U.S. SERVICES PMIs

The divergence seen last week in the manufacturing PMIs is even more troubling with the services PMIs released yesterday. For the same reasons, I give more credibility to S&P Global’s survey.

• S&P Global: Business activity contracts at sharpest pace since May 2020 amid solid fall in new orders

August survey data signalled a sharp and quicker decline in business activity across the US service sector, according to the latest PMI™ data. The decrease in output stemmed from weak domestic and foreign client demand, as new orders returned to contraction territory. At the same time, weak inflows of new business led firms to moderate their hiring activity. Employment rose at the softest rate since January as backlogs of work contracted at the fastest pace in over two years. Although the degree of optimism picked up to a three-month high, it was below the series average as concerns regarding the impact of price rises on demand weighed on expectations.

On the price front, rates of input cost and output charge inflation eased to the slowest in a year-and-a-half. Concessions were reportedly made to clients amid decreases in some material costs and efforts to drive sales.

The seasonally adjusted final S&P Global US Services PMI Business Activity Index registered 43.7 in August, down from 47.3 in July and lower than the earlier released ‘flash’ estimate of 44.1. The latest data signalled a steep fall in output across the US service sector, and the fastest fall in activity since May 2020. The further loss of growth momentum among service providers was linked to weak client demand and greater client hesitancy in placing new orders.

Service providers recorded a solid decline in new business in August, with new orders falling for the second time in three months. The rate of contraction was the sharpest for over two years and among the fastest on record. With the exception of the initial pandemic period, the fall was the quickest on record (since October 2009). The impact of high inflation and increased interest rates on client demand reportedly weighed on total sales.

The decrease in total new business coincided with a third successive monthly decline in new export orders midway through the third quarter. The downturn in new business from abroad was linked to strains on client incomes in external markets.

Meanwhile, average cost burdens continued to rise at an historically marked pace during August. The increase in operating expenses was often attributed to higher transportation, wage and material prices, alongside hikes in interest rates. Nonetheless, amid reports of decreasing costs for some items, the rate of input price inflation moderated to the slowest since February 2021.

Subsequently, output charges at service providers increased at a substantial, but softer pace, in August. Firms continued to note the pass-through of higher costs to clients, but some companies stated that concessions were made to customers in an effort to drive new sales. The rate of charge inflation was the softest for a year-and-a-half.

Weak client demand led to a slower rise in employment during August, with the rate of job creation slipping to the softest since January. Pressure on capacity fell for the third successive month as backlogs of work were reduced at a strong rate. The decrease in the level of incomplete business was the steepest since May 2020.

Finally, business expectations regarding the outlook for output at service sector firms picked up to the highest for three months in August. Although optimism was buoyed by hopes of greater client demand and the diversification of business lines, the level of positive sentiment was below the series average amid concerns regarding inflation and interest rate hikes.

The S&P Global US Composite PMI Output Index posted 44.6 in August, down from 47.7 in July, to signal a sharp contraction in business activity across the private sector. Although manufacturers also recorded a decline, the decrease was led by service providers.

In contrast to that seen in July, service sector firms registered a decline in new business in August. As a result, private sector new orders fell at the quickest pace since May 2020, while new export orders also fell at a solid pace.

Inflationary pressures eased further across the private sector, with average cost burdens rising at the slowest pace since January 2021. Output charges also increased at a softer rate as some firms sought to offer concessions to clients in an effort to drive sales.

Despite the degree of confidence rising to a three-month high, weak client demand led to a softer increase in employment in August. Pressure on private sector capacities waned as service providers recorded a strong fall in backlogs of work.

• The ISM: In August, the Services PMI^® registered 56.9 percent, 0.2 percentage point higher than July’s reading of 56.7 percent. The Business Activity Index registered 60.9 percent, an increase of 1 percentage point compared to the reading of 59.9 percent in July. The New Orders Index figure of 61.8 percent is 1.9 percentage points higher than the July reading of 59.9 percent. (…) The Prices Index decreased for the fourth consecutive month in August, down 0.8 percentage point to 71.5 percent. (…)

US Sector PMI: Broad-based contraction as all sectors indicate a decline in output in August

US private sector firms signalled a broad-based decline in output during August, as all seven monitored sectors registered contractions in business activity. It was only the second time on record (since October 2009) that all sectors have seen a decrease in output, the first time having been in May 2020 during the initial wave of COVID-19.

Exports, the Engine of China’s Slowing Economy, Are Sputtering Chinese goods shipments to the rest of the world rose by 7.1% last month, the weakest gain since April, reflecting the impact from rising inflation and slowing growth elsewhere.

(…) The result fell below a median forecast of 12.5% among economists polled by The Wall Street Journal, and decelerated from July’s 18% year-over-year gain.

Slowing exports partly reflect disruptions in factory production due to temporary power shortages as a severe drought and heat wave swept through central China last month, though economists expect the impact of that to be short-lived. Recent flare-ups of Covid-19 cases, however, threaten to disrupt manufacturing in more cities as authorities stepped up restrictions ahead of a Communist Party gathering in October, when Chinese leader Xi Jinping is expected to break with recent precedent and claim a third term. (…)

South Korea’s exports to China have dropped for three consecutive months, and were down 5.4% in August from a year earlier, contributing to a record trade deficit of $9.47 billion. The country’s semiconductor exports contracted in August for the first time since April 2020 due to weak consumer demand among other factors.

