The Q4 Business Cycle: Leads and Lags

0:08Hi, everyone. Julian here from Global Macro Investor with another update. For those of you who don't know me or haven't seen me, I head up global macro research at Global Macroinvestor. with Raul. And I've been coming on this year doing kind of a number of updates around our core thinking on the business cycle. And I thought that today would be an interesting time to come back and update you on our views for Q4. Now, for those of you who watched the last In Focus from Raul, what we did is we went through a presentation around Tesla and this big kind of inverse head and shoulders pattern. And then we worked backwards from that bullish chart to construct kind of a narrative around what would be required for that to break out, right?

1:00So we covered that from a number of different angles, you know, from macro to liquidity. And I thought that I would do the same thing again today, start with a chart. And then we would kind of talk through around what would be required for it to kind of all kick off and take place. So what I'm going to do today is I'm again going to run through a presentation with you guys, starting with a chart, and then we'll look at it from all kind of core angles, including the business cycle, inflation, sort of our thoughts around where we are in the cycle via early cycle, late cycle, because that's another extremely loud narrative in the market right now, as well as liquidity and importantly, also sentiment.

1:50So I'm going to pull this up. So the first chart I want to show you, and this is the chart that is going to be the basis around this presentation, is the chart of S &P seasonality versus the current price trajectory that we've seen so far this year. And for those of you who aren't totally familiar with seasonality, essentially what I'm looking at here is the average price trajectory for the S &P 500 going back to around 1960, perhaps a little bit sooner. But again, a very good historical composite of daily returns. And what you can see is so far this year, we've been tracking this historical period with around a 91 % correlation.

2:39And as you can see, Q4 tends to be the most positive patch for equities, again, going back to around 1960. Now, this is also true of, on the next chart, here is the semiconductors ETF. Now, we've been long semiconductors all year. For those of you that are familiar with our work, you know, GMI is really about the business cycle. So we use that as our cyclical framework. But it's also about the secular framework. And so exploring the exponential age, our thoughts around the secular trends in technology, crypto, and that kind of how that all comes together. And when most importantly, we add to our secular bets due to where we are in the business cycle.

3:32So this is really what we're looking for here, right? It's opportunities to add to our secular bets at inflection points in the business cycle. And again, here is a chart of semis and Q4 tends to be that really kind of oversold or sorry that very explosive period for semis and if we look at the long channel if you pull it up on Bloomberg or something you'll see that we're minus two standard deviations oversold versus that channel so this is an interesting chart and from a very high macro level if we look at the next chart you can see that the semiconductor cycle is still in the process of bottoming right we're still very early days we've been showing this chart you know for really a number of months now.

4:19And it's a good global lead indicator, or I would lead indicator, coincident economic indicator of or barometer of how global growth momentum is behaving. So again, trying to start with that chart on seasonality. Now I want to work backwards and look at what needs to happen in order for that to take place. And what I think needs to happen is the ISM needs to continue higher, which I'm going to go through a couple of charts now on the base case for that. I think also, you know, we need to dispel the late cycle narrative. And, you know, this needs to not be late cycle, but, you know, early cycle, which I'm going to get into.

5:06We need to see some kind of improvement. and we've seen improvements in ISM, but we need to see a recovery in foreign demand. So let's say an improvement in countries outside of just the US. We also need to see core CPI head lower. And the reason I'm specifically targeting core is because I'm talking about central banks here. And I'll come into how to think about inflation a little bit later. Weaker employment data, and I'm really talking about unemployment here. We're going to talk about the latest payrolls number as well as a couple of other numbers here in September and get through that. So I'd like to see those numbers weaker into Q4 because I think that that gives the Fed cover to basically stop QT.

5:55So again, there we're going to talk about liquidity and then I'll basically wrap things up on sentiment. What we're trying to do here is in order to get this seasonal pattern correct, and see the kind of the melt up that that chart is implying is we want to catch basically the bears offsides, right? So we want to see depressed sentiment there. So we're going to do that as well later on. Now, in terms of growth, the first chart I think is always very helpful to start with is the GMI business cycle dominoes, okay? And what this is, is the showing the ISM leads versus lags. uh so again for those of you who have been in the pro tier uh for this year you love be familiar with this chart but just as a quick reminder anything to the right side of t equals zero ism leads the ism and anything at t uh equals zero and negative lags the ism and so raul and i have really been focused on our lead indicators like uh the gmi financial conditions index new orders to inventories, which just tends to be where risk assets operate.

