Last updated on March 7, 2023
Barry Knapp of Ironsides Macroeconomics rejoins the podcast to discuss his surprisingly sanguine view of the economy in 2023: Why cyclical stocks should outperform the technology and defensive sectors, and why he’s expecting inflation to drop to 3.5% by the second half of the year.
Content Highlights
- Inflationary recessions are different from deflationary ones. The last four were the latter. If there is a recession this year, it will be the former (02:18);
- Earnings downside is limited in this scenario, by 5% based on what happened in similar situations in the past, and earnings should actually go up (5:56);
- Tech margins should continue to be under pressure but economically-sensitive cyclical stocks should see margin expansion (10:50);
- The US labor market has actually started to weaken considerably — and not due to Fed policy (12:18);
- There have been some big adjustments in the labor market post-pandemic (16:47);
- The ‘wealth destruction effect’ from tech stocks selling off is negligible (27:35);
- One point of concern: the deficit. This is where the implosion in wealth could affect things (32:59);
- The coming budget battle in Congress is worth paying attention to (34:41);
- The ‘higher for longer’ Fed interest rate hike thesis has gained traction. What this means for stocks (43:27);
- Inflation: Expect 3.5% CPI by mid-year (47:37).
More Information About the Guest
- Substack: Ironsides Macroeconomics;
- Twitter: @BarryKnapp.
Not intended as investment advice!
Quick Video Highlights
Transcript
Nathaniel E. Baker 0:36
Barry Knapp, of Ironsides Macroeconomics joining us from Vail, Colorado. Thank you so much for rejoining the contrarian investor podcast today. Great to have you here. And you are the traditional curtain raiser or have become that for the outlook for the calendar year. And we are now one trading day into 2023. The end of 2022 wasn’t great. There’s a whole bunch of economic concerns kind of clouding the picture here. So very curious to get your views here on what exactly you expect will transpire in the economy and markets in 2023. The first question is recession, yes or no? Painful? How much? And when?
Barry Knapp 1:22
So within the spirit of the title of the podcast, I figured I’d I try and give my comments within the context of what I’m hearing generally from the street from other strategists and investors. I’ll begin when you ask the question about recession with this idea that it’s phrased and responded to far too generically as if all recessions are similar. And quite frankly, the last four, if we include the pandemic, at least initially were significant credit contractions, even balance sheet recessions, the 1991 recession was a function of the commercial real estate market collapsing changes in tax laws, tighter monetary policy, and commercial real estate collapsed. In 2000. As we know, that was the tech bubble bursting. And it wasn’t all equity, a lot of it was financed through banks to build out the internet infrastructure. And that was in weekends like Worldcom and global crossing. And again, that became a credit issue, there were problems in the banking system that lingered all the way into 2002. And then, of course, we know 2008 2009, when my Lehman Brothers went out, was surely a credit contraction. But the reason I bring all this up is when you contrast it with the recession in 1970, the very deep recession in 7374 1980, recession or 8182, when I began studying economics, those occurred during inflationary periods. And the key point of differentiation between those recessions. And the ones that followed, including the pandemic recession was that nominal GDP did not contract during those recessions, it continued to rise. earnings, of course, are nominal. And so the earnings contractions, even in that deep 7375. And 8182, very deep Volcker recession, were only 13% declines in s&p 500 earnings. The other two were less than that. And another key point of difference was the 60s was a period of very strong investment, particularly in physical structures, investment grew non residential fixed, fixed investment grew at 10% for the entire decade. And so when that recessionary contraction hit investment came down, and that that pressured earnings and corporate results as well left companies with a lot of excess fixed asset investment. None of that’s the case today. In fact, the numbers that came out yesterday for construction spending show investments now surging even as recession looms, because we under invested in our capital stock for two decades, as we outsourced everything. So we’re in a very, very different backdrop, as a consequence of this likelihood that nominal GDP will not contract even if we do have something that the NBR ends up qualifying or characterizing as a recession. I would characterize or estimate that earnings downside is limited to 5% or so, which is about how much it went down in 1980. And that’s a very differentiated differentiated point of view. I don’t I don’t actually think earnings are going to go down next year. I think they’re actually going to go up because we’ve already weathered the marginal cost margin. no revenue input output storm?
Nathaniel E. Baker 5:03
Well, that’s a contrarian view right there. Should have led with that!