China’s weakening export data came as the world’s business activity fell into contraction for the first time in more than two years, pointing to shrinking global demand amid economic fallout from the Ukraine war and interest-rate increases by central banks to battle inflation.

Global economic output contracted in August for the first time since June 2020, according to the purchasing managers index survey compiled by S&P Global. The headline PMI, which measures output for both manufacturing and services sectors, fell to 49.3 last month, down from 50.8 in July and below the 50 mark that separates expansion from contraction.

If lockdown months are excluded, the latest reading was the lowest since June 2009 when the world was ensnared by the global financial crisis, noted S&P Global. (…)

China’s imports weakened further in August, pointing to disappointing demand at home, as consumer confidence remains feeble while the jobless rate among young people rose to a record high.

Inbound shipment to China was flat as it gained 0.3% from a year earlier to $235.5 billion, down from a 2.3% increase in July. The reading was the weakest since April, when port and factory activities came to a halt due to lockdowns in Shanghai and other cities. It undershot the 1.5% forecast among economists polled by the Journal. (…)

As of Tuesday, 49 cities were under lockdown or various degrees of control measures, accounting for about a quarter of China’s gross domestic product and affecting a fifth of China’s total population, economists from Nomura estimated. As a result, they lowered China’s full-year growth forecast to 2.7% from 2.8%. (…)

Samsung Expects Sharp Downturn in Chip Sales to Extend Into Next Year Samsung sees the sharp downturn in chip sales extending into next year, the latest note of pessimism for a semiconductor industry reeling from a dramatic pullback in sales of PCs, smartphones and data servers.

(…) “The second half of this year looks bad, and as of now, next year doesn’t really seem to show a clear momentum for much improvement,” said Kyung Kye-hyun, who heads Samsung’s semiconductors unit and serves as the company’s co-CEO, at a Wednesday media briefing. (…)

Earlier this year, industry executives widely believed that the second half of 2022 would be stronger than the first. But by late spring, it became apparent that demand levels had “drastically changed” and would instead be softening significantly, Mr. Kyung said. (…)

Samsung also runs two chip-making plants in Xi’an, China. The South Korean chip maker expects potential difficulties in bringing new equipment to its China facilities due to U.S. export restrictions. But China, which makes up about 40% of global tech demand, is a market that can’t be overlooked, Mr. Kyung said. (…)

U.S. bank CEOs say consumers and businesses are still in good shape

U.S. consumers and businesses are still in good financial shape despite high inflation and concerns about a looming recession, some of the nation’s top bankers told a conference in New York on Tuesday.

Brian Moynihan, chief executive officer of Bank of America Corp (BAC.N), the nation’s second-largest bank, said customers spent 10% more in August from a year earlier, and bank account balances are higher for many than they were pre-pandemic. (…)

J.P. Morgan’s Chase consumer card spending tracker is not as buoyant, to say the least (remember, this is all in nominal $):

Chase’s control retail sales tracker points to a negative August:

• Inflation Now Causing Hardship for Majority in U.S. A majority of Americans, 56%, now say price increases are causing financial hardship for their household, up from 49% in January and 45% in November. The latest reading includes 12% who describe the hardship as severe and 44% as moderate.

(…) Lower-income Americans are more likely than others to be experiencing severe hardship — 26% of those whose annual household income is less than $48,000 say prices are causing severe hardship for their families. That compares with 12% of middle-income Americans and 4% of upper-income Americans.

Lower-income Americans are about as likely now as last fall to say they are experiencing either severe or moderate hardship — 74%, compared with 70% in November.

Middle-income (63%) and upper-income (40%) Americans remain significantly less likely than lower-income Americans to say they are experiencing hardship. However, sharply more middle- and upper-income Americans are struggling now than were last November. The increase has been greater among middle-income Americans — up 17 percentage points — than among upper-income Americans — up 12 points. (…)

The most common action, mentioned by 24% of those experiencing hardship, is to reduce spending, including buying less in general or buying only essential items. Another 17% say they are traveling less or canceling vacations, while the same percentage indicate they are driving less or trying to use less gas.

Other common strategies for dealing with higher prices are buying cheaper goods or generic brands of products (12%), eating out less (10%), buying fewer groceries or growing their own food (10%), staying home (8%), and cutting down on entertainment expenses (8%). (…)

Junk-Loan Defaults Worry Wall Street Investors Missed loan payments point to a hard landing for companies squeezed by rising interest rates

Defaults on so-called leveraged loans hit $6 billion in August, the highest monthly total since October 2020, when pandemic shutdowns hobbled the U.S. economy, according to Fitch Ratings. The figure represents a fraction of the sprawling loan market, which doubled over the past decade to about $1.5 trillion. But more defaults are coming, analysts say. (…)

“Borrowers are particularly vulnerable to the double whammy of weaker earnings and rising interest rates,” Morgan Stanley strategist Srikanth Sankaran said. That will trigger a wave of credit-rating downgrades and push average loan prices—currently 95 cents on the dollar—below 85 cents, a level breached only during the 2008 financial crisis and the depth of the Covid-19 pandemic, he said. (…)

The percentage of loans in default will likely rise to roughly 3.25% in mid- 2023 from about 1% now, but it could go significantly higher, said Jeff Darfus, a credit analyst at the bank.

