This is the full transcription of podcast 'Hidden Forces'.
A Recession, More Inflation, or Both Eric Basmajian #Podcast #Transcription #ReadAlong #KnowledgeUnlocked
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This is the full transcription of podcast 'Hidden Forces'.
A Recession, More Inflation, or Both Eric Basmajian #Podcast #Transcription #ReadAlong #KnowledgeUnlocked
economy is rolling over and their margins are getting compressed, they say, crap, what do we have to do? We have to cut costs or raise prices. And then the prices start to go up and everyone says, look, corporations are passing on price increases, but really that's just the lagged effect. Fascinating. So it's like a blow off top in inflation as we head into a recession. Exactly. There's something else that's counter intuitive, which I think is also interesting and striking. I just want to mention it. And again, I want you to stay on course here, Eric, which is when we're at the very beginning of our conversation, we were talking about the longer leading indicators. One of those were was monetary aggregates. Another one of those was interest rates. And interestingly enough, the Fed focuses on indicators like inflation and employment, which are late to the game, in order to adjust their behavior, which are actually the leading indicators, which is monetary policy. Exactly. Which I think (48/57)
said, I see signs that the economy's slowing, but there's no signs of recession. And you know what Bernanke was most concerned about in February of 2008? Inflation. He said inflation is going to be our problem now because oil prices were out $100 a barrel and they were contemplating the market was actually pricing in potential rate hikes because of the high inflation. And his main concern at that time was inflation. And we were basically six months ahead of catastrophic deflation. So here we are again, where inflation is very high, it's way too high. It's obviously being impacted by supply issues, geopolitical issues, and also the lagged effect of economic growth. So the Fed has to bring down the rate of inflation, but because of the lag nature of it, by the time they see that inflation is coming down in the CPI, that means the economy will have already been slowing for a year. And that's what we're seeing now. So I think that while the current headlines are about inflation, the (54/57)
What's up everybody? My name is Demetri Kofinas and you're listening to Hidden Forces, a podcast that inspires investors, entrepreneurs, and everyday citizens to challenge consensus narratives and to learn how to think critically about the systems of power shaping our world. My guest in this week's episode is Eric Besmejian. Eric is an economic cycle analyst and the founder of EPB Macro Research, an economics-based research firm focused on inflection points in economic growth and the impact on asset prices. His research has been featured across major financial media outlets and has been kind enough to provide a sample of his latest cyclical trends monthly update report for premium subscribers to our Super Nerd Tier that you can get through this week's episode page on our website at hiddenforces.io. This conversation is the latest in a series of episodes that I've been releasing on markets and investing with an especially strong focus this time on the macroeconomy and in particular the (1/57)
secular and cyclical trends in the rate of growth and inflation. Secular forces are things like demographics that the GDP levels, trends in globalization and the regular and predictable doubling in computing power commonly referred to as Moore's law. Long term trends in other words that remain in place through multiple economic cycles. Cyclical trends on the other hand are the six to 18 month fluctuations in growth determined by things like income, production, consumption and employment. We can anticipate changes in the direction and magnitude of these trends by relying on a variety of what are known as leading as well as coincident economic indicators. Things you've probably heard of before like building permits, new manufacturing orders, non-farm payrolls, personal consumption, industrial production, stuff like that. Understanding where you are in an economic cycle and what the long term secular forces are that are pulling you or pushing you in any particular direction is as (2/57)
important to investors as the weather and the ocean currents are to the navigator of a sailboat. They inform the allocation strategies and performance expectations of a variety of asset classes, business models and policy choices over time. My objective in bringing you this conversation today is to expose you to a framework for thinking about the macroeconomy that is empirical, data oriented and very much based in reality. One that you can use to forecast major economic inflection points and the resulting impact on asset prices as you try and manage your own portfolios and make your own investment decisions. As most of you already know, Hidden Forces is listener supported. I don't rely on advertisers or commercial sponsors. So the second part of today's conversation with Eric is available to premium subscribers only. You can access that part of the conversation as well as the transcripts and intelligence reports to each episode by visiting our website at hiddenforces.io selecting the (3/57)
episode that you're interested in and clicking on the premium extras where you can then sign up to one of our premium content tiers. Since some of this episode deals with investing, it should be absolutely clear that nothing we say on this podcast can or should be viewed as financial advice. All opinions expressed by me and my guests are solely our own opinions and should not be relied upon as the basis for financial decisions. And with that, please enjoy this week's episode with my guest, Eric Besmajan. Eric Besmajan, welcome to Hidden Forces. Hey, Dimitri. Thanks for having me. It's my pleasure having you on, Eric. You're a brilliant guy, man. I really, really appreciate your work. It's something I haven't been able to find readily anywhere else and I've looked for it for quite a long time. Before we get into your work, I'm curious, I want to know a little bit more about you and how you got into doing this because you have like this almost a passion for economic indicators that I (4/57)
