The Fed, Consumers, China, & Fusion

December 15 (Thursday)

The Fed: Higher for Longer. The FOMC provided its latest Summary of Economic Projections (SEP) today after the committee announced a 50bps rate hike to a range of 4.25%-4.50% (table). At his press conference, Fed Chair Jerome Powell acknowledged that that the rate is now restrictive, but not restrictive enough.

The SEP included the "dot plot" showing the forecasts of the 19 participants of the FOMC. Seventeen of them predicted that the federal funds will rise to 5.00% or higher next year. The median forecast of the committee's participants is now 5.1%, up from 4.6% in the September dot plot. The good news is that the median forecast drops to 4.1% in 2024 and 3.1% in 2025.

The SEP anticipates that the FOMC's higher-for-longer restrictive policy will weigh on real GDP growth, which is projected to be just 0.5% next year and 1.6% in 2024. In this scenario, the unemployment rate is projected to rise from 3.7% now to 4.6% at the end of next year. Headline PCE inflation is expected to moderate from 5.6% this year to 3.1% in 2023, to 2.5% in 2024, and 2.1% in 2025.

This soft-landing forecast makes sense to us.

Consumer Discretionary: A Brighter 2023. Two airlines gave differing views of consumer demand earlier this week. JetBlue Airways warned that the strong last minute demand it anticipated for December “materialized below expectations,” a December 13 CNBC article reported. That in addition to the impact of Hurricane Nicole in November means Q4 revenue per available seat mile will be at the low end of JetBlue’s prior guidance of a 15% to 19% increase from 2019 levels.

Conversely, the United Airlines Holdings CEO said the airline isn’t seeing a recession in its data, and business demand has plateaued. Investors opted to believe JetBlue’s more pessimistic story line, and airline stocks (which are in the S&P 500 Industrials sector) fell on Tuesday: American Airlines Group (5.2%), Delta Air Lines (4.0), JetBlue (7.7), Southwest Airlines (3.0), and United Airlines (6.9).

Before giving up on the US consumer, consider a number of reasons why the S&P 500 Consumer Discretionary sector could fare well in 2023. From the demand side of the equation, if employment remains strong, consumer spending may improve because the price of gas has dropped sharply in recent weeks. The price of a gallon of gasoline has fallen 34% from its June 13 peak of $5.11 to $3.35 (Fig. 1). That’s not far from where it started in 2022 and it’s in the neighborhood of where gas prices stood from 2011 through 2014. In addition, inflationary pressures as measured by the consumer price index have begun to recede. The CPI rose only 0.1% m/m in November, its smallest increase in three months (Fig 2). As a result, inflation-adjusted hourly earnings were up 0.5% in November, marking the fourth time in five months that wages rose more than inflation.

Costs for some retailers should come down sharply as well. Clothing retailers will benefit from the large drop in the price of cotton. The price has tumbled from $1.58 per pound at its peak in May 4, 2022 to a recent $0.79 (Fig. 3). Likewise, the price of transporting goods has also fallen in many areas as supply chains have untangled. There’s no longer a long queue of ships waiting at sea for a slot to unload their goods at the West Coast ports. And with inventory levels high, we presume retailers won’t need to pay extra to fly merchandise where it needs to go this year.

The yearly percentage cost increase for truck transportation has dropped by more than half from 24.9% at its peak in May 2022 to 11.1% in November (Fig 4). And the price to transport a 40 foot container by ship has tumbled to $2,139 as of December 8, down from $9,262 roughly a year ago, according to Drewry’s World Container Composite Index.

Wall Street analysts are optimistic about 2023 earnings growth for industries in the S&P 500 Consumer Discretionary sector. The sector is expected to produce stronger earnings growth next year than the 10 other sectors in the S&P 500. Yet the Consumer Discretionary sector’s stock price index has been among the worst performers of 2022. Let’s take a look at the discrepancy.

(1) Glum consumer stocks. The S&P 500 Consumer Discretionary sector’s stock price index has turned in the second worst performance of the 11 S&P 500 sectors ytd and it has lagged far behind the S&P 500. Here is the performance derby for the S&P 500 and its 11 sectors ytd through Monday’s close: Energy (52.6%) Utilities (0.6), Consumer Staples (-0.9), Health Care (-1.3), Industrials (-5.0), Materials (-10.1), Financials (-10.8), S&P 500 (-16.3), Information Technology (-23.7), Real Estate (-25.6), Consumer Discretionary (-32.7), and Communication Services (-38.2) (Fig. 5).

The stock price indexes of industries in the S&P 500 Consumer Discretionary sector have had very varied results this year. Results range from almost flat on the year (Automotive Retail) to down almost 50% (Automotive Manufacturing). Here’s the performance derby for some of the S&P 500 Consumer Discretionary industries ytd through Monday’s close: Apparel Retail (3.4%), Automotive Retail (-0.5), Restaurants (-5.6), Specialty Stores (-10.0), General Merchandise Stores (-18.4), Hotels, Resorts, & Cruise Lines (-18.5), Home Improvement Retail (-20.8), Homebuilding (-21.5), and Internet & Direct Marketing Retail (-45.3) (Fig. 6, Fig. 7, and Fig. 8).

(2) Investors ignore estimates. The Consumer Discretionary stock price index is about to end 2022 close to its lows of the year even though analysts are forecasting strong 2023 earnings growth for the sector. Stock prices usually start pricing in earnings forecasts roughly six months ahead of time. With Consumer Discretionary shares near their nadir, investors appear to be expecting the sectors’ earnings estimates to be revised downward in the coming weeks and months.

First, let’s take a look at what analysts are forecasting for the S&P 500 sectors’ 2023 earnings growth: Consumer Discretionary (30.7%), Industrials (14.4), Financials (12.4), Communication Services (6.5), Utilities (5.6), S&P 500 (3.7), Consumer Staples (3.4), Information Technology (0.8), Health Care (-2.9), Materials (-9.3), Energy (-12.0), and Real Estate (-13.3).

The Consumer Discretionary sector owes its outsized 2023 earnings growth forecasts to the expected rebound in Amazon’s earnings next year. According to Joe’s calculations, the S&P 500 Consumer Discretionary sector’s earnings are forecast to grow 30.9% in 2023, which includes Amazon’s earnings. But if the Internet retailer’s earnings are taken out of the mix, the sector’s earnings growth estimate for next year drops to a still respectable, but much smaller, 14.7%.

Here are 2023 earnings growth estimates for some of the other industries within the Consumer Discretionary sector: Internet & Direct Marketing Retail (1842.6%), General Merchandise Stores (35.8), Auto Parts & Equipment (27.2), Footwear (26.4), Apparel Retail (14.4), Leisure Products (11.4), Restaurants (10.8), Specialty Stores (9.9), Automotive Retail (9.7), and Apparel & Accessories (9.6). The Hotels and Casinos & Gaming industries would also presumably be on the list were they not rebounding from losses in 2022.

The exceptions to this rosy picture are Consumer Discretionary industries related to the home and/or affected by high interest rates. Many of those industries are expected to show a decline in earnings next year compared to 2022: Automobile Manufacturers (3.9%), Home Improvement Retail (1.9), Housewares & Specialties (-5.8), Household Appliances (-10.2), Home Furnishings (-20.5), and Homebuilding (-33.4).

(3) Putting the pieces together. The S&P 500 Consumer Discretionary sector is expected to report revenue growth of 10.9% in 2022 and 6.5% in 2023 (Fig. 9). The sector’s earnings are expected to flip from a decrease of 1.9% this year to an increase of 30.9% in 2023 (Fig. 10). While earnings estimates have fallen sharply through the past year for 2022, they’ve risen over the past year for 2023. However, the sector’s profit margin has been declining since March when it was at 8.2% to a more recent 7.4% (Fig. 11). The sector’s forward P/E has fallen sharply from a high of 40.5 in July 2020 to a recent 23.3 as earnings that shrank—or disappeared—during the Covid pandemic have recovered (Fig. 12).

China: Covid Continues. The Chinese government has lifted Covid restrictions on its people in response to protests, but that doesn’t mean the worst has passed for the nation. Recall that US citizens self-isolated during many periods over the past two years as the disease ebbed and flowed in our country. Anecdotal reports from Beijing indicate that the city’s citizens are doing the same. Travel remains largely grounded, stores and restaurants stand empty, and companies are maintaining “closed-loop” policies, to isolate workers from the outside world. It’s less clear how China’s citizens in other cities and in the countryside are faring.

The surge in cases initially spooked Chinese stocks. But the MSCI China stock price index has rallied 34.0% from its October 31 low to a three-month high through Monday’s close (Fig. 13). Covid is going to have to run its course before Chinese consumers and businesses open their wallets again. Here are some anecdotes from recent reports in the news:

(1) Restrictions lifted. China’s policy shift—from zero-Covid to no restrictions—has been amazingly fast. Those who have mild or asymptomatic cases are allowed to quarantine at home instead of being forced to move into state-run facilities. Frequent testing is a thing of the past. As are forced lockdowns where cases are detected. People no longer need to present a health code app on their phones to enter restaurants or shopping malls. And restrictions on travel between provinces have come to an end.

The country will no longer use a nationwide mobile tracking app that had been collecting data on users’ travel since 2020. It notified users if they were exposed to Covid and needed to test or quarantine. Regional or local apps may stay in use depending on the local government.

(2) Need more and better boosters. Only about 77% of the elderly population has had one Covid vaccination by late November and even fewer, 40%, has received a booster shot. Airfinity, a British health risk analysis firm, estimates that up to 2.1 million lives could be at risk now that the zero-Covid policy has been lifted. It blames the low elderly vaccination rate and the lack of general immunity in the population because there have been few previous cases of natural infection, a December 12 South China Morning Post article reported. Airfinity bases its estimate on Hong Kong’s experience during last February’s wave of Covid in that city.

The Institute for Health Metrics and Evaluation at the University of Washington also warned that the less effective Chinese vaccines, combined with the lack of widespread availability of antiviral medicines, and the unboosted elderly population will lead to a considerable death toll. Those who are 60 and older and have received all of their Sinovac vaccinations have a 0.21 percent fatality rate if they come down with Covid, compared to the 0.01 fatality rate of these who received the BioNTech mRNA vaccine.

China has approved Pfizer’s antiviral Paxlovid but it has not approved mRNA shots from US companies. Chinese pharmaceutical companies are studying mRNA vaccines produced by its domestic companies that may be available as soon as April. It would have been wiser for the government to roll out a booster shot program before it lifted zero-Covid policies or at least to have dropped restrictions in the spring or summer when cases generally fall.

(3) Hospitals fill up. As we’ve seen firsthand, deaths can occur because hospitals get so overwhelmed that they can’t effectively care for patients suffering from Covid or other diseases. China has 10 intensive care unit beds per 100,000 people, compared to 7.1 in Hong Kong and nearly 35 in the US, the SCMP article reported. There is concern that ICU availability is even lower—or nonexistent—in some parts of the Chinese countryside. Recall that in the US the goal was to flatten the curve, so that the health care system could handle the surge in Covid cases.

A December 11 Bloomberg article stated that Beijing residents are “flocking” to hospitals, which are struggling to find enough staff and suspending non-covid treatments. “Long lines have formed outside of hospitals and people are struggling to find medicine, while delivery services had been interrupted as couriers become sick,” the article relayed. China’s State Council has urged medical institutions to offer online services.

