Cycles Constantly Cycle
Feedback loops imbedded within the fabric of markets
Highlights
Reciprocal feedback loop has kept inflation persistent.
High-Yield Spreads getting wider (increasing), and the default rate is lifting at a lag.
Bankruptcy rate accelerating and tighter bank credit conditions on the horizon.
Breaking Headline: “AI is the New Stock Picker?”, seen on CNBC (4/13/23) Thursday afternoon. What a world we live in and ain’t that a beauty! I mean seriously, I wish that I was making this up, but as I briefly looked up at the muted TV in my office, that was the headline running across the screen! Good to know that the market is still feeling all good on all the “super cool AI stuff”. I am fully aware that one day this technology will produce meaningful advances for society, however not to the extent of rescuing the economy this instant from the growth slowdown and the other data points that I will be sharing today. As of yesterday’s close, the chase for returns remains intact and the manic behavior follows. Not surprised in the slightest that I looked up at the TV screen to see yet another mindless headline.
Speaking of headlines, this was a noisy week which presented a plethora of macro data for the un-informed volume to gaze upon and talk about yesterday’s news. For those that were depending on this week’s CPI report to “confirm” whether inflation had peaked, bless them. Core CPI (Ex-food and energy), however accelerated sequentially from +5.5% to +5.6%. Nothing major, but remains elevated nonetheless. This metric has ranged from 5.5% to 5.7% since December of 2022, so for the last four months, Core CPI has barely moved. Needless to say, inflation is still not falling fast enough for the consumers (the US general population) nor the Fed. Combine that metric with last Friday’s “strong” lagging unemployment report, and it creates quite the intoxicating cocktail for the fed to continue raising rates into this economic slowdown again in May.
Adding more fuel to this fire, the price of Oil (literal fuel) is up approximately +9%, and the CRB commodities index is up approximately +3.19% for the month of April. Comparatively, the price of Oil was up approximately +2.9% for the month of April 2022, while the CRB commodities index was +4.38% in April 2022. It would not be far-fetched to think that the data could potentially show some form of acceleration in the energy component come the April or May report. This dynamic is interesting because both of the above have strengthened amidst USD weakness. The weakness is a whole other can of worms that I will not be touching even with a ten-foot pole today. I will leave that to all the Youtube and twitter “experts” buying Chinese Yuan, “their new global reserve currency”.
Over the last year, commodity and asset prices have fought the fed the entire way down. As I mentioned last week, the process has moved slowly, and in recent months there has been artificial stimulus provided by the US Treasury via the TGA account spend to the tune of approximately $200B-300B per month (Tier One Alpha), which is also counterintuitive to the fed running quantitative tightening as this has potentially offset the effects and then some. This slow-moving process for markets on the way down has been a constant reciprocal feedback loop that commences as follows:
Inflation is a problem→ Fed tightens while growth is slowing→ USD strengthens→ Asset and commodity prices go down→ Market begs for rate cuts or Fed pivot→ USD weakens→ Market rushes to buy the former bubbles→ Commodity prices reflate→ Inflation is persistent→ Fed tightens further.
Quite fascinating to have observed this behavior over the last year. In a world where the main goal for central banks across the globe has been to fight inflation, at every turn, market participants have habitually returned to buying the former bubbles. The outcome generally has been a weaker USD for a moment in time alongside a simultaneous reflation of various components of the commodities complex. This makes me wonder if it has truly been human nature that has caused inflation to be more persistent? The entire process is paradoxical. Based on this and what is shown above, higher for longer remains the Feds path. The Fed’s only deviation would come as a reactionary measure to something “surprising” or catastrophic.
Switching focus to High-Yield Spreads. This is an important concept to discuss because this is one of the best gauges of underlying risk within overall markets. What are High Yield Spreads? This is the difference (spread) between the rate on High-Yield Bonds vs. the US Treasury rate or Investment Grade Corporate Bonds. High-Yield Bonds generally have a higher rate because there is more perceived default risk with the company that is securing the payments on that bond. As economic stress grows and company profits fall, the spreads for the example company would begin to rise (widen). When the spreads rise, the overall rate rises, which means the bond market is indicating that the debt is becoming riskier. This also contributes to a higher cost of capital for a similar company attempting to execute a debt issuance. In these circumstances, if some companies are not able to secure financing, then they will go out of business. The chart below shows various periods of time where High-Yield spreads began to rise and were followed by subsequent periods of economic turmoil or recession.
Fred Economic Data
Adjacent to the widening High-Yield Spreads, the default rate usually follows with a lag. The bond market becomes aware of the underlying risks and begins to price as such. Later down the road, the bankruptcies begin to surface. The following chart from JP Morgan Asset Management is a good visualization of this concept. Notice the significant acceleration in the default rate that is following the rise in High-Yield Spreads.
JPM “Guide to the Markets” US 2Q 2023 as of March 31, 2023
Lastly, I came across some updated bankruptcy data as of 4/4/23 from EPIQ Bankruptcy. Most notably, new bankruptcy filings were up 17% year over year (y/y) for the month of March and 42,368 new cases were filed, which is the highest monthly amount since April of 2021. The total bankruptcy filings for the month of March also accelerated +33% month over month in comparison to +2% for the month over month for February 2023. Commercial filings were up 24% y/y, commercial chapter 11 filings were up +79% y/y, total individual filings were up +17% y/y, and overall, for the entire Q1 2023, total bankruptcy filings were up 18% y/y. Seeing this data is not surprising given consumer delinquency rates have been accelerating for a few months now.
EPIQ Bankruptcy
The bankruptcy rate is accelerating according to the data shown above from EPIQ Bankruptcy. To be determined whether this will be sustained, but as more companies go out of business or consumers go BK, spreads will widen and banks will be forced to tighten their lending standards further. This is a negative cycle that ultimately increases the cost of capital, and can lead to more problems if access to credit is unavailable to those in need. Another feedback loop to consider.
No matter what market prices are doing, the cycle is always moving forward in time. While sometimes this may not be front of mind for all investors, various cycles constantly cycle quietly in the background. Today, various feedback loops were discussed, high yield spreads, and the rise in bankruptcy filings. The underlying credit data is moving in the wrong direction and is not conducive to a healthy growing economy. For those religiously infatuated with crypto, rarely do second chances present themselves, and for many of those “projects”, this is the last stop on the bus to get out. The debt Ceiling debacle can only last at most for a few more months and eventually the artificial stimulus will be withdrawn.
The following is not investment advice and is a reflection of my own viewpoints. “Never, ever invest in the present”- Stan Druckenmiller. Given the strength in Mega-Cap-Tech (making lower highs), it continues to be a great place to raise liquidity. Additionally, there have never been more times within the last two years where I have been approached by various people who have asked me, “Is the USD going to fail?” or have told me that, “The USD has lost reserve currency status”. That in its own right is a form of contra-indicator. Adding to the liquidity position by owning USD as an asset allocation can prove to be a strategic opportunity on this weakness.
Happy Friday,
Aaron David Garfinkel
Resources
EPIQ Bankruptcy (hyperlink below)
Fred Economic Research
https://fred.stlouisfed.org/series/BAMLH0A0HYM2#
JPM “Guide to the Markets” US 2Q 2023 as of March 31, 2023
Tier One Alpha (hyper link below)
Loved it!
Great stuff Aaron. Keep it up.