haven't really seen anywhere else. So how did that come about? Yeah, thanks. It's a little bit of a roundabout story. So I started studying economics at New York University and when I was there, I took a course on financial crises and it resonated with me so deeply because there were these repeated crises that happened throughout history and every single time that one of these crises happened, it was always somewhat unexpected or it caught everyone by surprise, but they all had very similar characteristics which were excessive levels of debt for the most part. The basis of the crises was some buildup of debt in some sector or many sectors of the economy. And I thought to myself, you have to at least have a foundation to understand when these financial crises have the potential for occurring because if you're in 2007, let's say, and you're doing bottoms up fundamental analysis on a company and then the crisis occurs, your analysis really doesn't matter. All the companies are going to go (5/57)
down. All equities are going to go down. So whether you're a stock specific analyst, no matter what market you're in, you have to have a foundation for understanding what I would call these secular economic trends or these long term economic trends that are basically signs of excess. So that really got me down the road of studying these debt buildups, the concept of debt deflation, and just the longer term secular economic trends, which are mainly a function of debt and demographics. So that was sort of how I got the wheels turning on the long term economic process. After school though, I went over and I worked at a quantitative hedge fund in Midtown, wasn't macro. It was a quantitative fund scanning for mispriced equity derivatives. So we would scan 60, 70, 80,000 options per day and look for what we thought were mispricings. And even though it was a little bit different than my macro background, I learned a great deal about statistical analysis, a little bit of computer programming. (6/57)
And while I was there, I was still sort of more passionate about macro. So I would read all the research on the street and I would read all of the prevailing macro analysis that was out there. And I thought it was quite poor in terms of spotting these major inflection points. Most of it seemed to go one direction. It generally seemed to be bullish until it was glaringly obvious that being bullish was not the right outcome. So I continued to study these economic trends. And I came across Jeffrey Moore, who was dubbed as the father of leading indicators. He co-founded the Economic Cycle Research Institute. And what was interesting about studying Jeffrey Moore's work is he was laser focused on what we call these leading economic indicators and trying to anticipate turns in the business cycle. And that was extremely insightful for me because I was working at a hedge fund that needed to mark performance on a quarterly and yearly basis. So I was sensitive to the fact that you couldn't stay (7/57)
laser focused on these 10 year trends. It was important to know, but you couldn't have your entire process be a 10 year trend because you needed to have some ability to mark performance on a shorter term basis. So I dug deeper into these leading economic indicators and I started to merge the two processes of these long term secular economic trends and these business cycle indicators, trying to spot these inflection points on a more timely basis. And when I did that, I started to sort of put these models together in my head. And I saw that there was really nobody that I could find that was doing it. There were some people who I view as mentors to me who were doing these long term economic trends brilliantly. There were people that were doing the shorter term business cycle work, but nobody was combining the two of them together. So I thought that there was a really good opportunity. And when I left the fund, I started publishing this work and the audience that I was publishing to just (8/57)
the community of investors was extremely receptive to the combination of this long term economic trends, sort of the gravity, I call it, but also the more timely cyclical inflection points. And I just continued to publish this work. I got a good reception from it. So that sort of developed into what I'm doing now, which is publishing these long term secular economic trends, establishing what the gravity in the economy is, but then also alerting investors to the more timely cyclical inflection points so that they can prepare for what's coming over the next couple of quarters. I love it. So a couple of thoughts and some questions that come out of this. One, I also want to highlight your use of the word gravity for listeners, because that's something that you commonly refer to. And you use it as an analogy to describe the secular trends. Is another way to think about secular versus cyclical as a difference between climate versus weather? I think that's a really good description, actually, (9/57)
because the secular economic trends are the longer term forces that are very, very, very slow moving. The secular economic trends will not change tomorrow or a year from now, even if you put processes in place to try and change them. So for example, demographics is a secular economic trend. Even if we put in place a policy that was geared around having a lot of babies today, it still wouldn't impact these secular trends for another five, 10, 15 years as that new class of babies came up through their early years and the economy had to divert more investment and more resources. So even though you can put policies in place today, it still takes some time. It's almost like they move at glacial speed. So I think that's a very good analogy is that the long-term trends are just very slow moving and you can make a difference over time, but they're very slow and it takes quite a bit of persistence to change them. Would you also put things like, so you mentioned debt demographics for secular (10/57)
