The U.S. Consumer Won't Quit

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1:31what's propping up the u.s consumer hi everyone welcome to our summer friday edition of the daily briefing with me today is darius dale founder of 42 macro hey there darius hey maggie happy friday how are you exactly darius are both mine we're talking about what a hectic week it was for everybody and we're psyched psyched that we made it to friday um so but on that note darius let's let's wrap up a little bit because we had a lot of information. We had a lot of things happening, Fed meeting, a lot of economic data. So as we kind of reflect on everything we learned this week, what's your take on what you saw and heard?

2:06Yeah. So, I mean, if I could summarize it, we can obviously unpack this for the, for the audience. If you think about kind of what happened with respect to the Fed meeting, we sort of termed it hunting for Bigfoot in terms of the Fed's posture, their shifting reaction function in terms of hoping for a disinflationary self-landing, which is a very unlikely probability in the U.S. economy. Shifting to the ECB, hunting for big game. This is sort of how I would contextualize Madam McGard's very aggressive, very hawkish press conference yesterday. And then lastly this morning, missed the hunting boat, I guess, if you will, in terms of the BLJ in Ueda.

2:44Or maybe crouching tiger, if you will. A sleep at the wheel. I don't know, something absent. Not quite on the hunt yet, but certainly in the woods. And, you know, it's got its vangs out ready. So we can unpack each of those things. But the conclusion, from my perspective, is we think the move down in the dollar has probably run its course. Maybe it has a little bit more juice to the downside here. But we ultimately think the dollar is likely to be grinding higher and draining global liquidity in the process in the coming months. So it's a lot to unpack. So why is the dollar? Why would the dollar be moving higher?

3:17especially when you see different policy decisions happening this week? What's driving that dollar higher? Yeah, so it really starts with, okay, where are we headed from the perspective of, okay, the data that are going to drive the central bank's reaction functions, and then more importantly, what's priced in with respect to those data. So I'll start with respect to U.S. inflation. We got U.S. inflation CPI on Tuesday. I want to say the kind of key highlights as it relates to sort of how we think about inflation on a three-month annualized rate of change basis. We saw Supercore CPI that decelerated 100 basis points to 3.1%.

3:53So that was very positive in support of this sort of hunting for Bigfoot posture out of the Fed. We saw Trim Mean CPI decelerate 110 basis points to 3.1 % as well. So we saw a pretty significant move down in inflation. And that supports kind of what that sort of sets us up for one more month of a significant move down in inflation on a year-over-year basis, which is what most of everyone else is looking at. We look at the sequentials, the front-run of the year-over-years. And the reality is we're probably going to see a significant drop-off next month in June with respect to year-over-year inflation.

4:25You've got the base effect on the headline inflation. It's going to drop off from 1.2 % month-over-month to zero. You have the base effect of core inflation. It's going to get cut in half from 0.6 % to 0.3%. And so as a function of that, I think the money markets are already pricing. Brian, if you can throw up slide three that we sent. And money markets are sort of already pricing this opportunity, this expectation in that the further inflation data are going to cause the Fed to maybe even pause at their July meeting, which may be the case. So on this chart here, I'm showing the blue lines in these panels.

4:58So let me start by saying this four panels. They represent the Fed, the ECB, the Bank of England and the Bank of Japan. The blue line in the panels represents the terminal policy rate as derived from the overnight index swap market, which are swaps on the respective policy rate in the locality, and the terminal floor rate, so what the main value is in terms of the two-year-out OIS curve. And what we're seeing here, if you look at a couple of interesting things happened this week. So the blue line in the top panel, which is the terminal Fed funds rate, was trapped and unchanged week over week at 5.37%, despite the hawkish dot plot revision of 5.625%.