Barry Knapp 5:09
And one of the ways to think about that the pressure is, so we went through what I would describe as the largest inventory cycle since 1949. In the aftermath of World War Two, we did have a huge inventory, restocking and then destocking cycle, in what I’ll call the Truman recession, when he was reelected with a campaign platform even further to the left of Roosevelt’s it was the fair deal. Anyway, you had collapsing business confidence, you had a big inventory, contraction dropping investment, that was the weakest investment we’d ever had post world war two recessions. But anyway, not to belabor that one, we had this incredible inventory, drawdown during the COVID recession as a percent of GDP. We all know why that happened. And then we had an absolute surge in inventories. In the first part of 2022. The import numbers in March, were the biggest ones I could find since the 60s, that then led to Walmart and Target having truckloads of excess inventory in their parking lots. And at the same time, we were having this adjustment from goods to services spending. So I’ve trended spending for goods and services and overall consumption back to mid 2014, which is when the deleveraging associated with the global financial crisis and the how access of household debt really ran its course. And consumption went from averaging one eight in the first five years of the recovery to 3% for the next five, which is close to the post world war two average. So if you trend from there, what you find is that goods consumption now is back on the trendline. And it looks like that adjustment is complete. The inventory investment as a percent of GDP is back on its longer term trend line. And services spending is still some $240 billion above trendline. I wouldn’t assume that’s immediately coming back to trendline. Because government transfers as a percent of GDP are at all time highs, and are not coming in this year, which the in this omnibus spending bill is not going to ease back on that. So that’s a key part of my thesis too, is that consumption is not about to fall off a cliff because consumers run through their savings that transfer payments are so big, that it’s likely to continue a pace. So if you if you put all those things together, and then you look at prices paid and prices received from the various fed regional Fed manufacturing surveys, they both were surging at this time a year ago, but the spread was quite wide so that widespread meaning prices paid were much higher than prices received, put pressure on margins. And that was evident in some sectors, although that’s not the whole story. Because if nominal revenue growth is up, fixed costs are fixed. So you have operating leverage. And if you look at the industrial sector in particular, you can see how that whole process played out. In over the last couple of months industrial sector margins have been stable and look like they may very well turn up because that spread between prices paid and prices received has collapsed to the lowest level since early 2016. After oil prices collapsed, China had a heavy industry hard landing, and then margins took off in 2016 and into 2017. So to me, it actually sets up where the storm for goods producers in particular has already passed. But the whole origin story isn’t really as homogeneous as strategists would like you to believe banks had some hits the margin last year because of changes in accounting standards and the fact that their loan growth surged. So they actually took their cash holdings down. They took their securities holdings down and low growth went up. So net interest margins are starting to really expand net interest income is expanding. So yes, the banks have to take reserves, which made it look like there’s pressure on their margins. But the credit is clean and it’s likely bank results will be much better than expected. Tech margins will probably continue to be under pressure. But economically sensitive cyclicals margins are probably going to go up this year, unless there is this just collapse in aggregate demand that some are looking for because the Fed has tightened but I don’t see any evidence of it in part as I said, Because of transfer payments. You know, if we step back just for a little bit, and we think okay, monetary policy works through asset ISIS, so it primarily creates asset inflation. consumer price inflation is a second order effect. Even within housing, there’s two effects, right? There’s the asset price of your house. And then there’s the rent service costs. So fiscal spending works directly through consumer prices, and there’s no slowing of the fiscal impulse right here. So thinking that somehow the Fed is causing this big collapse in, in demand, and really, is the reason why inflation is starting to slow is spurious, in my view. And we can come back and talk about the inflation outlook a little bit too. But, you know, when you when you realize that the fiscal impulse is still positive, and this is what happened, actually did happen in the 70s, it was not the Fed stop start, it was actually a fiscal impulse. So okay, I’ve gone on a bit.
Nathaniel E. Baker 10:57
Yeah, that’s a lot to start. But let’s, I mean, I guess one of the things you didn’t mention, which is kind of underlying all this strength, I’m assuming is the labor market in the US, which, as you know, is very healthy and cannot continue in the face of higher interest rates and businesses having to, you know, the cost of borrowing, increase in creasing and things like that. Is that not not a concern?
Barry Knapp 11:24
Well, first of all, I don’t think that the labor market, I think the demand for the labor for labor has has weakened considerably through the course of the year. And then I don’t attribute that to Fed policy, so much I attributed to this rebalancing process that’s taken place. If you
Nathaniel E. Baker 11:41
hold on, all the employment figures are positive, like if you look at a non farms and the initial claims and things like that. So —
Barry Knapp 11:50
I’ll disagree with what you said.
Nathaniel E. Baker 11:52
Okay.
