Q3'24: Genie's out of the Bottle

By: Jack Schibli

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TLDR: – "too long; didn’t read." We recognize our posts can be lengthy and challenging to digest, so here’s our executive summary:

The Federal Reserve has begun cutting interest rates – we think prematurely.
Messy labor market data makes for a challenging read of the true state of employment – even the Fed is confused – making their job to determine underlying economic strength harder.
The central bank easing of monetary policy, with the stock market at all-time highs and no glaring signs of economic weakness, re-opens the door for inflation to make a comeback.
We believe the Fed is subservient to the U.S. Treasury, which needs to bring interest costs down, as in August, “true interest expense” (interest + Medicare + Social Security) was 129% of tax receipts.
Ultimately, we suspect owners of long-term treasury bonds will be left holding the bag as the government keeps spending and the Fed keeps monetary conditions easy, and inflation comes to rescue the government's balance sheet.

The Ghost of Arthur Burns 👻

Arthur Burns was the infamous Federal Reserve Chairman of 1970-1978, blamed for the re-emergence and acceleration of the 1970s U.S. inflation. Burns was considered an expert on the business cycle (he literally wrote the “book” on it), and he was convinced that rising prices in the 1970s were a function of factors unrelated to monetary policy. Stephen Roach, an employee of Arthur Burns’ Fed, recounts Burns’ obsession with exclusions and carve-outs that would form the basis of today’s “Core” CPI metric, which excludes food and energy:

“When oil prices quadrupled following the OPEC oil embargo in the aftermath of the 1973 Yom Kippur War, Burns argued that, since this had nothing to do with monetary policy, the Fed should exclude oil and energy-related products (such as home heating oil and electricity) from the consumer price index. The staff protested, arguing that it made no sense to ignore such important items, especially because they had a weight of over 11% in the CPI. Burns was adamant… Then came surging food prices, which Burns surmised in 1973 were traceable to unusual weather—specifically, an El Niño event that had decimated Peruvian anchovies in 1972. He insisted that this was the source of rising fertilizer and feedstock prices, in turn driving up beef, poultry, and pork prices. Like good soldiers, we gulped and followed his order to take food—which had a weight of 25%—out of the CPI.”

It wasn’t until 1975, after stripping out 65% of the CPI basket for idiosyncratic reasons, that Burns admitted inflation (the remaining basket then running in the double digits) was pervasive and structural. Unfortunately, his prior monetary policy easing only worsened and lengthened the battle against inflation. Fast forward to today’s Federal Reserve; we belive the parallels are eerily similar. Jerome Powell’s Fed believes that the recent bout of inflation was primarily a result of pandemic-disrupted supply chains and the Russian/Ukraine war-inflicted oil price spike. Recall, we believe quite the opposite – while the pandemic’s stimulus may have been the match to light the fuse, the drivers of Western inflation are structural – the 4 “R’s” we have repeatedly discussed on this blog:

Re-Shoring = the economic divorce between China and the West is bringing supply chains closer to home, reversing the decades long exportation of inflation
Re-Arming = expanding Western military budgets to prepare for heightened geopolitical conflict, replacing aging stockpiles
Re-Energizing = effecting the energy transition entails subsidizing higher upfront cost sources to be more cost competitive with fossil fuels – the AI data center buildout has recently accelerated energy demand, in turn increasing demand for commodities
Re-Equalizing = record wealth inequality has buoyed populist and inflationary government spending policies

Powell took a victory lap in August at the Jackson Hole Symposium, claiming inflation has been defeated and “the time has come for policy to adjust”. At the September FOMC meeting, he followed through with a 50bps rate cut, citing the need for a “recalibration” of policy stance to sustain strength in the labor market. Powell seemed to be speaking out of both sides of his mouth. On the one hand, he seemed to suggest the labor market is truly weakening, citing the August payroll revisions, which effectively confirmed many suspicions that headline payroll numbers are not to be relied upon – more on that later. On the other hand, Powell reiterated numerous times the current strength of the U.S. economy, which begs the question – why is he cutting rates at all?! We believe the true reason is in service to the U.S. Treasury. Treasury Secretary Janet Yellen recently said, “It will be necessary to get deficits down to keep interest costs manageable”. We’ll give you our translation – “it will be necessary to get interest costs down to keep deficits manageable.”

