Risky Business of Regime Change

Strategic Outlook Q4/2024: Global Economic and Capital Markets

Q4 Strategic Outlook (Full Commentary)

Global Strategic Briefing

Key Topics: Flirting with Intermittent Recession, Inflation and Inflation Expectations, Explicit Moral Hazard result of Necessary Monetary and Interest Rate Normalization, Unsustainable Fiscal Deficits, Earnings Growth and Profit Margins, Risk of a Global Debt Liquidity Crisis, plus Global Tactical & Strategic Asset Allocation Forecasts.

Summary

We observe a regime change, which we have highlighted was likely taking root. This new regime began with the maturing of the Fourth Industrial Revolution coinciding with supply chain fragility that emerged during the Global Pandemic. This new regime is more similar to the 1981-2000 regime, before the Federal Reserve embarked on monetary policy experiments that didn’t reduce volatility or suspend basic principles of economics and finance.

The Risky Business of Regime Change, including need for higher-for-longer interest rates, raises concerns about the global bond market’s ability to absorb rapidly growing long government bond supply. Risk of a U.S. Government Debt Crisis is high given potential for rapidly steepening yield curves, even as central banks begin to cut rates, downgrade of U.S. debt, or a liquidity crunch.

So, what triggered Regime Change? President Biden sought to reverse nearly every policy, agency rule, and executive order, as well as tax reform and foreign policy of the prior administration. In so doing, many misguided economic, regulatory, energy, resources, transportation, trade, financial, education, criminal justice, immigration, and fiscal (inc. tax + spending) policies it applied had real effect on the U.S. economy. This combined with years of implicit moral hazard of monetary market manipulation (inc., forward guidance, quantitative easing, and low interest rates) for an extended period. That real effect began with soaring CPI inflation, peaking at 9.0% in June 2022, thereby boosting anchored inflation expectations. Average inflation will not simply retreat to 2% again.

This new differentiated economic regime emerging is characterized by higher secular inflation, thus higher inflation expectations (SFM: 2.5% PCE, 3.0% CPI inflation), reduced potential growth, and low productivity, while limiting profit margins and global competitiveness The inflationary consequences of the radical pivot in U.S. policies require higher equilibrium interest rates of 3.5%, not 2.9% implied in the Fed’s long-term forecast. Consider a 4.2% Fed Funds rate vs. 3.2% CPI inflation are 44-year averages (since 1980) compared to 2.5% CPI inflation and 2.9% Fed Funds expectations. Higher rates increase the fiscal deficit, while compounding the federal debt at higher interest rates.

Many are rightly fixated on the U.S. inflation rate as CPI price levels increased over 17.5% since January 2021, and will continue rising without deflation or recession. Unleashed higher inflation expectations and pricing power will be difficult to contain as higher wage increase persist still lagging behind higher cost of living. There is still a housing shortage keeping inventory low and prices higher with a surge in household formation.

The remarkable era of innovation since 2001, we've characterized as the Fourth Industrial Revolution, drove globalization and secular disinflation, but has moderatednow . We became accustom to lower inflation and interest rates, assuming the New Normal was forever. Back-to-back Crises (2000 Dot-Com & 2008 GFC) adjusted expectations of normal equilibrium, but Risky Business of Regime Change could lead to exogenous volatility, yield curve steepening overshooting, if not triggering a government debt crisis. Behavioral recency bias regarding lower inflation and interest rates is now suspect, as seen in rising normal interest rate and inflation expectations.

We believe Regime Change will require greater fiscal austerity from Congress to bring down the unsustainable debt burden, now over 120% debt/GDP, that exceeded the post-World War II peak. Enacted elements of the Build Back Better boondoggle misappropriated $4 trillion in imprudent wasteful spending. The US government ran a fiscal deficit of $2.3 trillion ($8.2% deficit/GDP) over FY2024 thru Sept 30th, thus requires cutting over $2.5 trillion from the budget to extinguish the fiscal deficit. There is no fiscal flexibility to manage any crisis for the foreseeable future now.

The anticipated U.S. economic hangover in the private sector continued in 2024. We expect lower potential economic growth of 1.8% or less given pivot in U.S. policies. Intermittent recession, if not stagflation, as consumer confidence suggests, and negative industrial production or real retail sales confirm. We expect slower earnings growth and lower margins with fiscal spending and monetary cliffs ahead. We foresee financial and economic headwinds increasing in the future.