Data from a recent Fed survey of loan officers at top banks showed tightening lending standards that a Barclays’s model predicted could cause roughly 4.5% of the loans to be in default a year from now, he said. (…)

Ironically, investors began piling into loans last year in anticipation of the Fed’s increases because their floating interest rates made them more attractive than bonds, which pay fixed rates. (…)

Companies with single-B ratings—one of the lowest rungs in the junk-debt category—now account for about one-quarter of leveraged loans outstanding, compared with 11% in 2010, said Frank Ossino, manager of a leveraged-loan fund at Newfleet Asset Management.

The trend is accelerating. Around twice as many loans received credit-rating downgrades as upgrades in the past three months, the highest multiple since October 2020, according to research by Bank of America. (…)

• Meanwhile, leveraged loan downgrades outpaced upgrades by a ratio of 1.89:1 last month according to LCD. That ratio held at less than 0.5 for the bulk of 2021 and remained below one as recently as this spring. (ADG)

The US Dollar’s Strength Is Rippling Across the World

Developed economies are taking a hit from the dollar’s appreciation to multi-decade highs in ways that were once more familiar to their emerging market peers.

Fueled by the Federal Reserve’s most aggressive tightening cycle in more than a generation, the stronger greenback is pushing rival currencies lower, driving up the cost of imported goods, constricting financial conditions and feeding inflation in other economies.

That’s ratcheting up pressure on other central banks to raise interest rates just as an energy crisis and spiraling consumer prices hobble Europe’s economies, and increases in borrowing costs cool housing markets in Australia, Canada and New Zealand. Yet their ability to influence the dollar’s strength is limited, meaning there’s little prospect for near-term relief. (…)

The Fed’s trade-weighted dollar index versus advanced economies has soared 10% this year to the strongest since 2002, while the emerging-markets measure is up a more modest 3.7% and remains well below its peak from the 2020 pandemic.  (…)

Top Fed official says US rates must stay high until inflation eases Richmond president Thomas Barkin says he has a ‘bias towards moving more quickly’ to tighten policy. Rates at 4% wouldn’t surprise him.

Mike Wilson Sees Stocks Tumbling To 3,400 In 3 Months, Slashes S&P EPS Forecasts As “Fire & Ice” Shifts Into High Gear

Courtesy of ZeroHedge (ZH emphasis):

(…) At the risk of stating the obvious, 2022 has been a challenging year for stock investors of all stripes. The Russell 3000 is down approximately 18% (total return) year to date (YTD): and while Russell 3000 Growth has underperformed significantly (-24%), it’s been no picnic for value investors either (-11%). Clearly, the relative value trade of value over growth has worked well this year, but we note it’s mostly been due to Energy’s outperformance combined with defensive cohorts, rather than cyclicals like Financials. In fact, only 2 sectors, Energy and Utilities, are up in absolute terms this year while just 24% of all stocks in the Russell 3000 are in positive territory. To put that into context, in 2008, 48% of Russell 3000 stocks were up on the year as we entered the month of September. Suffice it to say, this year has been historically bad for stocks in terms of both price and breadth, but that is not a sufficient reason to be bullish. We think that poor breadth is indicative of more challenges to come on the growth side of the equation, which we address in our note today. While some have recently argued the breadth thrust off the June lows is a sign of better times ahead, we firmly disagree as our top down earnings work does not support such a conclusion. Meanwhile, that breadth thrust is losing altitude quickly and looks vulnerable to taking out the 50-day moving average, something it did not do off the March 2020 lows. Let the debate begin. (…)

His more pessimistic view on the S&P 500 index, meanwhile, is based on analysis that indicates all of the 30% de-rating in the forward S&P 500 P/E that occurred from December to June was due to higher rates: “we know this because the equity risk premium (ERP) was flat during this period. Meanwhile, forward NTM EPS estimates for the S&P 500 have come down by only ~1.5% and P/Es are now ~8% higher. With rates now ~30bp below the June highs, the ERP has fallen once again, to just ~285bp. This makes little sense, particularly given the significant slowdown in earnings we think is still to come.”

(…) Wilson thinks that asset markets may be entering fire and ice part two. In contrast with part one, this time the MS strategist contends that the decline in stocks should come mostly via a higher ERP and lower earnings rather than higher rates.

Meanwhile, the bank’s earnings models are all flashing red for the S&P 500, and Wilson is highly confident that the decline in NTM S&P 500 EPS forecasts is far from over. In short, Wilson writes that “part two will be more icy than fiery, the opposite of 1H22. That’s not to say rates don’t matter – they do – and we expect bonds to perform better than stocks in this icier scenario.” (..)

