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.
Weirdness Factors (John Mauldin)
(…) The most obvious weirdness factor going into this recession is the still-strong employment data. Employers are hiring people faster than they are firing them, and many wish they could hire more. That doesn’t square with recessionary conditions. (…)
The market was expecting July job growth of 250,000. It got 528,000 plus another 28,000 in positive revisions for prior months. The labor force shrank slightly, helping the top-line unemployment rate drop to 3.5%, matching the 2019 low which was the lowest since the 1950s. While wages rose, participation rates dropped in the especially critical 25–54 age category.
This doesn’t seem like recession, at least not yet, but the two don’t always coincide. Remember the period after 2009. We spent years talking about a “jobless recovery.” The economy was growing, albeit slowly, without the kind of job growth you would normally expect.
If a jobless recovery is possible, maybe the opposite is too: A GDP recession without high unemployment. I’m leery of comparisons to past recessions because the demographic picture has changed. In 2008, the oldest Baby Boomers still hadn’t reached age 65. Now, most have, or are close to it, and some retired early due to COVID concerns. Subsequent generations aren’t big enough to fill the gap, hence the labor shortage that is keeping unemployment low. That could persist even with weaker business activity and consumer spending.
Some estimates show “Long Covid” could be keeping as many as 4 million workers sidelined. Between retirement, Long Covid, less labor force participation, etc. it is entirely possible that unemployment won’t resemble past recessions. (…)
Goldman Sachs made this handy chart combining the prime-age participation rate with the dates benefits went away.
Source: Lydia DePillis
They split the data by income, and it shows lower-income prime-age workers left the workforce even faster after enhanced benefits ended. Where are they going and how are they surviving? I don’t know but it’s an important question.
Finally, let’s note that scarce labor, manifested as low unemployment, can be a recessionary factor in itself. Labor-intensive businesses that can’t find labor (think restaurants) face limits in how much revenue they can generate. At some point, they may close. Many are already reducing hours in a kind of partial closure. This trickles through the economy. (…)
Credit Suisse strategist Zoltan Pozsar posted a fascinating research note last week, suggesting we are entering an entirely different era, one in which central banks are increasingly irrelevant to much larger forces.
Larger forces than central banks? Yes. One new era began in the early 1990s, giving us globalization, low interest rates, and persistently low inflation. All that is now ending. Here are some excerpts from Zoltan (emphasis mine).
“The low inflation world stood on three pillars: first, cheap immigrant labor keeping service sector wages stagnant in the US; second, cheap goods from China raising living standards amid stagnant wages; third, cheap Russian gas powering German industry and the EU more broadly.
“US consumers were soaking up all the cheap stuff the world had to offer: the asset rich, benefiting from decades of QE, bought high-end stuff from Europe produced using cheap Russian gas, and lower-income households bought all the cheap stuff coming from China. All this worked for decades until nativism, protectionism and geopolitics destabilized the low inflation world…
“Central banks went from waging a war against deflationary impulses coming from the globalization of cheap resources (labor, goods and commodities) to ‘cleaning up’ the inflationary impulses coming from a complex economic war.
“Think of the economic war between the US, China, and Russia as something that will weaken the pillars of the globalized, low inflation world described above – the process will be slow, not sudden, but it will be certain, where ongoing economic ‘tits’ for ‘tats’ will have the potential to drive more and more inflation.
“Think of the economic war as a fight between the consumer-driven West, where the level of demand has been maximized, and the production-driven East, where the level of supply has been maximized to meet the needs of the West… until East-West relations soured, and supply snapped back…
“ The unfolding economic war between great powers is stochastic and not linear, and what inflation will do in the future depends not only on the shocks that occurred in the recent past, but also on the many shocks that can happen still. These include more sanctions and the further weaponization of commodities, and more technology sanctions and further supply chain issues for cheap goods.
“Getting right where inflation goes from here is basically a matter of perspective; do you see inflation as cyclical (a messy re-opening after COVID, exacerbated by excessive stimulus) or structural (a messy transition to a multipolar world order, where two great powers are challenging the might and hegemony of the US). If the former, inflation has peaked. If the latter, inflation has barely started.”
To be clear, Zoltan isn’t saying structural inflation is certain. He sees a notable risk that inflation will stay higher for longer due to the ongoing economic warfare he describes—a risk for which investors should prepare.
Reading that in combination with both energy and labor markets where supply can’t keep up with demand, it is increasingly hard to see a return to the pre-COVID low-inflation regime. It has more likely ratcheted higher and will remain so until the forces of deflation weigh in (and they will!). How much higher will vary. We may well see lower US inflation as the Fed’s tightening efforts bring on recession. But if the structural forces don’t change, inflation will return.