There are reports that hoarding of fever and pain-relief drugs are causing shortages of those products in Hong Kong. Stock of Panadol, which treats fever, and traditional Chinese medicine Lianhua Qingwen is hard to find. Canned yellow peaches, which are high in vitamin-C are also in great demand as a defense against the disease despite any evidence of their efficacy.

(4) Businesses adapt. The official tally of the number of new cases has been dropping because few tests are being administered. Anecdotally, however, Covid cases in Beijing and Wuhan have increased sharply and businesses are short staffed as a result. More than half of the staff at a Beijing mall and a hotel have Covid, a senior executive at a firm that manages one of Beijing’s largest retail operations told Reuters in a December 13 article. The mall remains open, but the staff was split into two teams that alternate shifts. JD.com has sent test kits to its staff and is asking those who are sick to stay home. LVMH is offering paid leave for those who are ill. It’s like a bad flashback.

(5) Gloom remains. While Covid continues to spread, consumers and businesses are unlikely to boost spending. And unlike the US government, the Chinese government hasn’t doled out cash to help its population during the pandemic.

China’s urban unemployment rate was low in October at 5.5%, but the rate for those 16-24 years old has jumped sharply to 17.9%, up from 9.9% in early 2019 (Fig. 14). Retail sales dropped by 0.5% y/y in October (Fig. 15). Bank loans have fallen by 6.3% in November from the peak in March (Fig. 16). And China’s official manufacturing purchasing managers index has fallen to 48.0, with new orders falling to 46.4 (Fig. 17).

Of course, these data are backward looking and investors buying shares today may be looking out six months from now, hoping Covid cases will subside. We hope they’re right, but we fear there may be better buying opportunities ahead.

Disruptive Technologies: Nuclear Fusion’s Long Road. Lawrence Livermore National Laboratory’s National Ignition Facility (NIF) announced that a nuclear fusion reaction in its labs generated more energy than was needed to spark the reaction. In the scientific community this is a BIG deal. It was an accomplishment that some naysayers thought might never happen and the press release contained praise from no fewer than four US senators and two congresspersons.

That said, nuclear fusion has a long way to go before being tapped as a carbon-free way to generate electricity. The net energy created only includes the energy that entered the reaction chamber, 2.05 megajoules, and the amount of energy produced by the reaction, about 3.0 megajoules. It doesn’t include the 300 megajoules of energy needed to generate the laser pulse that sent the energy into the chamber, an excellent December 13 NYT article explained. The upshot: The math still doesn’t work, but the science is one step closer than it was before.

We’ve highlighted nuclear fusion and some of the small, private companies working to make it a reality in our March 31, 2022, December 2, 2021, and August 1, 2019 Morning Briefings. The NIF news will certainly mean that more funds will be raised by startup companies searching for the holy grail. This year about $4.8 billion in funding from private investors and government sources was funneled into the industry, up 139% from last year, according to the Fusion Industry Association’s annual survey.

The survey also found that 93% of the companies responding to the survey believed that “fusion electricity” will be on the grid in the 2030s or before. Kimberly Budil, the director of Lawrence Livermore National Laboratory, thought it would take a “few decades of research on the underlying technologies” before a fusion-powered power plant would be possible.

Companies are taking different approaches to nuclear fusion. “Eight companies, including Focused Energy and First Light Fusion, aim to use lasers to initiate fusion reactions,” a December 13 Reuters article reported. “About 15 companies, including Commonwealth Fusion Systems and TAE Technologies, aim to use powerful magnets to confine fusion fuel in the form of plasma, a fourth state of matter that contains charged particles. About 10 companies are trying other methods, including a combination of magnets and lasers.” The race continues. a

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Disinflation?

December 14 (Wednesday)

Inflation: Peaked & Moderating. What a bummer! We obviously aren’t referring to yesterday’s better-than-expected November CPI report. Rather, our data vendor experienced a hack attack, so we couldn’t sit back and enjoy flipping through our CPI chart books. We were hoping that Santa would deliver a happy holiday surprise, and he didn’t let us down. So the Santa Claus rally is likely to continue through yearend. That’s if Fed Chair Jerome Powell concedes that progress is being made on the inflation front at his press conference today. He needs to lighten up on his grinchiness.

The CPI rose 7.1% y/y in November, a slowdown from 7.7% the month before. Overall inflation has been decelerating on a y/y basis since hitting a peak around 9% in June. After stripping out food and fuel prices, which are volatile, the index climbed by 6%. The slowdown in inflation was driven by food, energy and used vehicles. Food price inflation slowed, but grocery bills remain historically high. Rents continued to rise rapidly in November.

The easing of inflation pressures boosted the purchasing power of workers’ pay. Real average hourly earnings rose 0.5% for the month, though they were still down 1.9% from a year ago.

US Economy: Small Business Survey Still Troubling. The Fed can take some comfort from yesterday’s CPI report. The same cannot be said for yesterday’s November’s National Federation of Independent Business (NFIB) survey of small business owners. They are reporting that their businesses are challenging and that they still face labor shortages, forcing them to raise their wages and prices. Consider the following:

(1) Business. There has been a modest rebound in the outlook for general business conditions reported by their “percent better minus worse over the next six months” rebounded from a record low of -61 during June of this year to -43 in November (Fig. 1). That’s still below all of the troughs in this series since the start of the data in 1974!

(2) Labor. The percent of small business owners with job openings fell to 44% during November (Fig. 2). That’s down from a record high of 51% during May of this year and September of last year. But it is still very high. This series closely tracks the job openings series included in the JOLTS report. Fed officials have indicated that they would like to see fewer job openings to take the pressure off wages. Both series are heading in the right direction, but not fast enough. Indeed, a near record 28% of small business owners are planning to raise worker compensation (Fig. 3).

(3) Prices. There has been some declines this year in the percent of small business owners raising their average selling prices and the percent planning to raise average selling prices. However, both remain elevated with the former at 51% and the latter at 34% (Fig. 4).

Strategy: Steady Earnings, For Now. During the Q3 earnings season, industry analysts scrambled to lower their S&P 500 operating earnings per share estimates for Q4 and all four quarters of 2023 (Fig. 5 and Fig. 6). They’ve stopped doing so over the past five weeks through the December 8 week as all five quarterly estimates have stabilized.

The same can be said for S&P 500 annual and forward earnings. For the past five weeks, the 2023 and 2024 estimates have been around $231 and $254, while the forward earnings has held steady around $230 (Fig. 7).

The dip in forward earnings is consistent with our soft-landing economic outlook (Fig. 8). That’s assuming it remains a dip rather than the start of a recession-induced drop. That’s our assumption, of course.

S&P 500 forward revenues peaked during the October 13 week (Fig. 9). The 2.1% dip in forward earnings since then through the December 1 week was almost all attributable to a drop in the forward profit margin from 12.9% to 12.7%.

Now let’s drill down to the 11 sectors of the S&P 500:

(1) Forward revenues. Standing out are the S&P 500 forward revenues of the S&P 500 Consumer Staples, Financials, Health Care, and Utilities sectors (Fig. 10). All four rose to record highs during the December 1 week. It’s hard to imagine a bad recession ahead when Financials are doing so well! The forward earnings of the other sectors have been mostly moving sideways at record highs in recent weeks including Communication Services, Consumer Discretionary, Energy, Industrials, Information Technology (a wee bit toppy), Materials, and Real Estate.

(2) Forward earnings. Among the S&P 500 sectors, the forward earnings of the following have been moving sideways at record highs since the summer: Consumer Staples, Energy, and Industrials (Fig. 11). Drifting lower since their summer record highs are the following: Communication Services, Consumer Discretionary, Health Care, Information Technology, Materials, and Real Estate. Financials and Utilities are the only sectors with forward earnings at a record high currently.

(3) Forward profit margin. Here are the 2020 lows in the forward profit margins of the sectors and their latest values as of the December 1 week (Fig 12): S&P 500 (10.3%, 12.7%), Communication Services (13.2, 14.2), Consumer Discretionary (4.7, 7.4), Consumer Staples (7.2, 7.1), Energy (0.2, 12.7), Financials (13.0, 18.1), Health Care (10.0, 10.1), Industrials (7.3, 10.1), Information Technology (21.6, 24.2), Materials (8.8, 11.5), Real Estate (12.4, 17.4), and Utilities (13.2, 13.7).

US Housing: Waiting for Affordability to Rebound. Lots of would-be-buyers have been priced out of the housing market. Buyers likely are walking away from the home buying process at least over the holidays and until they can get better fixed mortgage rates, or even lower prices. Home prices are falling but have remained elevated while mortgage interest rates have skyrocketed. Existing home sales and the Pending Home Sales Index both fell during October nearly to pandemic time lows (Fig. 13). These series dropped for the ninth consecutive month for the former and the 11th time in 12 months for the latter.

Affordability is a major challenge; the media has highlighted in recent weeks. For example, two recent articles in the WSJ were titled: “How Did the Housing Market Get So Unaffordable for So Many?” (see link dated December 12) and “Homelessness Worsens in Older Populations as Housing Costs Take Toll” (see link dated December 11). A recent CNBC video dated December 12 was titled: “Housing market ‘extremely unaffordable’ right now despite rates falling.” Because what goes up must inevitably come down, does that mean that we are in for a housing bubble burst?

Melissa and I don’t think so. Housing supply dynamics are supporting prices. Freddie Mac estimated that the US had a housing supply deficit of 3.8 million units, as of Q4-2020. And that gap preceded the pandemic, which only worsened it. Inventory is expected to remain tight because many homeowners are unwilling to trade up or trade down after locking in historically low mortgage rates in recent years. Because of low supply, housing prices are still expected to be up 9.6% for 2022 despite lower sales, followed by 0% in 2023 and 5.0% in 2024 (when sales are expected to pick up again), according to the National Association of Realtors’ (NAR) latest forecast released yesterday afternoon.

It’s notable, however, that these predictions may hold mostly for existing home prices, which compose the majority of the housing market. The supply of new homes is not as strained as for existing homes, but the lack of affordable inventory for new homes is a challenge for builders. They’ve been offering incentives like mortgage rate buy downs to sustain sales, but soon, they may be forced to lower prices. On the Toll Brothers December 9 earnings call, the CEO said: “We recognize that if market conditions do not improve, we will need to be more aggressive with price reductions to rebuild our backlog and turn our inventory.”

Melissa and I also agree with many housing market analysts that this time is not like 2007. Last time, mortgage rates were on the way down when home prices dropped. The 2007-09 housing crisis instead was driven by poor lending standards, which led to lots of foreclosures. Now lending standards are much higher, and homeowners have a healthy amount of equity in their homes. Mortgage debt is lower now than it was then relative to home values and as a ratio of disposable personal income (Fig. 14)

The next big housing tipping point will come when the Baby Boomers finally downsize into more manageable spaces, or assisted living facilities. For now, the Boomers largely are aging in place. Whenever they do start to move in a big way, demand still will be supported by the next generations of homeowners, Millennials and Gen Zers, but likely, affordable housing will be most in demand.

Consider the following:

(1) Single-family home prices fall, but don’t drop. Median existing single-family home price inflation had reached new heights at a rate near 20.0% during August 2021 on the basis of the yearly percent change in 12-month moving average. In October, the series fell to 12.5% (Fig. 15). But that’s still near the previous peak during 2006 before home prices took a dive. For new homes, the equivalent series fell to 16.1% during October also having recently peaked near 20.0% during April of this year. But it too, remained high relative to prior peaks.

