The Stagflationary Sagas:
The Descent
into 'Stag-tember’

Unraveling the Macro Map

Awakening the Stagflationary Serpents

The once-tranquil waters of the CPI fjords have now been thoroughly navigated, leaving their simplistic readings behind on the misty horizon. In the wake of this voyage, the great serpents of Headline and Supercore Inflation awaken, stirring once more from their slumber with a renewed fervor. Meanwhile, the winds of Demand have slowed after a brief and defiant gust of acceleration in July.

Ahead, a foreboding pairing emerges: the Loki and Fenrir of declining Demand and surging Prices, who have now etched their mark upon our domestic shores since the twilight of July. In distant lands, the shadows of a global and local industrial recession linger, steadfast and unmoving. The hearthfires of consumer strength wane, their flames dimming as they face a relentless winter chill. And as the Norns, the keepers of fate, would have it, the chronicle of impending income and discretionary consumption shocks accumulates, woven intricately into the tapestry of 'The Convergence' — a prophecy we heralded in our last quarterly tale.

The Saga of Rising Eastern Valhallas: Japan and India

As the prophecies foretold to those who listen, the Eastern realms of Japan and India continue to bask in the favor of Freyja, the goddess of prosperity. Their growing might is seen by the all-seeing eye of the Odin, urging the sagacious to hoist their shields alongside these rising powers. The alchemic blend of their monetary enchantments spurs forth growth, with treasure ships and wandering skalds heralding the post-pandemic resurgence, guided by the subtle whispers of a weakening Japanese yen.

Japan treads a path, embracing its new inflationary winds, defying the menacing grip of a strengthening dollar and the fiery wrath of rising energy costs.

The vast expanse of India thrives under the bounteous blessings of their own fiscal rain, their coffers burgeoning from lavish court spending, a favorable potion of commodity prices, and swelling credit tributaries.

But a long shadow looms over the European plains. In the waning months of 2023, their lands will be tormented by the relentless pull of economic Niflheim – the chilling embrace of economic deceleration by an icy grip of a strengthening dollar and surging energy costs. The global winter of industrial downturn blows its icy breath on Europe, with their master forges and workshops reeling from diminished global desires and the haunting echoes of capital costs stifling their grand designs.

Navigating The Global Macro Tempests

Fear not dear reader for in these echoing halls of our longhouse below, we shall proclaim how we are charting our course and sailing aboard the multi asset class long short longship: the Drakkar.

The Drakkar’s Portfolio Performance and Positioning

When Your Investment Process is Narrative Driven Instead of Data Driven

Equities

As a reminder, a long position (the most common type) means you make money when prices rise. A short position (far less common) means you make money when prices fall.

Performance

Returns in our equity positions were positive for the quarter as most major asset classes posted material losses. Our outperformance can be attributed to our long positions in energy and India and our short positions in real estate and financials.

New Positions

Long: Energy

We added material long positions to energy related equities with positions in carbon based energy and nuclear energy in late July as an expression of our near term stagflationary conclusions which Mr. Market rewarded handsomely.

Exited Positions

Long: South Korea, US Defense, US Healthcare, and Gold Miners

We removed these positions as both the incoming macroeconomic data indicated growing probabilities of headwinds which Mr. Market began pricing in. We much rather realize small losses before they become bigger losses.

Maintained Positions

Long: Japan and India

The incoming macro economic data continues to indicate macro economic weather patterns of spring and summer while Mr. Market continues to concur and thus reward these long positions.

Long: Market Neutral Strategies

As a reminder, an equity market neutral strategy is an investment strategy that aims to generate consistent returns irrespective of the direction of overall market movements. It is called "market neutral" because the goal is to profit from relative performance rather than the absolute performance. If the long positions perform better than the short positions (regardless of whether both are up or down), the strategy makes money.

The position was rewarded handsomely with a positive rate of return during the quarter while the majority of traditional long only equity strategies were down to a material degree.

As of this writing, the material net sector exposures are:

Net Long
- Sectors: Energy, Industrials, Materials, and Information Technology
Net Short
- Sectors: Consumer Staples, Communication Services, Real Estate, Financials, and Utilities

Bonds

Performance

Returns in our bond positions were positive for the quarter as most major asset classes posted material losses. Our outperformance can be attributed to our long exposures in US Treasury Bills and our selling of call/put spreads to harvest option income.