7:04And it's important, just I'm going to name a couple of data points. Only a few are on here, because otherwise it gets really confusing. But just to understand that basically everything else is lagging. You know, at minus one month, you have overtime hours, right? So hours worked. At minus three, you've got durable goods. You've got capital goods orders. You've also got GDP. So that's up at minus three versus ISM. At minus four, you have industrial production. You've got things like imports and exports. So that's at minus four. At minus five, you've got cyclical job growth. So there I'm talking about manufacturing, construction.

7:40At minus seven, you've got unemployment. Excuse me, at minus six, you've got unemployment. And these are average lags, right? At seven, CPI. And then all the way back, you've got things like wages and CPI shelter, the most lagging elements of the business cycle. And even if you come back up, you know, at minus two, you've got things like retail sales. Again, it's just the bulk of this data really lags the ISM. So in terms of ISM, what's actually been happening and what have we been talking about? Well,

8:20the RISM momentum index, right? Here we're talking about a six-month lead versus current ISM, had been projecting that the ISM would start to rise, right? And is currently suggesting a seven point rise in ISM by March of next year, which would suggest an ISM of around 53, you know, during Q1 of next year. And this is also in line a little bit less of a lead. But here we're looking at another one of our lead indicators, which has been pretty much spot on recently, suggests that the ISM will be a little bit higher, but mid-50 regions, region by Q1. So all of these, you know, our forward-looking indicators have turned higher.

9:09And, you know, looking back at where we were, In Q1 of this year, this is really what we've been calling it for. And you have to remember via the business like Domino's chart that equities bar anything systemic or entrenched will tend to front run the ISM. And that's what they've been pricing in, which is why during our New York interview that Raul and I did, I think it was back in February. You know, we were already talking about this happening and that this was going to be priced in and that the ISM would shortly turn higher. And even if some of our lead indicators were pointing lower, because some of them were split, right, suggesting that the ISM could go a little bit lower, we said that that was already in the price of equities and that had been priced in in Q4 of last year with an ISM of around 45 being priced in with the S &P 500 and something like 37.7 in the NASDAQ.

10:07So we said even if it does dip lower, which again, was our base case early Q1, but then we saw kind of everything turning higher. So we switched gears, but we were already saying that it wouldn't really matter for equities and that they would trade higher because they had already priced it in essentially. Now coming in a little bit closer, now we're coming into new orders minus inventories. So at three months versus current ISM, again, we saw another big rise in September. And even when we look at the coincident market data, and I mean coincident versus ISM, you know, enrichment fed numbers in September exploded higher.

10:48And it's exactly the same thing when you look at the Empire survey for future new orders. This is really the outlook for new orders over the next six months. I mean, big, big moves. And this is, again, what we've been expecting and talking about. And part of the reason why equities have been grinding higher this year, despite, you know, a correction over the summer months. Now, so just covering, coming back to that seasonality chart at the beginning, as I say, let's look at this chart, say what would need to be true in order for this to happen. And one of those is that, you know, the manufacturing sentiment would need to trade higher.

11:30And we think that that happens, right? Looking at these, continues to happen, looking at these ISM lead indicators. Now, public enemy number one right now, and there's three of them. This is late cycle. Public enemy number two is inflation. No, public enemy number two is actually the credit crunch that's coming. And public enemy number three is inflation's sticky and is going to remain higher. So let's talk about public enemy number one, which is that we're late cycle. And I really like, this is how I've always thought about the business cycle, is I've taken a series of indicators, which, and you can see here, we're talking about equity valuations, we're talking about the yield curve, we're talking about earnings, margins, labor market conditions, which I'll come to in a minute, CEO confidence.

12:29And you can see that really in Q4 of 2021 and early Q1 2022, that was economically speaking, we were at levels historically consistent with a late cycle economy, right? Wages were still rising, now they're falling. Job openings were still rising, now they're falling, right? But the yield curve wasn't quite inverted then, but it was nearly 15 bps from inversion or so by March of 2022. So we were very close. So the yield curve was very flat. Evaluations were expensive. They since come down. So the point is, when you look at the total number, while we were at 94%, as I say, with this region of Q4 to Q1 of 2022, we've since come down to 44%.

