After stocks and bonds were both battered, is the bear market rally over?
With the S&P 500 selling off on Dec. 5, the gold price followed suit; and with the USD Index and the U.S. 10-Year real yield rallying, risk off reigned on Wall Street. Moreover, with the bearish price action aligning with the hawkish payroll print from Dec. 2, the reality is that more of the same is required to curb inflation.
Please see below:
Source: Goldman Sachs
To explain, the dark blue line above tracks the U.S. federal funds rate (FFR), while the light blue line above tracks the Goldman Sachs Financial Conditions Index (FCI). For context, tighter financial conditions uplift the light blue line, with the ascent driven by higher interest rates, a stronger U.S. dollar, wider credit spreads, and lower stock prices.
Furthermore, a higher FFR is extremely bullish for the FCI, though if you analyze the right side of the chart, you can see that the FCI has declined dramatically, even as the FFR seeks higher ground.
Consequently, the pair's behavior mirrors the divergence that occurred in July/August, and unsurprisingly, the period culminated with the PMs and the S&P 500's previous bear market rallies. Yet, it wasn't long before the FCI hit new 2022 highs in September/October and risk assets suffered.
As it stands, the important point is not the correlation between the two lines; it's about the economic reality required to stabilize inflation. When the Fed increases the FFR, the central bank aims to increase the cost of debt and reduce consumption. In contrast, when the FCI doesn't accommodate, it reduces the FFR's effectiveness and makes the Fed's inflation fight more difficult.
So, while I warned throughout 2021 and 2022 that the fundamental outlooks were bullish for the FFR, real yields, and the USD Index, nothing has changed: the FFR needs to rise materially to normalize inflation, and the recent pullback in the FCI should culminate in higher highs before this bear market ends.
To that point, with more hawkish data hitting the wire on Dec. 5, resilient growth, employment and consumer spending continue to unfold as expected. For example, the ISM released its Services PMI, and an excerpt read:
“In November, the Services PMI registered 56.5 percent, a 2.1-percentage point increase compared to the October reading of 54.4 percent. The 12-month average is 57.2 percent, reflecting consistently strong growth in the services sector, which has expanded for 30 consecutive months.”
More importantly:
“Employment activity in the services sector grew in November after contracting in October. ISM ’ s Employment Index registered 51.5 percent, up 2.4 percentage points from the October reading of 49.1 percent. Comments from respondents include: ‘slow improvement in staffing levels’ and ‘recruitment fairs have helped enable open positions to be filled.’”
Thus, with demand still outweighing supply in the U.S. labor market, the fundamental backdrop is highly bullish for wage inflation. Moreover, the average hourly earnings (AHE) print on Dec. 2 proved that point. I wrote on Dec. 5:
Source: Investing.com
AHE increased by 0.8% month-over-month (MoM) in November, which was more than double the consensus estimate of 0.3% MoM. Likewise, the 5.1% year-over-year (YoY) increase also surpassed the 4.6% YoY estimate.
As a result, the crowd materially underestimates the resiliency of inflation and the measures required to control the pricing pressures. The ISM report added:
“The Business Activity Index registered 64.7 percent, a substantial increase of 9 percentage points compared to the reading of 55.7 percent in October.”
Please see below:
To explain, the blue line above tracks the ISM’s Business Activity Index, and the sharp rise on the right side of the chart highlights the strength realized in November. So, while gold is priced for a dovish pivot, the fundamental reality is much different.
Also, S&P Global released its U.S. Manufacturing and Services PMIs on Dec. 1 and Dec. 5; and while both headline indexes dipped into contraction, the employment results were relatively bullish for the FFR.
The manufacturing PMI report read:
“Although firms continued to fill long-held vacancies, numerous companies noted that
voluntary leavers were not replaced in order to reduce cost overheads. Employment rose at the joint-slowest pace since January.”
The services PMI report read:
“Despite a reduction in pressure on capacity, firms continued to hire midway through the fourth quarter. Nonetheless, where job creation was noted, firms largely attributed this
to the filling of long-held vacancies. The uptick in staffing numbers was only marginal and the second-slowest since September 2020.”
As a result, while hiring has moderated, any uptick in staffing is hawkish when the unemployment rate is at a ~50-year low. Remember, the Fed needs to increase the unemployment rate to reduce wage and output inflation; and with the labor force participation rate declining as payrolls increase, it's the opposite of the Fed's desired outcome.
As such, it will take a major collapse in inflation, employment, and economic activity to spur a dovish pivot, and we're nowhere near that scenario right now.
On top of that, Mastercard released its SpendingPulse U.S. Thanksgiving retail sales report on Nov. 29. An excerpt read:
“Shoppers drove U.S. retail sales during the Thanksgiving weekend up +10.9% YoY excluding auto (…). In-store sales increased +10.5% YoY while e-commerce continued to experience strong growth up +12.5% YoY for the weekend running Thursday, November 24 through Sunday, November 27.”
Michelle Meyer, North America Chief Economist at the Mastercard Economics Institute, added:
“Not only did consumers get their holiday shopping in this weekend but they also dined out with family and friends. Restaurants did particularly well, reinforcing consumer demand for the experience economy.”
Please see below:
Overall, while I warned for many months that demand was much stronger than the consensus realized, Americans’ ability and willingness to spend should keep inflation uplifted and drag the FFR higher. Therefore, while the gold price implies that rate cuts and QE are on the horizon, don’t be surprised if those hopes are dashed and a substantial drawdown occurs.
Alex Demolitor
Precious Metals Strategist