CRACKING CONFIDENCE & CRUMBLING COLLATERAL

In our latest Macro Analytics video, Charles Hugh Smith and I review the “Waterfall” that is presently underway in the area of:

1. 1. The Repricing of Risk
   2. The Revaluing of Collateral, and
   3. A Forced Increase in Productivity

Small Business Confidence leads Recessions and the Waterfall!. This is because they see and experience the impacts first. Small Business has their hands on the “pulse” of the economy. The media consistently only parrots the lagging data points.

Crippled Consumer Confidence and financing is at the root of current Small Business problems. Fear crimps their confidence and willingness to take risk. Fear of losing jobs and not paying bills because of inflation and possible layoffs crimps the consumer.This is what small business is feeling and seeing in sales activity. We discuss Business and Consumer Confidence in this newsletter below.

We have seen the beginning of a Banking Crisis and mounting concerns about Commercial Office Real Estate … the next will be problems within Corporate Debt! We feature this development in the “Current Market Perspectives” section below.

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WHAT YOU NEED TO KNOW

US SOVEREIGN CREDIT RISK GOING PARABOLIC?

US Sovereign credit risk protection has never cost so much as it currently does with anxieties going parabolic. The US Sovereign risk has now reached a record high. This is more than simply the ongoing worries about a potential US Debt ceiling default. This is now more about concerns regarding the US dollar weakening and with it dollar denominated assets on a global basis! It is about:

i) Repricing of US Risk

ii) Revaluing of US Collateral and

iii) Continuingly Falling US Productivity

US DOLLAR v CREDIT RISK: It Is Alarming When the US Dollar follows US Sovereign Credit Default Risk!!

• • There is a very real possibility of a US Credit Downgrade occurring during the ongoing Congressional negotiations to increase the current debt ceiling of $31.4T.
  • The US debt has doubled since the last downgrade in 2011 (from AAA to AA+), while US Sovereign Debt has since generally become less attractive (or shunned) by foreign sovereign buyers for official Currency Reserve purposes.

IT’S A “WATERFALL”: A Cascading Effect!

• • We have entered a Waterfall with: i) Repricing of US Risk, ii) Revaluing of US Collateral and iii) Continuingly Falling US Productivity.
  • My Co-Host of Macro Analytics, Charles Hugh Smith writes a post video article summarizing “It’s a Waterfall” Over the Falls: Credit, Collateral, Risk, Asset Valuations.

SMALL BUSINESS CONFIDENCE: Small Business Confidence Leads the Way! 

• • The NFIB Small Business Optimism Index has been steadily falling since Covid-19 struck and has not relented in its weakening since. We have written about concerns with Small Business landing in prior newsletters.
  • Historically, when the NFIB Small Business Confidence Index falls below the mid 90’s, we soon enter a US Recession! At 90.1 and rapidly falling, it will take some major developments to reverse what lies ahead.

CONSUMER SENTIMENT & CONFIDENCE: The Driver of a 70% US Consumption Economy!

• • In addition to the NFIB Small Business Optimism Index exhibiting a Head & Shoulders Pattern, we additionally have major Head & Shoulders patterns appearing across both Consumer Confidence Board’s Index and U. of Michigan’s Consumer Sentiment Index as well as the S&P 500.
  • This is particularly alarming in a 70% Consumption Economy like the US, driven historically by Small Business and Consumer Confidence and fed by market confidence in S&P 500 for IRA/401K Retirement holdings!
  • Watch “OEM” Traders for possible timing of a breakdown in market and consumer confidence.

CONCLUSION

Q1 EARNINGS: The Conference Calls Tell The Story!

• • It appears that negative earnings revisions are accelerating.
  • Global earnings expectations are now trending lower again. The 1-month net global EPS revisions have fallen to -15.% from -7.2% last month, and the more significant 3-month net global revisions are now at -13.7%, down from -13.2% over recent weeks.

In this week’s “CURRENT MARKET PERSPECTIVES”

we focus on:

CORPORATE BOND MARKET: The “Zombie”

HY Bonds Are A Shoe About to Drop!

• • Zombie lending and “rollover” refinancing is about to be amplified with the ongoing credit crunch, as banks weathering huge holes in their balance sheets, are now less willing to lend or will only do so at higher rates.
  • Banks have tightened lending by the most they ever have and credit availability just saw its largest drop in 20 years, according to the most recent small business lending survey.
  • The next six months to a year are going to be extremely challenging in terms of making sure that companies can service their debt. Expect many to face bankruptcy or takeovers!

We should all be alarmed when the US$ follows the movements in the US Credit Default Swap Rate!

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US DOLLAR v CREDIT RISK: It Is Extremely Alarming When the US Dollar follows US Sovereign Credit Default Risk!!

Recently we have witnessed the US Dollar start to track quite closely to US Sovereign Debt Default Risk or CDS (Credit Default Swaps) pricing. This likely reflects both concerns with both a potential devaluation of the US Dollar, in addition to the very real possiblility of a US Debt Rating downgrade.

The worry now is of a Debt Rating downgrade, triggered by US Congressional fumbling of increasing the legal Debt Ceiling limit, in a timely manner.

The US debt has increased dramatically from ~15T to ~ 31.4T or double since the last downgrade in 2011. At that time US debt was downgraded from AAA to AA+, which was also during a period of Congressional Debt Ceiling negotiations!

IT’S A “WATERFALL”: It’s A Cascading Effect!

My Co-Host of Macro Analytics, Charles Hugh Smith writes a post video article summarizing “It’s a Waterfall”:

Over the Falls: Credit, Collateral, Risk, Asset Valuations

Together, these factors generate a self-reinforcing cycle of debt saturation, declining collateral and credit contraction.

