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Economic Perspectives: 24 April 2023: Re-Acceleration!

U.S. Flash PMI: Stronger demand conditions support sharper growth in April, but also bring renewed inflation momentum

April data indicated a faster rise in business activity at firms based in the US, according to the latest ‘flash’ PMI™ data from S&P Global. Output rose at the sharpest pace for almost a year, as stronger demand conditions, improving supply and a steeper uptick in new orders supported the expansion. Solid growth in activity was seen across both the manufacturing and service sectors.

The headline S&P Global Flash US PMI Composite Output Index registered 53.5 in April, up from 52.3 in March, to signal the quickest upturn in business activity since May 2022. The increase in output was the third in as many months. The faster rise in activity was broad-based, with service sector firms registering the sharper rate of growth. Where a rise in activity was noted, firms linked this to greater customer confidence and a stronger uptick in new orders. Some companies also noted that an improvement in their ability to hire staff had boosted output.

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New orders at US firms increased at the sharpest rate for 11 months in April as new client wins, improved customer confidence and successful marketing strategies drove the uptick. The rise in new business was solid overall, building on a modest gain in March and contrasting with contractions seen in the opening months of the year. Growth was led by the service sector as the upturn in manufacturing new orders was only fractional, albeit returning to expansion for the first time in seven months.

Improvements in client demand were largely focused on the domestic market as new export orders continued to contract in April. Despite the pace of decline easing to the slowest for three months, subdued foreign demand conditions were broad-based. (…)

Encouragingly, the rate of job creation accelerated at the start of the second quarter of the year. Growth in private sector employment numbers was the quickest since last July as goods producers and service providers showed some success in efforts to expand capacity. Nonetheless, backlogs of work increased for the second month running as companies mentioned further struggles finding suitable candidates and retaining staff amid rising wage costs.

Business expectations among US firms remained upbeat during April, with the degree of confidence in the year ahead outlook ticking up to the second-highest since May 2022. The level of optimism was slightly below the long-run series average, however, amid concerns surrounding higher interest rates and inflationary pressures. (…)

Public responses to the pandemic continue to influence the economy. Rising inflation and higher interest rates did not meaningfully impact consumer spending. Goods consumption has only flatlined and remains 6% above trend while services are slowly catching up but are still 1.7% below trend.

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The March J.P. Morgan Global Manufacturing PMI revealed that “manufacturing production expanded for the second consecutive month in March” while “the rate of contraction [in new orders] was only mild and the weakest during that sequence”. New orders in China rose for the second straight month.

Last week’s April Flash manufacturing PMIs remained weak for the Eurozone and Japan but the U.S. manufacturing PMI edged up above 50, signalling “the first improvement in operating conditions at goods producers in six months” and “stabilizing demand conditions across the sector”.

Goldman Sachs shows how U.S. manufacturing has completely decoupled from other G7 countries in recent months.

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As I expected (here), since most goods sold in the U.S. are imported, the U.S. inventory correction has mainly impacted foreign manufacturers.

fredgraph - 2023-04-24T070334.110

The April surveys of manufacturers by the N.Y. and the Philly Fed both revealed improving new orders. In fact, new orders in the N.Y. Fed’s area “rose a whopping forty-seven points to 25.1”, matching its highest levels of the past 7 years.

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The widely forecast U.S. recession has failed to materialize so far as the economy experienced rolling recessions in housing (strong) and goods production (mild) offset by recovering services.

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That may explain why a historically reliable indicator such as the CB LEI has yet to deliver on its recession signals. The LEI has 10 indicators; 5 of the 7 nonfinancial components are goods-related plus 1 of 3 financial components, the goods-dominated S&P 500 Index.

 Smoothed LEI 

Similarly with the Chicago Fed National Activity Index, a much broader index: of its 85 components, 65 are goods-related (74% weight). The CFNAI has been negative recently without reaching the critical 0.70 level for an economic contraction.

CFNAI and Recessions

Interestingly, the CFNAI diffusion index has remained positive most of the time since the end of the pandemic in spite of its goods bias, thanks to its income and labor related components.

So, in an economy where goods now weigh half as much as services, goods-biased indicators can be misleading when services and employment stay reasonably firm.

