• Globally synchronized recession looks baked into the cake. Timing is uncertain, but may have already started as early as the beginning of the year. Risk assets look mighty dangerous from here.

  • GDP and GDI are two sides of the same coin but can differ in estimates depending on a cycle’s idiosyncrasies. They will be revised (to be more inline), but in the last 75 years, US GDI has never drawn down this much without the US in recession.1

    

• As noted in the last couple of notes, US Consumer “excess savings” and China reopening have been the two big unknowns in terms of economic momentum, but these seem resolved.

  • Excess savings appear to be getting closer to exhaustion, and with student loan repayments restarting (yes, they have been suspended this whole time) around July-Sept, consumers will likely pull back further.

    

  • China reopening has largely been weak. Domestic demand seems subdued, likely due to the ongoing real estate crisis, and manufacturing for exports seem to be pushing on a string (likely the bullwhip effect2 part of the inventory cycle). Will probably pick up, but who will be the customer?

• After the few positive prints of econ data (particularly Jan), things have decidedly turned downwards, and increasingly large revisions to prior months is a tell-tale sign of the fog-of-cycles3

• Some economically sensitive commodities, namely iron ore, copper, and oil are all failing to catch a bid. Particularly in copper, and oil, given the tightness in inventory levels, markets seem to be pricing in a whole lot of demand weakness. Could be explosive if markets are wrong, but scary for different reasons if they are right.

• While no indicators are infallible, when so many are flashing red, you have to admit - when it walks like a duck, sounds like a duck, and looks like a duck, its probably a material economic downturn.

US Economy

• Conference Board

  • The Conference Board’s4 Leading Economic Index (LEI) attempts to measure the “duration, depth, and diffusion” in economic downtrends to forecast recessions. The chart below is quite self-explanatory.

    

• Rates

  • Near term forward spread5, JPow’s own favourite yield curve indicator that has “The near-term forward spread had substantial predictive power…for the chances of recession” is the most inverted since 1981. He seems to have forgotten he believes this since saying it in March 2022.6

    

    • It is also worth noting this chart goes back to the start of the 60’s.

  • However an obvious (reliable) recession indicator, a rapid “bad” steepening7 of the yield curve hasn’t happened yet.

    

  • I believe this is because the Fed still has a tightening bias due to the stickiness of inflation (and fear of it becoming “unanchored”/”entrenched”, perceived tightness in the labour market, and the monkeys keep bidding stocks! Therefore, as usual, the Fed was be late to the party and now will be last to know when the cops arrive to shut it down.

    • The Fed will likely do +25bps in June and its quite mental to think that they are still tightening into a rapidly slowing economy.

• Banking Crisis

  • While things have calmed down for now, it is unlikely it was all just a bad dream. Regional banks are still chock full of commercial real estate with imaginary marks, but this is starting to unravel as a few sellers are forced to cross the spread to off-load problem assets.

  • Bank credit growth falling precipitously.

    

  • Bank lending standards continue to tighten, albeit at a slower pace.

    

  • Finally, bank deposits continue to draw down as people seek yield and protection in money-market funds (data to mid-May 2023)

    

  • While you may be thinking, but monsieur Tree, bank credit and deposits are both still up so much, why are you worried about such a little decline! Well astute reader, great question, more on this in the special section next month.

    

• Employment

  • Unemployment claims have started to move higher, but haven’t really taken off. This is expected, given employment is a lagging indicator (firing people you’ve spent money on hiring and training is expensive, one needs to be sure)

    

  • However, the more leading components of employment are quite clear.

    

China

• Markets expectations of a huge surge in economic activity out of China have been disappointed. While it has still not been that long (re-opening was Nov-Dec, everyone was sick Jan-Feb), its clear there will be no consumer led surge like in the rest of the world post reopening. Probably due to 1) China has never been a consumer led economy (one of their structural problems going forward) and 2) real estate is a secular religion in China, and it hasn’t been going well.

