Lacy Hunt: We're Facing A Perfect Storm Of 'Economic Deterioration'

The 12-month, 24-month, and 36-month rate of growth in bank credit (loans and investments) are all negative, which is very unusual and historically only occurs during or after recessions, but in this cycle the contraction in bank credit shows the markings of an old-fashioned credit crunch even before the economy is officially in recession.

“if you look at the 12 month 24 month and and 36 month rate of growth in bank credit which would be loans and Investments to the bank they're all negative what's in what's very significant”

Momentum driven markets with Fed-induced multiple expansion at extremely elevated valuations are dangerous for investors even when momentum is strong, because confusing momentum with fundamental strength leads to classic investment errors of buying near the top; position sizing is critical to manage risk.

“but when we're at valuations and extremities and narrowness like we've seen now um our our feeling is is that that's that's a pretty large wage should be making for you know money that people our clients don't get a do-over this is money that is all the money they're ever going to get more or less they've sacrificed their their during their working years to save and forego instant gratification so that they can have a secure future and and um to use a you know thing like a momentum indicator as as if it were a foolproof um uh blessing to to overstay a a a very uh extended Market there's huge context there that is is got to be taken into account”

Even if consumers buy only the same number of physical goods, inflation in prices means retail sales numbers in dollars stay relatively stable even as unit volume declines, so focusing on retail sales dollars rather than unit volumes provides a misleading picture of actual consumer demand.

“um I don't have the chart handy here um but there's a chart I saw recently that showed uh retail sales on a unit basis and those have been in pretty sharp decline right which basically is just showing that okay people are buying fewer things now the overall retail sales numbers aren't coming down as much because they're factoring in the price inflation people are just paying higher prices for fewer things and so the number's not changing quite as much but if you look at just on a unit basis the Slowdown is is really pretty sharp”

The pain from lag effects is already pronounced in the manufacturing sector excluding automotive, with material decline since last September, and there has been material impact on gross domestic income, but GDP continues to rise indicating we are in the early innings of the cycle, not the middle innings.

“I would say that the pain is pre-pronounced in the manufacturing sector excluding Automotive uh the very material decline since last September um there's been a material impact on on Gross Domestic income uh but very but GDP is continuing to rise so I I would say that um uh the the economy has uh experience um I would say they're beginning to feel the pressure but it's it's not we're not close to the to the middle Innings by any chance”

An inverted yield curve reinforces the decline in money supply, bank credit, and the consequences of high real policy rates because both banks and non-bank shadow banks profit by borrowing short and lending long, which they cannot do when the yield curve is inverted, eliminating a key source of credit creation.

“the inverted yield curve serves to reinforce the decline in money supply Bank credit and the consequences of High real policy rate because not only the banks but the non-bank entities the shadow Banks they make a profit by borrowing short lending long they they can't do that when they are converted”

The wealth effect from stock market gains only applies to a very small percentage of people; the vast majority do not have sufficient stock holdings to benefit, so whether the market is 'green or red' doesn't necessarily indicate where the economy is heading.

“there may be a wealth effect but it only applies to a very small percentage of our people the last the vast majority of our people do not have a sufficient holding in the stock market to to be a benefit to them”

Monetary policy works through several channels simultaneously—the policy rate, the money supply, and bank credit—and in this current cycle all three channels are telling you the economy is heading toward economic deterioration.

“I sort of think of it as like a perfect storm it's the fact monetary policy Works through several channels one is the policy rate one is money supply one is Bank Credit in this case they're all telling you the economy is heading toward uh economic deterioration”

The economy has not yet dodged the bullet from monetary tightening; while there can be fortuitous circumstances like favorable weather or energy market corrections, recent commodity price increases will disrupt household budgets at a time when household budgets are already in disarray.

“I would say that we have not knowledge the bullet and I think that um you can always you can always get better luck there can be fortuitous circumstances um the the fact that we've had poor weather and the energy markets have righted themselves this is really not a positive for economic activity it's it's not it's going to boost the inflation rate a little bit temporarily but more importantly it's going to disrupt household budgets at a time when household budgets are already in disarray right”

People typically change their financial behavior in two ways: either they project ahead and rationally change behavior to avoid negative outcomes, or the status quo becomes so painful that they are forced to change; currently consumers are extending unsustainable debt to maintain pandemic-era lifestyles funded by pandemic-era government support and stimulus programs that have now ended.

