Where Are We in the Cycle? With Warren Pies

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

1:40where are we in the cycle welcome to real vision daily briefing it's thursday august 31st 2023 i'm ash bennington joined today by warren pies co-founder of 314 research warren welcome back to real vision yeah thank you for having me always a pleasure to have you here listen warren we were chatting a little bit before the show went live. Obviously, this is an interesting moment for markets. Where do you think we are right now? Big picture, 50 ,000 foot view. As we talked about before the show, that's the question I think on everyone's mind. This has been a year that's thrown most forecasters for a loop.

2:19We came into the year with a record number of forecasters calling for a recession. And so the consensus was as tightly formed as I've ever seen it around the macro economy. And obviously the stock or the economy did not comply with the forecasters. And so our view, just to be brief, and I think anyone who's followed us on Real Vision or followed us on social media and knows where we stand, is our view was that we would have a range bound, longer cycle in the first half of the year, and then we would be in recession by the second half of the year. And we, even with our elongated cycle view, have been off, I think, on underestimating the durability of the underlying economy.

3:01So here we are in the second half after a big rally. And the question is when, the big question to me is when does the recession come? And that's on everyone's mind. Our best guess at this point in time is Q2 of next year. And that is an answer with false precision. Nobody knows when the recession is going to come. I think you can have a view, but it's better to have a framework. And so our framework focuses on the housing market and what happens with the jobs within the housing market. That usually leads the economy by about six months. We've seen some weakness there, but there's resiliency as well.

3:43So tomorrow with the jobs report is going to be a big number for us. It'll keep up either continue with that trajectory we've laid out to Q2 recession or show us that this cycle could be shorter or longer than that. So that's the framework that we're going to use to navigate this cycle. And obviously, where you place that recession on your timeline is going to dictate your order, your hierarchy for assets, whether it's commodities, stocks, bonds, cash, how you want to position yourself. And so to me, that's the big picture view is that we've got a little bit of time left in the cycle, but we are a late cycle.

4:17It's not a early cycle, in my view, and that's where we're at. Well, let's talk that through. One of the things that we've been hearing about from Jay Powell ad nauseam is this idea of long and variable lags in terms of monetary policy having an impact on the real economy. Obviously, we've heard the same message very consistently from Mr. Powell, which is this notion that they believe that inflation remains a long-term threat, that they are going to continue to be restrictive. And now we have this question of how far that sort of can gets kicked down the road in terms of the impact, the spillovers into the real economy.

4:49As you said, the consensus for just about everyone was recession here in 2023. That can's gotten kicked out further. I'm hearing, as you said, actually consistent with your view, a lot of H224 for the onset of this recession. What are you looking at in terms of employment situation and other indicators to give you a sense of where we are on that trend and how developed we are along that path to get to what seems to be a fairly large consensus for a recession forecast? Our number one within our framework, our number one view is housing employment. And so if you think about it, we peed in housing payrolls at the end of January of this year.

5:35And we've kind of gone sideways from there. but this last month we lost 5 ,500 jobs out from residential construction payrolls. And as I said, you get about an eight to 10 % drawdown in residential construction or housing related payrolls right before a recession. And so here we are, we're just at the very early innings of this decline in my view. So that's the number one data point to tell me as a lead. You wanna lead, because by the time we see unemployment tick up or wages start to fall off, you really are too late to have got the positioning right within assets, which is what we really care about.

6:17So to me, you look for things that are leading. And the number one leading area, the channel that's going to transmit this Fed policy that we're seeing into the real economy is the housing market. And so we're looking for housing related layoffs. So we had 5 ,500 layoffs last month, reduction in payrolls. We want to see a total of like 70 ,000 jobs lost in order to get us to that recession point. And so you can basically draw a straight line. If we were to lose five to 7 ,000 jobs a month from here, that puts us in early part of 2024. Obviously, you don't really go on a straight line. These things kind of can stair step, but that's the number one area we're looking at.

6:59Of course, there are subcomponents to that housing starts and pricing and affordability and rates. And those are important factors that go into our model. But when we distill it down, it's that housing employment number that we look at. So when you talk about 70 ,000 jobs as being kind of the bogey in terms of the recession forecast, but what's the time delay between when you get to those 70 ,000? Obviously, that's a cumulative number that you see month over month. That's your sort of net loss. What's the onset that duration, the gap between that and when you believe you actually see the onset of recession?

7:35About six months. Is it six months from that full-on drawdown? Let me say it this way. You actually, once you have that drawdown, the recession basically starts within a couple months, but you usually get that six-month lead time where you can see the writing on the wall with those job losses coming down. It's just really the first segment. So call it six to two months of a lead time based on your cycle. I do think that if we're going to be totally honest about our tools and their shortcomings in this cycle, this is going to be one where we get possibly a little less lead time out of the housing economy.