forces, would you also put something like Moore's Law in that bucket as well as, let's say, globalization? So we had decades of increased globalization. Now we're moving into a period where in some ways the world is showing clear trends of de-globalization. Would those qualify secular trends? Yeah, I would consider anything that is a consistent directional pattern over three to five or longer years to me would be a secular trend. The reason that I always describe them as demographics is because I'm focused on economic growth and if I had to boil it down to just two main factors, it would be the debt and the demographics or more specifically, productivity and demographics, debt being the most influential factor on productivity. So I think that there is a larger basket of things that you can put into these secular trends. My focus on demographics is not trying to be overly exclusive. It's just if I had to boil it down, I try and make the process as simple as I can. Those who I would say (11/57)
are the two major forces, but we definitely have a confluence of factors that drive the secular trend. So correct me if I'm wrong here, but when we talk about indicators, what we're really talking about here is cyclical indicators. In that regard, we have what we broadly call leading indicators, which give us information about what's going to happen in the future. We have coincident indicators, which tells us what's happening right now. We have lagging indicators that are like the forensic evidence that we can look at after the fact, after the event has occurred to say, ah, there was for example, a recession between this date and this date. And is it also fair to say that lagging indicators are actually the most accurate indicators? Yes, I think that was a perfect description. And there's a part in an economic process for all the indicators, the leading, the coincident and the lagging. The lagging indicators tend to be lagging one in terms of where they move in the sequence, but they (12/57)
also tend to be lagging in terms of their methodology or the way in which they're reported. So the most reliable economic data tends to be the government data, but it can be lagging because when it's first announced, then it gets revised, then usually it gets revised a second time. And then usually there's an annual benchmark revision. And then sometimes there's a five year benchmark revision. So when we do the forensic evidence looking back over many decades, the government data tends to be far and away the most accurate, but it takes a long time for it to increase in its accuracy once they move from a survey estimation to actually tabulating the information. The leading economic indicators can be much more volatile. They can be much more noisy, but they're reported on a more timely basis and they tend to move earlier in the sequence. So the leading coincident lagging process is one about the economic sequence, but it's also about the way in which economic data is reported as well. So (13/57)
I think that's a great point. All right. So I think now would be the appropriate time for you to explain your framework and walk me through how you try to understand the economy and walk me through that sequence and where we are in that sequence today. Okay. So before I get into the cyclical or the leading indicators, I always start with the secular economic trend because as I mentioned, that's economic gravity. And even though we're mainly concerned about what's going to happen over the next couple of quarters, it's very easy to overlook these secular economic trends. And I think that you do yourself a huge disservice if you don't first analyze the secular trends because you need to understand where the gravity in the economy is. Why is that important? The cyclical economic trends are the fluctuations in growth that happen on top of the secular trend. However, if gravity is pulling you down, you have to approach the data with a bias that the cyclical upturns will be more fleeting or (14/57)
shorter lasting and the cyclical downturns will last longer or will be harder to break. And the evidence of that is that if you go back over the last 30 years, since the early 1990s, the economy has only spent 42% of the time in a cyclical upturn. It's spent 58% of the time in a cyclical downturn. And the way that you can rationalize that is because the secular trends are declining. Debt levels are increasing, population growth is declining, that puts downward pressure on economic growth. Therefore, when we move to the cyclical trends, we have to approach the data with a bias that cyclical upturns will fade faster and will be shorter, cyclical downturns will last longer. Further evidence of that is that going back again to the 90s over the last three decades, cyclical upturns in economic growth have lasted 13 months on average, while cyclical downturns have lasted 18 months on average. So we have to be aware that the downturns are going to be lasting longer than the upturns because of (15/57)
that economic gravity. So once I establish the secular trends, then I move to the cyclical trends trying to understand where the economy is today. So let's now define the cyclical trend today. The cyclical trend is defined by what I call the four corners of the economy. The four corners of the economy would be consumption, income, production, and employment. Every economy has these four corners. Some have more than others, right? So China would have more production and less consumption. The United States would have more consumption and less production. But every economy has all four of those corners and they work in a cycle, right? So if you have more consumption, that means you need more production. If you have more production, you need more employment. If you have more employment, then you would generate more income. If you generate more income, that feeds through again to more consumption. And that will be what we call a virtuous economic cycle. It's cycling upwards. It could also (16/57)
