While the consensus assumes that a mild recession is possible, major imbalances signal a more ominous outcome.
While the bearish cocktail of unanchored inflation and higher interest rates drove gold, silver and mining stocks’ fundamental performances in 2022, a recession should push them to new lows in 2023.
For example, nine of the last 10 bouts of rising inflation have ended with recessions since 1948, and the Fed’s “transitory” error in 2021 aligns this iteration with the other economic malaises. In a nutshell: the Fed let the U.S economy run too hot, and now has to over-tighten to normalize inflation. In the process, the 2022 economic script should flip in 2023.
Please see below:
To explain, the red line above tracks the year-over-year (YoY) percentage change in the headline Consumer Price Index (CPI), while the green line above tracks the U.S. unemployment rate. If you analyze the relationship, you can see that the headline CPI often hits a cycle high, the unemployment rate hits a cycle low, a recession occurs, and then the metrics converge.
Consequently, while we warned repeatedly that high inflation and a robust U.S. labor market would push the U.S. federal funds rate (FFR) higher in 2022, a reversal of fortunes in 2023 should reduce inflation at the expense of employment.
To that point, history shows that large gaps between the YoY headline CPI and the unemployment rate elicit sharp reversions; and if you analyze the right side of the chart, you can see that the gap between the two rivals the major divergences from 1948, 1951 and the 1970s/early 1980s. As a result, if (when) the next iteration unfolds, the gold price should suffer as liquidations spread across the financial markets.
Furthermore, with hawkish economic data hitting the wire in December and for much of 2022, higher interest rates have suppressed investor sentiment. However, the economic impact of a higher FFR has been minimal, which highlights why the bearish fundamental thesis still has room to run.
For example, the Fed hoped that a higher FFR would reduce inflation and slow the U.S. labor market to a greater degree than what transpired. Moreover, while investors panicked about a potential collapse of the U.S. housing market, the damage has been immaterial, and much more weakness should materialize before this bear market ends.
Please see below:
To explain, the U.S. housing market is no different than the S&P 500; and with the crowd so used to the Fed saving the day, they buy the dip believing that the post-GFC trend of perpetually higher prices will continue. Yet, their recency bias contrasts the fundamental realities.
The gray line above tracks the S&P/Case-Shiller U.S. National Home Price Index. If you analyze the right side of the chart, you can see that the recent slide is inconsequential relative to the near-vertical ascent that occurred during the pandemic-induced stimulus frenzy in 2020 and 2021.
So, U.S. home prices have barely corrected, and investors are kidding themselves if they think the worst is in the rearview.
To that point, if you analyze the gray line’s ascent leading up to the global financial crisis (GFC), you can see that a sharp re-rating occurred as prices reconnected with fundamental reality; and while the narrative proclaims that the U.S. housing market has been crushed, the reality is that the correction has likely only just begun.
Remember, it’s not only the historical implications of unanchored inflation that signal a sharp recession in 2023, but the imbalances of near-record low unemployment and near-record high home prices highlight why the metrics need to rise and fall substantially to reach more normalized levels.
Continuing the theme, the frailty of leading economic indicators also highlights why recession pressures should accelerate in 2023.
Please see below:
To explain, the green line on the first chart above tracks the movement of RecessionAlert's short-term leading economic index, while the black line tracks the probability of a recession over the next three to four months.
Similar to the inflation-unemployment divergence that we highlighted at the outset, the short-term leading economic index has sunk into negative territory, while the recession probability metric stands at 98.57%.
Therefore, while Main Street sidestepped Wall Street's carnage in 2022, both should feel the pain in 2023; and as the drama unfolds, risk assets like gold should suffer, and silver and mining stocks will likely experience the greatest drawdowns.
In addition, the crowd still assumes that the Fed will cut interest rates in 2023. However, we've warned on numerous occasions that dovish pivots amid high inflation occur alongside major economic weakness, which makes the events bearish, not bullish. Or, to put it another way, the fear of an imminent recession overpowers the celebration of lower interest rates and causes a panic-like sell-off.
As such, investors have priced in an extremely unrealistic outcome in 2023, as even if the U.S. avoids a recession (highly unlikely), the fundamental backdrop is still more bearish than what's anticipated.
Please see below:
To explain, Goldman Sachs expects the FFR to peak in the 5% to 5.25% range in 2023. But, while its forecast aligns with the consensus, the latter expects rate cuts in the back half of the year.
Conversely, Goldman Sachs expects the U.S. to avoid a recession, which is why the investment bank projects no rate cuts in 2023; and therein lies the conundrum: if the U.S. economy remains resilient, the futures market will have to price in a higher FFR for the end of 2023.
On the flip side, recession-induced rate cuts are unlikely to increase optimism when corporate earnings forecasts are being cut dramatically. Thus, both scenarios are bearish, and risk assets need to fall further to reflect the challenges that lie ahead.
Overall, while the PMs outperformed stocks and bonds in December, they should play catch-up when the next bout of panic arrives. Consequently, we expect more weakness before long-term buying opportunities emerge.
Alex Demolitor
Precious Metals Strategist