Barry Knapp 11:52
Reason I will is the establishment survey has been strong, no doubt. But the establishment survey, I think, is overstated. There’s a couple of reasons to think that one is the Philadelphia Fed did some analysis using state level data to estimate what they think the benchmark revision will be to the establishment survey, and they came up with a million last jobs in the second quarter of last year, if there was a million last jobs in the second quarter, there was some about less than the third quarter. So part of the problem is a big component of the establishment surveys, the birth death model that estimates small business creation. And there has been, it’s one of the curious things about the pandemic is that the government started releasing this new weekly report of employee identification number applications as a proxy for new business creation. And it’s double what it was pre pandemic, but we don’t know how many of those businesses are going under. And so that’s what’s estimated. And that could be the source of, of the reason why Job Creation isn’t as strong as the establishment survey believes now, the household survey has been much, much weaker, even in the last few months, there’s a million job differential between the establishment and a household survey and the household survey. It’s not perfect, they’re calling people up. But it’s actually consistent with what we’re hearing from the Conference Board with their labor differential when they ask people are jobs plentiful or our jobs are to get the jobs plentiful. Measure has come down some 10% or so from Peak. Also I look carefully at flows in and out of the labor market. Those swamp the net change. So flows from employed to out of the labor force surged over the last couple of months from employed to unemployed surged over the last couple of months. And then you mentioned jobless claims, that initial claims numbers are likely distorted by problems with seasonal adjustment factors. When you have big macroeconomic events like we had those adjustment factors get thrown off, the government changed them in 2021, to try and account for things like well, people really weren’t going back to school, because in September, that’s this. That’s the lowest point for unseasonally adjusted claims. The highest point for seasonally adjusted claims is right now and they lay off seasonal workers. Anyway, that number, those numbers look a little distorted. But that continuing claims numbers have gone up from 1.3 5 million in September to 1.7 1 million during the establishment survey week in December. So they’ve had a pretty good, pretty good rise there. So, you know, you put all those things together and you think, okay, demand is softened a fair bit. And I have measures of labor market slack. I have 18 different measures I put into an index based upon a speech that former Fed Chairman Yellen gave And then Powell gave a similar one and they pointed all these little various indicators that peaked in March, nonsupervisory, average hourly earnings peaked in March. That’s loosened a lot back to where we were pre pandemic. And I think we just have this big adjustment going on. And there’s been some significant changes in the structure of the labor market to, for example, leisure and hospitality employment is well below where it was pre pandemic. But yet, if you look at aggregate sales for restaurants listed in the s&p 500, they’re 20%. Above. So guess what they did? They substituted capital for labor made you order on an iPad? Right. So margins are up. So there has been some some changes, some adjustment. I think that’s a lot what last year was about, I think the aggregate demand is soften. And importantly, I think the Fed tolerance for weakness in the labor market is a lot less than is perceived. I’ve sort of said this a couple of times, including on CNBC, that a 4% unemployment rate and the inclusive employment, members of the Federal Reserve, the FOMC, will come storming back, right? So
Nathaniel E. Baker 16:15
4%, because it’s like 3.7. Now, isn’t it? Right?
Barry Knapp 16:18
Right, and 4% is actually consistent with where that labor differential from the Conference Board surveys, and there’s similar surveys, right. So it’s not going to surprise me when we get to that we aren’t gonna get the benchmark revision to the household part of the survey on Friday. So that should be interesting. But anyway, I think labor demand is has softened, I don’t think, you know, we’re headed for this huge move in the unemployment rate, nor do I think it’s necessary. We didn’t, this wasn’t caused by a wage price spiral. And the Fed can’t really fix this, as long as those government transfer payments continue at the level that they’re at. Right. I mean,
Nathaniel E. Baker 16:57
how much does the jolts factor into your prognosis, prognosis at all into your models?
