Immaculate Disinflation?

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0:56Are we experiencing immaculate disinflation? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Darius Dell, founder of 42 Macro. Hi, Darius. Welcome back. Hey, thank you, Maggie. Just getting back from my honeymoons, a wonderful time in my life. How you doing? I'm doing well. I'm doing well. And we missed you while you were away, but I'm excited that you were able to unplug. And we were joking about it because, wow, what a month November has been. I know you were working for part of it, but we had a lot of big moves in the markets, Dow and S &P up 8%. I mean, the action was a little bit mixed today, the Dow up and we saw the NASDAQ down, but S &P and Dow up 8%, NASDAQ up 10 % on the month.

1:41Treasuries put in their best month since the 1980s. It's just been crazy. Does it feel like too much has happened too fast? Has happened too fast. I'll just kind of hop right into it. Brian, if you can just throw slide one on that screen there where we show our positioning model. One of the things we track, we try to look at various indicators of positioning and sentiment to give us an idea of where the market might be headed over the very immediate term. And one of those models that we use is the spread between the AAII bulls-bears surveys. Right now, that spread is in the 91st percentile of all-time readings.

2:18You've got the bulls in the 86th percentile, the bears in the 10th percentile. And so that 91st percentile suggests that discretionary investors are very overweight this market right now, and the market has a decent probability of experiencing near-term correction. Now, is that the beginning of the end of this bull market? I think that's a different discussion we need to have. Yeah, absolutely. And you're echoing something that our guest yesterday said as well. And by the way, this is normal, right? Consolidation, digestion, whatever you want to call it. When you've seen these massive moves, it would be surprising not to see some sort of backfilling and adjustment as we go here.

2:54So we'll talk about that longer view in a moment, but I want to sort of get through some of the stuff today as well, because We have the PCE indicator out, the inflation reading that the Fed closely watches. That was in line with expectation. That's just one day after U.S. GDP figures were revised higher, 5.2 % for Q3. It's a good-looking mix. I mean, this has everyone talking about that mythical, immaculate disinflation again. What are you seeing on the inflation front? Yeah, so everything you just said is very much contributing to this Goldilocks regime, the markets have been in. Brian, if you throw up slide six in today's chart pack where we show core PC, the core PC deflator, the Fed's preferred inflation metric, and that thing is exhibiting a textbook deceleration.

3:41There's nothing you can say about this statistic that suggests we have problems ahead as it relates to the outlook for Fed policy. So right now we have the three-month annualized rate of change of the core PC deflator coming down. It decelerated this month. It's 2.3%. that's lower than the six-month annualized rate of change of 2.5%, which itself is lower than the year-over-year rate of change of 3.5%. So when you study the statistics, the probability of inflation continuing to come down on some of these more lagging measures is actually quite high. And as you can see from a levels perspective, we're right around the level that the Fed would be comfortable with if you're talking about somewhere between 2 % and 2.5 % core PC inflation.

4:23One other chart we show in terms of this immaculate disinflation, it's not just core PCE. So if you throw up slide seven, Brian, it's not just core PCE. The super core PCE deflator, which is something Jay Powell has explicitly called out in recent months as being one of these kind of core features, core drivers in the Fed's reaction function, this is also exhibiting a textbook deceleration. So we have the three-month annualized rate of change of the super core PCE deflator, which is core services ex-housing. That number decelerated to 2.6 % on a three-month SAR basis. The six-month annualized rate of change is 3%, whereas the year-over-year rate of change is 3.9%.

4:59So again, the probability, the likelihood that we continue to see downward momentum in the months and quarters ahead in this particular statistic is actually quite high. So that's obviously very positive for asset markets. Yeah. So what does that mean now as we look forward? because that combination of slowing inflation but a still strong economy seems like it would be really positive. But can it continue? What are we expecting as we move through this? And I guess the really important question is, what does it mean for consumers? Because they've been really out there spending. But it's always hard to tell.

5:36Are they front-loading it because the sales are so early? I mean, they were putting Christmas trees up before Halloween. So maybe everybody did their Christmas shopping early. I don't know. You've done that out there if you're watching. Shame on you for doing that. Exactly. That's what I say. Too soon. But does it look like we're in this kind of Goldilocks? Did the Fed get the soft landing that's so elusive and so hard to do? Great question, Maggie. So one of the things, discussions I've been having with our institutional clients here at 42 Macro is the concept of having to arrest your brain or free your mind of being in the soft landing versus hard landing camp.

6:14And here's why. Asset markets can price in both of those things in succession. And right now, I do believe one of the things we kind of left with when I left at the beginning of the month to head for my honeymoon, we left that week. You go back to the last week of October into that first week of November. One of the things we explicitly called for a paying trade higher in stocks and bonds, and one of those core drivers of many, you had the QRA was a surprise. You had the Fed surprise dovishly as well. But to me, the most important statistic that week was not the QROA. It was not the U.S. Treasury.

