The report on GDP this morning showed the economy grew at a 3.3% annual rate in Q4.
As you can see in the chart below, the Atlanta Fed undershot in its estimate (the green line). And the economist community missed by almost two percentage points (the blue line).
If we look back at Q3, the economists were looking for a little better than 2% growth. It came in at 4.9%.
The worst offender was the Fed. Coming into 2023, they were looking for just 0.5% growth.
For the full year, it was closer to 3%. Meanwhile, throughout that period, the media messaging was all about “looming recession.”
They got it wrong.
But maybe 3% is recession-like, when we should be getting far higher growth.
Clearly the Fed has done everything they can to induce a recession. They took real rates (inflation-adjusted rate) to historically high levels. And if we thought the levels were dangerously high, they told us they would stay there, “higher for longer.”
Indeed, higher rates have clearly impacted affordability. And the Fed’s threats have clearly impacted psychology. You can see the former in the housing turnover. You can see the latter in the sentiment and inflation expectations surveys.
So, after all of Fed’s imposed downward pressure on the economy, how did we get the type of economic growth mostly seen over the past thirteen years when accompanied by zero interest rates and QE?
As we discussed here in my daily notes, it’s because of this …
Remember, the massive monetary and fiscal response to the pandemic (plus the subsequent agenda spending binge) ramped the money supply by 40% in just two year’s. That was almost ten years worth of money supply growth (on an absolute basis), dumped onto the economy over just two years.
And the level of money supply is still very elevated. If we extrapolate out the pre-pandemic trend growth in money supply, the economy still has more than $3 trillion in excess money sloshing around.
With all of this in mind, with the Fed doing its best to strangle the economy, we still had 6% nominal growth last year. Clearly it could be much stronger.
If the Fed would accept a higher inflation rate for a period of time, and encourage companies to raise wages to align with hot productivity levels, the economy would boom (likely double-digit growth). And that’s precisely what’s needed to reduce the debt burden (i.e. it would increase the denominator in the debt/gdp measure).
The kings of the technology revolution continue to lead the stock market. Nvidia, Microsoft and Meta (Facebook) all made new record highs today.
But a bad Treasury auction spoiled the moment. Stocks went down. Yields went up.
The Treasury has a ton of bonds to issue (money to raise), to finance a bloated deficit. So supply is heavy, and it's being met with weak demand — which means higher yields are required to find the demand. That creates deserved scrutiny about the unsustainable U.S. debt load/ rising debt service cost, and the continued extravagant spending on Capitol Hill.
With that, we've had two similar bond auction hiccups over the past two months. But as you can see, neither could break the momentum in stocks — and that momentum was triggered by the Fed's November meeting, where Powell signaled the end of the tightening cycle.
Today's episode in the bond market comes as stocks are printing record highs. And it was enough to reverse the tide. As the day ended, the S&P 500 had given up all of its gains.
Now, unlike the two prior episodes in the chart above, today's poor bond auction looks more likely to be a catalyst to break the momentum in stocks — particularly considering the big economic data points that are coming over the next two days.
We have Q4 GDP tomorrow which is expected to come in at half the rate of Q3. And then on Friday, we get the big December inflation data (core PCE).
Remember as we discussed early in the week, based on the recent estimates from Fed Governor Chris Waller, the 12-month change in core PCE would come in lower than the Fed projected last month. It would leave the 6-month average annual change in core PCE at 1.9%. And the 3-month change at just 1.6% — both under the Fed's target.
Lower inflation sounds good to most, but that would be concerning territory for the Fed (i.e. deflationary risk).
Keep in mind, the Fed has successfully convinced the markets that it won't be aggressive on the timing and the number of rate cuts it will deliver this year.
So, if the data over the next two days comes in weak, things are set up for a market that will perceive the Fed to be overly tight, and making another big policy mistake. That would weigh on stocks.
And, of course, this all leads up to the Fed meeting next Wednesday.
In my note yesterday, we talked about the growth potential of the economy that is being strangled by a Fed that is overly tight.
With that, let’s revisit the Fed’s new financial conditions index, which gauges the impact of financial conditions on future economic growth.
