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[This blog post is an excerpt from a recent commentary at specuative-investor.com]

We consider gold bullion and the S&P500 Index (SPX) to be effectively at opposite ends of an investment seesaw, with the SPX doing better when confidence in money, central banking and government is rising and gold doing better when confidence in money, central banking and government is falling. As discussed in a few TSI commentaries and blog posts over the past two years (for example, HERE), our investment seesaw concept was part of the inspiration for the Synchronous Equity and Gold Price Model (SEGPM) created by Dietmar Knoll.

In general terms, the SEGPM uses historical data to define a quantitative relationship between the SPX, the US$ gold price and the US money supply. More specifically, it is based on the fact that adding the SPX to 1.5-times the US$ gold price (and applying a scaling factor) has, over the long-term, resulted in a number that tracks the US money supply. Consequently, it indicates the extent to which the combination of the US stock market and gold is currently under/over-valued compared to the money supply and can provide clues regarding likely future price levels for gold and the SPX. For example, a forecast of likely future levels for the SPX and the money supply would project a likely future level for the US$ gold price.

The following monthly chart shows our version of the SEGPM. On this chart, the red line is US True Money Supply (TMS) and the blue line is the Gold-SPX Model (the sum of the S&P500 Index and 1.5-times the US$ gold price, multiplied by a scaling factor).

The Model’s current message is that at today’s levels of the money supply and the SPX, the gold price (around US$2150) is in the right ballpark. A much higher ‘fair value’ for gold would require a larger money supply and/or a lower SPX. For example, if the money supply were 5% larger and the SPX were around 4200 (about 20% lower than it is today), the Model would indicate a ‘fair value’ for gold of around US$3200/oz.

In the middle of last year (the last time we discussed the Gold-SPX Model) we thought that the low-$3000s for the US$ gold price was a plausible target for the first half of this year. While it is not out of the question that this target will be reached during the first half of this year, this is no longer a likely scenario because the SPX has performed much better than we thought it would. However, there is a good chance that the low-$3000s will be reached before the end of this year.

[This blog post is a brief excerpt from a commentary published at speculative-investor.com last week]

The combination of the ISM Manufacturing New Orders Index (NOI) and the yield curve, our two favourite high-frequency leading indicators of US recession, has been warning of imminent recession since September-2023. Clearly, the warning has not been timely in that no recession has materialised yet. Furthermore, a month ago we noted that while the message of the yield curve was unchanged, the NOI had just risen by enough to move well above its recession demarcation level of 48. Although this did not cancel its recession warning (it would have to move above 55 to do so), January’s rise to 52.5 was unexpected. Have subsequent data provided useful new clues?

The answer is yes and no. The following monthly chart shows that the NOI turned back down in February, meaning that its recession warning is intact. At the same time, the SPX made a new all-time high as recently as Monday 4th March. As previously advised, it would be unprecedented for the SPX to make a new 52-week high AFTER the official recession start time.

This means that recession warnings remain in place, but the earliest time for the start of a recession has been pushed out again. Specifically, the March-2024 new high for the SPX suggests that a recession will not start any sooner than May-2024.

By our reckoning, during the first half of 2022 the US economy entered the bust phase of the economic boom-bust cycle caused by monetary inflation (rapid monetary inflation causes a boom that inevitably is followed by a bust as the receding monetary tide exposes the boom-time mal-investments). The bust phase almost always culminates in a recession, although it doesn’t have to.

So far, the performances of commodity prices in both US$ terms and gold terms are consistent with an economy in the bust phase, in that the GSCI Spot Commodity Index (GNX) made a 2-year low in US$ terms in December-2023 and currently is near a 3-year low in gold terms. The following daily chart shows GNX in gold terms. What’s not consistent with the bust phase are credit spreads, which have returned to their boom-time levels. Note that the narrowness of credit spreads and the strong upward trend in the stock market are linked, in that they are both symptomatic of a widespread view that a new boom will begin without a preceding severe economic downturn.

The above-mentioned conflict will have to be resolved over the months ahead by credit spreads widening substantially in response to evidence of economic weakness or by the prices of industrial commodities rising substantially in response to evidence that a new boom has been ignited. We think that the former is by far the more likely outcome.