6:47It was not the Fed. It was the productivity number that we got. And the reason that productivity number accelerating, I want to say, to 2.2 percent, but that's going to be revised higher in the coming days, productivity of trend pace gives us sort of a clear runway to envision immaculate disinflation, a soft landing scenario. because ultimately what rising productivity does is it alleviates the pressure upon corporate margins that is currently causing them to kind of push through elevated cost increases on the consumers. So to me, this market has, in my opinion, the market has it right. Brian, if you throw up slide two, slide two is just kind of an ugly chart for TV, but I'll explain really quickly how this model works.

7:29We have this process, what we call our volatility adjusted momentum signal here at 42 Macro, And we use that model to determine what the momentum at a particular market indicators are and the probability of that momentum sustaining based on that volatility adjustment. And so we summarize each of the major markets across all the major asset classes on a daily basis. And we sort of summarize that on slide three where we determine what the top-down market regime is. What is the market pricing in? Is it pricing in Goldilocks? Is it pricing in reflation? Is it pricing in inflation? Is it pricing in deflation?

8:00And we've recently transitioned, I want to say about a week and a half ago, to a Goldilocks regime. And so our opinion that Goldilocks regime can be sustained if we don't slow to a significantly below trend pace in real GDP growth over the medium term. Because right now, if you look at the consensus estimates for growth over the next few quarters, you're talking about 1 % Q over Q annualized here in Q4. And you're talking about basically close to 0 % to 0.5 % Q over Q SAR annualized in Q1 and Q2. You could easily trudge through all three of those quarters with somewhere between 1 % and 2 % to maybe even 3 % real GDP growth.

8:38In our opinion, that would create rising expectations of a soft landing amongst investors. Now, a soft landing may not be the modal outcome, but the market can take this and run with it because positioning, generally speaking, has been light all year. Yeah, and everyone was really bracing for that recession and or for the Fed to be aggressive. So this does seem like it's a big turn in sentiment. How do we think the consumer is? You and I have talked a lot about why people got the recession wrong, how they underestimated some of the things underpinning the consumer. If inflation's coming down, that's got to be a positive for consumers.

9:15We haven't seen mass layoffs. how is the consumer positioned heading into 2024? Well, it's an increasingly, great question, Maggie. It's an increasingly complicated question, right? So let's take a step back. If you've been spent most of this year as a bond bull or an equity bear, I'm probably one of your least favorite people, right? Because I'm probably the guy who created you, Maggie. You and I were here 16, 17 months ago, banging the table, resiliency of the US economy. And so we're here now. In terms of answering the question on the consumer, we obviously got the personal consumption, expenditures, and income data this morning as well.

9:52Brian, if you throw up slide five, we can try to quickly roll through what's happening just in terms of what's happening at the margins to the consumer. So real PCE growth slowed to 2.1%. That's a slightly below trend pace. It was mostly driven by sharp deceleration in goods spending to 1.9%. We're tracking right at trend for services consumption at 2.1%. And then we bounced a little bit to 1.2 % quarter over quarter or three-month annualized in terms of real personal income. And so we're kind of steady as she goes as it relates to consumer spending. Now, there's a couple of things that give me cause for concern, not the least of which is we're seeing a pretty significant reduction in fiscal support for the consumer.

10:34Obviously, October marks the beginning of the student loan moratorium. But to me, it's not just the student loan moratorium. It's the broader sort of fiscal policy dynamics that we've observed throughout the year. You've got California not really paying taxes for much of the year, and that really caused the budget deficit to expand by almost a trillion dollars on a year-over-year basis kind of towards the middle of this year. And that's exactly what we saw in terms of Q3 being so juiced to the upside from a nominal and real GDP perspective. At the margins, that fiscal impulse has waned substantially.

11:06I want to say in the month of October, we were only up$255 billion year-over-year in terms of that year-over-year delta in the nominal budget deficit. And that's going to continue to come down in the months and quarters ahead once we get big states like California back online, et cetera, et cetera. So we got the cost of living increase next in January as well. That's going to be significantly reduced relative to what it was in 2023. It's going to be somewhere around 3 % versus 9 % for this year. So when you're kind of answering your question, putting a Tiffany bow on this, Maggie, the consumer is doing fine as long as the labor market continues to hang in, which is a big if.