Remember, this index is designed to incorporate the lags of monetary policy, and project (in this case) one-year forward what the impact will be on real GDP growth.
They just made an update to the index last week. Let’s take a look …
In this chart above, if the line is above zero, it represents tight financial conditions, which project a drag on economic growth (from restrictive policy). If it’s below zero, it’s a boost to growth (stimulative policy).
As you can see, based on the Fed’s formula, which factors in the current Fed Funds rate, the 10-year yield, the 30-year fixed mortgage rate, the lowest investment grade corporate bond rate, the DJIA stock market index, the Zillow house price index, and the value of the dollar, the Fed’s new index projects about a 1/2 percent drag on economic growth one-year forward.
So, despite the run-up in stocks over the past couple of months, and slide in bond yields, financial conditions remain historically very tight.
And if we look back at these moments (denoted in the chart) where financial conditions were historically very tight, every moment was soon followed with some form of Fed easing (either rate cuts, QE, or in the case of 2015-2016, removing projected rate hikes).
There is one exception.
The 1994-1995 period, where the Fed continued raising rates into a low inflation, slow economic recovery.
It was a mistake. By July of ’95, they started cutting rates, and set into motion a boom-time period for growth and stocks.
The economy went on to average 4.5% quarterly annualized growth through the end of the 90s. And stocks put up five big, double-digit return years, averaging 26% per annum.
What other similarities does the current environment have with this mid-to-late 90s period?
A technology revolution, and a (related) productivity boom. The mid-90s came with the commercialization of the internet. And now we have the commercialization of generative AI.
Stocks are on record highs, as we head into this week's big inflation report.
We'll get December core PCE on Friday.
As we know, this is the Fed's favored inflation gauge. That said, the Fed already set the expectations on this report.
In the December Summary of Economic Projections, they saw core PCE ending the year at 3.2% (year-over-year). And then last week Fed Governor, Chris Waller, got even more granular, giving an expectation for December monthly change. He said, based on the recent CPI and PPI data, he expected core PCE to come in at a 0.2% monthly change.
He went on to say that the December report would show inflation around the Fed's target of 2% (based on the recent three and six month averages).
Let's take a look …
As you can see, if Waller's right on the monthly change in core PCE, then the 12-month change will come in lower than the Fed projected last month. It will leave the 6-month average annual change in core PCE at 1.9%. And the 3-month change at just 1.6%.
This should be concerning territory for the Fed (deflationary risk). If the Fed isn't going to act sooner (than they've projected), then they may have to do bigger cuts in the coming months (50 bps, maybe 75 bps).
Remember, as we've discussed often, as the trend of falling inflation continues, it makes current Fed policy more and more restrictive (i.e. current policy puts more downward pressure on the economy, and on prices). And it's self-reinforcing.
With that, we'll get the first look at Q4 GDP on Thursday, which is expected to come in around 2.5%. That's a good number, relative to the slow growth era following the global financial crisis. And it's a good number relative to the recession calls we've heard for the better part of the past year.
But is it a good number, considering the economy had a decade's worth of money supplygrowth over a span of just two years?
We looked at the chart below last month. As you can see, the money supply remains significantly elevated. If we extrapolate out the pre-pandemic trend growth, the economy still has more than $3 trillion in excess money sloshing around.
The question is, where would economic growth be, if the Fed weren't overly tight by nearly 300 basis points (relative to where they have told us they see the long-run Fed Funds rate when inflation is at their target of 2%)? Higher.
And how sharply will the economy surge when the Fed removes the choke hold?
In my note yesterday, we discussed the important speech made by the newly elected President of Argentina, Javier Milei, at the World Economic Forum. He pierced the bubble of group-think in Davos.
Let's talk about the main point of his speech, his review of economic history and how it may relate to the nascent technological revolution being set into motion by generative AI.
Milei opened with the following statement about the state of the world, and his criticisms were squarely directed at the crowd in the room.
He said, "I'm here to tell you that the Western world is in danger. And it is in danger because those who are supposed to defend the values of the West are co-opted by a vision of the world that inexorably leads to socialism and thereby to poverty."
He goes on to say, "the main leaders of the Western world have abandoned the model of freedom for different versions of collectivism."
Why? What is their motivation?
