Is It Time to Go Risk-On? with Darius Dale

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1:24is the risk trade on hi everyone welcome to the real vision daily briefing with me today is darrys dale founder of 42 macro hi darrys maggie it's great to be back how you doing it's great to be back i'm doing well and we are talking to officially a married man congratulations darrys Thank you, Maggie. Appreciate you. Shout out to my beautiful wife, Allie, and her lovely family. Well, we're so happy for you. And I'm sure the wedding was beautiful and everything you hoped it'd be, and I'm glad you got some time off. I'm sure our fabulously wise community probably has some great marriage tips for you.

2:00So if there's anything you want to share to Darius, bring them on in, put them in the chat. I heard the best one is happy wife, happy life. Yeah, yeah. I'd say That's a good one to start with, for sure. So, boy, you really like pop right back into the action, didn't you? Because we had an action-packed week, a lot of information. We had the tame inflation readings back-to-back, CPI and PPI, which really set the market off. We had bank earnings today, JPMorgan, Citigroup, better than expected. Consumer confidence really blowing past expectations, a two-year high. When you put it all together, and stocks, by the way, which are a bit flat right now, but stringing together a really nice-looking rally.

2:44When you put it all together, Darius, what are you thinking about? What do you make of all this? What I make of all this is this was to be expected. I mean, this is something we've been talking about on the program since almost a year. I mean, it goes back to last August when you and I were discussing our resilient U.S. economy theme. I come on the program every week and say the economy is booming. The economy's booming. The economy's booming. Now, it obviously slowed down since that time period. But we've been very consistent since last fall that the U.S. economy would remain resilient, at least until you get into Q4 this year and or Q4 of next year.

3:21That's when we have the recession timing. So let's unpack some of the data that we got today, because I think it's very important to contextualize this stuff in order to understand where we're likely headed next. So, Brian, if you throw up chart three, you know, where we go, where we show the University of Michigan Consumer Sentiment Index, we show the Current Conditions Index, and we show the Expectations Index, and we see just on a headline basis, the headline ticked up by 8.2 points to 72.6. That 72.6 is the highest number we've seen since September of 2021. But more importantly, that plus 8.2 delta is the fastest month-over-month increase we've seen in this time series since December of 2005.

4:02So, I mean, this is pretty clear in our view what's driving this improvement in consumer confidence and ultimately the resiliency of the consumer economy here in the U.S. is what we show on slide four. Brian, if you throw that slide up, where we show immaculate disinflation has been a contributing factor. At the top panel on this chart, we show the expected changes in prices over the next year. The median statistic, that number ticked up very marginally, 3.4, but it's down from right around 5.5 about a year ago. And so that immaculate disinflation and expectations amongst consumers has really contributed to an improvement in their expected financial situation over the next year, which is the chart in the bottom panel in that chart.

4:44And that number is up plus eight points on a month-over-month basis. That's to the highest level we've seen since July of 2021. So when you put everything together, we've had a considerable amount of macular disinflation in the economy. It's inflated consumer incomes both on a real and expectations basis. And ultimately, we've been able to hang in there from the perspective of consumer spending. And hanging in there from the perspective of consumer spending has really kept the labor market buoyant, which are all things that we presaged in these conversations last fall. Yeah. So I guess it's funny that you say the immaculate disinflation because there were so many doubters, right?

5:19I mean, when you first started talking about that, we really had people divided in camps. And so many people just didn't believe it. They just didn't. They thought the economy was about to crater. You know, this recession timeline has been getting pushed out so much. In fact, Andreas, I'm going to run this now because it's right in line with what we're talking about. Andreas dropped the latest episode of Steno Signals, and he gives some more meat on why this recession has been so hard to pin down. Let's listen to that, and we'll talk on the other side. Let's have a look at four reasons why the recession risks proved to be overpriced and why the recession can ultimately still arrive.