work in reverse though, right? So if you have less income, then you have less consumption, you have less production, then you need fewer employees, and that feeds through again to lower income. So the economy is always cycling upwards or cycling downwards. And the combination of those four corners is what defines the cyclical trend. It's important to look at all four corners of the economy because when you look at something like GDP, for example, or real GDP, it's not entirely comprehensive. It's what we use to define the business cycle broadly. But GDP doesn't take into consideration the income side of the equation. For that, we use GDI or Gross Domestic Income. It doesn't really take into consideration employment. And these are all different corners that really influence the way that the economy is cycling. The way that the economy is cycling. So it's important to look at all four corners and the comprehensive movement in which that these indicators are cycling. So you look at things (17/57)
like non-farm payrolls. You look at things like real personal consumption. You look at things like industrial production or real personal income. And the combination or the blend of those coincident indicators defines the current trend. So if we take where we are today in July of 2020, we have a strong deceleration in the growth rate of real personal income. Obviously inflation is quite high. It's damaging people's real incomes. The growth rate of real income is trending definitively lower. As the stimulus payments wear off, real consumption growth is starting to trend down in a really meaningful way. And that in turn is pulling production growth down. And employment is the last leg to fall. We see jobless claims starting to rise. So employment in turn will follow the other three corners. We're in a very clearly defined cyclical downturn. Now, quick question. Let's take employment since it's the last of the four to turn. At what stage in the economic cycle are we when we begin to see (18/57)
fall offs in employment? When you start to see fall off in employment or like a negative non-farm payrolls number, most likely at that point you're already in a recession. So by the time you see a contraction in these four coincident indicators, at that point you're basically at the start of a recession. When I define the trend, the trend is about the direction of economic growth. So if growth moves from 5% to 2%, that's a cyclical downturn. Even though growth isn't negative, 2% is still positive, that's a directional decline. The momentum in the economy is moving lower. So where we are now is the direction of the economy or the momentum of the economy is strongly to the downside. But we're not technically in a recession yet because employment growth unless it gets massively revised is still running at about 3% to 4% positive. So directionally economic growth is moving down. We're in a cyclical downturn but we're not quite in a recession yet. The reason I'm able to, what I feel is (19/57)
confidently assert that a recession is an extremely high likelihood is because I know that the trend is down but now we have to study the leading indicators because the trend just tells you what's happened last month or what happened as of the most recent economic data. The leading indicators tell you where you're going and if we're moving downwards, if the growth rate is decelerating, you're dangerously close to the zero bound in terms of positive or negative growth and the leading indicators tell you that you're going to keep moving down, then the chances are you're going to slice right through zero and growth will be negative on all four of those corners. So I love this. Give me a second here so I can clarify it. The coincident indicators give us a month to month view of where the economy is. And while they're not telling us where it's going, they can tell us important information about the trend that we've been experiencing month to month. So that is in some sense a way of thinking (20/57)
about what the future is going to hold. It's telling us the momentum. And then you couple that with indicators that are more predictive, the leading indicators, correct? Exactly. So a lot of people talk about leading indicators now and I think that there is a strong tendency with a lot of the chart work that we see to sort of overlay two lines and if one leads the other one, people say that's a leading indicator and it may be, but the process of leading indicators, as I was schooled through my study of Jeffrey Moore, is a little bit more in depth than that. It's the correlation doesn't equal causation, right? Like the price of Bitcoin and avocados, right? In my process, that would be disqualified because we have to see a consistent lead time across history, but it also has to make sense. It has to make logical sense in the economic sequence. So for example, hours worked or weekly hours worked would be a logical leading indicator of employment because a employer would slash somebody's (21/57)
hours before they took a more binding and permanent step of firing or hiring somebody. Another example would be building permits. You need a permit before you start construction. So it would be logical that the trend in new permits would lead something like construction employment or construction spending. So you need to have a logical correlation and then it needs to be proven across history and not just five years or 10 years, the longer, the better, obviously. So once we know the coincident trend or the momentum, we study the leading indicators to say, hey, is that momentum going to continue or are we nearing an inflection point where things are actually going to start, the momentum is going to change. And those inflection points are everything. All the money is really made or lost at these inflection points because the crowd is going one way. Everyone sort of extrapolates what's happening today into the future. Most economic models like what the Fed uses are really based on these (22/57)