5:37Number two, we saw the terminal ECB policy rate gallop higher week over week, up about 14 basis points. And then kind of the key takeaway we call out here is that money markets are pricing in twice as much easing by the Fed as they see out of the ECB over the next two years. 198 basis points for the Fed, 100 basis points for the ECB. And in our view, that's very unlikely given that, A, the European economy is in recession. Two, the European inflation tends to lag U.S. inflation by two quarters, which means they're about to head into the most disinflationary part of their disinflation process over the next two quarters, kind of starting in the second half of this year.

6:18So when you kind of put all those things together and tie a bow around that with respect to valuations on slide two, Brian, where we show our real interest rate differential model, we see that the dollar is slightly undervalued on a carry basis. So on the x-axis, we show the year-over-year basis point delta in the one-year real interest rate. And on the y-axis, we show the year-over-year percentage change in the nominal effective exchange rate, which is a broad trade-rated basket for the currency. And as you can see, most currencies are generally on the trend line. But the U.S., with the strongest carry in the world in terms of all these major currencies, it's certainly much below the trend line.

6:53And it seems to us that the market has kind of run with this dollar bear narrative, at least in the short term, a little bit too far. You know, so I'm going to I'm going to ask you for clarification, because I'm glad I put that out there that it's Friday and it's been a long week because I think my brain might be might be slightly lagging, but itself. So you're not because at first I'm listening to the Fed's hawkish. We're hawkish. This is a skip and it's the most hawkish skip there could be. Listening to them say that the market disregarded it, you know, the easing's out. but it still seems like everybody thinks the Fed may just be on hold now or that the rate hikes are done.

7:30So I'm thinking, why is the dollar going to strengthen on that? If I'm understanding you right, it's less you're looking at maybe they're just overestimating the amount of tightening or rate hikes or hawkishness from the ECB. And that's the side of the equation they have wrong. Is that right or did I did I go astray? Not quite, but it's it's it's along the appropriate path. What we're effectively arguing, going back to that slide three, where we show the terminal and floor rates and the spreads between them, is that the market has already effectively bought into this story that the Fed has effectively done.

8:03Seeing maybe a half of rate hike priced into the terminal Fed funds rate, whereas the ECBs you saw see move up substantially and continue to trend higher. We sort of really flatline in terms of terminal policy rate expectations out of the Fed. So the market is not buying. The Federal Reserve is going to continue tightening rates, hiking interest rates. which we believe is a very, you know, we want to take that option. We want to take that bet in terms of, you know, we want to invade that market expectation. And the reason we want to take that bet, Brian, if you go up chart four, quite a busy chart, but as you know, I'm not here to explain them.

8:36So, you know, we definitely believe that we're setting up to see a series of upside inflation surprises throughout 2023, at least until the market kind of catches up to where we are, where we've been at 42 macro with respect to the U.S. business cycle. Recall that since the fall of last year, we've thought that the highest probability of a recession, the highest quarter with the highest probability for a recession commencing in the U.S. economy was Q4 of this year. And the second highest probability is Q1 of next year. And we have a fun business cycle timing models to get us to that view. And so we understand that, hey, consensus is calling for the recession to commence in the third quarter.

9:15That used to be the first quarter. That was wrong. It used to be the second quarter. That was wrong. So they're just going to roll a quarter forward here. But if that's wrong, if that continues to be wrong, what's more than likely to happen is that as we get past those easy base effects in June on inflation and start to get into the July data and beyond, it's very likely that we're going to start to see a firmness of inflation, certainly on a relative basis to consensus, but potentially on an absolute basis as well. So going back to this chart, what I'm showing in this chart across these five cycles here, we're showing the median trailing 10-year delta adjusted Z score of a basket of indicators that represent these particular cycles in the economy.

9:55And it's sort of benchmarked to the number of months before and after when the recession starts. So there's housing. There's about 12 indicators in there. Orders is about 12 indicators in there. Production and profits, I think there's five indicators in there. Employment, I think there's 10 indicators in there. And inflation, about six or seven indicators. And again, we're showing the median trailing 10-year delta adjusted Z score. And so the Xs on these lines indicate when on balance, the compendium of indicators in each of these buckets breaks down below trend sustainably ahead of recession.

