On the first of each month, I share reflections on the market in our private podcast. This enables me to tie together the various threads of our work and connect the dots between what I observe and hear during my travels and interactions with people. 

While many of you are podcast buffs, some prefer the magic of the written word. This is an edited transcript of the recording, without my typical writing flair. Here goes:

When I think about communicating ideas, I think of four buckets: politics, policy, economy, and markets. I try to get a sense of whether each of those four categories are giving signals that are bullish or bearish. And of course, when all of them are aligned, that’s when you can develop the most conviction. I think we’re getting there. 

Let’s start with politics. For some time now, I’ve actually argued that politics don’t matter. We obsessed about it so much during the Trump presidency where it did matter, that now we’re sort of tired out. 

But that’s not the conventional wisdom because geopolitics has become a buzzword and multipolarity as a theme is widely discussed. This is surprising to me because it is so obviously the case for the last twenty years. It’s not something new. 

Now in the present, we realize that the debt ceiling was just a distraction. Senate leaders are imploring their colleagues to move quickly to approve a House passed bill ahead of the Monday default deadline. It didn’t really matter to markets.

And as for US-China relations, while strategic rivalry will continue for many years, there are periods where diplomacy brings the two sides closer, and I do think we’ve been in such a period since the G20 meeting last November. 

Just to remind you, President Biden said that the US should “compete vigorously” with China but he was not seeking a new Cold War. Xi Jinping admitted that US China relations were not meeting global expectations and that they needed to be set on an “upward trajectory.” 

Biden emphad that America’s one-China policy had not changed despite several divergent comments and Nancy Pelosi’s July visit to Taiwan. When Xi Jinping mentioned Taiwan in his Chinese New Year’s speech in January, he avoided using the word “unification” and instead said that “both sides of the Taiwan Strait are of the same family.”

Despite these positive statements, however, US attempts this year to bring China back to the table have largely been rebuffed. A comment from the Chinese foreign ministry best captures this: “The US says it wants to speak to the Chinese side while seeking to suppress China through all possible means. Is there any sincerity in and significance of any communication like this?” 

This grievance comes after Biden, at the recent G7 summit, referenced the unpleasantness caused by a “certain silly balloon” and said that he wants to open more lines of communication with China. He said, “I think you're going to see that begin to thaw very shortly.”

For me, that is still the direction of travel, the intent of thawing relations in the near term. The real positive signal is in German Chancellor Schwartz’s visit to Beijing, as well as French president Emmanuel Macron, who was accompanied by a European Commission president Ursula von der Leyen.

This is what she said: “I believe it is neither viable nor in Europe’s interest to decouple from China. Our relations are not black or white, and our response cannot be either. This is why we need to focus on de-risk, not decouple.”

The politicians sound less belligerent. So while strategic hostility may remain structurally, we’re entering a period where political risk is declining sequentially. 

I want to now read my favorite passage as it relates to politics. It comes from The Screwtape Letters, a masterpiece of religious satire written by C.S. Lewis. The story takes the form of a series of letters from Screwtape, a senior demon in the Bureaucracy of Hell that are sent to his novice nephew and protege Wormwood, a junior tempter, who is charged with the responsibility of securing the damnation of an ordinary young man known only as “the Patient.”

My Dear Wormwood,  

Be sure that the patient remains completely fixated on politics. Arguments, political gossip, and obsessing on the faults of people they have never met serves as an excellent distraction from advancing in personal virtue, character, and the things the patient can control. Make sure to keep the patient in a constant state of angst, frustration and general disdain towards the rest of the human race in order to avoid any kind of charity or inner peace from further developing. Ensure that the patient continues to believe that the problem is “out there” in the “broken system” rather than recognizing there is a problem with himself. 

Keep up the good work, 

Uncle Screwtape 

I love that so much. 

On policy, I just want to make a point that, unlike the popular concept, I don’t believe the economy is a machine. So when the Fed increases interest rates, there are lots of nuanced ways in which other economic actors change their behaviors. So we can’t just assume that the Fed funds rate is at 5 percent so the economy will grind to a halt. 

Let me give a few examples such as mortgage rate by downs. Say a buyer plans to pay $375,000 for a home, make a 20 percent down payment and finance the remaining $300,000 with a mortgage. The monthly payment on a $300,000 loan at 7 percent is $1,996. With a 2/1 buydown, the interest rate would fall to 5 percent for the first year, and the buyer’s payment would drop to $1,610—a savings of $386 a month, or $4,632 that first year. This is how home buyers are getting around some of the pressures of higher interest rates.