8:12And that's because there is this underlying shortage of housing. And we've seen this with maybe the home builder stocks, which have been bid and home builders are still in this environment where they have fat margins and they're controlling the market. They're able to buy down rates. So they're kind of counteracting some of this Fed policy. So we're seeing national mortgage rates somewhere between seven and 7.5%. But these builders are able to buy down rates, which is just a monetary incentive ultimately on their end to that 5.5%, 6 % level and continue clearing houses. So these ingredients, fat margins on the builder side and ultimately an undersupplied housing market give us a little less lead time, but I still think that you're going to see, you know, in this world, we have so much of a, we haven't even talked about the fiscal deficit we have, which is kind of acting as a counterbalance to some of the Fed policy.

9:06In this world, you have to really, you know, work hard to find those leading indicators. I still think housing is going to be the best of a group of imperfect tools for this cycle. Boy, a couple of points there. You know, the first, this idea of buying down rates, I mean, it does imply that you might have this, you know, kind of almost a pig in a python problem when you see this working through the system. Those rates mean materially higher as those rates rise, obviously, and those incentives put on by the builders to effectively reduce rates working against kind of Fed policy and tightening. What you have ultimately is going to be ballooning payments, which is going to significantly have an impact on that market.

9:44You'd have to think when that eventually plays out. Yeah, absolutely. I mean, it's a slow burn for now, but it's all fine until it's not. And that's really the nature of the market. That's why you have to kind of have a, we've built out this, really to get at it, you have to have multi-factors that you're looking at. Whether it's single family starts, multi-family starts, the number of employees per unit, and all of those things are baked into our estimate ultimately. And you really have to get fine-brained with it. And then you have to look at builder margins because that tells you, you can say, okay, how high do mortgage rates go to basically take this buy-down game off the table?

10:25And so there are a lot of moving parts, and it could sneak up on us. I think there's one of those, you could have one of those months where housing starts to come in, and especially for rates. I think rates sensitivity around this level is really important. It's why, as you see, in my view, it's why I've seen the equity market have such a violent reaction once we have rates go above 4 % on the 10-year. And as rates have kind of relaxed here in the last 10 days with that jolts number that we got, that's where you've seen equities kind of firm. So everything is looking at that rate number ultimately on the long end, not on the short end, but on the long end.

10:59So the Fed's probably done hiking. Now the question is, what gets transmitted through the long end? And there's a bunch of stuff into that. We're going to take a quick break and be right back with more of the day's top analysis on the Real Vision daily briefing.

11:16Warren, let me ask you something here. And this is just kind of an imprecise term, but how do you sort of factor in the weirdness factor of this? This sense that we all have who watch markets that we've never really seen anything like this, right? And we can talk about the unprecedented nature of these markets in a couple of different ways. Number one, these weird rebound yo-yo effects that we've seen after the pandemic. You essentially shut the economy down. Then you open it back up. You throw on massive fiscal stimulus. You get inflation that starts rising. Then you have to slam the brakes on by rising very quickly.

11:48Those rates throw into this the fact that we've been in a 40-year bull market or thereabouts on bonds. I guess the question is that when you look at your models, and I'm sure this is something you think about, When you look at these models, how do you know that the historical correlations that we've seen hold true are going to hold true now? And if so, if they're going to be, you know, just slight modifications, maybe that the lag or the delay changes a little bit. I mean, these are very complicated models. And obviously, as we've been saying, you've been alluding to, we are in kind of just an unprecedented moment.

12:20Yeah, I think you have to have a few things, a few kind of rules of thumb in mind. For one, we always say strong opinions loosely held. And I think that that goes double for this cycle. You need to have an extra kind of dose of humility when you're doing your forecasting. We've talked about the fiscal side for well over a year, introducing so much forecast uncertainty for everybody, you know, and you could have been, I've seen permabowls take victory laps this year and they were wrong last year. and I've seen bears get kind of down on themselves this year, I think you need to understand that this has been a really difficult cycle to go and it will continue to be.

13:04And so I think just having strong opinions loosely held, number one. And we also have this phrase at 314 Research, it's that we build conviction off of fundamentals and macro, but we manage risk off of price and technicals. And the truth is you need to probably let the market lead you a little bit more this cycle because there is that collective wisdom of markets. And you could obviously pick holes in technicals all day long, but there is a highly efficient market comprised of the world's smartest people trying to compete with each other and squeeze some alpha out of these things. And so if the market's moving against you, you better have a really good reason to maintain the current posture that you're in.

