this is something we've been talking about, Andreas, here at 42 Macros since the beginning of 2022 when we authored our sticky inflation theme. Well, the key takeaway from that theme is that we were probably going to have a jump condition higher in the underlying trend of core PCE, i.e. that inflation wasn't transitory. Recall that that was a debate back then. And so I think we've been proven right on the fact that inflation was not transitory, and ultimately it's likely to settle out at a level that is inconsistent with the Fed's 2 % target. But again, we don't believe that they are willing to do what it takes to generate 2 % inflation on a sustained basis.

6:17We think 3 % is the new 2%, and ultimately we're going to figure that out as investors as we progress throughout 2025. But again, I don't know if there's any market risks today to deal with associated with that. There is looking at the details from the last inflation report, a couple of the good old culprits, shelter costs and transportation services kept the inflation momentum intact to a certain extent. So how do you view the path towards 2 %? Is it even a feasible scenario to discuss PCE inflation at 2 % before year end? Or how do you view the path given these shelter and transportation services components still being elevated?

6:55Yeah, I mean, so we could see 2 % inflation by year end, and we already have below 2 % inflation when you look at it on an annualized basis, you know, specifically the three-month annualized rates of change for inline and core BCE already at or below trend. But we just do not believe that they're going to durably stay there if the economy continues to expand, because that's kind of the historical progression of the business cycle. So let's kind of talk about the business cycle and how inflation has historically sort of evolved in the business cycle. I think that's a really important determination to how investors should be thinking about inflation from a, you know, kind of one year forward plus time horizon perspective.

7:33So if you throw a slide 44 here on the screen, Nick, where we show our business cycle analysis. So what we did, we did a big deep dive study to help our clients understand how the business cycle works and how the various cycles within the business cycle work. And essentially, the study involved stacking the time series on top of each other instead of sort of analyzing them in linear format so that we can assess how they have historically evolved in and around business cycle downturns and in and around business cycle recoveries. And so this chart on the left just shows the median trailing 10-year delta-adjusted Z-score in months before and after recession before with zero being a recession.

8:13And so what we mean by delta adjusted is that we just invert things that are rising, that are countercyclical to the business cycle so that the chart is easier on the eyes. And so in terms of how the business cycle works, typically you have policy sort of breakdown or in straight terms break out kind of about 15, 18 months ahead of a recession. Then you have profit, corporate profits breakdown about three to four quarters ahead of a recession. Then you have liquidity breakdown kind of simultaneously around that or maybe a quarter after that. And then you have growth breakdown. Then you have stocks breakdown.

8:43Then you have employment breakdown. Then you have credit breakdown. Then you have inflation breakdown, which typically happens somewhere around, you know, three to four quarters, sorry, four to five quarters, actually, after a recession has started. So the key takeaway from this analysis is that you should not, as an investor, expect a sustained breakdown below trend in inflation in the absence of a recession. In fact, there is no in all these. So this is the median value from the 12 or 13 business cycles that we've had in the U.S. economy since in the post-war U.S. economy. And in fact, there is actually no business cycle in the post-war U.S.

9:17economy where inflation broke down sustainably below trend before recession started. And so we do not believe there's a high probability of recession over medium term time horizon, which in our nomenclature is three to 12 months from now. And so as a function of that, we are expecting the inflation time series to cycle lower over the coming months, bottom and start to meander higher in Q4 and really start to really materially accelerate in the first half of next year. Yeah. So, Darius, in relation to this recession discussion and the spillovers to inflation, we've seen a couple of months. Have you ever wanted to trade Bitcoin but haven't dared try?

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10:52rising unemployment in the US economy. We've even triggered the so-called SAHM rule. The author of that rule, Claudia SAHM, released a block immediately after the rule being triggered, saying it was not meant to be triggered because we have an increasing labor force and that's not how it's designed. So how do you view the unemployment rate, the labor market, and the spillovers to inflation in relation to this recession discussion? Yeah, it's a great question, man. And we actually published our lead-off morning note, I want to say, right before she posted that blog. Sorry, right after she posted that blog.

11:30And our analysis was we shared the same conclusion, which is that the unemployment rate is rising primarily as a function of the growth of the labor force, not as a function of the growth of people getting fired from the labor market. Now, we understand, however, that the labor market is cooling and softening. But we again, as I mentioned, we do not see elevated risk of a recession over a medium term time rise based on the current, you know, based on the persistent leading indicators of the cycle and how they are currently trending. So if you go to slide 27 here, Nick, we show that same analysis.

