The guest commentary below was written by written by Mitchel Krause. This piece does not necessarily reflect the opinions of Hedgeye.
We began our 3Q2022 note off with an Aesop fable, “The Ass & His Driver.” To my surprise, some readers were unfamiliar with both Aesop and this particular “fable.” Though, as we noted then: “The beauty in these fictional tales resides in their elegant simplicity.”
Given the “disconnect” between current economic conditions as defined by THE DATA vs. recent equity market reaction as most perceive it to be, we felt it appropriate to break things down … and simplify things as best we can!
This month, we’ll discuss the data (which we’ve primarily gotten very right); liquidity, which we’ve gotten both right and wrong (on timing) and more.
To start, we’re going to piggyback off of last month’s theme of “reflexive loops,” as they become more transparent daily, but first:
The Hare & the Tortoise
A Hare was making fun of the Tortoise one day for being so SLOW. “Do you ever get anywhere?” he asked with a mocking laugh. “Yes,” replied the Tortoise, “and I get there sooner than you think. I’ll run you a race and prove it.”
The Hare was much amused at the idea of running a race with the Tortoise, but for the fun of the thing, he agreed. So, the Fox, who had consented to act as judge, marked the distance and started the runners off.
The Hare was soon far out of sight, and to make the Tortoise feel very deeply how ridiculous it was for him to try a race with a Hare, he lay down beside the course to take a nap until the Tortoise should catch up.
The Tortoise meanwhile kept going, slowly but steadily, and, after a time, passed the place where the Hare was sleeping. But the Hare slept on very peacefully; and when at last he did wake up, the Tortoise was near the goal. The Hare now ran his swiftest, but he could not overtake the Tortoise in time.
Moral of the story: The race is NOT always to the swift … similarly, when it comes to investing, we’ve noted in the past that, “patience, at times, is prudent”!
The proverbial noose tightens
Lending is tightening – it’s no longer up for debate … while we’ve been detailing it for nearly three-fourths of a year via the Federal Reserve’s Senior Loan Officer survey (SLOOS) and last month per the Dallas Fed Survey … at this point, all of Wall Street has now become an expert on a data series they never spoke about until recently.
Admittedly, they’ve been busy shifting the laser pointer around trying to focus everyone’s attention on the performance of seven large cap tech names and everything other than the rot under the hood of the economy, including the U.S. banking system … but this most recent report is too damaging for them not to address.
The April SLOOS included three sets of special questions, which inquired about banks’ changes in lending policies for CRE loans over the past year; about the reasons why banks changed standards for all loan categories over the first quarter; and about banks’ expectations for changes in lending standards over the remainder of 2023 and reasons for these changes.
In response to the first set of special questions, banks, on balance, reported tightening lending policies for all categories of CRE loans over the past year, with the most frequently reported changes pertaining to wider spreads of loan rates over banks’ cost of funds and lower loan-to value ratios.
Regarding the second set of special questions about reasons for changing standards on all loan categories in the first quarter, banks cited a less favorable or more uncertain economic outlook, reduced tolerance for risk, deterioration in collateral values, and concerns about banks’ funding costs and liquidity positions.
Finally, regarding the last set of special questions about banks’ outlook for lending standards over the remainder of 2023, banks reported expecting to tighten standards across all loan categories. Banks most frequently cited an expected deterioration in the credit quality of their loan portfolios and in customers’ collateral values, a reduction in risk tolerance, and concerns about bank funding costs, bank liquidity position, and deposit outflows as reasons for expecting to tighten lending standards over the rest of 2023.
In August 2022 when discussing this topic, we explained to readers:
“The Federal Reserve reaches out to Senior loan officers at financial institutions across the country asking 3 primary questions in regard to ALL types of lending: C&I (Commercial and Industrial), CRE (Commercial Real Estate), RRE (Residential Real Estate), Consumer lending, etc.
The question asked are: 1. Are you tightening lending standards? 2. Are you increasing spreads? 3. Are you seeing stronger demand?”
“What’s more troublesome, as noted by Hedgeye Financials sector head/Macro team member Josh Steiner on “The Hedgeye Call” from August 2nd (2022):
“When 2 of those 3 (the questions asked) have inflected to net tightening conditions, you’ve had a recession every time shortly thereafter. In all cases, we’re seeing this here … a massive increase in the net percentage of firms tightening standards.”
