The Breakdown - Why the Recession Conventional Wisdom is Wrong

Episode Date: July 9, 2023

A reading of Alex Kruger's thread: https://twitter.com/krugermacro/status/1675989375765852160?s=46&t=5Nl1EhwpFOmRdaVNr7DApg Full report from Asgard Markets https://www.asgardmarkets.com/post/the-big-picture Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Sunday, July 9th, and that means it's time for Long Read Sunday. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly. pod. Hello friends. Today for Long Read Sunday, we are reading a thread from Alex Kruger, which is the summarization of research from his firm Asgard markets. In many ways, it's all about a recession that

seems like it's upcoming. And I think what makes this such an interesting discussion is two things. First of all, for the last couple years, basically ever since we started raising interest rates, a recession has loomed large as the thing that was right around the corner. At many points, Wall Street has been rooting for a recession, thinking that it was the only way to get Powell off of his interest hiking cycle. Yet, at the same time, we don't really have a mental model for a recession that isn't predicated on a financial crisis. For most of modern memory, recessions have been the fallout of emergency events, rather than just a normal part of the business cycle. Indeed, one of the warppings of the zero interest rate era was the fact that we weren't allowed

to really have recessions in the same way. Because of that, it doesn't really seem like people have great models mentally or economically for what a recession might actually look like, and so I think this sort of research is really valuable in that light. So this was originally tweeted by Alex Kruger at Kruger Macro on July 3rd. Let's dive in. Kruger writes, A recession is imminent, risk assets are expensive, and stocks always bottom during de-leveraging driven recessions. Is a major crash inevitable?

Not at all. In this research report, we explore how prevalent bearish theses are flawed and why we are bullish on risk assets. Backdrop number one. Most data points indicate a recession is coming. Leading economic indicators have been moving sharply lower, consumer expectations are extremely pessimistic, and employment is ticking higher. The inversion of the yield curve has been ringing the alarm for a while.

This phenomenon where the yield on longer-term bonds falls below that of shorter-term bonds has historically been a reliable indicator of impending economic downturns. Curve inversions serve as a warning sign that investors are demanding higher returns for the perceived risks associated with the future economic outlook. Additionally, the March banking crisis has heightened fears of a broader impact on the economy. The fear of this crisis spreading and causing significant disruptions in the financial sector has contributed to the prevailing sentiment that a recession is on the horizon. Backdrop number two.

The inflation problem. Unlike recent cycles, inflation has become a genuine concern and has exhibited resilience even in the face of the Federal Reserve's historic hawkishness. What initially was touted as driven by supply chain disruptions has permeated into various sectors such as housing, services, wages, and tradable goods. While there are signs of inflation receding, the pace is not fast enough to warrant a Fed pause just yet. Kruger then shows a chart that highlights where we are in terms of core CPI and unemployment versus past years when the Fed started cutting rates, and the reality is that we are just way,

way lower when it comes to the unemployment rate than basically any other period of cuts in history. Back to Kruger. Backdrop number three. Equities always bottom during strong recessions. Traders often believe stocks always bottom during recessions. Historically, equities bottom either around monetary policy easing or re-acceleration of economic activity. As showcased by a Goldman Sachs study diving into the S&P's drawdowns of greater than 15% since 1950, when the correction is driven by de-leveraging, the bottom happens during recessions,

close to the ISM trough, i.e., re-acceleration of economic activity, and long after the Fed has started to ease. Backdrop number four. Stocks are expensive by many metrics. For example, the earnings yield on the S&P 500 12 months forward is now around the same levels than the yield on U.S. corporate investment grade bonds and the rate of three-month treasuries. It were to seem a recession is inevitable. Risk assets are expensive

and stocks always bottom during de-leveraging driven recessions. Guess a major crash must thus be inevitable. Alex then includes a graphic that says dramatic pause and continues. Let's explore the other side of the coin and debunk it all. First, recessions. The upcoming

recession, if any, has been the most widely predicted recession in the history of civilization. Therefore, both markets and economic actors have front-run it, which by definition reduces the probability of its happening, and its magnitude if it does. Economists and analysts lowered their forecasts in response, leading to one of the most important drivers of equity performance this year, economic activity consistently surprising to the upside. And that makes sense. After all, markets are pricing mechanisms, and what truly matters is not if data comes in positive or negative, but if data comes in better or worse than what is priced in.

The view that risk assets must bottom if the U.S. enters a recession is also flawed due to the very limited sample size of U.S. recessions. Plenty of counter-examples exist outside of the U.S. For example, the DAX has been printing all-time highs while Germany is in recession. Second, valuations are in the eye of the beholder. Bias in data and time frame selection can make all the difference. There are metrics that depict fair pricing and merit-closer examination, such as forward PE for the S&P 500 X-Fang. Third, markets are forward-looking and the AI revolution is real.

