THE DAILY EDGE: 14 NOVEMBER 2022

Cautious Optimism on Skirting Recession (Moody’s)

We are sticking to our baseline assumption that the Federal Reserve is able to engineer a soft landing that skirts a recession as inflation, over time, returns to the central bank’s target. Though the U.S. is not in recession, the economic expansion is highly vulnerable to anything that might go wrong. (…) However, if a downturn is in the cards for the U.S. economy, it is likely to come from a currently underappreciated weakness brought to light by the sharply rising cost of capital. (…)

The risk of overtightening seems to be one that the Fed is willing to stomach. Tightening accommodative policy, which acts on a lag, too quickly and by too much represents the most significant potential catalyst for a U.S. recession. (…)

Rising long-term interest rates create problems for corporations. Overleveraged firms, accustomed to the Fed’s previous commitment to easy credit given inflation’s generation-long absence, are set to come under pressure as rates rise. A string of corporate defaults or a significant widening of corporate bond spreads could dampen investor sentiment and soften investment. This would presage a turnaround in the labor market, which to this point has been relentlessly tight, and given the Fed cover to continue raising rates. (…)

The U.S. labor market’s strength continues and makes it hard to believe that an economic recession is knocking at the door.

There were, however, some conflicting signals within October’s report that suggest things are beginning to weaken. According to the household survey, the unemployment rate rose from 3.5% to 3.7%. The uptick was owed to a reduction in jobs and the size of the labor force. Generally, we consider the payroll survey more credible because of its far-larger sample. The household survey, however, may hold some value when the labor market is at a turning point. The household survey, for example, can capture the impact of firm closures, something that the payroll survey is less successful in capturing.

Since March 2022, payroll employment is up 1.6% while household employment is up only 0.1%. Full time employment (from the household survey) is actually down 0.3% during the same period.

Is this like the recent discrepancies between Gross Domestic Product and initially faster growing Gross Domestic Income which was eventually revised down to reveal an actually slower economy than originally measured by GDI?

Last month, the household survey was much weaker than the payroll survey with a 328k decline in household employment driven by a 489k decline in the important prime-age employment. The BLS household employment measure adjusted to reflect nonfarm payrolls methodology showed an even larger employment decline (-741k).

Investors read the latest CPI report with their almost total focus on the eventual Fed pivot. Core CPI, up 0.27% MoM, came in somewhat lighter than expected.

Perhaps the most important line in this CPI report will prove to be the headline CPI, up 0.44% after +0.39% in September, and up 7.8% YoY and eliminating any positive growth in real labor income (blue vs red lines).

The slowdown in real spending growth will thus accelerate (it was +1.9% YoY in September). The hope that accumulated excess savings will act as offsets may be just wishful thinking. Actually, Americans have already tapped out their borrowing capacity and banks have significantly tightened lending standards.

This next chart deflates aggregate payrolls with my “CPI-Essentials” series, only focusing on inflation in food, energy and shelter which together account for 54% of the CPI. Essentials inflation jumped from zero in July and August to +0.4% in September and +0.85% in October (+9.0% YoY). As a result, aggregate payrolls deflated by CPI-Essentials (red line below) declined -0.9% YoY and will likely drag real spending into negative territory in coming months.

Goldman Sachs Friday smartly observed that “Investor euphoria over the prospect of a “Fed pivot” contrasts with the deteriorating profit margins and darkening business outlook expressed by many S&P 500 firms.”

• Disney to Cut Costs, Says Layoffs Likely Chief Executive Bob Chapek announced company-wide cost-cutting measures and told division leaders that layoffs are likely, according to an internal memo viewed by the Journal. The moves come days after Disney reported lackluster earnings.

• Walmart Is Flexing Its Muscle Again The largest U.S. retailer and other industry giants are taking an increasingly aggressive stance with suppliers as the economy slows. ‘The world has turned.’

America’s biggest retailer has a new message for its suppliers: We’re not going to pay higher prices anymore.