As is the case today, as it was back then … in all cases, we’re seeing a net tightening in conditions.
First, let’s take a look at CNI (Commercial and Industrial) lending per the report:
We added red arrows as a guide to illustrate when tightening in previous cycles began, while the vertical blue lines provide readers with an understanding of timing as it relates to the peak of previous CNI tightening cycles … and how they historically coincide with major drawdowns/crashes in U.S. equity markets. Again, in all cases: LENDING STANDARDS TIGHTENED PRIOR TO MARKET DRAWDOWNS.
You can see the same dynamic/timing take place as institutions increase spreads:
And finally, STRIKE 3 … loan demand SLOWS prior to previous historical drawdowns.
What these three charts illustrate is the very foundation of the reflexive loop we described last month. As the economy slows down, financial institutions tighten lending standards, as we’ve been discussing it for nearly 17 months; the Federal Reserve then tightens into this economic slowdown, which exacerbate the problem further … as extreme tightening conditions accelerate how it adversely affects the:
… who continues to struggle today, which is clearly visible in the data.
For starters, U.S. Weekly Redbook Sales did end April with a slight W/W acceleration of +1.8%, before it continued its slide to a new post-pandemic low of 1.3% for subsequent weeks throughout May. For context, Weekly Redbook Sales data began the year up in the neighborhood of roughly +10% and has been steadily weakening since.
Headline Retail Sales data has also collapsed in lock step with the weekly Redbook numbers; what began the year at +7.41 Y/Y has since cratered to +1.60 Y/Y, a 581 basis-point or -5.81% deceleration, is one of the largest decelerations over a 3-month reporting period EVER … as we stare at a more difficult comp setup moving forward.
Earlier this week, Hedgeye Consumables sector head Howard Penney dropped another data bomb re: the consumer:
“Restaurant/casual dining has seen a 1,600 basis-point slowdown from the first month of the first quarter (2023) to the first month of the second quarter (2023) … with a 1,300 basis-point slowdown in (foot) traffic, down almost 700 basis points in April alone!”
As credit dries up, the consumer has little to spend on anything but necessities.
Per the Federal Reserves, Quarterly Report on Household Debt and Credit, household debt is now in excess of $17.05 TRILLION, with interest on credit cards spiking to ALL-TIME high of 20.33% … and while historically, consumers pay down their credit cards in the first quarter of the year, 1Q2023 is the first year in over TWO DECADES they failed to do so.
The cost of capital on home equity loans and mortgages are also at levels not seen in decades, and still, there is an insatiable demand for more credit. Why? Because people don’t have any money and borrowing is their only option.
Which is why we’re seeing credit applications get rejected at an epic pace. Per the National Association of Credit Management’s more recent CMI (Credit Managers’ Index) report, REJECTIONS have accelerated with April’s factor index hitting 47.9 (which is THROUGH GFC levels) as card delinquencies continue to spike!
The need/want/thirst for more credit is there, but as we’ve been detailing, the pace in which banks are now tightening credit standards, especially in the aftermath of the largest bank failures in history, is accelerating, expeditiously cutting more borrowers from their lifeline, which bolsters our ouroboros thesis from last month.
So, it should surprise none of our readers that total credit card spending data published in a recent Bank of America report saw its largest decline since February 2021 in April, down -1.2% Y/Y. Americans don’t have any more money to spend!
You may note this rapid deceleration in consumer spending data coincides with 42 million Americans losing SNAP payments we discussed in March.
In the same section of that March note, we also highlighted the moratorium on student loan payments would be ending shortly, forcing roughly 40 million Americans to start repaying their loans. At the time, we quoted Hedgeye’s Josh Steiner:
"The average payment for an undergraduate is $235 per month, student loan with a graduate degree is on average $600/month … so net net, on average, we’re looking at roughly a $400 per month ($393), per household payment that’s set to resume."
We are that much closer to those words being a reality:
“The student loan deferment program will end no later than June 30, 2023, and payments are expected to resume by September 1, 2023.”
With debt servicing at its highest level EVER (on average, 20.33% as noted above), the cost to service debt is eroding the consumers purchasing power at the fastest pace, EVER! Half of all Americans have less than $500 in savings and/or NO emergency money (as we detailed in February, citing data from the Prudential Pulse Survey).