linear extrapolations of what happens or what's happening now is going to continue happening in the months ahead. That's why whenever growth is strong, people always confuse a cyclical trend for a new secular trend. Like when Trump was in office, growth accelerated from 0% in 2016 to almost 3% in 2018. Everyone said, this is it. We're going to hit a scape velocity. We're going to hit a 5%. Yeah, we're going to hit a 5%. We're going to hit a scape velocity. But as soon as growth was hitting 3%, you saw the leading indicators start to crest and start to move lower, which gave you strong confirmation that, no, this is not a secular change. This is just a cyclical trend. So the leading indicators, I separate them into two buckets, what we would call longer leading economic indicators and shorter leading economic indicators. And I do that for two reasons. One is because when you study leading indicators, some happen to have longer leads and some happen to have shorter leads. So it's good to (23/57)
break them up into two buckets, which is what I do. It also gives you a secondary confirmation. If you see longer leading indicators inflect, and then you see shorter leading indicators inflect in a logical sequence with historically consistent lead lag times, then you have that much more confidence that, hey, long leading moved, short leading moved, coincident data, or the trend is about to change versus just having one step, you have a confirmation step. So in other words, there's a historical sequence across the entire historical dataset that we have going back. I don't even know. Maybe you can tell us how far back the dataset goes, where we have enough data to look at all of these different indicators. But there's a consistent sequence and the tighter it adheres to that sequence, the more data points that you have fall in line, the more confident you can feel. Exactly. So for example, I got a question the other day on a client call that somebody said, I know that industrial metals (24/57)
like copper are declining really fast right now. But don't you think it could be a one-off because of XYZ factor? And my answer was that it could be a one-off factor, but if I have a basket of eight long leading indicators and all eight or seven out of eight move lower, and then copper or industrial metals would be a shorter leading indicator, and it starts to decline exactly as you would expect with the historical sequence, exactly on schedule in a predictable pattern that gives you a lot more confidence that this is not a one-off, this is actually part of a broader economic cycle or a broader economic sequence. Okay, so where are we now? We know that the current trend is lower and we're dangerously close to the zero bound in terms of positive or negative growth. So any further deceleration will put the economy into a recession. What are the latest growth trends right now? Like where are we? So based on the composite of consumption, production, income and employment, growth is (25/57)
trending at about 1% right now. And it's being held up by employment, which we know is generally the last leg to fall. A lot of people think that two negative quarters of real GDP is a recession. It generally works. It's a good rule of thumb, but it's not the actual definition of a recession. Actual definition is a decline or negative growth across those four indicators that I suggested. We're going to likely have two negative quarters by the time this is over. We may see two negative quarters, but and I'm not trying to justify a way weakness in the economy because we are trending lower, but the first two quarters are pulled significantly lower by inventory components. So these two negative quarters of GDP may very well reflect a recession, but it's not exactly the definition. So when you say they're pulled lower because of inventory components, are you saying because companies stocked up on inventories heading into those two quarters that they didn't buy as much during that period? (26/57)
Exactly. So they didn't buy as much than when the inventory clears those shelves that acts as a drag on economic growth. And was that stocking up on inventory driven by how much of that was the result of the fact that there were supply chains issues, so companies were trying to get ahead of disruptions and they ended up stocking up on inventory? I think huge. I mean, we saw record inventory builds. So I mean, you always have over time, the inventory component of GDP nets to zero. It neither adds nor subtracts from GDP over the long term, but we saw three or four consecutive quarters of inventory adding a whole two points or a whole three points to GDP growth. And now that's unwinding. So GDP growth in this second quarter is subtracting about 2% as of the latest estimate. So if you look at real final sales, which is just GDP excluding the inventory component, it's probably actually going to be slightly positive in the second quarter. But again, that's not to discount the weakness that (27/57)
we're seeing. Growth is trending at about 1% right now. So we're very, very close to that zero bound. Any further deceleration is going to knock us below zero and that will officially be a recession in the NBER's eyes. But recession or no recession is less significant than the direction. Where's the momentum heading? And the momentum is lower and we're about 1% right now. So then we go to our leading indicators. And let's start with the longer leading indicators. The longer leading indicators are generally your monetary aggregates, your credit aggregates, your changes in interest rates and the housing sector. Things that are very interest rates sensitive technically because the Fed, people may have heard the term, when the Fed engages in tightening or easing monetary policy, it has long and variable lags. That sort of gives you your first clue there that those long and variable lags are longer leading indicators. So when we look at the monetary and credit aggregates right now, they're (28/57)