Barry Knapp 17:02
So yeah, I looked at the openings versus, you know, the vacancies. So openings versus employment measures that Waller gave a speech about, it’s the so called Beveridge curve, and this idea that we could reduce those job openings, and still not raised the unemployment rate. And he’s not far off. Although when you look through where the job openings are, there’s areas like health care, health care had 500,000 Excess jobs, pre pandemic, now they have more than a million, and those jobs aren’t getting filled. They’re just a lot of home health care kind of jobs. And that’s just going to remain the way it is. I suspect, manufacturing openings surged, those are coming down. We could talk there was a that. I talked earlier about this inventory cycle. For me. That’s why we had we’ve having a global manufacturing recession, but I think it’s just about run its course, and ism, manufacturing will turn up sometime in the first quarter, the world looks like it’s bottoming around a 4647. It’s unlikely we have a deep manufacturing recession. We had one in early in the early in 2018 2019, during the trade war, and having another deep one seems unlikely. But anyway, you know, when you look through where those openings are, yeah, there’s some scope for those to come down. But there’s other stuff that’s kind of structural, as I said, like health care, for example. But where I really like the jolts data is looking at the dynamism of the labor market, that turnover, or churn of the labor market. So it’s hirings plus separations as a percentage of the workforce that actually can drive real wage growth or sustainable wage growth over time, right? If people go, if we have a dynamic labor force, which we didn’t through much of the early 2000 and 10s, in the aftermath of the global financial crisis, if we have a labor force where people can go get jobs because they can work remotely or whatever, ultimately, they’re going to be more productive. And productivity, I think, is part of the missing story. Most people assume because they look at GDP numbers, which I think are terrible, much prefer gross domestic income data. I think productivity is actually going to improve, not deteriorate, and it has been improving. It’s just masked by this massive inventory cycle that caused a big negative contribution from net exports and then a negative contribution from inventories. And so in fact, productivity is going up not down because of this turnover, dynamic interest dynamism in the labor force.
Nathaniel E. Baker 19:49
Speaking of that, on the last thing on the on the jolts, did you look at it quits levels because it’s something that Jay Powell has cited in his current reign is
Barry Knapp 19:57
I do well, it’s part of the separation stories. So So, when you when you think about separations, you could sort of, and I, I’ve done this analysis to look at good turnover versus bad turnover, right? It means Yeah, you have separations because people are getting laid off. It’s not quite as good news is because people are quitting now. Exactly. You said, I think that’s one of the things that the Fed gets wrong, though is they say, Okay, well, quits, are going up. That’s bad, right? Because it drives wages up. Now. That’s wrong, actually. Because ultimately, that will lead to productivity over time. Right. So if you another way to think about this is if you look at the Atlanta Fed wage tracker, they have a couple of really good measures in there, they have job switchers, versus job stairs. So that’s sort of a measure of quits that are people leaving because they’re going to get another job. And what’s that? What’s the reward to that if that spread goes up, which it’s at historically high levels, or just off the historically highest levels, since that series began in the late 90s. Well, sure, that drives wages up in the short run, but it’s also likely to drive productivity up over time. They also give you income by quartiles. And so the bottom quartile wages are going up by relative to the top wage quartile by the highest percentage, again, since that series began, that probably doesn’t carry positive productivity with it. Right? If you’re, you know, if you’re going out and you’re just hiring anyone, because you need bodies, you’re probably driving productivity down. So wages are going up because of scarcity, and then lack of supply, then that will probably be productivity negative. But if people are, if the labor force is dynamic, people are quitting and going to get jobs they really want. That will probably carry a positive productivity dividend. And I say probably, but we actually did see this. After the end of extended unemployment benefits at the beginning of 2014. When we had to five years into the recovery, we had the most dynamic biggest increases in labor, supply, demand and and supply, we had a huge increase in the size of the labor force, the low end got pulled up, everything happened and real wage growth went up. Right, it didn’t really push through inflation. It didn’t matter for consumer price inflation, but wage growth went up. And productivity went up too. So okay, that to me is the model. They’re
Nathaniel E. Baker 22:31
very interesting. Let’s go back to the demand side, though, before we got sidetracked by labor market, the demand. Yeah. And so you think this can hold up? Because we just had a story yesterday, Apple is cutting production, they say due to demand? Who knows? But is that not a concern? Granted, that’s just one company in the whole scheme of things. But consumption of iPods, iPhones is obviously a big thing. One would think,
Barry Knapp 22:56
well, yes, of course. That’s what last year was all about. And I think we’re we’re coming somewhat towards the end of that process, the rebalancing of growth, or goods versus services, right. And that’s why I said, goods look like they’re back to the trendline. You know, but again, it’s it’s not necessarily homogeneous story, that people over binge on phones and that sort of thing. Yeah, they probably could very well have. That’s, that’s likely. I’m, I’ve been negative on tax since the summer of August of 2021 2021. And I continue to be negative on on tech. And so we can talk about that, too. But
Nathaniel E. Baker 23:48
yeah, well, I mean, that’s, I mean, if you have all these things like that are going down, I mean, if tech keeps falling apart, I mean, what was the NASDAQ down last year? 30%. You know, if that if you have this wealth, destruction going on, and we haven’t even talked about the crypto industry yet, which we can maybe touch on. But but all those all that wealth destruction, won’t that have an effect economically?
