REACCELERATION?
Goldman Sachs just reduced the odds of a recession over the next 12 months to 25%, from 35%, against a consensus at 65%.
(…) incoming data have strengthened the case for a soft landing. All four steps of the rebalancing process needed to tame inflation are now underway: demand growth is below potential, the jobs-workers gap has shrunk, wage growth has fallen, and inflation has slowed.
While this progress is encouraging, the Fed needs to keep growth below potential for a while longer to further rebalance the labor market. Our baseline forecast implies that additional hikes in March and May will be enough to achieve this. But we see some risk that as the drag from monetary and fiscal policy tightening diminishes, the economy could reaccelerate prematurely.
As a result, we see the risks to our 5-5.25% forecast for the peak fed funds rate as tilted to the upside. If the FOMC eventually decides it needs to take a more hawkish path to keep inflation moving back toward the 2% target, we think the most likely option would be to add on a longer string of 25bp hikes, not to return to 50bp hikes or to add hikes at last cycle’s quarterly pace.
We do not expect the FOMC to cut the funds rate until a growth risk emerges.
We doubt that a decline in inflation alone will be enough to prompt cuts. Cutting shortly after an unsettling inflation surge with a still-tight labor market would risk reputational damage if inflation flared back up.
Data: CME Group; Chart: Axios Visuals
Manhattan median rent rose to the third-highest on record as the vacancy rate slipped for the first time in nine months.
After peaking in July, median rent continued to move sideways at a nominally lower level as new leasing levels expanded in the New Year. The median rent rose 15.4% annually to $4,097, the third-highest on record and 14% higher than pre-pandemic levels. Average
rent and average rent per square foot followed a similar trend.The market share of landlord concessions declined annually to 16.5%, 23.7% less than pre-pandemic levels. The average landlord concession was 1.8 months of equivalent rent, the highest since September 2021.
The vacancy rate slipped for the first time in nine months to 2.52%, consistent with the decade average of 2.74%.
The credit hype machine is going to break
According to Bloomberg, January was a record month for investment grade (IG) corporate bond ETF flows as the credit hype machine went into overdrive. As a result, the amount investors are being compensated for the additional risk relative to US Treasury bonds (known as credit spreads) has declined rapidly. (…)
Low quality credit simply does not perform well during earnings recessions and the investment grade market’s weight in BBB-rated bonds (the lowest quality IG rating) is near a record high at 50%. Investors appear to be focused solely on the above-mentioned health of the market and seem to have forgotten about downgrade risk (due to an earnings recession), liquidity risk, and most importantly, volatility. Corporate bond investors hate volatility; they want the certainty of earning their coupon and the ultimate payment of principle. A good gauge of this risk is equity option volatility as proxied by the VIX Index*. Should equity volatility spike, credit spreads will likely widen.
Consider the following: an investor today can buy a 2-year Treasury note with virtually no credit risk and little downgrade risk for just 60bps less yield than what is offered by the investment grade market. On that basis, 2-year Treasuries have rarely been cheaper relative to IG bonds and has historically been a great opportunity to reduce credit risk. The IG market appears to be priced for perfection by this measure.
It is clear that one need not own credit to generate income at the moment. Treasury yields are at post financial crisis highs, after all! But don’t forget the potential for total return. The decision of whether to own IG bonds (credit risk and interest rate risk) or Treasuries (just interest rate risk) comes down to how credit spreads are likely to change.
If one owned a 20-year Treasury bond and interest rates across the yield curve fell by 50bps, they should generate a return of nearly 10%. For IG bonds to generate the same return, credit spreads on IG bonds would need to decline to near post crisis lows. This seems like an unlikely outcome given lower Treasury yields tend to cause wider, not tighter, spreads, especially when accompanied by an earnings recession.
On the other hand, if interest rates were to rise, it would not be surprising to see credit spreads widen (perhaps in a disorderly way), creating a losing outcome for IG bonds from both interest rates and credit spreads.