So what are Wilson’s new S&P ESP forecasts following today’s downward revisions which point to continued and increasingly significant EPS growth downside well into 2023? Here is the answer:

• cut the 2022 base case EPS estimate to $220 from $225 (down 2%),
• 2023 base case estimate cut to $212 from $236 (down 10%),
• 2024 base case estimate cut to $226 from $237 (down 5%).

The ’22/’23/’24 base case estimates are now 3%/13%/14% below consensus, respectively, and more notably, in Morgan Stanley’s base case, 2023 now marks a modest earnings contraction (-3% year-over-year growth), although Morgan Stanley is still terrified to make a recession its base case scenario (that would scare off too many clients).

The logic here is that nominal top line growth slows, but remains positive (mid-single-digit territory), while margins contract materially (1-1.5% margin compression) driven by sticky cost pressures, particularly on the labor side. The bank’s 2023 bear case EPS is  modestly lower to $190 from $195 – a case which continues to assume an economic recession (consistent with views published in our mid-year outlook), and implies an 11% year-over-year EPS growth contraction. The ’23 bull case EPS forecast also comes down to $234 from $245. In this scenario, nominal top line is slightly better and margin pressure is less significant. (…)

Wilson’s call for price downside as a result of declining EPS into mid-2023 – the basis of this note, and a high conviction view – is very much a tactical view (next 3 months). To further reinforce this point, the strategist notes that the market multiple typically troughs when EPS is only a third of the way through its decline (i.e., price front-runs EPS declines).

Putting it all together, Wilson’s base case tactical view remains that fair value price for the S&P 500 is ~3,400, and while he expects that price level to be reached before year end, stocks will then work back toward 3,900 by mid next year (actually they will be much higher as the QE needed to monetize all the energy stimmies will long have been in play by then). As previously noted, Wilson thinks tactical fair value in his bear case (an economic recession) is 3,000, which implies an overshoot to the downside of his June ’23 bear case price target in advance of that date. …)

the next several quarters will end up containing some of the most significant downward revisions to forward EPS forecasts seen in the past several cycles. As for valuation, the Morgan Stanley strategist thinks very little of these revisions have actually been discounted, as evidenced by the still depressed ERP component of the S&P 500 P/E ratio. While that view could be challenged as a subjective one, Wilson is confident that his ERP model suggests it is at least 100bps too low today and probably even more since the US is headed toward a recession (our bear case). That said, the strategist certainly appreciates that “this debate is what makes a market and have no illusion markets can trade more richly than they should for long periods of time.” On that note, he thinks the increased size of QT that is expected to begin this month could play a significant role in changing the market’s view of fair value for the ERP.

Speaking of ERP, Callum Thomas offers this:

Despite some reduction in valuations (e.g. PE Ratios have fallen), the issue is that bond yields have gone up as well, so the equity risk premium has not really improved.

For instance, compare and contrast the current levels of the ERP [Equity Risk Premium] vs that seen during the peak of the pandemic panic or the 2008 financial crisis. Current levels are simply not compelling, certainly not compared to those episodes.

The ERP works well as a key input for asset allocation e.g. by giving buy signals when it spikes (n.b. higher = better) because it reflects outright valuations, but also valuations relative to the risk free alternative (i.e. bonds) — and indirectly also reflects sentiment and monetary conditions with regards to changes in bond yields.

Simply put, the higher the ERP, the better compensation you are getting for being in risky assets vs “safe“ assets. So clearly, a lower ERP means less compensation for risk, and hence a riskier setup, all else equal.

The key takeaway is that the current level of the ERP is not particularly attractive for US equities. Even the rest of the world, while boasting a higher ERP vs the USA, still hasn’t moved up to previous major buying opportunity levels at this point. Hence again, we see another indicator saying “not yet“ for global equities.

• Goldman Strategists Warn Stocks Yet to Make ‘Decisive’ Low

U.S. Job Market Cooled in August but Remains Solid The tight labor market loosened some as employers hired fewer workers, more people sought work and wages rose at a slower pace. The jobless rate ticked up to 3.7%. Still, job growth remained well above the prepandemic trend.

Employers added 315,000 jobs last month, down from the prior month’s revised 526,000 jobs, the Labor Department said on Friday, with new jobs spread across the economy. (…)

The jobless rate rose to 3.7% in August from a half-century low of 3.5% the prior month. The increase in the unemployment rate reflected more workers entering the labor force. The share of adults working or seeking a job rose to 62.4% in August from 62.1% in July, as participation among women ages 25 to 54 jumped to the highest level since 2000.

The rise in labor-force participation—along with other signs such as lower average weekly hours worked—suggested employers are finding it easier to hire. That could help ease wage pressures in the coming months. The Federal Reserve is closely watching the health of the labor market and wages trends, an important factor in the outlook for inflation.

Average hourly earnings rose 5.2% in August from a year earlier, in line with the previous month and down from a recent peak of 5.6% in March. Wages rose 0.3% in August from a month earlier, down from July’s increase. (…)

All Friday morning, equities rose, agreeing with Axios’ summary: “This is the jobs report the Fed wanted”.