13:47And so like, for instance, I'll be a real-time example. We were pretty underweight equities from March into through May. And we saw this massive divergence in the underlying market structure where mega caps were leading the market higher and the rest of the market, the bottom 490 stocks basically, were lagging. Extremely, extremely thin advance. Exactly. And so we started doing these studies of like, what happens when you get these divergences. And what we found is that really it's the breadth following the divergence that dictates the next direction. And it's gonna be a powerful direction. So we ended up at the end of May, we got some good economic data.

14:33So of course, this is the market scene that that recession is not a 2023 event. As that economic data came in, you saw the market broaden out to other segments outside of the top in stocks. And that was the impetus for us to move our equity position higher and reduce our bond position. So we really went almost max underweight bonds in early June and pushed those chips into the stock market. And that's been, while we came out of March wrong-footed, that was, we had to reverse course and that was really based on technical. So that's what I mean by, you have to build your fundamental conviction, but then you manage risk on price.

15:12And sometimes you're gonna be wrong with your view and price will tell you. So that was a real-time example where we were fundamentally wrong in that broadening rally kind of signaled to us that, and along with the macro data, to be fair, that it was time to get a little bit more into equities and out of bonds. Yeah, I mean, S &P 500 up about 18%, as you know, year to date. Obviously, this massive jump up in the 10-year showing that the prices have collapsed significantly. But boy, what I hear you saying there is when your macro thesis doesn't agree with the price action that you see in markets, that's time for your antennae to go up and to ask yourselves, boy, how convicted are we on this and why?

15:53Yeah. Do you want to be right or do you want to make money? That's the old phrase. And ultimately, you can't. There's a whole George Soros phrase that we were writing about, which is he says, I like being wrong. I'm smart because I am wrong and I know what I'm wrong. And to me, there's a lot of power in invalidating a thesis and being able to admit you're wrong, I think you lose money and you fall behind when you allow yourself to stay in a position for too long. And so that to me has been, those are wise words in my view, is that you don't want to dig your heels in. And so given what you were saying, just as another example of things we've talked about is fiscal deficit at 8.5 % of GDP right now.

16:40We're at an unemployment rate of 3.5%. We've never seen that combination. We've never seen this large fiscal deficit when unemployment was basically at 3.5%. We had full employment. This is a pro-cyclical deficit. We've never seen that going all the way back to post-World War II time. We've never seen that. So we should all be very open to a range of outcomes that could be diverged from what we expect. And so there's so many things like that when you talk about a weird cycle that we've seen, whether it's fiscal spending, market structure, all types of things. So that's the background that we're all trying to predict into right now.

17:24Boy, Warren, that's so well said. I learned that lesson during the global financial crisis because I saw all these folks who were a lot smarter than me, who had decades of experience in markets. I mean, not the whole world, but there was this percentage of them saying, you know, this cannot stand. You can't just dump money into an economy via monetary policy and have the price of stocks rise. It's just wrong. I just I disagree with it. I fundamentally disagree with it. And the people who took these ideological positions who, you know, for whatever sort of philosophical reason, were upset about the fact that the Fed had cut to zero and stayed at zero for a long period of time and was buying bonds, doing massive quantitative easing.

18:02Some of these folks went short equity markets and they got just crushed, absolutely blown out. Yeah, I can remember that time. And it was actually a great learning experience for me because the idea is if we're going to print dollars, we're going to have inflation. We're printing dollars through QE. We're going to have inflation. And so you go short bonds was the thought process. Right, right. Right. And I remember buying the ETF TBT, which is like an inverse bond ETF, lost some money. And that's what sent me down this road to modern monetary theory. Not that I adopt all the precepts, but I found it very interesting because they actually were able to create a theory of the world that matched the outcomes I was seeing.

18:48And so to me, the lesson has been when you go these odd times, look for potentially heterodox explanations for what's going on. So, I mean, there's the fiscal dominance theory that's been out there right now. And I've looked into that. I think it's extremely interesting. The idea is that the fiscal deficits are so large right now that the Fed is essentially powerless to tighten the economy. And we're actually, despite the fact that Fed funds rate has gone up to five and a half percent, the Fed's actually still behind the curve on tightening the economy. I think there's some truth to that. I think there's some truth to that theory.

19:24At the very least, the economy is more resilient because of the fiscal side. But at the same time, I still see evidence the Fed is tightening things, that the economy is slowing, that we're not early cycle. To go back to your first question, where are we in the cycle? Everything points to late cycle. We're seeing default rates pick up in fixed income and leveraged loan markets. Inverted yield curve is not an early cycle phenomenon. And bear steepening out of an inverted yield curve is not an early cycle phenomenon. These are late cycle issues. We've seen housing starts go from 110 ,000 single family starts per month to 70 ,000 single family homes per month.