13:23The ISM peaked. It's now troughed. Inflation was extremely high. It's now come down. And here I've excluded shelter, the lagging component. Labor market conditions, people are looking at a 3.8 % unemployment rate. But there again, I'm not talking about the unemployment rate because as I said before, that's lagging versus the ISM. So you need to be focused on leading indicators of employment. And that's what I have within this framework. So that's come down already considerably. What else? What else can we look at? CEO confidence. CEO confidence was extreme. It's now bottoming. We're going to look at that in a second as well when we get into kind of the credit crunch public enemy number two.

14:08So the second or part of this late cycle thing, and as I mentioned earlier, is what we, there's a lot of people still talking about foreign demand remaining week in 2024. But the point that I've been making for a while now is that it's already very weak. And if you look at Eurozone imports from non-European countries, it's very likely that Europe's already in recession. And we've been talking about this for a couple months. And also, you know, countries like South Korea, their imports have been improving over the last two months, which is, you know, again, what we've been expecting. But you can see that this was basically recessionary levels a couple of months ago.

14:48So foreign demand is already extremely, extremely weak. But when you look at forward-looking indicators, so here we're looking at the percent of EM countries with rising OECD country breadth. So the number of countries rising month-on-month creating a diffusion index. And this is advanced 11 months versus South Korean imports. So you can see here we're really talking about an environment where over the next three to six months, these numbers should be higher. And it's also highly inconsistent to see the ISM turning higher without global exports also turning higher because the US tends to be leading in the cycle.

15:30Now, beyond economic momentum turning higher, what we're also seeing is, and again, I've shown this chart a couple of times now, it's interesting to watch it progress. Because I had shown this chart when we fell below 10 % of countries with lead indicators above trend, the way to think about this above trend being 50 and expanding. we felt we were below 10 % historically speaking going back to what is it 1965 or so every time we've fallen below 10 % it tends to be a pretty good or I should say a very good strategic buy signal for equities and I think I showed this at 16 % a couple of months ago so we were rising now we're at 29 % but we're nowhere near you know the levels that would you know peak economic levels within that late cycle framework in fact um this is not included there but you can very much see that uh peak levels are you know not quite at 100 percent but you know clearly above that 80 percent level consistent with um a lot of the other indicators right when i say we get above that 80 percent 80 percentile of the indicators included within that late cycle composite, that tends to be signaling that we're late cycle.

17:18opportunity, 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. S &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 Plus 500. With over 20 years of experience, Plus 500 is your gateway to the markets. Visit us.plus500.com to learn more.

17:54Trading 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.

18:06So public enemy number two is, as I said, the credit crunch. and we actually covered this Raoul covered this briefly um and it wasn't the latest in focus um but an update uh as well in the pro tier because this is something I've been talking about as well um since really April in on Twitter or X whatever um and the point here is this is what people are really talking about. People keep saying, respect the lag. And I mean, I would say that that's overused, misused, kind of misunderstood. There are leads and lags in the business cycle. We've outlined them within the dominoes, but this is one historically, this relationship between bank lending and bank lending standards.

18:56So here I'm basically looking at large, medium, and small firms within this CNI loan bucket, so commercial and industrial loans, as well as household credit. And I've basically aggregated them all together to create this bank lending standards, all sectors bucket, and it's advanced 12 months versus bank lending. So what people are saying is, from mind the lag, bank lending is about to slow. And what I've been saying, as I say, since basically April when I wrote this thread on this, is that just like bank lending standards are leading versus actual bank lending, the ISM also leads bank lending standards by around 12 months.

19:40But again, going back to the GMI business cycle dominoes, the equity market tends to front run the ISM by around three months trading in line with those new orders to inventories. And then Raoul and I are further out trying to anticipate these transitions. And so the point here is that the market tends to move in line, if not a little bit before the tightening in credit standards, but tends to look through the tightening in actual bank lending because of the lag. And more recently, if you look at this chart, you can see that the ISM has actually been perhaps even leading a bit further. And indeed, here there's a four-month lead versus bank lending standards.