New Positions

None

Exited Positions

None

Maintained Positions

We currently are maintaining our positions to US Treasury Bills which provide an excellent base layer rate of return of approximately 5.4%. This combined with the layering of selling call/put spreads for option premium income further boosts this into the mid to high single digits.

As a reminder, selling call/put spreads is akin to selling fire insurance (collecting a premium of say $100) and then buying firestorm reinsurance (spending a premium of say $10) thus resulting in a net premium collection of $90 in a risk hedged manner.

The position was rewarded handsomely with a material positive rate of return during the quarter while the majority of traditional long only bond strategies were down to a material degree.

As of this writing, the material call/put spread exposures are:

20 Plus Year Treasury Bonds
S&P 500
Amazon
Visa
Doordash

Alternatives

Performance

Returns in our alternative positions were positive for the quarter as most major asset classes posted losses. Our outperformance can be attributed to our long positions in Crude Oil and the Euro and our short positions in US Treasury Bonds, Canadian Treasury Bonds, Japanese Yen, and Gold.

New Positions

Quantitative Investment Strategies

We added a position to a basket of quantitative investment strategies which run four distinct strategies of carry, volatility, technicals, and liquidity across the five asset classes of equity, credit, rates, commodities, and currencies.

Each systematic strategy is designed to capture proven market return premiums which when added all up is designed to provide absolute returns in a highly portfolio diversifying manner.

The position was rewarded handsomely with a material positive rate of return during the quarter while the majority of traditional long only equity and bond strategies were down to a material degree.

Exited Positions

Long Duration US Treasuries, Gold Bullion

We removed these positions as both the incoming macroeconomic data indicated growing probabilities of headwinds which Mr. Market began pricing in. We much rather realize small losses before they become bigger losses.

Maintained Positions

Managed Futures

We continue to hold a managed futures position.

As a reminder, these strategies are trend followers in that they go long what is trending up and short what is trending down using price, volume, and volatility models. The scope of what trends can be harnessed spans all asset classes of equities, credit, rates, commodities, and currencies.

Moreover, it was these strategies that materially protected our capital in 2022 when virtually every long only stock and bond investor got crushed.

The position was rewarded handsomely with a very large positive rate of return during the quarter while the majority of traditional long only equity and bond strategies were down to a material degree.

As of this writing, our positions are:

Long
- Commodities: Sugar, Live Cattle, and Crude Oil
- Currencies: Euro
Short
- Commodities: Soybean Oil, Natural Gas, Wheat, Corn, Copper, Silver, Gold
- Rates: 3 Month SOFR, US Fed Funds, US 2 Year Treasuries, US 5 Year Treasuries, US 10 Year Treasuries, Canadian 10 Year Treasuries, and US 20 Year Treasuries
- Currencies: Japanese Yen
- Equities: MSCI Emerging Markets

Q3’s Market Weather Report

After a strong first half to 2023, global equity markets declined in the third quarter. The S&P 500 Index reached a 2023 high at the end of July, but from its intra-quarter high the index declined 6.3% through the end of September. This was the second meaningful decline this year; the S&P 500 fell 7.5% in February and March during the regional banking failures. Despite the decline, the index is still up 13.1% year to date.

Small-cap stocks (Russell 2000 Index) also had momentum early in the quarter but changed course and ended the quarter down 5.1%. Year-to-date, small-cap stocks are still up 2.5%, but meaningfully trail large-caps. On a style basis, growth stocks lagged value stocks during the quarter.

With virtually all segments of the stock market posting gains this year through September, one might think that we’re in the midst of a broad-based rally.

However, stock gains have remained unusually narrow, with the largest stocks in the index leading the way.

The standout performers are those sectors with the largest stocks, while most other sectors have been relatively flat.

Consumer discretionary has been driven higher by a 51% gain from Amazon.com and a 103% return from Tesla. The information technology sector has outperformed thanks to Apple (32%), Microsoft (33%) and NVIDIA (198%). Communication services has been propelled higher by a 48% return for Alphabet and 149% from Meta Platforms.

These seven stocks make up the “Magnificent Seven” that account for the majority of year-to-date returns of the S&P 500. Further illustrating the market-cap effect, the equal-weighted S&P 500 index is roughly flat this year through September.