10:25And housing, as you can see, breaks down on balance around 18 months ahead of the recession. Orders takes down about kind of 10 months ahead of recession. Production and profits kind of break down around six months ahead of recession. employment tends to break down right as the recession is starting. And inflation being the most lagging indicator of the U.S. business cycle tends to break down kind of six to eight months after the recession starts. So we've already had a lot of transitory disinflation, going back to some of the inflation that we saw last year was indeed transitory. But we're going to get to the part of the movie where you're just not going to get significantly more positive inflation outcomes without having a significant drawdown in an overall labor market and an increase in slack in the labor market.

11:08Hey, 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.

11:21So, yeah, that's interesting. And this is where, for those of you who remember the conversation you had with Raoul, where you and Raoul have differences in terms of the timing of that recession. So do you think the Fed is going to resume? Do you think that we have more rate hikes coming from the Fed? Yes, absolutely. In our view, yeah, without question. It may not be in July because, again, the June data point we're going to get is going to be pretty dovish. It's already kind of priced into the market, so it's unlikely to surprise markets if the Fed does not hike in July. But certainly by their September meeting and, again, perhaps in their November meetings, they're tightening policy further.

11:55So interesting. And you certainly don't see that in the market right now. Before we get to sort of where things may be mispriced with the market, because, I mean, it was incredible. The Fed took such pains to deliver that message. Stocks rallied right through. We just saw the market kind of just not believe them because of some of the language. When we're talking about recession, we saw University of Michigan consumer sentiment rise to a four-month high today. That is interesting and kind of feeding into that conversation about the economy being stronger. What's propping up the consumer? We started the show with that.

12:30Where's that coming from? Why is sentiment holding up? So there's a variety of things that are propping up the consumer. But specifically as it relates to today's University of Michigan Consumer Confidence data, we saw almost 100 basis point deceleration in the one year forward inflation expectation. And that survey tends to be much more anchored on inflation dynamics relative to the conference board survey, which is much more anchored on labor market dynamics. With respect to labor market dynamics, that's also one of the things that's been holding up and propping up consumer spending, which, again, this is something we've been talking about 42 Mac research since July of last year in terms of the booming U.S.

13:05labor market. And it's obviously continued here throughout 2023. So that's one factor that's been supportive of the consumer in the broader U.S. business cycle. Another factor that's been supportive is the amount of cash that we continue to see on household and corporate balance sheets. Everyone talks about this kind of wonky concept of excess savings, but nobody tells you where it's excess above or below because no one's actually doing the math and the research on this stuff. They just kind of parrot other people's sayings. So we do the math and the research on this stuff. And in terms of the total amount of cash on household balance sheets and corporate balance sheets, we're about 3 % of total assets.

13:40We have to go all the way back to the late 1960s to see that high of a ratio of cash on consumer and corporate balance sheets, respectively. So that's one factor. Manufacturing as a share of the economy's declined significantly. It's only about 14 % of GDP. It's only about 18 % of GDP, 14 % of the labor force. Manufacturing on balance, if you look at the 12 post-war recessions that we have labor market data for, manufacturing on net tends to account for 98 % of the net job loss in the recessions on a median basis across those 12 recessions. So the more volatile sector of the economy is just smaller.

14:13So we got to do more damage to it to actually have a recession spill over into the services sector. And then one final thing, you know, Chair Powell talked about this on Wednesday, which is like housing is just not as housing is proving to be quite resilient relative to the interest rate shock that we were experiencing. And part of the reason for that is because of the interest rate shock. Ironically, you took interest rates in terms of the marginal mortgage rate for anyone in the market to buy a home from effectively zero to 7%. But you didn't take the effective mortgage rate across all the mortgage debt outstanding to 7%.

