There's no clear path
Can the equity rally survive deteriorating fundamentals, a tight-as-a-drum job market and inverted yield curve?
Travel this week took me to paradise, Naples and Marco Island, Fla., with many LOL meetings and my colleague who’s got a prize-winning laugh that could be identified around the world! Indeed, residents here are mostly well-to-do conservatives and the feel is reminiscent of previous boom times. I was told that people here and in the Tampa area are spending like “drunken drummers” (probably an inside reference to a band of boomer friends) and they “don’t care how much it costs.” Sporting events priced at twice pre-pandemic levels, and the stadiums are filled. Lavish pajama and “prom” parties, complete with tuxedos and evening gowns, attended by 30- to 50-year-olds! Impossible to book dinner reservations until three months out in Tampa and Miami. The Naples restaurant scene is packed and vibrant—no spot at the bar. The biggest complaints are flu season, traffic, undocumented immigration, young people who “don’t want to work” and the national debt. An advisor tells of a client who’s so worried about a debt default that she “doesn’t want to own a Treasury in May.” Futures markets suggest that’s a worry for August, assuming the two sides soften their currently intractable positions. Markets certainly aren’t fretting about this now as the risk-on rally continues. Year-to-date, high-beta stocks (last year’s losers) have clobbered low-beta stocks (last year’s winners)—up 15% for the former vs. down slightly for the latter. And credit is behaving as if the economy is mid-cycle, not on the cusp of recession, as both investment-grade and high yield spreads continue to tighten.
Perhaps the global economy is normalizing from the shock of the Ukraine war and zero-Covid China lockdowns. European data surprises are their highest for 18 months, China is surging on its reopening trade and inflation continues to moderate (more below). Technicals, notably breadth and momentum, are favorable, too. Still, economic fundamentals in the U.S. are deteriorating (more below) and UBS puts recession odds at 100%. When and how bad are the questions. There have been rolling recessions since spring, first in housing (which is now showing signs of bottoming, more below), then retail as stores massively discounted to pare bloated inventories, and finally tech as it is laying off tens of thousands after a hiring surge for a post-pandemic paradigm that didn’t pan out (more below). Are resilient (and all-important) consumers next? They are spending less (more below), borrowing more and blowing through $1 trillion+ of excess Covid-relief savings. Flow of funds data that track money going into and out of homes show U.S. households in aggregate did not save a penny in Q2 and Q3, spending all their income (and more). With job growth slowing and credit card debt rising—it’s nearly $1 trillion, almost $100 billion above pre-pandemic levels (and at variable rates averaging almost 20%)—support for spending is fading. To be sure, consumer balance sheets remain relatively healthy, particularly among middle to higher-income classes. And at 7.3% year-over-year (y/y), nominal GDP growth is still a tailwind. But as goes the consumer, so goes the economy. The earliest a recession has ever ensued after a Fed tightening cycle started was 11 months. The first hike was 10 months ago. The clock is ticking.
Europe is not out of the woods, either. A mild winter, lower energy prices, fiscal stimulus, diminished spillover from the war and China’s reopening have lowered recession odds across the pond (more below). But just six months into its rate-hike cycle, the ECB (unlike the Fed) continues to signal full steam ahead on outsized increases. By fall, there will have been 12 months of hikes. Deutsche and Piper Sandler still expect a European recession by year-end. TrendMacro wonders if the best days are behind its markets. Since a bear-market bottom in late 2022 on the U.K. gilts crisis, euro markets have rallied strongly, causing their equity risk premia to jump from very wide to very narrow. While relative valuations compared to the U.S. remain attractive, what’s left to price in? Back at home, whether there’s a recession or not, Fundstrat sees reasons to think October’s low of 3,492 on the S&P 500 may represent a U.S. market bottom. It could be challenged later if profit growth worsens or contracts—Q4 earnings so far are on track to eke out a gain and forward estimates have been slow to adjust downward much. It’s not unusual for stock prices to rebound between an inflation-driven sell-off, as has happened since October, and a growth scare that doesn’t appear to be on the near-term horizon. Since 1960, six S&P rallies under similar circumstances saw gains of 10-15%. Two (1979 and 2006) rallied 25%. The latter would put it at 4,350 off October’s low. Is that the top of the range? It’s at the high end of ours at Federated Hermes. Many advisors down here in paradise believe the lows are in. They see this as a garden variety rate cycle with the Fed’s mission nearly accomplished. The vast majority expect a Fed pivot by year-end—a soft landing. So, what’s not to like? “This is a breakout. I’ve just invested for my clients.” But what about deteriorating fundamentals, a still tight-as-a-drum job market and the historically reliable message form the yield curve? Yield curve, schmield curve … no clear path.