• While its impossible to get a good read on the CCP’s intentions (because they are lying lairs who lie), it seems clear that, as stated, they will not go back to the old playbook of stimulus for construction. They are still still pushing supply-side policies to juice industrial production/exports, but it will be interested to see how much the RoW can absorb if they are in a recession.

• All I know is the Yuan is volatile and weakening again, and that is never a good sign for anyone.

Oil

• OPEC cut production and (Brent) Crude got to $88, but is now trading at $72.

• The physical supply and demand balance is reasonably tight, but the market seems to be sure demand will be weak.

• There is a strong longer term bull thesis for oil (structural under investment), but need to see how the near term plays out to develop an entry.

• Ironically, oil moving lower ahead of a recession is likely delaying a recession as it takes pressure off consumers. Lower oil = Tax cut. (But remember, the Saudi’s want their taxes)

RoW

• Despite the dollar taking a breather over the last few months, much of the world is limping along at best.

  • UK is battling stubbornly high inflation and rapidly slowing growth.

  • Germany (my EU bellwether) has posted 2 consecutive negative quarters of real GDP growth. And the EU as a whole decelerated to 1.3% yoy for Q1 based on current estimates.

  • South Korean industrial production (my Asia bellwether) is starting to look like 2008 (below)

    

• It seems difficult to find a bright spot in RoW at present (perhaps India), and if the USD dollar does indeed start a wreckin’, as I expect it will, things will likely deteriorate rapidly from here.

Markets

• USD Wrecking Ball

  • She’s back.

    

  • Ok, perhaps that is a bit premature, however, it certainly does seem like the dollar has found it feet and is beginning another leg higher. One to watch, if the dollar takes off here, take cover.

• Equities

  • Breadth is terrible but mega-caps and AI are holding everything together.

    • Just look at the difference in recent performance in NQ, SPX, and RTY. As John Hussman often says, in bull markets speculation is “indiscriminate” and therefore breadth is wide,8 these ragged divergences are not indicative of a healthy “bull”. Incidentally, he just posted this fantastic chart.

      

  • US equities seem to be playing the old game. Where any weakness was in markets garnered a rapid reaction from the Fed to keep asset prices high. However, that was the game sans inflation. Now the Fed’s reaction function is changed. It can no longer be so one dimensional. Which makes me think being long equities here is quite the risk.

  • We are entering the low liquidity summer period, which is more accident prone. This little AI driven blow off top could be the bell.

    ---

Positioning

(New this month is a short abbreviated summary on positioning, for my own records)

• Long 2Y Futs - yields should collapse with fed funds expectations in a recession.

• Long SOFR Calls - deep OTM 2023-24, convex in v hard landing

• Gold straddle (Put bias) - hedge long term miner & physical + convex in liquidation event where gold is sold.

• Short ES Futs - for slow bleed lower (e.g. 2022 no vol theta bleed)

• Long ES Puts - deep OTM various tenors focused on rest of 2023 (vol play)

• Long Tech Puts - as above + TSLA (biggest), NVDA, AAPL, GOOGL

• Long O&G (&Coal) equities - accumulating for long term and as hedge on moar fiscal (and therefore inflation ripping)

• Short AUD/USD via Puts (also small positions short Cable, EUR, & JPY)

• Long USD Cash (short AUD FX)

3

The Worked Shoot

Analyzing the madness of crowds with help from Ric Flair and Benoit Mandelbrot

By Kayfabe Capital

A Fayfabe-ism.

• Econ data still weakening, but certainly holding up better than expected in some places likely due to “excess savings” and bigger than budgeted fiscal in the US.

• China reopening still an unknown quantity (how sheepish are Chinese consumers after being whacked by zero covid and a real estate crisis), however there seems to be a renewed fiscal impulse into (unproductive) investment (unsure if really “stimulus” yet), which could improve demand conditions globally in the short term. Large risk to base case of imminent global recession, TBC.