Within foreign markets, developed international stocks (MSCI EAFE) declined 4.1% in the quarter, and are up roughly 7.1% year-to-date. Emerging-markets stocks (MSCI EM) fell 2.9% in the quarter and are up 1.8% this year through September. The U.S. dollar (DXY Index) surged over 3% during the quarter, resulting in a headwind for foreign markets. Both developed international and emerging-markets stocks outperformed the S&P 500 in local currency terms but underperformed after converting returns to U.S. dollars.

Moving to the bond market, core bonds (Bloomberg U.S. Aggregate Bond Index) fell 3.2% in the quarter as interest-rate rose. The benchmark 10-year Treasury yield climbed nearly 70bps in the quarter, ending the period with a 4.59% yield, the highest level since 2007. High-yield bonds (ICE BofA US High Yield) managed to eke out a small quarterly gain and are up 6% for the year-to-date period.

Finally, multi-alternative strategies (Morningstar Multistrategy Category) and managed futures (SG Trend Index) demonstrated their diversification benefits. Multi-alternative strategies returned 0.3% and managed futures gained 1.2% in the quarter.

Closing Thoughts

As we look ahead, a recession is still our base-case looking out to 2024. Of course, the timing and magnitude of the Fed’s response to economic data will be critical to the outcome. Currently, the Fed is signaling 50 basis points of rate cuts in 2024, but it’s quite possible that they will cut more meaningfully. Therefore, we can’t rule out the possibility that the Fed does thread the economic needle and successfully guides us to the rare soft landing. Given the uncertainty, we expect volatility, and we think that it will be more critical than ever to keep our pencils sharp and be ready to take advantage of market dislocations. This is not to suggest that we are changing our stripes as long-term investors.

We continue to believe that taking a disciplined long-term view is the path to successful investing. We will maintain a balance of offense and defense, seeking attractive risk-reward opportunities that are supported by thorough analysis.

We thank you for your continued confidence.

The Market’s Hyper Local Weather Report

In our unending quest to improve our analysis for our client’s benefit, we began incorporating into our analysis the metaphorical equivalent of a hyper local weather analysis.

Why you may ask? Flow dynamics (can) sit independent of fundamental trends and increasingly influence/dominate short-term price action.

Short term dislocations (positive or negative) might not have a fundamental reason but that doesn’t mean it didn’t happen.

In the chart below, we show how a single $1 invested in the S&P 500 compounded from 1926 to today. This covers over 25,200 trading days. Just missing the 10 best days, 10 worst days, or 10 best AND 10 worst days (all very short term time frames) makes a massive difference in the long term result of compounding capital despite being 0.039% to 0.079% of the entire timeline.

This is effectively another risk management tool in our toolbox to handle the reality of how the 6 foot man drowned in the pool that was 5 feet deep on average i.e. it is NOT the average of things that matter but the specific thing that happens at the specific time.

Now let us discuss market microstructure.

Market microstructure refers to the study of the processes, mechanisms, and structures through which securities are traded, and how these influence the formation and evolution of asset prices. It delves into how specific trading mechanisms, like the arrangement of orders and transactions, affect price formation, liquidity, transaction costs, and information dissemination in financial markets.

In essence, while traditional finance theories might consider markets as abstract mechanisms for price determination, market microstructure examines the "nuts and bolts" of the marketplace.

Current Hyper Local Market Weather Conditions

Today, much of daily trading is driven by rules based mechanical flow. Understanding the trigger levels and estimated magnitude of flows associated with Volatility Control Funds, Commodity Trading Advisors, Risk Parity funds, and Passive funds is key in tactically risk managing the immediate-term.

When Dealer Gamma is negative, it amplifies price and volatility movements. When Dealer Gamma is positive, it suppresses price and volatility movements.

Volatility remains the primary exposure toggle – directly for Volatility Sensitive Strategies and indirectly for everyone else (even if they don’t conceptualize it that way).

Understanding the trigger levels and estimated magnitude of flows associated with Volatility Control Funds, Commodity Trading Advisors, Risk Parity Funds, and Passive funds is key in tactically risk managing the short term which as previously illustrated can make a material impact to one’s long term wealth.

Dealers remain firmly in negative gamma (now by far the longest stretch since 2022) and intraday volatility on both sides remains firmly the story of the day. The high degree of market distortion suggests that futures and index ETFs are the preferred trading vehicles and strong outperformance by higher quality large caps is indicative of stock investors rotating (when they can) into defensive positioning. That this defensive positioning tends to correlate with buying the largest stocks in the S&P 500 leads to confusing market behavior – occasionally big stock prices UP is risk off!

