Month: August 2022

Note: I am travelling (ancient word: “go from one place to another, typically over a distance of some length”) in Europe until August 23rd. Postings will thus be sporadic, limited and time-zones impacted.

John Mauldin’s recent Thoughts From The Frontline covers a lot of ground in the current uncertain, rather puzzling, environment.

(…) Markets evidently think the Fed will stop hiking sooner rather than later. They are literally not paying attention to what multiple Fed officials are saying in speeches all over the country. Let’s look at what normally uber-dove Neel Kashkari says:

“The idea that we’re going to start cutting rates early next year, when inflation is very likely going to be well in excess of our target, I just think it’s unrealistic,” Minneapolis Fed president Neel Kashkari said.

He further stated that, “I think a much more likely scenario is we will raise rates to some point and then we will sit there until we get convinced that inflation is well on its way back down to 2% before I would think about easing back on interest rates.” He went on to state that the Fed “is far away from declaring victory on inflation, and while this is the first hint that price movements are moving in the right direction, it doesn’t change my path for rates.” (…)

We are in uncharted waters. The Fed is raising rates into an inverted yield curve and has clearly expressed its intention to continue doing just that. (…)

The yield curve is flashing a strong recession signal three to four quarters out. What makes this curious, and a little more difficult to predict, is that we already have a stagnant/negative growth with two straight quarters (if revisions show Q2 still negative) of declining GDP.

Inversions typically precede recession by anywhere from a few months up to two years. The yield curve is usually back to normal by the time recession actually arrives. But nothing about all this is “typical” so maybe this time is different.

Or more likely, the real recession is still coming. (…)

Last week my friend/business partner Steve Blumenthal flagged a report from Bridgewater’s Bob Prince on “Transitioning to Stagflation,” an ominous but probably accurate title for where we are headed. Here’s the core of it.

(…) “The markets are discounting a very different scenario. They are discounting one sharp round of tightening—comprised of a rise in short-term interest rates to just above 3%, combined with more than $400 billion of contraction of the Fed’s balance sheet—and that this will be enough to bring inflation down to 2.5% with stable growth and no dent in earnings. From there, markets are discounting that the achievement of these goals would allow a subsequent 1% drop in rates from their peak.

“Asset returns are driven by how conditions unfold in relation to what is discounted. Our approach is to have an excellent reading of current conditions and a time-tested understanding of the cause/effect linkages, leading to a reliable probabilistic assessment of what comes next: an optimal response to known conditions. Today, our indicators suggest an imminent and significant weakening of real growth and a persistently high level of inflation (with some near-term slowing from a very high level).

Combining this with what is discounted, the difference between what is likely to transpire in the near term and what is discounted is the strongest near-term stagflationary signal in 100 years, shown below. Longer term, as we play it out in our minds, we doubt that policy makers will be willing to tolerate the degree of economic weakness required to bring the monetary inflation under control quickly. More likely, we see good odds that they pause or reverse course at some point, causing stagflation to be sustained for longer, requiring at least a second tightening cycle to achieve the desired level of inflation. A second tightening cycle is not discounted at all and presents the greatest risk of massive wealth destruction.”

^{Data estimated through June 2022. Estimates based on Bridgewater analysis.}
Source: Bridgewater Associates

The Bridgewater report goes on to describe how all this tightening will unfold and what it needs to do in order to bring inflation down to the 2.5% area. They expect about two more years of tightening to reach that point.

Markets aren’t priced for anything like that scenario. This means, among other things, mortgage rates will continue to choke the housing market, with substantial knock-on effects including many lost jobs.

That won’t be an accident. It’s what the Fed wants. (…)

How this goes depends a lot on the next few economic reports. Currently the federal funds rate, the Fed’s primary policy rate, is at 2.5%. It will likely be at least 3% after the September meeting, maybe higher if August inflation and jobs data remain strong. It’s easy to imagine 4% by year-end if inflation isn’t falling fast enough. They need to get real rates to a positive number, at least, and that is probably a lot higher than 4%.

A yield curve starting at 4% and bending down to 2.5% 10-year yields is possible, I suppose, but I can’t imagine it staying that way very long. Some combination of yields needs to move differently.