declining at really a historic pace, the fastest since the 1980s because this is, you know, the fastest and most aggressive tightening cycle since the 1980s. So we'll look at things like the monetary base, you can look at other deposit liabilities in the banking system. And what I like to do, a really strong indicator that I use is I take a composite basket of mortgage rates, treasury rates and corporate rates because that sort of captures the entire economy. Everyone is going to feel a change in those interest rates no matter where you sit, whether you're a household, a corporate or the government. So the change in treasury rates, mortgage rates and corporate rates, the rate of change. So are the interest rates higher or lower than 18 months ago, let's say. And we see that the interest rates across that composite basket are about 300 basis points higher than 18 months ago. And that is the most extreme magnitude of change in interest rates since the 1980s. Can I ask you something else (29/57)
there, Eric? Also, I want to mention something for listeners who either heard our episode with Levin and or didn't, which is we discussed the challenges of measuring broad money supply because of the role of shadow banking and the expansion of dollar liquidity that goes far beyond the US banking system. So the focus on interest rates is important in that context because that allows you to measure the price of money versus the supply of money, which is in the form of monetary aggregates. The other thing I just want to also point out and ask you, and then please I want you to continue, I don't want to interrupt this flow, is, I mean, how important is it that the nominal value of the interest rate rise today versus in the early 1980s comes from a much lower level of interest rates? So the impact that it has is much greater because you're starting at such a lower level and that reflects the larger levels of outstanding debt in the economy. Exactly right. So it's the largest change in (30/57)
interest rates in terms of absolute change, 300 basis points in 18 months since the 1980s. But exactly like you just mentioned, in 1980, the last reference point, aggregate debt to GDP was 150%. It's 370% now. So we're trying to push the same interest rate shock onto the economy with 200% more debt as a percentage of GDP. So that's likely to have an even larger effect than the 300 basis point change in the 1980s because there's going to be that much more debt that has to roll into those higher interest rates. When we think about how interest rates affect the economy, a lot of people talk about how there's a lot of fixed rate debt out there and that's certainly true. But the weighted average maturity of this massive debt pile that we have is still around five years with 20% of it rolling every two years. So if interest rates are 300 basis points higher than 18 months ago, that's almost two years ago, there's a significant amount of debt that's going to have to roll into those higher (31/57)
rates. And since that number that I'm quoting is a blend, it's going to impact how the government rolls their debt. They have a significant amount of short-term debt that they roll. It's going to impact the household sector and it's going to impact the corporate sector. We know that the corporate sector rolls debt extremely frequently and that's going to impact their earnings. It's going to impact their margins and that's why it's a leading indicator because they feel the impact and now they have to respond. So what's their response going to be? And we'll get to that as we move through the sequence. And I also want to mention that the important part about this process is that it's a basket approach. As you mentioned, there can be some differences in how monetary aggregates act today versus 20 or 30 years ago and that's why it's important to never make these inflection point determinations off one single indicator. When the whole collective basket is moving together, that also gives you (32/57)
increased confidence that this is a cyclical or an economic event that's causing all of these longer leading indicators to move in the same direction. Whenever I look at the basket of longer leading indicators, I'm looking at the magnitude of the change like we just mentioned, but I'm also looking at the breadth of the change. Is it just one of six indicators that's moving or is it seven out of eight? Seven out of eight is a lot different than two out of eight, let's say. So now we have a significant tightening through monetary aggregates, we have a significant tightening in our credit aggregates, and we have a record rate of change increase in interest rates. The other long leading indicator is the housing sector because, not surprisingly, the housing sector is very sensitive to those changes in credit availability and interest rates. And what do we see going on right now in the housing sector? It's basically absorbing all of the headlines. We see a very significant slowdown in the (33/57)
volume of housing transactions. Now, a lot of people jump in right there and they say, but prices are still going up. If we think about where inflation is in the economic sequence, inflation comes at the end. It's a lagging economic indicator. Inflation often peaks in the middle of a recession. And when we talk about the housing sector, we have to separate volume versus price. Volume leads price. So we're always going to see a significant decline in the volume of the housing sector before we see a decline in prices. When you say the volume of the housing sector, what do you mean? Volume of transactions. So we see new home sales, for example, down 30% from peak. We see existing home sales down 25, 30% from peak. And the reason that's important, it's actually kind of funny. Existing home sales, by that I mean a home that's already been built that someone is living in, the transactions in the existing home sale market only make up about 90% of the total housing volume. But it really (34/57)
contributes almost nothing to economic activity. The economic activity comes from new construction. It's the building, it's the labor, it's the ordering of new supplies. So even though the new home sale market is only about 10% of the volume, it's all of the economic activity. So we see a substantial decline in the volume of new home sales. We're starting to see a decline in building permits. I have a question just there again for my own interest here. The decline in volume is a way of understanding what that means. Does that suggest that buyers are not getting the price they want and so they're pulling there, they're not necessarily transacting at those prices. So there's a period of time that sellers or buyers need to get comfortable with the new pricing dynamics in the market. Is that what that reflects? So it can reflect a lot of different things. It could reflect buyer hesitation because prices have increased too high. So they've sort of hit their threshold of we can't afford (35/57)