Aggregate gamma remains near the worst levels since pre-Covid. While not a catalyst unto itself, these levels suggest risks that an exogenous event can lead to a rapid rise in realized volatility. Higher realized volatility leads to mechanical selling flow.

Longer term context for Negative Gamma Environments helps illustrate the utility more clearly.

Notice that when dealers are in positive gamma (green), S&P 500 (equities) has a tendency to drift up smoothly and thus “buy the dip” i.e. mean reversion strategies tend to work.

Conversely, when dealers are in negative gamma (red), S&P 500 (equities) has a tendency to move swiftly and thus “sell the dip” i.e. trend following strategies tend to work.

The Global Macro Weather Report

As a reminder, there are two key elements to our analytical framework:

The rate of change over time is more important than the level.
Bayesian reasoning is superior to deterministic reasoning.

Rate of Change Over Time

For example, driving at 100 miles per hour is your speed. If you maintain that speed your rate of change is 0. If you go from 100 miles per hour to 0 miles per hour that is a negative rate of change or deceleration. If you go from 100 miles per hour to 200 miles per hour that is a positive rate of change or acceleration.

Now, if you go from 100 miles per hour to 0 miles per hour in 60 seconds that is a leisurely pace to a full stop. If you go from 100 miles per hour to 0 miles per hour in 0.1 seconds…well you are pink mist i.e. the rate of change is a life or death matter.

You might think that example is humorous but not applicable to markets or economies. If so, I invite you to go speak with the stockholders of Silicon Valley Bank, First Republic Bank, and Credit Suisse.

Bayesian Reasoning vs Deterministic Reasoning

Imagine you're trying to determine if the driver in front of you is drunk based on how they're driving.

Using a deterministic analytical approach is like saying, "If a driver swerves X number of times within Y distance, they're definitely drunk." It's a fixed rule based on observed behavior.

On the other hand, using a Bayesian analytical process is like saying, "Based on how they're driving, there's a 70% chance they're drunk, but I also know that 1 in 5 drivers on this road at this hour are usually drunk, and this particular car model is often driven by younger people who statistically have a higher rate of DUIs." In this approach, you're continuously updating your belief with new information.

Deterministic analysis sets firm rules for decision-making, while Bayesian analysis updates probability estimates as new information becomes available, offering a more flexible and adaptable perspective.

As you can see, deterministic analysis requires less work since there is minimal need to gather new data since it is largely fixed rule based. Bayesian reasoning is clearly more work since it constantly requires gathering new information and computing updated probabilities to inform action.

With that established, let us proceed…

Leading Indicators continue to decelerate.

Source: Factset, Hedgeye Risk Management

Government spending growth accelerated to one of the highest levels in decades in Q2 while mega cap tech has begun to decelerate while the median stock for the year is now down.

Source: Factset, BEA, Hedgeye Risk Management

Barry the Permabull: But but but….the GDP estimates are ridiculously good!

No worries Barry, as the GDP estimates below clearly show, you have enough room to fly a 747 between the difference in GDP estimates as determined by the people in charge of estimates and steering policy!

Source: Atlanta Fed, NY Fed, Cleveland Fed, Hedgeye Risk Management

We should give the various government agencies a break on GDP estimates because even past data is not even sure of itself.

For example, Non Farm Payrolls have been revised lower every month this year. For perspective, the last time we had 7 consecutive negative revisions was during the Global Financial Crisis (GFC).

GDP in the GFC period received serial large-scale negative revisions for years. The Current Spread between GDP (gross domestic product) and GDI (gross domestic income) – which, in theory, should measure the same thing – has never been wider and hasn’t been this wide since the GFC.

In other words, more (large) revisions are in queue and liberal use of salt grains is advised in interpreting the reported data.

Barry the Permabull: But but but…the news and company management teams keeps saying we will have a soft landing!

Barry, never ask a barber if you need a haircut. Remember that narratives are easier than analysis.

Source: CNN, Cleveland Fed, Bloomberg, Hedgeye Risk Management

Source: Google Trends, Hedgeye Risk Management

Right at the peak of “soft landing” celebrations in July along with equity prices, Mr. Market begins the chapter of the Stagflationary Chronicles with a fast acceleration in oil prices at the surprise of the macro unware.