“you change Behavior one of two ways right you project ahead and say oh if I keep doing this this this bad implication is going to happen so let me change my behavior today sadly I think it's a minority of people that do that most people change because the status quo just becomes so painful to continue that the pain of continuing it eventually exceeds the pain of changing and so right now it seems that people you know had a lot of help during the pandemic with the money that was mailed directly to them and the forbearance programs and the tax credits and all that stuff and they shifted their lifestyle or their spending and now with all that stuff in the rear view mirror rather than downshifting their Lifestyles yet they're trying to continue it for as long as they can by putting it all on revolving credit”

This extension of unsustainable consumer debt can continue only up to a point, after which an economic injury will occur not just to household balance sheets but to the economy broadly, since consumer spending comprises 70 percent of GDP, and the collapse of consumer spending will be sharp and sudden, like a Hemingway bankruptcy (gradual then sudden).

“and that can continue only up until a point right and then it can't continue any further and then you really get an injury not just to household you know balance sheets and budgets themselves but but to the economy because as you were saying earlier you know 70 of our GDP is consumer spending and so my point is is you tend to it's sort of like the Hemingway things where you you go broke pretty quickly at the end right you know it's it's it's it you don't see much of a change then all of a sudden you really do because you just can't continue the status quo anymore”

In the Maturation and Ease Off phases of the business cycle, the statistics look almost identical, with lagging indicators remaining the strongest component and leading indicators deteriorating while coincident indicators are mixed, making it difficult for observers to know in real-time whether the economy is slowing.

“the most uh concrete that I can say about maturation and ease off is that the statistics look almost identical um the lagging indicators are Remain the strongest component in both maturation and ease off the leading indicators are deteriorating and the cons the coincident indicators are are mixed”

Corporate debt that was issued at low interest rates during the period of monetary looseness will eventually have to be refinanced at much higher current rates, roughly two times as high as the original rates, which will significantly reduce corporate profit margins when this refinancing wave hits.

“as time goes on more and more of those corporations are going to have to go out and refinance and their interest rates are going to re-rate in most cases probably around two times as high as what they were paying so this is one of those things where people are like yeah the lag effect what lag effect like everything's going fine this is sort of an artificial you know benefit little window of benefit that these companies are getting but unavoidably that debt is going to have to reprice and that is going to really whack corporate margins”

In the bursting of major bubbles, the most speculative assets get hit the hardest first (as seen with growth stocks in 2022), followed by a recovery period (usually January following tax-loss selling), a brief surge where money flows back into former darlings at perceived bargain prices, and then additional waves of selling as the broader implications of the bust unfold.

“you see the most speculative assets get hit the most first and that's what we saw in 2022 with all the high flying growth stocks but then you see kind of a recovery usually in January of of the next year as all the tax loss sellings occurred and all the proceeds are then looking around and saying oh well we now have these bargain values in these former Darlings well let's put money back into them and they they shoot up again so what Grantham is seeing and to a large extent to what Lacey is seeing is yes we have this sort of like with what they would call sort of a fall summer right now in terms of of the markets and sentiment”

Periods of extreme inflation generally lead to periods of extreme recession; when inflation accelerates and the real growth rate stagnates, the Maturation phase becomes unsustainable and transitions to recession.

“periods of extreme inflation generally beget periods of extreme recession right so these are important developments or shoes that are likely to drop in the future”

The stock market has been the most exuberant this year with a rally driven exclusively by multiple expansion (expensive assets getting more expensive) rather than earnings growth, and earnings estimates were actually reduced going into the second quarter, meaning the rally was detached from profit fundamentals.

“this is a market that has gone higher almost exclusively on what we call multiple expansion uh not an increase in earnings in fact earnings you know numbers and estimates were were reduced going into the second quarter um so you had a complete rally basically this year on on multiple expansion and the laypersons take uh interpretation of that is the expensive just got more expensive it's not like things suddenly became undervalued and deserved to be bit up and priced to a more fair value quite simply the expensive got more expensive”

Semiconductor sector stock prices have surged higher in 2023, yet actual semiconductor chip inventories have spiked dramatically high, indicating dead inventory not being sold; this inventory spike has only been comparable to the housing bubble burst or possibly the tech bubble, signaling major underlying weakness in demand.