prices at these levels. We have to wait for them to come down before we're ready to start transacting again. It could mean something as simple as home building companies are getting worried about the environment. So they're putting less supply on the market. They're building less homes. So there's less available to transact. Whether it's supply or whether it's demand, people always ask me, it doesn't really matter because the impact of the economy is in the aggregate activity. It's in the volume of transactions. If there's less transactions going on, you think about a new home and this is why housing is a longer leading indicator. If a new home gets sold, you have to build it. You need labor to build it. You need to order raw materials to build it. And then once the house is built, somebody moves into it, then what happens? Somebody needs to order new furniture. They need to order new appliances and that comes up as new orders and that is exactly where we move from longer leading (36/57)
indicators to shorter leading indicators. So now the housing sector is either cycling upwards or cycling downwards and that's going to impact how many new orders that customers or companies are placing. And those new orders are generally for durable manufactured goods. It's for home appliances. It's for furniture. It's for all of these things that require a manufacturing process. So the next part of the sequence as you transition from longer leading to shorter leading is you start to see a change in the volume of new orders that is in the same direction as the longer leading indicator. So moving where we are in our sequence today, we're cycling downwards on the current trend. We see a very significant decline in the longer leading indicators, meaning the monetary credit and interest rate aggregates and the housing sector. So then the next place that you would expect this slowdown to show up is in the volume of new orders. And what did we see on the last report, Dmitri? ISM new orders (37/57)
fell to 49.2. That's a contraction in the volume of new orders exactly when you would expect it. So that's not a one-off. That would be, okay, that's moving exactly when we would expect it. What else is a shorter leading indicator? The general sentiment of manufacturers would be a shorter leading indicator because the ones feeling our customers ordering more, are they not ordering more? Are we worried about the future? Are we less worried about the future? So you have manufacturing sentiment. And then you also have your industrial raw commodities because if they have less new orders, they know that they're going to produce less over the next couple of months. So they're going to have less demand for these raw materials to build those durable goods. And what do we see happening right now? Massive declines in copper. And it's not just copper. I look at a whole basket of industrials, which includes rubber, rosin, tallow, wool tops, zinc, everything that generally goes into a manufacturing (38/57)
process. And those prices are falling at a very precipitous rate. See, that's actually great. So just to highlight that, whereas certain types of commodities are traded in futures markets and benefit from an enormous amount of speculative liquidity, something like wool tops don't. Exactly. Exactly. How significant is that looking at those types of indicators and how does all that fit into your model? And then please continue. Like I said, I don't want to interrupt the trend. It's super important. I get that question all the time. They say, well, isn't copper depressed because there's so many speculators? And yes, when we differentiate between these commodities that are traded very actively on futures markets versus commodities that aren't, if we're seeing a discrepancy, that's something to note. But the fact that we're seeing these lesser traded commodities like rosin, rubber, wool tops, they're trending down and copper's trending down, then you have more confidence. Again, this whole (39/57)
process is about building confidence as you move through the sequence. You say, well, if rosin, rubber, tallow, wool tops, all those are going down and copper is going down. Well, it's probably not speculators. It's probably part of this broader sequence where all of these industrial commodities are moving lower. Notice how I didn't say oil though. Oil tends to be a little bit more service sector based. It definitely contributes largely to manufacturing processes, but it's also like airlines, driving, that's more service sector. So when we study this sequence, the fact that oil is still elevated while these industrial commodities are plunging is actually very historically consistent. Oil tends to fall once the recession arrives because the service sector really only starts to contract in a recession. Service sector almost is very non-cyclical. So the fact that we have industrial commodities going down, but oil prices staying elevated, yes, there's a supply component, there's a (40/57)
geopolitical component. But as far as the economic sequence, we've seen oil come down for about 120 to the 90 range. It's come off a little bit, but it's not falling at the same speed as the industrials makes a lot of sense with the economic sequence. So now we've moved from the longer leading to the shorter leading. Now we're seeing declines in new orders, industrial materials. We're also seeing inventories start to bloat at retailers. You're seeing these reports from Walmart, these reports from Target, these reports from major retailers that are saying, hey, look, we have a little bit too much inventory. What does that mean? If you have sales that are starting to come down, but you have too much inventory, that is a leading indicator of future production, because they're going to have to order less in the future. So all of this is happening very timely with the historical consistency. So if we see longer leading indicators moving down, it's transitioned to shorter leading indicators. (41/57)
