Is the U.S. Skidding Toward Recession?

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1:24And now to the top analysis of today's markets.

1:35Is the U.S. skidding toward recession? Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Darius Dale, founder of 42 Macro. Hi, Darius. Great to see you. Hey, Maggie. It's a pleasure to be back with you. How are you? I'm doing well, thanks. I'm doing well. We are looking at kind of mixed action in the market today. We had the Dow up, NASDAQ lower, equities just closed here as we're speaking. Treasury yields fell a little bit. But it seems like the focus has really been on some of this economic data that's been coming in. Much of it this week weaker than expected, including those private payrolls, ADB private payrolls we had today and ISM services index.

2:12What is your dashboard suggesting? Is the U.S. economy headed toward recession? What do you see happening? Yeah, I mean, look, we've been saying this for a while now. But A, U.S. economy is very resilient for a variety of different factors, which we can unpack. And as a function of the resilience, the Fed is going to tighten more than the markets are anticipating. Both of those things have been realized, both in the data and in the market and in Fed reaction function terms. And as a function of B, C is we're going to wind up in an economic downturn. I happen to believe the economic downturn we're likely to experience is something that's likely to commence.

2:47Our models would suggest that it's likely to commence sometime in Q4 of 2023 or the very latest Q1 of 2024 that may be in the process of being pulled forward. I'm not sure we have enough data to confirm that or not. But ultimately, I think the number one thing that I think market participants are missing is they're debating soft landing versus mild recession, where we're debating mild recession versus severe recession. And I think that's a debate that the market is eventually going to be forced to have, I think, sometime in the second half of this year. Yeah. And you kind of see that playing out now because when the weak data first started coming in, everybody was – or certainly equities – certainly shouldn't say everyone, but equities were like, oh, this means the Fed's going to pivot.

3:29And then all of a sudden now they're trying to fill in like, well, what does that mean if the data is coming in weak or if the market is pricing in eventual Fed easing, which we can talk about whether you agree with that, what happens in the interim to get us there? And that's the thing the market seems to have glossed right over. Yeah, I've been saying that for a while now, but we're not going to get the drugs without going through the soup first. And the soup is the economic downturn and ultimately the market pricing in of that economic downturn that gets the Fed's attention to supply the market with the liquidity that it needs to have extended bull markets.

4:05We've been in this sort of what we call phase one liquidity cycle downturn since going back to the fall of 2021. And we've been on this program talking about helping investors protect their hard-earned capital from that part of the process. We are now in the part of the process where markets are appropriately trying to discount whether or not this is going to be a soft landing or if we're ultimately going to wind up in what we call the phase two credit cycle downturn, which is the result of all that liquidity reduction that we're seeing. And on that liquidity reduction, we are now starting to see some pretty significant moves lower in things like M1 bank deposits in small regional banks.

4:43Brian, if you throw up chart 100 from our March Macro Scouting Report, we just contextualized the move in liquid deposits from some of these small regional banks. I don't even want to say the word small. That's what the Fed calls them. The 4 ,000, let's call it 675 banks that are not in the top 25 in the U.S. banking sector are technically small, according to the Fed and their H8 release. And this chart shows we're currently drawing down liquid deposit of these institutions at a rate that we've never seen before in the 60-something, 70-something year history of the time series. So that's very concerning.

5:18Also very concerning is the fact that M1 is contracting at its fastest pace ever at down 5.8 % year over year. Bad things happen when liquidity in the private sector starts to evaporate and deflate the way it does, and you don't have the commensurate amount of money reflation out of the public sector. And in order to get that money reflation out of the public sector, I'll tell you two things that can happen. If you go up slide 29, Brian, where we show the inflation indicators in our macro scouting report, whether it be median CPI compounding at 7.5 % on a three-month annualized basis, trim mean CPI compounding at 6.2 % on a three-month annualized basis, whether it be median PCE at 5.2%, trim mean PCE at 4.7%, and the Fed's preferred inflation gauge at 4.8%.

6:06All these numbers are compounding at levels that completely remove the Fed from the liquidity supplying business for an extended period of time, in our opinion. And so ultimately, we think the Fed knows that, which is why if you look at slide 46, Brian, they're forecasting a mild recession. You know, if you look at their forecast or if you look at the most recent summary of economic projections, which we got a couple of weeks ago, their target for the year for the unemployment rate for year 2023 is 4.5 percent. that current unemployment rate, we're going to get the number on a couple of days, but the most recent one for the month of February is 3.6%.

