Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones – Friedrich August von Hayek
Anyone familiar with the scientific community understands the prevailing notion that data does not lie. This belief is rooted in the widely held view that data is inherently objective, grounded in evidence, free from subjective biases, and devoid of personal opinions.
Since the 1950s, economists have increasingly downplayed the significance of theory while advocating for a greater emphasis on empirical research using data. In a 2017 Bloomberg article, Noah Smith observed that economics is becoming a lot more empirical, focusing more on examining the data than on constructing yet more theories. Economist Daniel Hameresh classified papers in top economics journals in 2013, and discovered that the discipline has shifted away from theory since the mid-1980s.
Smith also noted that empirical economics is becoming more directly and immediately relevant to policy matters. These two quotes succinctly capture what many professionals in the field still believe today: data holds greater importance than theory. Milton Friedman once posited that economics should be a positive science, where models should predict rather than merely explain observations.
Since Friedman's time, an increasing number of economists think that theory isn't as critical if econometric models can provide accurate predictions. Consequently, many now put the cart before the horse, first scrutinizing the data and then formulating theories or using it for forecasting.
Irrespective of one's perspective on this matter, it is evident that the models currently employed often fall short. For instance, at the close of 2021, predictions for the S&P 500 on Wall Street ranged from 4,300 (Michael Wilson, Morgan Stanley) to 5,300 (Brian Belski, BMO). Still, the S&P 500 closed at 3,850, a 20 % decrease from the year's outset and approximately 10% lower than the most pessimistic estimate (Wilson).
A more recent example pertains to September's Nonfarm Payroll Report. Wall Street economists expected a range of 90,000 to 250,000 seasonally adjusted job creations for September. Once again, these predictions proved significantly inaccurate. According to the BLS, 336,000 new jobs were added in September, 34.5 % higher than the highest estimate. This led veteran trader Nick Givanovic to question the rationale behind employing "economists."
While the situation is somewhat more complex for Nonfarm Payrolls, as they are derived from actual employment and wage data and are often revised in subsequent months, the models used by Wall Street economists are fundamentally akin to their stock price forecasts. They rely on historical data, which they feed into econometric models. The stock price tomorrow is considered a function of today's price, with a random shock added.
In a 2022 article, Robert Murphy precisely emphasizes this point, criticizing the idea that this is how prices evolve. The real reason today's price isn't drastically different from yesterday's isn't due to the price being a function of the previous day's price but rather because, most of the time, the underlying factors today don't vary significantly from yesterday's conditions.
There's a humorous saying that economists were invented to make meteorologists look good, and there's certainly a grain of truth to it. No meteorologist would assume that today's temperature solely depends on yesterday's temperature; they understand that causal factors are at play.
Although the econometric pioneers may understand why certain assumptions are made and can offer a priori justifications such as "rational expectations" for the details of a particular model, the students of such pioneers are often caught up in the mathematical technicalities and lose sight of the true causes of economic phenomena.
The simplest explanation for why economists often miss the mark, to put it bluntly, is that they tend to be followers of trends. This is why they frequently lag behind and readily attribute their errors to irrational markets or external factors.
Consequently, one might question whether the field of economics took a misguided turn by emphasizing econometrics while neglecting the fundamental driver of economic outcomes: human behavior. Until economists recognize this, they will face criticism for their inaccurate predictions. Did economics veer in the wrong direction?
This week, the Wall Street Journal published a report indicating that economists have reduced the probability of a recession to below 50 % and anticipate that the Federal Reserve has concluded its interest rate hikes.
Fueling the optimism are three key factors: inflation continuing to decline, a Federal Reserve that is done raising interest rates, and a robust labor market and economic growth that have outperformed expectations.
This aligns with my expectations since the beginning of the summer when Fed Chair Powell stated that he no longer anticipates a recession. I can't help but recall that this scenario often unfolds months before a recession strikes: central bankers and politicians taking victory laps. They look in the mirror and extrapolate this into the future.
Indeed, the US economy has held up better than expected, and to some extent, so has the Eurozone. Last weekend, Christine Lagarde of the ECB noted that the labor market shows no significant signs of weakening. This week, Janet Yellen commented on the economy performing exceptionally well. It appears they are already celebrating because things have gone smoothly so far, and they assume they will continue to do so in the future.
While I still maintain my prediction of a recession beginning later in this quarter, I concede that the likelihood of this forecast coming to fruition diminishes day by day. Perhaps it's off by one or two quarters. Nevertheless, I have always argued against positioning for a recession before it materializes. At the moment, signs are emerging, but one should exercise caution before assuming that the US economy will remain as robust as it appears today in the coming quarters.
It's important to remember that, for example, in the first quarter of 1990, the annualized quarterly US GDP accelerated to 4.4 %, yet the US slipped into a recession two quarters later. Therefore, I would advise everyone to be wary of assuming that the strength of the US economy will persist as it appears today in the quarters ahead.
Currently, the Atlanta Fed's Nowcast for annualized GDP in Q3 2023 stands at 5.4% due to consistently stronger-than-expected economic data. The US economy's remarkable resilience has surprised many economists, given their earlier expectations of a recession this year.
