Albert Edwards of Societe General with the note
Many seem at a loss to explain the recent bond market rally in the face of higher-than-expected inflation data. Readers of these pages will not have been surprised, as the collapse in the credit impulse we have been highlighting was calling for just such a rally. More recently, the explosion in cases of the Delta variant ofCOVID-19 around the world is leading to fears that the nascent economic recoveries will be derailed as economies might be locked down yet again, further extending the bond market rally.
The NBER has just spoken. This organisation traditionally dates the beginning and end of a US recession using a much wider array of indicators than the traditional definition of two consecutive quarters of falling GDP. Indeed, that six-month minimum definition has now been chucked out of the window because the NBER has decided the US recession lasted only two months with the economy peaking in February 2020 and bottoming in April. It might have been one of the deepest recessions on record, but blink and you missed it.
The COVID recession is easily the shortest in history, with the January to July 1980 pullback the next shortest at six months. That is notable partly because the subsequent recession began surprisingly quickly–exactly a year later in July 1981 and lasted a much longer 16 months. I know events were very different back then,but that certainly is something to reflect on.
One question that bothers me is whether this recovery should really be considered a new economic cycle or merely a continuation of the old one, briefly interrupted by the pandemic. Normally in a recession, especially at the end of a record long 130-month cycle like the one we saw up to February last year, excesses like too much leverage are purged and there is a sort of reset. To the extent that did not happen due to super-sized monetary and fiscal largesse, are those vulnerabilities still lurking with the potential to trigger another recession much earlier than anyone suspects? That would definitely be a major market shock.
Meanwhile, the collapse in lumber prices will give the Fed confidence that soaring inflation rates will ease as the economy reopens. The NYT highlighted that it was predominately DIY enthusiasts flush with government cheques that helped drive lumber prices higher and as supply recovered, prices have collapsed-link. The Fed looking at this, together with the unusual divergence in the core CPI inflation rate from the Median CPI, will be reinforced in their belief that high inflation is transitory. We agree but show two startling charts inside to challenge that.
Only one thing shocked me about Monday’s plunge in equity prices. As Zero Hedge said, “Welldone Jay Powell, you’ve enabled the most fragile market in history. With the S&P 500 around 3.5% off its record highs, we note that fear has exploded. The last time fear was this high, the S&P was down 40%!”. I have stated recently my own view on the inflation debate that we are indeed transitioning out of a deflationary Ice Age environment, but that this will occur later in the economic cycle and so markets have moved far too early and are now vulnerable to disappointment. My Equity Derivatives Strategist colleague, Jitesh Kumar, is one of Soc Gen’s macro thinkers I like to bounce ideas off. At the end of last year he comparedthe business cycle/monetary policy cycle to the volatility cycle–link. He was updating his charts and noticed something shocking. The Congressional Budget Office(CBO) have massively revised their calculations for the US output gap–which suggests US inflationary pressures are far hotter than previously thought.
The ‘Output Gap’ is important because many economists, especially Keynesian economists, tend to believe inflationonly shows up when the economy is growing beyond potential capacity constraints. Normally in a recession as demand collapses it takes many years for the output gap to return from disinflation/deflation-inducing negative territory back to zero, and then beyond that into positive (inflationary) territory. Not this time though. The CBO have had a total rethink and believe the economy will be operating 2% beyond full capacity as early as Q1 next year! Jitesh notes that if unemployment follows its traditional close correlation with the CBO output gap, we could reach record low levels of unemployment far sooner than anyone expects. Jitesh also flagged up to me this recent article from the San Francisco Fed which splits core PCE inflation into a cyclical component and an a cyclical (uncorrelated to the domestic output gap) inflation time series. Jitesh notes, “To get directly to the point–the following chart shows the cumulative change in cyclical core PCE inflation over the three years following a recession in the US. It has “This time is different” writ large–a combination of timely monetary/fiscal support has managed to interrupt the “cycle” in the US. Normall y15 months after the beginning of the previous three recessions in the US, cyclical core PCE was down between 0.5% to 1.5%, whereas it is above pre-recession levels this time around.”
Food for thought indeed to challenge the prevailing ‘high inflation is transitory’ viewpoint.
I am aware of this dynamic and watching it closely. But it must be remembered that the Fed and Biden administration both want higher wages. Tight capacity is a prerequisite. So, this does not necessarily mean any sudden shift in policy.
Moreover, US unemployment dropped to 3.5% in the last cycle and wages still only manage to nudge over 3%.
The deflationary forces are immense…
As for this being a new business cycle, only on paper. Most importantly, we saw no flushing of the bad debt or capital misallocation so there’s not much productivity growth dividend coming and lot’s of timebombs hidden just beneath the surface.
So, the idea that this new cycle will shorter than the last is pretty solid.