• The baby-banking crisis during the month was the first serious cracks showing in the edifice. Unlikely to be the last. Further discussion below on causes/effects and implications.

• Rates markets are a complete mess, apparently caught between the economy ostensibly holding up (“higher for longer”) and banks collapsing. The distribution of outcomes for the end of the year is rates at ~5% or back to near 0% (ignore the “3 cuts priced in for 2023” nonsense from the pundits), not healthy or easy to manage basis risk. Can’t forget that caution can be self-fulfilling (individually rational and systemically toxic e.g. a bank run).

• OPEC+ is not fucking around. They were clearly not happy with Brent having a 70 handle. Cheap energy not coming back anytime soon outside of a really ugly demand picture. Additionally, potentially some signal here for future demand weakness?

• Overall, 2023 recession more likely given the banking issues. Econ data already weakening, and credit conditions likely to tighten rapidly in the aftermath of this event.

• Oft underdiscussed as a large underlying force on econ activity is collateral values. As part of the credit cycle: Increasing optimism > New credit > Upward pressure on asset prices (+ more increasing optimism) > More collateral for borrowing > New credit. Repeat. This is the ‘virtuous’ part of the credit cycle. Massively oversimplifying, rising rates has put this cycle into reverse and will likely play out over a number of years unless interrupted.

Econ Data

• US Economy

  • The ISM PMI (survey data, diffusion indexes) for US manufacturing has been in contractionary territory for 5 months and is accelerating. The services PMI is holding up ok, but worth nothing that the cyclical elements of the economy lead into recessions and weakness likely won’t show in services until it’s too late.

  • Focus is on “New Orders” (and new export orders) as they are the most leading elements.

    

    

  • Industrial production came in ok in March. With some upward revisions, the survey weakness not showing sharp deterioration but certainly not much growth.

  • US housing activity appears to be rolling over. Drawdown in building permits is a good leading indicator of future activity. Flashing orange.

    

    Chart from @EPBReseach on twitter, a lot of great macro content on his twitter feed and youtube channel which is great for all levels of accumen.

  • Excess consumer savings is still the biggest driver of uncertainty for strength in the US economy, how willing are they to draw this down before they tighten their belts?

    • Remember “Excess savings” is really implying that consumers will readily draw down what they were given “above trend” all the way back to trend before cutting consumption. While this certainly may be true for some who will need to spend their accrued excess to cover expenses, others will want to hold on to their windfall. Therefore, the distribution of these gains is important, and much is held in the upper quintiles of the US population.

    • Good chart from Warren Pies, a couple of months old now tho. Note the level of excess savings is dependent on where one draws the initial trend line so estimates vary wildly. I think the important part is that they are being drawn rapidly, and what happens to corporate earnings and economic activity when this force is exhausted. Hangover.

    

  • A lot of Jan data that surprised to the upside across the board – Jobs, hours, Retail Sales, PMI’s etc have rolled back over, suggesting that was in fact seasonal adjustment noise.

    • My underlying assumption is that seasonal adjustments have been broken by covid and this has exacerbated the already present problem of “Fog of Cycles” as @Kayfabecapital eloquently coined.

    • Jobless claims support the idea of general resilience. However, Quits & Openings seem to have rolled over. Jobs always lag, don’t rely on them to get a read on the economy.

    • Initial claims and continued claims are slowly ticking up, and given employment is a lagging indicator, this is a confirmatory sign of weakness rather than a counterpoint.

  • Fiscal Impulse

    • As noted last month, for FY23 the US Federal Budget Deficit is budgeted to be $1.4tn. However, as at March the deficit is already $1.1trn and with a lower expected tax season (much less cap gains), it is unlikely the full year will end the year anywhere near below $1.4trn. This is an economic tailwind and could forestall a recession (but prolong “inflation”)

    • As a side note on tax season, with tax payments coming up, that is a big liquidity drain from markets generally, interesting to see how that plays out this year in a fragile system. Sell in May and go away?