If the credit markets start to price in an earnings recession, the case to own them will be more compelling… but it is clearly not today.
Topdown Charts adds that:
- Tighter lending standards point to upside risk for credit spreads.
Banks are tightening standards across the board:
(…) The latest Senior Loan Officer Opinion Survey indicates that risks are skewed to the downside for near-term growth in consumer credit. The net percentages of banks tightening lending standards for credit cards and auto loans rose by nearly 9.5 and 15.3 percentage points, respectively, to their highest in more than two years. On net, banks are also implementing stricter standards on all other consumer loans.
(…) the Fed is getting the stricter lending standards of banks that it wants. (…)
As of December, revolving credit is 1% short of where it would have been if its pre-pandemic trend had persisted over the past three years. Moreover, revolving credit makes up only 10.5% of wages and salaries, whereas that share was typically above 11.5% in the couple of years prior to the pandemic.
BTW, Starwood CEO Barry Stenlicht on CNBC (h/t Luke Gromen & David Hay): “Volcker did not have a $32 trillion debt…So what Powell faces, if he keeps going up, you have the Weimar Republic–he has to keep printing US dollars to pay interest on the deficit, and you wind up printing and printing…”
In 1981, gross federal debt was 32% of GDP. It is now 122%. The Fed has obliged…
The CBO on February 8: “Net outlays for interest on the public debt increased by $58 billion (or 41 percent) [in the first four months of F2023], mainly because interest rates are significantly higher than they were in the first four months of fiscal year 2022.
FYI, from the U.S. Treasury on Jan. 30th:
During the January – March 2023 quarter, Treasury expects to borrow $932 billion in privately-held net marketable debt, assuming an end-of-March cash balance of $500 billion. The borrowing estimate is $353 billion higher than announced in October 2022, primarily due to the lower beginning-of-quarter cash balance ($253 billion), and projections of lower receipts and higher outlays ($93 billion).
During the April – June 2023 quarter, Treasury expects to borrow $278 billion in privately-held net marketable debt, assuming an end-of-June cash balance of $550 billion.
So, next 6 months, the gross federal debt will rise by $1.2 trillion or almost 4%. This, along with rising interest rates, will boost interest expense even more. The CBO will release new projections on Feb. 15.
BTW # 2, courtesy of Evergreen/Gavekal’s David Hay:
Greed might be driving the market into another Thelma & Louise-like cruise off a cliff. As you can see above, it’s extremely rare to have BBB-rated corporate debt yield essentially the same as 90-day T-bills. This is because the former has both credit and interest-rate risk, unlike short-term treasuries. Regardless, it is a reflection of extreme risk tolerance that, in the past, has consistently led to an unhappy outcome, sometimes of disastrous proportions.
Chart: Hartnett
EARNINGS WATCH
From Refinitiv/IBES:
Through Feb. 10, 344 companies in the S&P 500 Index have reported earnings for Q4 2022. Of these companies, 69.2% reported earnings above analyst expectations and 27.0% reported earnings below analyst expectations. In a typical quarter (since 1994), 66% of companies beat estimates and 20% miss estimates. Over the past four quarters, 76% of companies beat the estimates and 21% missed estimates.
In aggregate, companies are reporting earnings that are 1.6% above estimates, which compares to a long-term (since 1994) average surprise factor of 4.1% and the average surprise factor over the prior four quarters of 5.3%.
Of these companies, 66.6% reported revenue above analyst expectations and 33.4% reported revenue below analyst expectations. In a typical quarter (since 2002), 62% of companies beat estimates and 38% miss estimates. Over the past four quarters, 73% of companies beat the estimates and 27% missed estimates.
In aggregate, companies are reporting revenues that are 1.2% above estimates, which compares to a long-term (since 2002) average surprise factor of 1.3% and the average surprise factor over the prior four quarters of 2.5%.
The estimated earnings growth rate for the S&P 500 for 22Q4 is -2.8% [-2.2% on Jan.6]. If the energy sector is excluded, the growth rate declines to -7.1% [-6.7%].