For Illustrative Purposes Only

In 2024, interest expense on the national debt is projected to become the third largest line item in the government budget behind Medicare and Social Security. The chart above, based on a proxy for interest expense, estimates go-forward interest expense at nearly 6% of U.S. GDP – rising interest expense crowds out essential government spending. If we include Medicare and Social Security expense lines as mandatory spending (which they are), we find that “true interest” costs have risen to 129% of tax receipts.

For Illustrative Purposes Only

We believe this is precisely what has catalyzed the Fed’s actions, the intentions of which are not just to bring interest costs down but to keep tax receipts elevated by avoiding even a whiff of weakness in the economy or financial markets, the former now seemingly highly reliant on the latter. In the process, Powell is likely sacrificing longer-run inflation for short-term growth, seemingly revealing that inflation is not a priority for the Federal Reserve. This should not be a surprise, as we continue to repeat our assertion that inflation is a government asset, enabling the repayment of debts with dollars whose purchasing power has been debased. Any committee serious about “returning to a long-run average target of 2% inflation” would know that mathematically requires several readings below 2%. Instead, policy has shifted with inflation running at 2.4% in September – a number we think will mark the low for this cycle as inflation picks back up in the coming months due to worsening base effects and a rising commodity complex (thanks to record Chinese stimulus actions – the timing of which we do not find coincidental in this era of economic warfare).

We remain adamant about the dangers of long-term Treasuries, a theme we have been writing about feverishly since 2020. The following chart, which compares the return of both the stock market and gold to a long-term Treasury ETF (TLT), drives home our thesis that the government’s survival rests on these ratios moving up and to the right until the debt/GDP ratio returns to a reasonable level – hint: not anytime soon.

For Illustrative Purposes Only

We find ourselves in a scenario where the government cannot afford a crisis, and in our view, the Fed’s recent pivot is an admission of such. In the event of a deep recession, we suspect the required stimulus amount to be in the neighborhood of $4 trillion of additional Treasury issuance, for which there are likely no buyers other than our own central bank. Powell is choosing to support growth and accept inflation. We believe this is the kiss of death for long-term Treasury holders by letting the inflation genie out of the bottle more permanently. They appear to have not gotten the message, as term premiums remain well below the historical average.

Labor Market Intricacies 🕸️

“We’ll take confusing labor market data for $300, Alex.”

As we alluded to earlier, many market participants, including Jerome Powell, have questioned the accuracy of headline payroll data. This “jobs report” data is first printed by the BLS (Bureau of Labor Statistics) as an estimate based on surveys and various modeling factors. The establishment survey covers 120,000 businesses and government agencies, and the household survey captures approximately 60,000 eligible households. Two revisions are then announced at the time the following two months data is released, which accounts for late responses and more comprehensive data. Lastly, an annual revision takes place based on the Quarterly Census of Employment and Wages (QCEW) which covers ~97% of jobs and is based on unemployment insurance records providing a more accurate read on the job market. The QCEW report has multiple iterations, with the final revision released in February of the following year. In August of 2024, we received a preliminary QCEW revision for the 12 months ending March 2024, which showed a revision of 819,000 jobs relative to the reported figures (which had already gone through the monthly revisions).

For Illustrative Purposes Only

The result is a 31% decrease in the number of jobs added during the period versus what the headline data suggested at the time. This makes the job of the Federal Reserve quite difficult given their “data dependent” mantra – what use is data dependency if you can’t trust the data? We believe a key component of the divergence is something known as the birth/death model adjustment, which attempts to estimate job creation based on net new businesses formed in the period. The trouble is that “businesses” in the modern era are now far more likely to be much smaller and, in many cases, represent just a few jobs. Think of the explosion of Airbnb rental owners running their properties through LLCs or freelancers, consultants, and other gig economy workers doing the same thing – these do not create the same number of jobs as a wage-paying company. Even among wage-paying companies, we suspect employee size has been reduced thanks to technology platforms (cloud computing, software, etc.), which have enabled the existence of smaller firms. Take Lane Generational (us), for example – we could not have existed 15 years ago without the various technological advancements in the industry allowing us to run our business with fewer employees. The total birth/death adjustment to the period ending March 2024 was equal to 45% of the total jobs created, and 28% of these were in Leisure and Hospitality (we believe skewed by Airbnb) and another 23% from Professional Services (we believe skewed by freelancers, consultants, etc.).