Milei says, "some have been motivated by well-meaning individuals looking to help others, and others have been motivated by the wish to belong to a privileged caste."
He related the current trajectory of the Western world to the fall of Argentina of the past century — after trading capitalism and world power, for socialism and poverty.
With that, he laid out the evidence for "free enterprise capitalism" as the "only possible system" to achieve prosperity and end world poverty.
Here's the chart of economic history that he referenced…
This chart shows the long history of stagnation in per capita GDP (wealth and standard of living).
Then came capitalism, and with it came exponential growth and prosperity.
Capitalist economic principles brought about innovation, which brought about industrialization. And with industrialization, Milei points to the rapid gains in per capita wealth (as you can see in the chart above).
Per capita GDP began to double, and did so at an accelerating rate from 100 years, to 66 years, to 33 years, to the recent 23 years. As he says, the industrial revolution lifted 90% of the global population out of poverty.
Now, let's consider this backdrop, and how it relates to the early stages of this current technology revolution.
What were the two most important technological advancements of the Industrial Revolution?
The steam engine and electricity.
Each played a critical role in transforming societies and economies — wealth and prosperity.
Guess what generative AI has been compared to? The advent of the steam engine and electricity.
So, we have upon us a catalyst for explosive growth in per capita GDP. And as we know, that comes with tremendous benefits for humanity.
And history shows us, when you hit a certain level of per capita wealth you get the kind of improvements in quality of life that begin to drive exponential demand for things like electricity, air conditioning, cars … energy (and commodities in general)!
You can see it in the chart below …
So, back to the opening of this note, we can now see why the capitalist system and the related incentives to innovate are an affront to the World Economic Forum agenda/climate agenda.
Within the agenda, there is an explicit goal of lowering global energy consumption, in the name of climate. Conversely, this technology revolution will, undoubtedly, increase energy consumption — not just from computing power demands, but from the global wealth effect.
As an investor, we have to operate under the assumption that the world, over time, will improve, will grow and will be a better and more efficient place to live than it was before (democracy and capitalism will withstand the challenge). Some times the confidence level is higher than others. But the record is good.
With that, we should expect this technological revolution to accelerate the doubling rate of global per capita GDP. And with that, we should expect rapid demand growth for energy and commodities coming down the pike.
As you can see in the chart below, the trend that dominated much of last year is back, with divergence between the performance of big tech stocks and small cap (and value) stocks.
The Nasdaq is now just 3% off of the 2021 record highs. Meanwhile, the Russell 2000 (small caps) is still 21% off of the 2021 highs.
We talked late last year about the opportunity for small caps, the laggard, to catch up. And there was indeed a big run into the year end. The Russell 2000 rallied 28% over the final two months of the year (Oct 27 through the year end).
What's driving the divergence thus far in the New Year? It continues to be all about generative AI. And the past two weeks have been a global promotion for it. It started with the Computer Electronics Show last week in Las Vegas. And this week, as we discussed yesterday, the climate agenda in Davos seems to have been upstaged by the technology revolution.
The pendulum seems to have swung from fear to greed.
What the investment community hasn't sorted out just yet, is the productivity influence generative AI will have on all businesses — all people. And given that small companies tend to have less benefit from economies of scale than large cap companies, small caps could have the most to gain from the productivity gains of generative AI.
Now, perhaps the most important moment at this World Economic Forum this week (thus far) was the speech made by the newly elected President of Argentina. It's a must watch. This link below uses AI to translate to English, in his voice (original transcripts also here).
It's a very important speech in a very important year — a year that will determine the direction of the global economy, policy and (very likely) the balance of power in the world. You can click on the image below to play (and you may need to scroll back if it doesn't start at the beginning) …
As we discussed last month, world leaders at the climate summit in the United Arab Emirates realized that their experiment to transform the global energy system is very, very expensive.
According to the European Commission President, they need trillions of dollars of funding every year, not billions.
They already committed and spent trillions of dollars of global taxpayer money on the agenda. Not enough. They need to tap private capital, they say.
But this comes as appetite for the agenda and for climate finance has deteriorated over the past year.
And that's clearly reflected in the performance of the biggest clean energy ETF …
With that, this week they return to the place that shaped the climate agenda — the World Economic Forum, in Davos.