Walmart Inc. WMT 0.15%increase; green up pointing triangle Chief Executive Doug McMillon delivered the warning in person last month in an appearance before companies that produce products sold by the company’s Sam’s Club chain. Inside a hotel auditorium, he said Walmart would be pushing back against suppliers’ efforts to raise prices, according to people familiar with the situation. (…)

Walmart, long known for its ability to lower prices by squeezing vendors, is once again showing its muscle as a slowing economy and an inventory glut upend a power dynamic between retailers and suppliers that took hold during the pandemic, when demand surged for everything from paper towels to patio furniture. (…)

Large retailers are canceling orders, resisting price increases and in some cases asking suppliers to provide discounts. This puts pressure on product makers that are struggling to adapt to shifting consumer demand. It could also contribute to a slowing of inflation. (…)

The pullback from retailers is spreading across numerous companies that make products sold in stores around the country. (…)

The WSJ numbers show that Amazon inventories were up 58% YoY in July, Target: +36% and Walmart +25.5%. Their aggregate sales exceed $1.2 trillion! U.S. GDP in 2021: $23T.

• Price Rises Are Helping European Manufacturers While increases boosted quarterly results, executives see signs that consumers’ tolerance for higher prices may be hitting its limits.

European companies have defied the continent’s darkening economic prospects by raising prices, but there are signs the strategy that has protected their profits is sputtering.

Executives at some of the companies that have benefited from sharply higher prices are warning that soaring energy and food bills and concerns about jobs are beginning to deflate consumers’ appetite for their products. (…)

In Germany, the European Union’s biggest economy, incoming orders for manufacturers fell 4% overall in September after falling in August. Orders for German manufacturers from the eurozone fell twice as much. (…)

Yet, company earnings have surprised on the upside, largely thanks to price rises that have matched or exceeded rising costs. (…)

Coming to company reports soon: slower real sales, slower price hikes, if any, “naturally” squeezing margins for goods producers and distributors.

But there’s also, unbeknown to many, the FIFO accounting margin squeeze soon to hit P&Ls. The WSJ last June 27:

Inflation Puts Spotlight on Companies’ Use of Last-In, First-Out Accounting

Concerns about rising inflation and slowing growth are putting the spotlight on an accounting method U.S. companies use to lower their federal tax bill by inflating their costs, which also squeezes their quarterly earnings. (…)

With LIFO—which is permitted under the U.S. Generally Accepted Accounting Principles, but not under International Financial Reporting Standards—companies recognize their most recently acquired inventory through their cost of goods sold. With inflation around a four-decade high, such inventory is more expensive than goods purchased earlier, and acts as a drag on earnings.

Companies use LIFO to lower their taxable income. But to do so, they also must use it for financial accounting, even though it can ding financial results. By contrast, under first-in, first-out accounting—another popular accounting method—companies record the cost of their oldest inventory first.

In 2021, approximately 15% of companies in the S&P 500 used LIFO as their primary inventory method and 50% used FIFO, according to Credit Suisse Group AG , citing annual reports. The remainder used an average-cost method, a combination of methods, or methods that couldn’t be determined, Credit Suisse said. (…)

When costs are rising, FIFO accounting initially boosts margins as selling prices rise faster than input costs. Eventually, the more recent, more costly physical inputs, begin to enter COGS. If selling prices then stall or decline, gross margins are reduced.

When inflation stays high for long periods, FIFO accounting produces inventory profits and rising margins which investors tend to discount as non-operational and fleeting.

EARNINGS WATCH

From Refinitiv/IBES

Through Nov. 11, 460 companies in the S&P 500 Index have reported earnings for Q3 2022. Of these companies, 70.7% reported earnings above analyst expectations and 25.0% 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, 78% of companies beat the estimates and 18% missed estimates.

In aggregate, companies are reporting earnings that are 3.4% 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 7.0%.

Note that 5 of the 11 sectors have a negative surprise factor averaging -4.3%.

Of these companies, 69.8% reported revenue above analyst expectations and 30.2% 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, 74% of companies beat the estimates and 26% missed estimates.

In aggregate, companies are reporting revenues that are 2.3% above estimates, which compares to a long-term (since 2002) average surprise factor of 1.2% and the average surprise factor over the prior four quarters of 2.7%.

The estimated earnings growth rate for the S&P 500 for 22Q3 is 4.1%. If the energy sector is excluded, the growth rate declines to -3.6%.

The estimated revenue growth rate for the S&P 500 for 22Q3 is 11.5%. If the energy sector is excluded, the growth rate declines to 8.1%.

The estimated earnings growth rate for the S&P 500 for 22Q4 is -0.1%. If the energy sector is excluded, the growth rate declines to -4.9%.