Barry Knapp 24:12
Oh, that’s a great question, actually, because I’ve written a fair bit about wealth effects. So this this, this fascinates me. And as much as people think that, you know, Powell and the FOMC committee is really focused on where the stock market is. So So here’s the math, right. household net worth, and by the way, this is important within the context of the broader story of what happened in the aftermath of the global financial crisis. So, financial crisis, household net worth in the US was $71 trillion. Roughly before the financial crisis began at peak, it dropped to 59 trillion. So 15 16% hit, it didn’t recover until the third quarter of 2012, house prices didn’t recover until 2018, your prior peak stock prices into 2013. So you had this massive hit when we talked about a Fed put in the aftermath of the global financial crisis. There was a Fed put to some extent and as much as they needed to protect household balance sheets, because household debt was at all time highs, financial obligations ratios, meaning the percent of disposable income that went to interest payments were at all time highs, and balance sheets had gotten seriously impaired. Well compare and contrast to what happened during the Cold War. During the pandemic, we went from 117 down to 110, in the first quarter of 2020. And then we’re above it by the end of the second quarter, then we went to 150 trillion. We’ve taken a $7 trillion hit. So we’re still 22% above where we were pre pandemic. So I argued, you know, this time a year ago, they were fed put was strike was a lot lower. And it BAM, right, they had no need to try and protect household balance sheets. The other side of this coin, though, is this is the least efficacious to use a Fed word, way to try and slow growth. Because if you if you do the math, based upon things like the landmark case, Shiller study on wealth effects, it’s three to 4% of the change in wealth over a two year time period. So 7 trillion times three, or four divided by two divided by nominal GDP is 50 basis points of nominal GDP per year. That’s it. So that’s, that’s what the dramatic decline in the stock market did to consumption was probably accounted for a 50 basis point off nominal GDP hit this year. And next, it’s just not that big a deal when nominal GDP is growing at 8%. So
Nathaniel E. Baker 27:06
okay, okay. But I mean, if that happens, and if the whole VC thing dries up, maybe 2000 is a good comparison for this, because that was when we saw a similar implosion in tech, and what that did to the labor market every study that and looked at that, and
Barry Knapp 27:20
not so much the labor market, because I think that would be an exercise in futility. There’s just not that much employment related to it. But what it does for the deficit is a big deal. And that’s an interesting story, where I’m not going to sound quite as sanguine just sounded on the aggregate economy, because there’s a there’s an A. So the story is that when? Well, let me just step back a little bit, there’s an empirical observation known as housers law. And all housers law says is that, regardless of the structure of the tax system, you’d have a 90% top marginal rate or 28%, top marginal rate, the government collects 17 and a half to 18 and a half percent of GDP. In tax receipts, there’s two years where we got close to 22,000, we actually got 20% of GDP. And last year, we got 19.8 was the biggest prints. Well, in 2001, it dropped by 1.1%. The CBO projects that it’s going to drop by a percent this year. Spending, however, is in those days was only 70% of GDP, we’re actually running surpluses, well, right, right now, spending is 23.8% of GDP and not headed down, based upon the deal that McConnell just cut with the Democrats and the omnibus spending bill for 9% or 10% increase in defense spending. And it’s six but it’s really not six because there’s another 40 tossed on more like a percent discretionary spending. Plus, we know that all the mandatory spending stuff is accelerating because of the big security cost of living adjustments and so on and so forth, though, we’re gonna have a much bigger than likely expected deficit next year. And that’s really where the implosion in wealth is going to affect things. So you think what what asset will struggle as a consequence of that stocks or bonds? Yeah, well, the treasuries because we’re gonna have to weather all that supply with much weaker foreign demand than we had in those days twos.
Nathaniel E. Baker 29:37
Yeah, but I mean, the deficits been growing since 50 years 60. How long forever. So what’s another couple trillion among friends right?
Barry Knapp 29:48
Now it’s going to be among friends They’re not going to be friends in Congress. I can tell you that because if you think to what happened in 2011, you know, we’re setting up for something similar this go around and as much as you We are, presumably will get a speaker that house sometime soon. And this is going to be an unbelievably strong point for the Republican Party to fight the Democrats on. And they although they cut a deal on the on the spending for this year, they didn’t cut a deal on the debt ceiling. And so there will be a battle coming, because it’s a strong selling point for the Republicans that all this spending is the real cause of of inflation. And, you know, I’ve illustrated how that could be. So earlier by talking about all these transfer payments, being at all time highs, by the way, when you look at those transfer payments over time, the periods when they were stable, like under Reagan or under Clinton is when inflation was low and stable. And when it was rising is when inflation started to go up. And believe it or not, it was actually stable for most of the Obama era after that big budget fight in 2011. So there’s a budget battle coming. And that’s going to be an issue for financing of, of debt and death.