One possibility is long-term yields rise, restoring normal slope to the yield curve. That would mean higher mortgage rates, with all the attendant economic damage, as well as higher interest costs on the federal government’s gargantuan debt. Hardly benign—but quite possible with QT about to begin in earnest.

Note also that Charles Evans, another FOMC dove, said last week that “we must be increasing rates the rest of this year and into next year.” So much for data dependency.

Goldman says that “bringing down wage growth and inflation, shows little convincing progress so far. Wage growth has moved sideways at 5.5%, 2pp above the 3.5% pace that we estimate is compatible with 2% inflation. On inflation, the good news is that falling commodity prices and supply chain recovery are delivering a long-awaited and much-needed disinflationary impulse from the goods sector. The bad news is that high inflation is broad-based, measures of the underlying trend are elevated, and business inflation expectations and pricing intentions remain high.

Investors cheered a surprisingly strong payroll report, with continued wage pressures, then cheered again at a surprisingly soft inflation report. A strong “disinflating” economy with 5%+ wage gains?

Meanwhile, Q2 corporate results keep surprising on the upside, but mostly due to higher energy and commodity prices. Otherwise, the severe margins squeeze that started in Q1 has continued in Q2 and is forecast to remain through the rest of the year.

Recall the very bad productivity data released last week. Revenue growth will no doubt shortly slow below unit labor costs (+10.8% YoY in Q2) as companies pay the cost of hoarding labor.

David Rosenberg questions the apparent strength of the economy:

Please — as if there was anything going on in the economy to tell anyone that there truly was a +528k employment surge in June. The historical odds of seeing this with both the manufacturing and service-sector ISM employment subindices below zero is zero.

Jobless claims have trended higher and already flashed the recession signal. Challenger layoff announcements are soaring.

The Household survey has flashed successive declines in full-time jobs and a spike in multiple job holders, which is a classic counter-cyclical indicator (along with sharply accelerating usage — +20% at an annual rate these past four months in revolving credit balances). Within that nonfarm payroll report, more than 150k of the jobs came from the “birth-death” model even though business creation has contracted by 8-1/2% from a year ago.

This is why nonfarm payrolls take a back seat to the Household survey — in both directions — at turning points of the economic cycle. Heading into recessions, the payroll survey overestimates net new business creation and the skew this gives to the headline data, and the opposite when the recession swings to expansion.

Go back to the 2008-09 recession as an example. After the BLS “corrected” the flaw in its model, the combined level of employment ended up being revised to show more than 1 million jobs vanished compared to the initial estimate! A downward revision (the data for over 90% of the months in the Great Recession were ultimately revised down!).

Go back to this last pandemic/lockdown recession — the March 2020 payroll number today stands 672k lower than the initial “take” by the BLS! This is what the Fed stakes its ground on and what traders react to?? Come on.

Whatever one looks at, data has surprised one way or the other but their reliability is questioned. So much for a data dependent Fed.

In truth, nobody really knows the future course of the critical variables, inflation, employment and interest rates, although on the latter, FOMC members and Mr. Powell are insistent on their likely and desired journey.

EARNINGS WATCH

Through Aug. 12, 456 companies in the S&P 500 Index have reported earnings for Q2 2022. Of these companies, 77.6% reported earnings above analyst expectations and 18.2% reported earnings below analyst expectations. In atypical quarter (since 1994), 66% of companies beat estimates and 20% miss estimates. Over the past four quarters,81% of companies beat the estimates and 16% missed estimates.

In aggregate, companies are reporting earnings that are 6.1% above estimates, which compares to a long-term (since1994) average surprise factor of 4.1% and the average surprise factor over the prior four quarters of 9.5%.

Of these companies, 69.3% reported revenue above analyst expectations and 30.7% reported revenue below analyst expectations. In a typical quarter (since 2002), 62% of companies beat estimates and 38% miss estimates. Over the past four quarters, 78% of companies beat the estimates and 22% missed estimates.

In aggregate, companies are reporting revenues that are 2.9% above estimates, which compares to a long-term (since 2002) average surprise factor of 1.2% and the average surprise factor over the prior four quarters of 3.4%.

The estimated earnings growth rate for the S&P 500 for 22Q2 is 9.7%. If the energy sector is excluded, the growth rate declines to -0.9%.

