August 25, 2023
By Steve Blumenthal
“What is now happening hasn’t happened before in our lifetimes but has happened many times throughout history—typically, just before civil wars. In my opinion, this is a VERY big, bad deal yet most people are quietly going along with it.“
– Ray Dalio, Founder, CIO Mentor, and Member of the Bridgewater Board
I just finished reading Dr. Lacy Hunt’s quarterly update letter. If you don’t read Lacy, I recommend you do. He is Executive Vice President of Hoisington Investment Management Company, Vice-Chairman of the Strategic Investment Policy Committee, and Chief Economist for the Wasatch Hoisington Treasury Bond Fund. An institutional investment management shop with a simple strategy, they invest in long-duration Treasury Bonds or short-duration Treasury Bills. One or the other, not both.
Lacy is one of the great economists of our day. He invests with conviction, has real skin in the game (managing $3 billion), and has a thirty-plus-year excellent performance history. So, he’s not just advising and pontificating from the bench. Unless you are an economist, Lacy’s letters may be hard to follow. (Lacy, don’t read that last sentence). But he sure is brilliant. (Lacy, please do read that one).
In a world where every asset is ultimately dependent on the cost of money (the level of interest rates), understanding where they are now and where they are going is the #1 job in the investment business. For his part, Lacy can weave his way through complex issues and ideas and zero in on the most important points exceptionally well. His letter is all about the outlook for the direction of interest rates. It informs how he positions his clients’ money. For now, he continues to believe interest rates are going lower.
Hoisington’s recent quarterly letter speaks to a question I received from a very smart client of ours, Robert, who, though now retired, previously headed the fixed income division at CitiGroup. Confused by the current landscape, he wrote:
Steve, I have attached a recent article from the Mises Institute on the falling money supply. It seems that we are at an extreme, which is a bad omen for the economic outlook. Yet most economists seem to have taken the hard landing scenario off the table, and the economy seems to be growing above trend this quarter, supported by consumer spending due to remaining pent-up savings, low unemployment, and rising wages.
Something is out of whack here, but I don’t know what it is. Personally, I sense the consumer savings data is distorted by all the billionaires out there, especially considering that some economists maintain that 60% of households live paycheck-to-paycheck. It’s almost like the economy is like Wile E. Coyote in the Rode Runner cartoons, where Wile doesn’t realize that he ran off the cliff until he looks down.
Can you make any sense of all these conflicting data?
All the best,
I’m going to do my best to answer Rob’s question today, in part by starting with some high-level takeaways from Hoisington’s most recent Quarterly Review and Outlook letter (by Lacy, Van Hoisington, and their team), which concludes, “The continued tightening of financial cycle conditions with lower inflation and poor economic performance will mean that long-dated U.S. Treasury yields will continue to trend lower.”
Will we see a soft landing, a hard landing, or no landing (a.k.a. no recession but no significant let-up in interest rates)? It seems “no landing” is the consensus view today, though the Fed still hopes for a soft landing. I see no way of avoiding a hard landing. I could be wrong. I hope I’m wrong. Time will tell.
Speaking from Jackson Hole today, Fed Chairman Powell said, “Inflation is too high,” adding that they are prepared to raise interest rates further. Meep meep!
Grab your coffee and find your favorite chair. In addition to my high-level takeaways from Lacy’s letter, you’ll find Dalio’s latest post updating the macro big picture. He says, “What’s happening now hasn’t happened in our lifetimes but has happened many times before in history.” Dalio sees “Disorder” ahead, shares what he’s seeing, and asks if we agree. Importantly, he goes on to explore what we might do about it, individually and collectively.
Here are the sections in this week’s On My Radar:
- Credit Crunch at Hand, Dr. Lacy Hunt
- Declines of Truth, Trust, and the Rule of Law Have Throughout History Led to, and Are Now Leading to, Disorder, Ray Dalio
- Personal Note: Adversity
- Trade Signals: The 10-year Treasury is Challenging Last Years Secular Trend High at 4.33%
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Credit Crunch at Hand, Dr. Lacy Hunt
Following is my best attempt to answer Rob’s question about M2 – the falling money supply. Special note to Rob: I know you know what I’m about to say. I’m writing it for others who weren’t the head of fixed income for one of the world’s biggest banks. After the brief explanation, the bullet point notes from Lacy’s recent quarterly letter follow.