Nathaniel E. Baker 31:03
When is that happening?
Barry Knapp 31:04
That’ll get started. Presumably, in that first quarter second quarter? I, my understanding, last I saw is that the Treasury can probably keep they will run through their extraordinary measures till probably about mid year or so. And that’s when we’ll have a real.
Nathaniel E. Baker 31:24
Okay. So that’s one of the things that you’re that you’re watching as far as a potential hiccup, but you don’t see the demand picture that consumer unemployment, and all that really presenting a concern quite yet.
Barry Knapp 31:37
Correct. If we just step back in the economy and say, All right, well, let’s look at the big components to GDP. And as much as I still say, I don’t really like the GDP figure I prefer aggressive domestic income. But that notwithstanding, consumption is likely to remain fairly robust household balance sheets are the antithesis of what they were, after the global financial crisis, we talked about household net worth sure it’s taken a little bit of a hit. But it’s 22% above where it was pre pandemic financial obligations ratios, the cash flow that goes to service debt is at the lowest level since the Fed started measuring it in 1980. So household balance sheets are in great shape transfer payments are strong. Unless the labor market I’ve described, demand is weakening for labor, but we know there’s excess demand over supply. So it’s unlikely you get a big collapse as a consequence of the labor market falling completely apart. We’ve gone through the big inventory, destocking cycle, manufacturing has likely run its course, housing is another question. I think it’s got further to run. And we could talk about that, because I’ve done some work, I think is pretty unique on that.
Nathaniel E. Baker 32:46
But yeah, that we do think housing. I mean, it’s been dropping.
Barry Knapp 32:50
Yeah, we just table that for a second and finished my broad summary and I’m gonna come back to housing. And then we have capital investment. And I can generally mentioned earlier how capital investment is surging on physical plant and structures, bottom up s&p 500 capex keeps going up. It was already 40%, above stock buybacks as much as people say, you know, companies are just buying back stock not investing. That wasn’t true pre pandemic. It’s not true now. But capex looks really strong. And there’s a big broad case to rebuild our manufacturing base to rebuild our capital stock. And and that’s a secular story that I think will persist through any marginal downturn, particularly if I’m right, that nominal GDP is unlikely to contract. Right. So yeah, yeah. And, you know, we’re, we have a lot of economic momentum. So the housing story here is, here’s my my work on that, that I think is pretty unique. So back in 2011, I created a correlation matrix of the 20 cities in the Case Shiller House Price Index. As a way my Bayesian prior at the time was to try and prove that excess inventories in Vegas were no longer impacting prices in Phoenix. Or another way to think about this is recourse states versus non recourse states. Were no longer we no longer had this homogeneous, just decline in house prices. That correlation was starting to fall apart. And it did prove that and it you It allowed me to call a bottom and housing in 2011. When we were going through that debt ceiling debate and downgrade. I was actually quite bullish at the time. And it was a pretty good call for me when I was Barclays equity strategist was, yeah, listen, housing is is bottoming here and that is going to set the stage for a big recovery in the economy and forget all the shenanigans in DC. And, and that was a good call at the time. Well, fast forward to 2021 house price correlation of those 20 cities went to point nine seven, India January and stayed there through October. So I’ve heard Fed officials, including Governor Waller characterize the boom and house prices as primarily related to the pandemic and people’s desires to work from home and have bigger houses and home offices. That’s bull. That is complete bunk. You don’t have a point nine, seven R squared against across 27 heterogeneous cities in this country for any reason other than the Fed bought a third of the mortgage market and drove the spread of mortgage rates to treasuries and the absolute level of mortgage rates to all time lows. That’s how you get a point nine, seven r squared. And of course, once they stopped, that correlation collapsed. Now, as it turns out, right now, correlation is surging because all 20 cities, house price charts are going like this. But in the latest month, in October, when mortgage rates peaked, house prices fell about half as much as they were expected to fall, they were supposed to fall 1.1%, and they only fell a half a percent. So I started looking through all 20 of those charts. And I found that in 12 of the cities, the growth rate of house prices is back to pre pandemic levels. So the activity level activity data for November. And house price data is a little stale, right. But that activity level, data for November was still weak. The Fed is impaired both supply and demand. Remember though nhp surveys gone from 84 to 31, single family housing starts are down almost, you know 35% or something. But it could be this house price data is starting to get to a point where we’ve wrung out a lot of the excess. So I don’t know the builder stocks act like yeah, we’re making the bottom here. And we’re running into core demand from, you know, millennials forming households and that sort of thing. And we know that the level of household equity is its best level since 1959. So we’re not really worried about the household sector getting crushed by the low slowing house prices might be a little bit more worried about Blackstone and star with Laci can buy it, although there’s no real mechanism for them to get crushed, per se. I think this is important to realize that a lot of what QE did during the period was what I would describe as malinvestment. It didn’t create excessive debt necessarily. But a lot of people are going to have really subpar investments for a long time. I mean, if you put your money and be read, God bless you. Yeah, I think you’re gonna wind up with a pretty lousy bottom return over time. So, yeah, that’s that’s where I come out on that. So housing is, housing is really interesting here, because, as I said, that correlation number is still going up because everything is falling, or slowing. By 12. The cities are back down to levels that they were at pre pandemic, and the process is incomplete. But who knows if it could be complete sometime in the first half of
Nathaniel E. Baker 38:18
what are the the new supplies doing? The, you know, the new new construction and the building permits?