[This blog post is an excerpt from a recent commentary at speculative-investor.com]

The HUI peaked at over 600 way back in 2011 with the gold price about $100 lower than it is today. However, this provides no information whatsoever regarding the HUI’s current value or upside potential. The reason is that the average cost of mining gold is much higher now than it was in 2011. Due to the ever-increasing cost of mining gold, over time it takes a progressively higher gold price to justify the same level for the HUI. Putting it another way, due to the increasing costs of mining gold and building new gold mines, the price of the average gold mining share is in a long-term downward trend relative to the price of gold. An implication is that the HUI isn’t necessarily cheap today just because it happens to be more than 60% below its 2011 level.

Over periods of two years or less, however, the ratio of a gold mining index such as the HUI to the price of gold bullion can be indicative of whether gold stocks are cheap or expensive. This is because the average cost of mining gold usually doesn’t change by a lot over periods of less than two years.

The following daily chart of the HUI/gold ratio suggests that at the moment they are cheap. In particular, the chart shows that at the end of last week the HUI/gold ratio was near the bottom of its 2-year range — very close to where it bottomed in September-2022 and October-November-2023.

This doesn’t mean that a substantial rally is about to begin. On the contrary, in the absence of a major geopolitical scare we doubt that there will be anything more than a countertrend rebound over the next few weeks. This is because the risk-on trend is still very much intact in the stock market, the gold/oil ratio has begun to trend downward due to temporary strength in the oil market and a downward correction in the bond market has not yet run its course. What it means is that in the short-term there is not much additional scope for gold mining stocks to weaken relative gold.

By the way, we did not expect that the HUI/gold ratio would re-visit its 2022-2023 lows at this time. Our expectation was for a normal correction from the late-December high, which would have taken the HUI/gold ratio no lower than its 40-day MA (the blue line on the chart) before the short-term upward trend resumed.

Gold mining stocks also look cheap at the moment relative to general mining stocks. This is evidenced by the following chart, which shows that the GDX/XME ratio has almost dropped back to its lows of 2022 and 2023 even though gold has been trending upward relative to the Industrial Metals Index (GYX) since the first half of 2022. The comparison of the GDX/XME ratio and the gold/GYX ratio suggests that gold stocks have some catching up to do.

A cycle peak for the GDX/XME ratio is ‘due’ this year, so the catching-up should begin soon. We suspect that gold mining stocks will reach their next cycle peaks relative to general mining stocks in the same way that a character in an Ernest Hemmingway novel described how he went bankrupt: “Gradually and then suddenly.”

So, a reasonable argument can be made that gold mining stocks, as a group, are cheap right now. At least, on an intermediate-term basis they are cheap relative to gold bullion and general mining stocks. This provides no information about likely performance over the next few weeks but creates a good set-up for large gains to be made within the next six months.

[This blog post is an excerpt from a recent commentary at speculative-investor.com]

The year-over-year growth rate of the US CPI was reported last Thursday to be 3.4%. This was 0.3% higher than the number reported for the preceding month and 0.2% higher than the average forecast, but the overall picture (refer to the chart below) is unchanged. The downward trend that began in June of 2022 is intact and we expect that the 2023 low will be breached during the first quarter of this year. However, the main purpose of this discussion is not to delve into the details of the latest CPI calculation but to debunk the persistent idea that the price inflation of 2020-2022 was mainly due to supply disruptions.

The idea that the price inflation of 2020-2022 was transitory and mainly due to supply disruptions is absurd, but many smart people continue to tout this wrongheaded notion. Based on the above chart a reasonable argument can be made that the rapid PACE of inflation (currency depreciation) was transitory, but not the inflation itself. Let’s consider what would have happened if disrupted supply actually had been the dominant driver the high “inflation” of the past few years.

The following chart shows the price of natural gas in Europe. This is an example of what happens when a supply disruption is the main cause of a large price rise. After the supply issue is resolved, the price falls back to near where it was prior to the disruption.

By the way, there are many commodities that over the past few years experienced spectacular price rises due to disrupted supply followed by equally spectacular price declines. We could, for instance, make the same point using a price chart of oil, wheat or coal.

The next chart shows the US Consumer Price Index (the index itself, as opposed to a rate of change). This chart makes the point that on an economy-wide basis, NONE of the currency depreciation of 2020-2022 has been relinquished. In fact, prices in general continue to rise, just at a slower pace.

It’s happening this way because the main driver of the inflation was a huge increase in the money supply combined with a huge increase in government deficit spending. In effect, all of the purchasing power loss that has occurred to date has been locked in and the best that people can expect from here is for their money to lose purchasing power at a reduced pace. In this respect the inflation is operating the same way as compound interest, except that instead of getting interest on interest people are experiencing cost-of-living increases on top of previous cost-of-living increases.

So, when someone tells you that supply disruptions were the main reason for the large general increase in prices, ask them why the general level of prices didn’t drop after the supply disruptions went away. And why are we now getting more price increases on top of the price increases of the past?

[This blog post is an excerpt from a recent commentary at speculative-investor.com]

Over the past few hundred years there has been a relationship between the extent of global military conflict and secular trends in commodity prices, with secular upward trends in commodity prices coinciding with increases in both the frequency and amplitude of military conflict. We’ve covered this topic in the past, but not recently (the most recent discussion was in 2017). Due to what has happened over the past two years, this is a good time for a revisit.

In his book “War Cycles Peace Cycles”, Richard Kelly Hoskins discussed the aforementioned relationship and presented a chart similar to the one displayed below. The chart depicts the secular trends in commodity prices over the past 260 years. Hoskins explained that most of the important military conflicts occurred during the up phases on the chart, and therefore referred to the secular commodity-price uptrends as “war cycles”. The secular commodity-price downtrends were termed “peace cycles”.

A plausible explanation for why long-term advances in commodity prices are accompanied by a general increase in military conflict is that war leads to more monetary inflation, government spending and government intervention in the economy, as well as large-scale resource wastage and supply disruptions — the perfect recipe for higher commodity prices. In addition, when structures get destroyed by war, the commodities that are embedded in these structures are destroyed and eventually get replaced as part of a rebuilding process, causing a large temporary increase in commodity demand. There is also a feedback mechanism whereby military conflict and the associated monetary inflation bring about higher commodity prices, while higher commodity prices add to international tensions and increase the probability of military conflict.

A new “war cycle” began with the secular low for commodity prices in 1999 and has been marked, to date, by the 9/11 terrorist attacks, the Afghanistan and Iraq Wars, the nebulous “War on Terror”, the “Arab Spring” uprisings, the overthrow of Libya’s government, the rise of the Islamic State organisation, an initial increase in tensions between “the West” and Russia in 2008 related to the expansion of NATO (in particular, talk of adding Ukraine and Georgia to NATO) and culminating in the annexation of Crimea by Russia in 2014, a long and devastating war in Yemen involving Yemeni factions and Saudi Arabia, a war in Syria, China’s provocative expansion in the South China Sea, a further increase in tensions between the West and Russia leading to Russia’s invasion of Ukraine in 2022, the Israel-Hamas war that began in October-2023 and the recent Houthi attacks on ships in the Red Sea.

At this stage the current war cycle has lasted about 25 years, while the average length of a war cycle during the period covered by the above chart is 33 years. Therefore, the historical record indicates that if the current cycle is close to the average length then we can ‘look forward’ to another 8 years or so of rising commodity prices and increasing geopolitical conflict.

[This blog post is an excerpt from a commentary published at speculative-investor.com about one week ago]

The latest calculation of the Personal Consumption Expenditures (PCE) Index, an indicator of “inflation”, was reported on Friday morning (22nd December) in the US. The following chart shows that the latest number extended the downward trend in the index’s year-over-year (YOY) growth rate, which is now 2.6%. Moreover, the “core” version of the PCE Index, which apparently is the Fed’s favourite inflation gauge, has risen at an annualised rate of only 1.9% over the past six months. This essentially means that the Fed’s inflation target has been reached. What does this mean for the financial markets?

An implication of the on-going downward trends in popular indicators of inflation is that the Fed will slash its targeted interest rates next year. That’s a large part of the reason why the stock and bond markets have been celebrating over the past two months.

It’s important to understand, however, that the markets already have priced in a decline in the Fed Funds Rate (FFR) from 5.50% to 3.75% (the equivalent of seven 0.25% rate cuts). This means that for the rate-cut celebrations to continue, the financial world will have to find a reason to price in more than seven rate cuts for next year. Not only that, but for the rate-cut celebrations to continue in the stock market the financial world will have to find a reason to price in more than seven 2024 rate cuts while also finding a reason to price in sufficient economic strength to enable double-digit corporate earnings growth during 2024. That’s a tall order, to put it mildly.