Q4’22 earnings are now seen down 0.1% vs +5.8% on Oct.1. Ex-Energy: -4.9% (+1.4% on Oct. 1), a third consecutive negative (accelerating) quarter with Q1’23 barely positive for now vs +5.1% on Oct. 1).

Corporate guidance is gloomier:

Alibaba Reports Weak Singles Day Sales Growth The annual retail festival is another sign of depressed consumer sentiment under China’s stringent Covid-19 policy.

Alibaba on Friday didn’t disclose exact sales figures for the first time since it started its signature event, known as Singles Day, saying the results were in line with last year’s turnout. Alibaba reaped $84.5 billion in the total value of merchandise sold across its platforms last year, up 8.5% from 2020, the slowest increase since the company started the festival. (…)

Its rival JD.com Inc. also didn’t reveal total sales numbers, saying that sales set a new high and that growth was faster than the industry average. (…)

The country’s retail sales grew 2.5% in September from a year earlier, weaker than the 5.4% expansion seen in August, government data show. Elsewhere, China’s headline measure of joblessness, the surveyed urban unemployment rate, inched up to 5.5% in September from 5.3% in August. Unemployment among young people remained elevated at 17.9%. (…)

China Plans Property Rescue as Xi Surprises With Policy Shifts

Beijing issued its most extensive 16-point rescue package for the struggling real estate market, according to people familiar with the matter, marking a decisive effort to turn around an economy devastated by two years of Covid Zero curbs. (…)

Unlike previous piecemeal steps, the notice included 16 measures that range from addressing the liquidity crisis faced by developers to loosening down-payment requirements for homebuyers, the people said.

As part of the rescue plan, developers’ outstanding bank loans and trust borrowings due within the next six months can be extended for a year, while repayment on their bonds can also be extended or swapped through negotiations, the people added. (…)

Authorities on Friday also issued a set of measures to recalibrate their pandemic response, publicly outlining a 20-point playbook for officials aimed at reducing the economic and social impact of containing the virus.

The changes by no means signal the end of Covid Zero. A day after releasing the new parameters, officials were quick to clarify that Covid rules were being refined, not relaxed, and a strict attitude toward stamping out infections remains China’s guiding principle.

Global investors of Chinese property dollar bonds are still likely facing massive losses. (…)

Still, the financial backstop is dwarfed by the looming debt maturities facing developers. China’s property sector has at least $292 billion of onshore and offshore borrowings coming due through the end of 2023. That includes $53.7 billion in borrowings this year, followed by $72.3 billion of maturities in the first quarter of next year. (…)

From the numbers in the chart above, home prices have only declined 2.1% in the past year. I would not trust these NBS numbers.

For one, the independent CEIC has house prices down 3.9% YoY in Sep. 2022. This is still likely too low low. The South China Morning Post says that “Based on sales data from 21 cities, the transaction volume plunged 38 per cent from a year ago, with Hangzhou, the capital of East China’s Zhejiang province, diving 80 per cent, and Beijing’s witnessing a 60 per cent fall.”

Terry sent me these two intriguing links:

• Tesla mulls exporting China-made EVs to United States-sources Tesla is considering exporting made-in-China electric cars to the United States, two people with knowledge of the planning told Reuters, a reversal that would reflect the automaker’s deepening cost advantage at its Shanghai plant and slower demand from Chinese consumers.

• Nigeria offers concession on $1.3 billion China-funded hydro power plant Nigeria plans to grant a concession on its $1.3 billion hydropower plant now under construction and is seeking bids from private investors to operate the China-funded plant, authorities said on Friday.

(…) The private partner will be responsible for repaying the Chinese loan, the privatisation agency told investors in an online roadshow on Thursday, because it wanted to reduce government’s financing of the plant.

TECHNICALS WATCH

After my favorite technical analysis firm (Lowry’s Research) was acquired by a private equity firm last spring, they boosted my costs and changed the terms such that I regrettably had to cancel. I did not totally mind given the evolving bear market. I expected them to come back to their senses as the bear worsened.

That happened last week. Near bottom?, although Lowry’s is not calling that yet.