The estimated revenue growth rate for the S&P 500 for 22Q4 is 5.0% [4.1%]. If the energy sector is excluded, the growth rate declines to 4.1% [3.3%].
The estimated earnings growth rate for the S&P 500 for 23Q1 is -3.7% [-2.5% last week, +1.0% on Jan. 6]. If the energy sector is excluded, the growth rate declines to -5.6% [-4.3% last week, -1.1% on Jan. 6].
Negative guidance is widespread this quarter…
…leading to continued downward revisions:
The above numbers simply count the number of positive and negative revisions.
But sell-side analysts are a slow moving herd when forecasting the magnitude of the potential decline. Ex-Energy, the last 3 quarters have seen accelerating negative earnings growth and Q1’23 should keep the sequence alive. Bad breath is spreading with 7 of the 10 ex-E sectors averaging -12.3% in Q4’22 and -12.5% in Q1’23. These are recessionary contractions, highly unusual in a non-recessionary environment.
Earnings growth is expected to resume in Q2’23, even though 61% of economists see the U.S. in recession then.
Corporate insiders are not so optimistic, voting with their feet:
(Barron’s via Isabel.net)
INK Research:
Although investors are taking a shine again to the US broad market, pushing it higher on expectations that the Federal Reserve is near the end of its rate hike cycle, insiders are not attending the party. American insider sentiment as tracked by the INK US Indicator fell a couple of points to 38% from 40% a week ago. At 40%, there are four stocks with key insider buying for every 10 with key insider selling.
Industrials have reported very strong earnings in recent quarters, +40.5% expected in Q4’22 and +18.5% in Q1’23, but INK’s reading of insiders activity in that sector is the third lowest at 26% after Consumer Cyclicals (25%) and Technology (14%).
INSIDERS ACTIVITY: INDUSTRIALS
Here’s the inside on Industrials’ strong earnings growth:
The Airlines industry reported a profit of $2.4 billion in Q4 2022 compared to a loss of -$1.2 billion in Q4 2021. Boeing, American Airlines Group, United Airlines Holdings, and Delta Air Lines are the largest contributors to earnings growth for the sector. If these four companies were excluded, the blended earnings growth rate for the Industrials sector would fall to 8.4% from 36.8%. (Factset)
Canada: Impressive January job gains start 2023 strongly
At the sectoral level, for the fourth consecutive month, no less than 10 sectors over 16 recorded an increase during the month, demonstrating the widespread nature of the recent surge. However, thanks to a substantial increase in the participation rate and a record population growth (since 1976), the unemployment rate has remained unchanged just above the record 4.9% reached this summer.
But we do not think that the labor market is as overheated as it was then. The average hourly wage for permanent employees has risen by only 2.5% over the past three months, compared to an annual rate of 8.9% between May and August. This moderation is supported by the fact that fewer small and medium-sized firms are reporting that labor shortages are limiting their production capacity.
The same can be said for large employers, as the Bank of Canada’s January survey of businesses showed that firms still see significant labour shortages but are no longer willing to offer wage increases as large as they were six months ago. An easing of the bidding for employees that was generating wage pressures is good news for the central bank.
Despite the surprisingly strong January print, we continue to believe that moderation is in the cards, especially since the same BoC survey shows a darkening economic outlook. A decline in sales volume is expected by as many as 30% of survey respondents, a record high outside of a recession.
Keep in mind that Labour Force Survey data can be very volatile, and we recommend waiting for releases in the coming months to confirm the sustainability of this strength. We continue to expect a hiring freeze over the next few months amidst an extremely tight monetary policy environment.
The participation rate ticked up 0.3pp from an upwardly revised 65.4% in December, suggesting that improved labor supply contributed to strong job gains in January.
Wage growth of permanent employees was -0.1% MoM in January. On a three-month annualized basis, wage growth was +2.5% vs. +4.7% in December. It peaked at +8.9% in August. Go figure!
Similar situation in the USA: wage growth is slowing amid strong labor demand:
