Genteel and a survivor
Helpful qualities in a market that's distributing so much pain.
Having just celebrated her Platinum Jubilee, at age 96, Queen Elizabeth II has ruled for longer than any other Monarch in British history. The Mister chides that I am obsessed with the royals … so, what if I am? My Mom used to scold me, “Do you think you were a princess left on our doorstep?” when I was a young brat. So, what if I did? Well, this week took me to genteel Richmond, Va., where our first meeting was with a fierce survivor of many market cycles and protector of her clients’ portfolios, who has definitive thoughts on current leadership in D.C. (Not suitable for our weekly, but, you know….) A large advisor group meeting accepted my sober outlook, with another “survivor” and veteran wondering why more isn’t discussed about the impending “quantitative tightening” and its possible implications for a market which has known nothing but easy policy. Tighter money and surging inflation (and an extremely sour mood—initial June Michigan sentiment fell to a record low) aren’t slowing the consumer. The benefits of unprecedented stimulus (fiscal and monetary) and the wealth effects from a pandemic bull market don’t stop on a dime just because the Covid relief party has ended. Pent-up demand after two years of isolation is powerful. Consumers bought a lot of stuff and now want to have fun. Despite higher prices and fares, OpenTable and airline reservations are back to pre-pandemic levels. Vehicle miles driven, too. So, even with the shift from goods to services by consumers, costs aren’t going down (more below). Not when everyone is going out and traveling and gas is topping a record $5 a gallon.
Americans are dipping into piggy banks to pay for it all. The savings rate has plunged to a 14-year low, and revolving and non-revolving credit in April grew at roughly double their year-ago pace. That continued in May, Bank of America says. Yet median household checking and savings accounts remain above pre-pandemic levels, and lower-income debit card spending growth continues to outpace credit card spending growth. A strong labor market helps. Nominal labor income is rising at an 8.5% annualized pace (just enough to keep pace with inflation). Temp help and truck transportation employment, two key economic indicators, hit new highs in May. Evercore ISI’s weekly surveys show hiring plans accelerating. Payroll growth would need to slow to 150K/month to start calming wage and price pressures, Goldman Sachs calculates. That would be painful. Slowdowns of this magnitude have happened only a few of times without recessions. Businesses also are spending more. ISI contacts report companies are ramping up capex, and Piper Sandler’s onshoring/expansion survey is at a new high. All that cash pouring into capex (and buybacks—the latter is now at an all-time high) could dig deeper into free cash-flow margins. They contracted by a third in Q1 as capex at S&P 500 companies grew at a 20% annual pace. A worry, but not a big one yet. Higher rates and record high home prices have slowed housing (more below). But with existing home inventories and vacancy rates at record lows, and millennials entering prime buying years, the market’s demand/supply imbalance likely will adjust, just as it always has before. Even with this year’s 200+ basis-point increase, a 30-year mortgage still averages just over 5%, well below the 8% average over the past 50 years. We would have killed for such a rate when we bought our first home.
All the above suggest little margin of error for the Fed. Maybe that’s the “super bad feeling” Elon Musk and the “hurricane” JPMorgan’s Jamie Dimon were talking about. Since 1965, the Fed successfully engineered only three soft landings out of 11 attempts. Not good odds. Major challenges—supply chain bottlenecks, China’s Covid crisis, Russia’s invasion of Ukraine and central bank tightening—are spread out, meaning headwinds continuing into next year. The reality is fiscal policy went way overboard and the Fed printed too much money—the money supply grew far faster than nominal GDP during the pandemic, with a lot of the “excess cash” ending up in financial assets and housing (not to mention cryptocurrencies), bidding prices up to historic levels. It’s going to bite like crazy to pull it back. With quantitative tightening causing money growth to plunge from 27% year-over-year (y/y) to 6%, recent declines in asset prices may get much worse before getting better. Gavekal Research thinks the critical question is whether commercial banks continue to grow credit. If there’s a material slowdown, all bets are off. With the relationship between the expected returns of low- and highly valued stocks back to its long-term norm, the market isn’t paying enough to make a bet on any one scenario, Empirical Research says. The unknowns are truly unknown. Hmm. My final event was an annual meeting in the ballroom of the historic Tuckahoe Woman’s Club in a most genteel neighborhood of Richmond, from which my colleague hails. He remembers fondly the cotillion he attended a few decades ago but won’t provide details. (We never heard of a “cotillion” in my working-class suburb of Pittsburgh, back in the day). On Q&A, I was asked, “Not to be political, but [a political question]. And another, “Not to be political, but …” Finally, I was asked what I would do if I were president, or Queen. My response: “I’d fancy being a queen. At this point, I’d loosen regulations to allow energy companies room to maximize production for U.S. energy independence.” Applause! And now I must be off to tea and a marmalade sandwich.
- Closet refresh! Wholesale inventories surprised, up 24% y/y in April, and durable goods production has risen at its fastest four-month pace since October 2020. The flood comes as demand for goods has moderated—retail merchandise inventories are at record levels. Great for sales … and more moderate inflation.
- Trade may be additive April’s trade gap narrowed more than expected to a 4-month low, and after adjusting for import/export prices, the “real” trade gap narrowed sharply, too. Exports rose to a new high while imports fell, in part on goods linked to China, with Chinese imports plunging the most in seven years. Real net exports are on track to boost real Q2 GDP by a percentage point.
- China perking up China’s May exports handily beat expectations, hitting a new all-time high—another sign global supply chain bottlenecks are easing, lessening supply-side inflation pressure. At the same time, Beijing pledged to more measures to further stabilize foreign trade and investment and promote the country’s reopening.
- Elusive “peak” Brent and West Texas Intermediate broke out again, both topping $120/barrel to new highs on the year. The market seems of the view that dislocations in the oil patch are structural and have a way to go, particularly with China picking back up, Russia oil/refined products struggling to make it to markets and domestic producers holding steady. Despite lapping every other sector in year-to-date performance, Energy ranks fifth in flows—more money has flowed to Utilities.
- Elusive “peak” Annual headline CPI inflation jumped more than expected to a new 40-year high, driven by surging energy costs but also the first double-digit increase in food prices since March 1981. The news at the core level was better, as prices slowed a second straight month to a 6% rate (though that was a tick above the consensus at 5.9%).
- Home is where the cash is Data firm Black Knight reports that mortgage holders withdrew more than $75 billion in equity via cash-out refinances in Q1—the highest such volume in 15 years. Higher prices and lower rates before the Fed started tightening made the option attractive. Now, mortgage refinance and purchase applications are plunging, down in the latest week to their lowest level in 22 years, the Mortgage Bankers Association says.
Unintended consequences Policymakers everywhere are cutting taxes on gasoline and diesel, offering untargeted energy subsidies or introducing price gouging legislation. In the U.S., eight states accounting for close to 9% of global gasoline demand have either introduced tax breaks or are considering suspending state taxes on gas. The result: more demand that’s only making the price problem worse.
Hoping it stays this way By 1980, excess inflation had prevailed for a decade or more and had become entrenched in inflation expectations. Today’s excess inflation is only a year old and medium-to-longer term inflation expectations (even those derived from surveys and in particular those derived from market/TIPS breakevens) remain within the range historically consistent with the Fed’s 2% target.
Shout-out to small caps Historically, small-cap stocks performance picks up when the yield curve is steepening, as has been the case of late. It helps that, unlike large caps that have started to roll over, small-cap operating margins, while off their highs, remain elevated when compared to the last 10 years. And Russell 2000’s weighted median forward P/E multiple is now well below its long-term average and has fallen a little below its pandemic lows.