The latest data on M2 showed a continued shrinkage of the money supply. M2, in nominal terms (which means the calculation is before inflation is factored in), is down 3.7% from a year ago. The conundrum is that nominal GDP for Q2 2023 is up 6.3% from a year ago. What this means is that, somehow, the broader economy is getting by with less money circulating around in the system. The oil in the engine is getting low, but the engine is still running.
The best analogy I heard on this is to think of money supply like oil in your car engine. It comes courtesy of Tom McClellan, famous for creating the McClellan Oscillator.
- It takes a certain amount of oil to keep your car engine lubricated and working. When the oil level drops a little, your engine will be okay for a while, but when it drops too much, your engine will start to fail.
- But this can go both ways; there is also a problem if you put too much oil into your engine. I did that recently, and my car started to shake, knock, and then shut down.
- In the same way, if you put too much money into an economy, you get some serious problems. I.e., the recent big wave of inflation. Now that the money supply is coming down, the inflation wave is also coming down.
Another side effect of all that extra money supply is that it is bullish for stock prices. Excess money tends to end up in people making investments, and much of it goes into stocks. More money buying stocks pushes prices higher.
But now, the money supply is shrinking. Stock prices have been going up until recently. With M2 falling, it makes stocks overvalued. The current level is high when looking at comparative data back to 1959. At this level, a bear market followed in comparison to the other instances. The one exception was the great tech bubble in the late 1990s. But that one, too, eventually led to a bear market.
Tom added that shrinking the money supply is arguably a good idea if the problem that you are trying to solve is high inflation. So kudos to the Fed for making that happen. As individual investors, we cannot do anything about inflation. Our concern is knowing what stock prices are going to do.
- This M2 shrinkage is not bullish news for stock prices, although a bear market may not begin immediately.
You can learn more about McClellan Financial Publications here.
Ok, back to Lacy.
Hoisington Quarterly Review and Outlook letter Q2 2023
SB high-level bullet points:
- Monetary and fiscal indicators continued to tighten significantly in the second quarter, pointing towards a material slowdown in the U.S. economy.
- Negative money growth, increasing fiscal deficit, rising real interest rates, and central banking guidance of higher short-term interest rates are creating a classic ‘credit crunch.’
- This credit crunch comes as the economy progresses further down the current financial cycle, slowing growth and limiting upward pressures on inflation.
Credit Crunch at Hand:
First a quick definition – Other Deposit Liabilities is Lacy’s preferred measure of money supply. This is an alternative measure of money supply. The main difference between ODL and M2 is that ODL does not include currency or retail money market funds—this is from MishTalk.
- Currency is accepted at an increasingly smaller number of business establishments and simply cannot be used for very large transactions. Retail money market funds never became an important medium of exchange. Both are becoming a far less used medium of exchange. ODL has the additional advantage that it is the main source of funding for bank loans and investments, making ODL both a monetary and credit aggregate. Milton Friedman would not be surprised that the need to change the best definition of what constitutes money would change over the years.
Back to Lacy:
- In looking at Money Supply and Velocity. Lacy’s favorite is “Other deposit liabilities” or (ODL).
- ODL in real terms, has turned negative for the last 36 months, while the 12- and 24-month rates of contraction accelerated.
- The money mountain created in 2020-21, which supported spending and inflation, has been eliminated.
- Historically, real ODL has increased at 3.2% per year. Although ODL velocity (ODL-V) rose in 2022, and in the first half of this year, the gain has been insufficient to offset the record contraction in real ODL over the last three years (Chart 1). As the quarterly data indicates, real ODL fell at a 1.2% annual rate over the past three years (the ending point Quarterly Review and Outlook Second Quarter 2023 for the blue line in this chart), compared to a 2.3% rate of increase in late 2019 just before the pandemic (‘C’ on Chart 1) and a 3.2% rate of increase since the early 1950’s.
- Over the last three years, ODL-V averaged 1.7 (‘C’ on Chart 1), down from 1.9 when the pandemic hit and a 2.5 mean over the past seven decades.
- Even a stable ODL-V will severely limit the Fed’s capabilities to stimulate economic growth.