(2) Mortgage rates take a breather, possibly from a peak. Meanwhile, the 30-year fixed mortgage rate rose from 2.87% to 5.50% from last August through this August. The rate was above 7.0% this October, the highest in 20 years. It appears like the rate may have peaked, having moved down to 6.81% as of the latest data on December 9. Nevertheless, homebuyers and investors are waiting to see if the drop in mortgage rates persists as this sort of breather had happened recently over the summer.

(3) Affordability is squeezing buyers, especially for new homes. Despite home price trends moving downward, the NAR’s housing affordability index sunk below the 100 mark during October (Fig. 16). New home prices have risen into new territory, almost touching $450,000 during October. Existing home prices too are in the upper $300,000s, flirting with $400,000. For a 30-year fixed mortgage, the monthly payment on a $400,000 home at a 6.0% interest rate would be around $2,300 not including taxes and interest. At a 3.0% rate, the payment obviously would be much more affordable for most Americans at $1,700.

(4) Traffic & pending home sales plummet to recent lows. Because of the affordability problem, traffic of prospective homebuyers sank nearly to 2020 lows during November, according to the National Association of Homebuilders (NAHB) Housing Market Index (Fig. 17). Pending home sales also dramatically fell in October, the latest month with available data, according to the National Association of Realtors (NAR) (Fig. 18).

(5) Home supply slipping further & builders pulling back. Supporting prices, however, the months’ supply of existing homes on the market remained puny at 3.3 months during October 2022 (Fig. 19). Back in 2010, the supply was over 10 months.

Compared to existing homes, there is a notable divergence in the supply of new homes, which are up to around nine months from a pandemic low near three months (Fig. 20). However, the supply of new single-family homes could be poised to drop as builders pull back. Single-family housing starts and permits both dropped through October (Fig. 21). Even so, the market is much more heavily weighted toward existing homes, with 1.08 million single-family existing homes currently available for sale versus 470,000 new homes.

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The Bubble in Everything Has Burst. Now What?

December 13 (Tuesday)

Strategy: Bubble, Bubble Toil & Trouble. In Shakespeare's play, Macbeth, the three witches predict that Macbeth’s troubles will double for killing everyone on his way to the crown: “Double, double toil and trouble / Fire burn and cauldron bubble.”

Since 2021, pessimistic prognosticators have been predicting that the “bubble in everything” would burst. They've been mostly right, though they’ve been much too pessimistic about the implications for the financial system and the economy, so far. Then again, many of them aren’t convinced that the worst is over for financial assets and for the economy.

According to the bearish narrative, the bull market from 2009 through 2021 was primarily attributable to the ultra-easy monetary policies of the Fed and the other major central banks. These policies were largely justified by the deflationary forces unleashed by the GFC. The result was that all the major central banks undershot their 2.0% inflation targets. That was their excuse for implementing so-called unconventional monetary policies including zero-interest-rate policies (ZIRP), negative-interest-rate policies (NIRP), yield-curve-control policies, and quantitative easing (QE).

Just when it seemed that these unconventional policies had become the new normal, inflation soared around the world over the past year, and now all the major central banks are scrambling to subdue inflation rates well exceeding their 2.0% targets by tightening their monetary policies.

In the US, the bullish case looking forward is that “this too shall pass,” and indeed is passing. In other words, most if not all the bubbles have burst already, so not much more collateral damage lies ahead. The Fed is likely to raise the federal funds rate by 50bps on Wednesday and one more time early next year then pause for a while. Monetary policy has turned restrictive enough to moderate inflation without causing a recession. So corporate earnings are more likely to move sideways than take a dive. The same goes for valuation multiples. Moreover, US financial markets continue to benefit from “TINAC,” i.e., the very sound investment rationale that “there is no alternative country” to serve as a safe haven for global investors during these challenging times around the world.

Let’s review the latest developments in the bubble-in-everything narrative:

(1) Bonds. The unconventional central bank policies became all too conventional. Their response to the GVC was to triple and quadruple down on their QE bond purchases. Fiscal authorities, especially in the US, widened their budget deficits dramatically by providing all sorts of pandemic relief programs. Advocates of this monetary and fiscal extravaganza justified it with Modern Monetary Theory. Others called it a necessary provision of “helicopter money” to avert an economic and financial meltdown.

The US bond yield dropped from 4.04% at the end of 2007 to a record low of 0.52% on August 4, 2020 (Fig. 1 and Fig. 2). Contributing to that drop was the Fed’s zero-interest-rate policy during most of the period from the GFC through the GVC (Fig. 3). The Fed’s four rounds of quantitative easy programs also kept bond yields down (Fig. 4). Importantly, negative bond yields in Europe during the pandemic along with the Bank of Japan’s pegging of Japan’s government bond yield around zero since 2016 also put downward pressure on US bond yields (Fig. 5).

These developments all led to a massive bubble in global bond markets. In the US, the 10-year bond’s P/E based in the reciprocal of its yield soared to a record 161.3 during July 2020 (Fig. 6). It was back down around 25 during November as the yield soared to 4.00% recently.

The bursting of the bubble in the bond market has been extraordinary. Just as extraordinary is how little collateral economic damage there has been, so far. Single-family housing activity has been pushed into a recession. But the overall economy continues to grow.

Of course, there have been substantial capital losses in the bond market this year. The Fed’s US Financial Accounts of the United States was updated last week through Q3. It shows that the face value of total US debt rose to a record $92.2 trillion (Fig. 7). The iShares 20+ Year Treasury Bond ETF (TLT) fell 36% from January 3 through October 24. It was down 26% ytd through Friday’s close. Of course, most investors probably didn’t sell their bonds and are planning to hold them to maturity rather than take the capital losses.

(2) Cryptocurrencies. Arguably, the collapse of crypto exchange FTX was one of the major financial crises that was triggered by the Fed’s tightening of monetary policy, so far. However, the price of bitcoin peaked at a record $67,634 on November 8, 2021 (Fig. 8). It plunged 70% through October 31 (Halloween). That’s before FTX imploded in November.

It probably would have failed regardless since it turned out to be the latest big Ponzi scheme. The Fed’s May 6, 2021 Financial Stability Report (FSR) mentioned cryptocurrencies just once—as the ninth-greatest risk to US financial stability as determined by a survey of wide-ranging viewpoints. Here is an important excerpt on cryptocurrencies from the Fed’s most recent November 4, 2022 FSR: “The turmoil in the digital assets ecosystem did not have notable effects on the traditional financial system because the digital assets ecosystem does not provide significant financial services and its interconnections with the broader financial system are limited.”

Former Fed Chair Ben Bernanke, in an interview published by the Swedish journal Dagens Nyheter on December 7, stated he does not think cryptocurrencies constitute a threat to the current financial system because no bank is sitting on a large pile of these assets. He added, “I believe that so far cryptocurrencies have not been shown to have any economic value at all.”

In May, Bernanke said bitcoin was used “mostly for underground economy activities and often things that are illegal or illicit.” He further explained that while bitcoin is being used as a speculative asset, he does not think it can reach the status of an alternative currency. In his latest interview, Bernanke opined, “Either they are not regulated and then they will collapse because people distrust them or they are regulated and then they will collapse because they are mostly used for criminal activity.”

(3) ARK, meme, and SPAC stocks. This is just one of many speculative bubbles that have burst since early last year—including ARK, SPACs, meme stocks—without causing a credit crunch or a recession, which is consistent with our rolling recession scenario. Indeed, the Fed’s latest Financial Stability Report didn’t mention them at all.

ARK Innovation ETF was the poster child for the speculative excesses of the bull market. It bought lots of stocks with the potential for disruptive innovations, though many of them didn’t have earnings. It soared 210% from March 13, 2021 to February 11, 2022. It is currently down 77.6% from its record high.

The December 6 Financial Times observed that more than 350 companies have gone public in the US since the start of 2020 by merging with a Spac. These entities are cash shells set up to make an acquisition and allow a company to avoid a traditional initial public offering. Companies that come to market via a Spac are sometimes called “de-Spacs.”

On December 5, Bloomberg reported: ‘The market for SPACs has been hit by a broader rout in more speculative assets amid concerns about tighter regulation from the US Securities and Exchange Commission. The De-SPAC Index is down 71% in the past 12 months compared with a 13% drop in the S&P 500 Index. More than one-third of the roughly 400 companies that merged with a SPAC are trading below $2 a share.”

(4) S&P 500. The bear market in stocks this year may have further to go in early 2023. That’s not our view, but there are plenty of vocal bears who think so. They rightly observe that lots of air has come out of the S&P 500’s valuation multiple, but there is plenty more that can come out if inflation doesn’t moderate, the Fed continues to tighten aggressively, and the economy falls into a hard landing.

The bear market in stocks from January 3 through October 12 was led by a 30% fall in the S&P 500’s forward P/E from 21.5 to 15.1 (Fig. 9). Over the same period, the forward earnings of the S&P 500 rose 6.2% (Fig. 10).

We are impressed with the recent rebound in the forward P/E to above 17.0. That’s especially since the forward earnings peaked at a record high during the June 23 week and has been edging lower since then.

Nevertheless, the stock market still does have a valuation problem. That’s easier to see by looking at the S&P 500’s forward price-to-sales ratio (Fig. 11). It was 2.2 at the end of last week. That’s down from a record high of 2.9 during the first week of the year, but this weekly daily version of the Buffett Ratio remains elevated.

(5) Real estate. Finally, residential real estate is under duress, especially the single-family home market. Over the 24-month period through May, the median existing single-family home price soared 44.9% as the pandemic boosted demand for such housing (Fig. 12). They were still up 21.1% through October on the same basis. That’s surprising since both new and existing home sales have plummeted this year and mortgage rates soared. A shortage of homes for sales seems to be propping up home prices. In any event, the odds of another housing-led GFC are low in our opinion since homeowners have more equity and less debt in their homes.

(6) Bottom line. So far, the transition from the New Normal which spanned the GFC to the GVC back to the Old Normal has been remarkably smooth. Maybe the lags in monetary policy will destabilize the financial markets and the economy in 2023. We doubt it.

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The Call Of The Wild

December 12 (Monday)

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Strategy: The Howling. Last week wasn’t a good one for Santa. The S&P 500 failed to hold on to its 200-day moving average (Fig. 1). The index is now down 18.0% from its January 3 record high through Friday’s close. It is still up 10.0% from its October 12 closing low. However, the bears are growling that the bear market isn’t over, with many of them expecting new lows early next year. Their call of the wild was confirmed by the howling of a pack of bankers who warned that consumer spending is slowing, suggesting that a consumer-led recession may be nearing.

Leading the pack of pessimists (again) was JPMorgan Chase Chief Executive Jamie Dimon. On Tuesday, he told CNBC that consumers and companies are in good shape but noted that may not last much longer as the economy slows down and inflation erodes consumer spending power. “Those things might very well derail the economy and cause this mild-to-hard recession that people are worried about,” he said. Consumers have $1.5 trillion in excess savings from pandemic stimulus programs, but it may run out some time in mid-2023, he told CNBC. Dimon also said the Federal Reserve may pause for three to six months after raising benchmark interest rates to 5%, but that may “not be sufficient” to curb high inflation.

Also on Tuesday, at a Goldman Sachs financial conference, Bank of America CEO Brian Moynihan told investors that the bank’s research shows “negative growth” in the first part of 2023, but the contraction will be “mild.” Goldman Sachs CEO David Solomon said at the same conference, “Economic growth is slowing. When I talk to our clients, they sound extremely cautious.”