“look at a couple sectors that have gone gang gangbusters this year uh the semiconductor sector has gone gangster Busters higher stock prices yet um you can look at semiconductor uh chip inventories they've gone through the roof meaning there's all this dead inventory that's not getting sold I think you have to go back to like the the uh housing bus to think or maybe even Tech bubble to see similar kinds of spikes in inventory so here you have a hot sector but you know all this activity is just showing up in inventory”

Healthcare sector bankruptcies are spiking higher now that pandemic-era stimulus support has ended and healthcare companies are off government life support, indicating sector-specific stress from loss of artificial supports.

“there's been a a pretty sharp rise in corporate bank and this is even before you know the real credit crunch has happened just saw today a a headline about uh the health care sector for example uh now that they've they're off the life support excuse the pun of of covid uh stimulus to respond to the the coven emergency uh Healthcare bankruptcy Healthcare uh company bankruptcies are are spiking higher”

Warnings from major logistics and shipping companies like FedEx, UPS, and other international shippers have been issued in 2023, and Yellow, a major short-haul trucking company, is facing bankruptcy partly due to inability to meet pension payments because they're not making enough money—these are real-world signals of economic weakness in physical goods movement.

“we've had warnings from FedEx we've had warnings from UPS you know other big International shippers in the US here this week I think we're seeing the bankruptcy looks like of yellow which is a a short haul uh trucking company and yes they've got some issues with their unions and whatnot that are kind of complicating the situation but a big issue is is that they were unable to meet some of their their pension payments because they're just not making enough money right”

Markets often rally strongly in the false dawn before recessions and major downturns because people believe inflation and monetary tightening impacts have already been absorbed, but ultimately the effects do congeal and recessions arrive; we are currently on the cusp of moving toward the Plunge phase.

“we we often go through a process in which people will say the recession is not coming that this time is different because the initial impact of the inflation and the monetary response don't seem to congeal But ultimately they do so comes after ease off and that's what we haven't seen yet okay and it feels like we're right on that cusp right now we're moving there”

The Chicago Fed National Activity Index consists of about 80 different economic components; in June only 30 of those components were advancing while the rest were declining, indicating narrowing breadth in economic recovery and typical of an economy starting to slow and face trouble.

“when you look beneath the surface like for example he referred to the uh Chicago fed National activity index is something like 80 different components there and um uh in June only 30 of those components were advancing the rest were declining so there's a uh and I think in to paraphrase there's a beneath the surface um there's a narrowing of the economic um uh advancing uh and and that typically uh is is very typical of a of an economy that's that's starting to slow down”

The financial cycle leads the business cycle which then leads the price and labor cycle; Hunt pinpointed late fourth quarter 2021 as when the financial cycle peaked, coinciding with stock market all-time highs; from that peak to now is 7 quarters, and typical lags are 7-9 quarters from financial cycle peak to business cycle peak, so the economy is right in the zone for meaningful slowdowns in key areas.

“he pins late uh fourth quarter of 2021 as as probably this cycle stopped in the financial cycle and it's not uh surprising that's when the the recent uh all-time highs were achieved in stock markets to be seen if we take those out uh with with recent advances and near-term uh direction of the stock market but from there he um I think nicely um pointed out that no one cycle is always the same so as much as we want to pinpoint you know what is the lag typical lag there's a inherently arranged to that because of the way that Nuys are different every cycle but he said pretty robustly that typically you see about a seven to nine quarter lag between a financial cycle peaking and the business cycle peaking and that would put us right now uh in in the seventh quarter”

Robert Half, a major staffing company specializing in temporary professional placements, has shown negative year-over-year quarterly revenue growth for the first two quarters of 2023, the first such declines in 15-20 years outside of the COVID meltdown and 2008-2009 financial crisis, indicating companies are already pulling back on discretionary spending and optimization before permanent workforce rationalization.

