Sour Fed growth view not dour enough (BlackRock)
(…) The Federal Reserve is on its fastest rate hiking cycle since the early 1980s. The Fed now sees the fed funds rate rising to 4.6% by the end of 2023, a significant bump from prior views. The problem? Updated economic forecasts are too optimistic, in our view. The Fed still sees positive growth this year and sees it picking up next year. But it also wants to see evidence core inflation is on a decisive 2% trajectory beyond 2023 before it stops hiking.
This soft landing doesn’t add up to us. We think quashing inflation that quickly amid constrained production capacity would take a recession – a roughly 2% hit to economic activity and 3 million more unemployed. We think the Fed is not only underestimating the recession needed but ignoring that it’s logically necessary.
Why would a recession be needed to reduce core inflation? Unusually low supply can’t meet demand. That’s driving inflation. There are two reasons why.
First, a labor shortage – people who left the workforce during the pandemic haven’t returned yet.
Second, the economy wasn’t set up to match consumer spending’s massive shift from services to goods that hasn’t fully reversed even as the world moves on from the pandemic. Central banks can’t fix these constraints, in our view, hence a brutal trade-off: trigger a deep recession by hiking rates or live with more persistent inflation.
The Fed’s forecasts don’t acknowledge this trade-off. It reconciles this by assuming production constraints will rapidly dissolve, causing inflation to fall quickly. But if that’s the outcome, what’s the point of the fastest hiking cycle since former Fed Chair Paul Volcker’s era? (…)
We think central banks will keep raising rates until it’s clear that core inflation is coming down. That means economic activity is set to fall across DMs. The Fed’s current policy may drag down U.S. growth far more than it realizes. In Europe, we see the European Central Bank’s resolve to push inflation down fraying as it wakes up to the bleak outlook. But that reaction will come too late to prevent the central bank from amplifying the energy shock’s recessionary forces, in our view. The continent will see a deeper recession than in the U.S.
We’re tactically underweight DM equities as stocks aren’t fully pricing in recession risks. We don’t see a “soft landing” outcome where inflation returns to target quickly without crushing activity. That means more volatility and pressure on risk assets, we think. We prefer investment grade credit as yields better compensate for default risk. Plus, high quality credit can weather a recession better than stocks. We find inflation-linked bonds more attractive and stay cautious on longterm nominal government bonds amid persistent inflation.
Central banks could reduce the hit to growth by taking longer to bring inflation (see yellow line on chart) back to target instead of trying to wrestle it down quickly (dark red line). The gradual approach would give the economy a chance to find a new equilibrium as production capacity slowly recovers. The cost of that choice is inflation staying somewhat higher for longer (pink line). But if inflation expectations remain anchored, that could overall be a better outcome for society.
This is the most difficult economic environment to navigate in half a century. There’s no desirable outcome at this stage – the question is which is the least bad. That’s why it’s time for a public debate.
This has become the main narrative with the risk tilted to the worst: inflation staying higher than desired and the Fed, and perhaps other central banks, hammering on the economy until the “job” is done.
The Fed has tightened 325 bps since February and all financial markets are in bear markets, adding another 100-150 bps of tightening to financial conditions per many estimates.
U.S. Durable Goods Orders Fall in August
Activity in the factory sector remains firm, despite a 0.2% decline (+8.8% y/y) in new orders for durable goods last month, which wholly reflected a decline in civilian aircraft bookings.
New orders for nondefense capital goods excluding aircraft surged 1.3% (8.8% y/y) In August after a 0.7% July gain. It was the largest monthly increase since January. (…)
The chart below deflates new capex orders with PPI-Capital Goods. August’s +0.8% rise was very timely to, maybe, save the quarter. However, YtD new orders are down 0.5% in real terms.
Nobody mentions it but there is also high inflation in capex after a decade of sub-2%:
Mid-September manufacturing surveys say:
The Empire State Manufacturing Index of General Business Conditions rebounded to -1.5 in September after having collapsed to -31.3 in August. However, the continued negative reading indicated that business conditions weakened further in September but at a much slower pace than in August.
- New orders rose to 3.7 in September from -29.6 in August
- The number of employees index increased to 9.7 from 7.4 in August.
- The prices paid index fell to 39.6 in September, its third consecutive monthly decline, from 55.5 in August.
- The prices received index declined to 23.6 in September, its lowest reading since February 2021, from 32.7 in August.
The Philly Fed’s current general activity diffusion index fell 16 points in September to -9.9 from a 6.2 reading in August.
- The index of new orders fell 13 points to -17.6 in September from -5.1 in August.