We’ve said it before: If a recession is coming in 2023, it will be the most widely anticipated recessions of all times. It would be the first time that we’ve collectively talked ourselves into a recession, and the bankers are among the most vocal pessimists, leading the way with their unsettling howling.

So what are the bankers doing to prepare for their widely expected hard landing? Not much, so far, other than lending more money to their customers. Commercial bank loans and leases are up $1,134 billion ytd to a record $11.9 trillion during the November 30 week (Fig. 2). Commercial bank allowances for loan and lease losses showed little change ytd, down $0.3 billion to $166.7 billion (Fig. 3). That’s well below low the pandemic peak of $220.5 billion during the September 2 week of 2020.

Now consider the following related developments in the S&P 500 Financials sector:

(1) Security issuance. Depressing the big bankers is that their equity issuance business has imploded back to pre-pandemic levels (Fig. 4 and Fig. 5). On a 12-month-sum basis, total equity issuance plunged from a peak of $474.8 billion through April 2021 to $110.5 billion through October of this year. Both initial public offerings and seasoned equity offerings have plummeted since the 2021 boom.

Down but still holding up relatively well is corporate bond issuance. The 12-month sum peaked at $2.5 trillion during March 2021 (Fig. 6). It was down to $1.6 trillion during October.

(2) Forward revenues & earnings. The bankers are crying all the way to the bank. The forward revenues of the S&P 500 Financials sector rose to a record high during the December 1 week (Fig. 7). During the Great Financial Crisis (GFC), forward revenues peaked during the November 1 week of 2007 and plunged 48% through early 2012. The sector’s forward earnings has been in record-high territory in recent weeks (Fig. 8). During the GFC, it went into a freefall, dropping 78% from the 2007 peak through the 2009 trough.

(3) Market cap & earnings shares. If a recession is coming, it’s hard to see it reflected in the performance of the S&P 500 Financials sector. In the past, tightening monetary policy often triggered a financial crisis, which morphed into an economy-wide credit crunch and recession. This time is different so far. That’s been our pitch for a while. Bloomberg’s Rich Miller came to the same conclusion in a December 8 story titled “The Federal Reserve Is Deflating Financial Bubbles, Without a Crash.”

The story observed: “Financial reforms instituted after the financial crisis helped ensure that the latest housing cycle didn’t feature the kinds of loosening in credit standards seen in the early 2000s. The so-called Dodd-Frank measures have left banks much better capitalized, and much less leveraged than they were back then.”

We observe that the S&P 500 Financials sector accounts for 11.6% of the market capitalization of the S&P 500 (Fig. 9). That’s reasonable considering that the sector’s earnings share of the S&P 500 is higher at 16.1%.

(4) A risk-off week. On Monday of last week, investors were unnerved by November’s stronger-than-expected NM-PMI. They concluded that the economy may be too strong, requiring the Fed to raise interest rates still higher and increasing the risk of a recession. Of course, a strong NM-PMI implies that consumers are continuing to spend on services. Nevertheless, Tuesdays’ nattering nabobs of negativity convinced investors that consumer spending is suddenly weakening, raising the risks of a recession.

By the way, on Thursday of last week, I spoke at a conference at The Breakers Palm Beach. The airports were mobbed. The planes were full. The hotel was packed. So were its restaurants and recreational facilities.

In any event, last week was another risk-off week in the stock market, with the S&P 500 down 3.4%. Defensive stocks outperformed cyclical ones, as evidenced by the performance derby of the S&P 500 and its 11 sectors: Utilities (-0.3), Health Care (-1.3), Real Estate (-1.9), Industrials (-3.2), Materials (-3.3), Information Technology (-3.3), S&P 500 (-3.4), Financials (-3.9), Consumer Discretionary (-4.5), Communication Services (-5.4), and Energy (-8.4). (See Table 1.)

(5) No recession in GDPNow. Friday’s update of the Atlanta Fed’s GDPNow tracking model showed that real GDP is up 3.2% (saar) during Q4, following Q3’s 2.9% increase. Consumer spending is up 3.7%. Capital equipment is up 10.7%. The weak sectors are nonresidential structures (-3.9%) and residential investment (-19.8%). There’s no economy-wide recession reflected in the tracking model. There is a rolling recession that is rolling through single-family housing activity and nonresidential construction, however.

Inflation I: Moderating PPI? On Friday, we learned that November’s headline PPI inflation rate rose 0.3% m/m, higher than the 0.2% expected, and October’s increase was revised up from 0.2% to 0.3%. The good news is that the y/y comparisons showed that the PPI final demand inflation rate peaked at 11.7% during March and fell to 7.4% during November, the lowest since May 2021 (Fig. 10). Of course, that’s still too high, but it is falling at a relatively fast pace. Here is more good news, especially in the latest three-month annualized data:

(1) PPI final demand. While the PPI final demand rose 7.4% y/y during November, the three-month annualized rate was only 3.5% (Fig. 11). Here are the same happy comparisons for PPI final demand goods (9.6%, 4.1%) and PPI final demand services (5.9%, 2.9%).

(2) PPI services. Moderating significantly are trade services (10.9%, 1.2%) and transportation & warehousing services (12.7%, -3.3%) (Fig. 12). The former measures markups. A bit more troublesome are services less transportation & warehousing services (2.7%, 4.6%).

(3) PPI personal consumption. The PPI release includes series related to personal consumption (Fig. 13). They too continue to moderate significantly, as comparing the y/y and three-month annualized rates highlights: total personal consumption (6.7%, 3.8%), personal consumption of goods (11.3%, 7.6%), and personal consumption of services (5.2%, 2.5%).

(4) CPI vs PPI personal consumption. The January 2014 issue of Monthly Labor Review discusses the differences between the PPI personal consumption and CPI measures of consumer prices:

“The scope of the PPI for personal consumption includes all marketable output sold by domestic producers to the personal consumption sector of the economy. The majority of the marketable output sold by domestic producers comes from the private sector; however, government produces some marketable output that is within the PPI’s scope. In contrast to the PPI’s scope, that of the CPI includes goods and services provided by business or government when explicit user charges are assessed and the goods or services are paid for by consumers.

“The most heavily weighted item in the All Items CPI, owners’ equivalent rent, accounts for approximately 24 percent of the overall index. Owners’ equivalent rent is the implicit rent that owner occupants would have to pay if they were renting their homes and is included in the CPI in order to capture the cost of shelter for owner-occupied housing units. The PPI for personal consumption does not include owners’ equivalent rent within its scope, because owners’ equivalent rent is not a domestically produced, marketable output.”

Inflation II: Peaking Wage Inflation? Investors were unsettled on Thursday by November’s wage growth tracker (WGT) released by the Federal Reserve Bank of Atlanta. There was no evidence that WGT is moderating, though it does seem to have peaked. The non-smoothed WGT peaked at a record-high 7.4% during June (Fig. 14). It has been hovering around 6.3%-6.5% for the past five months through November. There are more signs of moderation in average hourly earnings for production and nonsupervisory workers; its reading was 5.8% y/y during November.

November’s WGT showed that job switchers saw their pay rise 8.1%, while job stayers had a 5.5% increase (Fig. 15). This significant differential certainly explains the remarkable turnover in the labor markets, with record and near-record highs in quits, job openings, and hirings over the past year. That’s weighed on productivity, which has also boosted labor costs, fueling the wage-price spiral.

Nevertheless, the spiral may be starting to decelerate. The Bureau of Labor Statistics reported last Wednesday that unit labor costs in the nonfarm business sector increased 2.4% (saar) during Q3, reflecting a 3.2% (!) increase in hourly compensation and a 0.8% increase in productivity. Unit labor costs increased 5.3% y/y during Q3, which suggests that inflationary pressures on the CPI peaked during Q2 (Fig. 16).

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On Industrials, P/Es & Chinese Protestors

December 08 (Thursday)

Industrials: Surprising Strength. Given all the talk of recession, the S&P 500 Industrials stock price index has held up surprisingly well. It has fallen 6.3% ytd through Tuesday’s close, far outpacing the S&P 500’s 17.3% drop over the same period. The sector is benefitting from trends that should be tailwinds even if the economy suffers from a shallow recession. The airline industry continues to rebound from years of depressed travel because of Covid. Defense spending is elevated and may continue to be for many years due to the war in Ukraine and the need to modernize. And finally, restructurings at Boeing and General Electric, two of the largest companies in the sector, may finally be bearing fruit.

Here’s how the Industrials sector’s stock price index has faired compared to the 10 other sectors in the S&P 500 ytd through Tuesday’s close: Energy (53.6%), Utilities (-1.3), Consumer Staples (-2.0), Health Care (-2.8), Industrials (-6.3), Materials (-10.4), Financials (-11.4), S&P 500 (-17.3), Information Technology (-25.6), Real Estate (-26.7), Consumer Discretionary (-33.0), and Communication Services (-37.7) (Fig. 1).

The Industrials sector’s stock price index’s ytd performance has been bolstered by the following industries: Construction & Engineering (30.5%), Agricultural & Farm Machinery (27.8), Aerospace & Defense (13.4), Construction Machinery & Heavy Trucks (11.8), and Environmental & Facilities Services (0.1).

The stock price indexes of all other industries in the sector are in negative territory ytd including: Human Resources & Employment Services (-33.8%), Air Freight & Logistics (-21.4), Building Products (-21.4), Trucking (-17.6), Railroads (-17.0), Electrical Components & Equipment (-15.3), Industrial Machinery (-15.3), Research & Consulting Services (-11.9), Industrial Conglomerates (-9.3), Airlines (-7.6), Diversified Support Services (-5.8), and Trading Companies & Distributors (-5.2) (Fig.2 and Fig.3).

Looking into 2023, the Industrials sector is expected to report the second strongest earnings growth (14.4%) of the 11 S&P 500 sectors. The sector’s growth is bolstered by the Airlines industry, which is expected to report the strongest earnings growth in the Industrials sector, 94.6%, as it continues to rebound from a loss in 2021. Otherwise, the Aerospace & Defense (45.6%), Agricultural & Farm Machinery (19.5), and Industrial Conglomerates (17.1) industries are expected to post the strongest earnings growth next year.

Here’s the 2023 earnings growth forecast for the other Industrials industries: Construction & Engineering (10.9%), Construction Machinery & Heavy Trucks (8.8), Building Products (8.2), Trading Companies & Distributors (7.7), Diversified Support Services (7.3), Environmental & Facilities Services (6.6), Research & Consulting Services (6.6), Industrial Machinery (4.2), Railroads (2.1), Air Freight & Logistics (-2.4), Trucking (-2.5), Electrical Components & Equipment (-3.0), and Human Resources & Employment Services (-11.3).

Let’s take a deeper look at what’s driving the strong earnings growth in the Aerospace & Defense industry and the Industrial Conglomerates industry next year.

(1) War: Bad for humans, good for defense contractors. The Ukraine war has depleted US and NATO ammunitions and reinforced the importance of a strong, technologically advanced military. But replacing those munitions and modernizing the military will take time and should benefit contractors’ bottom lines for many years.

Contractors complain the Defense Department has been slow to issue new contracts, but new contracts have started to dribble out. The Pentagon recently awarded $3.9 billion of new contracts to equip Ukraine, replenish US stocks of weapons, and backfill those supplied by allies. Many of those purchases will occur over the next several years, rather than in the short term, an October 29 WSJ article reported.