1.   Target denotes top of published ¼% policy target range

The economic surprise of 2024 may be the resilience of U.S. GDP, indicating the economy skirted recession. We observe recessionary-like conditions in weakness of higher frequency economic variables, such as retail sales, industrial production, business sales, and even earnings. Economic conditions seem more consistent with recession, or flirting with recession. Without new government spending programs, wasteful entitlements or transfer payments, and government hiring, we think GDP and unemployment would have lagged more.

The next charts illustrate a clear economic decline in U.S. growth since early 2021 despite government spending more than $3 trillion in unnecessary fiscal spending. Economic growth measured by industrial production oscillating around 0% since May 2023, negative real retail sales, and ISM Survey persistently below 50 are indicative of a private sector economy flirting with recession. Business Sales and Export growth also rolled over.

Real GDP remains positive by virtue of U.S. government spending and public sector employment growth. U.S. equity profits languished over the last three years despite fiscal spending that should have bolstered growth. Since growth peaked in Spring 2021, private sector real growth declined to a negligible level. ISM is a reliable higher frequency indicator of U.S. growth and suggests the economy is weaker than GDP implies. ISM has hovered below 50 since Fall 2022, and is trending lower in 2024, highlighting dismal policy effects since 2021.

Inflation & Rates Predicament

Higher inflation expectations could have been limited if not for excessive fiscal stimulus on top of monetary stimulus exceeding pandemic-driven support needed in 2020. The Fed was too late normalizing monetary policy, believing inflation was transitory, while the Build Back Better boondoggle, split between the American Rescue Plan, CHIPS and Science, and the Inflation Reduction Act, proved costly in imputed policies for little benefit to society. Intermittent recessionary conditions in 2023 were a prelude to disappointing growth in 2024-2025. We forecast slower US GDP of 1.8% in 2024, as CPI inflation moderates, but still averaging 3%, and above the Fed’s implicit target.

We expect U.S. CPI inflation to normalize around 3% with heightened inflation expectations—inflation is likely to remain above the Federal Reserve’s implied target of 2.0% PCE inflation, which slid after more than a decade of disinflation, as behavioral recency bias guided it lower. CPI Inflation increased 20% and producer prices (intermediate goods) increased 27% since Jan 2021—only deflation of a sustained recession can reverse price increases. Volatile food and energy have led inflation lower, but we are concerned inflation may struggle to fall further. Reducing the inflation rate only slows price increases, but the economic damage is irreversible.

Economists often associate yield curve inversions with recessions, but yield curve inversions also seem to anticipate equity corrections with greater predictability. Consider timing of the last six yield curve inversions. Is the latest trough a spectre of an imminent correction? There are similarities today vs. 1999-2001 (Dot.com bubble). Money supply remains volatile, but now is likely to expand below the normal pace of nominal growth for the foreseeable future as the Fed reduces its bond holdings. Restrictive monetary policy (inc. higher interest rates and reducing Federal Reserve holdings of Treasuries) will limit economic growth, as inflation is subdued. We think the bizarre behavior of Treasury bond yields (persistent yield curve inversion) is primarily a consequence of experimental monetary policies that induced explicit moral hazard for over a decade, including exceptionally low interest rates, successive periods of quantitative easing, and extended forward guidance since the Financial Crisis of 2008.

Equity markets soared since October 2023 on hopes the Federal Reserve would cut rates up to 6 times this year, but deferred until September. Our forecast of higher-for-longer called for just two cuts this year, combined with an increase in Long Treasury supply between a still large fiscal deficit, reduced Fed holdings, and need to extend Treasury issuance maturities. Yet, we believe the inverted yield curve should steepen even with interest rate cuts.

Artificial Intelligence Grows UP

We’ve highlighted since 2022 that disinflation effects of the Fourth Industrial Revolution were sunsetting. Artificial Intelligence (AI) involves the creation of processes, systems, or machines that can mimic human intelligence executing tasks or driving systematic processes. It is evolving rapidly, and likely will bolster productivity growth a few more years, but can’t alter the secular trend of diminishing productivity gains observed.