Financial markets were in for another data surprise this week. Seasonally adjusted retail sales (excluding autos) in September saw a 0.6 % growth, far exceeding the anticipated 0.1 % increase. Furthermore, August's figures were upwardly revised. Nevertheless, as highlighted by Unlimited Funds' Bob Elliot, factors like declining consumer confidence and BEA card data still raise concerns.
It appears that US consumers are seemingly undeterred by rising interest rates, continuing to sustain their spending habits. Does this, then, make it logical to assume that a recession isn't looming in the coming quarters? If we adhere to the beliefs of the economists on Wall Street, these numbers indeed support that notion.
However, the glaring issue is that recessions tend to arrive when least expected. It's more common for them to catch market participants off guard. One reason is the Federal Reserve, which presumably possesses more data than the average economist on Wall Street. They see part of their responsibility as spreading positive economic sentiment. Often, Fed officials attempt to boost investor morale even as signs of economic trouble emerge.
Furthermore, there are various reasons behind the economy's robust performance. As I mentioned last week, many solid companies have benefited from the rate hikes by issuing long-term bonds when interest rates were still low and are now parking their cash at risk-free rates of 5 % or more. The same holds for households with financial assets.
Households holding financial assets benefit from a risk-free rate above 5% while benefiting from their low fixed-rate mortgages. They have, in fact, profited from the rate hikes so far, as stocks continue to hold steady, and money market funds offer a less risky alternative now.
Even for households whose primary asset is their home, there are advantages. Nominal income has increased while their fixed-rate mortgages have remained the same, resulting in a lower proportion of their income being allocated to servicing their debt. So, despite an average credit card interest rate of 28.15 %, as reported by Forbes, households, on the whole, find themselves in a better financial situation than they have in decades.
It's worth emphasizing that this figure represents an aggregate number, which may paint an overly optimistic picture of the financial situation for less affluent households. It's evident that they are already grappling with the weight of elevated interest rates. Nevertheless, one could ponder that their spending may still be more resilient compared to past economic downturns. Why? The emergence of Buy Now, Pay Later services:
BNPL has already seen strong traction this year. Thus far in 2023, BNPL users have spent $46.7 billion, up a significant 14.7% YoY and $6 billion more than during the same period last year. BNPL growth has been driven by categories including groceries, where its share of spending grew by a staggering 37.5% YoY. Other categories driving BNPL growth include home/furniture (up 25.9% YoY) and apparel (up 15% YoY)
Researchers at the New York Fed have recently noted an increasing adoption of BNPL services by individuals facing more financially precarious situations, including those with lower incomes. The observation that people are now resorting to BNPL solutions for everyday expenses like groceries suggests that some are already grappling with financial challenges but are attempting to stretch their payments over a more extended period to sustain their consumption.
To some extent, these factors could clarify why consumer spending remains more robust than many would anticipate. It's easy to argue that financial innovations like BNPL have artificially prolonged the economic expansion. However, they cannot forestall the inevitable.
Conversely, the supply side of the economy appears notably fragile. To revisit the Adobe Forecast I mentioned earlier:
Adobe anticipates discounts will hit record highs – up to 35% off listed prices – this holiday season, as retailers contend with an uncertain spending environment and consumers who continue to deal with rising costs in areas such as food and gas.
One might naturally assume that increased discounts would impact businesses' profit margins, making them less profitable and more susceptible. The most recent Fed Beige Book, released this week, highlights that sales prices have risen at a slower pace than input costs. This is because businesses are struggling to pass on cost pressures to consumers, who have become more price-sensitive.
This situation doesn't support the notion that the economy is thriving simply because retail sales are strong. I would argue that it reinforces what I emphasized a few weeks ago: the impending economic turmoil won't stem from a lack of demand but from a declining supply.
The contrast between the Russell 2000 and the larger corporations supports this assumption. Prominent companies can still weather the current interest rate environment because they've locked in higher interest rates. However, most businesses in the overall economy, primarily small and medium enterprises, face a different reality.
While manufacturing may receive some tailwind from government subsidies under the Biden administration, the service sector grapples with mounting headwinds due to increased costs and the challenge of passing them onto consumers. They'll attempt to manage on slimmer profit margins until it becomes untenable.
Lastly, regarding the situation in the US, I'd like to briefly touch on Bank of America's earnings report, which bolsters my suspicion that the Fed won't be able to end BTFP next year as planned. Many banks marking their assets at par as "held to maturity" assets make their balance sheets appear stronger than anticipated. In the case of Bank of America, as noted by Jack Farley, unrealized losses on held-to-maturity securities now exceed 130 billion dollars.
While extending BTFP may help prevent a banking crisis on a much larger scale than seen in the spring, it will undoubtedly impact future security purchases. Commercial banks, the Fed, and foreign investors have been the heaviest buyers of US treasuries in recent years. Now that they're likely to buy significantly less, other buyers like pension and hedge funds will step in, but they may demand higher compensation for their involvement.
While the US remains a distance away from a recession, despite arguments that one could occur sooner than expected, the Eurozone is in decline, with Germany teetering on the brink of recession. The EU and Eurozone's largest economy has stagnated since the beginning of the year, and the recession is presumed to have already begun in Q3.