14:45It's still down around three and a half percent. And so what's happened is there's a complete stasis in existing home sales because no one is going to trade their 3.5 % mortgage for a 7 % mortgage. And so that's ironically put a lot of upward pressure on the demand for new homes, which is why the housing market is really kind of not tanking the way it would have historically tanked in recent cycles. That'll end once the labor market starts to deteriorate a little bit. But again, we've been very consistent on this for three quarters now. A recession at earliest is Q4 of this year. and second highest probability is Q1 of next year.

15:20That's a lot of time and space for bears to continue getting squeezed between now and then. That is a great point about housing, Darius, because, and the US is sort of known for mobility. That was one of the features of the economy, both labor and people were willing for that reason to sell their house. But you're right, no one is budging out of that three year, that 3%, whatever it is, low interest rate that they had. So that's very interesting that it would be putting that pressure on new homes and just hurting supply. We talk about demographics, but not a lot of people talk about that mortgage aspect of that.

15:50So the longer we push out the recession, does it just delay it or does it increase the risk that it's more severe for some reason? So I do want to clarify, we are not pushing out the recession. We've always been in that camp. Right, yes. To kick the can down the road on the recession. For consensus, right, you're right. For those who were expecting it to be sooner. I can't remember who said this. it was not, I don't know if it was Druckenmiller or Gunnlach, someone who was some sort of, you know, person of that nature that was talking expressed some concern that if we kept going, if there was strength that exceeded the consensus or the, you know, those who were looking for it, that it would just mean it would be harsher when it came.

16:36Do you see it that way or is it just going to be what it is? No, it's just going to be what it is. There's no historical evidence that like consensus being surprised about a recession means it's going to be harsher. What makes a recession tough in magnitude or, you know, kind of more less than shallow or less than mild is obviously the amount of tightening that we see. That's why I think they worried about that. Now that I'm thinking about it, I think it's because they thought if it seems strong, prompt the Fed to keep going, increasing the risk that they pile on maybe in a way that. Perhaps, but the key takeaway that's sort of not missed, that's missed in that view is that clearly if the Fed has to keep going, then they weren't at restrictive territory.

17:15It's only what happens after you get to restrictive territory and or how long you remain in a restrictive territory that really has an impact on the actual business cycle. So, you know, we've had, we said in August of last year, I think I said it on this show, you know, the number one thing we're going to be talking about next year is what's the actual level of the neutral Fed funds rate? It's probably gone up. It's probably gone up a lot, but deciding that cash analysis that we just highlighted, tons of cash on corporate and consumer balance sheets. Yeah, that's a great question. What's a neutral Fed fund rate?

17:45I think that's something that we're gonna be chewing over a lot over the summer. Very interesting question from Joel that I think I'll bring up here. This year, the Fed changed inflation measuring, now looking just one year back instead of two. Thinking of last year's spike, how much does that new measurement impact the current number? does it make it look better than it is? Ironically, it's actually making it look worse because again, we sent a little shift back to services. And so we're obviously consuming a lot more services, a lot more services demand in the economy currently relative to where we are in this kind of post-pandemic cycle.

18:20So it's not necessarily making things better or worse. I wouldn't focus on that. I would just focus on the actual deltas of the data. And the deltas of the data have been, we've gotten a lot of positive outcomes on the inflation front that historically very not, they typically do not happen this far ahead of a recession commencing. And so what it's telling you is that some part of the Fed, that 9 % CPI number we had last year, some significant chunk of that was in fact transitory as a function of the pandemic, et cetera. But there's also some significant chunk of that that is very not transitory.

18:54We continue to see the Employment Continents X, the most recent parents compounding getting nearly 5 % quarter-over-quarter annualized. We continue to see, obviously, the cash that's in the economy. And where does this all come from? Well, we know that we had bipartisan support to inflate the federal balance sheet. We grew public debt by$6.4 trillion in the two years ended 2021. Two sets of White House, two sets of Congresses. And guess how much of that$6.4 trillion of debt the Fed monetized on its balance sheet with outright Treasury securities purchases? $3.3 trillion, almost 52%. So clearly, there's going to be some residual impact on that for years to come in terms of resetting that amount of cash that's just sloshing around the U.S.