We have a high degree of confidence that what's going to happen next, those coincident indicators that we defined first are going to take another leg lower. Why is that? Because if Walmart, for example, has too much inventory and the housing sector is slowing, for example, people are going to need to order less of those goods that they have too much inventory of. So they're going to call their manufacturers and they're going to slow their rate of production. And when they slow their rate of production, you're going to see that show up in industrial production, which would be our coincident indicator. If production starts to slow and manufacturers are pumping out less unit volume, they're going to hang on to these employees as long as they can, because it's very difficult to fire and hire people. It's a lot of friction involved with that. But if production keeps slowing, eventually they're going to say, we just don't have enough work. We don't have enough units to pump out. And then (42/57)
employment starts to come down. So you can start to get the picture of how we move from Fed tight ends. It contracts monetary aggregates. It contracts our credit aggregates. It pushes higher interest rates across the economy. That slows the housing sector. And then the housing sector feeds through to our new orders, our manufactured goods, our inventory components from retailers. And then they are forced to slow their rates of production, which causes the output at manufacturers to go down and eventually the employment to go down. We just looked at that from the housing sector. But we can also look at it, and I'll do this a little bit more quickly, from the corporate sector. I just looked at it from the lens of the housing sector and mortgage rates. But let's say that that basket of interest rates that we took includes corporate rates. So a corporation issued debt at 2.5%, 18 months ago. Now they're staring at 5.5% percent rates that they have to roll that debt into. So if they're (43/57)
going to roll debt at 300 basis points, higher interest rates, that's going to massively increase their interest expense. What do we know about the duration of outstanding corporate debt today? How does it compare to the past? And what can we infer about the severity of the recession based on that duration? Great question. And the need to roll it over. Yeah, we know for sure that the average maturity in the corporate sector has lengthened. There's no question that it's lengthened. But that still doesn't mean that zero debt rolls every single year or every two years. Is that a result of corporate borrowing increasingly moving into the bond market? It is. And it's also, they've felt every single time they go to issue, they feel that interest rates are very low. So they try and lock in these rates in the future. But because of this secular trend that we've talked about, because of this gravity, they always find themselves with lower and lower and lower interest rates. That actually makes (44/57)
a lot of sense. That actually makes more sense than what my life is. Exactly. So they have tried to extend their maturity outwards for sure. But a significant portion still does have to roll because there were some companies that issued five years ago or seven years ago, and now that debt's coming due. But you do bring up an important point, which is the magnitude of the change in interest rates is very important in terms of determining the severity of the economic slowdown. But the duration that interest rates stay elevated is also a very important consideration. So if we go through a tightening cycle like 2018, let's say, interest rates kind of went up and they came down very quickly. We had the Powell Pivot in 2018. There wasn't a whole lot of time for lots and lots of corporates or lots and lots of households to roll into that debt. But if the Fed feels that they need to stay on this tightening path longer and more aggressively, and interest rates stay elevated for 18 months, 24 (45/57)
months, 36 months, now there's less and less people that are going to be able to avoid rolling into that higher debt. So magnitude is important, but the duration that interest rates stay elevated is also important. And we're at a point now where we have interest rates that are starting to be up for quite a while. When you have such an indebted economy, when interest rates stay up for six months, a year, 18 months, it starts to really be impactful. So going back to our example of a corporate, they're going to roll their debt into a higher interest rate, let's say 300 basis points. That's going to dramatically increase their interest expense. So this is a longer leading process. Another longer leading indicator would be corporate margins. Why is that? Because if their interest rates are going up, their interest expense is going up, but the momentum in the economy is falling. So their revenues aren't really increasing. If you have flat and declining revenues, but higher interest expense, (46/57)
that's going to compress your margins. It's going to reduce your earnings. So compressed corporate margins would be a long leading indicator. So you see margins falling. And when did margins peak? Q3 of 2021, longer leading indicator. So a corporation is now going to feel that their margins are getting squeezed. And Wall Street punishes you if you have declining gross margins. So what does a company have to do in order to preserve those margins? They have to cut costs somewhere. First, they try and maybe scale back some of their investment, which shows up again as new orders because they're going to invest less and maybe plant and equipment or invest less in the economy, which requires less ordering. So they're going to do all these marginal things to try and preserve their margins. Another thing that they're going to try and do is they may try and raise their prices. They may try and raise their prices, which shows up as inflation, which comes later in the economic sequence. So as the (47/57)