Candyland

Off to Alabama this week enjoying the beauty and southern hospitality. At a women’s event in Andalusia, the ladies offered me hugs and boasted that their “men have manners.” They were escorted one by one to their cars in the rain by umbrella-holding gentlemen. Our hosts hunt turkey and deer in a perfect “wild turkey habitat.” Indeed, more than 60% of Alabama is covered in timberland, making it ideal for many types of game animals. This south Alabama town also is home to “Christmas in Candyland,” where kid-sized, candy-covered play cottages, an ice-skating rink, slides for sledding, Santa and home-made snow bring a taste of northern holiday celebrations. Markets got a bit of summer Christmas cheer this week on a surprising June CPI report. There was a lot to like. Big drops in aggregate measures—trimmed-mean, sticky and median CPI—that offer reliable guidance on underlying price pressures. But Credit Suisse thinks consensus is misreading inflation trends. The report benefitted the most from easy comparisons against the headline’s year-ago 9.1% peak.  In fact, it estimates these easy comps will run through December, pushing core readings to 3.2-3.3% by year-end. That’s well below the Fed’s projected 3.9%. The optics of hiking in such a disinflationary environment wouldn’t be good. So, after this month’s presumed quarter-point move, perhaps nothing more happens until November, Renaissance Macro says. Markets in “Candyland.”

Meanwhile, the Fed is focused on wages. On a 3-month annualized basis, average hourly earnings accelerated last month to 4.7%, and Goldman Sachs’ puts the Q2 yearly rate at 5.1%, and the Atlanta Fed at 5.3% y/y in June. Overall labor costs have climbed to near a 7% annual pace. Rising pay and slowing CPI aren’t good for margins. And if the Fed insists on its 2% inflation target, there should be pain … eventually. It typically takes a big jump in unemployment to drive down both wage costs and consumer demand. When that starts to happen, it usually happens fast. So, who’s at risk? Not lower-wage service workers like the staff at my Marriot in Montgomery (I’m a Marriott girl). At check-in, I asked when the restaurant opens for breakfast. “6 a.m.” I checked back after dinner. “We open tomorrow at 7 a.m.” … Nope. In the a.m., “We open at 8.” I just want a cup of coffee! Where are all the workers? Earnings will determine when layoffs pick up. They fell in Q1 and, despite this morning’s upside surprises from the big banks, Q2 is expected to be a bigger down quarter. After that, Yardeni Group sees flat y/y earnings growth in Q3 and an 8% jump in Q4. That would represent an unusually mild earnings recession driven by falling margins rather than revenues—forward revenues in fact are at a record high. Applied Global Macro Research isn’t as sanguine. Even if there’s just a mild recession, it thinks profits could fall 20%.

Not if Candyland holds out! Hard data suggest activity is picking up in services (especially “revenge travel,” see below), auto sales, new home sales, computer-chip & green-energy plant construction (over the last two years, companies have pledged to spend $365 billion in new semiconductor and battery investments, of which less than one-fourth has been spent) and infrastructure projects. Manufacturing’s weakness vs. services strength has never been so stark, but BCA Research thinks manufacturing could be on the verge of a prolonged up-cycle, citing historical patterns in which activity tends to move down for 18 months and then up for 18 months. We’re at the bottom now, and an inventory rebuild cycle appears to be starting, not to mention a budding rebound in capex. Cyclicals, which typically outperform when manufacturing PMIs are rising, have started to move, and participation is broadening beyond mega-cap techs. More than 80% of S&P 1500 constituents are above their 200-day average, and valuations for the S&P 500 sit at a reasonable 15X EPS excluding the “Magnificent 7” mega-caps that accounted for 73% of first-half returns. It’s getting harder to be a bear.

Positives

• Immaculate disinflation? On top of June’s CPI and PPI that surprised, the Fed’s beige book showed price increases slowing in several districts, with contacts reporting a reluctance to raise prices. June import and export price data softened more than expected, and a New York Fed gauge of underlying broad inflation that incorporates macro factors such as ISM orders and unemployment fell four-tenths of a point to 3.2% and a half-point to 2.5% for “prices only.” Manheim used-car prices posted their biggest monthly drop in three years, and with auto production picking up, new car prices are topping out, too. Finally, rents on new leases are falling as rental vacancies rise.
• The consumer reigns supreme July preliminary Michigan sentiment rose to near a 2-year high, and anyone who thinks we’re in a recession hasn’t been to the airport lately. Airlines and cruise ships are packed. Restaurants, too. Retail sales of food services & drinking places now exceed spending on food at home. Taylor Swift concerts aren’t only sold out everywhere, they’re drawing thousands of fans who just come to buy the merch and hang out. This “revenge spend’’ shows no signs of slowing …
• … not even for graduates Bank of America’s research suggests student loan holders have checking and savings balances that are still 40% above their January 2020 levels. Interestingly, across all income cohorts, people who did pay down debts have similar strong balances compared to non-payers. This implies a financial ability to resume payments.

Negatives

• Probably not immaculate While June CPI was softer than anticipated, a big chunk was driven by outsized declines in airfares and lodging away from home. Core prices didn’t fall nearly as much and, at 4.8%, remained well above the Fed’s target. As discussed above, wage pressures remain elevated, too. There is a limit to how much inflation can improve when unit labor costs are running at 4-4.5%.
• Small businesses feeling squeezed While rising to a 7-month high, NFIB optimism nonetheless remained well below its 49-year average for an 18th straight month as inflation and labor shortages/elevated wages continue to be challenges. Job openings in fact fell, and the average interest rate paid by U.S. small businesses rose to 9.2%, the highest figure since July 2007.
• We bought a lot of goods during the pandemic Trucks and railcars that haul merchandise sold by wholesalers and retailers to consumers are struggling as their costs have gone up and demand for goods has softened. The American Trucking Associations truck tonnage index and intermodal container traffic are weak, consistent with a growth recession in the goods-producing and distribution industries. Inflation-adjusted real consumer spending on goods has been flat since the second half of 2021.

What else

Potential tailwind from China If it concedes its recovery is faltering and stimulates as markets expect, U.S. equities likely would benefit, Strategas Research says. It notes that during such stimulative periods in the past, the S&P median advance was 12.5%, with five of six such periods posting positive returns. The outlier was the most recent, as China stimulus came amid aggressive Fed tightening.

When it happens, it usually happens fast In most cycles, headline labor market data looks strong, right up until the point that it does not. June’s slowest jobs growth since December 2020’s decline and May’s moderating job openings could be early signs.

Joe sure could use this If core inflation subsides to 3% by year-end, an outcome for which it’s still skeptical, Gavekal Research says the economic, political and financial effects will be immediate and dramatic, led by a vanishing risk of recession in 2024. In politics, a return to low inflation and modestly rising real wages should greatly improve President Biden’s reelection prospects.

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