      

  • Credit Impulse

    • Post the baby-banking crisis we will likely see sharp reductions in bank lending. Strangling an economy of credit is a quick path to a recession, to avoid recession we need to see this line moving up, sideways is not enough.

      

    • Tightening lending standard is a bad omen for credit creation.

      

• In last months report, it was clear that the US economy had turned down, it is now clear that we are on a path to recession unless something intervenes.

• May Note will include RoW and Markets analysis (along with updated US info).

  ---

• Special Note: Duration Risk v Credit Risk

  • Much of our attention is rightfully directed at “Credit Risk”, which is a measure of the additional cost of borrowing (above the “Risk-free” rate) to account for default risk (can the counterparty actually repay?)1

  • This was of course a huge issue in the GFC, where credit spreads blew out so far (representing a sharp deterioration in liquidity) that rolling financing arrangements was largely impossible, and chaos ensued as levered players blew up in the mad scramble for (good) collateral.

  • The situation is quite different today. Spreads have thus far behaved well. However, the “risk-free” part of total rate (that is Risk-free + credit spread = total rate) has not. Sometimes people forget that “risk-free” refers to credit risk, there is still duration risk.

  • Put simply, “Duration” is the sensitivity to the price of a security to a change in interest rates. Duration increases the longer the term of the cash flows. (The details aren’t important, so don’t fret).

  • So as rates have declined for the past 40 years, long duration has paid off handsomely (the value of long duration assets increases as rates fall), encouraging more and more to take on duration risk. It’s been all one way for a long time.

  • More recently, as rates have risen, long duration assets have suffered the reverse of this effect.2

  • This is obviously painful for holders of long duration assets. A system which gorged itself on duration and is levered against the value of that collateral, which is now falling, faces significant risks. Risks that, in aggregate cannot be hedged (these hedges are zero sum). So the pain must be felt somewhere.

Thanks for reading. Hopefully, you found this helpful or interesting.

• Feel free to provide questions/comments/feedback.

• Subscribe to get new notes as they are released.

Homework (/Sources)

Good thread on construction cycles:

https://twitter.com/EPBResearch/status/1633103320079269890

EPB “How to predict a recession”:

“Excess Savings” Discussion:

https://twitter.com/WarrenPies/status/1644424945210982401

“Fog of Cycles”:

https://twitter.com/kayfabecapital/status/1647698050192736258

• Econ data in a downward trend.

• Avoiding a recession largely relies on a strong China reopening and or renewed US fiscal impulse (both possible).

• Rates would fall in a recession scenario, but this is unlikely to protect financial assets (risk aversion overpowers loose money) in the short term.

• If a recession is avoided, this will almost certainly mean rates will be in the “higher for longer” scenario.

• In the context of financial assets, it seems - Bad news is bad news, and good news is bad news.

• This is the exact opposite of the last 15 years where good news was good because it was non-inflationary (therefore no risk of a rates shock like now) and bad news was good news as this would mean looser monetary conditions.

• The perceived change in inflation regimes being the key difference in interpretation. Remember, Central Bankers’ primary mandate is “stable prices”, inflation is the biggest risk to their jobs (and the economy).

• Overall, it seems like we are on a knife edge. I lean toward recession (already or soon to begin), but can see a wide path to another 6-12 months of ok growth and continued inflationary pressure (then probably worse recession). Either way looks bad for financial assets.

Economic Conditions

Econ Data

• Jan data surprised to the upside across the board – Jobs, hours, Retail Sales, PMI’s etc. While the breadth is convincing, there is room to consider fading this news which has pushed many into the “Higher for longer” camp:

  

  • Huge seasonal adjustments in Jan;

  • All contrary to recent trends (i.e. is it just one month in noisy data?);

  • Econometric models notoriously bad at turns (probably worth whole technical note on this).

• The US economy has clearly turned downward, what is unclear is whether this is a gully or a canyon.

• Jobless claims support the idea of general resilience. However, Quits & Openings seem to have rolled over (decide for yourself if that tick up in openings is just noise).