The world is undergoing an AI revolution comparable to the internet evolution or the industrial revolution. Invidia's earnings have just skyrocketed. Analysts estimate AI could replace up to 25% of current employment in developed countries. While generative AI could raise annual productivity growth by 1.5 percentage points over 10 years, and this productivity boost could eventually increase annual global GDP by 7%. Is an AI bubble forming? Likely so, and it is just getting started. Fourth, liquidity. The market has been placing extreme emphasis on the TGA draining liquidity. Many analysts see the Treasury refilling the TGA as a strong headwin for risk assets, akin to quantitative tightening, whereas the Treasury issues bonds in exchange for liquidity.

So TGA up, risk assets down, right? Wrong. The TGA is known to be decorrelated from risk assets for very long periods of time. In fact, the four largest TGA rebuilds over the last two decades have had a minimal impact on the market. Contrary to popular belief, liquidity is not the main driver of asset prices. It's all about flows, not liquidity. Positioning, rates, liquidity, growth, valuations, and expectations are what drive flows. After all, liquidity is a snapshot, while prices are forward-looking. While QT represents an asset swap that increases duration in the market, swapping long for short, TGA replenishment at present simply changes investor allocation from one cash-like instrument to another, as most issuances in bills short-term treasuries. Furthermore, much of

the TGA refill comes from market funds rotating holdings away from the Fed's overnight reverse repurchase facility, having therefore no impact on net liquidity. Fourth, the Fed is almost finished hiking. The main reason for risk assets to crash in 2022 was the Fed's tightening cycle. The Fed has delivered 20, 25 basis point rate hikes in its fastest and most aggressive hiking cycle in history. The tightening cycle is thus likely 90% done, with the Fed talking about two more hikes ahead. Given 20 hikes already behind us, what difference would it make if the Fed were to raise three more times instead of two? The answer is simple, likely not that much. Sixth positioning is cash heavy.

According to the ICI, money market funds hit a record 5.4 trillion, while institutions hold 3.4 trillion as of June 28th, roughly 2% above the prior highest level on record, which happened in May 2020, the darkest point of the pandemic. TLDR? Everyone is bearish, but the recession has been front run. AI revolution is real, the Fed is almost done, and the market is cash-heavy. We see no reason for changing our bullish stance, which we've held for all of 2023. The trend is your friend, and the trend is up. What could go wrong? The market is estimating a 25 to 35% probability of recession in the U.S. A market crash, would require an information shock, such as significant deviations in inflation, PMIs, adverse geopolitical developments, or a dismal earning season for big tech.

All right, back to NLW here. This is a super, super information-dense LRS, given that it's a huge report that's just consolidated into a Twitter thread. And I highly encourage you to go check out both the thread and the research paper it comes from, both of which, of course, I will link in the show notes. But what I love about this and what I always love about Kruger's thinking, is that it actually puts numbers behind contrarian thinking, and it's never contrarian for the sake of being contrarian. Much less than most people who are commenting about markets on Twitter, Alex isn't really

out to prove anything to anyone else. Historically, he's made most of his money by trading his own money, meaning he's not just trying to look smart. What you get then is a pretty unvarnished perspective based on different ways of squinting at the same data that other people are looking at with a huge amount of context. I think that if you take nothing else away, one of the most salient points is his point about the fact that this has been the most anticipated recession in history. If you've listened to the breakdown over the last 18 months or so, you know that it has been just in some ways an endless game of waiting for that to actually happen. However, it hasn't. And there are a number of reasons for why it hasn't. But the reality is that this year, there has

been a new exogenous force that people did not expect in the form of the AI revolution. that whatever bubbly dynamics it might have in terms of stock prices is clearly to everyone who has interacted with these technologies, a real phenomenon and a real force. It strikes me as highly possible that the markets have at this point gotten sick of waiting for a recession to happen and are just going to move on with their damn lives now, so they don't miss anything else when it comes to AI or other interesting areas. You can feel physically this shift away from dumerism in so many different spaces. certainly crypto being one of the leaders. And in this way, I think crypto and Bitcoin are leading

indicators of where the rest of the market is likely to head. Now, to Kruger's point, there's a million external factors that could end up changing the trajectory of markets. But I think for now, there is a lot of truth in what he has written here. Thanks to Alex and his team for this great research report. Thanks to you guys for listening. And until next time, be safe and take care of each other. Peace.