What is Making the U.S. Economy so Resilient? with Darius Dale

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

1:40what's making the u.s economy so resilient hi everyone welcome to the real vision daily briefing with me is darius dale founder of 42 macro hi darius hey happy summer tuesday maggie how are you absolutely we were just talking about this is the best stretch because we all know it's coming to an end soon at least here in north america so we're we're squeezing the best out of the last of the days. But yeah, and it's been a little hard because a lot of people just want to unplug and go away, but you really can't because there is an awful lot going on in the economy right now. The beginning of this week's feeling a little bit like momentum's a little bit slow.

2:17Some people are just, I think, trying to reset and figure out what's going on. We saw a little bit of a mixed picture for stocks for most of the day, although it looks like they're all going to end in the red. Actually, Nasdaq kind of bopping back in the green again, but right on that unchanged break-even level. Weakness in the banking sector was sort of weighing on the S &P 500. Treasury yields look like they're off their recent highs, but, I mean, they're still elevated. So what's top of mind for you, Darius, as we look across what's happening in markets? Well, to me, it's clearly this move that we're seeing in rates and how it's come home to roost with respect to compressing valuations and equities, raising credit spreads and things of that nature.

2:55It's the sustainability of the move that we need to figure out, the terminal level of the move that we need to figure out as it relates to valuations for other asset classes? And then ultimately, what's the endgame? We've got Jackson Hole on Friday in terms of Powell's speech. Where is this going? Where are we headed? Is it really truly higher for longer? Are markets going to have to finally start to price that in, which is something we've been calling out and calling out as a real key market risk for several quarters now in the context of our resilient US economy theme? Yeah. And so we'll talk about Jackson Hole in a second because it'll be interesting to see what happens.

3:31How resilient, let's tackle the question at the top. How resilient is the U.S. economy? Is this a sort of a lag? Are the leading indicators really that strong? You have been flagging, hey, this is stronger than everybody thinks for a while. And we are seeing that, but we're still getting a little bit sometimes of mixed picture. So what's going on? Is it as strong as it seems? Yeah, so we'll start by saying, A few things. So we authored the theme, resilient U.S. economy, last August. It's now August of 2023. And I think a lot of what we've been discussing on this program and other programs has really come home to roost in the data.

4:10So to answer your question specifically, Maggie, we are seeing it in leading indicators as well. Brian, if you do up chart one where we show our weather model, we have about 20 different features that each contribute independently to our asset class dispersion forecast on a systematic basis each day for our clients. And if you look at the top right component there where we show growth, we track growth in terms of the OEC composite leading indicator. And that number has been trending higher. If you look at the bottom middle of the page where we see the grid regime, the Goldilocks, which is a situation where growth is accelerating and inflation is decelerating, the U.S.

4:40economy has now casted itself into Goldilocks for the past five months. And it's likely to continue here in August per the data that we're getting in the leading indicator space. We obviously on the lagging indicator basis, we've gotten GDP accelerate for each of the last two quarters on a realized basis. Atlanta Fed's up at 5.8 percent, you know, effectively threatening a third consecutive quarter of reacceleration. And then there's a few other things that, you know, we sort of talked about. I think on the last time I was on the show in late July, we were talking about the potential for an inventory rebuild cycle in the second half of this year.

5:11When you go back and you sort of look at the level of goods demand in the economy, we're sort of growing goods demand in terms of real goods PCE at 5.4 percent on a three-month annualized basis in the most recent month. And if we continue at anywhere near that current pace of growth, we're talking about inventory cycle that's going to have to come home to roost. Corporates have been shedding inventories for the past five quarters on average to shaving about 73 basis points off of GDP per quarter. And so that's, in our opinion, something that could obviously inflect the manufacturing PMIs. It's already caused industrial production in black tire.

5:43We're seeing it in new home sales, et cetera. And there's a bunch of reasons for all that. Yeah. So since you brought up home sales, that's a good one to talk about because we did see it looked like sales were down. But what's going on? Is this the impact of higher rates or is this supply? What's happening with housing? Well, so there's just no supply. So I think what we saw today, I think we got the existing home sales number. That number came in at minus 20.5 % on a three-month annualized rate of change basis. Brian, you can throw that chart up, slide five, where we talk about is residential fixed investment making a comeback.