Our view is that the Fed will end up cutting the FFR to around 2.0% by the end of next year, meaning that we are expecting about twice as much rate cutting as the markets currently have priced in. The thing is, our view is predicated on the US economy entering recession within the next few months, and Fed rate-cutting in response to emerging evidence of recession has never been bullish for the stock market. On the contrary, the largest stock market declines tend to occur while the Fed is cutting its targeted rates in reaction to signs of economic recession.

Fed rate cuts in response to emerging evidence of recession are, however, usually bullish for Treasury securities and gold. That’s why we expect the upward trends in the Treasury and gold markets to continue for many more months, with, of course, corrections along the way.

[This is a modified excerpt from a recent commentary at speculative-investor.com]

Gold bullion could be viewed as insurance or a portfolio hedge or a long-term investment or a long-term store of value, but a gold mining stock is none of these.

Gold mining stocks always should be viewed as either short-term or intermediate-term trades/speculations. During gold bull markets, you scale into them when they are oversold or consolidating and you scale out of them when they are overbought. The scaling in/out process obviates the need for accurate short-term timing, which is important because, as anyone who has followed the sector for many years will know, gold mining stocks tend to go down a lot more and up a lot more than initially expected.

We include the following chart in a TSI commentary about once per year to remind our readers why gold mining stocks always should be viewed as trades. The chart shows more than 100 years of history of gold mining stocks relative to gold bullion, with gold mining stocks represented by the Barrons Gold Mining Index (BGMI) prior to 1995 and the HUI thereafter. The overarching message here is that gold mining stocks have been trending downward relative to gold bullion since 1968, that is, for 55 years and counting.

We’ve explained in the past that the multi-generational downward trend in the gold mining sector relative to gold is a function of the current monetary system and therefore almost certainly will continue for as long as the current monetary system remains in place. The crux of the matter is that as well as resulting in more mal-investment within the broad economy than the pre-1971 monetary system, the current monetary system results in more mal-investment within the gold mining sector.

Mal-investment in the gold mining sector involves ill-conceived acquisitions, mine expansions and new mine developments that turn out to be unprofitable, building mines in places where the political risk is high, and gearing-up the balance-sheet when times are good. It leads to the destruction of wealth over the long term. Physical gold obviously isn’t subject to value loss from mal-investment, hence the long-term downward trend in gold mining stocks relative to gold bullion.

The difference between the gold mining sector and most other parts of the economy is that the biggest booms in the gold mining sector (the periods when the bulk of the mal-investment occurs) generally coincide with busts in the broad economy, while the biggest busts in the gold mining sector (the periods when the ‘mal-investment chickens come home to roost’) generally coincide with booms in the broad economy. The developed world, including the US and much of Europe, currently is in the bust phase of the economic cycle, meaning that we are into a multi-year period when a boom is likely in the gold mining sector.

[This blog post is an excerpt for a commentary published at speculative-investor.com on 19th November 2023]

There was a government-spending-fuelled burst of economic activity in the US during the third quarter of this year that led to a high GDP growth number being reported for the quarter, but signs of weakness are now appearing in coincident economic indicators.

The most important of the aforementioned signs is the rise in Continuous Claims for Unemployment Insurance. With reference to the following weekly chart, Continuous Claims bottomed in September-2022, moved higher into April of this year, dropped back to a higher low during September and has just confirmed an upward trend by moving above its April-2023 high. This is consistent with our view that a US recession will begin before the end of this year, although based on the historical record the recession start date won’t become official until the second half of next year.

Another sign is the decline in the year-over-year (YOY) growth rate of Industrial Production (IP) to negative 0.70%, the lowest level since February-2021. The YOY growth rate of IP in October-2023 is similar to where it was in the month before the start of the 2001 recession and is well below where it was at the start of the 2007-2009 recession. Below is a chart of this coincident economic indicator.

It probably will be many months before the US coincident economic data become consistently weak. In the meantime, we expect to see — and should see, if our current outlook is correct — a gradual increase in the proportion of economic statistics that are worse than generally expected. We also expect to see a gradual shift away from the “soft landing” narrative (the belief that the US economy will make it through the monetary tightening without a recession) towards the recession narrative.