- The employment index declined to 12.0 in September from 24.1 in August.
- The prices paid index plummeted to 29.8 from 43.6 in August, the lowest level since the 27.1 reading in December 2020.
- The prices received index rose to 29.6 from 23.3 last month.
The Federal Reserve Bank of Kansas City reported that its manufacturing sector business activity index fell to 1 in September from 3 in August and 13 in July. The September reading was well below a record-high 37 in March and 21 last September, indicating Tenth District manufacturing activity growth continued to decelerate this month to the lowest level since July 2020.
- The new orders index rebounded to -11 in September from -16 in August, registering the fourth consecutive negative reading and down from 4 last September.
- The employment index was unchanged at 10 this month, the lowest level since December 2020 and down from 20 last September.
- The raw materials index was at 41 this month, up from 38 in August and back to the same level as July. However, it was well below 78 last September and a record-high 88 last May.
- The prices received index for finished products rebounded to 27 in September from 25 in August, but down from 37 last September.
The Dallas Fed general manufacturing activity index declined for the 5th consecutive month in September.
- The growth rate of orders improved to -1.7 in September, though it was negative for the fifth straight month and down from a high of 31.6 last April.
- Labor market strength continued to wane with the hours worked index falling to 8.0 from 14.4, down from a high of 24.5 in July of last year.
- The wages & benefits index fell to 36.6 from 45.8 in August. It reached a high of 55.2 six months ago.
- The index for prices received for finished goods fell to 18.1 in September, the lowest reading since January 2021 and down from the March 2022 high of 47.8.
The Richmond Fed composite manufacturing index rose from −8 in August to 0 in September, matching its July level.
- New orders rose from −20 in August to −11 in September.
- The employment index fell to 0 from 11 in September, as hiring challenges persisted.
- The wage index also increased dramatically, surpassing its July and August levels.
- The average growth rate of prices paid and prices received both decreased markedly in September.
Overall, the manufacturing sector is hanging in, but barely. New orders are weak and employment sluggish. (I am wondering if those new orders surveyed are nominal or real $. The Census Bureau data above is nominal $).
Selling prices are dropping along with input prices. The Goods sector is behaving as the Fed wants.
On services, the “S&P Global Flash US Services Business Activity Index posted at 49.2 in September, up notably from 43.7 in August to signal a much slower decline in output. The fall in business activity was the softest for three months as firms stated that a pick up in new orders and client demand dampened the contraction. The upturn in new orders was only slight overall.”
This is corroborated by the Richmond Fed’s Survey of Service Sector Activity out yesterday.
Fifth District service sector activity improved modestly in September. The revenues and demand indexes increased notably to 0 and 5, after being negative in July and August. (…)
Firms’ assessments of local business conditions continued to improve from August, with a reading of −2 in September. (…)
A slightly larger share of firms reported increased hiring in September, but their ability to find workers with the necessary skills deteriorated. Firms were split on the issue of labor availability over the next six months and expect elevated wages to persist. On the other hand, growth in prices paid and prices received decreased in September [although very slightly].
Demand for services is also sluggish but not collapsing. Same for employment and wages while prices are showing signs of flattening, good news in itself if it transpires in official inflation measures. Consumer spending and PCE inflation for August are out this Friday.
- Money’s running out (Axios)
Data: Morning Consult/Axios Inequality Index; Chart: Axios Visuals
- On September 27, the GDPNow model estimate for real GDP growth in the third quarter of 2022 is 0.3 percent, unchanged from September 20 after rounding.
(…) “A recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.” In the [NBER] committee’s view, three criteria—depth, diffusion and duration—each must be met to some degree to declare a recession.1 Thus, emphasis is placed on a variety of measures of economic activity rather than on a single measure, such as GDP growth.
More specifically, the NBER considers these additional economic indicators:2
- Real personal income less transfer payments
- Nonfarm payroll employment
- Employment as measured by the household survey
- Real personal consumption expenditures
- Wholesale-retail sales adjusted for price changes (real manufacturing and trade sales)
- Industrial production
Historically, how do these indicators behave around the beginning of recessions? The table below shows the percentage change of these indicators, on average, across recessions since 1947 for (1) the period prior to the recession, defined as the quarter prior to the peak and quarter marking the peak; (2) the first two quarters subsequent to the peak; and (3) the entirety of the recession (the quarter after the peak through the quarter of the trough, inclusive).