11:40And I think that's probably our next set of questions here. Yeah. Labor market continues to hang in. The consumer will be fine. Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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12:58That is exactly what I was thinking about. And so was G. Blackburn, who asked, any concern about the trend in continuing claims? Oh, yeah, very much concerned. So if you throw up slide eight, Brian, where we show the three-month annualized rates of change for the four-week moving average of initial jobless claims in the top panel. In the bottom panel, we show the three-month annualized rate of change for continuing claims in the bottom panel. What those lines indicate in both of those panels is the median value for the time series that's been observed at the start of recession. And so what we're trying to do is use the rate of change of initial jobless claims and continuing jobless claims to give us a near real-time indication of the economy potentially going into a recession.

13:41And right now, we have already crossed that median threshold for continuing claims, i.e., the continuing claims on a three-month annualized rate of change basis are up plus 24%. That plus 24 % is above that threshold. So right now, you can make the case that continuing claims are signaling an elevated probability of a near-term recession in the U.S. economy. Now, that's not what we're observing in initial claims, that down minus 15%. So it's kind of a back and forth here. So on a net basis, we would argue that there's a probably middling probability of a near-term recession in the U.S. economy, something to be concerned about, but not necessarily anything to do as it relates to your portfolio.

14:16If you throw slide nine, Brian, up there, we have a broader set of indicators that we call our FAB 5 recession signaling indicators, their 42 macro. And by and large, they're also signaling a middling probability of a near-term recession in the U.S. economy. And so what we did is we did a big statistical study to understand which of the indicators give us the leading edge on determining whether or not there's a near-term recession developing in the U.S. economy. That's the University of Michigan Employment Survey, the Conference Board's Labor Survey differential. We have the continuing claims divided by the total labor force ratio, cyclical unemployment, and temporary unemployment.

14:55And right now, that continuing claims, total labor force ratio, and cyclical unemployment, the rate of change of cyclical unemployment, are both indicating a high probability of a near-term recession in the economy. Now, that's being countered by the Michigan survey and the Conference Board survey, both indicating a low probability of a near-term recession in the economy with temporary unemployment kind of right at the line. So on a net basis, whether you look at the Fab Five recession signaling indicators or if you look at initial and continuing jobless claims, you could say that the probability of recession is rising.

15:26But it's not yet at a level that you need to be overly concerned about as market participants. Because of one thing we talked about in recent programs, Maggie, that the market is not particularly forward looking when it comes to recession. The market tends to peak pretty close to the breakout in jobless claims, the breakdown in total employment. Does it matter what kind of recession we have to Darius? Because, you know, there's a big difference between a really deep, painful recession and a shallow one that or rolling one. We've got all these sort of scenarios that you could argue, you know, that maybe maybe we've seen some weakness already in some areas, but, you know, strength and others.

16:01And so how much does that matter in terms of, you know, the market? Yeah, so we've done this with performance statistical analysis to answer that question as well, 42 Macro. And one of the things we found is that in terms of the market response to a recession, which is what we call a phase two credit cycle downturn, it's not necessarily correlated to the depth of recession or the degradation in the labor force or the labor market. It's actually mostly correlated to the starting valuation that the market is at entering that downturn. Recall that, for example, we had a 50 % drawdown in the S &P and I want to say 80%, 90 % drawdown in the NASDAQ throughout the 2001 recession, which was actually the shallowest recession in U.S.

16:45history. I think it was like 30 basis points peaked the trough in terms of GDP. And so it's not about the actual outcome. It's about the behavioral dynamics that are associated with the positioning cycle and the valuation cycle leading into the downturn. You know, I think, again, you know, investors need to be a lot more humble after 2023. And, you know, this is a year where folks got blown up, longing bonds and shorting stocks all year. And so I think a lot of investors would do well if they're, you know, trying to improve themselves and improve their process to go back to the drawing board and just be a lot more, you know, I don't know, water when it comes to investing in financial markets.

17:22You don't have to be in the hard landing camp or the soft landing camp. You can be in both camps. Right now, you're in the soft landing camp because our model is saying we're in Goldilocks. And until the model says we're no longer in Goldilocks, we will remain in the soft landing camp, and it could easily pivot to a hard landing in the coming weeks and months. Right. Don't get locked into your narrative because it changes quickly. Doug asking a good question, what's causing the productivity to trend higher? Yeah, that's a great question. So, I mean, to answer that question would require a lot of hubris because economists have no idea what drives productivity.

17:54Right. That's right. Yeah. Yeah, it's just this magical thing that we plug into our models and ultimately hope. And for those who tend to be permabulls on Wall Street, you just plug a value of two and just keep it moving. That's how that process works. So, Doug, I wish I could have answered your question. It's a great question, Doug. And I think it does. I mean, we tend to think these central bankers are all knowing. I mean, people argue they also really don't understand the inflation dynamic completely. But I would think with productivity, there's a lot happening with technology that we're just it's very hard to capture.