20:03That's a transmission of monetary policy. We've seen CNI, commercial and industrial loans, on a six-month basis begin to roll over into negative territory. That's a late cycle thing. So all these things point to late cycle. I don't want to say we have no idea where we're at. I think we have a pretty good idea that we're late cycle, but for asset managers and the way that the path you travel can be very important for the reality, for your reality. So if we go through this next year, if it's six months for a recession, the path for asset markets can be way different than if it's 18 months for recession.

20:39But I would argue in either case, you're still pretty much late cycle. Yeah. I mean, to your exactly that point, two's tens went inverted, what, in June of 2022. So we're coming up on the, whatever it is, 15 month or so point on that inversion in the yield curve. Yeah. And that's the, you can go back and everyone, this has been a classic debate. I think you do start second guessing yourself. These cycles kind of drag on and people start wondering, well, hey, does the, does the yield curve you mean anything anymore and there's some there's enough evidence or thought behind the theory that no like maybe this is an outdated thing or it doesn't matter anymore but i've always been of the opinion the yield curve it's not a reflection of a recession is coming it's actually causing a recession typically it's causing a recession because it's actually up ending the banking uh the modern banking business model so you're no longer able to lend short borrow short lend long because of the inverted yield curve.

21:35So it, by definition, starts to choke off loan creation and money growth. And we're seeing that. Again, back to CNI loans rolling over, but there are really two ways to create money. You can create money through a fiscal deficit and fiscal spending and through the banking economy. And that's the problem when you're running big deficits is that you have to punish the banking economy a lot in order to bring the economy to break the economy enough to slow. That's at least how I see it. We're going to take another quick break and be right back with more of the day's top analysis on the Real Vision daily briefing.

22:18Yeah, and that's where you see compression of net interest margins. That's where you see the CNI lending contraction. That's where you see what we saw in regional banks earlier this year when you have this mismatch between assets and liabilities and you have this hemorrhage from banks that don't have access to broader funding bases and cheaper costs of capital. Listen, I want to call back to something that you mentioned earlier when we were talking about job markets, because we have just a great quote here from Andreas Steno-Larsen from a show called Is the Labor Market on the Verge of a Downturn, where he talks about some really interesting correlations.

22:47This is on the essential tier today, August 31st. Let's take a look at that clip. If we look at the job openings posted by SMEs, we now have a crystal clear trend as well towards fewer openings relative to three quarters ago. And there is typically a very neat correlation between the amount of openings posted by SMEs and the average duration of unemployment. I have a chart showing the average duration of unemployment in light blue and then the NFIB survey conducted among SMEs on the amount of job postings that they post on a monthly basis. And we now have a clear signal here as well. We should expect the average duration of unemployment to go up as a consequence of a lack of job postings.

23:37The lead is roughly 11 months from the actual timing of the postings until we see that move in unemployment and the duration of unemployment. So everything we see today in the surveys will matter in 2024. That's what I'm trying to come across with here. So the evidence that we gather in these surveys does not necessarily mean that we have a recession around the corner. It means that we have a recession in the making for 2024. And I think that is of relevance relative to the current base case among economists and market participants. You know, Warren, one of the fun things about Real Vision is we get to look at this from different perspectives, different points of view.

24:23Andreas Steno-Larsen, of course, an economist, looking at a really interesting correlation there between the amount of openings of SMEs, small and medium enterprises, smaller businesses, and the average duration of unemployment. Let me just read again his conclusion there. I know there was a lot of material, but I want to read this key point just so folks understand it. Quote, we should expect the average duration of unemployment to go up as a consequence of a lack of job postings. The lead is roughly 11 months from the actual timing of the posting. So again, we're talking about variable lags.

24:54But to me, this certainly sounds like a bearish sign for labor markets. Warren, thoughts? Yeah, I mean, this is interesting. And it's interesting for me to see the reaction of asset markets really to the job openings data, which is what Andreas is kind of central to what Andreas is saying here. And so we saw job openings fall dramatically here recently. And yields dropped, which that's been the pressure on equity. So equities rallied. gold dollar drops because you read this as the fed's going to be able to be more dovish going forward dollar drops that's actually good for stocks and for gold so you see gold rally you've seen oil rally you've seen basically a rally across the board which is keyed off of rates um and it's really a soft landing kind of trade for right now uh the question is it's really difficult to tell the difference between the beginning of a soft landing and a hard landing It's really about where does it stop?

25:49And so job openings falling, if you look, there's a lot of charts and evidence out there. If you see, typically the momentum of job openings doesn't just stop here, it continues lower into recession. So of course you could, and I think there are a lot of problems with the Joel's data in general, and we've kind of torn it apart, but you could have a lot of these job openings that are kind of ephemeral anyways. So again, that kind of points to this fog of are we in a soft landing, hard landing environment? And to me, it's going to be really difficult. It's going to be really difficult to tell the difference here in the very early stages.