So, do we really think spending is going to re-accelerate in the face of 40+ million Americans being forced to start repaying their student loans again (roughly $400/month) as job losses continue to mount? Which brings us to:
Initial jobless claims ticked down to +230K from its prior week of +246K to finish out April, then subsequently moved higher throughout the month, coming in at +242K W/W and +264K; its highest reading since October 2021, further supporting what we discussed last month; that despite the nominal fluctuations W/W (Week over Week), claims TROUGHED September 24, 2022, at +182K and is trending higher; UP 45% from the cycle low.
After sequential increases, both the Challenger job cuts and continuing claims data took a breather “improving” slightly with the Challenger data coming in at +67K vs. +90K in March and continuing claims decelerated to 1.80 million vs. 1.84 million the previous week, to which we’d reiterate from last month:
- Continuing Claims bottomed at 1.289 million, a mere few weeks prior on September 10th, 2022
So even with the slight improvement it REMAINS +40% off its trough … and:
- We’ve been noting Challenger, Grey & Christmas data since January. In March, it was is up roughly 15% M/M … and roughly 320% on a Y/Y basis!
+320% on a Year over Year basis … very little goes up in a straight line.
For nearly a year, we’ve been detailing the deterioration occurring underneath the surface in labor markets and the dominoes continue to fall as another important early warning sign is flashing red; “layoffs” as a percentage of separations are rising while “quits” as a percentage of separations continue to fall … which means more people are getting fired vs. leaving on their own accord.
On its most recent Macro Themes Update, Hedgeye placed today’s labor data into historical context:
“The Y/Y change in continuing claims has NEVER been this high without a subsequent recession and 'warn notices' are pointing to an acceleration in initial claims.” - Hedgeye CEO Keith McCullough, 2Q2023 Macro Themes Update
A “Warn Notice” for those unfamiliar:
“The WARN Act requires large employers to provide 60 days advance notice of mass layoffs. WARN notices therefore LEAD actual layoffs by 1-2 months and can serve as a lead directional indicator for Claims/JOLTS.” Hedgeye Macro Themes Update, 5/17/23
Which also points to MORE near-term layoffs! As is, JOLTS job openings for March just registered its lowest level since April 2021, decelerating to 9.59 million, (-18.4% Y/Y vs. 11.755 million in April 2022), with both “overtime” and “temp” staffing collapsing! These are not numbers to be ignored.
When discussing labor, it’s negligent to not discuss the NFIB Small Business Sentiment, which recently hit yet another new cycle low of 89.0m registering its lowest level in over a decade.
The more worrisome part of this already miserable report is the FORWARD outlook component which continues to hover around all-time lows at -49.
A recent Market Edges email sent to Hedgeye subscribers spoke to the NFIB:
The National Federation of Independent Business goes straight to the source, asking everyday people how they feel about the economy. What they found is small business owners have lost confidence. The NFIB Small Business Optimism Index reached a new cycle low in April, plummeting even further than it did during the COVID pandemic.
As Mitchel Krause, founder of Other Side Asset Management and Hedgeye Power User, pointed out in this tweet, 99.9% of all businesses in the U.S. are small (500 or fewer employees) and contribute 45% to 50% of the U.S. GDP. These companies will have no choice but to lay off employees in a #Quad4 recession.
There’s a reason we’ve been discussing the importance of financials tightening lending standards, for it flows through to both, the consumer, and small businesses ... which are the true drivers of the economy. Credit flows to small businesses and consumers via lending, which drives consumer spending, and ultimately the economy.
A contraction in credit translates into a "lack" of spending, which equals a collapse in earnings. This, in turn, forces layoffs which feeds back into more tightening of credit (again, see reflexive loop).
The data is empirical fact, and it all began to decelerate well before the current "regional banking crisis," courtesy of the Federal Reserve hiking rates 500 basis-points in such a short time frame, creating a duration mismatch of the balance sheets of virtually all regional banks (where deposits continue to fall), per the WSJ.
So, if the data is truly as bad as it is, why haven’t certain “equity markets” as most define them, outright cratered?
While we’ll explain this catalyst below; let’s briefly take a step backward to move a few forward, for this dynamic is likely to change, and abruptly.