- Monetary policy could be thwarted even more if V’s dominant determinants (the bank loan/deposit ratio and the marginal revenue product of debt) turn down. V means velocity.
SB here: Banks are becoming more restrictive, and the marginal gains from new debt on top of already too much debt are well documented—a diminishing benefit. Ugh, our dependency on the Fed. We’re caught in a trap! Elvis Presley.
I can’t walk out
Because I love you too much, baby
Why can’t you see
What you’re doing to me
When you don’t believe a word I say?
We can’t go on together
With suspicious minds (with suspicious minds)
And we can’t build our dreams
On suspicious minds
So, if an old friend I know
Stops by to say hello
Would I still see suspicion in your eyes?
Back to Lacy:
Real Interest Rates:
- The real Federal funds rate also indicates significant restraint. Using the University of Michigan’s survey of consumer sentiment one-year inflationary expectations as the deflator, the real Fed Funds rate (FFR) troughed and turned higher, leading into all of the post-1978 recessions (for purposes of this analysis, we treat the two recessions of the early 1980s as one recession).
- The lead times varied considerably as the initial conditions were different in each cycle. The real Federal funds rate reached a record low in March 2022 of negative 5.2%, then rebounded to plus 1.8% in June of this year, an increase of 7 percentage points in fifteen months (Chart 2). This was a larger increase than prior to the Great Financial Crisis (GFC) recession of 2008-09 and the mild recessions of 1990- 91. (SB here: note the red dots)
Real Bank Credit:
- While money supply and real interest rates reflect a traditional tightening financial cycle, as is the case now, a contraction in real bank credit is unprecedented when real GDP is rising. Money supply leads bank credit.
- But the latest 12-, 24- and 36-month rates of change in real bank credit are all negative, respectively, -2.3%, -0.7% and -0.5%. Historically, real bank credit has increased at an average of 3.4% per year.
- As the second quarter ended, the contraction in bank credit showed the markings of an old-fashioned credit crunch.
Rising Budget Deficits:
- The U.S. Government budget deficit has taken a serious turn for the worse this year.
- The Inflation Reduction Act (IRA) and CHIPS and Science Act of 2022, as enacted, add over $1 trillion to the deficit over the next several years.
- The Penn Wharton Budget Model, however, indicates that due to the way instructions were written, the cost of the IRA is running three times greater than the amount appropriated by Congress. Interest expense has risen dramatically higher as well.
- The actual problem is even greater as gross federal debt could continue to increase throughout the current fiscal year. Piper Sandler’s policy group preliminarily estimates the FY 2023 deficit could be in the “$1.6 trillion to $1.9 trillion range.”
- Two different rigorous studies, one completed in 2011 and the other in 2012, each using different methodologies, both concluded government fiscal policy actions that either increase the size of government relative to GDP or increase the government debt relative to GDP significantly weaken the trend rate of economic growth.
- The evidence, from more than a decade since this research was published, confirms those findings and indicates that the government multiplier is becoming increasingly negative.
Reinhardt, Reinhardt and Rogoff (RRR):
- The Reinhardts (Carmen and Vincent) and Kenneth Rogoff, published in the Journal of Economic Perspectives in 2012, found that when gross government debt exceeds 90% of GDP for more than five years, then economies lose 1/3 of the trend rate of growth.
- Gross U.S. government debt moved decisively above this 90% threshold ten years ago.
- As previously stated, the trend rate of growth of real per capita GDP since 1870 is 2.2%.
- Over the last twenty years the average growth rate has fallen to 1.3%, a loss of slightly more than 1/3 of the yearly growth rate even though the last twenty years included some years in which the debt ratio was not above 90%.
- Other major considerations indicate that the U.S. economy is far weaker than recognized.
- Productivity, or output per hour in the nonfarm sector, declined by a record pace over the past ten quarters.
- Neither a rising standard of living nor increasing corporate profitability are achievable over time without higher productivity.
- For the eleven quarters since the pandemic/recession ended, real average hourly earnings (which cover 119 million full-time wage and salaried workers) fell at a 2.9% annual rate. This is the largest decline registered in any economic expansion of comparable length since the earnings series originated.