“I saw today over my my screen flashed according to the revenue growth year of your quarterly Revenue growth of Robert Half which is a behemoth staffing company they do temporary placements of professional and other Staffing and you know typically in a normal business cycle companies will obviously hire permanent employees to to right-size their Workforce for the for the business that they have and expect but though around the fringes um optimize their Workforce by taking on temporary workers you know be it a computer programmer for a nine month deployment that rather than hire someone full-time you get you know very skilled computer programming to come in and through a temp agency like Robert Half um quarter over year over year quarterly Revenue growth has fallen off cliff it's it's negative uh for the first three quarters the first two quarters of this year the only times in the last uh 15 almost 20 years that I see in this chart was during the covid Meltdown and uh the 0809”

Cardboard box shipments (a leading indicator of goods being purchased and shipped) have fallen off a cliff in recent data, indicating that actual consumer goods purchases are declining sharply despite stable headline retail sales.

“you got uh even just on the on the ground indicators like cardboard box shipments you know most things that people consume today is not walking into a retail store but going on Amazon and getting a cardboard box shipped to you and they've fallen off a cliff”

Tax receipts on corporate earnings have declined noticeably, indicating either tax avoidance behavior or actual earnings decline, but combined with other data suggests real earnings deterioration is occurring despite accounting gimmicks and CFO manipulation of reported earnings.

“but you know look at a real data point and you pointed this out and I think you have Adam too you look at the actual tax receipts uh by the treasury um you know the the tax receipts on earnings have have gone down so uh either companies are you know playing games and avoiding taxes which you know they certainly do plenty of that but you know the earnings seem to be dropping off a cliff or the the net earnings anyways um and and that's a real data point”

Employment is a lagging indicator that typically looks pretty good at the beginning of a recession when jobs numbers are still strong, and only shows its worst conditions when recessions are bottoming out, so the lack of current job weakness does not rule out severe upcoming labor market deterioration.

“as a lagging indicator if you go back and look at almost every recession the jobs numbers actually look pretty good at the beginning of a recession in hindsight and they actually tend to bottom they look their worst when recessions are are bottoming coming out”

Consumers should have a plan in place to protect their wealth before the significant economic risks and potential recessions that experts expect materialize, and should work with professional financial advisors to develop personalized portfolio strategies that account for elevated risks.

“everything that Lacey told us about just basically said look you should have a plan going forward for managing your portfolio here particularly if you're going to be invested long in in assets and we just highly recommend as we normally do that that the vast majority of people watching this program should do that working under the guidance and in the co-op with the partnership of a professional financial advisor”

We are very late in the game in terms of lag effects from policy decisions, specifically seven quarters since the maximum point of financial looseness, and the longest lags are nine quarters, so lag effects could still persist for another six months or so.

“we're very late in the game but the legs could still persist or another six months or something okay”

The best time to patch your roof is when the sun is shining, so now while markets are still functioning well is the time to have portfolio planning discussions with financial advisors rather than waiting until crisis conditions force action.

“there's the old saying that the the best time to patch your roof is when the sun is shining uh while we have this moment in the markets where Everything feels great uh and we're not entirely sure how long it's going to last um this is the right time to be having all of those types of discussions with John you know the first one being hey you know how's my portfolio positioned if things start getting rockier from here”

The stock market is not a reliable leading indicator of recession and provided little warning before the Great Depression (which started in September 1929) until October 1929 when it crashed, and has not been a leading indicator historically, particularly in the last 20-30 years.

“the last critical turning points uh the stock market provided no warning are only the to the barest of of warnings maybe of the few weeks or very limited um take the Great Depression of 1929. the recession the the Great Depression started in September the stock market did not Buckle until October of 29. um the the stock market uh there there may be a wealth effect but it only applies to a very small percentage of our people the last the vast majority of our people do not have a sufficient holding in the stock market to to be a benefit to them”

Major bubbles and super-valuations are rare occurrences constituting only a small percentage (perhaps 5-10%) of financial market history, and cannot be analyzed using the same patterns and conclusions as normal market cycles; these episodes are distinct and follow their own characteristic patterns of bursting.

“there are you know the vast majority of financial Market history you can kind of lump together as kind of normal times right yeah they're going to go through Cycles ups and downs but they're kind of relatively um homogeneous from a data standpoint and a behavior standpoint but every once in a while and very rare you get these super bubbles and frankly super sell-offs uh and those two episodes are very rare the super bubbles the super over evaluations are very rare I forget what percentage of financial Market history said maybe five percent or ten percent some small number and and you can't lump those in as history will be your teacher you can't lump those in and make the same kind of conclusions or takeaways as other times in Market cycles”