5:59but ultimately you also need to look for clues on the actual recession to actually take notice of it or to care about it from an asset allocation perspective. And the first reason I'd like to highlight is the relationship that we see between real wage growth and labor demand. So wage growth adjusted for inflation. What we saw through 21 and 22 was an outright nosedive in the wage growth adjusted for inflation. And what that means is that companies set higher selling prices relative to the wage component of their cost base. So in my humble opinion, this is positive for most companies because they pay less for their workers relative to their selling prices.

6:49And interestingly, you also get that exact pattern when you study it empirically. When there's a slide in the inflation-adjusted wage growth, companies tend to hire more people, which makes sense given that the price of labor has cheapened relative to their selling prices. And currently, we're seeing sort of the opposite scenario slowly but surely unfolding, wages growing faster than selling prices. And that could turn into an issue for the labor market, say, three, four, five months down the road, as the price of labor gets more expensive relative to selling prices. And I actually think that is the way that you should look at real wage growth relative to labor markets.

7:36And it's completely upside down relative to what most economists will tell you. And that full episode of Seno Signals is available on our website. If you're not already a member, you know what to do is scan the QR code and you can hop on a trial. So, Darius, where are we in terms of you've been, as you said, you've been flagging this and sort of, you know, warning people that the recession talk was or the recession calls were maybe premature. Where are we now? Are you worried about wage inflation? I know you have a chart that is when will immaculate disinflation conclude? I think that's what we're all wondering.

8:14Are we in this sweet spot and the Fed's going to get away with this soft landing where inflation's tame and the economy's doing well? It sounds too good to be true. What are you thinking about in terms of timing? You're 100 % correct in terms of identifying this as a sweet spot. We are in a perfect sweet spot of immaculate disinflation. And so the question is, is when did this sweet spot end and when does that driving force of immaculate disinflation conclude? And so we posed that question on slide six, Brian, if you could throw that chart up, where we show median CPI on a three-month annualized rate of change basis in the blue bars and the red line as the year-over-year rate of change.

8:49We saw trim mean CPI in the second panel and super core CPI, which is core services CPI x housing in the bottom panel. And what we've seen is that if you stick with the bottom panel, that immaculate disinflation that we've seen has really, really showed up in this sort of statistic that Powell and other central bankers are watching. We've seen the blue bars come down from kind of a six-month moving average of around 4 % to breaking down all the way to 1.4%, which again means that the three-month annualized rate of change of super core CPI is now down at 1.4%. That's the lowest print we've seen since September 21.

9:25So that ultimately means that the year-over-year rate of change is going to chase that lower. Similar dynamics we're observing in median CPI, top panel, trim mean CPI in the second panel as well, where we have the three-month annualized rate of change now down at 4.6%. That compares to a six-month moving average of six. We have trim mean CPI at 3.1%. That compares to a six-month moving average of 4.6. But what concerns me about this immaculate disinflation that we've observed, and again, we got all these data points this week. in the June CPI report. What concerns me about that is the stasis that we're starting to see in median CPI and trim mean CPI.

10:02And this goes to the point we've been making in recent discussions, is that immaculate disinflation is immaculate for a reason, right? We don't just make these things up. And the reason we call it immaculate is because it's very atypical. In fact, it's highly unusual to see such a breakdown in inflation ahead of an observed recession. Typically, inflation is the most lagging indicator of the U.S. business cycle, typically breaking down somewhere around two to three quarters after recession begins. And so ultimately, we understand that this immaculate disinflation process is going to conclude, and we're going to be left with higher rates of inflation relative to trend, higher rates of wage inflation relative to trend, and ultimately, we're going to need that recessionary process to get inflation back to 2%.

10:47Okay, so that is going to be disappointing to some. Oliver was asking, Darius, will my Friday night drinks cost more or less by the end of the year? Sounds like you're saying they're probably going to cost a little more. Well, the inflation, the disinflation in the rate of change will slow down. I mean, that's, you know, I don't want to say specifically about the alcohol, food and beverage category. But what we're seeing is we're starting to see a little bit of stasis where it matters. And, you know, in terms of these median CPI, trim median CPI time series. So we're going to continue to see year-over-year inflation, particularly core inflation, head lower and chase the three-month annualized rates of change down.