12:02So again, the median trailing 10-year delta adjusted Z score in months before and after recession begins. These are some of the higher frequency variables in the labor market that have been proven to be leading indicators for the broader business cycle. So in terms of these indicators, temporary employment is kind of the longest leading indicator. Then the University of Michigan Employment Survey breaks down. Then cyclical unemployment breaks down. That's the total number of people who are on total number of unemployed that have either have just been fired, or they have completed temporary jobs.

12:29Then you have the conference board's labor survey breaks down, then GDP growth breaks down, and then you have initial jobless claims, continuing jobless claims, and so on and so forth, breaking down with employment being the most lagging variable in that particular process. And so if you can see how they're currently aligned today, you can see that these leading indicators are sort of slowing and below trend in the way that growth is not. So we would expect over the medium term for growth to catch down to how these indicators are currently performing. So that's kind of step one. We do expect the labor market to continue softening.

13:01But as I mentioned earlier, we are not of the view that the economy is heading into a trend. So, and as I mentioned, this is how the business cycle is currently performing with respect to that business cycle analysis that we highlighted earlier. And as you can see here, the leading indicators of the business cycle, specifically with respect to growth and employment, things like corporate profit cycle, liquidity, and the policy, with the exception of the policy rate, those things are not necessarily suggesting that we are heading for a business cycle downturn. You would expect to see the chart on the right in these analysis look more like the chart on the left if we were in fact heading to a recession, let's call it three to four quarters from now.

13:39Right now, it's just very much not the case in terms of how the business cycle is performing. If you look at the corporate profit cycle specifically, which is one of the longest leading indicators of the broader business cycle, the corporate profit cycle right now is an ubiquitous accelerating upturn right now. So if you look at how that cycle has historically performed, Nipple Corporate Profits lead our corporate profitability model, which is how we track corporate margins on a real-time basis, which follows that. And then you have household net worth breaking down, then S &E 500 trailing 12-month earnings breakdown, then next 12-month earnings breakdown.

14:12Then you finally get the breakdown in gross domestic income and corporate net worth. And just none of that stuff is happening right now. In fact, we have the opposite happening right now in terms of a ubiquitous upturn in the corporate profit cycle. So in our opinion, we don't think there's limited recession risk over the medium term from this variable either in terms of this leading indicator of the broader business cycle. And then finally, I'll say non-farm productivity. When you look at some of the other indicators in the labor market, the more slower moving, lower frequency variables like non-farm productivity or private sector hours work.

14:42Those are the two longest leading indicators within the labor market cycle. non-farm productivity and hours worked in the breakdown, let's call it two to three quarters before, sorry, two to three quarters for hours worked, three to four quarters for non-farm productivity before a recession begins. And again, this is data using all the data that we have available for the post-war U.S. economy to determine how the median path these indicators have taken prior to recession. And we have a ubiquitous upturn, an accelerating upturn in and non-profit productivity, private sector hours worked are below trend.

15:15And so we would expect growth to kind of catch down towards that, but they're not, the direction of travel is not in a way, one that suggests we are likely to have a recession with medium term. So that's kind of a long-winded data-driven way of saying the bear porn that a lot of investors are sort of suffering from out there in terms of not being able to make money on the long side of risk assets. In our opinion, that bear porn is misplaced, but at the end of the day, it's never going to go away because that's how fair-form purveyors get paid. Yeah, you're absolutely right, Darius. When you look at the unemployment rate, assuming that there is an actual increase in unemployment and that we cannot just explain this away with an increase in the labor force, as an investor, it's obviously sad that we see an increase in unemployment.

16:01But as an investor, does the unemployment rate even hold any signal value when you asset advocate? I would argue no. And so going back to our business cycle analysis here on slide 30, the market cycle, so stocks tend to break down. If you're late in the business cycle, stocks tend to break down before the overall employment cycle. And so if you understand that, if you understand that, you should not be looking at things like the labor market to figure out where the markets are going. If you want to figure out where the markets are going, you have to pay attention to the cycles that lead the market.

16:35And that's the policy cycle. That's the corporate profit cycle. That's the liquidity cycle. And then ultimately the GDP growth cycle. And those cycles are, as I mentioned, are not aligned in a way that suggests we're going to have a significant breakdown in stocks over the coming, over the medium term. Now that will eventually change. We'll use the same exact analysis to say, okay, things are changing and evolving in a way that That suggests we are headed for something that's really materially negative. But for now, again, I think it's just misplaced to be focusing on the employment cycle as a leading indicator for stocks, because that's not how the business cycle works.