(…) Good is bad (a booming economy means the Federal Reserve will tighten the screws more). Bad is bad (nobody wants a recession). So what would “actually good” numbers look like? They would look an awful lot like the August employment situation report that came out this morning.

The new data threads the macroeconomic needle, showing continued robustness in the labor market and a softening of inflationary pressures. It thus amounts to a signal that a soft economic landing may be possible after all, and that the Fed may not need to act quite as aggressively to contain prices as the central bank’s recent communication would imply.

It’s not just one data point out of the 40-page report that supports this “Goldilocks” interpretation. It’s many of them.

• The 315,000 jobs added to employers’ payrolls, plus revisions that subtracted 107,000 from the previous two months, show job growth adjusting toward a more sustainable, moderate rate. It has averaged 378,000 in the last three months, versus 539,000 in Q1.
• The unemployment rate rose two ticks, to 3.7%, for good reasons. The number of people in the labor force rose by a whopping 786,000, but not all of those net new workers immediately found jobs. That’s good news for anyone who thinks the job market has been too tight.
• Average hourly earnings rose a moderate 0.3%, hardly a rate that will alarm those who fear an upward spiral of wages and prices.

This balanced labor report follows benign price readings for July. The first major August inflation reading is Consumer Price Index, due out Sept. 13. If it also points to a softening inflation trend, the Fed’s next decision looks more interesting.

• At its meeting concluding Sept. 21, Fed officials have indicated they will likely raise interest rates by either half a percentage point or 0.75 points.
• It seemed as if the higher number were more likely, especially following chair Jerome Powell’s tough-talking Jackson Hole speech last week.
• But in light of the new jobs numbers, that looks like more of an open question, especially if August’s CPI points to moderating inflation.

Goldilocks faded in the afternoon as several pundits, including Larry Summers, commented differently, some talking about continued inflation risks, others about continued recession risks. We could well get both at the same time before the latter defeats the former.

This chart illustrates the deceleration, but not the collapse, in private monthly payrolls income growth. Total man-hours rose 2.3% annualized in the last 3 and 6 months, a marked deceleration from the 5-6% average pace in the 6 months previous. Growth in hourly earnings has been stable at 4.8% annualized in the last 9 months.

In effect, labor demand is slowing and wage trends have stabilized around below 5%. Axios was right, the Fed must be happy about that softly slowing combination.

The Job Cuts Report for August, which will impact employment in coming months, notes that

• August marks the fourth time this year that cuts were higher in 2022 than in the corresponding month a year earlier;
• So far this year, employers announced plans to cut 179,506 jobs, down 27% from the 247,326 cuts announced in the first eight months of 2021. It is the lowest recorded January-August total since Challenger began tracking monthly job cut announcements in 1993.

The report concludes with “Employment data continue to point to a strong labor market. Job openings are high, layoffs are low, and workers seem to have slowed their resignations. If a recession is imminent, it’s not yet reflected in the labor data,” said Andrew Challenger, Senior Vice President of Challenger, Gray & Christmas, Inc.

If inflation does the same, the soft landing scenario would gain credibility.

Goldman Sachs’ inflation forecast:

• We continue to believe that the peak for core PCE inflation is behind us, as the surge in goods inflation caused by shortages and rising commodity prices has likely peaked and should moderate by year-end. We forecast core PCE inflation of 4.2% in December 2022 (vs. 4.5% previously), 2.6% in December 2023, and 2.3% in December 2024 based on our bottom-up inflation model.

• Unlike core PCE inflation, we expect year-on-year core CPI inflation to reaccelerate to just below the March peak over the next couple of months (GS forecast of 6.3% for Sept. vs. 6.4% for Mar.) before falling back to 5.7% in December. We expect core CPI inflation to fall more sharply next year (2.7% in December 2023), reflecting a negative swing in health insurance prices and shrinking contributions from across nearly every category but especially from normalizing auto prices, which have a larger weight in CPI.

The August CPI will be released Sept. 13. Given trends in oil/gasoline prices, overstocked retailers and the strong dollar, if services inflation comes anywhere near July’s 0.3% (after +0.8% on average in the previous 3 months), we might get another month of subdued core inflation (0.3% in July).

With Goldilocks still lurking, investors need to remember that equities are strongly correlated with profits and that subdued consumer inflation will hurt profits until corporate costs also decelerate.

Morgan Stanley’s Mike Wilson points out that ex-Energy earnings are 10% lower than expected earlier this year:

Equity investors should be laser focused on this risk, not the Fed, particularly as we enter the seasonally weakest time of the year for earnings revisions, and inflation further eats into margins and demand. Morgan Stanley’s leading earnings model sees a steep fall in EPS growth over the next several months.

(MS via The Market Ear)

Corporate profits are under pressure from unit labor costs and general corporate costs inflation, all rising in the 9% range after years of very subdued cost pressures.

A swift decline in consumer inflation would likely hurt profits initially, even more so if accompanied by lower sales volumes. So far, margins have not been hit much with top line growth at 10.6% in Q1 and 8.4% in Q2, but slower inflation will necessarily also slow revenue growth.