And earlier this week the Army awarded a contract for its next-generation helicopter to Textron’s Bell division, sending the company’s shares up 5.3% on Tuesday while the S&P 500 dropped 1.4%. The aircraft will replace Sikorsky’s Black Hawk helicopter, which is currently in use. The initial award was for $232 million, but it’s expected to be worth around $70 billion as the newest helicopter is produced over many decades, a December 5 Reuters article reported. Textron beat out Lockheed Martin’s Sikorsky division and Boeing.

Contractors have had difficulties finding workers and supplies, but this too could elongate the industry’s upward earnings cycle. For example, Lockheed Martin and Raytheon Technologies jointly produce the Javelin antitank missiles being used in Ukraine. They expect it will take two years to double output from the current rate of 400 a month, a December 6 WSJ article reported. Analysts expect Lockheed’s earnings to increase from $22.52 a share in 2022 to $27.21 in 2023 and $28.38 in 2024. At Raytheon earnings are expected to grow from $4.76 a share in 2022 to $5.13 next year and $6.13 in 2024.

(2) Boeing: Course correcting. Boeing’s travails with the 737 Max and its defense business cut its stock in half from 2018 levels. But the company believes it has fixed the problems plaguing the Max just as travelers are packing airports and global airline profitability is expected to return next year, according to International Air Transport Association data quoted in a December 6 Reuters article.

Airlines have picked up the pace of plane orders. United Airlines is reportedly close to buying dozens of Boeing 787 Dreamliners, a December 2 WSJ article reported. And Boeing anticipates delivering 450 737s next year up from 375 this year, a November 2 WSJ article reported. Boeing executives recently said they expect $100 billion of annual sales by 2025 or 2026 and expect to restart the company’s dividend as soon as 2026, a November 2 WSJ article reported. Southwest Airlines announced on Wednesday it also plans to reinstate its dividend, making it the first major carrier to do so. Boeing shares, which hit a low of $115.86 in June, took off over the last two months, closing at $178.43 Tuesday.

The S&P Aerospace & Defense industry is expected to grow revenue by 2.7% this year and 8.7% in 2023 (Fig.4). The industry’s earnings are expected to improve even more with earnings growing 8.2% this year and 45.6% in 2023 (Fig.5). Boeing’s turnaround certainly helps the industry. The company is forecast to lose $7.84 a share this year but earn $3.61 a share in 2023. The industry does sport a lofty valuation. At 22.1, the Aerospace and Defense industry’s forward P/E is at historically high levels (Fig.6).

(3) Splitsville. A member of the S&P 500 Conglomerates industry, General Electric shares have fallen by more than half since 2016. The storied manufacturer was plagued by its exposure to the aviation industry—it sells engines and parts—during the Covid shutdown. More recently its renewable energy business, which makes turbines for power plants and wind turbines, has come under pressure because of inflation, lower demand, and higher warranty pressure.

But GE is on the cusp of splitting into three companies, individually focused on aviation, power generation or health care. Shares rose 0.7% on Tuesday, while the S&P 500 declined 1.4% after an Oppenheimer analyst upgraded the stock’s rating to Buy with a price target of $104 because he believes the sum of GE’s three units will be worth more individually after the spinoffs, than they are worth together today.

General Electric has the second largest market capitalization of the companies in the S&P 500 Industrial Conglomerates industry. The industry, which also includes Honeywell International, 3M, and Roper Technologies, is expected to have little revenue growth this year, 0.8%, with modestly better results in 2023, 4.3% (Fig.7). Meanwhile, earnings are expected to grow 7.3% this year and surge 17.1% in 2023 (Fig.8). The forward P/E for the Industrial Conglomerates industry, at 18.6, is closer to its historical lows (Fig.9).

Strategy: P/Es Change With The Times. With the S&P 500 down 17.3% ytd through Tuesday’s close, it makes sense that the index’s forward P/E would contract to 17.9 from 20.5 one year ago. The forward P/Es for most of the S&P 500 sectors shrank, with the exception of the Consumer Staples, Health Care, Materials, and Utilities sectors, which saw their forward P/Es expand as investors flocked to “safe” havens during market selloffs.

Here are the S&P 500 sectors and their forward P/Es as of December 1 and a year prior: Real Estate (36.1, 48.0), Consumer Discretionary (23.3, 30.8), Information Technology (21.8, 26.9), Consumer Staples (21.5, 19.9), Utilities (19.0, 18.9), Industrials (18.7, 19.4), S&P 500 (17.9, 20.5), Health Care (17.7, 16.2), Materials (16.9, 15.9), Communications Services (15.3, 19.8), Financials (12.9, 14.1), and Energy (9.7, 10.5) (Table 1).

Let’s take a look at how forward P/Es have changed for the S&P 500’s industries, excluding REITS. First, we teased out industries with forward P/Es that dropped by roughly five points over the past year. Here’s what we discovered:

(1) Shrinking tech multiples. A number of technology-related industries that went into the market’s correction with lofty P/Es have much lower multiples today. The list includes Internet & Direct Marketing Retail, home of Amazon, which now has a forward P/E of 50.8, down 10.0 points from last year. Others include: Application Software (28.0, 47.7), Systems Software (24.2, 32.8), Internet Services & Infrastructure (21.6, 26.1), Electronic Equipment & Instruments (20.3, 27.4), Semiconductors (19.5, 24.2), Interactive Media & Services (18.3, 24.3), and Technology Distributors (18.1, 21.7).

(2) Growing earnings. Some industries’ forward P/Es shrank because their earnings are expected to grow sharply as they continue to recover from the impact of Covid. This applies to Movies & Entertainment (27.2, 38.8), Hotels (18.3, 27.2), and Airlines (9.1, 16.5).

(3) Consumer related names too. A number of industries catering to consumers saw their forward P/Es decline over the past year: Personal Products (38.0, 40.7), Footwear (31.9, 39.2), Automobile Manufacturers (20.7, 43.3), Home Improvement Retail (17.7, 22.8), Consumer Electronics (17.3, 21.4), Auto Parts & Equipment (15.7, 22.4), and Leisure Products (12.0, 18.0).

(4) A few P/Es increased. A surprising number of industries saw their forward P/Es increase over the past year. But P/E increases were much smaller than the decreases experienced by the industries with shrinking P/Es. A number of industries in the defensive Consumer Staples sector boast higher P/Es today than they did a year ago: Soft Drinks (25.5, 22.9), Household Products (24.6, 23.4), Packaged Foods (19.1, 16.4), Agricultural Products (14.6, 13.0), Brewers (13.4, 10.6), and Tobacco (13.4, 11.3).

Another defensive sector, Health Care, also contains many industries with forward P/Es that grew over the course of the year including: Managed Health Care (19.7, 18.2), Biotechnology (15.8, 10.5), Pharmaceuticals (14.9, 13.0), Health Care Distributors (14.6, 9.9), Health Care Facilities (13.0, 11.7), and Health Care Services (12.5, 10.9).

Some industries forward P/Es jumped because their earnings declined. Industries falling into this unfortunate category include Publishing (25.3, 22.4), Copper (23.3, 10.6), Steel (11.8, 6.4), and Commodity Chemicals (10.4, 6.9).

A lucky few had earnings that improved and their forward P/Es increased as well. The fortunate group includes Aerospace & Defense (22.1, 17.3), Property & Casualty Insurance (14.6, 13.4), Life & Health Insurance (10.1, 8.4), Apparel Retail (23.1, 19.4), and Interactive Home Entertainment (18.2, 16.8).

Disruptive Technologies: Chinese Tech Tussle. Chinese protests against a range of government policies and actions in recent weeks highlight how modern technology is a double edged sword for activists. In some situations, technology is helping protesters by making communication harder for the state to control. In others, it’s helping the government to identify and halt protestors’ efforts. Let’s take a look at this serious game of cat and mouse:

(1) The all-powerful cell phone. As much as the Chinese government would like to project only positive images of the country, videos taken and sent by cell phones have given the world a glimpse into what’s actually happening there. Censors struggled to remove the surge of posts about the protests that went viral on China’s social media sites WeChat, Weibo, TikTok, and Kuaishou, a November 28 article in Australia’s ABC News reported. In other cases, tech-savvy activists have used private networks to send videos to platforms outside of China, according to a November 29 Reuters article.

(2) Telegraphed by Telegram. One messaging service Chinese protestors use is Dubai-based Telegram, founded in 2013. While not popular in the US, the service is growing quickly internationally and has more than 700 million monthly users who can communicate directly to each other or within groups of up to 200,000 people.

The company’s stated goal isn’t to make profits but to offer private conversations free from snooping third parties. It promises not to share users’ personal data with advertisers or anyone else, and person-to-person communication is encrypted. The platform makes no judgement on who is communicating for good or for ill purposes. As a result, Telegram reportedly has carried messages from Chinese protestors and terrorists alike. It has become a hub for distributing pirated movies and music.

That said, the company’s guarantees of user privacy aren’t bulletproof. Telegram recently was forced by the Delhi High Court in India to disclose the name, phone number, and IP address of one of its channel’s administrators accused of copyright infringement, a November 30 TechCrunch article reported.

Here’s how Telegram works: It stores chat data in multiple data centers around the globe that are controlled by different legal entities across different jurisdictions. Its decryption keys are “split into parts and are never kept in the same place as the data they protect. As a result, several court orders from different jurisdictions are required to force us to give up any data,” the company’s website explains. The service also offers self-destructing messages that can’t be forwarded and can be opened only by the intended party (though recipients are able to take and forward screenshots of messages).

Wired’s February 8, 2022 article about Telegram’s beginnings and its tight band of employees is worth a read.

(3) Tech helps the police. There are reports that police in Beijing are randomly taking people’s cell phones and looking through them to see if the owners were involved in the protests. Police look for virtual private networks or the Telegram app on the phones. After this news broke, Chinese citizens reportedly scrambled to delete any texts, videos, and other evidence of participation in protests.

Authorities reportedly use cell phone location data to track down protestors. One Beijing university student was informed by his school that the police had used mobile phone data to track his movements to a protest site and was requesting a written explanation of why he was there, a November 29 WSJ article reported.

Technology also is used by the government to control the public narrative. Chinese government-controlled broadcasters avoided showing the crowds attending the World Cup soccer tournament because many attendees weren’t wearing masks. And nationalist bloggers have been posting claims that recent anti-Covid lockdown protests were fomented by “foreign forces,” a November 29 Reuters article reported.

(4) Harry’s invisible cloak? Chinese graduate students invented the InvisDefense coat, which prevents security cameras from determining whether the person wearing it is a human or an inanimate object. The coat is covered in patterns that blind security cameras during the day, and it sends out unusual heat signals at night. The coat reduces the accuracy of pedestrian detection by 57%, and its accuracy could improve in the future, a December 5 South China Morning Post article stated.

The coat and its technology could be used to help improve cameras, artificial intelligence programs, and facial recognition programs, said the Wuhan University professor who oversaw the project. “InvisDefense might also be used in anti-drone combat or human-machine confrontation on the battlefield.” Bet that never occurred to J.K. Rowling!

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On Bonds & Europe

December 07 (Wednesday)

US Bonds: Supply & Demand. Once again, we are learning that supply and demand aren’t as important in determining the bond yield as are inflation and the anticipated reaction of the Fed to the inflation problem. In other words, the bond yield is mostly determined by the shape of the yield curve. It tends to rise when the yield curve is upward sloping and the Fed is raising the federal funds rate. This scenario suggests that investors aren’t convinced that the Fed has tightened enough to bring inflation down. Once they are convinced of that, the yield curve starts to flatten and then inverts. At that point, investors believe that the Fed’s monetary policy tightening cycle is almost over because short-term rates are probably high enough to bring inflation down by slowing the economy or pushing it into a recession.