But the transformation getting most of the attention this week isn't energy, it's technology — generative AI. Attendees are said to be more interested in sitting in on workshops to learn about AI, rather than listening to panels theorizing climate disaster.
Here are some key takeaways from Davos today, from two guys that know the capabilities and development stage of generative AI better than anyone:
Satya Nadella, CEO of Microsoft calls generative AI "expertise at your fingertips." He says this is year two of a paradigm shift, and that 2024 is the year generative AI will scale. And he calls it a "productivity revolution."
Sam Altman, the CEO of OpenAI (developer of ChatGPT) says the next iteration of GPT is in the "reasonably close future" and "the world is going to change." He says it's a tool for productivity, which will magnify what we can do. And he says costs will go down, capabilities will go up.
As we discussed yesterday, it's productivity enhancing, it's growth enhancing, and it may be deflationary.
We're halfway through the first month of the New Year. And it's already fast moving, with plenty of noise.
We had the Computer Electronics Show in Las Vegas last week. And it was all about generative AI.
Remember, after the jaw-dropping Nvidia earnings last May, many called the boom in AI stocks unsustainable. But they underestimated the significance of this technological revolution. As we've discussed along the way, generative AI might be the most productivity enhancing technological advancement of our lifetime.
And high productivity growth is a driver of long-term potential economic growth. And productivity-driven economic growth comes without the inflationary side effect.
In fact, the annual growth in the cost per unit of output in the third quarter (the most recent report) was negative! And that came even as the wages paid to produce that unit of output were higher than any time in the two decades prior to the pandemic.
We'll get the fourth quarter productivity report on February 1st. But as we've discussed in recent months, although the Fed constantly blamed weak productivity growth as holding back the post-GFC economy, now that productivity is strong, they barely utter the word.
With that in mind, let's talk about the prepared remarks and Q&A by one of the Fed Governors today at the Brookings Institution.
Chris Waller is a voting member. His prepared remarks today were clearly written with intent to curb the extent of rate cut expectations priced in the market for 2024. After the inflation data of last week, by Friday afternoon the market was pricing in seven cuts (175 basis points) by the end of this year. Remember, the Fed has projected a total of three quarter point cuts for the year.
The market did indeed, back away from a seventh quarter point cut today (i.e. priced it out). But Waller did reveal some clues on a more aggressive rate path this year.
The Fed will get one more big inflation data point before its January 31 meeting. It's PCE. And Waller sees it around the Fed's target of 2% (on a 3-month and 6-month annualized basis).
So, target achieved. But he also says it needs to be a sustained 2%. He says the Fed can sit back and observe, to ensure it's not a temporary visit at 2%.
Keep in mind, with the effective Fed Funds rate over 5.3%, the real rate (Fed Funds rate – inflation rate) is now over 300 basis points. The Fed, itself, projects the long-run real rate to be just 50 basis points. So, the Fed is currently in a highly restrictive stance — putting downward pressure on the economy and on inflation.
That said, with deflationary forces hitting in China, Europe and Canada, I suspect the Fed Chair (Jerome Powell) won't find it too comfortable sitting and watching. Not only are they already at risk of inducing deflation by being overly tight, but they've created a position of weakness to fight off any economic or financial system shock.
In the latter case, they would likely find themselves back in the zero interest rate policy/QE business.
I suspect the markets won't let the Fed make that mistake. Lower stock priceswould force the Fed's hand (i.e. force earlier, more aggressive rate cuts).
Now, back to the productivity discussion…
In the Q&A today, Waller actually addressed productivity gains. As he said wage growth should equal inflation plus productivity gains. And he admitted that productivity is booming, at better than 5%.
5% + 2% = 7%.
We should have 7% nominal wage growth. It's running closer to 5%. The Fed should be encouraging wage gains, to close the gap with the rise in the level of prices over the past three years (to restore living standards). It would be growth enhancing, without stocking inflation.
As we've discussed for the better part of the past year, the rate-of-change in prices has been steadily moving in the right direction — lower.
And not only are we near (or at) the point where the Fed needs to start reversing its restrictive policy, but the Fed has, importantly, acknowledged it (finally).