11:22But what concerns me, looking at other indicators, focusing on, for instance, the ISM services or ISM manufacturing supplier delivery time surveys, those numbers months ago got back to levels that are more consistent with 2 % inflation. You look at the housing indicators. We have a resurgence in housing inflation, citing the fifth home price index. It's now up 9 % on a three-month annualized basis. You go back to the lag and you interpolate the lags from the current cycle, and we might see a soft rise in housing inflation over the next couple of quarters because that's what it did roughly 18 months ago when kind of interpolating that lag back to the time series.

12:01So there's some things that could have you concerned as an investor about this today being the crescendo of the peak in the soft landing expectations, the peak in immaculate disinflation expectations. And it could be the case that from here, soft landing starts to decay, immaculate disinflation starts to decay, and both of those get replaced by something called a recession and sticky inflation. So that's where I suspect we'll be in a few months' time. But between now and then, just like in any other period in mismanaging financial markets, you just have to lean on your technical indicators. Yeah.

12:34So I want to touch on a couple other things as we're talking about the turn. So you're looking at changes maybe in the best news of the inflation being the falling inflation maybe having peaked. you also I think point out some really interesting factors that are contributing to our resilient economy because a lot of people are scratching their heads and we often talk about you know maybe it's the haves and have-nots right we know that some people who are living paycheck to paycheck or toward the you know the bottom of the economy uh the income um uh you know stacking order right are are struggling a little bit a little bit and maybe those who are wealthy have more but you have some other things on here that are really interesting.

13:17Walk us through some of these. I'm especially interested in seeing limited credit cycle vulnerabilities. I thought that big rate reset was going to really hurt when it came to credit. We haven't really seen that. Walk us through some of these. There's a few things you said that are worth unpacking. I'll start by saying, as someone who grew up very poor in and out of homeless shelters, we are always struggling. That is the truth. No matter what's happening, there's a part of the economy that is always struggling. You're absolutely right. Taking a Twitter and just suddenly concerning yourself about poor people is not how you do financial market research.

13:52So let me make that point very clear. But putting up this slide five in today's chart pack, we list these sort of key factors that are contributing to our resilient U.S. economy theme. And many of these factors, by the way, were ever-present when we created the theme almost a year ago. So let's run down the list. We have near-record cash on household balance sheets. were right around$4.5 trillion in checkup deposits. That number is up from around$1 trillion prior to the pandemic. So this concept of excess savings and dwindling down and lower-income consumers running out of excess savings is all Wall Street nonsense.

14:28Just slap it down, move it along. It's Wall Street nonsense. You heard it here, folks. Near-record cash on corporate balance sheets are right around just side of$2 trillion. As a share of both of those cohorts' total assets household in corporate sector, that$2 trillion for the corporate sector, that$4.5 trillion for the household sector, is right around 3 % of both of those cohorts' total assets. You've got to go all the way back to the mid to late 1960s to see a ratio of cash on corporate and household balance sheets this high, which means both businesses and consumers still feel rich. They're flush with cash as a share of their total assets.

15:05Another factor is that private sector income and wealth have outpaced inflation on a structural basis. You look at, again, those statistics themselves. You add money market fund exposure into that. You add household net worth into that. You add nominal employee compensation into that. You add gross domestic income into that, looking at the business sector. And all of those factors have outpaced the growth of inflation since the start of 2020. And so on a structural basis, inflation is going to catch up, but it's just going to require time to catch up and make those things negative on a real basis.