In the two quarters leading up to the average recession, all measures were still experiencing varying degrees of positive growth. Real personal income grew at an average of 0.62% prior to the average recession, while industrial production grew slightly, by 0.05%. Meanwhile, immediately following the onset of the average recession, all six indicators declined, which ultimately persisted for the entirety of the recession. Interestingly, the last column in the table shows the most recent quarter (2020:Q2) of each indicator. All except wholesale-retail sales (which was barely negative) were still experiencing positive growth following the first quarter of 2022. (…)
Given the fact that the majority of the indicators are still experiencing growth rather than decline, there may not yet be a strong argument supporting the assertion that there currently exists a significant and widespread decline in economic activity. (…)
EARNINGS WATCH
- Goldman Sachs says analysts are behind the curve.
Relative to last quarter, consensus estimates for full-year 2023 EBITDA growth for the median IG and HY issuer have declined only modestly, by 0.5% and 1%, respectively. We don’t view the declines from June to today as fairly reflecting management commentary post 2Q regarding a less certain operating environment and, moreover, we don’t expect to see a rebound in EBITDA growth in full-year 2023 from 2Q levels, which is what analysts’ estimates are currently implying. (…)
A confluence of factors could drive realized margins to be worse than expected, including ongoing supply chain constraints and slowing consumer demand. As a result, we think the market is unfairly attributing a high probability to a soft landing. (…)
- Companies mentioning weak demand has surged… (The Market Ear)
BofA
As mentioned here yesterday:
The Cupertino, California-based electronics maker has told suppliers to pull back from efforts to increase assembly of the iPhone 14 product family by as many as 6 million units in the second half of this year, said the people, asking not to be named as the plans are not public. Instead, the company will aim to produce 90 million handsets for the period, roughly the same level as the prior year and in line with Apple’s original forecast this summer, the people said. (…)
The smartphone market is expected to shrink by 6.5% this year to 1.27 billion units, according to data from market tracker IDC.
“The supply constraints pulling down on the market since last year have eased and the industry has shifted to a demand-constrained market,” said Nabila Popal, research director at IDC. “High inventory in channels and low demand with no signs of immediate recovery has OEMs panicking and cutting their orders drastically for 2022.”
Richard Bernstein Advisors is calling the profit recession:
Chart 1 shows the combination of the Fed tightening and profits decelerating has been the worst combination for equity returns of the four possible. The probability of negative returns is the highest under the relatively certain scenario we envision. (…) It is very difficult to forecast exact growth rates, but we currently don’t see such a turn in the profits cycle troughing until 4Q 2023. (…)
A sharp falloff in corporate profits might help the Fed fight inflation. Whereas companies tend to hire when earnings growth is strong, they tend to reduce the number of employees when cash flow and profits come under pressure. If we are correct and there is a full-blown profits recession in 2023, then it seems likely the demand for labor will subside. If the profits recession is deep enough, then wage inflation pressures should also subside.
10-Year Treasury Yield Hits 4% The U.S. borrowing benchmark hit the milestone for the first time in over a decade and has climbed at its fastest pace in four decades–lifted by increasing expectations for how high the Fed will lift interest rates.
(…) Selling in the bond market has grown especially intense over the last few days for a range of reasons. Those include growing fears that central banks around the world will need to raise rates faster to fight inflation and prevent their currencies from weakening further against the dollar. That has contributed to a worldwide bond selloff, with yields rising sharply from Europe to Canada.
The two-year Treasury yield, which finished last year at 0.73%, crossed 4% last week and is now trading even higher.
“It’s shocking just the speed at which this has happened,” said Andres Sanchez Balcazar, head of global bonds at Pictet Asset Management. “But the new reality is inflation is much higher, so even at 4%, you ask yourself, is it going to be enough to bring inflation down?” (…)
“We’re all bumping heads and scratching our heads a little bit,” looking for explanations for the outsize move over the last few days, he added. (…)
“The new reality”? Core inflation has been above 3% since March 2021.
Maybe it took Mr. Powell to say last week that the Fed wants positive real rates across the curve. And the Fed is now actively selling Treasuries in a rather relatively illiquid market.
With QE a thing of the past, we may be heading back to the old normal, with help from QT.
But what is normal?
The red line is 10-year Treasury yields minus core CPI.
The blue line is 10-year Real Interest Rates per the Cleveland Fed calculations: “The Federal Reserve Bank of Cleveland estimates the expected rate of inflation over the next 30 years along with the inflation risk premium, the real risk premium, and the real interest rate. Their estimates are calculated with a model that uses Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations.
Neel Kashkari:
(…) You know, we are moving very aggressively. We have—if you look at real interest rates—medium- and long-term real interest rates—we have tightened policy by driving up medium- and long-term real interest rates much faster this year than we even loosened policy during the pandemic. And so we are moving very, very aggressively. Now, one of the challenges is, as we all know, that monetary policy operates with a lag.