But the latest data now suggest that the goods recession may be ending:

  • Demand for goods has been stable at a high level in the past 15 months, even improving a little since December.
  • Retailers and wholesalers inventories are about 5% below normal. That “new orders returned to expansion” in April is not surprising and may be sustainable. Retail inventories are particularly low at 1.23x sales from 1.43x pre-pandemic and a 1.35-1.50x range since 2010.

fredgraph - 2023-04-22T121921.211

  • Manufacturing production is where it was pre-pandemic while new and unfilled orders are 23% and 20% above respectively, both substantially higher than at previous cyclical peaks. Demand for goods would need to drop meaningfully for manufacturing production and employment to sink measurably.

fredgraph - 2023-04-22T121549.700

U.S. manufacturing employment keeps rising and could actually grow in 2023 helping sustain related services employment (e.g. transportation, restaurants, banking). KKR says that “in 2022 U.S. companies have revealed plans to reshore nearly 350,000 jobs, compared to 110,000 in 2019.” That would boost manufacturing employment by 2.7% (+0.2% in total).

This chart illustrates how past jobs recessions are essentially due to manufacturing. Non-manufacturing employment (91.6% of all employment) generally only slows down without declining much on an annual basis, It’s now turning up:

fredgraph - 2023-04-23T070856.271

As I wrote in December, if KKR is right on reshoring and employers keep hanging on to their scarce employees, this could well be a soft landing after all.

And here we are, 4 months later, with indications that manufacturing, far from crashing, is now about to contribute to growth, perhaps significantly given that supply chains have normalized, inventories are very low, labor supply is improving and consumer demand remains reasonably solid. Reshoring and nationalistic policies would only add fuel to this nascent fire.

Keep in mind that manufacturing carries more economic pull than its weight suggests: high salaries and important collateral effects on many services such as transportation, restaurants and banking act as economic multipliers.

So, if no major banking crisis, the Fed may well get its soft landing. But what about inflation?

The March PMI surveys said that manufacturers were still discounting but that service providers’ “rate of charge inflation quickened for the second month running and was the fastest since last September.”

The April flash PMI says inflation is broadening:

Following back-to-back months of softening cost pressures in February and March, April data indicated a pick-up in rates of input cost and output charge inflation. Operating expenses rose at a marked and historically elevated pace that was the steepest for three months. Hikes in supplier prices were often attributed to greater incremental increases in material costs during the month. Manufacturers and service providers alike recorded sharper increases in cost burdens.

Meanwhile, overall output prices rose at the fastest pace for seven months. Firms stated that more accommodative demand conditions allowed them to continue passing through higher interest rates, staff wages, utility bills and material costs to clients.

On April 10, I thought the Fed should pause:

  • “wage growth, at 3.2% annualized in Q1 is back to its pre-pandemic range, even with an unemployment rate at 3.5%. The Fed’s narrative will need to change. This is no longer a “very, very strong labor market””
  • jobless claims are rising and are now above their pre-pandemic level;
  • slowing labor income will restrain consumer spending;
  • “CPI-Services will likely decelerate sharply in coming months from 7.3% to 4.0-5.0% which would imply near zero monthly growth over the next 3-6 months, a significant change from the +0.6% monthly average of the past 6 months.”
  • bank lending will slow, aggravating the real estate market.

But the latest PMI supports more tightening, especially if inflation re-accelerates along with the economy. “One and done” is not a sure thing.

Fed’s Inflation Expectations Index Falls to Lowest Since 2021

A broad-based measure of inflation expectations compiled by the Federal Reserve fell last quarter to its lowest level in almost two years, according to data supplied by the central bank on Friday.

The index of common inflation expectations stood at 2.22% at the end of last quarter, down from 2.31% on Dec. 31, 2022 and the lowest level since June 30, 2021, when it stood at 2.18%.

Developed by Fed board economists in late 2020, the index comprises more than 20 indicators measuring the attitudes of consumers, investors and professional forecasters toward future price increases.

This was the third straight quarterly decline in the index after it hit 2.39% in the second quarter last year, the highest level in records dating back to 1999.

US Bank Deposits Fall $76.2 Billion, Led by Large Institutions The drop was mostly at large and foreign institutions, but they also fell at small banks.

