A New Paradigm

Economics of Life is intended to help market participants and lifelong students weed out the noise of modern news and narratives and take a date-dependent dive into the everchanging nature of global financial and commodity markets. My writing is an attempt to help the curious mind understand the cyclical, fundamental, and geopolitical stories of our time and profitably navigate the chaos. And to learn a bit about life along the way.

The Thesis

US markets are pricing in recession. The economic wheel is completing its revolution. The Fed is stuck between a rock and a hard place. Cut rates too soon and risk the return of inflation during a cyclical downturn (making recovery all the more difficult) -or- stay the course and watch the fastest acceleration in rate hiking history cause ripple effects through the credit, equity, and labor markets. With the lagging effect of monetary policy, the latter is all but guaranteed. If the Fed cuts rates prematurely, it is because their policy has already caused catastrophic damage to markets and employment numbers. Sooner-than-expected rate cuts are not necessarily indicative of a market bottom.

• The ‘69/’70 recession was hailed as “the end of inflation”. Arthur Burns began easing monetary policy too soon in response to cyclical, rather than fundamental deflation. When the economy crawled out of recession, inflation returned with vengeance. Powell knows this and would prefer to follow the path of Volcker (who is remembered as the man who slayed inflation) rather than Burns.

High debt/GDP incentives the government to suppress real interest rates and erode that ratio with sustained inflation (above 2%, but much lower than the 6-8% environment we’ve seen post-covid). If the inflation rate exceeds the interest rate paid on treasury securities, citizens’ loss of purchasing power serves as an indirect tax. Eventually, the debt/GDP ratio returns to more sustainable levels.

For this reason, and others that I will explain in greater detail, it appears that secular inflation has returned to the economy. A period of artificially low-interest rates, in conjunction with the underinvestment and villainization of traditional energy development, created a 10+ year period of growth-focused investment that largely neglected “the old economy”. If secular inflation is the new normal, we will likely see a shift in investor preferences from the cloud to the ground. In other words, the underinvested, dividend-paying mining and energy sectors are likely to outperform in a period of higher interest rates, regionalization of the world economy, and lower economic growth.

Where Are We Now?

The yield curve is perhaps the most reliable indicator of recession throughout history. The morning of 4/6/23, the 2s/10s curve was inverted 47 bps, steepening from a more than a 100 bps inversion a few weeks prior. The last time it displayed this level of inversion was in the early 80s, before a lengthy recession in 1982. Generally, the curve will steepen from deep inversion prior to recession (as rates fall at the front-end as the economic trough approaches). This occurred recently.

Credit spreads are still relatively tight. And bond market volatility, measured by the MOVE index, pushed up to levels not seen since the GFC.

These indicators lead me to believe that we are headed into a period of high equity market volatility that will coincide with some sort of credit event, putting the final nail in the coffin of the bear market before a potential recovery in the back half of the year.

Labor markets are seen as a lagging indicator. In other words, they are the last domino to fall. On 4/6/23, we saw an uptick in jobless claims and on 4/7, we saw the non-farm payrolls report come out lower than expected for the first time in 12 months. The Fed is aware of the lags in policy, which is probably why they decided to exponentiate the pace of rates hikes in 2022. Now that labor is rolling over, they can pause their hiking cycle (in May or June) and watch how the cards fall.

• For context, the ‘72/’73 recession ran for 7 months before job losses began in earnest.

The Money

Gold has the potential of benefiting from secular inflation, a deglobalizing world economy, and a local peak in interest rates. This market has already made its initial move, but as long as economic data continues to decelerate, the shiny, yellow metal should still outperform broad equity markets.

Bonds will likely outperform throughout Q2 and stabilize in the back half of the year. As inflation decelerates and labor eventually rolls over, rates will drop, and the safety trade will return to the bond markets.

Industrial commodities are investable longer-term, as ESG has villainized traditional energy investments while the world is still dependent on traditional energy supply. Particularly, metals and materials that will assist in phasing out fossil fuels over time. Copper, uranium, lithium, and cobalt to name a few. Traditional energy markets are likely investable as well. Decarbonization is not a switch that is easily flipped, and we will still be reliant on fossil fuels for the foreseeable future. Any weakness in these sectors throughout the coming recession should be seen as an opportunity.

Broad equity markets should be scaled into slowly throughout Q2 & Q3. Cyclical sectors (materials, industrials, discretionary) are likely to struggle while defensive sectors (i.e. healthcare, utilities, staples) should hold up better, alongside precious metals/miners. However, if the VIX pushes above 30 and makes new highs for this cycle, all sectors are likely to move significantly lower. Capitulation will ensure and “the bottom” could be marked sometime this summer.

“Be fearful when others are greedy, and greedy when others are fearful” - Warren Buffett

The Economics of Life

Everything is cyclical. Change is constant. In order to survive, mankind has had to constantly adapt to a changing environment. The same is true in markets. One must be constantly questioning their thesis. There is no shortage of (mis)information these days. Investors must stay nimble and be mindful of changing fundamentals.

It is analogous to the way plate tectonics shift beneath our feet. The process is generally slow-moving, but sometimes abrupt (e.g. earthquakes and eruptions). The landscape evolves over time, adapting to the new conditions of the world. In markets, a credit event or unexpected policy change may shake markets the way an earthquake shakes mountains. We do not always know when they are going to occur, but it is important to prepare for the possibility (via risk management, position sizing, hedges, etc.) At the moment, the “market seismograph” is sending warning signals. The question is when will the quake strike? We do not know. The bigger question is, will the fundamentals of the shifting plates be on the same path, or different paths when the dust has cleared?

Confirmation bias is an investor’s Achilles’ heel. Be mindful of your level of emotional involvement, conviction, and shortsightedness. Always be adapting and understand the dangers of your local environment.

I will not pretend to have all the answers. My goal is to stir the pot and provide evidence of how the plates are shifting. Then to assist the intelligent investor in questioning what they do and do not know and navigate the markets with prudence.