The estimated earnings growth rate for the S&P 500 for 22Q3 is 5.8%. If the energy sector is excluded, the growth rate declines to -0.9%.

China: July activity data broadly missed expectations

July activity data broadly declined from June and surprised markets to the downside, reflecting weak domestic demand amid sporadic Covid outbreaks, production cuts in some high-energy consuming industries and adverse impact of some risk events in the property sector, despite incremental policy support and favorable base effects. Industrial production rose by 3.8% yoy in July (vs. +3.9% in June), below market consensus of 4.3% yoy.(…)

Retail sales growth moderated to a weaker-than-expected +2.7% yoy in July from +3.1% in June, with Covid-sensitive catering sales growth remaining negative at -1.5% yoy. Fixed asset investment growth declined to +3.6% yoy in July from +5.9% in June on a single month basis, also weaker than expectations despite more infrastructure stimulus.

That said, surveyed unemployment rates edged down in July, suggesting labor market pressure has eased sequentially on more policy support.

On the back of weaker-than-expected activity, credit and inflation data, as well as recent risk events in the property sector, the PBOC cut its policy rates by 10bp this morning, in an effort to boost bank lending, economic growth and market sentiments. (GS)

CAPITULATION?

According to GS Prime, this rally has now become the 3rd biggest hedge fund short covering event in the last decade. (The Market Ear)

• On balance volume continues to refuse buying this latest melt up.

FYI:

Note: I am travelling (ancient word: “go from one place to another, typically over a distance of some length”) in Europe until August 23rd. Postings will thus be sporadic, limited and time-zones impacted.

CPI from Goldman Sachs:

July core CPI rose 0.31% (mom sa), below consensus of 0.5% and its slowest pace since September 2021. The year-on-year rate remained at 5.9%. Airfares declined 7.8% (mom sa), similar to our expectations, but inflation in the hotel lodging (-2.7%), used cars (-0.4%), communication (-0.4%), and education (+0.1%) categories was softer than we had forecast.

Shelter categories rose at a sequentially slower but still elevated pace (rent +0.70%, owners’ equivalent rent +0.63%), similar to our estimates. Monthly inflation remained strong for car insurance (+1.3%), pet services (+1.2%), recreation admissions (+0.9%), and household furnishings and operations (+0.6%).

Also of note, the labor-intensive “food away from home” category remained firm at +0.7%, and the climb in new car prices continued (+0.6%). Apparel prices edged down slightly (-0.1%), reflecting the interplay between higher discounting activity and continued upward pressure on base prices.

Headline CPI was flat (vs. consensus of 0.2%), as energy priced declined 4.6% and food prices rose 1.1%.

My CPI-Essentials data was flat MoM bringing the YoY change to 9.7% from 10.4%.

Axios:

• Online prices declined by 1% in July, compared with a year earlier, according to the Adobe Digital Price Index.
• It marks the first price decline in the index in 25 months — and it’s the fifth straight month in which the index has fallen.
• The downward trend suggests that retailers are dropping online prices for excess inventory.

Core commodities nonetheless rose 0.2% MoM in July and are up 7.0% YoY.

Core services rose 0.4% after 0.6% and 0.7%. They are now up 5.5% YoY, keeping pace with wages.

Curb Your Enthusiasm on the Good Inflation News Core inflation remains stubborn, and the Fed cares less about headline numbers than sticky prices. They’re still moving upward.

This piece by John Authers deals with most everything from CPI day and the market reaction. Some extracts:

(…) In this chart from Steven Englander of Standard Chartered PLC, the green line shows an “adjusted core” excluding the most directly pandemic-affected items. It also reduced last month, but at this point, the transitory effects are flattering the overall core numbers:

(…) Two widely followed measures come from the Cleveland Fed, which publishes a trimmed mean (excluding the biggest outliers in either direction and taking the average) and the median. These measures were never moved by rental cars or gasoline in the first place. And unfortunately, both continued to rise, and both are at their highest since the series started in 1984:

Narrowing down to look at the month-on-month change, however, it’s good to see that July’s increase in the trimmed mean was the lowest since last August:

The Atlanta Fed monitors prices that are “sticky” (which require lengthy planning to change and are hard to reduce), against flexible prices that can rise or fall swiftly with little difficulty. The early months of the inflation scare were dominated by flexible prices, for which inflation is beginning to drop a little. What matters for the Fed is whether expectations have become so dislodged that sticky prices are moving. And again, the year-on-year rate of sticky price inflation rose last month, to a new 40-year high. This is a big problem that implies a need for extreme central bank vigilance. The good news is that sticky prices didn’t inflate as much last month as they did the month before — but this is still strong evidence that as far as the Fed is concerned, the peak is not yet in:

Then there is the critical issue of housing costs, which account for about a third of the entire index. Year-on-year inflation in owner-equivalent rent, which aims to capture changes in accommodation costs for renters and buyers, rose again last month to set a new high since 1990. This number tends to come through with a lag; despite signs that the big increase in borrowing costs driven by the Fed’s tightening to date is already having an effect on the housing market, the number is likely to keep rising — and take core inflation up with it.

U.S. Productivity Declines in Q2, Pushing Unit Labor Costs Higher

Nonfarm business sector productivity fell 4.6% (AR) during Q2’22 following a 7.4% Q1 decline, revised from 7.3%. The 2.5% decline during the last four quarters was a record for the series which dates back 1948.

Nonfarm business output declined 2.1% (+1.5% y/y) after a little-revised 2.5% drop in Q1. Hours-worked rose 2.6% (4.1% y/y) after increasing 5.3% in Q1.

Hourly compensation strengthened 5.7% last quarter after increasing an unrevised 4.4% in Q1. As the labor markets tightened, forcing bidding wars to fill job positions, the y/y gain in hourly compensation remained strong at 6.7%. Adjusted for a 9.4% surge in price inflation, real hourly compensation fell 4.4% last quarter, down 1.7% y/y.

The combination of falling productivity and strength in compensation raised quarterly nonfarm business sector unit labor cost growth to 10.8%. It followed a 12.7% gain Q1. The 9.5% y/y increase was increased from a 0.9% low in decline in Q3’19.

In the manufacturing sector, output per hour grew 5.5% last quarter (0.4% y/y) following a 1.0% decline in Q1. Hourly compensation increased 4.9% (4.8% y/y) after a 5.8% Q1 increase. Real hourly compensation fell 5.1% (-3.5% y/y). That produced a dip in factory unit labor costs of 0.5% (+4.4% y/y), following a 6.9% Q1 rise.

Labor hoarding is becoming more expensive as companies retain less productive employees. The -2.5% YoY trend is unprecedented.

It is not impacting profits yet because sales are still rising at double digit rates thanks mainly to commodity prices. But you can’t have lowflation and strong nominal sales.

From maximum fear to a bit of greed

The Fear & Greed Model, based on the inputs published by CNN, has entered excessive optimism territory. Over the past 24 years, the S&P 500 has returned an annualized -0.3% when the model is above 80%.

Note that our figures will differ from the one published on CNN. We use different inputs for the put/call ratio and, more importantly, junk bond spreads. But the general inputs and model calculations are essentially the same.

The current level of optimism comes after what was, for all intents and purposes, maximum pessimism in May when the model fell below 5%. It has cycled from near-maximum pessimism to optimism seven other times when the S&P 500 was below its 200-day average.

The S&P’s future returns are interesting. During the failed bear market rallies, the index saw weakness almost immediately. During the bull markets ones, it didn’t.

The Risk/Reward Table highlights this further. After all the failed signals, the S&P never gained more than 3.5% at any point in the month following the first 80% reading. After all the successful signals, it rallied at least 3.5% each time.

So, that’s a good test here. If stocks can gain more than a few percent in the coming weeks, it will suggest a bull market.

When we zoom in on the 2001 instances, it’s obvious how limited the reward for buyers was after the model reached its extreme.

There were a couple of near misses for these sentiment cycles in 2007-08 when the model didn’t drop or rise quite far enough, though the implication was the same – limited upside and a quick reversal into a downtrend.

Contrast that to the bull market signals. After these triggered, buyers’ reactions were to just keep buying. There was minimal drawdown in the weeks after the model reached excessive optimism territory.