Crossroads: Marco Edition January 2023

In this edition, our teams explore the macro landscape, including

A look back to December 2022
A look into the near-term outlook
A look ahead into 2023

Inflation, recession, Fed pivot, unemployment, crypto. We got it all. Check out 7Investing here.

December 2022 and January 2023 By the Numbers

Inflation

Inflation reached a peak in June 2022 at 9.0% YoY. In December 2022, CPI registered 6.45%. decreasing for the fourth consecutive month.

As can be seen in the chart below, the month-over-month inflation rate tells a tale of two halves. H1 2022 = stark, consistent increases in inflation. H2 2022= less severe, more variable and even disinflation in December!

Part of the disinflation experienced in December 2022 can be attributed to these November statistics:

Retail sales declined by 0.6%
Internet sales (-0.9%).
Furniture and home furnishings (-2.6%)
Automobiles and parts (-2.3%)

Unemployment

The Fed must perform a balancing act in determining how soon and by how much they can boost the Fed Funds rate without plunging the economy off a cliff and into a recession, as rising interest rates often reduce economic growth and employment.

Surprisingly resilient labor markets persisted throughout 2022, with unemployment falling to a post-COVID low of 3.5% by year's end. At just under 3.5%, US unemployment has ticked down to its lowest level since 1969!

Employment growth permits the Federal Reserve to continue increasing interest rates. Ironically, solid job statistics over the past year has prompted expectations that the Fed will have more capacity to raise interest rates, which has had a negative influence on valuations. But don't tell that to the tech companies!

However, there are signs it slowing. New jobs added in December were down, and average weekly earnings have plateaued while the average hours worked per week is on the decline. This suggests employers are cutting their workers’ hours rather than letting them go altogether.

This would explain why the unemployment rate remains stubbornly low, as well as, the idea that Covid fundamentally changed the employment rate in the U.S. A strong argument can be made that Covid sent millions into early retirement or caused many duel-income families to switch to one income, thus forever changing the employment dynamic in the U.S. It may no longer be sensible to steer the economy using pre-Covid employment metrics as your benchmark.

Consumer Activity

The Good

Total US household debt service as a proportion of disposable income is at an all-time low, demonstrating that American consumers have maintained financial discipline.

The Bad

In the past year, as inflation has risen, so has consumer credit. Personal credit card debt/use is as high as ever and increasing sharply. The average American is struggling to make ends meet and has been forced to rely on credit cards. This suggests retail is relying more heavily on loans rather than being able to pay for their cost of living outright.

In addition, the American consumer is amassing absurd levels of debt while eroding their savings, as shown in the figure below. As of the conclusion of the third quarter of 2022, personal savings were 2.7% of total disposable income. Excluding a brief period in 2005, personal savings rates are at their lowest level since the Great Depression. When you combine the insanity of consumer credit expansion with falling savings rates and rising interest rates, a bleak picture emerges.

RE/ Housing

REITs Suggesting Trouble Ahead?

REITs, or Real Estate Investment Trusts, are important to the housing industry because they provide a way for individuals and institutions to invest in real estate without having to directly own or manage the property. REITs are companies that own and operate income-producing real estates, such as apartment buildings, office buildings, and shopping centers. They are required to distribute at least 90% of their taxable income to shareholders as dividends, which makes them attractive as an income-generating investment. Additionally, REITs can provide liquidity and stability to the real estate market by allowing individuals and institutions to invest in a diversified portfolio of properties and by making it easier for property owners to raise capital.

Some of the major non-traded REIT funds that have performed exceptionally well in recent years were forced to halt redemptions as investors attempted to withdraw their money in significant quantities. Before receiving a $4 billion capital investment from the University of California, Blackstone sealed the exits on their $69 billion BRIET product. Similarly, Starwood Real Estate Income Trust restricted redemptions when November's quota was reached. Both funds claim that the redemptions are prompted by the desire of their current investors to withdraw capital. However, I interpret this as a hint that these investors are becoming highly negative on commercial real estate as layoffs at large technology companies become the norm.

Home Buying

Home sales have begun to (quickly) decline from their 2022 highs. Buyers have been hesitant to enter the housing market, despite the fact that prices have begun to decline. This is because raising mortgage rates have offset any declines in price. Even with dropping prices, the monthly payments are still higher due to interest rates. Potential purchasers are likely to decide to wait for sellers to continue dropping their prices, which will have a major influence on the sellers' net worth.

