While the debt ceiling debate has grabbed the recent headlines, this year’s main event for investors is the great debate over whether the US achieves either a soft or hard economic landing.
Analysts have made many comparisons between the debt ceiling issues of 2023 and 2011, and three significant differences between these two events could affect the soft or hard-landing economy outcome.
The first is that currently we are in a QT (quantitative tightening)1 situation where the Federal Reserve2 (Fed) wants to remove liquidity from the market by selling Treasury securities off their balance sheet into the market. Conversely, in 2011, the Fed was still in a QE (quantitative easing)3 mode, adding liquidity by using the balance sheet to buy Treasury securities from the market. The 2011 debt ceiling deadline fell between two successive rounds of QE–the second round of QE ended in June 2011, just before the August 1 debt ceiling deadline. A third round of QE started on September 13, 2012. The Fed's liquidity additions helped offset the fiscal discipline at the federal government level. Lacking the liquidity addition from QE this time, an equal spending cut may slow the economy by more compared to the prior debt ceiling crisis.
The second difference is the interest rate backdrop. Federal funds rates were below 0.20% from March 2009 to December 2015,4 which created a very low and stable rate regime in the period before, during and after the 2011 debt ceiling situation. The reverse is now true after the Fed has completed 500 basis points in rate hikes during a 14-month period. Dramatic rate hikes are designed to cool the economy, creating an obvious economic drag now vs. in 2011.
The third disparity centers on the health of the banking sector. US bank failures totaled $34 billion in assets during all of 2011, while already in 2023 (through late-May) there have been $540 billion worth of bank failures5 representing three of the four largest bank failures in US history. Bank failures reduce liquidity to the market and cause a chill in lending activities–which is an obvious negative for economic activity compared to 2011.
A hard landing is not the only possible outcome. The US economy is driven by consumption, with 70% of gross domestic product (GDP)7 driven by consumer spending. So it is essential to think of the labor market in addition to interest rates. Currently there are 6 million more open jobs than unemployed people looking for work.8 Barring structural labor market misalignments, you need to see a drop in the number of open jobs before seeing a meaningful uptick in unemployment.
It is also important to remember we are in the third year of a presidential cycle. One of the best forecasters of US presidential election outcomes is the change in voters' after- tax, after-inflation income in the year prior to the election. A rise in income helps the incumbent while a fall helps the challenger–a point that is well known in Washington, DC. Keep an eye out for policies that can increase income including a potential rise in the child tax credit, 100% expensing of corporate capital spending, or other stimulus to satiate voters ahead of the 2024 election.
Events like these may contribute to a soft-landing economy where inflation is reduced without entering a severe recession. Meanwhile, Chinese fiscal and monetary policy responses could run counter-cyclical to that of the US. If the Chinese GDP number falls below target the reasonable expectation is that the government will provide some stimulus to boost growth. Chinese economic weakness months ago preceded an announcement of $1.8 trillion in planned infrastructure spending for 2023,9 and it is not hard to see a more positive demand story evolving in the country responsible for 50% of demand for most commodities, excluding energy.
The supply side of the commodity market is wholly unready for a soft-landing economy and may not even be sufficient to meet current demand. London Metal Exchange (LME)10 inventories for major metals are at or near 25-year lows. Global oil demand just hit a new all-time high. Gold miners are completing mergers and acquisitions because it is easier to raise production by paying a premium for a competitor than attempting to grow output organically. The world's largest copper miner, Codelco, reported copper production fell by 20% vs. 2016 despite copper prices that are 50% higher now compared to then.11
There is widespread evidence of commodity production being constrained by labor issues, higher tax rates, lack of electricity, permitting issues, lack of successful exploration for future mine sites, sanctions, and increasingly stressful geopolitics that disrupt global raw material trade. It may not take much of a surprise in economic activity to expose the lack of commodity inventory. A broad commodity index may be an asset to consider for your portfolio if this is your base case.
2 Federal Reserve - the central bank of the United States.
3 Quantitative Easing - a form of monetary policy in which a central bank, like the U.S. Federal Reserve, purchases securities from the open market to reduce interest rates and increase the money supply.
4 Bloomberg data, March 2009 through December 2015
5 https://www.fdic.gov/bank/historical/bank/bfb2011.html
6 Bloomberg data
7 Gross Domestic Product - the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period.
8 Bloomberg data 5/23/2023
9 https://www.bloomberg.com/news/articles/2023-04-10/china-bets-1-8-trillion-of-construction-will-boost- economy
10 London Metal Exchange - a commodities exchange that deals in metals futures and options. It is the largest exchange for options and futures contracts for base metals, which include aluminum, zinc, lead, copper, and nickel.
11 https://www.codelco.com/memoria2016/en/directorio.html, and https://www.reuters.com/article/codelco- results/chiles-codelco-profit-slumps-eyes-stable-2023-copper-production-idUSKBN2VX19W#
IMPORTANT INFORMATION
The statements and opinions expressed are those of the author and are as of the date of this report. All information is historical and not indicative of future results and subject to change. Reader should not assume that an investment in any securities and/or precious metals mentioned was or would be profitable in the future. This information is not a recommendation to buy or sell. Past performance does not guarantee future results.
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ETF002038 5/15/24
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