If we want to understand where the economy is going, credit and risk are good places to start. Credit/debt is how the system creates and distributes money: when a home buyer gets a mortgage to buy a house, that mortgage increases the money supply. When the mortgage is paid off, the money supply contracts.

The mortgage is secured by two things: the income of the buyer and the house, which is the collateral for the loan.

Risk is integral to credit. Should the income of the buyer or the value of the house decline sharply, the loan is at risk of default / loss. In the national/global economy, the cost of credit reflects trends and policies that raise or lower the risks which then influence the cost of credit: as risk rises, the cost of credit goes up.

As macro-risks rise, the cost of credit pushes mortgage rates higher, increasing the percentage of income the buyer must devote to service the mortgage. This leaves less income for additional debt or consumption.

Once their income is maxed out, the buyer reaches debt saturation: there is no more spare income to service additional debt. The workaround to debt saturation is to engineer lower interest rates, so the buyer can refinance debt at lower interest rates and reduce the monthly cost, freeing up more income for additional debt/consumption.

But when systemic risks rise, lowering interest rates is no longer possible. Rates rise to reflect the risk premium generated by uncertainty and the higher potential of defaults and losses.

Expanding credit is the lifeblood not just of consumption but of asset valuations. Home prices rise when the pool of buyers with sufficient income and creditworthiness to buy a house is larger than the inventory of available homes. When interest rates plummeted in the pandemic stimulus phase, house prices soared as buyers panic-bid for properties.

(The same mechanism supports stocks, as corporations borrow money and use it to buy back their own shares, boosting per-share valuations.)

Declining interest rates and rising asset valuations create a virtuous cycle in which higher asset prices provide more collateral to support bigger loans, loans which are easier to service as interest rates drop.

This self-reinforcing feedback of higher asset prices / increased collateral enabling more debt is clearly visible in the charts below of the Case-Shiller national Home price Index, which soared 43% in the two years from 2020 to mid-2022, and the Households Net Worth which increased by a staggering $44 trillion in the two years following the pandemic stimulus.

The risk profile of credit has changed both nationally and globally, and cost of credit cannot fall back to near-zero. I addressed this in Why Interest Rates Are Not Going Back to Zero.

At the same time, productivity and wages have stagnated, leaving less income to service additional debt. As I explained in Here’s How We’ll Have Labor Shortages and High Unemployment at the Same Time, workers with skills that are scarce and in demand will command higher wages, while those with skills that are not in demand will not be able to find work or maintain high earned incomes.

As risk and the cost of credit rise, the valuations of assets dependent on expanding credit decline. Not only do owners of assets such as houses feel less wealthy–the reverse wealth effect–the collateral available to secure additional credit drops.

Together, these factors generate a self-reinforcing cycle of debt saturation, declining collateral and credit contraction: risk rises, credit costs rise, incomes and collateral decline and all the consumption and asset valuations that are dependent on credit expansion go over the falls.

ABOVE: Pricing of Risk, Collateral and Credit are only in the early stages within the Commercial Office Real Estate (CRE) sector.

SMALL BUSINESS CONFIDENCE: Small Business Confidence Leads the Way! 

The NFIB Small Business Optimism Index has been steadily falling since Covid-19 struck and has not relented in its weakening since. We have written about concerns with Small Business landing in prior newsletters.

CHART RIGHT: NFIB Small Business Confidence Index below the ~97 Recessionary Trigger Level!

RECESSIONARY SIGNAL

Historically, when the NFIB Small Business Confidence Index falls below the mid 90’s we soon enter a US Recession!

At 90.1 and rapidly falling, it will take some major developments to reverse what lies ahead. In fact we may be facing something even worse than an approximately every decade “run-of-the-mill” recession!

The reason for this is that falling confidence is much broader than for just small buinsess owners!

CONSUMER SENTIMENT & CONFIDENCE: The Driver of a 70%

US Consumption Economy!

In addition to the NFIB Small Business Optimism Index exhibiting a Head & Shoulders Pattern, we additionally have major Head & Shoulders patterns appearing across both Consumer Confidence Board’s Index and U. of Michigan’s Consumer Sentiment Index. This is particularly alarming in a 70% Consumption Economy like the US, driven historically by Small Business!

The University of Michigan’s Consumer Sentiment Index is now testing its long term “Neckline” which, if broken, would indicate a major further drop is to follow!

The politically influenced Conference Board’s data is not yet as negative as the non-political UofM’s data driven reporting.

S&P 500 – SUPPORTING HEAD & SHOULDERS PATTERN

We also have a long term H&S pattern in the S&P 500, which supports the above collapsing Consumer Confidence & Sentment as well as NFIB Small Business Confidence.

YOUR DESK TOP / TABLET / PHONE ANNOTATED CHART

Macro Analytics Chart Above:  SUBSCRIBER LINK

SMART MONEY: Watch the Professional OEM Traders For Timing On the Right Shoulder

Are we at the point of decisively breaking key Head & Shoulders Necklines?

We have had a lot of success over the years watching how smart money trades the OEX. This is the Chicago Board Options Exchange ticker symbol used to identify Standard & Poor’s 100 index options.

When the buying reaches a high the smart money usually strongly shorts the market by intially shorting the OEX. This approach has had a strong record of preceeeding major market corrections.

The OEX Put/Call Ratio, shown to the right by Sentiment Trader, indicates an unusal high – normally a trigger point for Smart Money.

CHART BELOW: The OEX appears to be near overhead resistance with the proprietary MATSII Momentum Indicator also signalling overhead resistance.

YOUR DESK TOP / TABLET / PHONE ANNOTATED CHART

Macro Analytics Chart Above:  SUBSCRIBER LINK