Let’s review the latest supply and demand developments in the bond market:

(1) The federal deficit. The US federal budget deficit remains large at $1.3 trillion over the past 12 months through October (Fig. 1). However, that’s a significant improvement from the comparable record high of $4.1 trillion through March 2021, when federal government spending on pandemic relief was soaring. The 12-month sum of government outlays soared from $4.6 trillion in February 2020 to a record high of $7.6 trillion through March 2021 (Fig. 2). It was down to $6.2 trillion through October.

Another important development since the start of the pandemic is that federal government receipts soared, especially over the past year as inflation boosted incomes and thus inflated taxes owed by individuals and businesses. Over the 12 months through October, receipts rose to a record $4.9 trillion, up from $3.5 trillion through February 2020.

While inflation has been boosting tax revenues, the resulting increase in interest rates is causing net interest paid by the federal government to soar. Over the past 12 months through October, it rose to a record $488.2 billion, up from $383.7 billion through February 2020 (Fig. 3). We calculate that the federal government is currently paying an average effective rate of 2.0% on the debt (Fig. 4). If that rate rises to 3.0%, the government’s net interest bill would rise over $700 billion.

(2) The Fed’s QT2. Meanwhile, the Fed has implemented QT2. The Fed’s holdings of securities peaked at a record $8.5 trillion during the May 18 week. It was down by $309 billion through the November 30 week (Fig. 5). Over that same period, the Fed’s holdings of US Treasuries fell $235 billion, while mortgage-backed securities fell $74 billion (Fig. 6 and Fig. 7).

Arguably, the jump in the 10-year Treasury bond from 1.63% at the start of this year to a peak of 4.25% on October 24 was exacerbated by the anticipation and implementation of QT2 (Fig. 8). The same can be said for the 30-year mortgage rate, as evidenced by the doubling of the spread between the mortgage yield and the 10-year Treasury yield (Fig. 9 and Fig. 10).

(3) Commercial banks. QT2 has weighed on commercial bank deposits since the summer (Fig. 11). Meanwhile, commercial bank loan demand rose $1.1 trillion ytd through the November 23 week to a record high. To fund these loans, the banks sold $346 billion in their securities holdings from the February 23 week through the November 23 week.

(4) Bond funds. Also selling bonds have been bond mutual funds and ETFs. On a 12-month basis, their net collective sales totaled $136.1 billion through October (Fig. 12). That’s not much, but keep in mind that’s down from a record high of $1.0 trillion through April 2021!

(5) Foreign investors. The outflows from all the domestic accounts reviewed above have been largely offset by massive net foreign capital inflows into the US bond market. The Treasury International Capital data posted September data for net capital inflows (Fig. 13). Over the past 12 months through September, private inflows jumped to a record $1.7 trillion. Foreigners' net purchases of US bonds soared to a record $1.1 trillion. Meanwhile, foreign investors sold $265.5 billion in US equities over the 12-month period through September. For contrarians, this is a bullish signal since foreigners tend to get in (out) at stock market tops (bottoms) in the US.

We believe that global investors continue to view the US as a safe haven for their investments in a world that has been going quite mad. Their mantra is “TINAC” (there is no alternative country!).

European Economy I: Gas Relief? More frightening than a forthcoming economic recession for many Europeans is the prospect of being left in the dark and cold should the war-provoked energy crisis worsen. Europeans are prepping by taking courses on what to do in the event that “nothing works” anymore, wrote Reuters on November 11.

So far, the lights are still on in Europe. An unseasonably warm autumn has allowed the region to preserve more energy than usual; storage is currently 95% full, reported the November 24 The Economist. Soothing financial markets, natural gas prices also have fallen from the summer.

The Economist article was part of a cover feature warning that the worst is yet to come in Europe’s energy crisis. As we have noted in the past, cover stories tend to be contrary indicators because by the time journalists have done the work to devote a cover story to a trend, investors have already moved past it. So European investors likely have discounted the worst already, notwithstanding Monday’s negative developments.

Here's what happened on Monday and our take on the current situation:

(1) Ban and cap show. Starting on Monday, December 5, EU member states have banned seaborne imports of Russian crude and prohibited EU companies from financing or insuring Russian oil shipments to third countries. That same day, a separate price cap from the Group of Seven, EU, and Australia took effect, aiming to reduce Russia’s profits from energy sales. (The 27-member bloc also said a ban on imports of refined petroleum products will be enforced starting February 5.)

While that sounds dramatic, the $60-per-barrel price cap is close to where Russian oil was already trading. So it won’t do much to reduce Russian revenues from oil sales in the short run, observed the Financial Times editorial board on Monday. It’s also notable that the December 5 ban does not include Russian oil imported into the EU by way of pipelines.

Nevertheless, if Russia refuses to sell oil subject to a cap, as it says it will, the energy market could be disrupted by skyrocketing prices—unless OPEC+ mitigates the effects by increasing production. Already, Russia has shifted much of its oil exports to other buyers such as China and India who are not likely to adopt the EU-G7 policy. Russian oil in Asian markets was selling well above the price cap on Monday.

Importantly, not all—or even most—of Europe’s oil imports are at stake. Last month, Russian crude oil exports to Europe remained steady, reported the Paris-based International Energy Association (IEA) according to the November 15 WSJ. Russia’s total oil exports rose by 165,000 barrels a day in October to 7.7 million barrels a day. Russian exports to the EU were 1.5 million barrels a day (mbd). With the energy ban in effect, about 1.1mbd would be halted, said the IEA.

(2) Sourcing from other sources. The Economist noted that Russia used to provide 40%-50% of the EU’s imports of gas, but now provides only 15% as Russia abruptly cut off supplies over the summer. Until now, Europe has been able to replace its energy stores with fuel from other suppliers, including the US. Infrastructure in Germany to import liquified natural gas has been built and will start operating in January. And other European pipelines have opened.

Long term, the hope is that climate-friendly strategies will reduce both Europe’s reliance on oil and gas and its consumption of fossil fuels broadly; but they won’t be operational anytime soon. For now, Europe is sourcing gas just fine without them. In an interview yesterday, the European Central Bank’s (ECB) Philip Lane said: “I do think there’s a very difficult period to come, but also a faster transition to a more sustainable economy.”

(3) Europe’s great energy sucking sound. Our hunch is that it might not be Europe that suffers the brunt of the energy crisis caused by the war. While European households and businesses can expect to make sacrifices—energy rationing, high energy prices, inability to use plants’ full capacity—they won’t literally be left in the dark and cold this winter. Europe has been hoarding enough energy to sustain itself out of a major crisis.

The trouble is that hoarding in Europe is creating a shortage of natural gas in developing economies. That’s where it could get dark.

Europe II: Recession Relief? Many of Europe’s economic indicators suggest that the region soon could tip into a recession. A contraction in real GDP for at least a couple of consecutive quarters isn’t hard to envision after ever-so-slightly-positive growth for the past few quarters.

Energy prices are likely to rise with the western pressure on Russian oil. Broadly, prices already have been squeezing consumers. Retailers may find consumer demand dwindling as consumers use up their stores of savings and fiscal handouts built up during the pandemic. And manufacturers could start to see demand decline as a post-pandemic order backlog evaporates, especially for automakers.

Fueling inflation, fiscal policymakers have aimed to rescue their political bases with energy subsidies and public handouts. To curb these effects, European Central Bank (ECB) monetary policymakers are aggressively raising interest rates (Fig. 14).

Recently, we’ve begun to believe that a European recession next year is more likely than not. The ECB’s hawkishness is testing Europe’s economic resilience. But any recession could be short lived. Even the ECB expects economic conditions to normalize by 2024. Just yesterday, the ECB’s Philip Lane said in his interview: “Our current thinking is that if there is a recession it will be relatively mild and relatively short-lived.”

Previously, we wrote that the lifting of Europe’s Covid restrictions could offset some of the Ukraine war’s negative economic impacts. Indeed, economic data have not been overly worrisome (except for inflation data). Belying alarmist media headlines, analysts’ estimates for Eurozone revenues and earnings remain upbeat. European stocks have taken such a beating since February that overweighting them over the long term, or at least holding onto current positions, might be prudent.

Here’s a look at the latest economic indicators, which have worsened but still aren’t too bad:

(1) Growth. Eurozone real GDP expanded a mere 0.7% q/q on a seasonally adjusted basis during Q3, slightly lower than in Q2 but higher than the war strained Q1 growth rate of 0.4%, the slowest in a year. On an annual basis, growth managed to stay above 2.0% y/y, driven especially by strong household spending (up 4.2% y/y) (Fig. 15). The household lift could dissipate soon if high inflation persists and savings fall, but the strong job market could offset any savings shortfall.

(2) Inflation. Inflation is expected to remain very high in the coming months because of the energy crisis. Presumably, however, inflationary pressures should ease over the longer term as the war-related, energy-related, and supply-chain challenges abate. Eurozone CPI soared 10.6% y/y during October, surpassing the previous several months’ record highs (Fig. 16). Excluding energy, food, alcohol, and tobacco, the CPI also advanced at a record pace, of 5.0%. (Flash estimates for November predict a slowing in the headline rate to 10.0%, with core rate holding at 5.0%.)

(3) Unemployment. Unemployment in the Eurozone, now at 6.5%, has dropped well below even pre-pandemic levels (it was 7.2% when the pandemic began in March 2020) (Fig. 17). Europe’s labor market never took a dramatic hit during the pandemic largely because job-retention schemes maintained worker-employer bonds. The labor market remains exceptionally strong considering Europe’s challenges.

(4) Industrial production. Europe’s industrial production data for September was strong, indicating a full recovery from the pandemic and no sign of struggle from the war (Fig. 18). However, this series might take a breather once the sanctions on Russian energy kick in. German manufacturing orders—a leading indicator for production—are falling too. Industrial companies are likely to suffer the most from further energy conservation efforts, as they are subject to energy curbs before households and small businesses.

(5) German orders & auto production. Incoming orders for manufacturers in Germany, the EU’s largest economy, fell during September for the second consecutive month, but ticked up slightly during October (Fig. 19). Yet German automakers so far this year have remained surprisingly healthy (Fig. 20). That’s mainly because they still have a backlog of orders from the post-pandemic supply-chain pileup. Automakers could be in for a rougher road ahead as gas prices rise and as the US Inflation Reduction Act subsidizes US energy-efficient automakers, denting demand for European ones.

(6) Economic sentiment. Economic sentiment in Europe dove in October, dropping below its long-term average (Fig. 21). It edged up in November. And it isn’t as depressed as during the pandemic—at 93.7 now on the European Economic Sentiment Indicator (ESI) versus 60.9 at the April 2020 record low. However, Europeans clearly are not very optimistic. That’s especially true of European consumers: The consumer index weighting on the ESI fell significantly in recent months but has recently turned upward (Fig. 22).

(7) Retail sales. Retail sales have held up since recovering from the pandemic (Fig. 23). Main Street European retailers are discounting their products to boost sales amid a discretionary income squeeze for European consumers. Luxury retailers are successfully raising prices by tacking on energy and logistics surcharges. But how long these supportive tactics will remain feasible is questionable.