A few weeks ago (refer to the 30th October Weekly Update) we noted early signs that the financial world was starting to move away from the soft landing scenario. One of the indicators that we are tracking to check that this shift remains in progress is the January-2025 Fed Funds Futures (FFF) contract, a daily chart of which is displayed below. Note that the line on this chart moves in the opposite direction to interest rate expectations.

The substantial downward move on this chart from early-May through to mid-October reflects a major increase in the popularity of the soft landing scenario, while the relatively small upward move over the past few weeks is tentative evidence that a shift towards general belief in a less innocuous economic outcome has begun.

At this time, the soft landing narrative remains dominant. That’s why the SPX has rebounded to within 2% of its high for the year and the January-2025 FFF contract has retraced only a small part of its May-October decline. However, we expect that belief in a soft landing will dissipate over the next six months, leading to a substantial decline in the stock market and a substantial rise in the US$ gold price.

[This blog post is a brief excerpt from a recent commentary published at speculative-investor.com]

Why has the junior end of the gold mining world performed so poorly over the past two years. In particular, why has it performed so poorly over the past 12 months in parallel with a relatively strong gold market?

Understanding why begins with understanding that in the absence of a mining operation that can be used to PROFITABLY extract it from the ground, gold in the ground has option value only. The option could be valued by the market at almost zero or a lot depending on many factors, the most important variable being the public’s desire to speculate. Furthermore, a gold mining operation that generates losses year after year also has option value only, with the public’s desire to speculate again being the most important determinant of the option’s market value.

In other words, with the relatively illiquid stocks it comes down to the general public’s desire to speculate.

Hedge funds usually will focus on gold mining ETFs or the larger-cap gold stocks because they need the liquidity. Wealthy professional investors such as Eric Sprott typically will take positions via private placements with the aim of eventually exiting via a liquidity event such as a takeover. It’s the general public that determines performance at the bottom of the food chain and over the past two years the public has become progressively less interested in speculating. Hence, the market values of stocks with option value only have become a lot cheaper.

Although during the course of this year we have suggested directing most new buying in the gold sector towards profitable producers, we are still interested in gold stocks that have option value only. These are the stocks that will generate by far the largest returns after the general public starts getting interested in the sector. However, sparking that interest probably will require a minimum of all-time highs in the US$ gold price and gold mining indices such as the HUI breaking above their H1-2023 highs, which probably won’t happen until the first half of next year. In fact, based on the historical record, sparking the general public’s interest in speculative gold mining stocks could require the broad stock market to begin discounting the combination of a recovery from recession and much easier monetary conditions, which possibly won’t happen until the first half of 2025.

Until then, most (not all) new buying in the gold sector should be directed towards profitable producers, that is, towards the stocks of real businesses. But, only when they are oversold or consolidating. Don’t get excited and buy them after they have just gone up a lot.

[This blog post is an excerpt from a commentary published at speculative-investor.com on 29th October 2023]

Thanks largely to rapid government spending, inventory building by the private sector and about $500B coming out of the Fed’s Reverse Repo (RRP) Facility, US ‘real’ GDP grew at an annualised rate of almost 5% in Q3-2023. The GDP number included strong quarterly growth in Real Gross Private Domestic Investment (RGPDI), which could be explained in part by investment incentivised by the Federal government’s misnamed “Inflation Reduction Act”. What are the implications for the financial markets of this economic activity surge?

With one important exception, all of the implications are in the past. It has been known for a few months that the GDP growth number for Q3 would be high, meaning that a high number was factored into market prices well before last week’s news. To the financial markets, what matters now is what’s likely to happen to economic activity over the quarters ahead.

We suspect that the GDP growth number that gets reported for the final quarter of this year will look fine, partly because money is coming out of the RRP Facility at a rapid rate (about $450B came out over just the past four weeks) and partly because the US federal government will continue spending as if there were no tomorrow. However, it’s likely that much weaker numbers will be reported during the first half of 2024 due to the lagged effects of monetary tightening, the exhaustion of the RRP liquidity channel, the effects on the US economy of recession in Europe, and reduced consumer spending in response to declining asset prices (stocks and real estate).