Positives
- What path for manufacturing? Initial S&P Global (Markit) manufacturing data for January unexpectedly improved but remained well in contraction with a third straight sub-50 reading. The separate services PMI also topped forecasts but was still contractionary. Regional Fed surveys reflected similar behavior. December durable goods orders unexpectedly grew 5.6% off an upwardly revised November. But surging transportation equipment orders drove the increases. Ex-transportation, orders slipped as did nondefense capital goods orders ex-aircraft (a proxy for capex).
- What path for housing? Mortgage purchase applications rose a second straight week to their highest level since late summer, and new home sales rose a third straight month and more than expected (albeit against a downwardly revised November). However, housing remains a drag, with residential investment declining at an annualized 26.7% rate in Q4, slightly above Q3’s 27.1% y/y decline.
- Europe surprises Eurozone flash composite and service PMIs rose more than expected in January, edging into expansion territory. Manufacturing also beat consensus but remained recessionary. The readings corroborated recent improving-condition signals from other indicators such as the ZEW and Ifo.
Negatives
- Slow dance into recession? That’s the way Piper Sandler characterizes the initial take on Q4 2022 real GDP, which surprised at the headline level but was weak in the details. Stripping out trade & inventories, which contributed 2.1 percentage points to the 2.9% gain, the trend was just 1% y/y vs. Q4 2021’s 5.7%. While real activity and inflation (December core PCE hit 4.4%, its lowest since October 2021) are slowing rapidly, elevated nominal growth should keep the job market and compensation humming, aiding a diminishing consumer who cut spending the final two months of the year.
- Fed hawks don’t like wage pressures Jobless claims plunged to 186K in the latest week, well below their 4-week average of 198K. Judging from those claims and its proprietary employment surveys, Evercore ISI thinks payroll employment probably increased 175K this month, with the unemployment rate ticking down to 3.4%, which would be the lowest since 1968. A very tight labor market means that, even though they have moderated, wage pressures are likely to remain elevated.
- LEI, schmLEI Conference Board leading indicators declined again in December, driven by worsening measures of demand and sentiment. On a y/y basis, it has contracted 7.4%, historically a reliable recession indicator, especially when it has coincided with an inversion in the 3-month/10-year segment of the yield curve and restrictive monetary policy, as is currently the case across both fronts.
What else
Why tech layoffs aren’t systemic Recent job cuts represent a modest correction to massive over-hiring during the “free money” pandemic, with layoffs in the industry easily outweighed by labor hoarding in other industries. Many non-tech companies continue to retain tech workers and at least one tech giant—Apple—has yet to announce layoffs. Moreover, many of the eliminated jobs are being spread over time, aren’t in the U.S. and represent cuts to positions, not people.
Nothing personal. It’s just business Less than 9% of companies from the EU and G7 countries that owned subsidiaries in Russia have left the country since the introduction of sanctions last year, research by economists from Switzerland’s University of St. Gallen found.
How come 85% of women outlive their husbands? A jovial advisor I met this week suggests it’s because she won’t touch the mouthwatering hot dog wrapped in crispy bacon that he enjoyed in the Keys. Not to worry ladies, I’ve learned that for 80-90% of couples, the woman makes the financial decisions.