(8) Stock prices & valuation. The Europe MSCI Index was down 11.1% from January’s post-pandemic high when the Ukraine war began on February 24. The index recovered somewhat before bottoming at a 22.4% bear-market low on September 29 (Fig. 24). The index has bounced back some, reflecting improved energy prospects for Europe since this summer.

But our Blue Angels Implied Price Index shows that European valuations still are quite attractive (Fig. 25). Analysts have been raising their earnings expectations despite all the bad headlines (Fig. 26).

(9) Caution & silver linings. A word of caution: There’s always a possibility that the worst is yet to come. “Only a few degrees Celsius, or a few windless days, are what separate Europe facing blackouts from having enough power to make it through the winter,” wrote a self-proclaimed pessimistic Washington Post report.

Investors should also be mindful of a couple of global issues unrelated to the Ukraine war.

For example, US subsidies for cars, clean energy, and semiconductors outlined in President Joe Biden’s Inflation Reduction Act could threaten demand for these industries in Europe. But Europe could mitigate the effects by introducing subsidies of its own.

Another example is China’s ongoing national response to Covid and the lockdown protests within its borders. Further Covid lockdowns there could further strain supply chains, and China is an important trading partner to Europe. But China already seems to be softening its Covid stance amid the protests.

For now, we are looking on the bright side.

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Earnings Matters

December 06 (Tuesday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. Replays are available here.

Strategy I: Forward Earnings Have Stopped Falling for Now. The Q3 earnings reporting season caused industry analysts as a group to cut their earnings estimates for S&P 500 companies for Q4-2022 and each of next year’s quarters (Fig. 1 and Fig. 2). Now that the earnings season is over, their estimates for these five quarters have stabilized over the past three weeks. So have their consensus S&P 500 operating earnings estimates for 2023 and 2024 (Fig. 3). During the December 1 week, the former was $231.25, while the latter was $253.55. Likewise, S&P 500 forward earnings—which is the time-weighted average of the consensus estimates for this year and next year—has stopped falling over the past three weeks and is currently $230.41.

That’s the most recent good news. The question is whether analysts will resume cutting their estimates early next year during the Q4-2022 earnings reporting season. The answer will largely depend on the economy, of course. Nominal and inflation-adjusted forward earnings follow the business cycle closely (Fig. 4). They track both the Index of Coincident Economic Indicators and the Index of leading Economic Indicators (Fig. 5 and Fig. 6). The former rose to a record high during October, while the latter fell 3.8% over the past eight months, from its February record high through October.

As we look ahead to 2023, Debbie and I remain in the soft-landing camp, which would be consistent with forward earnings continuing to move sideways through the first half of next year. While it is widely feared that a recession might occur during the second half of next year (when consumers deplete their excess savings), we expect that economic growth will be recovering by then.

Strategy II: Purchasing Managers & Earnings. Among the timeliest economic indicators are the M-PMI and NM-PMI compiled by the Institute for Supply Management. They are highly correlated with the growth rates of S&P 500 revenues and earnings. November’s data show that manufacturing is relatively weak but still expanding, while nonmanufacturing remains strong. This is the latest confirmation that consumers have been pivoting from spending heavily on goods to buying more services. Consider the following:

(1) M-PMI. The US manufacturing sector contracted in November, as the M-PMI registered 49.0%, 1.2 percentage points below the reading of 50.2% recorded in October (Fig. 7). A M-PMI above 48.7% over a period of time generally indicates an expansion of the overall economy. Therefore, the November M-PMI indicates the overall economy grew in November for the 30th consecutive month following contractions in April and May 2020.

(2) NM-PMI. In November, the M-PMI registered 56.5%, a 2.1-percentage point increase compared to the October reading of 54.4% (Fig. 8). The 12-month average is 57.2%, reflecting consistently strong growth in the services sector, which has expanded for 30 consecutive months. A reading above 50.0% indicates the services sector economy is generally expanding; below 50.0% indicates it is generally contracting. The survey’s production index jumped by 9 percentage points to 64.7, the highest since last December.

(3) Prices. The M-PMI’s prices-paid index registered 43.0%, down 3.6 percentage points compared to the October figure of 46.6%; this is the index’s lowest reading since May 2020 (40.8%). While inflationary pressures are abating in manufacturing, they remain persistent in non-manufacturing. Prices paid by services organizations for materials and services increased in November for the 66th consecutive month, with the prices-paid index registering 70.0%, 0.7 percentage point lower than the 70.7% recorded in October. It was the fifth consecutive reading near or below 70% following nine straight months of readings above 80%.

The M-PMI and NM-PMI prices-paid indexes suggest that inflationary pressures have peaked (Fig. 9 and Fig. 10). However, this is more clearly the case in the former than the latter.

(4) Revenues & earnings. The M-PMI is highly correlated with the y/y growth rate in S&P 500 operating earnings on a quarterly basis (Fig. 11). So the recent drop in the M-PMI below 50.0% suggests that earnings growth turned negative during Q4.

On the other hand, the NM-PMI suggests that S&P 500 earnings growth might have remained slightly positive during Q4 (Fig. 12).

Strategy III: LargeCaps vs SMidCaps. Often during past periods of tightening monetary policy, stocks with large market capitalizations tended to outperform those with small market caps. That’s because tougher credit conditions would cause recessions, which were tougher on small companies than large ones.

On the other hand, speculative excesses drove the relative outperformance of the S&P 500 LargeCaps relative to the SMidCaps (a.k.a. the S&P 400 MidCaps and the S&P 600 SmallCaps) in the late 1990s and during the pandemic. When those bubbles popped, the former index underperformed the latter. In other words, there isn’t any simple rule of thumb to judge when to overweight/underweight LargeCaps relative to SMidCaps.

This year sure has been a wild one in this regard. The sharp increase in interest rates increased the prospects of a recession, favoring the LargeCaps over SMidCaps. But the former stocks were overvalued and were hit hardest when rising interest rates weighed on their valuation multiples. In addition, tight monetary policy caused the dollar to soar, which has weighed more on the earnings of LargeCaps than SMidCaps.

Let’s have a look at the latest developments:

(1) S&P 500 equal-weighted vs market-cap-weighted. So far this year through Friday, the S&P 500 equal-weighted index is down 8.6% compared to a decline of 14.6% for the market-cap weighted index (Fig. 13). The ratio of the two is the highest since June 2019 (Fig. 14). Early in bull markets, this ratio continues to advance, sometimes to new highs.

(2) S&P 500/400/600. Also slightly outperforming so far this year are the S&P 400 MidCaps and the S&P 600 SmallCaps (Fig. 15 and Fig.16). They are down 9.4% and 11.2% ytd through Friday versus down 14.6% for the S&P 500 LargeCaps.

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Don’t Stop Thinking About Tomorrow

December 05 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webcast on Mondays at 11 a.m. EST. You will receive an email with the link to join in one hour before showtime. Replays of the Monday webcasts are available here.

Strategy I: Thinking About Yesterday. British rock and roll musician Christine McVie died last Wednesday at the age of 79. McVie wrote many hit songs, played the keyboard, and sang as a member of the group Fleetwood Mac. Their 1977 hit song “Don’t Stop” is a refreshing ode to optimism: “Don’t stop thinking about tomorrow / Don’t stop, it’ll soon be here / It’ll be, better than before / Yesterday’s gone, yesterday’s gone.”

During 2022, there certainly has been more pessimism than optimism in the financial markets. Consider the following:

(1) The S&P 500 fell into a bear market from January 3 through October 12. It fell 25.4% over that 282-day span (Fig. 1). The drop was led by a 30% drop in the forward P/E of the S&P 500 over that period (Fig. 2).

(2) Joe and I did our best to remain relatively optimistic. At the beginning of the year, we expected a correction, not a bear market. In fact, the S&P 500 was in bear-market territory (with a decline of 20% or more) for only 45 of the bear market’s 282 calendar days. It was a relatively short bear market (assuming that it ended on October 12, as we do). The average length of the 21 bear markets prior to this one since September 7, 1929, was 344 days; it was 367 days counting just the 12 post-WWII bear markets. (See our Stock Market Historical Tables: Bull & Bear Markets.)

(3) Nevertheless, pessimism matched the extremes of the 517-day bear market that slashed the S&P 500 by 56.8% between October 9, 2007 and March 9, 2009. We could see that in Investors Intelligence’s Bull/Bear Ratio (BBR). Early in the latest bear market, the BBR fell to 0.60 during the week of June 21. It briefly rebounded during the summer but fell to a new bear-market low of 0.57 during the October 11 week (Fig. 3). The BBR bottomed at 0.41 during the bear market of the Great Financial Crisis (GFC) during the week of October 21, 2008. Earlier this year along the way, we observed that BBR readings of 1.00 or less have offered great opportunities for long-term investors (Fig. 4).

(4) We did jump the gun a little bit when we declared that the S&P 500 might have bottomed on June 16 at 3666. (We clearly have a hang-up with the DaVinci Code!) But then we did conclude that a retest of that low might be ahead when the S&P 500 failed to rise above its 200-day moving average on August 16 (Fig. 5). Fed Chair Jerome Powell’s uber-hawkish Jackson Hole speech on August 26 did the trick, sending the stock prices reeling to a new low on the S&P 500 of 3577.03 on October 12. But the S&P 500 was back above 3666 by October 21 and is now up 13.8% from the October 12 low, but still down 15.1% from the January 3 high.

(5) From a more fundamental perspective, the most perceptive mantra for investors to chant earlier this year was: “Don’t fight the Fed when the Fed is fighting inflation.” It was hard to be bullish when the Fed pivoted from years of ultra-easy monetary policies that started as unconventional ones but turned all too conventional, especially after the pandemic hit. But the dramatic rebound in inflation forced the Fed to reverse course rapidly and implement the most restrictive monetary policy stance since the late 1970s, when inflation was also raging.

Fears of a recession proliferated rapidly. Along the way, Melissa and I argued that the terminal federal funds rate might not soar the way it did during that previous inflationary period. We observed that QT2 and the strong dollar (attributable to the Fed’s hawkish pivot) were together equivalent to at least a 100bps increase in the federal funds rate. So we are pleased to see that the 2-year Treasury note yield as well as the inversion of the yield curve both suggest that the terminal federal funds rate is near (Fig. 6 and Fig. 7).

In the past, inverted yield curves accurately predicted that monetary tightening policies would soon cause a financial crisis that would turn into a widespread credit crunch, causing a recession. This time may be different, since the financial system is much sounder now following the GFC. There certainly have been meltdowns in cryptocurrencies, private equity, and the ARK, meme, and SPAC stocks. But none of these developments has turned into a widespread credit crisis. So this time, the inverted yield curve may be signaling that inflation has likely peaked and will continue to moderate.

(6) Debbie and I predicted that inflation would likely peak during the first half of this year, led by a drop in the inflation rate for durable goods, while the services inflation rate would remain troublesome—but not troublesome enough to stop the headline PCED inflation rate from falling. We’ve been predicting that it would drop from 6%-7% during the first half of this year to 4%-5% during the second half to 3%-4% next year (Fig. 8). So far this year, it fell from a peak of 7.0% y/y in June of this year to 6.0% in October.

(7) Last, but not least, Debbie and I have been in the soft-landing camp since the start of this year. We’ve observed that consumers still have plenty of excess saving to bolster their purchasing power, which largely has been eroded by inflation over the past year (Fig. 9). That excess saving might be gone by the second half of next year, but rising wages should continue to boost consumers’ purchasing power. Indeed, September and October data suggest that wages may be starting to outpace prices already (Fig. 10).