15:35We also have limited credit cycle vulnerabilities. You know, one thing that I've learned from studying business cycles for 15 years is that you tend to need to see in order to have a recession, you tend to need to see two factors. One, capital misallocation and financial tightening. We've had financial tightening and we're going to continue to get financial tightening as it rolls its way through the system on a lag. There's a long and variable lags in monetary policy based on the term of debt and duration, et cetera, all that stuff. But what we have not seen in this business cycle is a growth rate of credit that would be commensurate with capital misallocation.

16:10Everyone keeps talking about credit card debt this, credit card debt this. Again, terrible statistics. Credit card debt as a share of nominal disposable personal income has not budged since 2015. It's literally been like a flat line dead person heartbeat since 2015. So you've got to do the statistics correctly if you want to understand these things and ultimately make money with this information. And so we've got a couple more things. We have very limited exposure to the volatile manufacturing sector in the U.S. economy. The manufacturing sector accounts for 14 percent of total non-farm payrolls.

16:39That's down from like 45 percent in the 1940s. It accounts for 18 percent of GDP. We only get my statistics since 2005, but it's obviously on a secular low. And the reason I bring that up is because when you look at recessions, the sector of the economy that accounts for most of the job loss in recessions is the manufacturing sector at around 98 percent of net non-farm payroll drop loss. And so you've got to do a lot more damage to a tiny part of the economy in order to really create a recession. And the problem with creating that and even doing that is that one large chunk of the manufacturing sector is the housing sector.

17:13And we have this boom in new home sales because we have this record spread between the marginal mortgage rate and the effective mortgage rate. So it's like, how are we even going to do that, right? And then a couple of final things, I'll be quick. Labor hoarding, we obviously see the labor force as low relative to the trend. And so, of course, domestic income is high relative to its pre-COVID trend. And so as a function of that, you're obviously seeing companies being very unwilling to let go of talent early in the business cycle downturn. And then finally, which is arguably the most underappreciated factor on this entire page, which is biodynamics.

17:46We have a president that thinks it's a good idea to spend money to take inflation down. Yeah. He said it a year ago. We laughed at it. And now a year later, he's doing it. We have a record non-war, non-pandemic, non-anything fiscal budget deficit. Like we've had deeper budget deficits, obviously, but during recessions, but not outside of recession. We've never seen an 8 percent budget deficit to GDP here in the U.S. economy. So that's obviously contributing to the resiliency of the economy and ultimately what we think by, you know, a quarter or two from now may contribute to the resiliency of U.S.

18:21inflation prior to, you know, the recessionary process that it needs to get back to 2%. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved. And the great thing is that in addition to crypto, Plus500 gives you access to a wide range of instruments.

18:53S &P 500, NASDAQ, gas, and much more. Explore equity indices, energy, metals, Forex, and beyond. With a simple and intuitive platform, you could trade anytime, anywhere. Experience the fast, accessible futures trading you've been waiting for with Plus500. With over 20 years of experience, Plus500 is your gateway to the markets. Visit us.plus500.com to learn more. Trading in futures involves the risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus 500, it's trading with a plus. Yeah, interesting. And we are going to talk a lot more about that. You're right, it doesn't come up as much.

19:29We're going to talk a lot more about that, you know, as we turn the corner, I think, into the fall. It's on our radar, certainly. But I'm really glad. And I'm so glad you put this list down because I think sometimes people scratch their heads And as you say, rely on sort of information that's floating out there or a line you hear someone say, or I think we all sort of have financial insecurity. So we're like, wait a minute, things don't feel that good. But this is a really comprehensive list. So my question is, do these factors mean that even if we go into recession, it's not a severe one? Yeah, it's highly likely to not be severe.

20:03So let me answer that question two ways. From an economic standpoint, it's unlikely to be severe because, again, we're talking about labor hoarding that may be persistent even in a recession. It may just be harder to get rid of headcount because, again, ultimately companies know that in the next expansion, if they fire too many people now, they may not be able to replace those people when they actually need to grow again. Right. That's an issue. So that's one thing that can contribute to this. But going back to the limited credit cycle vulnerabilities, one thing that we found is there's a pretty sharp statistical relationship between what we call the private non-financial sector credit gap.