The one important exception mentioned above is the potential effect of the just-reported high GDP growth number on the future actions of the Fed. In particular, even if it is likely that the rate of GDP growth will be significantly lower in Q4-2023 and turn negative during H1-2024, the Fed tends to look backward and therefore could be encouraged by last quarter’s strong growth to stay tighter for longer.

It turned out, however, that during the hours following last Thursday’s announcement of the strong GDP growth number the expectations of the Fed Funds Futures (FFF) market shifted in a ‘dovish’ direction. Specifically, according to this market, last Thursday the probability of another Fed rate hike before year-end dropped from around 29% to around 20% and the expected Fed Funds Rate at the end of next year fell from 4.68% to 4.60%.

The market responses to last week’s strong US GDP number and generally good news on the corporate earnings front could be early signs that the financial world is beginning to move away from the “soft landing” scenario (the idea that the US economy will avoid a recession). This is to be expected, in that every recession begins as a soft landing and then turns into something more painful. The timing is usually difficult to pin down, though, because on the way to a recession there invariably are many twists and turns.

[This blog post is an excerpt from a commentary published at www.speculative-investor.com on 25th October 2023]

We aren’t geopolitical experts and do not know how the Israel-Hamas war will unfold*. Nobody does. There are far too many unknowns at this stage for even the geopolitical experts to do anything other than guess. What we are able to do is figure out what the markets are discounting, that is, what the majority of market participants currently believe will happen. Today’s assessments of how the conflict will play out may turn out to be wrong and therefore could necessitate large price adjustments in the future, but when deciding what to do in the markets it is important to know what’s currently priced in. Here’s what we think is priced in right now:

1) The oil market

At the time of the Hamas attack on Israel the oil market was slightly oversold due to a price plunge over the preceding week. Consequently, at least a countertrend rebound was likely regardless of news.

During the three trading days after the war news hit the wires (9th-11th October), the oil price bounced and then pulled back. We wrote in the 11th October Interim Update that this price action suggested an expectation among large oil traders that the conflict would not broaden or that if it did broaden then Saudi Arabia would act to offset any loss of oil from Iran.

The subsequent price action indicates that the oil market has not ‘changed its mind’. We say this because the rebound in the oil price from its pre-war-news low looks more like a countertrend reaction than the start of a move to above the September-2023 high. Also, the extent of the backwardation in the oil futures market has decreased over the past week, which suggests less urgency to stock-up on physical oil.

In summary, the oil market does not believe that the war will have a significant negative effect on global oil supply.

2) The gold market

Prior to the war news hitting the wires the gold market was very oversold in both momentum and sentiment terms and therefore was poised for a rebound. As a result of the war news, the rebound has been much stronger than it otherwise would have been.

The performance of the US$ gold price indicates that large speculators initially were uncertain as to how big the war would become. Would it be confined to Israel versus Hamas in/around Gaza, or would it expand to encompass direct involvement from the US and Iran? Also, how much additional US government spending would result from the war in the Middle East and how would this spending affect the resources directed towards the NATO-Russia war in Ukraine?

At the moment large speculators in the gold market believe that these are open questions, with a substantial expansion of the war being one of the more likely scenarios. That’s a reasonable conclusion because the gold price continues to hover around resistance at US$1980-$2000 — about $180 above where it was three weeks ago.

We’ll know that the perceived level of uncertainty/risk has increased significantly if the gold price breaks above US$2000. By the same token, we’ll know that the perceived level of uncertainty/risk has begun to wane when there is a clear downward reversal in the US$ gold price. Note that a downward reversal in the US$ gold price is likely to precede a turn for the better in the news from the Middle East.

3) The stock market

In the US stock market, the war has prompted a shift away from risk but has been very much a secondary issue. The primary issue is the downward trend in the bond market (the upward trend in long-dated Treasury yields).

4) The currency market

In early-October the Dollar Index (DX) was very overbought and had just begun to ‘correct’. The war news may have reduced the magnitude of the correction, but up until now has not been sufficient to propel the DX above its early-October high.

As far as we can tell, according to the currency market the outbreak of war in the Middle East has increased the attractiveness of the US$ relative to other fiat currencies but also added to concerns about the pace at which the US government is going into debt. Putting it another way, what’s priced into the currency market at the moment is both the uncertainty regarding the outcome of the war and the offsetting consideration that the war is increasing the risk of a US government debt spiral.