Meantime, commercial bank lending rose $13.8 billion last week on a seasonally adjusted basis. On an unadjusted basis, loans and leases fell $9.3 billion. (…)

But lending increased for a second week in a row, led by residential and consumer loans, indicating that credit conditions are stabilizing. (…)

The $13.8B rise mentioned above is for the week ended April 12. The chart below plots changes for the 2 weeks ended April 19: +18.9B after -$69.7B.

fredgraph - 2023-04-22T062214.615

From recent bank conference calls:

Most regional banks report that deposit outflows have been manageable and have slowed significantly. The key risk has therefore shifted from fast-motion bank runs to a slower-motion credit crunch.

Large banks report that they have not materially tightened lending standards, but many regional banks report that they have already reduced their lending or plan to soon. (…)

Our central estimate is that tighter credit will reduce 2023 GDP growth by 0.4pp, leaving demand growth closer to the desired below-potential pace than it appeared to be in the first months of the year. (GS)

In today’s WSJ:

(…) “What’s going on nationwide is every one of these banks has either frozen their loan-to-deposit ratio or, more likely, is very intent on shrinking it,” said former Dallas Fed President Robert Kaplan on a call hosted by investment-banking advisory company Evercore ISI this month. “That is why a lot of small and midsize businesses in this country are getting a phone call saying, politely, ‘At the end of the year, we are not going to be able to give you a loan anymore, or we’re going to reprice your loan.’” (…)

The current bank crisis “is in the second or third inning, not the seventh inning,” said Mr. Kaplan. He thinks the Fed shouldn’t raise interest rates until it has a better view of the fallout, particularly because it would be damaging to have to cut rates later this year to address a bigger crisis. “I’m afraid we’ve got something coming that we don’t fully understand,” he said.

Any lending squeeze could disproportionately affect small businesses because bigger companies that mostly borrow in the capital markets have seen little change over the past month in credit costs or availability.

Businesses with fewer than 100 employees receive nearly 70% of their commercial and industrial loans from banks with less than $250 billion in assets, and 30% of such lending from banks with less than $10 billion, according to Goldman. (…)

Credit for small biz was already tightening during Q1 when average interest rates reached 7.8%:

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(NFIB)

Moody’s Downgrades 11 Regional Banks, Including Zions, U.S. Bank, Western Alliance

The downgrades hit lenders including U.S. Bancorp, with some $682 billion in assets, Zions Bancorp, with $89 billion, and Bank of Hawaii Corp., with $24 billion.

Western Alliance Bancorp, one of the banks hardest hit by regional banking turmoil, received a two-notch downgrade. First Republic Bank, which faced a run last month, had its preferred-stock rating cut. (…)

The rating agency said strains in the way banks are managing their assets and liabilities are becoming “increasingly evident,” and are pressuring profitability. Recent events “have called into question whether some banks’ assumed high stability of deposits, and their operational nature, should be reevaluated,” the ratings firm said in its report. (…)

The other downgraded banks are Associated Banc-Corp., Comerica Inc., First Hawaiian Inc., Intrust Financial Corp, Washington Federal Inc. and UMB Financial Corp.

FDIC Starts Selling $114 Billion of Bonds From Failed Banks Agency forecasts a $3.3 billion net loss for deposit-insurance fund

The Federal Deposit Insurance Corp. has begun selling bonds it inherited from Silicon Valley Bank and Signature Bank to recoup the cost of rescuing the failed banks’ depositors.

The FDIC put up for auction about $700 million of high-quality mortgage-backed bonds Tuesday in what could prove to be a test of how much the U.S. government recovers on the $114 billion in face value of the bonds it assumed.

“Per the median price guidance from the six dealers who have published price talk so far, the government should expect to get back around 86 cents on the dollar for the entire portfolio,” said Adam Murphy, founder of Empirasign, a bond-data service.

The FDIC estimates that its deposit-insurance fund will lose about $22.5 billion from depositor payouts. Most of that will be reimbursed through an assessment on other banks, resulting in a $3.3 billion net loss, the agency said. (…)

EARNINGS WATCH

We now have 88 reports in, a 76% beat rate (93% the previous week) and a +7.8% surprise factor (+12.7%). Only ten of the 23 Financials that reported last week beat estimates bringing the overall beat rate for Financials to 53%.