We have long championed Artificial Intelligence in our future themes. Yet, we expect growth in related profits will be slower than anticipated, even if the economy gets a global boost from productivity. The drive to invest in anything-AI across private and public markets, particularly Generative AI, is still speculative. Where AI will have the greatest impact has been and will continue to be in automation and systematic workflows, or quantitative analytical work. AI expanded our thinking and what is realistically possible, tapping unstructured data and natural language, which increased public visibility and accessibility. Commercialization potential increased.

AI is a creative application of mathematics and statistics, including use of decision-making optimizers and data science. AI research for decades reached a tipping point recently with the consumer releases of Generative AI capabilities, which captured our imaginations. I’ve often discussed its promise in Future Themes work updated every couple of years since 2004, as well as in these commentaries. Indeed, speculative enthusiasm reached a fevered pitch driving the Magnificent Seven and other technology companies to risky valuations, in our opinion. Yet, we still have yet to see much broad payoff in economic or earnings growth—AI has become a ubiquitous tool needed to succeed, but not a giant maker with high barriers to entry.

New innovative software tools reduced coding experience required to build robust application, but begs the question—how to preserve sustainable comparative advantage driving excess margin with lower barriers to entry? The AI phenomenon may boost economic productivity (lower labor cost), but likely lowers margins too, reducing potential earnings growth. Many investors don’t seem to understand consequences of ignoring competitive threats in free markets, particularly as companies are stumbling over each other, and have limited ability to protect intellectual property or first mover advantages in an open-source world. Capital expense building out AI infrastructure will depreciate rapidly with innovation, and may yield low return on capital this cycle.

New algorithms can solve more complex nonlinear optimization problems more efficiently and effectively in simulated quantum environments on a scale of orders of magnitude. Complex optimization problems are the heart and soul of mathematical decision-making that enables machine learning, reinforcement learning, and even Generative AI algorithms—think faster convergence with better solution outcomes for solving the most difficult problems or previously unimaginable in a fraction of the time on available computer systems. Progress in quantum computing need not wait for quantum processors to be available before software algorithms can make a leap forward solving more difficult problems with faster convergence to better solutions.

Eventually, as realization of Quantum Computing in new types of processors become more stable with low error rates at room temperature (vs. super-cooled), this can yield an order of magnitude higher computational efficiency when combined with tailored software applications. This should reduce both energy intensity at such an astonishing rate that the power need plunges, particularly if we can ditch super cooling requirements, or the expensive infrastructure as many are scrambling to thread large networks of conventional processors.

Dismissing History and Speculative Myopia

The most effective way to destroy people is to deny and obliterate their own understanding of their history.

― George Orwell

We think US equities will struggle to grow into the current valuation multiple (S&P 500 > 25x trailing earnings or 21x forward estimates) given recent lackluster S&P 500 earnings growth. We believe the equity market is stretched as P/E multiples rose with marginal earnings, even as interest expense increased. U.S. equity performance coincided with P/E multiple expansion rather than earnings growth. We think the magical thinking of AI growth speculation resembles a Party like its 1999 proceeding the Dot.com bubble. Valuations are the most extreme in the S&P 500 since 2001.

The anticipated economic hangover is visible now with fiscal spending and monetary cliffs ahead, as excessive U.S. government hiring should stall. Policy decisions from January 2021 unleashed inflationary forces, undermined US competitiveness, and stalled economic growth in the private sector. Beyond earnings challenges, stretched valuations and slowing growth with higher interest rates are a cruel potion for global equity and bond markets already engaged in Magical Thinking.

Treasury yields are well below their long-term historical average with insufficient term risk premium to inflation—this is Risky Business of Regime Change. Bond yields will need to rise significantly to clear excess supply.  Nor has US Treasury taken advantage of an opportunity to extend debt maturities with yields well below expected long-term Treasury yields of 5-6%. With the inverted yield curve, issuance should be piling on longer-term maturities rather than short-term T-Bills.

Risk of a Global Debt or Liquidity Crisis is increasing, exacerbated by manipulating free markets (bond yields) for an extended period. Bloated holdings of central banks must wind down, and U.S. Treasury likely recognize losses flowing through fiscal budgets. Massive fiscal deficits increased our debt burden as interest rates increased. Need for tight monetary policy is required to reverse effects of central bank induced explicit moral hazard. Inflation is still not under control, even as Japan and China continue to reduce their share of Treasuries, all of which increases bond supply and may limit liquidity.