18:24We're just not sure what's driving that. But I'm sure that there are a lot of people who are trying to figure it out, Doug, and taking a good look at AI and some of these other things to see if they're contributing. Before we move on to productivity, one thing I will say is the long-run trends in productivity have been remarkably stable in the U.S. economy. Whether you look at the 10-year, the trailing 10-year mean is somewhere around 1.4%. The trailing 20-year mean is somewhere around 1.6%. And the trailing 30-year mean is somewhere around 1.9%. So basically, take those three means, your median is somewhere around 1.6 % in terms of productivity growth in the US economy.

19:00And this is over the last 30 years. We've had a lot of cool stuff come out in the last 30 years. I mean, I'm talking to you via Zoom. Exactly. All that stuff was built in the last 30 years. And so I think the expectation that AI is going to create this sort of productivity boom that was significantly more productive than, I don't know, this thing called the internet or personal computers, to me, I think it's a lot of Pollyannish belief there. But that won't stop the market from pricing it in as long as we remain in this Goldilocks regime. And it doesn't mean that it's not going to increase productivity.

19:35It's just that we see this consistently with waves when it comes to technology. Totally. And this is just the latest. Mark has an interesting question. Dale, does this mean transitory Goldilocks is no longer your base case in early 24? Can it come back? What would be the indicators? Weaker demand? No, no. Goldilocks is very much our base case. Yeah, that's why it was interesting. I'm not sure what Mark was referring to, but it sounds like you are saying that we're in transitory Goldilocks and we're going to stay there until something your indicators tell you otherwise. Yeah. I mean, to me, it's really about the market.

20:17There's a terminal destination to transitory Goldilocks, right? Eventually, the economy is going to be too slow for the earnings outlook to support the current pretty rosy earnings outlook out there. But as long as economy is slowing to an at-trend or only slightly below-trend pace, asset markets can do just fine in that scenario. Because as we've seen, the market is very comfortable taking expectations of policy rate cuts and running with that. And this is a Federal Reserve that I want to say, I think we talked about this the last time I was on. This is a Federal Reserve that has an asymmetrically dovish reaction function.

20:50This is a Federal Reserve that does not want to over tighten the economy into a recession, but is totally fine doing what it can to prevent really negative outcomes. And obviously, in our opinion, that in and of itself is a positive catalyst for asset markets, a positive underlying fundamental that, in my opinion, is likely to suck in some flows. I throw a couple of statistics at you. We've obviously had this very positive month of November. I think it's like the fifth or sixth best November in the history of the S &P 500. So maybe I should go on honeymoons more often, I guess. Exactly. That's a real thing.

21:26So when you go back and you sort of apply appropriate filters and apply some conditional analysis to seasonality, what we find is that December is a pretty decent month. Whenever you have a November that's increased on par with or greater than the current increase that we are experiencing here in November, and then January tends to be an extremely positive month. Extremely, I want to say the median return for that sample of six is about plus 5 % in January and about 1.5 % in December. So it's not to say the market's going to go up every single day between now and then. But it is to say that until we see data that can really change the market's mind about immaculate disinflation, particularly on the productivity side, and perhaps until we get into late January and we may potentially see data from the Treasury Department in terms of the updated quarterly refunding announcement, that may change the outlook for the fiscal supply trajectory.

22:24In our opinion, there's not a lot of negative catalysts between now and let's call it the end of January. And so just getting between now and then, I think if you're bearish, you're going to need a lot more than what I think the current market narratives are out there. So speaking of the Fed, we have a Fed meeting in December. A couple of weeks. Yeah. What do you anticipate in terms of their messaging? I mean, it seems like given the data coming out, they'll be on hold. But do you think J-PAL is worried about some of the market gains that we've seen? Will he want to temper that at all? How do you see that playing out?

22:57No. Well, I think increasingly, just going back to those original charts we showed, you can throw them back on the screen, Brian, slide six and slide seven. Just going back to where the discussion started, they are at the margins achieving their inflation outcomes. They have not achieved their inflation outcomes, but we are very much making progress towards that outcome from their perspective. And not only are we making progress towards that outcome from their perspective, they're going to have to revise down their 2022 inflation projections, which may, just from a base effect perspective, cause them to revise down their 24 and 25 inflation projections in terms of how quickly we are likely to, quote unquote, arrive back at the destination, this perfect destination of right around 2 % core PC inflation.

23:38Now, we take offense to that if the economy does not go into recession at any point in time next year, because it's very unlikely we're going to see that last mile of disinflation achieved, let's say going from three to two, in our opinion, or three and a half to two and a half, in our opinion, is going to be quite difficult. But as long as we can and staying at that level, but as long as we can kind of, you know, convince ourselves as market participants and more importantly, convince ourselves as policymakers that we are well on track to that, they're going to high five each other and sing kumbaya because what they're doing is working.

24:10We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.