6:16So we've had this weird dichotomy in the housing market whereby the existing home sales market has been sort of starved of supply because investors are not dumb enough to trade their 3.5 % mortgage, which is the effective mortgage rate nationally, for 7 % mortgage. Obviously, duh, no one's going to do that. And so what's really happened is that we're seeing a real big supply response from the builder community. Now, if you go and look at the top two panels of this chart here where we show building permits. Those numbers are growing. Those building permits are growing 7.1 % three-month annualized.

6:46We look at housing starts, which is the second panel there, growing 31 % on a three-month annualized rate of change basis. And then the final panel there where we show new home sales, which are growing at 36 % on a three-month annualized basis. And Brian, if you throw chart seven up there, I can explain why this is this sort of where dichotomy is happening in the housing market and why it's created some incremental resiliency in the U.S. economy above and beyond what we've already highlighted and have been highlighting since last summer. So if you go and look at slide seven, in the middle panel there, again, we show the effective mortgage rate.

7:19That's the blue line there. It's at 3.6%. The red line shows the marginal mortgage rate. It's at 7.6.2%. And then we show the spread between those two lines. And because there's that widespread again, folks are not putting their existing homes for sale. So you're seeing the supply response to the builder community. And that takes us to the bottom panel in this chart where we show the blue line, which is the housing starts divided by existing home sales ratio. That ratio is at an all-time high at 36%. And so builders are really coming to the forefront and saying, hey, we have to fill in the supply gap here in terms of keeping the housing market lubricated and such.

7:56So in our opinion, this has been one of those factors that have contributed to the resiliency of the U.S. economy, it's number seven in a list of 10 factors that I've highlighted several times on this show throughout the year. And ultimately, I think we're seeing a lot of this come home to roost in fixed income markets. And that volatility is obviously spilled over to broader asset markets. That's so interesting. So I guess, does that bode well for home builders? Are they going to be able to sell those homes? Because the new buyers will have to pay those higher mortgage rates, right? Yes and no.

8:27So there's all these sort of programs that they can do in terms of helping folks with financing, taking points off, et cetera, et cetera. I don't know what percentage. I don't want to pretend like I've done enough research on that. But I don't know what percentage of that in terms of incremental sales that is. What we do know is that housing starts as a percent of total existing home sales is now at an all-time high. And so there is a supply response. So from the perspective of the economy in terms of keeping construction workers employed and keeping the folks at Home Depot standing outside waving to the developers buying lumber, it's continuing to click.

9:02That's so interesting. So in a way, this has come up before, but in a way, the higher interest rate environment is actually stimulative as opposed to being restrictive. Is that something we need to think about? Because contrary to what people think, right? Oh, low rates are stay-a-militative, high interest rates. The Fed's trying to slow the economy. But in this case, they're stoking housing construction. 100%, Megan. It's all about the long and variable lags and respecting the x-axis on these processes, right? And so you think about the Fed jacked rates from 25 basis points to 5 and 50 basis points in a matter of, let's call it, three or four quarters.

9:41That happened really quickly. And so if you go back, Brian, if you put this slide six on the list where we show all the key factors contributing to our resilient U.S. economy thing, most of these we authored and discussed going back to last summer in our published research at 42 Macro in terms of helping investors understand the likelihood that we wouldn't go into a recession as soon as Wall Street thought we would. Bond yields probably had a month more upside relative to what folks were trying to price in to the curve at that particular time. But I'll draw your eyes to number six there when you look at the longer, long, and variable lags.

10:11So let's kind of play this out, Maggie, in terms of, you know, kind of how all this stuff kind of hits the economy. When the Fed jacks interest rates to, let's call it 5.5%, the first thing that happens is no one really needs to refinance. Because if you go back and you look at the duration on corporate credit in terms of the broader aggregate corporate credit index that Bloomberg keeps track of, and the mortgage-backed index as well, we have duration in those indices as high as they've been since going back to the early 80s. And so that means that the demand for investors or for folks in the housing market, consumers, and for businesses in the corporate credit market to refinance debt is actually quite low.

10:49Well, not only is their demand to refinance debt is low in terms of the duration on their existing debt, but you also have to think about it from the perspective of the spread between what they're paying on their existing debt relative to what they would have to refinance into. So not only do they not need to refinance in terms of having very long duration securities in terms of debt obligations, but they don't want to refinance because they look out and see interest rates as, you know, four or five, six hundred basis points higher than what they're currently paying. And so it sort of slays this whole refinancing game that we've been used to on Wall Street over the past over the past, you know, kind of a couple of decades.

11:24And what it's done is it's reduced supply of incremental supply in the mortgage market. It's reduced incremental supply in the credit market. And that's one of the reasons we've seen credit spreads actually quite tight this year. Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus 500 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.

