Heaven and Earth

We are in a new Gilded Age.  A time of extreme inequality, which has spurred a populist wave in politics, which ironically has just exacerbated the inequality.  This inequality originates from corporations financing campaigns and using lobbyists, who have bought out politicians, ensuring favorable taxes and regulations.  These regulations and lack of anti-trust enforcement, has created a M&A boom, which has effectively turned most US industries into oligopolies, providing corporations with unprecedented pricing power, which they have exercised to full effect over the past 2 years.  Excess money supply from fiscal pork stimulus, along with greedflation, are the 2 main reasons you had an inflationary wave after 2020.  

Corporations had a convenient excuse to continually raise prices with all the talk about supply chain issues, and rising commodity prices.  And now that commodity prices and raw material input costs have come down, they are sticking with their margin over volume strategy, sacrificing some revenues for higher margins and higher net profits.  This margins over volume strategy requires less labor, as there is less production.  This should embolden companies to be more willing to layoff workers, not a great sign for the economy.  

Corporations can only get away with this strategy if there is limited competition.  And that's the case for most industries, as competitors have been acquired, leaving fewer players left on the field.  The fewer the competitors, the easier it is to raise prices and quietly collude to maximize profits.  This pricing power flows through to the bottom line, as can be seen by the trend in profit margins as a percent of GDP. 

Having few competitors also means you can pay workers less because there are fewer competitors for that labor.  

 

The over the top Covid stimulus of 2020 and 2021 ended up flowing mostly to the wealthy, a kind of reverse trickle down effect.  When most of the poor get money, they spend it, or if they do invest it, its often in bad investments such as meme stocks, random crypto coins, or they just leave the cash in the bank collecting 0% interest.  So whatever stimulus money the poor receive, it eventually ends up trickling up to the top.  That's what has played out over the past 3 years.  So the excess savings, while declining, is also changing in composition.  A higher percentage is now concentrated among the upper class, those who have much less propensity to spend their income and wealth than the lower and middle class.  

How does a 5.25% Fed funds rate affect this situation?  Well, you can break it down into those who have excess cash to invest in high interest savings accounts/money market/T-bills and those who need to borrow money.  It is heaven for those with excess cash, as the high interest rates provide passive, risk-free income.  On the other side of the coin, it is back to earth for those that need to borrow money to either operate businesses or to maintain their current standard of living.  Don't forget that those who want/need to borrow money have a much higher propensity to consume and spend their excess cash than the wealthy who won't change their consumption patterns based on receiving a few extra percent on their cash.  

For those benefiting from the higher interest on cash, they won't be much affected by the extra income.  But those that are hurt by the higher interest will either find it difficult to get loans or credit extensions, or just be unwilling to pay the high interest rates (for those looking to make investments/run a business).  In particular, those that rely on leveraged loans (variable rate), are feeling the pain.  

This ties back to the current environment of a working population that is flatlining, especially without all that illegal immigration of the past.  When you don't have a growing working population, you don't have a vibrant economy.  The only growth you are seeing is in the elderly population, and they are mostly consumers, who are not providing productive capacity to the economy.  The elderly are just fueling more inflation by consuming while not producing.  I sometimes hear arguments about how tight the labor market is, how wage growth is strong and thus the economy will be strong.  Let's play a hypothetical game.  Let's say you cut the working age population by 90%, and wages go up 1000%.  The labor market would be super tight and the wage growth is super, duper strong.  Is that a sign of a strong economy?  No, its just a sign of a tight labor market.  Tight labor market =/= strong economy.  Just look at Japan and their sub 3% unemployment rate.  No one would consider the Japanese economy as being very strong.  

 

What the crazy amounts of fiscal pork in 2021 and 2022 has done to Wall Street is confuse a short term crack up helicopter money fueled boom with a sustainably strong economy.  The US is not an organically strong economy.  Population growth rates, among those age 15-64, is miniscule.  What's been fueling the strength since 2020, and to a lesser extent since 2017, is an increase in budget deficits through a combination of tax cuts and increased government spending.  That's poor quality, inflationary growth that comes purely from handing out cash to the private sector from the money printer.  As you can see below, inflation (in red) is the vast majority of the contribution to nominal GDP growth since 2020. 

 

While big budget deficits are still continuing, its the fiscal impulse (change in budget deficits) that affects economic growth.  And the fiscal impulse is only marginally positive for 2023, mainly from less capital gains taxes being paid and a slowing economy.  The main driver of US economic growth, big budget deficits, won't be able to overcome the tightening credit conditions which should lead to the well advertised recession later this year.  

 

Consumer demand should continue to trend lower as the labor market weakens, inflation remains sticky due to greedflation/oligopoly pricing, and as credit tightens, reducing the cash flowing to consumers.  While it is consensus that we will be getting a recession later this year or in early 2024, investors are not optimally positioned for it.  You are seeing big overweight in equities and cash, and big underweight to fixed income.  The best performer in a recession is fixed income, even if inflation remains sticky.  The Fed has been adamant that they are higher for longer, and that they will not cut rates this year.  If that is the case, which I don't believe, that would just make the economy even weaker than if they were more willing to cut.  So in a paradoxical way, Powell's stubborness and unwillingness to cut will create conditions which are optimal for fixed income.  Yet, that's not how most investors view the current situation.  They believe that a hawkish Fed that keeps rates too high and doesn't cut early is bad for bonds, when in reality, its actually great for bonds. 

The markets these days have slowed down and many days just feel like a holiday, with not much happening.  This market has gotten complacent, but not bullish.  There is a difference.  People are not fearful, but they also realize that economic conditions are not favorable for equities.  This creates a situation where the market remains sleepy and trading in a small range until the cumulative effects of the monetary tightening and deposit flight bear their weight on the banks first, and then to the overall market.  

 

Investors who are unwilling to chase stocks higher as the economy slows is not an environment where the SPX can grind higher.  It will probably just be range bound.  I can picture a similar situation to what happened in 2015, as the volatility compressed for several months until it exploded higher in August 2015.  

The latest news these days is the debt ceiling, and how catastrophic it would be if the US defaulted on its debt.  It would just be a technical default, as they would just delay payment until the debt ceiling was raised.  And it will get raised eventually.  What's interesting this time is that the House Speaker McCarthy is in a bit of a hot seat, as he can be kicked out of his post quite easily, the deal he made to become speaker after failing multiple votes.  This will incentivize him to get a palatable deal for his party, which means he would rather default than pass a clean debt ceiling deal.  So at the margin, this should reduce government spending a bit for the next budget.  In any case, the volatility will just be temporary and will be much about nothing, just taking the focus away from the important issues to the market, which is the tight monetary conditions and the continuing deposit flight from the banks.  

Not much to do these days, added to some individual stock shorts that rallied last week.  Expecting continued low volatility for the next few weeks, with occasional dips  that get bought, similar to what you saw from April to July 2015, before you get the big waterfall decline.