The recent extreme volatility is typical of bear markets. We had 5%+ days in 2001 (Jan. 3) and in 2002 (July 24, 29) before the S&P 500 bottomed in October, 14% lower (with another big dip in March 2003). There were 8 mega up days during 2008, averaging +7.2%, the last one on December 16 (+5.1%) with a 913 close, 27% above the March 6, 2009 low of 666.

This snapshot of 2002-03 illustrates the extreme volatility and the behavior of the 100dma and 200dma trendlines (charts courtesy of TradingView):

• 2008-09:

• 2022:

The body of technical evidence says that most long-term measures remain in a downtrend.

• S&P 500 Large Cap Index – 13/34–Week EMA Trend at the Nov. 10 close (CMG Wealth):

• The large gap with the S&P 500 200dma has been closed…once more…

• …but the 200dma is still falling

FYI, this week, FOMC member will be sharing their thoughts on the recent CPI report and monetary policy. It starts today at 11:30 with Vice-Chair Lael Brainard and at 6:30PM with NY Fed’s John Williams, both highly influential. There are eleven other speaking engagements this week, none from Jay Powell.

• Fed’s Waller Says There’s a ‘Ways to Go’ Before Rate Hikes Done

Stocks vs Bonds: The ASR global stocks vs bonds indicator is saying 2 things:

• -there’s a long way to go in the equity bear market
• -odds are massively in favor of bonds beating stocks in the coming months/years (Callum Thomas)

@IanRHarnett

Morgan Stanley Sees Rough Ride for US Stocks in 2023

US stocks will end 2023 almost unchanged from their current level — but will have a bumpy ride to get there, according to Morgan Stanley’s Michael Wilson.

The top-rated strategist sees a “volatile path” to get to his 2023 year-end S&P 500 base-case target of 3,900 index points, about 2% below where the gauge closed on Friday. He expects stocks to fall as earnings estimates come down, before rebounding in the second half of the year.

“The path forward is much more uncertain than a year ago, and likely to bring several twists and days/weeks of remorse for investors regretting they traded it differently,” Wilson wrote in a note on Monday. In the short-term, he sees the stock-market rebound sparked by last week’s good inflation data running for a few more weeks.

The portfolio strategist — who correctly predicted the slump this year and is ranked No. 1 in the latest Institutional Investor survey — said consensus earnings estimates for 2023 are still much too high. His base case is for US company profits to decline 11% in 2023, before a strong rebound in 2024 as positive operating leverage returns. (…)

Wilson expects the S&P 500 to trough between 3,000 and 3,300 index points — at least 17% below current levels — in the first quarter. (…)

JPMorgan Chase & Co. strategist Mislav Matejka is more positive. He sees continued support to equity markets from a peak in bond yields, cooling inflation, light positioning, and the likelihood of a smaller-than-typical earnings contraction, according to a report on Monday.

FTX starts bankruptcy proceedings and Bankman-Fried resigns as CEO (Axios)

Sam Bankman-Fried, SBF, as he’s universally known, was in many ways the public face of crypto.

• No other industry player had so much credibility — and money — that Tony Blair and Bill Clinton would fly to the Bahamas to make a joint appearance at his crypto conference.
• That credibility is now shot to smithereens, and there’s no one who can take his place. It’s a safe bet that neither Clinton nor Blair will ever appear at a crypto conference again.

Scam Bankrupt Fraud, as ZeroHedge nicknamed him, tweeted last Monday: “FTX has enough to cover all client holdings. We don’t invest client assets (even in treasuries).”

• That tweet has been deleted, probably because it’s simply not true. The WSJ has reported that FTX lent more than half of its customer funds to its sister company Alameda, and Reuters earlier reported that FTX had transferred at least $4 billion of its funds to Alameda.
• That would explain why FTX had to pause withdrawals on Tuesday morning — it simply didn’t have client assets on hand.

All fake, except some $9B in client losses… And now this:

• Bankrupt FTX Hit by Mysterious Outflow of About $662 Million “Abnormalities with wallet movements”

Trust, anybody?

The NBA’s Steph Curry, the NFL’s Tom Brady and tennis star Naomi Osaka are among the celebrity athletes who partnered with FTX.

Iran’s Protesters Mark ‘Bloody Friday’ Deaths Demonstrators in southeastern Iran clashed with security forces as they gathered to mourn the deaths of dozens of people during the antigovernment protests that have swept across the country, in one of the most serious challenges to the clerical establishment in decades.