Chill in 'Emerald City'
Bears and bulls facing off on what the Fed may do.
I traveled to Seattle this week, called the Emerald City because of its lush greenery, spectacular mountains and water. I spoke at a local winery, where my “sobering” message didn’t bother this upbeat group of millennials and baby boomers, many working in tech and some retirees. Healthy and fit (I met a 90-year-old lady who looked much younger). This group loves to talk about outdoor activities and wine. A nice respite from some of my Wall Street sources. Piper Sandler has “never been more bearish.” It sees nothing in this growth-led rally to suggest recession odds are lower than they were at market lows two months ago. It notes stocks don’t tend to bottom until housing does, and data to date (more below) suggest it’s got a ways to go. Near-term gains may come on lower inflation and smaller job gains as the economy slows. But UBS sees market declines resuming once it becomes clear the Fed’s not backing off. It’s one thing to get underlying cyclical inflation to 4-5%. Getting it lower is a structural challenge. The Dallas Fed projects year-over-year (y/y) owners’ equivalent rent, which accounts for roughly a third of headline CPI, will rise from 5.4% in June to 7.7% in May ’23. With the labor market tighter than at any point since the 1940s (the retirement of 3 million baby boomers and immigration restrictions are big reasons why), median wage growth is only just beginning to slow. It averaged 8.5% for job-changers in the three months ending in July and 5.9% for those who stayed put. In the ’70s, it took three recessions after two too-early Fed pivots to finally quell structural inflation. No one knows whether this Fed will have a better luck, or resolve.
But, basking in the warm Seattle sunshine, we can think positive for a while anyway. The percentage of S&P 500 stocks above their 50-day moving average has eclipsed 90%, a level that historically has seen impressive returns three, six and 12 months out. Fundstrat, which says technicals indicate June’s 3,666 low was the market bottom, believes a retest of old highs by year-end is possible. Evercore ISI agrees, drawing parallels with the ’70s’ three bear/bull market cycles. A bullish expansion into small caps, with the Russell 2000 breaking out absolutely and relatively for the first time since ’20, sends a powerful signal. The latest 2023 S&P earnings estimate now stands at $243.79, down only 3% from its peak. Seems certain to fall further. But the number of companies with lower price targets has rolled over dramatically, suggesting that, at least for now, analysts expect most of the negative news to be priced in. Consumers’ willingness to take most price increases in stride (more below) helped the Q2 reporting season to again surprise to the upside. With over 90% of companies having reported, aggregate earnings-per-share growth of almost 10% is well above the original estimate of 5.6%. The Energy sector provided a big boost, accounting for 77% of y/y sales growth. But pre-tax margins for the core of the market (ex-Energy) were 13%, matching the average of the last decade. And ex-Energy, eight of the remaining 10 sectors beat initial estimates.
I guess that’s what’s make a market. Bears and bulls. Pessimists and optimists. The July Fed minutes signaled either continued hawkishness or an early pivot, depending on whom you read. As a veteran in this business, I just know you’re not supposed to FIGHT the Fed! But if you were going to fight the Fed, you certainly could do so for a while if you have $2+ trillion in your pocket. Indeed, BCA Research shows U.S. households have accumulated $2.2 trillion—9% of GDP—of excess savings, most of which reside in highly liquid bank deposits. My millennial host at our Seattle event is a wine collector with an extensive basement collection. As he explained how the tannins change the taste of wine as it ages, I began to wonder. Should I mention that for decades, I used to stock my wine cellar with my one favorite red and one favorite white. An easy choice for my dinner guests. His business is welcoming a remarkable number of new millennial clients. His partner calls them “Henrys,’’ high-earning, not rich yet. This generation is marrying and settling down in droves—a maternity ward nurse in attendance said she delivered twice as many babies last year than in most years in her career. Very life affirming. When, in my remarks, I noted that Google searches for “recession” are as high as peak “Covid,’’ the group simply laughed! On Q&A, the best question I’ve had this year: “What is your favorite Washington wine?” “I don’t yet know but I bet it will come from Walla Walla.” Applause!
- Americans like to spend … Core retail sales surprised, rising 0.7% in July, a robust start to Q3. Strength was aided by Prime Day spending and plunging gas prices that provided room for consumers to spend across other categories (clothing, restaurants and airlines). This spending effect was strongest in lower-income households. Notably, sales for the prior two months also were revised up.
- Peak cyclical inflation Manheim used-car prices have sunk 3.6% so far this month and are well off earlier y/y double-digit gains. Philly Fed and Empire (below) prices paid and received continued year-long declines. July’s median existing-home sales price (more below) fell $10,000 from June, with Redfin noting sharp price drops in many former red-hot cities. Ag commodity prices are rolling over—wheat, corn and soybeans are down a respective 35%, 25% and 17% the past three months. And gas and airfares have plunged.
- Parts of manufacturing … rebounded from June’s slump, led by a 6.6% jump in motor vehicle and parts as July industrial production doubled expectations. August’s forward-looking Philly Fed reading also surprised, returning to positive territory after four months of declines on improvement in new orders, shipments, delivery times and capex.
- … but many Americans priced out of housing Existing home sales fell a sixth straight month to May ’20 lows and are down 26% on the year. The combination of high prices and spiking mortgage rates have pushed the y/y percent change in estimated monthly mortgage payments above 50%, the fastest growth rate since the late ’70s/early ’80s. August’s NAHB gauge of builder sentiment fell an eighth straight month to its lowest level in more than two years, and July starts plummeted to a March ’21 low. The decline in permits, typically a better indicator of underlying construction, wasn’t as deep.
- Warning signs? A PricewaterhouseCooopers survey shows roughly half of companies have layoffs in the works, and Evercore ISI’s temp and permanent employment company survey has rolled over. Conference Board leading indicators declined a fifth straight month, dropping the y/y change to zero, and many segments of the Treasury yield curve are inverted (though the important 3-month/10-year is still positive). In the markets, the Investors Intelligence bull-bear reading is sounding a strong contrarian negative alarm, with bullishness spiking to its highest reading since early January.
- … other parts of manufacturing have too much inventory August’s Empire gauge contracted sharply, eviscerating July’s improvements, and new orders declined in the slightly expansionary Philly reading. Industrywide, the ratio of real inventories to real sales is back to pre-Covid levels as manufacturers, wholesalers and retailers have experienced deteriorating sales the last six months. As inventories get replenished, the need for additional production declines.
The Fed’s credibility is on the line TIS Group shares the following from a 2017 discussion between Paul Volcker and hedge fund manager Ray Dalio: “There were so many feeble efforts to deal with inflation in the 1970s. They said, ‘Don’t tighten monetary policy too aggressively, you will get some unemployment.’ So, we went a decade that way, and we ended up with more inflation and more unemployment.”
Curiouser and curiouser One would think European markets would revert to reality amid dollar strength and crumbling macro fundamentals, yet France, Spain, Portugal and Greece are all outperforming the S&P year-to-date. With the U.S. rally proving utterly confusing to most clients it has spoken to, the Institutional Strategist wonders how a European rally into year-end would be perceived.
TINAC’s turn Just as pundits attributed the ’20-21 Covid equity rally partly to TINA (there is alternative) as low yields limited other options, TINAC (there is no alternative country) is credited for $1.5 trillion of net capital inflows into U.S. markets on a 12-month basis through June. The record pace, driven by the country’s haven status at a time of global turmoil, is a major factor behind the dollar’s surge.