We got 7 corporate pre-announcements last week, 5 negative and 2 in-line. But we have 25 fewer pre-announcements than at the same time after Q1’22, suggesting that many companies are unsure how the quarter or the year-end will look like. Compared with one year ago, the trend is much more downbeat.

Analysts are getting nervous. EPS growth estimates have been cut from 11.1% to 5.1% for Q3 and from 10.6% to 6.3% in Q4. Ex-Energy, Q3 and Q4 EPS are expected down 2.1% and 1.5% respectively.

The decline in the bottom-up EPS estimate recorded during the first two months of the third quarter was larger than the 5-year average (1.9%) and the 10-year average (2.7%) per Factset numbers.

Trailing EPS are now $220.44. Full year 2022: $225.37. 12-m FW: $232.57. Full year 2023: $243.61.

At 3924, the S&P 500 is selling at 17.8x trailing and 16.9x forward EPS.

The Rule of 20 P/E is 23.7. If analysts are right, trailing EPS will be $223 after Q3. The R20 P/E is 23.5 on that basis. A 15% decline in the index would bring it to the 20 fair value.

This is with inflation at 5.9%. At 4% inflation, fair value would be 3580 after Q3.

Reminders:

• Bob Farrell’s rule #8: Bear markets have three stages – sharp down, reflexive rebound, and a drawn-out fundamental downtrend.
• Seasonality: Topdown Charts’ Callum Thomas:

Historically, on average, September has been the worst month of the year for the S&P500 (returns were -0.5% on average, and positive only 47% of the time).

So there are a few things to comment on around this. First of all, 47% is pretty close to 50/50 — albeit it does stand in contrast to some of the other months which were in the 60-70%+ range.

Second, September *did not* have the worst drawdown, OR the smallest upside, and it did not have the greatest dispersion of results either.

But one thing I will note, when I look at seasonality across different asset classes and markets (also looking at the seasonality of asset class relative performance), it is this Aug-Oct period of the year which is generally the worst for risk assets.

Typically we see defensive assets outperform this time of the year (e.g. gold, bonds, defensive equities), while risk assets lose ground (VIX, credit spreads go up, and equities go down).

Seasonality is interesting because it definitely is a thing – statistically, and it is often influenced by physical seasons, actual fundamentals and real life patterns of activity.

But it shouldn’t be the first thing you look at. I always say, put together your core thesis first, and then look at secondary/third-tier factors like this to round out the case or build conviction.

Of course in this instance, I would say that negative seasonality does gel with the generally weak backdrop, so I wouldn’t be inclined to go against it in the current backdrop, and would at the margin travel a little more cautiously.

The 200-day average has been dropping for 90 straight days

While most short- to medium-term time frames suggest somewhat flat returns, the six-month window looks troubling, especially the win rate and z-score. Signals since 1969 show a consistent pattern of negative returns across all time frames, with the 2-week window showing a loss in all nine instances.

It’s not unprecedented to see a 200-day average signal coincide with a tightening cycle from the FOMC. However, most of the time, we see a neutral or easy Fed. While the previous instances occurred during multi-year bear markets, the drawdown difference between the two is notable.

• Copper seasonality

The annual seasonal chart below reveals that copper is about to enter a period of general price weakness. For 2022, this weak period extends from the close on 2022-08-29 through the close on 2022-09-27. Historically, this stretch showed a gain during 11 years but a loss during 22 years.

U.S. Factory Orders Unexpectedly Fall in July for the First Time Since September

Factory orders decreased by 1.0% in July, below consensus expectations for a small increase, while growth in June was revised down 0.2pp to +1.8%. Growth in core capital goods orders (-0.1pp to +0.3%), core capital goods shipments (-0.2pp to +0.5%), durable goods orders (-0.1pp to -0.1%) and durable goods orders ex-transportation (-0.1pp to +0.2%) were all revised down in July. Manufacturing inventories increased (+0.1%).

A Slowing China Helps Rein In Inflation Around the World China is a key factor in falling costs for energy and commodities, but domestic factors are still keeping U.S. inflation high

Global inflation eased in July, to 0.3% on a monthly basis, down from an average of 0.7% a month in the first half of the year, according to analysis by Nora Szentivanyi, a global economist at JP Morgan, and colleagues. The figures omit Turkey, where inflation is unusually high.

“Weaker global demand in the face of diminished purchasing power through the past year is now driving disinflation through two main channels,” said Ms. Szentivanyi—first, by weighing on some commodity prices, and, second, by easing global supply-chain constraints.

She and her colleagues estimate falling commodity prices and easing goods price pressures will lower global inflation to a 5% annualized rate in the second half of 2022, from 9.7% in the second quarter. (…)

While wide-scale Covid-19 lockdowns drove much of spring’s decline, China’s property collapse is now dragging heavily on growth.

Slumping investment by developers, in particular, has quashed demand for industrial and energy commodities. The volume of gasoline imports fell 36% in July from a year earlier, while that of steel dropped 25%, according to Chinese government data.