  

  • A lot of high profile layoffs announced recently, many of which haven’t been effected yet.

  

  

  • Additionally, these are clustered in more “white-collar” sectors. Interesting in that usually “blue-collar” cyclical part of the economy (housing & manufacturing) generally lead job losses (but also, job loss data tend to be late to the recession party).

  • The white-collar worker might be less inclined to file an unemployment claim immediately, which may explain the claims data, however, they may also just be finding another job easily.

    • Worth noting that the higher income earners have a much larger footprint on consumption (and capital markets flows), so theoretically much fewer job losses required to impact aggregate demand/financial flows.

• The consumer held up throughout 2022 better than expected, this was likely due to the large stock of “excess savings” accumulated during the pandemic & the ongoing suspension student loan payments etc.

  

  • $2.1tn at peak, roughly $1tn at Dec 22, but not evenly distributed, likely that the majority of these savings are sitting with the wealthy, but potentially this could keep us out of recession and inflation pressures on if consumers keep spending.

    • Credit card debt rising rapidly is a tell that perhaps lower income households have already depleted their stock of savings and are feeling the pinch of falling real wages. However, we are not just back on the pre-covid trend, so there are a few interpretations.

      

  • Excess savings is a loose concept and there is not guarantee consumers keep running them down as they have over the last 12 months. The decision of what to do with this $1tn will be the deciding factor of when a recession may begin (that and China reopening).

• Overall, it is a choose your own adventure scenario presently – Recession or Higher for Longer, Feb and March econ data likely won’t help tell us what is the economic reality but will be extremely important for the short end of the rates curve (Fed reaction function).

Fiscal Impulse

• The Fiscal Impulse is useful for understanding cash flowing into the real economy (which shows up as corporate earnings, domestic private savings, and foreign savings (accounting identity) in the immediate term).

• For FY23 the US Federal Budget Deficit is $1.4tn, compared to $1.3tn in FY22. Despite the rise, the figure is almost equal in % of Nominal GDP terms (5.2% v 5.3%)

  • Net interest expense is up $165bn yoy and should mostly flow to holder of financial assets and stay in the financial economy (i.e. not helpful for main street in the way infrastructure spending is). So overall, with drawdowns in excess savings slowing (which is just delayed fiscal), the fiscal impulse appears to be slowing. However, this is just Federal, spending at other levels of government needs to be considered.

Credit Impulse

• Large increase in Commercial & Industrial loans in 2022. Three broad interpretations:

  • Businesses borrowing to finance capex or additional working cap in expectations of growth

  • Businesses drawing on credit lines early for fear that the lines won’t be available in a credit event (e.g. GFC 2008)

  • Corporate bond markets have become less active and therefore some of this has shifted to bank debt.

• Overall, all three likely happening anecdotally 2 & 3 seem the larger force.

China

• Reopening underway for the last two months. Too early to tell what this means given 1) they all got sick & 2) golden week was also in data (makes for hard comps), 3) these things take time.

• The key question is, was is the Chinese economy weak due to zero-covid, or other more endemic factors. If the former, there should be a global growth and inflation impulse, if the latter, then quite the opposite.

  • Some expecting significant stimulus but that doesn’t seem forthcoming. Similar to the US, the economic prospects seem to hinge on the willingness of Chinese consumers to draw down on excess savings built up during the pandemic. This may not be as straightforward as in the US with the severe contraction in Chinese Real Estate still ongoing(?), and potentially weak export demand creating significant economic uncertainty domestically.

Europe

• Mild winter saved Europe from disaster but still required economic self-mutilation.

• With Germany posting -0.4% Real GDP in Q4 and -0.9% yoy. As the pillar of economic strength in Europe and a global manufacturing bellwether, this is rather concerning if China reopening does fizzle.

  • Some data showing euro industrial production held up ok during Q4 which contradicts the above somewhat, need to investigate further, but either way, not ‘strength’.