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12:47Yeah, that makes a lot of sense. And it's, you know, again, it's important to, I think, understand that where you were sitting, the situation we were at going into this episode, because it certainly looked different for residents and housing back in 07, 08, when people had so many floating, but with so many people unfixed. And the same thing with corporations, if they'd cleaned up their balance sheets and they have longer duration, super important to understand that. It's been fascinating to see that because we put the factor up or the resilient every time you come on, Darius, and it feels like another one of those points is really highlighted in what's going on.

13:21And we're seeing it with more clarity in the data. So it's very interesting in terms of this interest rate reset. So Julian and Rao were talking about yields at these levels in their latest monthly pro-macro insider talks. And Julian remains worried that yields have further to run. Let's listen to a clip from that. And then we'll talk on the other side. And it started a few weeks back with some of these other curves in the rest of the world. And we've obviously had tensions in the JGB market. We've got the BRJs down there. We've talked a lot about fungibility. So the idea that all of these fixed income markets are linked with each other.

14:07So if bond yields move higher, If GILT yields move higher, if JGB yields move higher, that's going to apply pressure on treasuries. And the whole thing becomes to a certain degree circular. And I think to Raoul's point, I think this thing has got more room to run. I wouldn't be surprised to see 5 % in 10-year yields maybe. Maybe if you get up there, certainly the sort of high fours of maybe five or 30s. But I think that's kind of where we're going. And I think it goes, and this is probably, I guess, where you and I tactically disagree a bit, Raoul. I think it goes until we have acute pain. And acute pain, to my mind, only comes about in the equity market.

15:03That full interview and conversation with Raoul and Julian, they do it monthly. available on our platform if you'd like to join or upgrade so you can watch it every month. Just scan the QR code and join our waiting list. We're not taking anyone new at the moment, but there is a waiting list, so jump on it. So Darius, I don't know, what are your thoughts about that? Do you worry about higher rates eventually causing a severe downturn in equities? They will eventually, yeah, for sure. It's just about respecting the x-axis on these business cycle processes. This stuff just takes time to play out, and I think that's what a lot of investors sort of gotten wrong in the first half of this year, you know, positioning for a recession, both in terms of being long, overly long fixed income and underweight equities.

15:42It's just that this stuff just takes time. You got to respect the X axis. And so, you know, to Julian's point on 5 % on the 10 year, it's not unreasonable. I mean, obviously we're not that far now, around 430 or so. But, you know, we've had a view going back to, you know, summer and fall last year that we thought we would see 5 % on the 10 year. And I think we sort of, you know, kind of got shotgun shy about that view at the end of the regional banking crisis. But it's pretty clear from our tracking of the H8 data that there's no regional banking crisis from the perspective of credit creation.

16:12And so we have to start really asking ourselves, what is the path to getting to 5 % on the 10-year? And I think it's a pretty easy, credible path if you want to put some real math on it. Right now, we're tracking around minus 30, minus 40 basis points in terms of term premia on the 10-year. And that's not to be confused with the term spread, which is what everyone's citing in terms of expecting a recession, the term premium is the excess return you get for blocking in your rate, your capital, as opposed to rolling it over for the same duration. And so that's about a minus 40 basis points. If we just go back to zero, you're talking about 475-ish on the 10-year.

16:45And I think you could easily see another 25 to 50 basis points of lift on 10-year inflation expectations. We run a model that we refresh every month for our subscribers at 42 macro, which is where that key factors page that we just showed a highlight came from, is that model shows that the underlying trend of core PCE is likely gravitated from around 1.6 % in the previous decade to about 3 % in this particular decade. And that doesn't sound like much. But if we're talking about 3 % core PC inflation, we're not talking about 2 % break evens on a sustained basis. We're talking about something that looks closer to 3.5 % 10-year break-evens on a sustained basis.

17:25Now, I don't think we're going there in a straight line, but I think over the next, you know, call it three to five years, it'll be pretty clear in the rearview mirror that inflation settled out at a much higher level relative to the Fed. And this is where we get our call for the Fed to ultimately amend its inflation target. You know, they're going to push back hard against that on Friday, in my opinion, but I think two, three years from now, an unemployment rate that's at five and a half or six and a half, as opposed to three and a half, I think you're going to hear a way different sort of course from Federal Reserve policymakers.