- While firms continued to add employees, the rate of increase in wages have lagged inflation. Moreover, while establishments have continued to add employees, they have simultaneously reduced the number of hours that their staff are working.
- Since January, non-farm payrolls have increased by 1.2 million, but the average workweek has dropped from 34.6 hours to 34.4 hours, leaving aggregate hours worked virtually unchanged. To restore productivity, firms will need to rationalize their workforce, which will simultaneously reduce labor costs, inflation and household purchasing power.
- The continued tightening of financial cycle conditions with lower inflation and poor economic performance will mean that long-dated U.S. Treasury yields will continue to trend lower.
You can find the link to the Hoisington Quarterly letter here.
SB thoughts: Think about what this means to an overvalued stock market. Pressure on net margins and earnings. Bearish for equity markets, bullish for long-term, high-quality bonds.
- Seems to me we are approaching an epic, bullish 30-year Treasury bond trade and an attractive, bearish (short) High Yield Bond market trade. Use technical indicators to help with entry points. I continue to believe investors should avoid buying and holding cap-weighted stock index funds. Active stock selection makes more sense, in my view, and talented long-short investment managers are worth a look. Reach out if you have any questions. Not a recommendation for you to buy or sell any security.
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“Declines of Truth, Trust, and the Rule of Law Have, Throughout History, Led to, and Are Now Leading to, Disorder,” by Ray Dalio
The text below is a direct reprint of the first section of Ray Dalio’s most recent edition of his LinkedIn newsletter, Principled Perspectives. You can view the full and original text here.
What is now happening hasn’t happened before in our lifetimes but has happened many times throughout history—typically, just before civil wars. In my opinion, this is a VERY big, bad deal yet most people are quietly going along with it. I wonder why—do they see this differently, don’t they care, do they feel helpless? For these reasons, I am going to show you dispassionately and analytically what I’m seeing and ask you five questions to see if we by and large agree on what is happening. Then, if we agree, we can explore what we individually and collectively might do about it.
Over my 50 years in the global macro world, I have focused on trying to understand the most important cause-effect relationships to bet on what’s going to happen. My experiences led me to study history to see how things worked, which led me to see that most things that are now happening have happened many times before for logical reasons. By studying many past cases, I could better understand the most important cause-effect relationships.
In the process, I discovered that there are big, long-term cycles that transpire over many years (typically about 100, give or take about 50). These have led, and continue to lead, to big changes in circumstances that have always, and continue to, take people by surprise because they haven’t experienced them before. I have found that by understanding them I could do a much better job of anticipating big changes that didn’t happen in my lifetime but have happened many times before. For example, I see that it is now true, and that it has always been true, that a confluence of five big forces drives most of what happens in ways that are understandable. These big cycle forces are:
- the financial/economic force (that tracks debt and debt monetization) and productivity
- the internal peace-conflict force (that tracks wealth, values, and political gaps)
- the external peace-conflict force (that tracks relative wealth and powers levels of leading world rival powers)
- the force of nature that is manifest in droughts, floods, and pandemics (especially now with climate change) and
- the force of man’s inventiveness, most importantly of new technologies (especially now via AI).
To the best of my ability, I tried to understand and then explain the cause-effect relationships and my template for understanding how the machine works in my books, and then I follow how things are transpiring relative to this template and describe them in my posts.
I believe that what is now happening is almost precisely following the template I laid out in my book, Principles for Dealing with the Changing World Order in Chapter 5, “The Internal Peace-War Cycle.” We are obviously in Stage 5 of that cycle (which you can read about starting on page 167 and judge for yourself how well it describes what is now happening). I will reference the book at times in this post, but I don’t want you to have to think about the full internal order cycle to explore what’s happening now. This is because I think things are so obvious and so concerning that one doesn’t need to have that historical perspective to see it.
The Timeless and Universal Truths and Principles About Order and Disorder That Are Most Relevant Now
I believe that it is true for all people in all collective activities (sport, organizations, governments, etc.) that if…
a) there is no acceptable way to agree on what is probably true (e.g., there is no equivalent of instant replay in a sport) and…
b) both sides don’t trust the referees/judges because they believe that they are under the influence of the other side, and …
c) rather than judgements being made and enforced according to the rule book, they are made and enforced by the opinions of people that make up an unruly crowd…
…chaos and chaotic fighting will follow.
