Below is a chart and brief excerpt from today’s Market Situation Report written by Tier 1 Alpha. If you’re interested in learning more about the Hedgeye-Tier 1 Alpha partnership, there’s more information here.
Today's bonus chart illustrates three data points working in unison: a combination of inflation and unemployment in the misery index and Michigan sentiment. From the chart, both indicators have an inverse relationship, particularly notable around recessionary periods.
Remarkably, the misery index is relatively low, lower than levels preceding the GFC of 2008. CPI's food and energy component in 2008 was obviously significant, with $140 oil contributing to higher inflation. Moving to our current economy, we are experiencing 3.9% unemployment, around the pre-pandemic historical norm for the last ten years.
Assuming Michigan confidence remains stable, then what closes this alligator chart? Higher inflation, higher unemployment, or both? The financial cycle typically precedes the GDP cycle by 5 to 9 quarters, and the GDP cycle then leads the labor market cycle. With the peak of the financial cycle in Q4 2021 and the subsequent impact on income, consumer sentiment has been affected, leading to inflationary pressures easing one to two quarters after GDP declines. Despite a drop in inflation from 9% to 4%, further reduction is needed to address affordability issues.
Assuming the Fed is “successful,” we start seeing higher unemployment. Subsequently, the basement fire starts to spread throughout the entire house; we are concerned the Fed does not have the tools to correct the problem and is faced with the oldest economic principle in human history. David Ricardo originally conceptualized the law of diminishing returns in 1815 as one of the factors of production, such as debt capital, increases beyond a certain point, the resultant growth in GDP begins to flatten and eventually decline. The United States, having accrued significant debt, is now in the phase of diminishing returns, rendering the notion of borrowing to spend our way out of economic trouble ineffective. Over-indebtedness leads to a loss in the trend of growth, not an improvement.
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