Small blips in the global economic locomotive

Stock markets have continued to rise and Nasdaq Helsinki’s general index is once again hitting the psychological 10,000-point mark. A level where, unfortunately, we have been hanging out since 2017…

In this post, I’ll talk briefly about the liquidity situation, which supports equities. Then we look at the blips in the economic locomotive of the United States. The threat of a recession has receded from investors' minds as the S&P 500 index is a stone's throw away from all-time highs, but it's still something worth to keep your eyes on. It wouldn’t be the first time that recession managed to surprise careless investors.

Liquidity supports equities

Let's talk briefly about liquidity, which has developed favorably for equities in recent weeks. The US Federal Reserve, the world's most important central bank, has improved its net liquidity to the market, although officially the bank is continuing its balance sheet reduction operation. This graph juxtaposes net liquidity, which measures the amount of money in the monetary system and the Fed's balance sheet total, which has a lot of elements that don't slip into the system. In practice, monetary conditions haven’t been tightened in this sense for over a year as I've pointed out in many of my post, most recently in this one.

The turnaround in the S&P 500 index coincides with last fall, when net liquidity bottomed out. Michael Howell, who follows liquidity, argues that liquidity will improve gradually, as the Fed doesn’t want to create wrinkles in the financial system while trying to suppress inflation. Officially, the Fed looks hawkish and tightening, but at the same time the market is being fed oxygen through the back door.

It’s important to distinguish between monetary inflation and real-life inflation. The central bank can tame consumer price inflation in the real economy through interest rates, while pumping money into the financial system.

And this phenomenon isn’t just a momentary relief.

In the big picture, developed economies around the world face the same problem. Populations are aging and social and health spending in welfare states is expanding while economies, and therefore tax revenues, are growing slowly. It's difficult to see how the debt accumulation wouldn’t continue. Central banks have a role to play in ensuring the financial security of the public sector in one way or another. The Fed isn’t the only supportive central bank, and the US economy is actually in the best position in the world because the population is still growing. Investment legend Stanley Druckenmiller has compared the US public finances to the historically mismanaged Argentine economy, but compared to the US, other countries look like Zimbabwe. The Chinese and Japanese central banks are currently injecting money into the system as much as they can, and the European ECB is similarly between a rock and a hard place.

Asset classes sensitive to liquidity and monetary inflation, such as Bitcoin and gold, have also reacted sharply. And so have the world's biggest listed companies. Bitcoin has more than doubled from its fall 2022 lows and slower moving gold has risen +20%. Mega-techs - or the Magnificent Seven - has risen by almost 100%. As the challenges of public deficits and central bank implicit debt monetization continue, such liquidity-sensitive assets can provide an interesting diversification to an investor's portfolio.

Small blips in the global economic locomotive

For equities on average, the dream development would be as follows. The economy continues to grow. In particular, the US, the world's consumption driver, but also Europe and China, are expected to recover their healthy growth trends. At the same time, inflation is cooling, bringing interest rates lower. Earnings growth continues and equity valuation multiples recover. Everyone is happy, except the bears. 

This is called the Goldilocks economy after the classic fairy tale in which a little girl called Goldilocks discovers a house of bears while exploring the forest, and eats Little Bear's porridge, which is just the right temperature. Not too hot, like Papa Bear’s porridge, or too cold, like Mama Bear’s porridge.

At the beginning of the year, investors still feared a recession and a collapse in stocks. Many investment banks predicted an economic meltdown. Fewer people felt that a soft economic downturn and a cooling of inflation without a deeper recession were possible. But ironically, that's exactly what has seemed to happen so far. Stocks have risen globally. The global stock index has rallied 15% and even excluding US stocks, which have been carried by mega-techs, have risen 7% since the beginning of the year.

Investors' fears of a recession have receded. This is well reflected, for example, in the news headlines about a soft landing. Only in the mid-1990s was there a soft landing, but usually a recession is preceded by a lot of talk in the news about a soft landing. Of course, in this cycle everything is different because of the pandemic and the super-stimulus, so past history gives a poor indication of what is to come.



It would be ironic if, as investors breathe a sigh of relief, the recession were to surprise them.

However, there have been some dubious blips from the world's economic powerhouse, the United States, even though right now the economy looks robust. 

Talk of a soft landing is not the only thing that will increase before a recession. The second is credit losses and the increasing insolvency of companies. The junk category has seen a rapid increase in the stagnation of repayments, as in the run-up to many past recessions. Of course, such a development is understandable when interest rates jump up at a moment's notice, and not every time the economy went into recession. For example, the industrial recession of 2016 and 2017 was, as its name suggests, mainly in industrials, while the rest of the economy pushed forward.

The world's largest retailer, Walmart, which generates absurd memes, commented in its third quarter earnings call that rapid price increases are coming to an end. The company is even rowing through deflation, or falling prices, in the coming months. Walmart said it was good news for its customers, as price cuts always are. This leaves money to buy other products on Walmart's endless rows of shelves.

News of cooling inflation is good, as long as the cooling of inflation doesn’t slip too far into deflation. This is poison for the economy, as a more permanent fall in prices encourages people to save for future purchases. After all, one person's expenditure is another person's income, so saving is effectively cutting into another person's income.

Second, the real value of debt starts to rise in deflation. In an indebted economy, such dynamics are not welcome. Walmart also saw a sharp drop in consumer spending in the last two weeks of October, but said November started reasonably well.

Deflation is also reflected in producer prices. For example, the price index for industrial materials and components has been falling in the US since the summer of 2022. This will of course ease the cost pressure on manufacturing companies, at least initially, but keeping prices high in a competitive economy is difficult. On an annual basis, producer prices have indeed been falling since this summer. Deflation is therefore also partly present in manufacturing.

Even the strong labor market is cracking a little in the US. Last week, our economist Marianne Palmu also raised the Sahm Rule, named after the Bloomberg columnist. If the three-month average unemployment rate rises by half a percent above previous lows, the economy is already in recession, even if it doesn't feel like it at the time. After all, a recession is almost always a state of affairs that is realized rather late. The unemployment rate has now risen by 0.33% on a three-month average, meaning that the limit of the Sahm recession rule hasn’t yet been reached. Claudia Sahm herself also comments that because of the pandemic-ravaged economy, this empirical rule may not apply this time.

 

As a final curiosity, I could bring up the price of oil. Despite the crisis in the Middle East, the war in Ukraine and attempts by oil-producing countries to limit oil supply, the price of black gold has fallen sharply. The global economy runs on oil, so the fall in prices may indicate a global slowdown.

 Thank you for reading the post! Read analysis and make good stock picks!