Source: Factset, ISM, Hedgeye Risk Management

Inflation reasserted itself as the captain thus driving up bond yields and thus dragging down bond prices. We are now at 3 straight years of losses for those who had long positions in bonds.

Source: Factset, Bloomberg, Hedgeye Risk Management

**Bond Market Reaction to Federal Reserve’s Assessment of Inflation**

Moreover, the evidence of stagflation pressures i.e. rising prices and falling volume/demand is quite visible to those who pay attention.

And as macro aware multi asset class long/short risk managers, we added long exposures to energy (yellow green box) in late July while maintaining our shorts to inflation sensitive areas (red box) like financials, regional banks, and real estate. Below is a proxy illustration of the value in such macro situational awareness, directional ability (long or short), and position ability (all asset classes).

Barry the Permabull: But but but….the consumer is strong! I don’t feel these negative pressures and I hear about it all the time on the news.

Barry, don’t conflate your personal situation in being a member of the top 20% of wealth and that of everyone else.

Real Retail Sales are still decelerating.

Source: Factset, BLS, Hedgeye Risk Management

The wealthy consumer continues to decelerate.

Source: Placer.AI, BLS, Hedgeye Risk Management

Services consumption is still trending downward despite the countertrend bounce in January and July.

Real CAPEX spending by businesses is still decelerating.

Real Manufacturing Orders are still decelerating.

Industrial Production is still decelerating and this is before the auto strikes currently in effect show up in the data.

Source: Factset, Federal Reserve, Hedgeye Risk Management

Global trade volumes are still decelerating.

**Barry the Permabull: Ok stag-tember was just a fluke that no one could see coming. Q4 and forward is all upside because AI is here.**

Barry, don’t conflate your inability to see anything other than upside in a narrow sliver of the world with everyone else.

Instead, let us measure, map, and cooly analyze.

Uncle Sam wishes you a happy Shock-tober in Q4.

Sept 1st: Student Loan Interest Begins (re)Accruing
Sept 14th: IRS Halts ERC Payments ($250B)
Sept 15th: UAW Strike Begins (Economic cost = $200-600M/Day)
Oct 1st: Student Loan Repayment Begins ($10-15B/Mo)
Oct 1st: Childcare-Cliff ($24B Funding Expiring, ~3M Impacted)
Oct 4th: Kaiser Permanente Worker Strike (75K HC Workers)
Oct 15th: California Tax Extension Deadline – The Bill is (Finally) Due
4Q23: Health Insurance Premium Spike
4Q23-1H24: Continued Unwind of Pandemic Medicaid Coverage. (Coverage Loss for 8-24M people)
4Q23-3Q24: EIDL Pandemic Loan Repayment ($380B in Loans)

Historically, Government Shutdown periods (orange bars in chart) have had mixed effects on markets, but protracted shutdowns produce all manner of distortions in the production and interpretation of macro data.

Source: Bloomberg, Hedgeye Risk Management

Let us not forget the recent developments regarding the UAW workers on strike at the time of this writing. 18K+ UAW workers on strike thus far with -$1.6B in economic loss in week 1 (Sept 15-Sept 22). That loss total will nearly 2X in the most recent week. August already saw the largest work stoppage in over 2 decades with the writers strike and more strikes are in queue for October.

Source: BLS, Anderson Economic Group, Hedgeye Risk Management

The pandemic linked American Rescue Plan awarded states $24 billion in “child-care stabilization grants” that could be used for raising staff pay, reducing tuition, and defraying rent and maintenance costs.

That funding ends on September 30th.

Source: Washington Post, Century Foundation, Hedgeye Risk Management

The FFCRA was a pandemic program that enhanced Medicaid funding and required Medicaid programs to keep people continuously enrolled through the pandemic. That program (required coverage and enhanced funding) ended in March. An estimated 8-24 million people are expected to lose coverage over the next 8 months.

As of September 26th, 7.5M have been disenrolled.

The pandemic CARES act expanded eligibility of Economic Injury Disaster Loans (EIDL) from the SBA. $380B in Loans were dispersed over 2020-2021 with payments deferred (with interest accrual) for 30-months. The earliest of those loans began repayment in late 2022 with repayment deadlines ramping though 2023 and into mid 2024.

Unless Congress acts to approve forgiveness, those loans now need to be paid.

Source: Bloomberg, Congressional Research Service, US Chamber of Commerce, Hedgeye Risk Management

The ERCT was a pandemic credit available to small businesses and non-profits as an incentive to keep works employed and allowed small businesses to receive up to $26,000 per employee.