Just look at the percentage of high yield issuance that is secured this year. It is at a record high of 55 percent. Why? Because high yield corporates are looking to reduce their interest costs by issuing secured bonds rather than unsecured bonds. The yield difference is generally on the order of 1 percent.

In 2009, the last time we had an economy wide credit crunch 30 percent of high yield issuance was secured. We’re also seeing strong convertible bond issuance, roughly $60 billion annualized, which is more than we’ve seen in any year in the last decade. The reason is simple: coupon differentials continue to favor convertibles by a wide margin. The average convertible coupon this year is 3.1 percent compared with 8.5 percent in high yield. That differential equates to $270 million in savings on a $1 billion, five-year bond. 

My point is simply that we need to be more patient in our understanding of how Fed tightening makes its way through the economy. For now, we think the Fed is done hiking, and we’re looking to see rate volatility decline. That will allow for more issuance as more maturities beckon.

Turning to the economy, what if we’re already in a recession? Historically, manufacturing has been acutely sensitive to business cycles. While services GDP has not really shrunk from one year to the next since at least the Korean war until the Great Recession. That was a period encompassing 10 recessions. 

So for example, monthly business surveys show manufacturing has been contracting since November, and the downturn is confirmed by falls in container freight, diesel consumption, and industrial electricity sales. The ISM manufacturing PMI is below the 50-point threshold at levels consistent with the onset of the last four recessions in 2020, 2008, 2001 and 1990. 

If we look at the senior loan officer survey, the CEO confidence measure, the University of Michigan consumer sentiment index, the yield curve—they all say the same thing that we are in a recession. The S&P 500 decline of 23 percent last year was in line with recession behavior, and so is the decline in oil and industrial metals. Oil prices are down 50 percent, and some commodity miners are down as much as 70 percent. 

In other words, this recession would be very much like those ten recessions between the Korean War and the Great Recession, which saw manufacturing contract but services continue to expand. 

The NBER uses both GDP and GDI to determine recessions. Real gross domestic income decreased by 2.3 percent in the first quarter, compared with a decrease of 3.3 percent in the fourth quarter. The average of real GDP and real GDI, a supplemental measure of US economic activity that equally weights GDP and GDI, decreased by 0.5 percent in the first quarter compared with a decrease of 0.4 percent in the fourth quarter. If you look at the average, the way NBER looks at this, the economy has contracted four of the past five quarters, though it is still positive year on year. 

So there are two observations. This is an economic recession without a labor market recession. Are we going to see the labor market crack? And second, is the recession going to get deeper or is the worst behind us and we’re in a new recovery phase?

It is interesting that mentions of the word recession on earnings calls declined for the third consecutive quarter. Total mentions in the first quarter were less than half of what they were in the second quarter of 2022. Our work suggests that housing is recovering, manufacturing is bottoming, and the US economy can operate at higher interest rates. 

As for the labor market, we wrote how we are witnessing a secular tightness in the labor market. In other words, we don’t think that the labor market will crack despite the fastest mighty tightening in four decades. 

The distinct demand dynamics of the auto and construction industries are disrupting the patterns normally associated with a recession. Many services businesses expect to continue hiring over the next six months. Job openings are above ten million again. And in the past couple of months, the most strength in jobs is coming from small businesses, those that employ less than 50 people. Employment is going to hold up in our view. 

This is critical because we consistently hear that the final leg lower in risk assets is going to start when the unemployment rate picks up 50 basis points off the lows. This is basically the economist Claudia Sahm’s rule for recessions. That’s why each week everyone’s focused on the initial jobless claims number. 

Finally, we got the breakout in the S&P 500 we were looking for and the charts look constructive. What I would like to see now is for some of the lagging sectors to play catch up. 

For example, year to date, the technology sector is up 34 percent consumer discretionary is up 19 percent, but industrials are flat, staples are down 2 percent, banks and healthcare are down 6 percent, utility is down 8 percent, and energy is down 10 percent. So we need to see improving performance from some of the cyclically oriented sectors to confirm our confidence in the economy. 

I’m also watching USDCNH, which rose 3 percent In May. That reflects poorly on China and global growth. Commodities, including gold will be under pressure as long as the yuan keeps weakening. We are trying to get a handle on how best to think about China. 

Overall, I feel pretty comfortable with the state of play in politics, policy, the economy, and markets, which bodes well for a more constructive stance on risk assets.