Thor versus Loki
It's inflation versus recession with the Fed in the starring role.
July’s rally isn’t getting much love. It reminds Evercore ISI of failed bounces in January, March and May, a sign it’s too soon to say a durable low is in. While Tuesday marked the first “90% up-day” since the S&P 500’s early-January peak, the percentage of issues making more than a +2 standard deviation advance was a very light 8%; it was only 5% for the Nasdaq. “Hardly resounding,’’ as Strategas Research put it. Less than half the S&P is above its 50-day moving average—historically, it takes a move north of 90% to achieve escape velocity. Weak sentiment is a positive—Bank of America’s monthly fund manager survey found investor allocations to stocks at October 2008 lows and cash at 2001 highs. 58% of respondents reported taking lower-than-normal risk levels, surpassing financial crisis levels. Only 26.9% of respondents were bullish in AAII’s most recent survey. Negative, but not single-digit negative often associated with capitulation. Sales and earnings to date have surprised to the upside, though off a low hurdle rate. Robust nominal growth has masked issues and notably, forward earnings for the year have been revised higher. Downside earnings revisions would seem unavoidable, a reset markets have yet to fully price in. In past recessions, forward earnings would be down 20-50%; they currently are at peak. Even a slowdown without outright recession would dictate lower earnings, though Piper Sandler thinks a recession is inevitable. It sees renewed market weakness ahead and a possible new cycle low. The biggest risk to its call: the Fed backs off early (a pivot optimists expect).
The doom that macro research firm TIS Group hears is far more about the economy than markets. Headwinds abound. With companies playing catchup only to confront falling demand, market-wide inventories in Q1 surged at the second-fastest rate since the mid-1970s, pushing the inventory-to-sales ratio to early 2007 highs and spilling over to manufacturing and services, where Philly Fed and Markit surveys reflect softening activity. Housing’s slump (more below) is worsening as low availability, record-high prices and 30-year mortgages at 6% are driving down affordability. As long as the Fed aggressively hikes (markets expect an additional 200 basis points of rate increases by year-end, including a 75 basis-point move next week), mortgage rates are unlikely to fall back. The supply of homes also looks to stay tight. Baby boomers, who hold 58% of the value of the housing market, tend to stay put. And starts (along with builder confidence) keep slipping. Consumer sentiment is bad—Michigan readings are flirting with all-time lows, and a Monmouth poll found an astounding 87% of Americans believe the country is on the wrong track, one of the worst right track/wrong track readings ever registered. To top it off, several key elements of inflation—rents, wages and food—could run hot for some time (more below), forcing the Fed to choose between recession (which in the past always stopped inflation) and higher unemployment.
As we’ve noted before, after soaring at a record rate during the pandemic, growth in the nation’s money supply is slowing fast and, as I write this, may be contracting. Extremely rare. That it comes as unprecedented Covid fiscal stimulus stopped on a dime means on top of everything else, the economy is dealing with the withdrawal of some $9 trillion of support. But because the effects of changes in the money supply tend to hit with a 12-18-month lag, the economy’s also dealing with the inflationary effects of all that liquidity thrown at it the past two years. (And will be dealing with its disappearance in late 2023-24, when the economy may need it.) In many ways, Piper Sandler says we are just unwinding what was wound up during the fastest liquidity (P/Es) and EPS (stimulus checks) bubble ever. Given this insanely elevated starting point, it says, large drawdowns in equity prices, P/E multiples and earnings well beyond the “average” recession, whatever that is, should be expected, with the duration of the downturn a function of the speed and magnitude of the tightening that caused it. That, and whatever “breaks” as global growth slows. (My nightmares mirror these comments). It would seem the Fed currently cares very much about the level of inflation, which according to its own forecasts, will take far longer than six months to get near its 2% target. In fact, the last time the Fed cut rates with inflation as high as today was December 1981—a time when inflation was dropping precipitously amid a severe recession. What will it be this time? The Fed tightening fast and inflation declining noticeably, which the market will love. Or a slog and malaise. Thor vs. Loki—which one is the Fed? Been in this business a long time. Here's what I know—don’t fight the Fed.
- Supply chains normalizing Bottlenecks eased again in June and, at the median global level, are now just 1.8 standard deviations away from normal (vs. 4.4 last October), according to UBS. There’s been broad-based improvement—shipping costs and delivery times are declining rapidly, backlogs are clearing and parts shortages related to the Russia-Ukraine war have largely dissipated. European gas supply remains a worry. Russia restarted Nord Stream 1 flows this week but left the door open for future cutoffs.
- Capex on the rise Often one of the first areas to be cut during a slowdown, capital spending has risen at a healthy 7% annualized pace the last six months, breaking out of a range where it’s hovered since 2000. The Business Roundtable says CEOs are committed to investing and are more confident about the economy than they were leading up to either the 2008-09 or 2020 recessions. In another sign of confidence, businesses continue to raise dividends, too.
- Peak volatility? After wreaking havoc on the financial markets this year, the VIX has fallen back, settling in the mid-20s, well off its high of 34. Also, S&P 500 sector-price dispersion readings collapsed from the highest-quintile to the second-lowest quintile; historically, the stock market does best when dispersion is low. The bond market’s volatility gauge, the MOVE Index, also has pulled well off its highs for the year.
- Housing a drag June existing home sales fell more than expected, housing availability remained historically tight, housing affordability hit new lows, starts fell for the sixth time in seven months, July mortgage purchase applications fell a third straight week and ex-April 2020’s Covid plunge, NAHB sentiment suffered the largest drop in its 37-year history. All three builders’ survey components—sales conditions, sales expectations and buyer traffic—posted double-digit declines. Renaissance Macro is forecasting residential investment, which accounts for about 4.5% of GDP, to contract in Q3.
- Wage-price spiral “sticky” Even with jobless claims at a high for the year and a slowdown in Tech hiring—and even some layoffs, the labor market remains as tight as it’s been since the 1940s, Empirical Research says. New entrants into the labor force are failing to keep pace with baby boomer retirements and immigration restrictions, and job switchers have seen +6.5% wage gains in the last 12 months, 1.7 percentage points above those who stayed in place. While average hourly earnings cooled in recent jobs reports, the Employment Cost index and the Atlanta Fed’s monthly tracker show wages still accelerating.
- Food inflation “sticky” Global food prices remain high and are back to 1970s levels in some parts of the world, due not just to the pandemic and war shocks but also severe weather-related disruptions and avian flu. Barclays believes this inflation will remain persistent, further eroding household spending and making it harder for policymakers to achieve their inflation targets.
Extreme(ly) troubling It’s estimated that extreme temperatures now kill 5 million people every year, more than car crashes, homicides, tuberculosis and HIV/AIDs combined. And extreme-weather events that used to occur twice a century are now occurring two times every decade.
Ciao, Mario This week’s resignation of former ECB President Mario “Whatever it takes” Draghi as Italian prime minister means Italy has now had 132 governments in 161 years, with the average tenure under 15 months. Draghi beat the averages, lasting nearly 18 months.
Useless information for a summer barbecue Bank of America shares that the world’s population could all fit inside Los Angeles if everyone stood shoulder to shoulder. And if you took out all the empty space in our atoms, the human race could fit in the volume of a sugar cube.