The Big Picture 

| May 6th, 2022


A Global Downturn
Employment & Inflation

To describe the current environment as challenging is an understatement. Global inflation has spiked, exacerbated by the war, financial conditions have materially tightened and the global economy is in a synchronised slowdown that had begun months before the war started or China entered its Covid shutdown.

Looking back over the past six months, the core themes of the decline of liquidity and the demand and income shock combined with softer growth have played out well. However, in contrast inflation has been higher and more persistent than I believed it would be and, in turn, the (priced) reaction function of central banks has been greater.

Will the tightening of financial conditions and the longstanding issues of economic health, excessive debt and demographics overpower the lagged effects of excessive stimulus and supply disruptions?

That was the core issue in a client meeting yesterday and in most of my conversations with investors.

A long-standing view has been that many tend to look back at pre-pandemic days through rose-tinted glasses, forgetting that most of the world’s central banks were easing monetary policy in 2019 because of weak growth. In short, the patient wasn’t in the best condition before they caught Covid.

Two years on, it seems that the global economy has a degree of long Covid. Extreme actions by governments and central banks concealed many problems. Companies that would have gone to the wall in normal times were protected by moratoriums, grants and loans while individuals also benefitted from government income schemes and forbearance still ongoing in the case of US student loans.

I have called this the ‘great deferment’. It’s now ending. More on that later.


The weird and wonderful world of ‘money’ is difficult to follow. For me, reserves at Federal Reserve banks are one of the best indicators of pure liquidity and I’ve focussed on them since the beginning of the year when they started to fall sharply. They are a much better indicator than total Fed assets which have yet to start falling.

Since peaking in December, they have fallen by almost $1 trillion (22%), plunging by a record $320 billion in the last week of April.

This simple chart has worked wonders when it comes to equities.

Moreover, over a much longer period of time they have been a reasonable guide to margin debt.

Away from reserves money growth has slowed to a halt.

Weekly deposit data gives us a good lead on the monthly money supply. Deposits at commercial banks are where they were in January and are now only 7% higher over the past year. The implications for M2 growth are clear.

Money growth is slowing rapidly.

In addition to reduced liquidity there are growing signs of a collateral shortage.

3-month bills are over 30 basis points through OIS.

2-year swap spreads are at their highs.


Closely tied to the falling liquidity view was that MBS would widen in anticipation of the Fed moving to QT. In turn to would increase the pressure on other credit spreads.

Compared to US treasuries mortgage rates have rocketed. The 30-year fixed national average has surged over 220 basis points this year to 5.5%. This is the fastest increase in mortgage rates since the early 1980s.

In its MBS reports Bloomberg uses the Fannie Mae 30-year current coupon against the blended 5 and 10 year US treasury as its main reference. It began to widen rapidly at the start of the year, flashing a warning sign for credit as a whole. It signals further problems for IG and HY bonds.

However, falling margin debt (as per reserves) also indicated increased risk.

Moreover, the fall in the ISM PMI added further weight to the view.

Add in this…

This downward pressure is unlikely to ease given…

The Global Downturn

Global activity peaked around the middle of last year.

The S&P Global Manufacturing PMI Output Index is now in contraction.

China is the primary source of recent weakness thanks to its approach to Covid. However, Chinese manufacturing orders have been weakening since the second quarter of last year and the US is not immune.

Nor is Korea.

Weaker domestic demand in China is understandable given the extent of shutdowns etc, however export orders have been even weaker with the manufacturing subindex falling to 41.6.

But we should not be surprised by this.

Global consumer confidence has collapsed.

Retail sales are weakening, goods demand was brought forward by the pandemic, there are multiple reports from retailers and producers of faltering demand (AO, Sealy, Whirlpool, Amazon etc) and inventories in the US have surged to record highs.

Inventories have played a powerful role in boosting US GDP growth over the past three quarters with real GDP excluding inventories growing by a meagre 0.37% annualised.

Coincidentally, the contribution of final sales to GDP has also averaged 0.37% over the past three quarters.

Meanwhile, the fiscal contraction will continue to weigh.

Against this background the Fed’s reduced March projection of real GDP growth of 2.8% looks increasingly implausible.

It is even more challenging when one considers the building housing bust.


Sales are falling rapidly as mortgage costs have surged and affordability has plunged. Sales volumes of existing and new homes have already fallen sharply while mortgage purchase applications and pending sales indicate a return to 2018 levels of activity, at best.

Much worse, the construction industry, in classic boom-bust behaviour has a record number of homes under construction, 1.6 million. Another example of record inventory.

Housing bulls will say that there is a shortage of supply. However, The St Louis Fed would differ.

Looking ahead, residential construction (roughly $1 trillion a year), is likely to become a negative for GDP over the next four to six quarters.

The record 1.8 million people employed in real estate (not construction) is likely to be a lot lower in a year’s time.

So too will housing prices. The income multiple has surged and that doesn’t even reflect the rise in mortgage rates. The monthly payment of a $300,000 30-year mortgage has increased from $1,300 at the end of last year to $1,700.

The US housing market has yet to crack. It will, especially as rate-sets from last year expire.

Meanwhile, don’t forget what’s happening in other frothy markets such as Australia, Canada and New Zealand. Prices are falling materially, by double digits.

Employment & Inflation

One, current, saving grace for the US economy is the continued strength of the labour market. The latest JOLTS data supports that view, for now. However, the labour market is a lagging indicator. Unemployment proved a useless guide in 2018-19 when it was at 3.6% before the FOMC eased.

Moreover, note the latest slippage in ISM manufacturing employment index and small business hiring plans.

Fears of a tight labour market reinforcing the highest rates of inflation in a generation dominate central bank thinking for now. Understandably so given the threat to what credibility they have left.

Monetary and fiscal stimulus have been the prime drivers. With the benefit of hindsight, stimulus was excessive, but given the nature of the pandemic who knew what was correct?

However, I have long regarded the current experience as similar to China in the aftermath of the GFC. Stimulus was vast with M1 and M2 surging by 40 and 30 percent respectively. The end result was that it took much longer for its effects to wash away. Inflation didn’t peak until the end of 2010.

I believe that we are in similar environment now. Note this chart of US M2 and deposit growth against CPI.

We know where money growth is going. Lower, and its downward trajectory will accelerate as the Fed (other central banks) reduces its balance sheet.

Meanwhile, demand is faltering, quickly.

Against this background, I believe that goods inflation will be in negative territory by the last quarter of this year. As we move into 2023, shelter costs are also likely to ebb.

The outlier is energy. However, if Covid has taught us anything, it’s how quickly the environment can change and governments adapt. For example, an LNG import facility will be operating in Hamburg by the end of the year.

Necessity is the mother of invention.

More immediately, base effects are very powerful in the second quarter. US headline and core CPI averaged +0.8% month-on-month in Q2 21.

Separately, looking at the Dallas Fed Trimmed Mean and Core CPI, the Dallas measure suggests that we may see another downside surprise on core inflation. The long run average of the two is zero.

Perhaps, even better, is the fall in the Manheim Used Vehicle Index YoY for April.


An easing in the headline rate, even with an aggressive Fed, is likely to prove supportive for fixed income and, in turn, cause a reduction in volatility and slightly easier financial conditions.

Outside of crisis moments, financial conditions have rarely been tighter.

And I find this hard to ignore.

As for the dollar, I was a bull from May of last year, in line with the curve flattener.

I called time on the curve at the end of March.

For now, the dollar looks in overshoot territory.

The curve is off its lows.

And rate differentials have not moved in its favour for some time. The pain feels like EURUSD above 1.08.

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