Bonds and Interest Rates

Despite inflation numbers that were less than anticipated, the U.S. As expected, the Fed increased interest rates by 0.5 percentage points in December. In addition, the central bank issued a hawkish statement indicating that interest rates will continue at over 5% till 2023. The European Central Bank, the Swiss National Bank, and the Bank of England took similar actions. This increases the total monetary tightening in the United States this year to 425 basis points, compared to 325 basis points in England, 250 basis points in the eurozone, and 175 basis points in Switzerland.

However, despite the Fed’s aggressive actions, current inflation numbers are still above the Fed Funds rate, suggesting that either inflation needs to come down further or interest rates need to continue to be raised. The reality is most likely a mix of both.

Debt

Servicing the Debt

Rising interest rates may help fight inflation, but it also hurts the government’s ability to service its own debts. From our last macro update, “For the entirety of the 21st century, the U.S. government has gotten into the habit of running enormous deficits, only made possible by ever-declining interest rates. Unfortunately for our current situation, the majority of the debt is very short-term, and interest rates look to 20x by next year. This means servicing the enormous debt will become far costlier and require a greater percentage of the nation’s budget than in years past.”

Government interest outlays, the payments it makes to lenders on outstanding debt, have gone parabolic to ~$750 billion as of Q2 2022.

In the next two years, a large amount of US Treasury notes and bonds, worth around $6 trillion, will reach maturity and their coupon rate is less than 2%. Given that current interest rates in the US are around 4%, the government's debt repayment burden will double if these rates remain high. This discrepancy between expectations for long-term interest rates and the reality of the US's cheaply financed debt is significant and suggests that Treasury yields may not stay at 4% for much longer. Additionally, the US Treasury is not able to rely on the Federal Reserve for additional profits to make up for declining tax revenue. The Fed has been paying out less and fewer profits to the Treasury recently as a result of their quantitative tightening policies, which is removing assets that pay interest from their portfolio.

QT and Lack of Liquidity

In addition to raising interest rates at the quickest clip in decades, the Federal Reserve has started shrinking its large balance sheet since June. The process known as quantitative tightening or QT quickened in September, and its effects are beginning to be felt as short-term dollar borrowing costs spiked at the beginning of December, indicating a tightening of liquidity. This year, global monetary tightening has weighed significantly on risk assets, with both crypto and tech equities declining by double digits.

How It Affects Crypto

The US economy, being the largest in the world, is closely connected to other economies through trade, investment, and financial markets, and a recession in the US usually leads to a decline in other countries. The macro-environment significantly affects all markets, including crypto.

Crypto saw a significant decline during the short recession in early 2020 and suffered all of 2022 as interest rates rose and liquidity was withdrawn from the market. Take a look at the charts below. The first shows the relationship between BTC and the US money supply. The Bitcoin market cap took a nosedive as soon as the US money supply began contracting in 2021. The second shows BTC declining around the same time as the US 10Y began to rise. Rising interest rates + less liquidity = BTC down bad.

One important indicator to watch is the Treasury Yield Spread, which compares the difference in interest rates between 10-year bonds and 3-month bonds. When the yield curve inverts, meaning that short-term bonds have a higher interest rate than long-term bonds, it is often a sign that a recession is likely to occur within the next 7 to 24 months. The 10-year-3-month treasury has inverted, with the 10Y yielding ~1.33 percentage points below 3-month Treasuries. That’s the most negative divergence between the two in 50 years!

The bull case: The Fed successfully manages a soft landing.

Inflation continues to consistently decline in an organized fashion
the credit markets due not seize up due to a lack of liquidity
unemployment levels remain healthy
The Fed pauses rate hikes and eventually drops them as inflation comes down sometime in H2 2023

The bear case: the Federal Reserve (Fed) maintains a hawkish monetary policy throughout the year, causing the bear market to continue.

Inflation remains stubbornly high, causing the Fed to send the Terminal rate above ~5%
This cause further pain in markets and with jobs, causing a recession and negative growth

Did Bitcoin Miners Get the Memo?