Persistent Inflation + Inverted Yield Curve
My friends Robert Arnott (founder of Research Affiliates) and Campbell Harvey (of Duke University) have a new paper titled “ No Excuses: Plan Now for Recession.” Rob contends inflation will be high, if not higher, at the end of the year. I have learned over our 20 years of friendship to be very careful disagreeing with him. He is extraordinarily careful and precise. Here’s an excerpt:
“… The near-term prognosis for inflation is not good. Each month’s 12-month inflation rate matches the previous month’s inflation rate, plus a new month, minus the corresponding month dropped from the previous year. We can’t know with any confidence what the new month’s rate will be, but we know with precision the rate of the month being dropped. The next four months to be dropped from 2021 will be 0.9%, 0.5%, 0.2%, and 0.3%, respectively. The Cleveland Fed produces an “inflation nowcast” which estimates what the monthly inflation would be if the month ended today. If their nowcast is correct, the 0.9% from June 2021 will be replaced with 1.0% for June 2022. If inflation in each subsequent month through year-end 2022 matches the average inflation rate over the prior 12 months, we should finish the summer at 9.9% and finish the year at 10.8%. If, alternatively, monthly inflation recedes to match the trailing 36-month average, then the current 8.6% inflation rate would remain steady through year-end. This simple analysis leads us to believe that inflation will likely get worse before it gets better.
Source: Rob Arnott“… There’s another problem with the way CPI inflation is calculated. The largest component, shelter, is one-third of the total and is smoothed and lagged. According to the Bureau of Labor Statistics (BLS), their chosen measure for the cost of home ownership, owners’ equivalent rent (OER), is up 7.3% in the last two years, while the S&P/Case-Shiller Home Price Index shows that US home prices have risen by 37% in the two years ended March. The BLS switched to OER after the last inflationary surge in 1979–81; indeed, if inflation was calculated today like it was in 1981, we would already be solidly into double digits.
Similarly, the BLS estimate of rental prices, rent of primary residence (RPR), is up a near-identical 7.1% in the last two years, while the CoreLogic Single-Family Rent Index is up twice that in the last year alone (and an astounding 41% in Miami!). The BLS uses survey data to gauge shelter inflation. Homeowners’ perceptions of their property rental values anchor on the past and only respond to soaring home prices slowly, gradually, and over several years.
The one-third of CPI for shelter will be playing catch-up for some years to come. Empirically, most of that catch-up occurs over the subsequent two to three years. Note that this inflation has already happened; it simply hasn’t made its way into CPI quite yet.”
I have probably written more on the yield curve and recessions than any single topic over the last 23 years. A yield curve inverted as deeply as today’s is as close to guaranteed recession as it gets.
I am sure my friend Dr. Campbell Harvey, who wrote the first paper on inverted yield curves in recessions back in 1996, might be able to find a similar time, but today we are inverted from six months to 30 years. The 2-year/10-year curve is inverted a significantly deep 42 basis points.
Inverted yield curves are tricky, but the deeper they are and the longer they persist, the higher recession odds rise.
Source: BloombergIf we get another strong employment report in August, with 8%–9% annual inflation, will the Fed have any choice other than to hike 75 points? That won’t make the yield curve any less inverted.
As I wrote long ago, the Fed has painted itself into a corner it can’t escape. Failing to fight inflation will mean That 70s Show all over again.
If Rob and Harvey are right, and rates are still well above 8% at yearend, the Fed will be raising rates more than the markets are currently predicting. What will it take to crush demand? A 4% fed funds rate? 5%? I don’t know but we are going to find out. Otherwise, the Fed will lose all its credibility against inflation.
That adds up to a tough investment outlook for the coming years, but don’t despair. We’ll still have opportunities; they’ll just be different ones.
While I don’t welcome inflation, I do welcome a challenge. We are being handed a big one.
My vacation-in-progress contribution to the challenge: there is a clear, almost direct relationship between initial unemployment claims (blue below, inversed YoY) and employment growth as this 1975-2015 chart shows:
However, the sharp drop in claims in 2021 through Q1’22 was not accompanied by a commensurate increase in employment, likely because of the severe shortage of labor. The recent increase in claims also has not triggered a decline in employment, presumably because employers are keeping their scarce employees as long as possible.
This is supported by the fact that the average workweek has remained stable at a historically high level since March amid an admittedly slowing economy. CEOs and CFOs are accepting a margin compression rather than lose scarce valuable employees. For how long?