• TTF the benchmark European Natural Gas Hub saw prices rise markedly throughout 2022 as fear of a shortage in winter had governments hitting the offer for whatever price. Obviously, the winter Armageddon didn’t eventuate, however there are remaining ramifications for economic activity going forward:

  • Gas at EUR47/MWh, this is double the pre-covid average.

    

  • Energy utilities need to recoup the cost of the extremely expensive gas they purchased. Depending on the country and policy, some of this will be borne by governments, some will be borne by consumers and businesses.

• Overall, the extreme volatility and continued high energy costs will make the operating environment for German/Euro consumers and businesses highly uncertain, which can be a short path to a confidence-induced recession.

Markets

Rates

• The “stronger” econ data is increasing short-term inflation expectations and putting upward pressure on yields.

• Rates vol has come down a bit recently , which increases ability for levered and insto players to enter rates positions, but many still cautious given uncertain inflation outlook.

Equities

• 0DTE options, which appear to be a function of regulatory loopholing, seem to be creating localised gravity at the money. This is supressing Vol locally, but could potentially exacerbate a move if the local limits are breached.

• Vol and Skew are out of fashion after chronic underperformance in the last few years.

• Overall, option markets have become a huge determining factor in the way the equities complex reacts to incoming data.

  • It appears to my basic understanding that toward the end of a monthly option expiration cycle (and even moreso on monthly and quarterly OpEx dates) option decay flows (Vanna & Charm, for Vol and Time respectively) can dominate overall flows.

  • Additionally, Gamma effects (depending on overall positioning) can pin markets as OpEx approaches.

• Long story short, there appears to be very cyclical windows of weakness and strength in the equities complex which can overpower and influence the reaction to more fundamental type data coming into the market.

US Dollar

• Had a strong 2021 & 2022 before retreating significantly at end of year. Potentially turning higher again with US rates, however its hard to know which is leading.

• Higher US rates should be $ positive as they attract inflows but many other factors involved.

• If trade continues to slow, mercantile $ flows will slow and this should create additional demand in wholesale dollar funding markets.

  

• Simultaneously, if a recession is on the cards, any credit shock will likely significantly disrupt the supple of dollars in wholesale funding markets (via collateral scarcity)

Commodities

• Oil is the big one, oil is headline CPI. Oil is off big from its highs which started in March 2022 (yoy comps important for CPIs).

• Incredibly difficult to determine the current situation with China not yet reopened. Oil will be a big tell for if the China reopening story is a growth impulse.

• Most commodities have been generally rangebound for some time. Not much to say really.

Australian residential property has peaked. The bubble is bursting. The pain will cut wide and deep. The unbelievable returns from a non-productive asset class will, not surprisingly, prove an illusion. I’m talking proper millennial bearporn. Of course, I could be wrong (like every Australian property bear has been for the last 30 years) and I have been among their ranks for some time. However, I have never felt compelled to write a salacious doom piece with scary charts. That is because I draw a distinction between an overvalued market, and one primed for a fall. I believe the Australian residential property market finally ticks both boxes.

As noted above, over the years many have pointed out the imbalances in the Australian residential property market. The chart below tells me sometime around the year 2000, we collectviely lost the plot.

The accumulation of housing-related debt is staggering - from ~20% of income in 1960, to ~140% today.

The process at work here is quite understandable:

• Young households take on mortgage debt to own a home and start a family, essentially secured (for them) by their future earnings.

• This willingness to lever up puts upward pressure on prices; more money chasing limited stock.

• Rising prices would generally mean rising debt servicing costs (and attract construction), creating a natural limit, but not in an environment where rates have been declining steadily for 30 years.

• Additionally, declining interest rates have ‘justified’ high prices (see below).

• Rising prices invite speculation (I mean after all, can’t expect those boomers to keep their nest eggs in the bank earning 0%!).

• Repeat.

No worries. Except, you may have noticed declining rates is a key feature of that process.