On January 15th, the difficulty of mining Bitcoin, a measure of how hard it is to find new blocks, reached a new all-time high, increasing by 10.3%. This difficulty is adjusted approximately every two weeks by comparing the time taken to mine 2,016 blocks to the estimated 10 minutes per block in order to maintain a 10-minute average for block production despite changes in the network's hash rate. The increase in difficulty likely reflects the addition of new mining power to the market. Despite challenges in the mining sector, many miners purchased mining rigs when the price of bitcoin was higher, and the delivery of these rigs likely caused the spike in hash rate. Some mining companies have the financial resources to continue expanding their capacity, and prices are still above the break-even point for sites using inexpensive energy. Therefore, it is likely that the network's hash rate will continue to increase until this capacity is fully utilized.

Genesis: The Last Shoe to Drop?

Genesis Global, a company in the cryptocurrency industry, filed for chapter 11 bankruptcy in the US Court of SDNY in mid-January 2023 after many months of uncertainty. The company owes its top creditors more than $3.6 billion, with the largest creditor being "Various Lenders as defined in certain Master Digital Loan Agreements entered into with Gemini Trust Company," with $766 million in unsecured claims. This filing was a restructuring rather than a liquidation and the market seems to not care much about liquidation proceedings that are expected to take a long duration. Genesis still has $150 million in cash which should provide them with a sufficient amount of runway to continue operations for some time, but it is uncertain if anyone would want to use Genesis anymore.

Looking Ahead to all of 2023

Recession…. Or Something Else?

As mentioned previously, inverted yield curves typically precede recessions, especially the 10Y-3M. Is this time different?

How about another leading indicator? The Sahm Rule Recession Indicator, developed by economist Claudia Sahm, is another tool that has been successful in predicting recessions in the past. The indicator is based on the idea that changes in the Unemployment Rate can be used to identify the start of a recession. The rule states that if the average of the unemployment rate over the last three months increases by at least 0.5 percentage points compared to its lowest level in the past year, it is a sign of a recession. This indicator is considered easy to use and has a high accuracy rate in predicting recessions with very few false positives.

Near-term dates

January 24th - US PMI data (expected to confirm that the US economy is in contraction)
January 27th - Personal Income and Personal Spending data (important for GDP data and understanding the health of the individual consumer)
January 31st - Case Shiller home price data
February 1st, 2:00pm EST - FOMC statement (now all but guaranteed for a 25 basis point rate hike)
February 3rd - Employment and wage data
February 14th - next CPI data

Feb 1 Fed Meeting and Beyond

The market anticipates that the Fed will raise rates by 25 basis points in February and March until they reach a minimum of 4.75 to 5.00 percent, at which point it will stop and finally begin cutting rates again in the second half.

Does a pause constitute a “pivot”? Powell has stated that he focuses on the interaction between wage growth (US hourly wages) and core personal consumption spending rather than solely CPI. Powell has signaled that he will base any judgments regarding a potential policy reversal on not only the CPI but also US wage growth relative to core PCE. Therefore, we should not expect any magical inflation number or % drawdown in the stock market to spur a reversal/pivot. Instead, we need to watch employment numbers, market liquidity, and core PCE/inflation numbers.

Hiding in the data, there has been a reduction of ~110,000 temporary jobs since July 2022, with tens of thousands of full-time tech and crypto jobs lost as well. Moreover, a substantial drop in unemployment looks strong, but the unemployment rate only counts the individual as one, even if they have multiple jobs. December's data does not show an increase in full-time employment.

Similarly, the reduction in the head count of recruiters is another sign of a softening labor market, jobs in this industry fell by 35,000 in December and 111,000 over the past five months, which is a huge leading indicator that job openings are softening dramatically.

Since the Global Financial Crisis (GFC), the growth in the U.S. M2 money supply has been a significant factor in the increase of asset prices. Over the past 63 years, M2 has grown at a compounding rate of 7% per year or 7,349% overall, and it has had a significant impact on asset prices. However, since last March, M2 has decreased by 1.79%. This is the first annual decline in M2 since the Great Depression of the 1920s. When taking into account the annual compounded increase of 7%, this represents a net impact of -8.79% to M2. This decline in liquidity, which is the lifeblood of financial markets, is of historical proportion and is the result of the Federal Reserve (Fed) draining substantial amounts of liquidity from U.S. and global markets. Without growth in liquidity, the only reason for prices to rise would be if the market believes that the liquidity squeeze is coming to an end or if there is a dramatic bear-market rally. However, there are exceptions, such as war driving up oil prices.

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