China in 2021 consumed 72% of the world’s iron-ore imports, 55% of refined copper and more than 15% of oil globally. Any slowing of its resource-hungry economy tends to put downward pressure on commodity prices everywhere, said Edward Gardner, commodities economist at Capital Economics. (…)

The country’s producer-price index—a broad measure of pipeline inflation pressures—fell 1.3% in July from a month earlier. (…) Prices for U.S. imports from China increased 2.8% from a year ago in July, down from a 4.9% pace in March. (…)

To be sure, many other forces are still pushing the other way on U.S. inflation: service prices are rising, in particular for housing, and tight labor markets have pushed wage growth to its highest in at least 20 years. (…)

FED UP? MAYBE NOT!

Hubert Marleau at Palos Wealth Management:

The upcoming Federal Reserve interest rate decision scheduled for September 21 will probably be the last bump. I expect a 0.75% increase. It will likely be followed in months to come with a narrative shift, but will enter a long period of inertia that may last as long as a year. That is about the amount of time needed to bring demand and supply into alignment.

I rest my case on six reasons: the strength of the dollar, the application of quantitative tightening, the crushing weight of energy and food, the cooling of the job market, the easing of supply constraints and the fall of industrial prices.

The bond market is already predicting that the annual rate of inflation will be 2.1% by next September mainly because monetary growth is collapsing. Monetary models, which track and correlate changes in the money supply with N-GDP, are suggesting, with a 6-to-12 month lag, that the inflation rate could fall precipitously from here to more acceptable levels.

Goldman’s Jan Hatzius is more reserved:

Increased signs of adjustment on growth, labor markets, and inflation suggest that we are moving closer to a slowdown in the Fed’s aggressive rate hike campaign. Admittedly, the risk to our forecast of a 50bp hike in September followed by 25bp moves in November and December remains on the upside because recent Fed communication suggests that the burden of proof is on the side of disinflation.

Any material signs of slippage (e.g. in the August CPI report released on September 13) would thus probably lead us to lift our near-term funds rate forecast somewhat further. However, we think it would be unwise to chase the post-Jackson Hole increase in the market-implied funds rate at current levels.

FUNDS (OUT)FLOWS

• Investment-grade corporate bond funds: -$4.6 billion over the week ended Aug. 31 following a record 18 week stretch of net withdrawals through early last month.
• Leveraged loan funds: -$1.1 billion
• High-yield: -$5 billion, the second largest of the year, bringing the two-week tally to $9.5 billion. 
• Municipal bonds: -$3.4 billion over the week ended Sept. 1.
• Domestic equity funds: -$10.19 billion over the final seven days of August, the largest sum since the mid-June nadir in the S&P 500.
• Global equity funds: -$9.4 billion, the fourth-largest sum so far this year.
• Ark Innovation ETF (ARKK): -$803 million in August, the first such net cash withdrawal since January and equivalent to 10% of the fund’s assets. ARKK had net inflows of $1 billion over the first seven months of the year. ARKK records a 58% year-to-date decline and a 74% downdraft from its February 2021 peak.
• 2,119 c-suiters sold shares in their own company last month per the Washington Service. That’s the largest swath of sellers in a month since November of last year, as the Nasdaq 100 logged its high-water mark. Following the corporate crowd has proven wise in the past. As the virus panic climaxed in March 2020, the Washington Service’s ratio of insider buys to insider sells reached 1.75:1, the strongest relative showing since another memorable month, March 2009. (Via ADG)

Nord Stream Pipeline Closure Lands Blow Against Europe Power prices surged, European currencies hit multidecade lows and governments scrambled to contain the economic hit after Russia cut its main natural-gas pipeline to Europe.

• “At current forward prices, we estimate that energy bills will peak early next year at c.€500/month for a typical European family, implying a c.200% increase vs. 2021. For Europe as a whole, this implies a c.€2 tn surge in bills, or c.15% of GDP” (Goldman Sachs)
• OPEC+’s Warning Shot Oil producer cartel cuts output targets just days after U.S.-led agreement to establish buyer’s alliance seeking price-setting power over Russian crude. The Organization of the Petroleum Exporting Countries and Moscow-led allies decided on Monday to reduce its output by 100,000 barrels a day starting in October. (…) The Group of Seven Western countries on Friday announced a plan to introduce a price cap on Russian oil. If successfully implemented, the agreement could create a buyers’ alliance with some power over global crude prices.
• Brussels pushes for EU-wide caps on gas price Emergency proposals come in response to Russia ‘using energy as weapon’ and aim to soften soaring energy costs
• Macron Backs EU-Wide Windfall Tax on Energy Company Profits

Pound Falls to Lowest Level Since 1985

Japanese yen hits 24-year low against dollar

China’s Central Bank Moves to Slow Yuan Depreciation

GDP GROWTH

Population, particularly working age population is very, very slow:

• Immigration isn’t helping

The decline in nonimmigrant visa issuance is so huge that it seems likely that the number of such visa holders working in the U.S. is actually now declining, on an absolute level, as old visas expire. In other words, far from ameliorating the labor shortage, visa issuance levels are exacerbating it. (Axios)

Note: H1B includes H1B1s. Data: U.S. Department of State; Chart: Erin Davis/Axios Visuals

• Productivity is slower:

• Will the slowdown accelerate?