Anyway, who says 1.8x1 debt to disposable income is bad? Beware a lonely statistic I always say! We should compare with some peers.

Note: some differences in RBA v OECD data, but its immaterial to the point.

You’ll note the 2007 US “housing bubble” is well and truly dwarfed by Australia and Canada based on this metric. However, as I’m sure the bulls among you are itching to point out, a high debt to disposable income is clearly no catalyst for a crash! Otherwise, we would’ve had one in the last 15 years. And I think that is correct. But perhaps you’ll agree it’s a dangerous precondition, akin to dry tinder on the forest floor.

To drive this point home, if we show real (that is, ‘inflation adjusted’) house prices v disposable income for a few countries, here it what you see. Spicy.

Are you convinced? I hope not, that would be too easy. We need moar.

Arson, Lightning, or Minsky? The three horsemen of the property apocalypse.

“Inflation” is back! And with a vengeance.

In March 2022, Australian inflation printed above 5%yoy for the first time since sept-2008 (an especially fun time from memory). This number was driven by broad price increases.

In my opinion, headline inflation will almost certainly continue higher in the near term:

• Rent up 0.99%yoy is far too low, and rents are reasonably sticky. See another great chart from Alex Joiner below showing the lag in the official data.

• May 21 AUD/USD was 77c, now 70c. ~9% decrease yoy has effectively increased the cost of imports. This may shock you, but we don’t make much stuff here anymore, so rising import costs hurt. Conversely, this is handy for exporters, but that’s little consolation for consumers in the short-term. As AUD falls, we import “inflation”.

• Crude Oil was US$70/Barrel in May-21, now US$110, 57%yoy, largely thanks to Vlad and derelict western energy policies. Australia is a net importer of refined oil products, which are actually a key bottleneck and therefore increasing more than crude. Higher energy costs impact the cost of producing almost everything, not just what you pay at the pump. This will continue to flow into CPI while energy costs stay so elevated.

• China’s insane zero-covid policy has dashed any hopes of the supply side of any supply chains returning to normal in the near term.

Therefore, I am left convinced we will print higher CPIs until something breaks, and even then, it’s no sure thing.

While the above can certainly change, without a catalyst the path we are on probably leads to higher inflation numbers than are politically acceptable, and from this I think we can glean some insight into the future.

Enter, the Arsonist: the Reserve Bank of Australia. I am not going to bash the RBA, that’s not in our scope today. They are the arsonist in this story because they do not have the tools to fix this problem, and yet politically, they are expected to extinguish the fire. Therefore, they will act by starting fire, to fight the inflation fire. Below are the market expectations; by the end of 2022, the market expects short dates rates to be ~3.00%.

It’s been 10 years since the RBA target rate was at that level, and I would argue economic fundamentals have only deteriorated in the intervening years – increased debt, older demographics, and our largest trading partner (China) slowing abruptly. So, colour me sceptical if we get to 3% without the RBA turning a fire into a blaze.

The heat begins with rising rates, which means increased debt service (mortgage) costs and therefore tighter financial conditions. Left unchecked, this will likely lead to decreased credit creation and falling asset prices, then lower investment & consumption—which if not exquisitely tuned (read: “soft landing”)—leads to a recession and debt defaults. That scenario can quickly spiral out of control. I believe the RBA know this, but they have no choice but to try because they must do something. As noted, they don’t have the right tools for the job, all they can hope to achieve is to slow demand enough to relieve inflationary pressures. The RBA raising rates is not going to pump more oil out of the Middle East or get more ships through Chinese ports, but they can destroy domestic demand via reverse wealth effects (in theory you spend less when you feel poorer), and recession (you’ll spend less because you’ll be scared of the future). It does seem like performing surgery with a machete though.

To summarise: the RBA is going to start a recession fire in the hope they can keep it under control and that their fire will extinguish the inflation fire. Make sense? Na, not to me either. Even so, I would have much more confidence if there weren’t so many other exogenous factors working against them. The largest problem seems to be the gathering storm that is a global economic slowdown, which could produce a lightning strike, catching the RBA and their controlled burn by surprise.