17:07The business cycle works in the reverse order relative to kind of the bare part we're hearing out there. And then one thing I'll say, actually, two things I'll say with respect to the labor market cycle, because while we're on the subject, I think it's an important thing to unpack with respect to this kind of labor hoarding phenomenon, which has been a contributing phenomenon to the resiliency of the U.S. economy, which is something we've been highlighting throughout the duration of our resilient U.S. economy theme, which is almost two years old now. And so if you look at this chart here, what we show on slide 37, we show Joe's total job openings divided by total unemployed workers.

17:40That number has been slowing sharply for the past couple of years, and it's kind of nearing a trend level. The private sector hires rate, that's at 4.1%, and that's below trend now currently. The private sector quits rate, that's at 2.3%. That's below trend. So all these things are suggesting that there's slack being created in the labor market. However, we are not seeing people get fired in the labor market. And that's where we get this concept of labor order from. Because historically speaking, when you've seen slack created in the labor market, it's usually done through the actual layoffs and discharges rate rising, which it's not.

18:13It's actually at an all-time low of 1 % in the most recent month. And you also see a total employment falling. And it's not. Total employment continues to meander higher, whereas total job openings continue to grind lower. So this is the first time in the history of the time series where we had a significant divergence between the hires rate and the quits rate from the private, from the layoffs and discharges rate. And it's also the first time in the history of the U.S. labor market time series. And again, these time series only go back to 2001. So it's not a lot of business cycles, but it is noteworthy that it's happening.

18:43The first time here is that we have a divergence between job openings and total employment. So in our opinion, these divergences are not going to resolve themselves until we get an inflection in the corporate profit cycle, because, again, we know the corporate profit cycle leads the broader GDP growth cycle, which leads the broader employment cycle. Right now, as I mentioned earlier, we see the corporate profit cycles in a ubiquitous upturn, as evidenced by the trends in NIPA corporate profits growth and our corporate profitability model, which is a proxy for corporate margins. So finally, just kind of wrapping up, I'll take you to our grid model here for the U.S.

19:17Again, we see growth slowing over the medium term. We just don't see growth slowing as fast as consensus is expecting growth to slow. We're kind of getting towards the bottom of the sine curve with respect to inflation. And by the kind of the first half of next year, our projections are suggesting that inflation is likely to materially diverge, as I mentioned. So it's an interesting setup. But we're not as concerned about the economic outlook as a lot of investors, but we are more concerned about the medium term inflation outlook than most investors. And so that probably means that we are probably going to have less policy rate easing on a next 12 month type investment horizon than it's currently priced in the markets.

19:54And so I think that's one key takeaway investors should probably take away from this discussion. Yeah, good point, Darius. I read an article written by one of our colleagues at Bloomberg. He made a very simple study on the historical returns if you bought equities exactly at the date where the Claudia-Sam rule was triggered. And it was a very, very good timing to buy equities, actually, historically. So it goes to show that you're absolutely right, that this is a lacking component to look at in your asset allocation approach. But I want to ask you this, Darius, because, I mean, we have a lot of moving parts in the US economy right now.

20:37With unemployment on the rise, it is very easy to get worried about the economic outlook. And I get why a lot of people get worried about the outlook when they see headlines of rising unemployment. So how do you structure your asset allocation approach to sort of avoid being dragged into taking decisions by your feelings in such a scenario, if you know what I mean? Yeah, no, that's a great question, Andreas. So as you know, we're very systematic here at 42Macro in terms of how we help clients manage assets. We have two separate processes that we use to help clients manage assets, which is our KISP-for-Foil construction process, which is primarily designed to help retail investors stay on the right side of market risk.

21:17And then our discretionary risk management overlay, a.k.a. Dr. Mo, which we use to help professional investors and sophisticated retail traders stay on the right side of market risk. So with respect to where we currently are in our KISS portfolio construction process, we are currently at, you can go to the slide up from 11, Nick, slide 11. We're currently at 40 % cash. We're at 50 % of our max exposure of 60 % in the equity market, at least by ETF. and KISS. We're at 100 % of our max exposure of ag fixed income in the equity, in the fixed income market vis-a-vis the ag ETF. And we're currently at 0 % of our max exposure of 10 % in the Bitcoin asset class vis-a-vis the FBTCF ETF.