(Neil Azous) We are pleased that our ETF strategies had a positive absolute return or significant relative performance last week, especially in fixed income. This is a testament to our “active” management approach. With the below the top of mind, we continue to be positioned extremely defensive.
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Following the economic data released last Friday – Consumer Price Index (CPI) and University of Michigan Consumer Sentiment – the outcome we were most fearful of emerged.
We believe Friday the facts changed materially enough to result in a “break the glass moment.”
Sentiment fundamentally changed through the close of this past week, whereby the connections between inflation, interest rates, and recession risks are clear.
Conclusion: There is now an emergency, and the responsible actors must take drastic action. The Federal Reserve will likely shift its reaction function to “Old Testament mode.” We define that biblical response as 0.50% interest rate hikes (or more) until the Fed funds rate is at least 4.0%.
The Deciding Fact That Broke The Glass
Everyone has a silver lining or tidbit regarding economic data releases. While the CPI report was dire, the University of Michigan consumer sentiment report tipped the scale.
Here is the pedestrian observation:
The University of Michigan composite sentiment gauge fell by 8 points to 50.2 in early June. That is the lowest reading on record, going back to 1978. Think about that for a second. Economic growth is robust, the unemployment rate is near a 50-year low, and consumers are gloomier than they have been at any time in the last 45 years, including the early days of the pandemic, during the Global Financial Crisis, after 9/11, and through the deep recession of the 1980s.
Here is the global macro observation:
The median UMich Expected Change in Prices During the Next 5-10 Years rose to 3.3% from 3.0%. The Fed’s mandate is to anchor long-term inflation, and the sentiment is now well-above the long-term average.
Here is our observation, or the “sight beyond sight®.”
The mean UMich Expected Change in Prices During the Next 5-10 Years rose to 4.3% from 3.5%.
We highlight the difference between the mean and median because it reveals the central tendency currently. The mean is used for normal distributions and is highly sensitive to outlier data, such as in this case. It defines the central value of the data set. The median is used for skewed distributions and is less sensitive to outlier data. It defines the center of gravity of the midpoint of the data set.
The mean of 4.3% is significantly higher than the median of 3.3%. Historically, the “delta” between the two is 0.20% to 0.40%. The expansion of the “delta” to 1.0% highlights how massively skewed the right side of the inflation expectation distribution is now.
This is a clear example of the public losing confidence in the Fed being able to anchor long-term inflation expectations.
The Fed is mindful that inflation has “institutional memory” and should be accounted for. Meaning, that once inflation is embedded into the system, it is even harder to remove. Close adviser to Chair Bernanke, Chair Yellen, and Vice-Chair Brainard, John Roberts has highlighted over his career that models should account for the “memory” of the inflation regarding how long it is embedded in the system.
Qualitative Comment: How can the University of Michigan report be the worst on record. The short answer is “cumulative misery.”
During the height of the Global Financial Crisis, there was the prospect of recovery. The blackest point felt like “past tense.” Also, housing and stock prices dropped substantially further than now.
Currently, that claim cannot be made regarding inflation or asset prices. The “world” peaked during the 2020 pandemic recovery period. Therefore, the starting point was still low on an absolute basis. Now, the consumer is dealing with the highest prices in the modern era and growing recession probabilities. If this was a baseball game, the “present tense” is the third inning.