17:53Which is so important to point out because that's going to impact everyone's model. By the way, Timothy says key factor sheet is epic. Thank you, Timothy. We agree. So you mentioned something, two things I want to tease out from that. First of all, you mentioned that was your thought and then you had a moment when you were reconsidering when we had the banking crisis. I think that happened to a lot of people, right? You had that happen in the moment and everybody went, wait a minute, this could be a different game. And then we got past it and people went back and the market tracks that. The yields, we've seen that create a lot of volatility in yields.

18:37Do you think we, you just said we don't have a financial sector, a banking situation. We do not. Talk to us a little bit more about that because we see Citibank is very weak. We see Charles Schwab laying off people, issuing debt to raise capital. We've had downgrade, more downgrades in the financial sector. They seem to be a laggard and dragging on sentiment today. Talk to us about what you're seeing in the financial sector, in the banking sector. Yeah, I mean, to me, it just comes down to four simple letters, which is BTFP. The issue in the financial sector was all this duration, risk that all these banks had to wear on their balance sheets, and ultimately they don't really have to wear it anymore.

19:18And so it sort of removes the kind of left tail from the distribution of outcomes. It doesn't mean that banks are, you know, they're going to be swimming in money and like Scrooge McDuck anytime soon. But the reality is, is we just don't see it. And again, when you track the HA credit data, we're seeing a recovery in credit growth. I mean, again, and it's still down, it's still negative, contracting at a negative rate, but it's improving at the margin in second derivative terms. And this is something you can obviously see just, you know, eyeballing GDP statistics, But obviously you go underneath the hood and some of these other indicators of the economy.

19:49Retail sales last week accelerated 8 % for retail sales. I mean, come on. I don't know how people are missing this stuff. You know, industrial production accelerated. You had housing, the home development accelerated. And New York Fed has this index of services sector activity that accelerated for the month of August. I mean, this is an economy that is very clearly not being restrained by kind of credit growth, which, by the way, is only about 34 % of total private financial sector credit here in the U.S. economy. So when you're thinking about credit in the U.S. economy, you have to think off bank balance sheet.

20:19You've got to think non-bank financial sector in terms of those fluctuations. And those fluctuations are always going to move where the S &P is at, where credit spread is at, where the dollar is at, and ultimately where interest rate volatility is. So Dan asking, you mentioned Jackson Hall. So people like to say, oh, it's a sleepy summer conference for bankers and a lot of wonky conversations, which is true many times. But it's also an opportunity for them to reset market expectations if they choose to. and if they want to. So it's always something we have to pay attention to because you never know which one it's going to be.

20:49Super boring or they drop a bomb. Dan asking, I think, a really smart question. We were just talking about will the 10-year hit 5%. Does the Fed really need to raise rates again if the bond market is doing the work for them? No, no, they do not. I don't believe the Fed has to raise rates again. And certainly it's unlikely that they're going to by September because it's unlikely that we're going to see anything in the development of adverse wage, adverse labor, adverse inflation data, materially adverse relative to the current state of the condition of the data between now and then for them to raise interest rates.

21:23And I think the further you go in time, the more likely the Fed just gets comfortable with how much time this process is taking, right? They've already kind of given us a hint on their future policy, right? I think they, you know, when they had that awkward, you know, I think it was the June FOMC when they had the awkward, you know, like, no, the pause, but we're going to put two more hikes on the dot plot. I think that was just Powell acquiescing to some of the hawks on the committee or vice versa. Maybe they were acquiescing to Powell in terms of wanting to maintain the hawkish posture. But the reality is they don't need to.

21:53I mean, eventually these rates will become restrictive as we move forward in time and we start to lose, you know, borrower A, borrower B in the household sector, borrower C, borrower D in the corporate sector. These things just take time as firms and households have to come up to the belly up to the refinancing beast. that's just going to be a long process. But ultimately, you know, we're ultimately going to get some of the outcomes the Fed wants in terms of slowing the economy materially enough. It's just not happening now. And the reason, you know, again, we just go back to that slide, Brian, I think we can just leave this up for the whole discussion is like six, just contributing to our resilience economy theme.

22:28And I'll be frank, you know, not all 10 of these were on the list when we created the theme last August, but we've been accumulating them throughout the year and really to just, you know, continuously push back against this barest chorus of investors that were constantly worried about a recession. We still think of recession as a mode of outcome. It's just not going to come when people think needed to come in terms of their positioning. But one factor that we have accumulated this year in terms of supporting this is number eight, which is biodynamics. A record non-war, non-recession budget deficit here in the US economy.