COMPOSITE PMIs Eurozone business activity falls for second month running Latest PMI® data suggested that the eurozone private sector moved further into contractionary territory during August as the service sector joined manufacturing in seeing output fall during the month. The decline was particularly marked in the euro area’s largest economy, Germany. Weakness in activity generally reflected falling demand, with new orders also down at a faster pace midway through the third quarter. Employment continued to rise, but the rate of job creation softened amid lower workloads and muted business confidence. While remaining elevated, rates of inflation of both input costs and output prices continued to soften, providing some respite for firms. The seasonally adjusted S&P Global Eurozone PMI Composite Output Index posted below the 50.0 no-change mark for the second month running in August, dipping to 48.9 from 49.9 in July. Although still only modest, the rate of contraction signalled in the latest survey period was more pronounced than that seen at the start of the third quarter. The overall reduction in output reflected declining activity across both the manufacturing and services sectors in August, as services activity moved into contraction for the first time since March 2021. That said, the reduction in output at service providers was only marginal and much weaker than that seen for manufacturers, where production declined solidly again. Manufacturing output has now fallen in three consecutive months. Falling activity was largely a function of a worsening demand environment, with steep inflationary pressures and associated cost of living concerns leading clients to hold off on buying decisions. National PMI data indicated that Germany was the key driver of the overall decline in eurozone business activity, seeing output contract at a solid pace that was the steepest since the initial wave of the COVID-19 pandemic. The only other country to see activity decrease at the composite level was Italy, where output dropped for the second month running, albeit marginally in August. Although output continued to increase in France, Spain and Ireland, rates of expansion were only modest and slowed to the weakest in 17, seven and 18 months respectively. New business across the euro area declined for the second month running in August, and at a sharper pace that was the most marked since November 2020. As was the case with output, both sectors posted reductions in new orders, with manufacturers seeing the steeper contraction. International demand also remained under pressure, with new export orders* decreasing for the sixth month running. In fact, the drop in new business from abroad was faster than that seen for total new orders. Despite falls in activity and new business, companies across the eurozone expanded their workforce numbers again midway through the third quarter, largely reflective of continued efforts to rebuild capacity following the pandemic. Higher employment was seen across each of the monitored countries. That said, the overall rate of job creation softened for the third month running amid a weakening demand environment, with the latest rise in staffing levels the slowest since March 2021. A combination of higher employment and lower new orders meant that companies were able to keep on top of workloads, and backlogs of work decreased for the second month running as a result. The rate of input cost inflation continued to ease from the series record posted in March, reaching the slowest in almost a year in August. That said, input prices continued to rise at a pace unprecedented prior to the current spike in inflation since the series began in 1998. Similarly, output prices increased at a softer pace, but one that was among the sharpest on record. Similar price trends were seen across the two monitored sectors. Business expectations remained historically muted, despite a slight improvement in sentiment since July. A renewed positive outlook in manufacturing compared with services confidence ticking down to the lowest since October 2020. The S&P Global Eurozone PMI Services Business Activity Index dropped below the 50.0 no-change mark in August, bringing to an end a 16-month sequence of rising service sector output. At 49.8, the index was down from 51.2 in July and signalled a marginal decline in activity midway through the third quarter. The renewed contraction in business activity reflected further signs of demand weakness as new orders decreased for the second month running. The rate of decline in new business was modest, but quickened to the fastest since February 2021. The weakening demand environment also dented confidence among firms regarding the year-ahead outlook for activity. Optimism dropped for the fourth successive month in August and was the lowest since October 2020. Service providers in the eurozone continued to expand their staffing levels, thereby extending the current sequence of job creation to 19 months. That said, jobs growth waned further in August and was the weakest since May 2021. Inflationary pressures continued to soften, but remained elevated. Both input costs and output prices increased at rates unseen prior to the pandemic, but at the slowest rates in six months.

China: Service sector growth remains strong in August

Chinese services companies signalled a further marked increase in business activity in August as the sector continued to recover from the recent wave of COVID-19. The upturn was supported by a solid rise in overall sales, as companies reported higher customer numbers as market conditions continued to normalise. International demand remained subdued, however, with foreign sales falling again in August. Prices data showed that input costs rose at the quickest rate in four months, but charges set by services companies rose only slightly.

Business confidence strengthened to a nine-month high in August, with many firms anticipating a further recovery in demand and activity levels in the months ahead.

(…) Higher business activity was generally linked to improvements in customer demand and numbers, as disruption due to the pandemic and impact of restrictions continued to recede.

Total new business also expanded at a strong, albeit slightly softer, pace during August. The rate of new order growth was the second-steepest since October 2021 and broadly in line with the series average. There was evidence that the upturn continued to be led by firmer domestic demand, as companies registered a further drop in export sales. Moreover, the reduction in foreign demand was the quickest seen for three months, with a number of firms mentioning that the pandemic continued to weigh on international orders. (…)