Trailing EPS are now $217.66 (19.0 P/E). Full year: $219.58e. Forward EPS: $225.86 (18.3 P/E).

The number of revisions remains negative…

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…but the earnings recession is seen ending in Q3 (Q2 ex-Energy)…

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…thanks mainly to rising margins starting in Q3 and jumping in Q4…

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If manufacturing is turning:

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SENTIMENT WATCH

The S&P 500 VIX was down to 16.8 on Friday. This series is highly correlated with the percent of bears, which was down to 24.0%, in the latest weekly Investors Intelligence survey. From a contrarian perspective, there may not be enough bears to drive the stock market higher for now.

In addition, the looming debt ceiling crisis might boost bearishness more than a Fed pause might boost bullishness. That would be bullish from a contrarian perspective since the debt crisis will be resolved one way or another, which should allow stock prices to move higher this summer. (Ed Yardeni)

(…) We’ve seen this rather distasteful movie before, and investors have become inured to it as annoying background noise. Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors, puts it as follows:

The debt ceiling is a game of chicken with politicians in the driver’s seat. Just like it’s difficult to predict natural disasters, it’s difficult to predict how politicians will act. One would hope that they would act as rational players, and realize that there’s a real cost to their unnecessary brinksmanship, but that has just not been the case over the past couple decades. Logic would dictate that they come to a deal well ahead of a potential default, but who knows?

(…) According to Goldman Sachs, receipts this April are running 29% below their level for April 2022. That in turn means a faster approach of “X-Day,” when there is no more financial finagling that can keep the Treasury below the debt limit. Goldman leans toward a “late July” deadline, but “it would take only a few days of slightly weaker tax collections to tip the deadline to early June”. (…)

Steve Sosnick, chief strategist at Interactive Brokers, admits that this year’s dynamic looks more troubling than past episodes:

I am more worried than usual, when we typically see brinkmanship and then cooler heads prevail to kick the can down the road for a while. This time it’s not clear that McCarthy has control of a caucus that will rely on the votes of either ideologues or nihilists that have proven resistant to the norms. I think that T-bills are nervous too.

(…) McCarthy himself is also at issue. He has prioritized keeping the Republican caucus together, which means being able to pass legislation without Democratic votes. If he can’t get a majority of his own caucus to agree, the scary possibility is that he could decide not to bring the issue to a vote at all. That would ensure that the ceiling could not be lifted, regardless of what Democrats or even moderate Republicans thought about the issue. The risk of a political accident that forces a default looks, it’s fair to say, higher than in any previous debt ceiling standoff. (…)

Dan Clifton of Strategas Research Partners emphasizes that this issue isn’t binary:

Too many investors are focused solely on whether the debt ceiling is raised. The debt ceiling is likely to be raised. The more important question is how the debt ceiling is raised. In fact, nearly all the S&P 500’s decline during the 2011 debt ceiling fight came AFTER a political agreement was reached. The reason for this is that the $2 trillion of spending cuts were far greater than the consensus expected and growth was downgraded.

Disaster came closest in 2011, when newly elected “Tea Party” Republicans clashed with President Barack Obama’s administration. What’s fascinating is to see that the S&P 500 just about held on to its gains for the year right up until late July, when the issue reached a head. With disaster averted, stocks began to fall. This became a near rout when Standard & Poor’s decided to downgrade sovereign debt from AAA to AA+. Disaster had been averted, but the ratings agency wasn’t impressed by the deal that stopped default.

Stocks only began to recover after the Federal Reserve, some two months later, resorted to “Operation Twist” — reinvesting the cash it made from maturing bonds in its portfolio into long-term bonds, a move that was meant to flatten the yield curve. But it’s notable that while the S&P 500 ended the year almost unchanged in nominal terms, and logged impressive gains relative to gold once the Fed had intervened, it ended the year a long way behind long bonds.

It’s possible that this year’s negotiations will end up obliging the Fed to buy bonds again, which would be great news for asset prices. But the bottom line for now is that uncertainty is greater than in previous episodes, and it can’t safely be ignored. Even if default is avoided, the gyrations could have profound and unanticipated effects on markets. Sadly, we’re all going to have to spend time watching events in Washington.

Investors are piling into ultrashort-term Treasury bills to avoid getting caught up in the debt-ceiling drama.

