Economic Irrational Exuberance? Or why consumer sentiment disobeys the Business Press and the experts.
Stanley Druckenmiller: “The one thing I’ve learned about markets over time is that they tend to train you to ignore something and then humiliate you once you figure it doesn’t matter.”
I think that sums up the markets right now. The conventional wisdom is that the economy is so strong that it can absorb a massive tightening cycle without entering a recession. The magnitude of this tightening cycle has been similar to the early 1980s, which triggered the deepest recession since the Great Depression at that time.
Is this time really different? IMO, probably not, and the psychology of economists reminds me a lot of bubble-style thinking like we saw in 2006 with real estate and in the late 90s with the stock market bubble. Most market professionals knew that stocks and real estate were ridiculously overvalued in the years leading up to their respective busts. Who can forget Alan Greenspan’s “irrational exuberance” comment in 1996? The point is that people often recognize something that something is amiss, but after waiting for a calamity that doesn’t materialize, they end up rationalizing why circumstances are different.
The soft landing / no landing crowd is claiming the economy is too strong (and the labor market too tight) for a recession to happen. This explains the steepening of the yield curve from strongly inverted to close to flat. An inverted yield curve has historically been a good (but not perfect) recessionary indicator. The curve inverted after the stock market bubble burst and the residential real estate bubble burst. It is the market’s way of anticipating rate potential rate cuts. If rate cuts aren’t going to materialize, then then yield curve reverts to its normal pattern of long-term rates rising above short term rates. And that is where we are now, which explains the absolute rout we have seen in the bond market over the past two months.
An inverted yield curve is said to have predicted seven of the last five recessions. In other words, sometimes the curve inverts and the recession doesn’t materialize. The yield curve inverted in 1998 (during the Long Term Capital Management saga) and we didn’t see a recession. It inverted slightly in 2019 ahead of the Fed’s easing cycle but we didn’t see a recession. The market prognosticators are betting that we are in another 1998 or 2019 scenario.
The difference between today and 1998 and 2019 is that we have experienced one of the most drastic Fed tightening cycles in history. Just like people who thought the stock market was overvalued in 1997 and residential real estate was a bubble in 2004, the recession crowd has been wrong. Eventually people get embarrassed by being wrong and either shut up or doubt their conviction. And I think that is where the economic bears are at the moment.
The sell-off in Treasuries feels like the market becoming comfortable with the idea that the US economy will be able to shrug off a dramatic Fed tightening cycle and maintain an unemployment rate in low-to-mid 4s. I wouldn’t bet on it. Those who have crowded into the Magnificent 7 while the rest of the financial world burns will probably end up looking just as foolish as those who think the Fed can dramatically raise rates without breaking anything. Note the bank stocks are down about 50% over since January 2022 and have given back the entire rebound after Silicon Valley Bank went kaput. That is not an indication of a soft landing. I suspect, like Stan Druckenmiller suggests, a lot of people are talking themselves into ignoring the 525 basis point elephant in the room.
The US economy supposedly grew at 4.9% in the third quarter of 2023, which in retrospect is exceptional growth. It doesn’t feel like it, does it? If you look at statistics like the ISM Surveys or consumer confidence, the economy appears to be lousy, or at least below average. So if the economy is so great, why aren’t other data points confirming it?
I plotted consumer confidence versus GDP since the 1980s. Over the time period, the correlation between GDP growth and consumer confidence has been about 14% - not great, but they do correlate a little which makes sense. Ever since the pandemic, GDP growth and consumer confidence has negatively correlated. In other words, GDP growth has risen, but consumer confidence remains dour.
The thing I find interesting is that we saw something similar in the late 70s / early 1980s - strong GDP growth along with lousy consumer sentiment. I think the takeaway is that GDP growth in an inflationary environment doesn’t feel the same as growth in a non-inflationary environment. In other words, inflation is the driver of sentiment, not growth. It turns out the correlation coefficient between inflation and consumer sentiment is -32%, so it explains the current zeitgeist a bit better.
You can see how we saw the same phenomenon in the 1970s, where we had high inflation, high growth and lousy sentiment. That era was probably best captured by Mary Tyler Moore rolling her eyes at the price of beef at the supermarket before tossing it into her cart anyway.
The sentiment issue is driving the business media (and probably the Biden Administration) absolutely nuts. My favorite take has to be Paul (Dr. Cowbell) Krugman posting a chart on X saying that if you strip out food, energy, shelter, and used cars, the battle for inflation has been won (at little cost). Sure, if you ignore most people’s biggest expenses, inflation isn’t so bad. This is the “assume a can opener” joke in real life.
Who are you going to believe? Political hacks or your checking account? This is the explanation for the Scooby Doo Mystery of why people don’t feel great even though the BLS, BEA and the Business Press all insist you should. Don’t forget - falling inflation does not imply falling prices. It just means that prices will rise at a slower pace going forward, but those price hikes over the past two years are baked in the cake and won’t be reversed.
The upcoming week will be big, with the FOMC meeting on Tuesday / Wednesday and the jobs report on Friday. The Fed Funds futures are a lock for no rate hike next week, and they have been slowly paring back bets that the Fed hikes in December. We will also get house prices, productivity, ISM data and the Employment Cost Index. We also will get a 10-year and 30-year bond auction. The government’s bond auctions have been lousy as of late and this has been hammering sentiment in the bond market.
The market sees 183,000 jobs being created in October, although the UAW strike probably will introduce some noise into the numbers. The unemployment rate is expected to remain at 3.8% and average hourly earnings are expected to rise 0.3% MOM and 4% YOY. Next week promises to be interesting.