Admittedly, this might be an over-simplistic representation of the complex being that financial markets are ! But I do feel it all boils down to who takes the speedier elevator down – Inflation or Economic Growth! Here’s a look at the seesaw of indicators to help you decide who is riding the faster elevator down….
One of the key thesis behind a soft landing narrative is the assumption that in a moderate inflation environment (or in the expectation that we will get down to a moderate inflation environment soon enough), companies won’t fire workers because nominal sales increase with inflation and if companies don’t provide comparable wage increases then profitability can be maintained without firing workers. The key assumption here is that the economy does not enter the labour market doom loop.
So what makes us nervously smile ?
- A US Consumer that remains incredibly resilient….
Many had expected the US consumer to wilt by now in the face of constant elevated inflation. Indeed, there has been a slowdown in consumption. But simply not to the extent that Chair Powell would like to see.
Here’s a chart for simple comparison. Real PCE has grown at annualized rates of 1.3%, 2.0% and 1.4% in the 3 quarters of 2022. By comparison, in the 4 quarters of 2008, annualized GDP growth rate q-o-q was -1.10%, +0.06%, -3.00% and -3.70%. I am not suggesting that we are in a 2008 type of global crisis scenario. Not even remotely close! But even if you look at the last soft period in late 2018 and early 2019, Real PCE growth rates were closer to 1%. Remember that inflation was a lot benign then and the Fed could afford to reverse tightening policy and let the economy get some breathing space. With CPI at 8%, Real PCE at 1.5% is simply unacceptable to the Fed.
Unarguably, one of the key reasons for the strength of the US consumer has been the large fiscal support payments received during 2020 and 2021 and the resultant excess savings. A recent Fed paper estimated that US households accumulated about $2.3 trillion in 2020 and 2021 above and beyond what they would have saved if income and expenditure had grown at pre-pandemic trend rates. i.e. truly excess savings. The same paper also suggests that US households still hold three fourths of these excess savings!
The October 2022 Retail Sales was a fairly high print as well…
Nominal Retail sales increased 1.3% month over month and 8.2% year or year. Adjusting for inflation, real retail sales increased 0.8% month over month and 0.5% year over year. See graphs below. Once again, the summary is that these graphs do not show a US consumer that is rolling over.
Below is a great chart that I picked off advisorsperspective .com. It shows Real Retail Sales as a percentage of the all time highs. This better depicts where we stand in the consumption cycle compared to past recessionary periods.
- Main Street CEOs that do not seem to have received the recession memo yet….
Business investment still remains strong. Take durable goods orders for instance. Durable goods orders reflect new orders placed with domestic manufacturers for delivery of long-lasting manufactured goods. Below is the Durable Goods New Orders for the last 12 months. New Orders were up 1.0% in October – up seven of the last eight months!
Even if we exclude the more volatile and lumpy transportation sector, core durable goods new orders are still significantly high and not yet pointing towards a rapid decline in business investment.
This can be seen also in the quarterly GDP data. The most recent Q3 2022 data showed Non Residential Fixed Investment in Equipment and IP Products grow at an annualized rate of 11% and 7% respectively. The overall gross private domestic investment number fell a massive 8.5%. But that was dragged lower by a weak housing market that resulted in Residential Fixed Investment falling at a 26% annualized rate. Business investment was still growing fairly strong.
- A job market that defies all odds of a recession…
Layoffs so far have been more idiosyncratic than broad based. I don’t think there is any doubt about the fact that the layoffs thus far have been mostly tech sector specific and a reflection of the easy money era excesses than broad based and pervasive throughout the economy. One of the biggest learnings for corporates and businesses worldwide through this pandemic has been the difficulty in hiring workers, facing supply shortages and excessive dependency on just-in-time inventory strategies. Add to this a recency bias in behavior, and it comes as no surprise that employers have been reluctant to let go of employees.
Initial jobless claims, while rising back over the last 8 weeks are still substantially lower than the 2008 crisis peaks. Notably, the current levels are lower than even the 261K print in July 2022.
This Friday 2nd December, all eyes will be on the next Non-Farm Payroll report. Consensus expectations point to a slowing jobs market and payrolls are projected to have risen 200K. While growth in payrolls is moderating, it is still indicative of a tight labour market – the main impediment between the Fed and its supreme goal of keeping inflation expectations anchored. Just to recap – The US added roughly 400K jobs every month in 2022 and 562K jobs every month in 2021! That is significantly higher than the historical pre-pandemic average. Also, just to add context, the US adds roughly only 50K adults on average every month.
Given this picture, it is not surprising that the S&P500 today is almost 15% higher than the 2022 low. With a greater likelihood that rates might peak soon (compared to the likelihood at the start of the year), a soft landing can indeed give a nice tailwind to equity markets. The latest Atlanta GDP Now tracker has generated a lot of interest of late. It projects a 4Q 2022 GDP growth rate at a whopping 4%! Hardly indicative of an economy which is supposedly in the throes of a recession!
Ok. Then what makes us cringe? Lets look at the other side of the coin now..
- Purchasing Managers who are turning increasingly pessimistic with every passing month…
PMIs are one of the best leading indicators of the economy. There are 2 PMI reports that the market tracks closely S&P Global and the Institute of Supply Management.
S&P Global
The S&P US PMI has been trending down since the highs of mid 2021. After a couple of months of fairly optimistic PMI readings, the indicator has picked up pace once again to the downside. November saw a significant contraction in business activity across the private sector. The fall in activity was the second fastest since May 2020. More importantly, new orders fell also at the fastest pace since May 2020. The pace of decline in new export orders also picked up pace. The sharp falls in new orders and new export orders led to a reduction in outstanding business / business backlogs. While we still have not started seeing broad based layoffs, the PMIs have started indicating a meaningful reduction in hiring.
