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Second Successive Quarter of Negative GDP Growth Suggests US Economy is Technically in a Recession Image

Second Successive Quarter of Negative GDP Growth Suggests US Economy is Technically in a Recession

August 08, 2022

Second successive quarter of negative GDP growth suggests US economy is technically in a recession.

 

What Are The Implications for the Commodity Complex?

 

The Federal Reserve raised its key interest rate by 0.75% yesterday, for a fourth time this year, to 2.50%, to try and dampen runaway inflation.

 

Its Chairman, Jerome Powell, stated that whilst recent indicators of spending and production had softened the jobs market remained resilient and he did not think the US economy was in recession.

 

Q2 GDP data released today shows the US economy contracted for the second successive quarter by -0.90% which suggests the US economy (despite Powell’s rhetoric) is in fact technically in a recession.

 

The stock market rallied yesterday following comments by the Fed Chair in his press conference that he acknowledged a slowing economy and the need for future rate hikes to be data dependant.

 

Since the Global Financial Crisis, US central bank rates have peaked at around 3%, saddled by debt. Whilst smaller rate hikes are still on the agenda in the second half of the year; we expect the Federal Reserve to pivot towards easier money sometime in early 2023 to support economic growth.

 

Some market commentators have been comparing this inflationary cycle to the 1970’s when Paul Volcker was at the helm of the Federal Reserve and pushed short term key interest rates to nearly 20% to dampen inflationary pressures. A few have been calling for market forces to determine the right level of interest rates which would be in the region of 12% based on the most recent inflation reading of 9.1%.

 

That’s just not possible in the current environment. US Debt to GDP was about 35% in the 1970’s providing scope for much tighter monetary conditions. The US debt/GDP ratio currently stands at 120% on a par with Spain and Portugal – which is hard to believe.

 

Calls for much higher interest rates seem to ignore the fact that some of the inflationary pressures has been caused by supply chain disruptions arising from the pandemic and the war in Ukraine.

 

Please see the video below where the Fed Chair Jerome Powell testifies before the Senate Banking Committee on monetary policy.

 

 

There is limited scope for further US rate hikes due to current debt levels of around $30 trillion exasperated by recurring budget deficits, increased miliary spending to support the war effort in Ukraine and a revived climate bill of $369 billion.

 

Managing the debt at zero interest rates was easy enough as there was virtually no debt servicing costs but with rates now at 2.50% its costing the US Treasury $750 billion annually (and rising) to cover interest payments.

 

When interest rates hit 3% in the autumn close to $1 trillion of tax revenues will go towards servicing the national debt. The US Exchequer raised $4 trillion in tax receipts in 2021 which means that 25% of tax revenues (ie. $1 trillion) will be used to service the debt leaving a massive hole in public finances. This is not a financially sustainable situation which will require either:

 

  1. tax increases into a slowing economy with mid-term elections looming;

  2. a significant reduction in public expenditure which would be contractionary;

  3. raising the debt ceiling and borrowing even more money to cover the revenue to expenditure shortfall which seems pointless when they are trying to improve finances.

 

The Federal Reserve is trapped making a pivot towards a more dovish monetary policy highly likely within the next 3-9 months.

 

This leads us to the commodity complex which has been underperforming in what is supposed to be a very favourable inflationary environment which is incredibly frustrating for investors. We mustn’t forget that ‘time’ is the most critical aspect of investing.

Its easy to forget that some market analysts were saying just six months ago that capital which would have naturally flowed into gold as a safe haven asset was now being invested in crypto currencies and that Bitcoin exhibited the same properties as gold – and was an even better ‘store of value’. Well ‘time’ has put that argument to bed with bitcoin falling 75% in a relatively short period and a few crypto currencies going bust.

 

Leaving that minor point aside, what are the strong headwinds facing precious and industrial metals, which can justify the poor performance.

 

HEADWIND 1

 

The US Federal Reserve has tightened monetary policy more aggressively than other central banks (particularly the ECB) with rising bond yields attracting capital flows from yield seeking investors who have shied away from non-interest paying commodities.

 

HEADWIND 2

 

Investors have been piling into the US Dollar, which has been appreciating strongly against a basket of major currencies (more than 15% in a year) which in turn has driven gold prices lower. The strong currency appreciation is hurting US exporters resulting in a deteriorating US balance of payments deficit in goods and services which can be corrected through a currency devaluation. A strong US Dollar is causing havoc in world markets particularly in emerging markets which trade in the greenback and require a soft US Dollar for exports. The consequences are severe and range from deepening poverty levels, to squeezing corporate earnings and the risk of debt defaults spreading across markets. There is a possibility that policy makers may soon have to intervene to rein the dollar back.

 

HEADWIND 3

 

A global recession would of course trigger a general sell off across all asset classes however precious metals always have a vertical lift off on signs of an economic recovery compared to equities which lag behind.

 

HEADWIND 4

 

China was in a much stronger financial position during the global financial crisis than it is now resulting in less demand for industrial metals.

 

CONCLUSION

 

Despite all the doom and gloom in the commodities space the long-term fundamentals remain rock solid.

 

The US Dollar is arguably overbought (given the extent of monetary debasement) and has been propped up by rising US interest rates however once the Federal Reserve starts loosening policy the US Dollar will correct propelling precious metals higher.

 

A whole raft of technical graphs including the 14-day relative strength index as well as the Dow Jones to Gold Index support this thesis.

 

Market extremes are never sustainable and fundamentally gold should be trading at much higher levels. In October 2021 we stated that gold tracks the growth of M2 US Money Supply and therefore a fair value would be around the $2,500 mark. There is of course no guarantee that gold will mean revert but this is a realistic target. Interestingly Goldman Sachs is one of the few elite private banks to issue a research note (January 2022) recommending gold with a target price of $2,500.

 

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