20:20Here I'm looking at bank lending anymore. We're going back to that lending standards metric. And you could see that if anything, the tightening, the worst of it is now behind us with the ISM starting to base. And what's being implied by new worst inventories is that we should see bank lending standards altogether starting to ease from here or at least tighten less significantly, right? So turning higher. And you're also getting a sense of that. CEO has got a pretty good sense of what's going on at a high level, at a macro high level. And conference board CEO confidence has been trading higher for a couple of quarters now.

20:58It leads bank lending by around, well, a quarter. So again, we're nearing the end of this tightening cycle. And that's what equities have started to price in. Very similar to our GMI financial conditions index. The worst of the tightening was already behind us in Q4 of last year. I mean, our financial conditions index was as tight as it was during the global financial crisis. So, you know, something like 2.5 standard deviations. It was a really, really big move. And our financial conditions index was leading the Goldman Sachs measure, you know, by a number of months. And so people were still looking at the Goldman measure saying financial crisis are extremely tight.

21:36But they had already actually started to ease. So if anything, this data, the bank lending standards is leading, as I say, bank lending, but it's not a good leading indicator of the economy because the ISM tends to lead that by, you know, recently by around four months. And as we said, based on our lead indicators, the ISM is starting to base and should be back in expansion territory, you know, next month or the month after that, and well on its way to 55 by Q1 of next year. And coming back to this equities, you know, having already priced this in and financial conditions being as tight as they kind of since global financial crisis in Q4, you can see here, here I'm not talking about bank lending, I'm talking about the standards component again, which is again leading bank lending, actual bank lending activity by 12 months.

22:33The S &P 500 has already priced this degree of tightening last year, which is what Raoul and I were arguing all along, was that with equities down as much as they were in Q4 of last year, that we've already priced in a significant tightening in bank lending standards and therefore bank lending with a 12-month lag. and that essentially things couldn't really get a whole lot worse in terms of the year-on-year comps and equities would need to price in an increase in the rate of change because that's where markets discount. It's not the nominal index level that matters. It's actually the rate of change.

23:21Um, so, uh, again, financial conditions, uh, have loosened, sorry, loosened. Um, there's, they're starting to tighten a little bit now with what we've seen with the dollar. Um, also bond yields kind of remaining elevated, but the interesting thing about bond yields is given the year on year comps, even if yields are starting to rise a little bit more here, The year-on-year comp is still coming down, which in a way is also an easing of financial conditions. But the fact that commodity prices have also started to rise has tightened things. So what we need to see is essentially what's been driving financial conditions looser over the course of from June 4 essentially through to the middle of this year was dollar weakness coupled with commodity prices falling as much as they did.

24:16Now those two tailwinds have become headwinds to an extent, but the fact that bond yields in year-on-year terms are still kind of coming down, that can create the next event of potentially a rollover in the dollar as well. because what's going on with the dollar is why the dollar has been bid recently is because what we've seen is on the left-hand side of the dollar smile when the u.s when u.s growth outperforms the dollar tends to strengthen which is what we've seen versus europe and you know the countries like south korea which i showed you before but the dollar also strengthens within our framework our quantitative framework which is winter when growth is lower and inflation is lower which is essentially a scramble to buy safe haven assets, dollar included.

25:11But at the low end of that dollar smile, essentially a period where global growth momentum starts to improve, we see synchronized global growth momentum, which is what I just showed you with the ISM versus global exports. That tends to be a phase where the dollar is weaker. So that could also drive the next lay higher in financial conditions. But our GMI financial condition index leads the ISM by nine months and it leads equity markets by six months, given that three-month delay that I've just discussed. So we have a view whereby equities might trade a little lower into one of next year for a period of time before financial conditions start to ease again.

25:55But we have a lead on that, so we can monitor that. It's essentially. Now, the public enemy number three is inflation. Okay. So sticky inflation. And I've covered this dashboard a couple of times, but the important thing is from a very high level is understanding the split of inflation. So we're at a very strange, not strange, very normal point of inflation whereby, you know, energy is 7 % of overall CPI. Food is around 13. And then core is 80 % of headline CPI. And within that core number, that 80 % is split roughly at around 21 % goods, so commodities X, energy and food, and 59 % services, of which that service is all basically rents or shelter.