Barry Knapp 38:26
I mean, therein lies the issue with monetary policy. Right. It’s it’s it’s a blunt instrument. Yeah, they wanted to weaken demand, but they also crushed supply. So yeah, they caused this excessive investment, and now they’re causing, they’re impairing the supply side. And it was already an under supplied housing market. Well, that’s the good news in the bad news, right? I mean, the good news is that you don’t have a bunch of excessive investment, you’re not going to have a whole bunch of builders go under because there’s still there just wasn’t excess supply. When you look at if you look at new home supply, as a, you know, months, the number of months, there are, yeah, it’s up at the higher end of the range, maybe seven, eight months, but existing home sales, which is more than 10 times that number, it’s still at three months. So there’s just not that much housing stock out there. So we will run into a floor before too long, just in terms of coordinate and hopefully, you know, a level of affordability for those forming households because household formation is strong. Right now we have the biggest age cohort that we have in key household formation.
Nathaniel E. Baker 39:36
Right. Interesting. Okay. So good stuff there, too. Let’s turn to the Fed and the time we still have here knows the Fed pivot. Do they blink here? What will it take? What are they going to do in the first couple of meetings? Yeah,
Barry Knapp 39:52
it’s interesting after the September meeting, when they had that very hawkish dotplot they caused financial in stability, right we, the next morning, I was in New York and had a dinner with clients at sparks steakhouse is pretty fun old school on the night of the Fed meeting. And, you know, my call was, listen, this was super hawkish. And the first shoe to drop on this is going to be dollar yen walked in the next morning, and the Japanese had intervened to the tune of $21 billion of yen. That Sunday night the pound flash crashed. It was not the trust government plan. That’s who we it was. It was the Fed. And the reason here is that the dollar has become a Petro currency. And the two most vulnerable economies were Japan and the UK because of their oil imports. And the fact that they don’t run current account surpluses like Germany and China do, and their currencies went in freefall. On Monday morning, the mortgage market went into freefall, mortgage REITs, were down 10%, that day REITs, the whole Fannie and Freddie paper, right? So they the Fed almost broke the mortgage market, they went too far. And that’s what forced them to slow the path right and slow the pace of rate hikes, that’s still a lingering potential source of risk, is the fact that mortgage spreads are quite wide fixed income ball is quite high. You know, they push too hard, and they can be right back in the same position. But what’s interesting relative to the DCE meeting, is they tried the same trick. You tried to use the dot plot as a form of forward guidance to convince the markets like the professor and Animal House, I’m serious. This is my job. I actually have that line on my Twitter profile. I like it’s so much right. I’m not kidding, this is my job, right? But this time the market said Mac, we don’t believe you, right. And the way to think about that is look at two year treasuries. They’re at 433. The Fed just told you they’re going to 510 and the markets like now you’re not and 433 is only a tick above where they are now. So the market is basically saying you’re not getting to 510
Nathaniel E. Baker 42:17
but the stock market kind of has been selling ever since. What’s that the stock stocks have been selling ever since that December meeting?