6:40So if you look at that implied 90 basis point delta, there's never been a 90 basis point delta to the upside in the unemployment rate in the history of the time series going back to the late 1940s that didn't coincide with the red bar in that chart, which is a recession. And so it's our belief that because inflation is too sticky, because the Fed is implicitly forecasting a mild recession, their response in, you know, liquidity provision terms, i.e. that unencumbered QE and those rate cuts that we ultimately really want as investors, it's going to take a lot, in our opinion. And that taking a while is going to be a problem for asset markets in the second half of the year, in our opinion.

7:14Yeah. So what happens? Where are we with inflation? We're getting some indicators out next week, some important gauges on that. Would you expect to see that fall in line with the fact that we are seeing economic growth fall and maybe the labor market weaken? Should we expect to see prices fall as well? Yeah. So inflation is likely to continue deteriorating and decelerating, but it's just not decelerating fast enough. I mean, that's the problem with analyzing. So this is the problem with most investors looking at inflation on a year-over-year rate of change basis. They're being sort of tricked, if you will, I don't know, for lack of a better word, by the change in the base effects.

7:53And then I realized that inflation on a sequential basis is still compounding at levels that are very wildly inconsistent with the Fed's price stability mandate. And so at best, we're talking about a Federal Reserve that has set up to pause, even as inflation continues to decelerate. And I happen to think it will continue to decelerate. If you just look at the data point we got today in the ISM services release, we saw the prices component slow 6.1 points to 59.5. That 59.5 is the lowest number we've seen since July of 2020. and that minus 6.1 delta is the sharpest deceleration we've seen since May of 2017.

8:27So inflation is decelerating. It's just decelerating to levels that are extremely inconsistent with the Fed's 2 % mandate, price stability mandate. And until we get some indication that inflation is going to sustainably get to 2 % and remain there, and I don't understand how you can get to that indication if we're not even compounding at 2%, let alone with the fully employed American economy. I just think it's going to take a while for us to get that liquidity that investors are speculating on in the markets right now. Yeah. Do you think that the Fed has any more rate hikes in store? Because, you know, as I mentioned earlier, we kind of flipped right to, oh, they're especially in the wake of the banking crisis.

9:07They're going to be easing. They're going to be, you know, cutting rates. Do you think they pause? They keep hiking? I mean, how do they deal with those two very different issues that they're addressing, both on the banking side and on the sticky inflation side? Well, Powell more or less called it out, which is they don't really know the full extent of the credit contraction we're likely to see as a function of this sort of revision and the asset liability max of these regional banks. Moreover, the changing regulatory environment that's likely to come by, we're still in a democratic regime. They still have full control over all the regulatory agencies in America.

9:47So we're probably going to see tighter regulation for some of these banks as well. So we're going to see the asset base of these institutions really start to decline. So that's an issue. The Fed knows that that's a pending issue. And so they're likely, as Powell communicated in the press conference, they're very likely to take it easy on rates. We may see one more rate hike. In fact, I do think if the jobs report comes in in line as it's expected to, or sort of comes in in line with where it's currently expected by Bloomberg consensus, for instance, I think we will see another rate hike. Because I think ultimately what's happening, this is an economy where the Fed has barely gotten the policy rate restrictive enough to really do a lot of damage.

10:26And the risk that they pause too soon and allow asset markets to reprice growth and inflation expectations from a nominal GDP perspective higher will ultimately cement all those numbers that we highlighted in terms of the 4 % to 5 % to 7 % median and core underlying inflation type measures. We're going to be stuck there is what I'm saying if the Fed allows asset markets to take their pause pivot and run away with that to the upside, both in market pricing terms and inflation expectations terms. So I don't think they want to do that. I think they want to act up for as long as they possibly can.

11:00But ultimately, that pivot that's coming is going to be a pause. And the issue with pausing here in our perspective, from our perspective, is that pausing is not going to be enough from the perspective of the long and variable lags of monetary policy. If we're right on recession commencing by Q4 this year or Q1 next year, pausing ain't going to help. You need to be cutting interest rates and doing QE. And that's the issue, and I think that's going to be a big issue for asset markets. They're going to have to use their price action to tell the Fed to deliver the drugs, in our opinion, by the end of the quarter.

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12:46Yeah, and this is, I mean, Cleveland Fed President Loretta Mester was sort of suggesting the same thing, that they need to go a little higher to deal with inflation. But as you just pointed out, they're really, and as many, we've been having these conversations for the last few weeks, certainly you and I for a while, but it's really picking up steam with the folks we have coming on saying, hey, hang on a second. The Fed's really stuck in a very bad spot here. Because if they do that, Darius, doesn't it just exacerbate some of what the strains we're seeing in the banking sector? If they don't ease, if they try to hike again, doesn't that just create more pain in the banking sector?