Summarising all of the above, the oil market is not concerned about a significant supply disruption, the gold market has priced-in considerable uncertainty/risk and could price-in more of the same before reversing, the US stock market is more concerned about bond yields than about the Middle East, and the currency market thinks that the benefits of holding the US$ in a period of increasing geopolitical instability are being mostly offset by the likelihood that a further increase in geopolitical instability would accelerate the already rapid pace of US government deficit-spending.

*As is always the case these days when major geopolitical events occur, many people quickly become ‘experts’ as a result of the large volume of information that suddenly becomes available over the internet. People who a month ago could not have identified Gaza on a map and knew nothing about the history of Hamas are now ‘experts’ who can confidently explain why the events have occurred and what’s going to happen. The actual experts, on the other hand, know that there are a lot of unknowns and therefore that the outcome is uncertain.

[This blog post is an excerpt from a commentary published at https://speculative-investor.com/ last week]

There is currently a major divergence within the US economy. Over the past 12 months industrial production has been flat and the ISM Manufacturing Report has been warning of imminent recession, but according to GDP calculations and forecasts the economy has grown and will continue to grow at a healthy pace (US GDP grew at a 2.1% annualised pace in Q2-2023 and is projected to have grown at a faster pace in Q3-2023). Furthermore, despite the warnings from reliable leading indicators, the dominant view now is that there will be a “soft landing” (a slowdown, but no recession). Before discussing what’s behind this divergence we’ll review the current messages from some of our favourite leading recession indicators.

First, the ISM Manufacturing New Orders Index (NOI) bounced during September-2023, but its overarching message continues to be that a recession will begin within the next few months. It would have to rise to 55 to cancel the recession warning.

Second, the following chart of the 10year-3month yield spread shows that although the US yield curve remains inverted to an extreme (the yield curve is inverted when the line on this chart is below zero), there has been a reversal from flattening/inverting to steepening. The reversal from flattening/inverting to steepening is a recession warning signal, meaning that the yield curve is now sending the same signal as the NOI.

Muddying the waters is the fact that the yield curve’s reversal has been driven by a rising long-term yield, whereas the reversal to steepening that precedes a recession usually is driven by a falling short-term yield. However, we will take the signal at face value as it is not unprecedented for the initial steepening to be caused by the long-term yield rising faster than the short-term yield.

Third, here is a chart of the Conference Board’s Leading Economic Index (LEI). This chart shows that the LEI has fallen by 10.5% from its peak and that 20 months have gone by since the peak.

In the more than 60 years covered by this chart, the LEI has never suffered a peak-to-trough decline of 10.5% without the economy having entered recession and the LEI has never declined for longer than 20 months from its peak without the economy having entered recession. Assuming that the economy is not in recession today (a reasonable assumption given the coincident data), this implies that with respect to the LEI’s messaging the economy is now in uncharted territory.

The US economy is not in recession today, but taken together the above leading indicators suggest a high probability of a recession getting underway before year-end. This doesn’t mean that recessionary conditions will become obvious to most analysts and economists before year-end, though, because recession start/finish dates are determined well after the fact and because in real time the economy can appear to be doing OK during the first few months of a recession.

Returning to the question we asked in the opening paragraph, the robust economic activity still evident in some statistics, chief among them being the GDP numbers, is most likely the result of rapid government spending. This is causing the parts of the economy that are impacted the most by government spending, such as anything linked to the military or the ridiculously-named “Inflation Reduction Act”, to be strong while other parts of the economy are weak.

As an aside, due to the way GDP is calculated it can be boosted by wealth-destroying activities. For a hypothetical example, if the US government were to pay a million people $1000 each to dig a hole and then another $1000 to fill it in, 2 billion dollars would be added to US GDP. For an actual example, the on-going destruction of Ukraine is adding to US GDP because it is increasing US production of military equipment and all of the parts/materials that go into the equipment.

If the current cycle ends up being unprecedented in terms of the time from leading indicator warnings of recession to the actual start of a recession, we think that it will be due to the federal government doing aggregate-demand-boosting spending much sooner than usual during the cycle. This could delay the start of a recession to beyond the historical range, but only by creating the conditions for a government debt spiral.