Institute of Supply Management
The trend lower in ISM Manufacturing continued in October. The overall index fell from 50.9 to 50.2. But the index is still in expansion territory (the 29th consecutive month of growth!). More importantly, new orders contracted similar to September. The big upside in this report was the Prices sub-index fell sharply to 46.6 from 51.7 providing solid evidence of easing price pressures. Supplier deliveries have also started accelerating indicating improvements in supply chain. But overall the downward trend is evident!
- A credit environment that is so benign it begs the question whether it is illusory…
Credit spreads, while higher from 2021 lows, are still nowhere close to crisis levels or even mild recessionary levels. Delinquency rates are so low that long experienced bank chiefs have been saying it is unlike anything they have seen their entire careers. But this also begs the question of whether there is a storm underlying this calm….
US Household debt increased at the fastest annual pace since 2008 in the third quarter of 2022, according to the latest figures from the New York Fed. Households added a total of $351 billion in overall debt in 3Q taking the total to $16.5 trillion! In an unmistakable evidence of what’s funding the retail sales spend, credit card balances have grown from $750bn in Q2 2021 to $930bn in Q3 2022. The rest test would be to see if debt servicing keeps pace with this rapid rise in borrowing when inflation eats into disposable income even more over the next 6-12 months.
As the debt pile increases and the servicing burden gets higher and the overall environment deteriorates, banks naturally start to tighten lending standards. A negative credit impulse has the strongest effect on demand and consumption across the spectrum. The evidence is visible in the latest Senior Loan Office Opinion Survey on Bank Lending Practices. You can read it here
- Money supply that’s actually fallen off a cliff…
Its not often that you pick up a chart of broad M2 growth in the economy and really pause to think about the often quoted line “Inflation is always and everywhere a monetary phenomenon”. Exceptional fiscal policies resulted in an explosion of money supply in 2020 and 2021. But, like many other indicators in markets, it is less about the absolute number and more about the rate of change. In 2022, for most of the year money supply (as measured by M2) has actually been falling.
If you look at Real M2 Money Stock, you will notice the drop has been even sharper – given the exceptionally high inflation rate we have been experiencing.
- Regional Fed Surveys that are almost screaming murder….
4.5 / -19.4 / -9.0 / -19.4 / -6.0. If you are wondering what is this plethora of negative numbers, these are the latest readings of business condition indexes from the Fed surveys conducted in the Fed districts of New York, Philadelphia, Richmond, Dallas and Kansas City. These manufacturing surveys provide an early glimpse of local economic health and collectively can represent the national manufacturing sector (which contributes approx. 15% to national GDP). Each of these Fed surveys (except Empire State) has turned decisively negative in the past 3-6 months indicating deteriorating business conditions, falling new orders and pessimistic expectations of the future.
- A housing sector that’s as quiet as a mouse….
Housing is beaten down significantly. Housing transactions have absolutely cratered.
As mentioned in my earlier post on the US Housing Market, housing gets reflected in GDP in two ways. First, through residential fixed investment which includes the construction of new single family and multi-family homes and some other related activities. In 2021, Residential Fixed Investment contributed $1,086 billion to US GDP (4.7%). Second, through all spending on housing services which includes renter’s rents and utilities and home owners implied rent and utility payments. In 2021, this category contributed approx. $2.8 trillion to US GDP (12.2%). Together, housing as a sector, hence contributes about 17% to US GDP. A sizeable number ! Residential fixed investment has fallen at annualized rates of 2%, 18% and 26% in the three quarters of 2022.
- A Central Bank that probably wants to cleanse its Balance Sheet sins of the past….
With rate hikes in prime focus, everyone seems to have forgotten the other elephant in the monetary policy ballroom ! Quantitative Tightening. Bank Reserves at the Fed now stand US$1.1 trillion lower than the peak in December 2021. There is a ton of debate on whether the purchase of long term government treasuries did anything at all in the real economy to spur growth and to the 2% inflation target in the last decade. But I doubt if too many people would be able to argue against the effect of QE on risk assets and financial assets. Likewise, Quantitative Tightening can also be expected to be a persistent headwind for risk assets as liquidity gets sucked out of the system.
At a clip of US$95bn per month, another US$570 billion can potentially be reduced from bank reserves over 1H 2023 ! Of course, that is also dependent on how much is the Fed able to pull out of US$2 trillion in the RRP facility and channel some of that back into the banking system. As per the latest November Treasury Refunding statement, the much publicised Treasury Bond Buyback idea of issuance of more bills to buyback treasury bonds still seems to be in the works and a few months away from actual implementation. In the meantime, liquidity is being drained thick and fast.
So whats the conclusion…
Ultimately, where the risk assets end up is anybody’s guess. And you should probably run miles away from anyone who claims to know with certainty!
I believe the current equity market environment is still one where bad news is good news since it gives a reason for a rate pause or pivot (in this context a pivot means any favourable change in Fed rate expectations on terminal rate as well as timing). But with prolonged passage of time bad news will be treated as bad news and this current narrative will change and the headwinds to the economy will become large enough that mere pauses or mild pivots in rates don’t prove sufficient. Which is where I believe 2023 is likely to be!
Disclaimer and Disclosure: Not meant to be investing advice. Do your own research! I am long the broad equity market including primarily SPY, QQQ, XLE and XLP. However, given the above thesis I regularly sell calls on the upside to generate ongoing yield. I am also long US Treasuries since mid 2022 (like I mentioned in my previous posts as well) in the belief that the headwinds are gathering enough steam to eventually send risk investors covering for safety. Also, just for the record, I am a dollar bull and dont have an iota of faith in the near term “death of the US dollar” story!
