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Iron Capital Insights

  • Iron Capital Insights
  • August 23, 2023
  • Chuck Osborne

Home, Home on the Range

Right now the market is “…Home on the range / Where the buffalo roam / And the deer and the antelope play / Where seldom is heard, a discouragin’ word….” Okay, that is probably the limit on this analogy. We hear lots of discouragin’ words from the pundits, however, we are frustratingly range-bound.

The recent worries have been about interest rates. The ten-year Treasury has climbed to more than 4 percent, and this has markets in a worry. After a rally in July, when the market finally broadened out from its AI craze, we entered earnings season with 80 percent of companies beating expectations, which is higher than the 77 percent average. The market has reacted by going down.

The bears are back and they sound like a broken record. “We are heading to a recession.” “Inflation is back, just look at oil prices.” The Fed is done (or almost done) raising rates, “…but they are going to keep these rates too high for too long.” Finally, they remind us that Fed policy has “long and variable” lags.

We know now that these experts have been dead wrong for a year and a half, but are they right now? Let’s take these points one at a time.

Are we headed to a recession? Through August 16 the Atlanta Fed’s GDP Now, which is a real-time measure of GDP based on the data that has been reported thus far, is saying that the economy is growing at 5.8 percent. Once again the “blue chip” consensus of economists predicted that we would grow at 0 as of the beginning of this quarter; they now have raised their estimates to 1.5 percent. This begs the question: How long can “blue-chip experts” be this wrong and still be referred to as “blue chip”?

Will GDP growth end the quarter at more than 5 percent? Not likely. There will be data points that come in weaker than that as the quarter goes on, but there is very little probability that we sink all the way to 1.5, let alone actually go to 0, as these experts projected. More importantly, in our opinion, than the astounding 5.8 percent number, is the trajectory: Data keeps getting better. The economy is improving, not going in the other direction.

Why are they so wrong? In my opinion it is because they are still denying that we had a recession last year. We had two quarters in a row of negative GDP growth – if that had been labeled a recession (as it had been every other time in economic history), then we would understand that we are in the recovery stage of the business cycle. It is a muted recovery, largely due to bad policy (that is for a future Perspective), but it is a recovery nonetheless.

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What was supposed to bring on this recession in 2023? The Fed raising interest rates. This may be one of the most controversial views I possess, but it seems clear to me that the Fed does not have the power that so many just blindly believe they have. For more on that please watch or listen to our podcast episode 2. Anyway, as inflation has been dropping, the pundits grabbed onto oil prices rising this summer to argue that inflation is still rising and therefore the Fed, which has accomplished nothing by raising rates over 5 percent, will send us to recession by going another 0.25 percent.

There are two problems with this nonsense. First, the Fed largely ignores energy prices. They stubbornly cling to “core” inflation measures, which do not include energy or food, as those prices are very volatile. This argument was really grasping at straws. However, even if the Fed did look at oil prices, they are simply trading in a range. They have basically been in the $70s for some time now. They will drop to the high $60 range and creep to the low $80 range, but that is it. This summer oil moved from the low of this range up to the high and now, sure enough it has evened out, and if anything looks to be going back down. Oil isn’t going anywhere, it is trading in a range.

In light of this, will the Fed keep rates high? Probably, because as we have pointed out before, the Fed doesn’t have a good track record of returning to “normal” after a crisis. However, if their policy isn’t slowing the economy now, why would it do so later?

Their answer would be, “Milton Friedman taught us that Fed policy has long and variable lags.” This means that it is hard to predict the impact of Fed policy and that there is a delay in the impact taking place. Milton Friedman proved this. What they don’t say is that Friedman came up with that phrase in 1962, and it was based on research of the economy from 1890 until 1950.

To take the lag argument seriously, one has to believe that our economy in 2023 moves no faster than it did in 1950. Sorry, but that is absurd. If there is any lag at all in our modern economy, it is most certainly faster than in the past.

The bear arguments carry no weight. We had a strong rally in July, and as is the case with markets, we then take a step back to move forward once more. The economy is doing fine: 80 percent of companies have beaten financial expectations. The rally will resume, we just have to be patient and prudent. Meanwhile, the pundits will continue their discouragin’ words, but we are just stuck home on the range.

Warm regards,

Chuck Osborne, CFA
Managing Director