26:46So you can see that here. I mean, basically goods inflation and energy inflation have already kind of done their thing. This is what drove headline lower over the course, in line with what Raoul and I were talking about since basically May of last year during our last roundtable, we were saying inflation was peaking. So this is what's driven headline CPI lower. But as you can see, the heavier component like shelter is still very elevated. And that's 35 % of headline and things like education, recreation. These are also included in CPI services. And they're not big weights, that are around, you know, 5%, but again, all peaking.

27:30And so this is, we're at this stage now where, you know, commodities can start to trade higher. So I can show you that on this next chart, you can see that, you know, this is the Bloomberg commodity spot versus CPI. We can see that commodity prices are actually still negative in year on year terms, but they had plunged and this was driving the CPI number lower. But it's also very normal if we look at the next chart that given where we are in the business cycle, so new orders, inventories, this leading commodity prices by seven months, that commodities will start to trade higher. But even things like food, which is, as I say, 13 % of CPI, when you look at lead indicators for food, prices.

28:21I mean, food prices are still on a year-on-year basis falling from something like 11 % down to just above 4 % today, but fertilizer prices are still collapsing. That's a good lead indicator for food. But more importantly, the shelter component, 35 % of total CPI, is still coming lower and should continue lower well into 2025 because case shiller house prices are leading by 15 months and so like i said actually i'm going to come back to the historical composite in a second gets to the bit a little bit later but in terms of those sticky this is the thing to focus on in terms of those sticky things so the things that are large and lagging there's still evidence that those are going to come down, including wages, right?

29:12There's absolutely no evidence out there. And we've been talking about this. We pushed back hard on wages basically all this year. But when you look at service sector wages from the Richmond Fed in September, they continued lower, right? Similar to wage expectations for manufacturing. Again, new cycle low in September. Looking at the Atlanta Fed wage growth tracker, so if we're looking at jobs, switchers collapsed again in August. And here's the thing is, this is what we've been looking at is our lead indicators for wages. So despite all the hype and the talk and, you know, I mean, at GMI, I try and remain as data dependent as possible, right?

29:54I mean, there's a whole bunch of narratives out there around, you know, everything from where we are on the cycle to wages was another one to the credit cycle. And, you know, again, trying to remain as data dependent as possible. And another chart here is the quits rate. So even in September, looking at the jolts, quit rate numbers, again, big down, right? And this leads the Atlanta Fed wage growth tracker by around nine months. So there's just, you know, no real evidence that wages will rise again from here. Yes, they're still elevated, but they'll continue to come down given where we are in the business cycle.

30:34When people, again, going back to the late cycle narrative, wages are rising in late cycle, not falling. And then coming back to that historical composite, you can see that actually as energy inflation, and here we're looking at the major five historical outbursts of inflation going back to the 1940s, kind of see that inflation headline comes down it starts to turn higher for a period of time as you know the kind of the leading elements of inflation so commodity inflation the higher commodity prices leads to higher goods price prices which late in the cycle leads to higher services prices services inflation as those as as the forward-looking stuff commodity prices starts to turn higher and all of that really heavy stuff actually Raul and his focus did some great kind of hand visuals with that you know peaking right so the the sticky laggy stuff is is peaking but they haven't really done their move yet and yet commodity prices which are in total 28 percent of cpi if you include the goods um plus energy but then you just have the shelter component alone which is bigger than that coupled with all the other things that i mentioned as these kind of this move hasn't yet happened yet and this is starting to happen you know cpi trades a little bit higher and then reverses lower again, which is hugely non-consensus.

31:55I think everyone's of a view that CPI has bottomed. And we saw something also very similar in the late 1940s. And this has been our kind of base case for inflation all along. And this is not the triple wave of the 1970s, which was largely driven by demographics. But what we know now is that it's not the same situation here. I mean, what we're looking at is post the 1940s is as the war ended, people left the military labor force, entered the civilian labor force, and you saw a big influx in both demand and supply-related inflationary pressures, which sent inflation skyrocketing higher. Then in 1947, it peaked, rolled over, bounced a little bit as those components started to, heavier components peaked, you know, a commodity started to base around and then continued lower and went negative for a period of time and then spiked higher and then kind of worked itself out.