19:36economy higher. And this is why we're having an inflation episode. This is why we're going to continue to see sticky, structural core inflation. And the Fed's going to find it very hard to go from 4 to 2. Getting from 9 to 4 is pretty easy because there's a lot of transitory inflation. Going from 4 to 2, that's going to take quite a while. And the Fed acknowledged that in terms of putting out, you know, big three punting on their inflation projections to next year. Yeah. Christopher reminded me it was Druckenmiller that that said that, along with others who've been on our platform, sort of worried about, you know, essentially the Fed, you know, keeping their foot on the hiking, slamming the brake more than they perhaps needed to as this plays out.

20:15And Jordan responding, my mortgage was the best hedge I've ever made. LOL. I feel like a lot of people feel like that. A lot of people are hoping to get back to that kind of time, but not clear. Not clear if we're going to get there. Another interesting comment. I love how you guys are rolling up here on a Friday. Well done. We got some brainpower going here. I love it. Compensating for perhaps my lack of. Renewable Energy Investments asking or commenting kind of both. Have we not been in a purchasing power recession for the past two years? is there no chance that the answer to an employee shortage and housing shortage is not mass unemployment and a housing crash?

20:58Say that again, the answer to it. Yeah, so he's saying we've been in a purchasing power recession. Basically, aren't we going to see, is the answer, is the way to solve the employee shortage and housing shortage basically going to resolve itself through mass unemployment and a housing crash? Is that how? So I would disagree with the characterization. We have not been in a purchasing power recession. In fact, real disposable personal income is actually accelerating in recent months. If you look at it on an annualized basis, I mean, we're up about 1.7 % in the most recent month. And that's pretty close to an 18-month high or something like that.

21:35And so as a function of the disinflation process, we are seeing an improvement in real incomes. As a function of the growth in the labor market in terms of jobs, we are seeing more people employed. and obviously, again, citing that cash analysis that we did in terms of household savings and corporate savings. But again, there's just a lot of money out there supporting consumption. So it's coming from a variety of factors. You know, I wouldn't get too bearish on the consumer here. You don't need to, in terms of focusing on the consumer, it's when jobless claims start the rise. Going back to that chart, throw that chart up again, Brian, in terms of chart four, where we show our HOPE plus I framework.

22:08And again, shout out to Mike Kantoritz for giving me the idea to do this analysis. I think he was the originator of this kind of framework of thinking about the business cycle. But in terms of this, the reason it's – there's a logical progression to this. The most interest rate-sensitive sectors of the economy go – break down first. Then we stop ordering all the things that support the interest rate-sensitive sectors. Then all the companies that support all those things start to break down in terms of their profits. They stop producing as much. And then eventually their profits are at a level that forced them to kind of right-size their business with employment layoffs.

22:40where, you know, it's just, it's a natural sequence and a very, you know, kind of beautiful process that the business cycle, you know, is. And ultimately, you don't have to worry about the consumer until we get into the part where you're seeing real layoffs. You actually don't even have to worry about the stock market. You know, we actually, so we have this concept called phase two credit cycle downturn. You know, when you're in these kind of multi-year bear markets, which I believe we're still technically in, because again, we believe the recession is still ahead of us. And every recession, if you go back and you look at them all the way back to the act of the Great Depression, they always have a market crash associated with the recession.

23:12We call that market crash the phase two credit cycle downturn because it's usually pricing in the credit cycle. And that markets tend to peak on a median basis right around one month ahead of the trough in the unemployment rate, which is another way to say it's kind of coincident when you start to see degradation in the employment in the labor market, and you start to see degradation in the stock market. So this sort of belies our call that we think the market probably has legs through year-end, perhaps. I still believe that we're going to correct this summer as liquidity cycle kind of adjust down in a negative manner.