It’s been fraught with fraud and abuse ... which is why the IRS shut it down in September.

The spending associated with this $250B in payments to individuals/small business owners will have a tail but it will definitely build as a progressive drag on discretionary consumption.

Source: CNN, Cleveland Fed, Hedgeye Risk Management

SNAP recipient households (30 million) lost between $95/mo - $441/mo beginning in March.

SNAP 2.0: P-EBT (Pandemic Electronic Benefit) which provided $391 per child for the summer was reduced to $120 at the end of 2Q.

Source: CBPP.org, Propel, Hedgeye Risk Management

Alas, we must not forget student loan payment resumption.

The payment pause notably favored higher-income households, who typically carry larger student loan balances and thus have greater payments.

This effect of the pause was amplified by the ensuing period of high interest rates which allowed borrowers at the high-end to accumulate interest on excess liquidity, in part derived from paused loan repayments, while future payments remained fixed in nominal terms.

Graduate degree holders usually have higher loan balances (as they borrow more) and income (due to the lucrative nature of many graduate degrees) compared to those with a bachelor's degree or less.

Thus, while the payment pause benefits various income groups, its greatest impact is on the top decile households.

Source: Brookings Institute, Hedgeye Risk Management

Highly Educated and High Earning you say?

More like Highly Indebted and Less Creditworthy.

Source: Earnest.com, Hedgeye Risk Management

5.2 million or 12% Of Student Loan Borrowers Have Outstanding Balances Greater Than $75,000 As Of 4Q21.

These are Doctors, Lawyers, MBAs, and Dentists who will moderate their spending once payments start back up in September.

Source: FRBNY Consumer Credit Panel, Equifax, Hedgeye Risk Management

Borrowers With Credit Scores > 660 Account For ~$ 1 Trillion.

Those With Credit Scores < 660 Account For ~$600B

Households with student loans spent more and took on other incremental debt during the student loan moratoria.

A significant percentage of borrowers have signaled they expect to boycott or go delinquent once repayment begins.

The impact may/may not be as sensational as the survey headlines (45% delinquency rate), but it will assuredly be a net drag.

Source: Creditkarma, Intelligent, Transunion, Federal Reserve, Hedgeye Risk Management

Barry the Permabull: Ok but student loans are a very small percentage of GDP so that does not matter. Besides, stock prices go up most of the time.

Barry, your reasoning is no different than saying most of the world is covered in water and therefore no population of size could be suffering from thirst.

It is not student loans relative to GDP that matters. It is the rate of change in spending i.e. real PCE growth that that matters.

While inflation has lowered the impact of fixed rate student loan repayments, we are looking at ~1.5 percentage point growth headwind to Real PCE come September 2023.

Barry the Permabull: Ok the consumer might be spending less but his/her balance sheet and savings are strong so the potential to increase spending and growth is there and thus they will carry us forward.

Barry, we discussed this. Don’t conflate your personal situation with the world.

Lets measure and map.

Interest income on cash reserves is obviously up as well but interest payments are growing more than interest income.

Its really only the top 20% of earners that disproportionately benefits from interest income anyway.

The Consumer Foreclosure/Bankruptcy/Delinquency Cycle continues to accelerate.

The key spending demographics of the Millennials and Gen-Z are leading the credit card delinquency rates to higher highs.

Small Bank credit card delinquency rates are at all time highs.

Source: Federal Reserve, Hedgeye Risk Management

The consumer continues to spend less on dining and retail.

Either consumers continued to borrow more as interest rates rose further in an attempt to smooth consumption or the increase is due to accrued interest, in which case those balances will continue to compound and further strain the capacity for discretionary/pseudo-discretionary consumption.

Source: NY Fed, Federal Reserve, Hedgeye Risk Management

Initial Speculation = They Can’t Pay.

Growing Confirmation = They Can’t Pay

The latest NY Fed data showed consumers failed to pay down (post-holiday) credit card debt in 1Q for the first time in at least a decade. When we first got the data we speculated around why. A growing body of evidence has since supported that initial speculation.

Delinquencies are at GFC levels and rising and more credit card customers are rolling debt than paying it off on a monthly basis for the first time ever.

Source: NY Fed, JD Power, Hedgeye Risk Management

The consumer may very likely not be able to borrow even if they wanted to.