For Illustrative Purposes Only

The gig economy may be impacting employment figures in other ways as well. We theorize the unemployment rate would be higher without the gig economy. Instead of driving their car to work, workers let go from their jobs can now drive around town picking people up and delivering food for the likes of Uber, Lyft, DoorDash, etc. An estimate from Flex, a gig economy trade association, puts the number of Americans who made money from these apps in 2022 at 27 million. Many use the gig economy as part-time supplemental income, but we suspect others use it to bridge the gap between jobs, which might be contributing to a low unemployment rate. This is sustainable so far as aggregate demand for these services remains high.

The constitution of employment has also been shifting. First, there is a stark difference between the growth of foreign-born workers and native-born workers. Since pre-pandemic (January 2020), the employment level of foreign-born workers has risen 16%, while the native-born employment level has flat-lined (+0.5%). Secondly, white-collar employment growth has recently stagnated but has been more than offset by strong growth in government and healthcare jobs.

For Illustrative Purposes Only

Given today’s market structure, we are focused on employment due to its feedback loop into financial markets. Regular readers will know our many comments on passive investment and its distortion of market structure. In short, the significant growth in passive assets under management created a momentum-based market structure where the big get bigger. A key contributor to passive flows is monthly 401(k) flows. The Pension Protection Act of 2006 introduced QDIAs (Qualified Default Investment Alternative), which effectively enabled human resource managers to pick a default investment for employees who had not selected a plan for their 401(k). In 2012, QDIAs were replaced by target date funds (TDFs), which operate by passively scaling down equity exposure and increasing fixed income exposure as a participant nears retirement age. Today, roughly 85% of U.S. workers who contribute to their retirement accounts use a TDF^[1]. This passive structure and automatic investment create a predictable and trackable “flow” into equities, with each paycheck now totaling $63 billion per month.

For Illustrative Purposes Only

Markets often reflect a recession in advance based on many leading economic indicators, yet employment is well known as a lagging indicator. However, we suspect these passive flows have created an interesting dynamic whereby the market may be more likely to ignore leading indicators (thanks to continuing employment-based supportive flows) and instead react only when employment finally does weaken. Job loss doesn’t just halt monthly inflows; it often restructures portfolios more defensively to weather the storm, which amplifies the effect.

As we’ve highlighted, it’s quite hard to discern the true state of the labor market. We believe it’s weakening in specific segments, and over the long term, we are most concerned about Artificial Intelligence’s ability to displace labor. We wrote at length about AI in last quarter’s blog post, the summary of which is Amara’s law – markets may be overestimating the new technology’s impact in the short-run and underestimating its long-term influence – is likely at play.

The International Longshoreman’s Association (ILA) port strike made headlines this past quarter. Aside from demanding higher wages, the union defended against automation at the ports. We believe this is a microcosm of what’s to come in the wake of AI. In just a decade, AI should be capable of automating many knowledge workers’ jobs, particularly repetitive tasks with static distributions. This will likely be a major headwind to the labor market, and we are already seeing its early impacts as many companies have made layoffs citing increased efficiency due to AI – this is likely just the beginning of a multi-year trend. In light of the ILA strike (and its positive outcome for workers), this begs the question – will we pay workers more to work less (to keep up with the systemic inflationary cost of living), or will workers be out of work? In any case, AI is a major deflationary force that governments will be forced to fight with more monetary expansion, further strengthening the case for continued currency debasement.

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Sources:

Unless otherwise noted, all financial data is sourced from Refinitiv Data or Federal Reserve Economic Data (FRED).

^[1] DiMartino-Booth, Danielle. The Bearable Weight of Being. The Weekly Quill. August 2024.