To me, it is obvious that this is now happening a lot and increasing.
What Do You Think?
In this piece I will ask you five questions about whether 1) most politicians in government, 2) most reporters and commentators in the media, and 3) most of the legal system do objective investigations of people and render unbiased judgements. I will also ask 4) where you think we are headed.
SB here again: Chin up. I know this all sounds like gloom and doom, but if we can’t identify big challenges, we’ll likely find ourselves looking like Wile E. Coyote: way out over the cliff’s edge – in a Wile Coyote-like moment.
The views expressed herein are solely those of Steve Blumenthal as of the date of this report and are subject to change without notice.
No Random Tweets this week.
Personal Note: Adversity
The high school soccer season is upon us. As regular readers know, my wife, Susan, coaches a boys’ high school varsity soccer team, and I live vicariously through her during the season. This is year five for her; I’ll be a volunteer assistant again this season. My job is to watch the opponent’s formations to clock their strengths and weaknesses. If I see something worth noting, I report it to Susan. The reality is that despite my love for the game, Susan is always way ahead of me. However, I am pretty good at helping injured Johnny limp off the field.
High-school tryouts concluded this week; the teams were selected, and cuts were made. After the last tryout, Coach pulled the boys together. “Let’s talk a little about adversity,” she told them, pulling out four jerseys, one from each of the prior four seasons she has coached at the school.
Each year, someone important from the school’s community is honored on the jersey. Coach Sue lifted up the first jersey. It had two initials on the sleeve. They were the initials of the school’s athletic trainer’s wife, who had tragically passed earlier that year. When the uniforms were passed out that year, the athletic trainer had no idea his wife was the one being honored. You can imagine the spectrum of emotions he and the team experienced as he saw her initials on the jerseys for the first time and the rest of the season.
Another year, the jerseys displayed a pink breast cancer logo. Two moms in the school community, one of whom was the mother of one of the players, had overcome breast cancer.“What sort of adversity did those women and their loved ones face?” she asked the boys.
In sharing the stories of the people behind these jerseys, Susan’s message was clear: Everyone will face adversity in their lives. You will, too. And some of you will experience adversity today. But, as everyone must, you will move forward.
“This year’s varsity team was very hard to make,” she concluded, and the boys headed home.
As the boys learned who had made the cut and who hadn’t, there was joy, anger, and tears. For some, adversity had hit.
Two goalies were selected for the varsity team. A third, who had not made it, felt slighted and pretty aggressively let Coach know how disappointed he was. But yesterday, the first day of practice for the junior varsity team, the JV coach asked Sue, “Do you know who the best player on the field was today?” She had no idea. It was the goalie! Sometimes, our greatest disappointments are our greatest gifts. I’m going to keep a special eye on that kid.
Adversity is one of our greatest teachers. Ask any successful athlete. Ask any successful businessperson. Ask any successful person. Of course, not making a team in no way compares to the great adversities we all will face in life, like battling cancer or losing loved ones. But what I like about team sports is what they teach us about how to better cope with the challenges that life throws at us. The ups and downs, the winning and losing, and the need to come together as one team.
We have a scrimmage on Saturday night and two more before the season’s first game. The talent level this year is exceptional. I’m so excited to see how they come together and, of course, quietly watching and learning from Coach Sue. Go Friars!
I sure hope your young ones are enjoying the journey, and I’m pretty sure you are really enjoying them!
With a fine glass of wine held high (a red Bordeaux for me), let’s toast together: “To adversity” and “To life!”
Thanks for indulging me… Ever forward. All the very best.
Trade Signals: The 10-year Treasury is Challenging Last Years Secular Trend High at 4.33%
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
– Charlie Munger
Bonds remain in a sell signal. The 10-year Treasury yield briefly traded above the 4.33% yield reached in October 2022. The MACD signal remains in a sell signal (red arrow bottom right-hand section of the chart). The Zweig Bond Model remains in a sell signal. The trend in interest rates is up.
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With kind regards,
Forbes Book – On My Radar, Navigating Stock Market Cycles. Stephen Blumenthal gives investors a game plan and the advice they need to develop a risk-minded and opportunity-based investment approach. It is about how to grow and defend your wealth. You can learn more here.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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