13:31Yeah. So yes, the answer is yes. The way I would couch the answer yes is this is kind of what they wanted, right? The Fed didn't hike interest rates so that there would be zero strain in the banking sector so that banks could remain extremely profitable and continue to extend credit. That's not why they had interest rates. They had interest rates to cause strain in the banking sector so that they could slow the credit machine and ultimately slow the real economy. And it alleviates some of that pressure from a supply and demand perspective in the labor market. This is what they want. They don't want banks going bust week after week and have a full scale banking crisis, what they want is more, you know, that's like a, you know, I liken it to an airplane analogy.

14:14You know, when you're flying and you're about to get to your destination, we're 25 minutes out, captain comes on and says, are we going to begin our initial descent? And you go from like 35 ,000 feet to 10 ,000 feet. And then you go from 10 ,000 feet to the ground in the second phase of the descent. The Fed wants that process. The Fed doesn't want the process where the captain comes on and drops the, you know, the oxygen mask out and says, you know, brace for impact at 35 ,000 feet. That's the bad part. Both outcomes land on the ground with lower inflation and higher unemployment. One is a more desirable path than the other.

14:46And I think that's what the Fed is trying to accomplish. Yeah. And you didn't mention all that turbulence and chop as you make your way down too. I thought that's where you were going with that analogy. And that would be accurate as well, because it's not, as anyone knows, once you start to make that descent, it's not smooth flying. It's often where you hit all the turbulence. We do have some questions coming in. We're going to get to them in a second. But for those, so it's interesting that we're having this conversation. For those, I had a chance to sit down with Harris Kupperman today, and we talked about some similar things.

15:18He's taking a really deep look at oil, the energy sector, especially in light of OPEC's production cut. But he was concerned, also concerned, about this issue of sticky inflation, what it means for the Fed. And he's actually worried that we could see both a banking crisis and an energy crisis at the same time. Let's have a listen to that clip. You don't hear a lot of people talking about an energy crisis. You hear them talking about a banking crisis. You hear them talking about a hard landing. You hear them talking about a knock on demand destruction off the back of that. So it sounds like if the market doesn't have their head wrapped around this, where's the pain trade?

15:59What suffers as a result of this? Well, I think consumers are going to suffer. I mean, we can have a banking crisis and an energy crisis simultaneously. There's nothing that says you can't. I mean, in the 1970s, we did both. I kind of think we're going to do both. I think the pain trade is anything tied to interest rates. I think that at some point in the not-so-distant future, Powell is going to have to make a choice between saving the banks and chasing oil across the screen. And I think he's going to decide to save the banks just because that's probably the more politically expedient thing to do.

16:36And he's going to let inflation run really hard. And I think the net result of that is the 10-year probably falls apart and then all the banks fail. Because if the 10-year goes to some high single-digit number, I mean, I don't think you have any banking sector. It's not just the little kind of fragile ones. I think you're going to have a banking crisis with an energy crisis. I mean, I think it's going to look a lot like the 70s. yeah and that was only a little small part of that Kupi had a lot of strong out of consensus views including some very blunt warnings about bonds but it was a fantastic conversation I encourage all of you to watch the whole interview and he does talk about how he's positioning and trading around this setup if you're not already a member scan the QR code come and join our community this is the exact time we need to be having these kinds of conversations But Darius, it is out of consensus.

17:30Certainly not everyone agrees with what Cubby's saying. The one thing I will say, though, is he's a little bit – this is his longer-term thesis. So I think it's kind of important to put that out there. But do you see this as a possibility? Could we have a banking crisis and an energy crisis, like an oil spike at the same time? I think it's all one and the same thing. And yes, I very much agree with him longer term. I don't know that I would use the word crisis because I think what's more likely to happen is just persistent capital outflows from the U.S. economy, which, by the way, we doubled our net international investment position in the 40 years to 2021.

18:07A lot of that capital has to go into find homes elsewhere as the, you know, for lack of a better word, U.S. bond market seems, you know, permanently impaired. I mean, we're obviously going to get a rally in bonds in the context of a business cycle downturn, but I don't think we're going anywhere near where we were prior to this, you know, COVID prior to this, you know, most recent business cycle. So in our opinion, bond yields are likely to make higher highs and higher lows over the long term. And that's likely to be supported by persistent capital outflows, you know, weaker dollar and then ultimately weaker dollar should continue to reflate energy prices.