Enough words, some charts.

It is my view the second half of 2022 will mark the beginning of a global recession, magnitude unknown.

China, the world’s growth engine, has PMI’s slowing precipitously (a proxy for economic activity). This is to be expected with the extensive and ongoing covid disruptions, but a problem, nonetheless. Can they rebound like in 2020, or is demand the new problem?

It’s not just China. Another major exporter, Germany, the bell weather for Europe is showing warning signs of recession.

Globally, ‘financial conditions’, a euphemism for financial markets getting rekt, have tightened rapidly, if consumer prices continue to rise, this almost certainly has to continue as central banks continue to “fight inflation”.

A global recession2 with an energy-led inflationary impulse could be the lightning strike for asset markets, including Australian property.

So far, the picture I’ve painted combines aggressively rising rates (as a political response to significant inflationary pressure) with a slowing global economy. The world has not seen an environment like this in decades. I expect all financial assets to have a tough time in this setup. However, the assets I expect to have the worst time are likely those which are fundamentally overvalued (e.g., crypto, meme stocks, and property markets with extreme debt to disposable income ratios which have recently experienced record inflows of capital).

Flows

This chart from the ABS going back to 2004, shows the sheer magnitude of capital flowing into the Australia housing market. This is new loan commitments that measures flow, that is, new debt capital entering the market per month (a good chart to keep an eye on as a proverbial canary). I interpret this as a full-blown FOMO mania. At the start of covid there was a feeling that this was it, this was the moment all those non-property owners had been waiting for, “finally a correction!”, but then: “to the moon.”

The chart below shows total housing stock in Australia is valued at $10 trillion. Up $3 trillion since the pandemic started. Now at 5x GDP! As Tarric Brooker wonderfully points out, the US housing market plus 2x the total US equity market equals ~5x US GDP. Whoops.

This next chart shows lots of first home buyers piling in, but they generally seem to be exhausting themselves. Another chart to watch as a leading indicator.

What happens when a mania runs out of buyers? This is usually the problem with credit driven manias; once you run out of new money, the pyramid tends to collapse under its own weight. An economist named Hyman Minsky is famous for something called the ‘financial instability-hypothesis’. I won’t bore you with the details, but adapted for the Australian property market, we have something like this:

• Hedge Finance – Those who can pay both the interest and principal portions of new credit from existing cashflows with comfortable headroom in their debt servicing ratio, and even manage during a recession.

• Speculative Finance - Those who are able to pay the interest but require the ability to refinance or “roll” the debt, or who can pay the principal with an uncomfortable portion of their cash flows. They are likely to come unstuck during a recession as their cash flows decrease and asset prices fall.

• Ponzi Finance – Those who rely on increasing asset values to service their debts. They are of lower credit quality who should probably never have been given a loan with 10% down at 10x price-to-income. They are forced sellers in a recession.

At some point the “Minsky moment” is reached where some combination of a lack of buyers, external shock, change in sentiment, or regulatory change sets the forest alight. I’ll refrain from speculating on how many would come unstuck with falling prices or incomes, but hopefully the data previously presented shows just how far we have strayed from anything resembling reasonable.

So, for the question of Arson, Lightning, or Minsky? My answer is: all of the above.

Therefore, I believe this time is different (for bears). This combination of an extremely overvalued property market, exhausted after huge flows caused a blow-off top, combined with a budding global stagflation event as rates rise, will likely reveal Australian property to be a future case study in the madness of crowds (and governments).

I have laid out the situation as it is, and my case for a crash. This piece is already longer than anticipated. It is worth covering, home equity withdrawals, bank funding and solvency, potential draw-down timing and depth, and of course policy response. Because I am sure as many of you are thinking, “They” won’t let something like this happen. And I agree They will try. But They will fail. More to come.

Not financial advice.