In February, we detailed the “liquidity” dynamics across global markets, highlighting an Financial Times article written by Michael Howell, managing director of Crossborder Capital and author of "Capital Wars: The Rise of Global Liquidity."
Howell contended, 2023 shouldn’t be “so bad for assets, because the cycle of global liquidity is bottoming out” … being of the belief that we’ve “just passed the point of maximum [global central bank] tightness.” and “stealth QE may be back next (this) year and make what looks to be a difficult year feel a tad better” … at the time we suggested his conclusion to “possibly be pre-mature."
To date, if you measure markets by the S&P 500, Nasdaq or Russell 2000 indices, he’s been right, we’ve been wrong … these indices are currently up on the year while at the same time, they continue to be down quite significantly, for the cycle.
However, remember how the math works: Inclusive of this year’s YTD performance, the Nasdaq is still down nearly -21% from its Nov. 19, 2022, cycle peak, which means investors still need to be up over 26.5% to break even; the Russell 2000 and S&P 500 are down roughly 27% and 14% from cycle peak, respectively; requiring a ballpark return of 35% and 17% to break even. Buying into the marketing of YTD returns skews these facts.
At the same time, the performance of these indices are being held up by roughly seven tech stocks, which now comprise a mind-numbing percentage of these indices and nearly 90% of their returns. $AAPL and $MSFT alone represent 14.5% of the entire S&P 500; and over 40% of the $XLK.
The chart below, tweeted by Seeking Alpha writer Leo Nelissen, shows the relative performance of these seven companies within the S&P 500 which have provided the "outperformance" while the rest of the S&P "493" have done virtually nothing on the year.
As it stands today, $AAPL has a larger market cap than the entirety of the Russell 2000 index.
For those who are frustrated we are not long these 7 names: $AAPL recently reported major decelerations in sales in most product lines and just cut their iPhone 15 deliveries by 30%; $MSFT just began laying off more employees last week and South Korean exports of semiconductor chips were recently down over 30%, yet $NVDA just added nearly $200 billion in market cap, in a single day, on a 14.4% Y/Y revenue deceleration, but a forward “guide” in revenue relating to AI (Artificial Intelligence) chip sales (i.e., something that has yet to happen).
Nvidia ($NVDA) is currently a stone’s throw away from a $1 trillion market cap, with less than $40 billion in annual revenues, making it six times the size of Intel ($INTC) with roughly half the revenue.
Decelerating sales, reduced demand and slowing revenue on a RoC basis does NOT equal “growth." They are bubbles, created and fueled by increased liquidity and the passive investing dynamic, which ultimately pop as liquidity dries up!
In his article, Howell was of the opinion that the Central banks would be running “stealth QE,” but they’re not. Outside of Japan and China, central banks have been muted! On the other hand, we can’t say the same thing for the U.S. Treasury.
To date, we’ve definitely underestimated the power of Treasury Secretary Yellen spending down the TGA (Treasury General Account), which has translated into roughly $200 billion per month, which has, in fact acted like a synthetic QE (Quantitative Easing).
Where ordinarily, the U.S. Treasury would be issuing bonds to fund the government’s current and future spending needs, given the debt ceiling limits, there has been no treasury supply to be bought … thus the liquidity that would ordinarily be soaked up by these treasury purchases has been free to slosh around in the financial system, primarily flowing through to a select number of risk assets, which happen to represent the largest percentage holdings of major indices, and as such, they are deemed the "most liquid."
While we knew this liquidity was out there, one item we outright missed was the liquidity dynamic generated from ERC refunds also known as, “employee retention credits” or government-subsidized Covid relief programs to employers that retained employees through September 2022, in order to receive a tax-free credit of nearly $27K for every employee retained through Covid.
This, along with other Covid aid, became a near $400 billion windfall for business owners over the past year and a half, but ERC’s have been largely paid out over 4Q2022 into 1Q2023.
When coupled with the passive bid that lives and breathes in markets daily, which amounts to somewhere in the neighborhood of $2.5 billion from Blackrock and Vanguard as 401(k) contributions remain largely intact (partially because of the ERC program), this excess liquidity has concentrated in the largest of names (described above). So, while layoffs have been rising, they have not reached a level which tames this daily passive bid … yet!