And so there’s a lot of tightening in the pipeline. We are committed to restoring price stability, but we also recognize, given these lags, there is the risk of overdoing it on the front end. And so I think we are moving at an appropriately aggressive pace, but we’re also not just simply saying we’re going to shoot up as high as possible as quickly as possible. I do think the pace that we’re undertaking right now is appropriate. (…)
Larry Summers:
(…) I think the Fed allowed itself to get way behind the curve for a long time in 2021 and early ’22, and in the process, sacrificed a reasonable amount of credibility. And in that context, it was necessary to—is necessary to move very strongly and to be very clear and straightforward.
That’s why I think Neel’s intervention after the July press conference, that was interpreted by the markets as being very supportive of asset prices rather than disinflation—I think Neel was very constructive afterwards and I very much welcomed the adjustments that Chairman Powell made. I think we do absolutely need to do what’s necessary to bring inflation substantially down, and the more determination with which that’s done the less painful the process is likely to be.
Of course, there’s a risk that it will be overdone. But, certainly, at the current level of interest rates of a 3% federal-funds rate when the most recent core inflation figure was 7% and the month was more than the quarter, the quarter was more than the half year, the half year was more than the year, I, certainly, don’t think it’s been overdone yet. (…)
But I would be very much with the understanding that just as a patient, to do the right thing, has to take their whole regimen of medicine even when they’re starting to feel better and even if there’s a bit of a side effect, that the fact that there was some dislocation and economic distress was not a reason to abandon the objective of a restrictive policy. (…)
NK:
But we’re also seeing wages continue to climb. We’re seeing that rents have been climbing. There’s a lot of increased inflation still in the pipeline. And this is stickier inflation, not just the volatile inflation that we’ve been seeing with commodity prices and energy prices as an example. So that makes me concerned that we have more work to do. (…)
The one mistake that I am acutely aware of that I want to avoid repeating from the 1970s is when policy makers saw the economy weakening, saw inflation start to tick down, and then they cut rates, thinking they had done the job. And then inflation flared back up again. That is a mistake I believe we cannot make and we will not make. And that means we need to get policy to a stance where we’re clearly tightening the economy, and then we need to be patient and allow inflation to come back down towards our 2% target. (…)
Home Prices Suffer First Monthly Decline in Years The index that measures average home prices in major metropolitan areas across the nation fell 0.3% in July from June, the first month-over-month decline since January 2019.
New single-family home sales during August rose 28.8% (-0.1% y/y) to 685,000 (AR) after falling 8.6% to 532,000 in July, revised from 511,000. The Action Economics Forecast Survey expected 500,000 sales in August.
A two-thirds sales increase (-21.9% y/y) in the Northeast to 25,000 led last month’s overall rise, following no change in July sales. Home sales in the South jumped 29.4% (10.4% y/y) to 467,000, the highest level this year. Home sales in the West improved 27.5% (-24.0% y/y) to 130,000, the highest level in three months. In the Midwest, sales increased 16.7% (5.0% y/y) to 63,000, recovering most of July’s fall.
The median price of a new home declined 6.3% during August (+8.0% y/y) to $436,800 following an 8.9% July gain. The average sales price of a new home weakened 6.3% (+11.0% y/y) to $521,800 following a 19.2% July rise. These sales price data are not seasonally adjusted.
Sales weakness accompanied a 0.4% increase (23.3% y/y) in the number of unsold new homes to a seasonally adjusted 461,000, up from a low of 142,000 in July 2012. The seasonally adjusted months’ supply of new homes for sale declined to 8.1 months from 10.4 months in July. The median number of months a new home stayed on the market plunged to a record low of 1.7 months. These figures date back to January 1975.
Bank of England warns of ‘material risk’ to financial stability as it intervenes in gilt market Emergency action follows sell-off in UK government bonds
The Bank of England on Wednesday said it would buy U.K. government bonds with long maturities “on whatever scale is necessary” in an effort to restore order to the market after a large set of government tax cuts sent borrowing costs soaring. (…)
In a statement, the BOE also said it would postpone the sale of government bonds under a program of quantitative tightening that was intended to help bring surging inflation under control. The program was agreed by policy makers earlier this month and was due to begin next week, but has been delayed until Oct. 31. (…)
The central bank said its purchases of gilts wouldn’t mark a reversal of its longer-term plans.
“These purchases will be strictly time limited,” the BOE said. “They are intended to tackle a specific problem in the long-dated government bond market.” (…)
Biden Officials Weigh Buying Oil at Around $80 to Refill Reserves
(