Lending Conditions are deteriorating, and the consumer credit box is tightening, quickly.

It is not a coincidence that with inflation re-accelerating, there is growing difficulty in paying for typical expenses.

Source: Fidelity, Hedgeye Risk Management

The House as an ATM had a good run but it is exhausted. At the same time as consumers tap out on revolving credit usage, housing as a source of funds is at multi-decade lows.

We just got the 2Q Data and its not encouraging. The purchasing power associated with savings for the bottom income quintile is down -8% vs. 4Q19 and has been negative for a full year.

Source: Federal Reserve DFA, Hedgeye Risk Management

As articulated in last quarter’s commentary, we are in a K shaped economy.

The Rich disproportionately benefit from higher rates as they get paid on their excess liquidity.
The Rich disproportionately benefit from reflation in asset prices as they own a disproportionate share of financial assets.
Big Banks consolidate share amidst banking stress and liquidity flight.
Everyone else gets plugged with higher (cost of living) inflation while broadly missing out on the income upside associated with higher rates .
Everyone else loses discretionary consumption capacity as share of wallet goes to service higher debt costs.
Everyone else becomes increasingly vulnerable to income shocks (ie end of student loan moratoria) as any residual cash cushion is exhausted and the above play out in reflexive and compounding fashion.

**The Distance Between the Haves and Have Nots**

Collectively, the bottom 80% of the income distribution has now more than exhausted their savings and consumption cushion. The purchasing power associated with that savings is now -3.4% below 4Q19 levels.

**Barry the Permabull during Federal Reserve Press Conferences**

Barry the Permabull: Stocks go up most of the time and US stocks are in great shape.

Barry, US stocks and balance sheets are not immune to gravity.

The cost of corporate credit keeps rising.

The cost of labor keeps rising. The prime age employment-to-population ratio is back at 4-decade highs (i.e. Tight) and unit cost growth is now rising faster than output price growth (i.e. profit margins are feeling the pull of gravity).

Pricing power is past its peak and is falling and thus profit margins continue to compress.

Not only is the cost of corporate credit up but the availability of corporate credit is down.

Corporate credit rating downgrades are now at the highest level in over a decade (ex-Pandemic peak) and the corporate bankruptcy cycle has clearly inflected and will continue up as macro pressure persists and ZIRP era debt gets rolled.

We must not forget going into the current rising rate environment, that nearly 33% of the Russell 2000 companies (small publicly traded US stocks) are not profitable which is near the highest level going back 1985.

Demand is slowing and the fed is tightening into the Macro Capitulation.

Consider the preponderance of confluent data we’ve presented and think about whether the balance of risk is towards an imminent immaculate (positive) inflection or further deceleration.

Fortunately, the world is a big place and there are always pockets of opportunity for multi asset class long short risk managers like ourselves.

If the soothing stories and narratives of Wall Street are more to your liking, there are plenty of story tellers.

**Wall Street Story Time for Barry the Permabull**

For those willing to board the Drakkar where its crew think and risk manage instead of just believing and hoping, climb aboard.

The Global Macro Opportunity Report

India and Japan are outperforming YTD in the Asia Pacific Region

Japan’s 2-10 Yield Spread is currently +71 bps, making it among the most auspicious across all countries. In fact, among all Developed Economies, Japan’s current yield spread is the most positively sloped.

India’s 2-10 Yield Spread is currently at 0 bps. While not remarkably positive like Japan’s nor is it particularly inverted like those of the US, Canada or Mexico.

Japanese bank lending is up. The last decade or so have seen the rate of change in Japanese bank lending lead Japanese equities.

Source: Bank of Japan, Hedgeye Risk Management

Confidence and sales are rebounding across Japan.

Source: Japan Ministry of Economy Trade and Industry, Hedgeye Risk Management

Positive and improving Tankan Business Conditions have been positively correlated with and lead Nikkei performance historically.

Japanese retail sales are in strong uptrend.

Japanese consumer confidence is still at local highs.

Source: Economic and Social Research Institute of Japan, Hedgeye Risk Management

The Japanese services economy is rebounding as seen in the Japan Services PMI.

Source: S&P Global, Hedgeye Risk Management

After decades of trying to escape deflation’s gravity, Japanese core inflation of 4.3% is well above the 2% target.

Source: Japanese Ministry of Internal Affairs and Communications, Hedgeye Risk Management

Domestic demand is powering reacceleration in India’s manufacturing sector.