Additionally, on average, share repurchases provide a bid of roughly $800 billion over the course of any given year … which, when combined with the 401(k)/passive bids, suggests roughly $1.5 to 1.6 trillion (or 5% of the S&P) will be bought throughout any given year, until certain dynamics change.
Again, we understand that there are reasons markets WANT to go higher and frequently do (in the face of bad news, and it’s not always the reason Wall Street sells you) … AT THE SAME TIME, cycles, fully loaded with deleveraging and credit events, happen!
Market crashes historically take place when the economy is slowing as defined by both growth and inflation simultaneously decelerating (Hedgeye #Quad4). CREDIT EVENTS typically occur under these same conditions but are exacerbated by poorly timed and executed Federal Reserve policy in the form of excess tightening via their “blunt tools”. A substantial increase in the cost of capital slowly but surely forces a deleveraging upon a system … which it can’t handle.
When these credit events take place, they are most frequently CRUSHING to the life’s savings of most investors.
As the cost of capital skyrockets (like it has), and access to capital in the form of credit dries up, funds are forced to deleverage. When asset prices in non-tradable investments collapse, firms will be forced to sell what they have the ability to … where they can find the liquidity; in the meantime, they will place whatever excess capital they have in what’s perceived liquid (creating a liquidity trap)!
So, what makes us think the liquidity dynamic is what will inevitably create such a credit crisis?
As we’ve been telling you, it already has … BREIT, SREIT, KKR, CIM Real Estate Finance Trust, Inc. (CMFT) is a $7.4 billion, public, but non-listed REIT among others that have all frozen shareholder redemptions. THIS IS A MASSIVE CREDIT EVENT!
When investors can’t get their money out of an investment, that’s a credit event! The masses rushing toward the perceived liquidity in roughly seven equities is also part of such an event. In the past, it is eventually where everyone is forced to pull their money from when redemption requests need to be met (as the above liquidity measures dry up) … performance like this should NEVER take your attention away from the enormous red flags that are being waved!
If pressed for more examples as proof that we’re in the heart of a major credit event … residential real estate and refinances have near frozen, with mortgages back over 7%; multi-billion-dollar commercial real estate deals are selling at a fractional of a. build cost and b. multi-decade pricing if bids and financing can even be found … Moody’s analytics recently noted that 84% of the $7.8 billion in commercial CDS scheduled to mature this year “could have trouble refinancing.”
And finally, for the purposes of this example, dare we mention we’ve had more bank failures to date than took place in all of 2008 throughout the GFC (Great Financial Crisis)? With the Federal Reserve bumping short term rates as high as they have, there’s little reason to keep your deposits in a bank that can’t compete with a treasury backed money market fund. BANK FAILURES WILL CONTINUE.
But broader indices are up on the year?! Yeah … I got it!
Market structure and liquidity dynamics have convinced many through price action that everything is fine. Meanwhile, THE DATA and underlying signals are singing the same song that has led to just about every major market collapse in modern history.
Just as the hare lost its race to the tortoise due to extreme overconfidence and arrogance, the impatient are very likely to figure out why “history rhymes” and so many people are caught off guard by it.
Please exercise some patience, as we’ve seen this story play out multiple times throughout our career. Over-confidence in the belief that we have the “all clear” in markets due to the price action in a few names that are holding up two broader indices. This can and often does lead to significant pain when the above-described liquidity games can no longer be played, and economic gravity becomes reality.
This ride has NOT come to a full and complete stop just yet, we suggest investors prepare accordingly!
Click here to read Mitchel's May note in its entirety on the Other Side Asset Management website.
This is a Hedgeye guest contributor piece written by Mitchel Krause and reposted from his most recent monthly report. Krause is an industry veteran of nearly 28 years, where he’s seen the industry from the inside out. Nearly a decade of private wealth service, followed by just under seven years with an institutional group focused on banks and thrift stocks. He’s been managing discretionary money since 2015. His career began at, Ryan, Beck & Company in 1996, a boutique firm specializing in financials and municipal bonds, which was later bought by Stifel Financial Corp in 2007. He opened the doors to Other Side Asset Management in 2018 in an effort to tell the “other side” of the investing story to those willing to listen. He continues to manage discretionary assets while publishing these notes monthly. His archives are open to the public. Currently, he both works and resides in Raleigh, North Carolina.
Twitter handle: @OtherSide_AM
LinkedIn: Mitchel Krause