20:37Now, that's a very wonky academic jargon for the deviation from trend in credit to GDP ratio for the private sector. And our deviation from trend is actually negative in the sense that we have not levered up and certainly have not levered up at a quick enough pace to suggest there's any capital misallocation in the economy. And that's saying that corporations are in pretty good shape. They're not overextended with credit. They've got a lot of cash on their balance sheet. So it's a pretty healthy corporate sector, which should help insulate what we hit in trouble. The reason that matters is because that health you decided is inversely correlated to the depth of the recession, both in terms of the drawdown in GDP and also in terms of the drawdown in nonfarm payrolls.

21:19And so we have one of the shallowest credit gaps ever ahead of a recession in the U.S. economy. Now, the data comes out in a lag from the BIS. It's going to get worse, but it may not get worse enough to suggest that we're going to have anything other than a mild recession. Now, that's the first half of my answer to your question, Maggie. Second half of my answer to your question, Maggie, is I don't think the market's going to care about how mild the recession is when it starts. And the reason I say that is because typically what causes the market cycle to inflect in a recession is the response in policy.

21:52Obviously, the Fed was very ineffective in 2001 and ineffective in 2008 in terms of its pivots. But generally speaking, by and large, the bear markets tend to bottom right around one month ahead of the inflection in the – oh, sorry, one month after the inflection in the liquidity cycle. I've done a tremendous amount of work on this, probably as much work on this as anyone in the world. And I will challenge anyone to put their work against ours on this. And so what we tend to see is that the Fed tends to cause bear markets to inflect. And the reason I bring that up as a negative value is because the Fed is implicitly forecasting a recession.

22:26If you look at the implied deltas in the summary of economic projections on unemployment, on core PCE, they're telling you higher for longer. They say it every week. And so my fear is heading in, when we get into that phase two credit cycle downturn process, which may be a few months away or a couple of quarters away, so that's kind of our modal outcome expectation. When we get into that process, it's very likely that the Fed is going to be sitting on its hands and not supplying the market with liquidity in a panicked fashion like it did in COVID, like it did in previous cycles. And that concerns me from the perspective of how much the market needs to go down to get the Fed off its high hopes.

23:04Yeah. Okay. So that's super interesting. And we started this by saying, is the risk on trade or is the risk trade back on? Because some people are feeling like that. They're seeing what's happening in stocks. They saw that inflation come down in there. But it sounds like you were a little skeptical. And let me ask, Saul has, I think, the same question. And he says, big fan, great talk on Macro Voices. I might be late to the party, but does the market narrative need to shift from higher rates equals recession, more likely to strong growth productivity equals SPY to the moon before prices are affected by the credit cycle downturn?

23:44Yes, probably. Yes. And that's exactly what we tend to see. So markets, by the way, markets are always very strong in the year leading up to recession. This is something we've done work on a couple of quarters ago, maybe, whenever we put it out. But the reason I brought this up – oh, no, sorry, about a quarter ago. The reason I brought this up is because the markets not only are very strong in the year leading up to a recession. On a median basis, the return of the S &P 500 is plus 16 % with an underquartile range of plus 14 to plus 20. But that's obviously – the fear is if you're a bear or someone who's not participated is you don't want to capitulate at the end of that process.

24:16What if today is the high, right? So what we've also done a bunch of work on is try to help investors understand, okay, when does the market tend to peak ahead of the recession? And on balance, it's about a month ahead of the trough in unemployment and also a month ahead of the breakout in jobless claims. So obviously, if you're watching jobless claims like a hawk, and we have a bunch of statistics on what to actually watch within the report from a rate of change perspective to give you an indication of whether or not it's a recession, but that's neither here nor there. If you understand that the market tends to peak right around a month ahead of the big breakout in jobless claims, then you understand that we probably have some time to price in more right-tail risk between now and let's call it Q4 of this year or Q1 of next year is when we think the recession process might commence.