Bloomberg’s Tracy Alloway suggests that history may be repeating itself so that employment may not currently be a dependable indicator of economic strength:
(…) it wouldn’t be the first time that the US labor market found itself both extraordinarily tight and very, very vulnerable. A new paper from the Federal Reserve looks at the historic parallel of the 1918 Spanish Flu pandemic, describing an economy that feels eerily familiar. The labor market was extremely tight and inflation was rising.
The Fed began raising benchmark rates in January of 1920 in an attempt to tamp down post-pandemic inflation. By September 1920, the authors find, labor-market tightness had fallen sharply — mostly driven by a big fall in job openings rather than a large jump in layoffs.
“Our findings have policy implications for today. Policymakers are concerned about inflation, which has risen to the highest level in the past 40 years in the United States, amid the recovery from the Covid-19 pandemic. In response, the Federal Reserve has begun raising interest rates to curb inflation and has started to scale back on quantitative easing. Strong (tight) labor markets can become weak (slack) faster than policymakers may anticipate. Indeed, our results demonstrate that labor demand reacted sharply and quickly to the tightening of monetary policy, at a speed which can outpace policymakers’ abilities to track current economic conditions.”
The rest is, as they say, history. By 1921, the Fed was cutting rates to deal with a deflationary bust. And while we should be wary of leaning too heavily on historic analogies, the Spanish Flu parallel might go some way toward explaining the weirdness of our current economic situation.
In the meantime, payrolls are trending up with rising contributions from both jobs and wages:
While job openings have declined:
Adding to the puzzle: Canada
Employment decreased by 31k in July, below consensus expectations at +15k, similar to last month’s 45k decrease. Employment rose 23k in goods-producing sectors but fell 53k in service-producing sectors. The fall in employment can be entirely accounted for by women aged 65 and older, and the Statcan release notes that a large share of these exits could be retirements. Total hours worked fell 0.5%.
The unemployment rate remained flat at 4.9%, below consensus expectations to tick up to 5.0%. The participation rate decreased 0.2pp to 64.7%.
Hourly wage growth of permanent employees edged down to +5.4% year-over-year from +5.6% in June and below consensus expectations at +5.9%. Monthly sequential wage growth of permanent employees remained elevated at 0.7% (mom, GS SA) while 6-month average annualized wage growth remained at 4% for the second consecutive month.
In the near-term, we think the BoC will still want to go above its neutral range given its view that the economy is in excess demand, and so maintain our 75bp hike forecast for the September meeting. Further out, we still look for a 4¼% terminal rate reached in January because inflation is broad-based and we expect it to remain elevated this year. (Goldman Sachs)
Whether there is a recession or not is not a moot point:
Choose Your Own Adventure!
Source: @NDR_Research via @DayHagan_Invest via Callum Thomas
Outside of tech, most US sectors saw softer business activity growth or a contraction in July. (The Daily Shot)
Small Business Job Growth Slows in July
Hiring at U.S. small businesses slowed for the fifth consecutive month, according to the latest Paychex | IHS Markit Small Business Employment Watch. The Small Business Jobs Index moderated -0.66 percent from the previous month and stands at 100.14. The pace of wage increases slowed slightly from the previous month, with average hourly earnings growth at 5.08 percent compared to 5.13 percent in June 2022.
CEO confidence is not encouraging:
The Chase card spending tracker remains rather weak through July 31 (remember this is in nominal $):
Also rhyming eerily:
Source: @t1alpha via Callum Thomas
EARNINGS WATCH
From Refinitiv/IBES:
Through Aug. 5, 432 companies in the S&P 500 Index have reported revenue for Q2 2022. Of these companies, 69.9% reported revenue above analyst expectations and 30.1% 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 2.8% 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 9.2%. If the energy sector is excluded, the growth rate declines to -1.5%.
The estimated revenue growth rate for the S&P 500 for 22Q2 is 13.4%. If the energy sector is excluded, the growth rate declines to
8.1%.The estimated earnings growth rate for the S&P 500 for 22Q3 is 6.6%. If the energy sector is excluded, the growth rate declines to 0.0%.
Factset has somewhat different data:
At this point in time, 72 companies in the index have issued EPS guidance for Q3 2022. Of these 72 companies, 42 have issued negative EPS guidance and 30 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance for Q3 2022 is 58% (42 out of 72), which is below the 5-year average of 60% and below the 10-year average of 67%.
At this point in time, 246 companies in the index have issued EPS guidance for their current fiscal year (FY 2022 or FY 2023). Of these 246 companies, 127 have issued negative EPS guidance and 119 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance for their current fiscal year is 52% (127 out of 246).