In light of this, I was somewhat surprised by Bundesbank head Joachim Nagel's comments, suggesting that Made in Germany will remain in vogue. The Bundesbank still anticipates a recovery in 2024, as Nagel pointed out. When I look at how German industry has responded to the recent challenges, I am broadly optimistic, he told Bloomberg.
According to the ZEW survey, financial market analysts and institutional investors share his optimism, although current sentiment still hovers at recessionary levels. Expectations, however, have rebounded and are now close to neutral, fueling hope for an improvement. Yet, it's important not to place too much weight on this survey, as it doesn't serve as a reliable indicator of economic growth.
German manufacturing isn't the only sector raising concerns; the housing market also sends distress signals. In September, German house prices witnessed an 11.2% year-over-year decline, influenced by a combination of persistently high inflation, sluggish economic growth, and elevated interest rates. As reported by Christophe Barraud:
German housing sector finds itself in the throes of an unprecedented crisis as construction projects face record cancellations, sending shockwaves through the industry. A recent survey by the Munich-based Ifo Institute revealed that in September, a staggering 21.4% of residential builders reported the cancellation of their projects, marking the highest level since records began in 1991—surpassing the previous month’s already alarming figure of 20.7%.
European countries are grappling with challenges marked by soaring interest rates, surging energy prices, and escalating regulations (despite purported attempts to reduce them). While European politicians, especially Greens, often praise the miraculous economic growth, job creation, and prosperity promised by the green transition, the harsh reality paints a starkly different picture.
This week, Sweden's Voltra Trucks declared its impending bankruptcy, citing production shortfalls attributable to supply chain disruptions. This predicament also casts a shadow over Austria's Steyr Automotive, the manufacturer of Voltra Trucks, the extent of which remains uncertain. Once hailed as future-proof jobs by climate minister Leonore Gewessler, they now hang in the balance.
In December, Ursula von der Leyen asserted that the future of the European Union's cleantech industry must be nurtured within Europe. However, the predicament lies in Europe's lack of competitiveness in renewable energy production, ironically due mainly to the exorbitant energy costs. Whether we embrace it or not, using fossil fuels, gas, and nuclear energy remains indispensable to prevent industries from relocating beyond the continent.
Regrettably, European politicians appear out of touch with the current landscape. The European Banking Authority has recently revealed that banks must incorporate ESG scores for their clients, which will inevitably influence lending to fossil fuel companies. This development is unlikely to reduce energy prices, considering that roughly 70% of the EU's primary energy consumption is derived from fossil fuels.
Now, let's delve into what these developments signify for financial markets moving forward. Given the circumstances above, I suspect that European stock markets offer little upside but considerable downside potential. Europe seems veering in the wrong direction, with politicians doubling down on their questionable decisions.
In contrast, US equities could fare relatively well, though I remain skeptical about the prospects for small-cap companies. The Russell 2000 appears poised for new lows this year, primarily due to its vulnerability to rising interest rates. However, some more giant corporations might exhibit more resilience, though I wouldn't place a strong bet on it.
Turning to the currency market, I favor the US dollar over the euro. The ongoing geopolitical tensions in the Middle East are far from resolved, and should the situation escalate, the dollar is likely to serve as a safe haven for investors. Another currency currently acting as a safe haven is the Swiss franc.
This suggests that the downward trend in bonds is expected to persist. Despite my initial expectation of a lengthier rally in the current environment, recent developments have proven otherwise. In this setting, a stronger dollar leads to higher yields, prompting foreign treasury sales and driving global yields and the dollar upwards. While many advocate for lower bond yields, I find it challenging to envision a scenario where this materializes.
In my opinion, investors should turn their attention to gold. Gold is a preferable hedge against a potential downturn in equities compared to bonds. In the short term, we might experience a brief correction after the recent rally, but I anticipate that gold will reach new all-time highs in the medium term.
This holds even if my recession prediction comes to pass, as I believe it would be driven by supply factors that policymakers are likely to maintain artificially. In such a scenario, bonds may find support and experience a short, sharp rally akin to what occurred from November 2022 until early this year.
Nonetheless, I wouldn't engage in this strategy until central banks commence interest rate cuts, signaling a potential stock sell-off. Moreover, any such move regarding interest rates would likely elevate long-term inflation expectations and, subsequently, yields.
As for when these changes will transpire, it remains uncertain. However, given that many aspects (except for inflation, most likely) are moving in the wrong direction, the reckoning could be abrupt for many.
I should have understood
I should have seen it coming
The signs on the road have changed
The fires on the mountain dieAmorphis - Wrong Direction
I wish you a splendid weekend!
Fabian Wintersberger
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(Please note that all posts reflect my personal opinions and do not represent the views of any individuals, institutions, or organizations I may or may not be professionally or personally affiliated with. They do not constitute investment advice, and my perspective may change in response to evolving facts.)
Nice summary Fabian. I must admit I concur with most of your thesis and see nothing that is going to prevent yields and the dollar from continuing to rally. I definitely do not want to try to catch that bond market falling knife!