Surging demand has driven one-month T-bill prices higher, sending the yield down to 3.313% from 4.675% at the end of March. Bills maturing in three months yield 5.105%—a record incentive for lending to the government for a couple months more, according to Tradeweb data going back to 2001. …)

If the limit isn’t raised in time, investors who own maturing Treasury debt might not be paid back right away. Most investors expect they will be made whole by the government later on, but even a temporary disruption would mean an unprecedented shock to the multitrillion-dollar funding markets relied on by banks and companies for managing their daily operations.

Some worry, for instance, that financial software hasn’t been designed to handle past-due debt from the Treasury.

With the debt-ceiling deadline looming, cash managers are looking to avoid having money locked up in Treasury bills around the X date, the day the Treasury will run out of room to sell new debt. (…)

Meanwhile, the lack of government refunding has led to a shortage of Treasury bills, reducing supply and lifting prices. (…)

(…) individuals have continued buying, at about five times the rate this year as in 2017 to 2019. (…)

Individuals are increasingly favoring diversified ETFs over single stocks, they are trading less actively, and by at least one measure, they are pulling back from the riskier options market. (…)

And individual investors’ inflows into money-market funds, traditionally considered a flight to safety, remain elevated as well.

Some of that caution is likely because the average individual investor’s brokerage portfolio is down about 27% from a November 2021 peak, according to Vanda’s estimates, a reflection of their high concentration in stocks such as Tesla Inc. (…)

Brokerage company Charles Schwab Corp. on Monday reported clients opened more than 1 million new brokerage accounts in the first quarter and added a net $132 billion in assets. Yet clients’ daily average trades were down 10% from a year earlier.

That continues a recent trend. In the fourth quarter of last year, trading volume at retail brokerages dropped to around 22.5% of total U.S. equity-market volume, down from a peak of 37% in January 2021, according to a JPMorgan Chase & Co. analysis.

The share of options activity among individual investors has also been dropping, most recently making up around 12% of the total market, down from roughly 18% in July 2020, according to the analysts. The bank’s data also show individuals have been net buyers of ETFs and net sellers of individual stocks in 2023, a sign investors are seeking to diversify more. (…)

For every dollar going into the SPDR S&P 500 ETF Trust (SPY), 26 cents goes into technology stocks.

Meanwhile, the “cost of contracts protecting against 10% decline in QQQ is now 1.7 times more than cost of options that profit from 10% rally, most since April 22.” (The Market Ear)

Bloomberg

Ed Yardeni illustrates the recent jump in IT stocks’ P/Es. Ed also points out that IT forward revenues are expected to rise only 0.3% with forward earnings down 6.9%, worst since 2008. Ex-IT, S&P 500 forward revenues are seen rising 6.1% with earnings down 0.3%.

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TECHNICALS WATCH

(…) one interesting angle is shown here — how the market has traded after making a major low without making a new low within the subsequent 6 months (which the Oct 2022 low qualifies for). General drift upwards, with a couple of exceptions. (Callum Thomas)

@bespokeinvest via @RyanDetrick

China’s Xi Pledges Support for Innovative Firms Amid US Rivalry

(…) Innovation led by companies is key to realizing “high-level technological self-reliance,” Xi declared at a meeting on Friday attended by senior Communist Party officials, including Premier Li Qiang. The government should help companies crack core tech challenges facing the country, the official Xinhua News Agency reported, citing the meeting Xi presided over.

Xi said the key to growing private business lies in removing institutional barriers that impede fair competition and calibrating policy to ensure better coordination and “solve companies’ real difficulties.” The state sector should be reformed to ensure national economic security, he added, while improving efficiency and oversight. (…)

President Joe Biden is considering signing an executive order in the coming weeks that will limit American business investment in key parts of China’s economy, Bloomberg News reported, citing people familiar with the deliberations.

Treasury Secretary Janet Yellen said Thursday the US was prepared to accept economic costs to protect national security interests from threats posed by Beijing. The US has already rallied Japan and the Netherlands to introduce export controls on shipments of advanced chip technology to China.

Xi’s comments also mark a shift in Beijing’s view of private business after years of intense regulatory crackdowns, especially on the tech sector. He has recently made calls for the world’s No. 2 economy to pursue self-reliance across key industries to counter the US. (…)