18:43And oh, by the way, this is all very consistent with the fourth term. And so you think about where we could be at this time, in this moment in the next business cycle, i.e. very late cycle, very high inflation, Fed fighting inflation. We're all going to be doing that process from higher, from a higher low, higher highs and bond yields, lower U.S. dollar values, higher energy values. And ultimately, we're talking about a situation which could be bumping up against what could be ultimately like the pinnacle of this fourth turning that we've all been living in from a geopolitical tension standpoint, from a domestic tension standpoint.

19:18There's a lot of stuff coming at us over the next five to seven years that I think ultimately will feel like an energy crisis and a banking crisis simultaneously because there's a lot of capital that's been dammed with like a water dam into the U.S. economy that is probably likely to find a home elsewhere. So I tend to agree with them, maybe just not in terms of the acuity of the whole situation. I think that's a really important comment, Arius, and I think this plugs together. A lot of times we hear people talk and they seem to have really, really opposing views, but I think you just explained it really nicely that this is part of a major shift.

19:51And so sometimes the timing's off, but when you hear people talking about disinflation or deflationary impulse coming and buy bonds, and you have to ask them always what their time horizon is because they may believe that short term. But if you go further out the time horizon, they may swing back to where Cuppy is. And Cuppy, as a hedge fund manager, kind of looking for that next move. So they may be connected and have more in common than they would appear to have at the surface. So I love the way that you just explained that. And I love the idea of the damned up capital of having to find a home elsewhere.

20:26I think that's going to be a really important shift and change, isn't it? That's going to be a huge challenge for the U.S. government for a long time. And I'm not one of these people that says, okay, interest expense is here, therefore the government's bankrupt. That's nonsense. We're still the reserve currency. But I am one of these people that understands that the term premium, let's use a 10-year example, in the bond market is still deeply negative. It's somewhere around minus 60 basis points. That's not going to remain the case in the context of secular capital outflows from the U.S. economy, persistently weaker U.S.

21:00dollar, and persistently high inflation. I spoke about our secular inflation model on this program and then quarters passed, and that model is currently tracking at around 2.9 % for the stationary mean of the Core PC time series, which doesn't sound like a lot, but that's almost double from where it trended at pre-COVID. And more importantly, it's above the Fed's 2 % inflation target. So unless they change the goalposts, move the goalposts, which I happen to think they're probably going to when Plumberary gets higher enough, but they won't be able to change the goalposts until then. Unless they change the goalposts, inflation is going to be persistently higher than their price stability mandate.

21:36Recall that we're exiting a regime where inflation was persistently lower than their price stability mandate, which gave them political air cover to consistently remove duration and treasury supply from the market. which made it very easy for capital markets to function, very easy for stocks and bonds and crypto and everything else to appreciate, made it very easy for us to buy Lambos and go on vacations. It's going to be the exact opposite. We're going to have a Federal Reserve that's going to be persistently tighter relative to where we've been in years past. And that comes with a whole different set of asset allocation instructions and rules.

22:10And ultimately, it's just going to be a much more difficult environment to generate returns from being just naked long of beta and expecting Fed to consistently supply the market with liquidity. And I think that's a that's a multi-year process. I don't mean it sound like that's something that you need to price in today or tomorrow, but I think this is the regime that we're in. And I think the sooner your viewers and our viewers realize that's the regime we're in, the better they will reorient their strategic investment objectives to account for that. We're going to take another quick break to hear a word from our partners.

22:36We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:45Right, which is why we keep hearing people say, and in fact, at one point, Cuppie said it's a great environment when he was talking about a dual crisis. And I said, well, watch the interview, everyone. But I challenged him on that and said, what does this mean? Doesn't this? And he said, it's a great time to be a macro investor. And this is what we all have to wrap our head around now. It's a much more complex landscape.

23:08Go ahead. 100%. And you never want to be the smartest gal in the room in a trending market or in the same regime. Where it pays to be the smartest gal in the room is during regime change. Because that's where the money is made. If you understand – if you understand this transition to different regimes sooner than the rest of the market, sooner than all the beta and the passive flows associated with the previous regime, that's how you can set yourself up to make some very positive strategic returns. But absent that, I mean, I think it's just going to be a very difficult environment for the next five to seven years throughout the duration of this fourth turning until we finally get the big solutions that we need to the big problems that sit a lot ahead of us.