So, for context, the market has priced in the first cut by the Fed in March. The Fed has projected, in its December Summary of Economic Projections, that the first cut will likely come in June.
So, that makes this morning's inflation data a key input in the Fed's decision making process.
What did we get?
The core CPI (excluding food and energy prices) ticked down for the ninth consecutive month, now under 4%. That's good. But the headline CPI ticked up from a prior 3.1% to 3.4%. Is this an indication that the disinflation (falling inflation) trend is coming to an end?
Not at all. In fact, we're about to see an acceleration in the fall of inflation.
Let's take a look at the CPI index, without the shenanigans of seasonal adjustments.
The government's Bureau of Labor Statistics likes to show us a monthly change in prices that has been adjusted by their special "seasonal" formula. In that case, they showed prices rising 0.3% last month.
But they like to show us the 12-month change in prices without seasonal adjustments. And that was reported this morning at 3.4% (December 2023 compared to December 2022 prices). As the BLS says, this unadjusted data is what shows the prices consumers "actually pay." That seems useful.
On that "what prices consumers actually pay" theme, what the BLS doesn't talk about in their report is the monthly change in the price index without seasonal adjustments. It turns out, that number was negative (i.e. deflation in the month of December). And as you can see in the table above, it's a trend (three consecutive months of deflation).
So, you can see this latest data displayed in the table. And you can also see how quickly the 12-month change in prices slides in the coming months, if we apply the average monthly price change over the past twelve months (0.23%) to the current index value. By the Fed's March meeting, this CPI index would be at 2.33%.
This index will be coming down fast, beginning next month.
On a related note, remember from last month, had the government not revised DOWN the prior four consecutive months of the most recent core PCE index data, the monthly price change would have been negative (i.e. deflation).
Considering all of this, the interest rate markets remained undeterred in their anticipation of a March rate cut, following this morning's inflation report. Furthermore, none of the Fed officials that spoke publicly today dismissed the possibility that the Fed could move in March.
We go into the December inflation report tomorrow with the S&P 500 near record highs, and the 10-year yield around 4% — and a market looking for six quarter-point rate cuts this year.
Let's revisit the inflation data of the past couple of months…
It was the November 14th inflation report (on October prices) that signaled the regime change for monetary policy.
In that report, the year-over-year change in headline CPI fell from 3.7% to 3.2%. And the monthly change was reported as flat (no change), but the actual change in the index was down 4 basis points from the prior month (i.e. a slight fall in prices).
We headed into that number with stocks set up for a bullish technical breakout. Indeed, stocks took off and never looked back …
The Russell 2000 jumped 5% that day. Yields fell 20 basis points. And the dollar had its third largest decline of the pandemic/post-pandemic era.
Again, this was a signal that the rate hiking cycle was over. The interest rate market immediately reversed bets for more rate hikes, and started pricing in more, and earlier, rate cuts for 2024.
Then we had the December Fed meeting. Remember, just months earlier the Fed had projected to be raising rates at the December meeting. Instead, they did nothing. Moreover, Jerome Powell all but claimed victory on inflation, and he telegraphed a quickening in the fall of inflation with projections on core PCE (the Fed's favored inflation gauge) ending the year at 3.2%.
That brings us to tomorrow. As we discussed earlier in the week, we should expect lower energy prices to have continued the drag on headline in inflation in December. The important number tomorrow will be the monthly change in both the headline and the core (excluding food and energy prices). Could it be negative?
If it isn't, the year-over-year headline CPI will get media attention. It should bounce aggressively from the last reading (which was 3.1%). Why? It will be measured against a low base of December 2022. In that case, it was a sharp fall in gas prices that dragged the December 2022CPI into negative territory (i.e. deflation) — pulling down the consumer price index.
If we do get a bounce in the headline CPI, we will likely get selling in stocks and bonds (bounce in yields).
But keep in mind, after tomorrow the Fed will still have one more (most important) inflation data point prior to its end of month meeting. They'll get December core PCE on January 26th. And they've already told us in their Summary of Economic Projections that they see it at 3.2% — which means the Fed is overly tight.
This chart shows the long history of stagnation in per capita GDP (wealth and standard of living). 