Source: Jibun Bank, S&P Global, Hedgeye Risk Management

Source: Central Statistics Office of India, S&P Global, Hedgeye Risk Management

Indian banks have accelerating credit growth.

Source: Reserve Bank of India, Hedgeye Risk Management

Indian services economy is rebounding.

Source: Jibun Bank, Hedgeye Risk Management

Indian CDS spreads remain near their lows. CDS spreads are a reflection of default risk i.e. higher spreads reflects greater default risk.

Indian central bank total assets and liabilities are up.

India has returned to its pre-pandemic core inflation regime.

Source: Central Statistics Office India, Hedgeye Risk Management

India has seen both manufacturing and services PMI remain above 50 while other Asian economies have struggled.

Source: Asian Development Bank, Hedgeye Risk Management

CDS spreads in Germany are accelerating towards previous cycle highs. CDS spreads are a reflection of default risk i.e. higher spreads reflects greater default risk.

Liquidity moving steadfastly in reverse.

M2 is outright negative and clearly lower.

Yet despite the ECB’s tightening it has yet to rein in core inflation. While finally slowing, core eurozone inflation remains ~5x the pre-pandemic average.

Source: Eurostat, Hedgeye Risk Management

Corporate credit spreads are elevated and trending higher. CDS spreads are a reflection of default risk i.e. higher spreads reflects greater default risk.

Credit availability is falling as credit conditions tighten. Specifically, the euro-area Credit Impulse is trending lower. Credit Impulse is the relationship between the change in net credit flows relative to prior period GDP. Credit Impulses are highly correlated annual Real GDP growth.

Eurozone bank lending to households is in a severe rate of change deceleration.

Source: European Central Bank, Hedgeye Risk Management

Lending to the corporate sector is the same story.

Chinese exports to the EU lead rate of change in EU growth by 3 to 4 months. Extremely weak Q2/Q3 Chinese export numbers suggest significant weakness ahead for Q4 EU Growth.

Source: Customers General Administration PRC, Hedgeye Risk Management

Viewed in the context of the longer-term, the negative trend is particularly notable.

Eurozone Manufacturing PMI is down.

German New Orders are making cycle lows and are already past the lows of 2000.

Eurozone Industrial Production is outright declining.

The Services Economy is uniformly contractionary.

Eurozone Business Confidence has cliff-dropped lower from February 2023 local peak.

Source: European Commission, Hedgeye Risk Management

Consumer confidence is going lower.

Yield Curve most deeply inverted in a long time.

Source: Deutsche Bundesbank, Hedgeye Risk Management

The U.K.’s Short-Term Fixed Mortgage Bomb.

Source: National Authorities, Moody’s Investor Service, The Telegraph, The Bank of England, Hedgeye Risk Management

Mortgage Debt Servicing has reached this level only five other times since 1983.

Source: Nationwide Building Society, Hedgeye Risk Management

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations.

Third Quarter 2023 Investment Commentary

The Stagflationary Sagas:
The Descent
into 'Stag-tember’

Unraveling the Macro Map

Awakening the Stagflationary Serpents

The Saga of Rising Eastern Valhallas: Japan and India

Navigating The Global Macro Tempests

The Drakkar’s Portfolio Performance and Positioning

Equities

Bonds

Alternatives

Q3’s Market Weather Report

The Market’s Hyper Local Weather Report

The Global Macro Weather Report

The Global Macro Opportunity Report

As Seen In

5851 Legacy Circle
6th Floor
Plano, TX 75024

Third Quarter 2023 Investment Commentary

The Stagflationary Sagas:The Descentinto 'Stag-tember’

Unraveling the Macro Map

Awakening the Stagflationary Serpents

The Saga of Rising Eastern Valhallas: Japan and India

Navigating The Global Macro Tempests

The Drakkar’s Portfolio Performance and Positioning

Equities

Bonds

Alternatives

Q3’s Market Weather Report

The Market’s Hyper Local Weather Report

The Global Macro Weather Report

The Global Macro Opportunity Report

Fourth Quarter 2023 Investment Commentary

Second Quarter 2023 Investment Commentary

As Seen In

5851 Legacy Circle6th FloorPlano, TX 75024

The Stagflationary Sagas:
The Descent
into 'Stag-tember’

5851 Legacy Circle
6th Floor
Plano, TX 75024