Barry Knapp 42:23
Well, the stock market is what I think the stock market is reacting to. And by the way, if you break the stock market up into three broad categories, cyclicals, defensives and ad tech and tech related the tech and tech related is what is leading the market down over the last three months really since that September meeting. industrials are up 15% materials are up 15% energy’s up 20% builders are up 20%. So the market is agreeing with me that the Fed is kind of run its course and the manufacturing recession has run its inventory recession has run its course, but they are starting to buy into the Fed higher for longer thesis. And that’s what is a problem for tech valuations and will ultimately be a problem for defensive valuations too because the defensives and tack are still expensive. cyclicals are cheap, there’s your opportunity, right, because at eight or nine times earnings for tack and 11 times earnings for Financials. If I’m right, and we don’t have some big economic shoe to drop that those, that’s where you’ll make money in 2023. And then the outperforming 2022 as well. So I think the market is buying into the higher for longer. But by the way, we haven’t talked about this. That is my call, actually, is that inflation, the path from nine to four, actually nine to three and a half now is very clear. And inflation will be at three and a half percent by mid year because goods prices are coming down. Because it’s only a matter of time before the shelter, rent of shelter comes down. And even the services less rent of shelter numbers. Those have been zero, the last two months. I think Powell is wrong about what causes inflation in those categories. But that notwithstanding, those comparisons are point eight, seven on average monthly changes for the first six months in the year. So that’s gonna go down as well. And we’re gonna find ourselves at three and a half percent at the middle of the year. But then because of the fiscal impulse I’ve talked about earlier, I expect it to stall. And so when I submit to Steve Liesman CNBC survey, I have them stopping well below five to five and a quarter, but then potentially hiking rates in September and December of next year. Small hikes, but I don’t have any rate cuts penciled in. But I also believe and this was a big contrarian view of mine a year ago, that the natural rate, if you will, the terminal rate that the economy could withstand was not two and a half percent, like in 2018. There were two exogenous policy factors, then the tax cuts and Jobs Act, which caused a one year adjustment in the housing market and the trade war. But the true natural rate that the economy could withstand was was more like four. And that’s about where we are now. And I think the economy can operate just fine at this level. And I look at, you know, bank credit creation in small banks, and see that being robust still, even with rates up at these levels. And the core demand I’ve talked about capital spending. I think the economy can operate at this level, so I don’t I do not see this as being excessively tight. I heard a strategist on CNBC this morning saying this we’re already too tight. I just we weren’t for you. We were too tight for the UK. We were too shy for the BOJ and you know, the rest of the world and and we were raising too rapidly, but I don’t I do not think this level that we’re at now is a level that will cause economic activity to crumble in the US.
Nathaniel E. Baker 46:19
Okay. Very interesting. So long cyclicals short tech, anything else here?
Barry Knapp 46:26
defensives are going to are going to underperform defensive underperforming ridiculously rich staples are rich utilities are rich. That’s awesome. Pretty hide out in that stuff when markets under pressure. But yeah, and those usually stocks are just expensive.
Nathaniel E. Baker 46:45
So there’s that? Yeah. Wow. Okay. Very cool. Awesome. Barry Knapp, thank you for all this maybe in closing tell us we have the sub stack Ironsidesmacro.substack.com. And your Twitter handle, which is @BarryKnapp. It’s simple enough. Those are the main two areas,
Barry Knapp 47:05
Yeah. So there’s, there’s some, there is my sub stack. And these weekly reports that come out, along with some inner week reports. They’re, you know, 2500 words or so with eight to 10 charts and tables. And it was really, it’s really institutional level research, but I’ve tried to make it a little more approachable for Wealth Advisors and sophisticated individual investors. It’s $1,000 a year, $89 a month for that product. It also comes with a weekly podcast summary summarizing the notes. Some people like it, even my brother says it helps him clarifies things. Yeah. And then for the the institutional clients out there, if you have any institutional followers hedge funds in the likes, I have an affiliate relationship with macro risk advisors, Dean carnets, equity derivative based in cash equity trading broker dealer, where I consult with them for clients that still want to pay for research the old fashioned way, and we create some specific products on that as well. And that’s kind of fun, because my origins in that business, really, I spent 15 years in equity derivatives at Lehman Brothers. And so that’s sort of an area of expertise parties for me, as well as thinking about how you implement these themes in ways, you know, interesting ways using using derivatives so very cool. So that’s, that’s, you know, that’s the business Ironsides. macro.substack.com To find me and out there on Twitter even got a blue checkmark just for the heck of it.
Nathaniel E. Baker 48:41
I have that too! Very cool. Awesome, Barry. Well, thank you so much for rejoining us and giving us this very contrarian outlook for 2023. Thank you all for listening. And we look forward to speak to you again next week!