January Recap and a Heads Up for March

The Inflation Deflation and Economic Cycle Model measures the liquidity impulse from fiscal and monetary policies. This is how we determine what will occur with the ROC of inflation and economic growth. The current liquidity factors that must be measured are the Treasury General Account (TGA), Reverse Repurchase Agreement (RRP), Fed's balance sheet, Federal Funds Rate (FFR), Bank lending practices, and the Bank Term Funding Program (BTFP).

On the positive side of the liquidity construct right now are the Reverse Repo Facility (RRF) and the BTFP. The RRF is being aggressively drained to purchase U.S. Treasuries, and the BTFP is being tapped each week to take banks' bad assets off their balance sheets, and in exchange, they receive reserves equal to the par value of those distressed assets.

On the neutral side, we have a static FFR and a static TGA level.

On the negative side, we have a shrinking Fed balance sheet (Q.T.) and bank lending practices, which are tightening lending standards. Hence, Commercial and Industrial (C&I) loans and M2 money supply is shrinking.

All counted, the current liquidity environment is positive.

However, come March, this very well should all change.

Three months from now, there should be no positive liquidity impulses.

In the neutral camp, there will be two: the TGA and the FFR should remain near their current levels.

But there should be four negative impulses: the BTFP will expire as planned on March the 11^th, bank lending practices will remain negative, the RRP facility will be emptied, and the Fed's Q.T. program is slated to remain in effect--albeit perhaps in the process of being wound down slowly if there is some fracturing of the credit markets. Hence, there should be a significant decline in liquidity come March, which should cause turmoil in the long end of the bond market and lead to a sharp correction in equities.

The truth is the spike higher in borrowing costs must soon begin to bite. Record-low, near zero percent borrowing costs that were in place for most of the time between 2008 and 2022 caused a massive dung pile of debt to be incurred.

Corporate debt is up 115% since 2010. Rising from $6.4 trillion to $13.8 trillion. The market for CLOs--securitized pools of leveraged loans--has ballooned from $300 billion in 2008 to $1.3 trillion today—that is an increase of 333%! The national debt is $34 trillion and is 122% of GDP, which is a record high. Annual deficits are $2 trillion. The interest on the debt will be $1 trillion this fiscal year. The annual deficit is 45% of revenue, and the outstanding debt is 750% of revenue.

Higher interest rates erode the economic footing like a torrent underneath the foundation of a building. You cannot convince me that this humongous debt overhang will be unaffected by the much higher cost of money.

In the meantime, the stock market is priced for perfection and remains on Fantasy Island. This is true even though a record 40% of companies in the Russell 2000 are unprofitable. For Q4 2023, the blended (year-over-year) earnings decline for the S&P 500 is -1.7%. However, Wall Street is pricing in 11% EPS growth for all this year. But in truth, the S&P 500 is on track for 4 out of the last 5 quarters having falling earnings growth. The forward 12-month P/E ratio for the S&P 500 is 19.5. This P/E ratio is above the 5-year average (18.9) and above the 10-year average (17.6). Meaning even if you get that ridiculously optimistic 11% EPS growth, the market is still overvalued--and not by a little bit. The stock market is 40% overvalued using the historical method of TMC/GDP.

After all, how healthy can an economy be when the goods-producing sector is on life support? The manufacturing sector of the economy has been contracting for the past 14 months in a row. The NY area manufacturing sector is in a depression. The level of that index is now at its lowest since the economy shut down in May 2020.

The real estate market is also a minefield. According to the National Association of Realtors, existing U.S. home sales totaled 4.09 million last year, an 18.7% decline from 2022. That was the weakest year for home sales since 1995 and the biggest annual decline since 2007, which was at the start of the Great Recession and Real estate crisis. The median home price-to-income ratio is at a record high of 5.56. This ratio was 5.0 in 2007. Buying a home is now over 50% more expensive than just being a renter. The previous peak of this metric was 33%, leading up to the real estate crash and GFC of 2008. According to the Federal Reserve Bank of Atlanta, annual homeownership payments, which include taxes and insurance, ate up 46.4% of the median U.S. household income, which is at a record high. The pre-COVID figure was 29%. According to the National Association of Realtors, only 23% of houses in the U.S. are affordable to the first-time homebuyer. That number was 50% a year ago.

The commercial real estate market is in shambles, but the ramifications have yet to be felt. $1.5 trillion in commercial real estate loans come due in the next two years. Interest rates have soared, and occupancy rates have plunged to an all-time low. The price of these office spaces and the loans attached to them have dropped by 40%. This is a huge problem for banks, which have 30% of their assets in commercial Mortgage-backed Securities (CMBS).

Given all these facts, it isn't any wonder why the leading indicators of the U.S. economy fell in December for the 21st month in a row. That is where the economic puck is going, Gretsky. However, in this negative context, the labor market remains strong, at least according to the official numbers from the Department of Labor. Combine that with the A.I. hype and hopes of rate cuts, and you get a new high in the S&P 500 in nominal terms. Of course, in inflation-adjusted terms, we are not even close to a new high. And the broader market, as represented by the Russell 2000, is still down more than 20% from its high seen in late 2021, and that is in nominal terms. This index is also down 3% YTD. So, at least we are seeing some reality there. The equal weight S&P 500 is down over 1% so far this year and is down 5% from its high of 2021. The very narrow rally, which was seen in just a handful of mega-cap tech stocks last year, continues to march on.

PPS remains net long the market due to quiescent credit markets and financial conditions. But that allocation could and should change significantly come March when the liquidity impulse turns negative. There should be a mad dash for the narrow emergency exit door at that time, especially in those few mega-cap tech names where investors believe they have achieved recession-proof shelter. We remain alert and fully prepared for it all.  

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