So far so good, but 2022 is almost gone. It’s time to think more about tomorrow.

Strategy II: Thinking About Tomorrow. Earlier this year, when the forward P/E of the S&P 500 was taking a dive from its January 3 high of 20.5, Joe and I predicted that it would probably find support at its historical average of 15.0. It subsequently fell to 15.1 on October 12. On Friday, it was back up to 17.7. We reckoned that 15.0 would hold in a soft-landing scenario. In a hard-landing scenario, the multiple would more likely fall below 10.0 at the same time as analysts scramble to slash their estimates for revenues, profit margins, and earnings.

In fact, all three of these S&P 500 metrics have been eroding in recent weeks, according to their weekly forward series through the November 24 week (Fig. 11). Forward revenues peaked at a record during the October 13 week and is down 1.0% since then; forward earnings peaked at a record during the June 23 week and is down 4.1% since then; the forward profit margin is down from a record 13.4% during the June 9 week to 12.7% currently. (FYI: Forward revenues and forward earnings are the time-weighted averages of analysts’ consensus revenues and operating earnings estimates for this year and next. We use them to derive the forward P/E and forward profit margin.)

In other words, the rebound in the forward P/E in recent weeks has been partly attributable to a small decline in forward earnings! Of course, the drops in the 2-year Treasury note yield and the 10-year Treasury bond yield also have boosted the forward P/E (Fig. 12).

On a related note, Joe constructed a diffusion index showing the percent of S&P 500 companies with positive three-month percent changes in forward earnings (Fig. 13). It plunged from around 80.0% at the start of this year to 49.3% during the December 2 week. The good news is that it tends to bottom near the end of bear markets and should be doing so now if a soft landing is the outlook rather than a hard landing.

Now let’s review some of the latest economic indicators that are relevant to thinking more about tomorrow from a macroeconomic perspective:

(1) Inflation. There was good news on Thursday of last week, when the Bureau of Economic Analysis reported that October’s headline and core PCED inflation rates were 0.3% and 0.2%, slightly less than expected. November’s M-PMI prices-received index was off 3.6 points to 43.0%, indicating that inflation is abating in the manufacturing sector (Fig. 14).

There was bad wage inflation news on Friday when the Bureau of Labor Statistics reported a higher-than-expected reading of 0.6% m/m for November’s average hourly earnings (AHE) for all private payrolls. It was up 5.1% y/y, and the three-month annualized increase was 5.7% (Fig. 15).

(2) Growth. The Atlanta Fed’s GDPNow tracking model currently projects that real GDP will rise 2.8% (saar) during Q4, down from 4.0%. November’s overall M-PMI reading was 49.0%. That’s still in expansion territory but the lowest since May 2020, when lockdowns depressed the economy.

October’s personal income jumped 0.7% m/m, and spending rose 0.8%. Both outpaced inflation. Nevertheless, the GDPNow model revised its Q4 forecast for real consumer spending growth down to 3.2% from 4.8%. That is still strong.

The GDPNow estimate for residential construction was cut from -18.5% to -21.3%. Spending on nonresidential structures was slashed from 0.8% to -4.9%.

It all adds up to a soft landing, which on balance remains bullish for bonds and stocks, in our opinion.

(3) Employment. November’s payroll employment report, released on Friday, also showed another big gain of 263,000 to yet another record high in addition to the solid increase in AHE. However, the average workweek fell by 0.3% m/m. As a result, our Earned Income Proxy for private wages and salaries in personal income rose 0.4% m/m and 7.7% y/y during November (Fig. 16).

The labor market remains tight. The percent of total part-time employment for economic reasons was at 14.1% during November, holding near October’s 13.9%, which was the lowest since December 2000 (Fig. 17).

By the way, payroll employment is one of the four components of the Index of Coincident Economic Indicators. Also in record territory during November were payroll employment in truck transportation and temporary help services, with the former reaching a new record high (Fig. 18 and Fig. 19). Both are highly correlated with the Index of Leading Economic Indicators.

Strategy III: The Roaring 2020s? Late last year, we spent some time discussing the possibility of a Roaring 2020s scenario, reminiscent of the 1920s boom in the US driven by productivity-enhancing technological innovations that boosted the standard of living. We still believe in this story, though this past year was more like a replay of the Great Inflation of the 1970s on fast-forward.

Clearly, one of the major issues facing the US economy during the current decade is the shortage of labor. This year, it has been a source of inflationary pressures mostly because lots of workers responded by quitting their jobs in large numbers for better pay. As a result, productivity suffered. We see this as a short-term problem that will be resolved with productivity-enhancing technological innovations that boost the standard of living just as happened during the 1920s.

Don’t stop thinking about tomorrow. It will be better than before.

Movie. “The Fabelmans” (+) (link) is a semi-autobiographical movie loosely based on Steven Spielberg's adolescence and first years as an amateur film director. He produced and directed it. It turns out that I have a lot in common with Spielberg. He makes movies, while I review them. His father moved his family to California to work at IBM in the 1960s. So did my father. On the other hand, my parents didn’t have a messy divorce, which is the focus of this movie. In many ways, it is more about Spielberg’s mother, played by Michelle Williams, who spent a lot of time playing depressing piano music and weeping about her unhappiness. She adopts a small monkey to cheer her up. She finally finds happiness by running off with her long-time friend played by Seth Rogen. Spielberg goes on to fame and fortune despite his dysfunctional family history.

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Powell, Onshoring & Tech

December 01 (Thursday)

The Fed: ‘Moderation’ Is the Word. Bond yields fell and stock prices rose in response to Fed Chair Jerome Powell’s speech on Wednesday at the Brookings Institution. Most importantly, he confirmed that the FOMC is on track to raise the federal funds rate by 50bps rather than 75bps at the December 13-14 meeting of the committee. Here is how he concluded his speech:

“Monetary policy affects the economy and inflation with uncertain lags, and the full effects of our rapid tightening so far are yet to be felt. Thus, it makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.”

“Moderation” is the key word. The markets seem to believe that the Fed is getting closer to the terminal federal funds rate, which is widely deemed to be around 5.00%, and that the economy can handle that “restrictive” level even if it stays there for a while. Indeed, during the Q&A session following his speech, Powell repeated that he still believes that there is a path to a soft (or “softish”) landing for the economy.

Investors have been fearing that the Fed might turn too restrictive, causing a recession. Powell specifically said that the Fed is aware of that risk and does not want that to happen. Of course, Fed officials are also expecting (hoping) that inflation will continue to moderate to validate the Fed’s moderation pivot.

Powell spent a good part of his speech talking about inflation:

(1) Inflation remains high and uncertain. Powell started his prepared remarks by “acknowledging the reality that inflation remains far too high.” He reiterated a frequent theme from his past statements about inflation: “Without price stability, the economy does not work for anyone.” He also stated that “[t]he truth is that the path ahead for inflation remains highly uncertain.” Then he proceeded to drill down on the outlook for the core PCED inflation rate: “To assess what it will take to get inflation down, it is useful to break core inflation into three component categories: core goods inflation, housing services inflation, and inflation in core services other than housing.” (Click “View speech charts and figures” below his speech to see charts of the three.)

(2) Focusing on three major components of inflation. Powell noted: “Core goods inflation has moved down from very high levels over the course of 2022, while housing services inflation has risen rapidly. Inflation in core services ex housing has fluctuated but shown no clear trend. I will discuss each of these items in turn.”

(3) Core goods inflation heading in the right direction. He was optimistic about the outlook for core goods inflation: “While 12-month core goods inflation remains elevated at 4.6 percent, it has fallen nearly 3 percentage points from earlier in the year. It is far too early to declare goods inflation vanquished, but if current trends continue, goods prices should begin to exert downward pressure on overall inflation in coming months.”

(4) Housing services inflation should moderate late next year. Powell observed that housing services inflation, which measures the rise in rent of primary residence and the rental-equivalent cost of owner-occupied housing, “has continued to rise and now stands at 7.1 percent over the past 12 months. Housing inflation tends to lag other prices around inflation turning points, however, because of the slow rate at which the stock of rental leases turns over.” He observed that “market rate on new leases is a timelier indicator of where overall housing inflation will go over the next year or so. Measures of 12-month inflation in new leases rose to nearly 20 percent during the pandemic but have been falling sharply since about midyear.” (Click “View speech charts and figures” below his speech to see his chart showing market rents.)

(5) Core services other than housing depends on labor costs. The third category is core services other than housing. It covers a wide range of services from health care and education to haircuts and hospitality. It is the largest of the three categories, constituting more than half of the core PCE index. Powell observed: “Thus, this may be the most important category for understanding the future evolution of core inflation. Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.”

Powell clearly is concerned that labor shortages may continue to put upward inflationary pressure on core services excluding housing. He noted that “recent research by Fed economists finds that the participation gap is now mostly due to excess retirements—that is, retirements in excess of what would have been expected from population aging alone. These excess retirements might now account for more than 2 million of the 3‑1/2 million shortfall in the labor force.” He added: “The second factor contributing to the labor supply shortfall is slower growth in the working-age population.”

He concluded that demand still well exceeds supply in the labor market. As a result, “[w]age growth, too, shows only tentative signs of returning to balance. Some measures of wage growth have ticked down recently.” (Click “View speech charts and figures” below his speech to see his charts of wage inflation.)

(6) Bottom line. The markets took comfort from Powell’s suggestion that the Fed’s tightening cycle is pivoting to a more moderate stance of rate increases. However, he concluded: “It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

Industrials: More Manufacturing Coming to America. The number of companies opting to build manufacturing plants in the US of A instead of abroad continues to gain steam. Almost 350,000 jobs will be created this year in the US as companies move their manufacturing facilities back to the US or foreign companies decide to start manufacturing operations here, according to a report based on H1-2022 trends by the Reshoring Initiative. The jobs created due to reshoring or foreign direct investment have increased to 260,000 in 2021 from 181,037 in 2020 and only 6,000 back in 2010.

Appreciation for domestic manufacturing grew after Covid caused supply chains to collapse and shortages of PPE and hand sanitizer turned us into scavengers. Tariffs on certain Chinese imports, the threat of China attacking Taiwan, and Russia’s war in Ukraine have further highlighted the importance of a US manufacturing base. US government funding provided over the past year through the CHIPS Act, the Inflation Reduction Act, and the Infrastructure Investment and Jobs Act has sweetened the pot for manufacturers breaking ground in the US.

The industries bringing the most jobs to US shores include electric vehicle (EV) battery manufacturers, chemical companies including pharmaceutical manufacturers, and makers of transportation equipment and computer and electronic products including solar panels, robotics, drones, and semiconductors, the Reshoring Initiative report states.

One challenge to onshoring is finding the skilled workforce to fill the new jobs. Companies, trade associations, and states are ramping up training programs, while automation and artificial intelligence (AI) are allowing workers to be more productive, the report notes. But the US onshoring trend may slow in coming years as industrial capabilities in Mexico and Southeast Asian countries improve and those countries increasingly attract companies.

US manufacturing jobs fell sharply in the decade after China joined the World Trade Organization in 2001. But since bottoming in 2009, the number of manufacturing jobs has been increasing, backtracking briefly in 2020 due to the short-lived Covid recession (Fig. 1). As technology companies announce massive layoffs, it may be employment in the manufacturing sector that softens the blow to the economy.

We first discussed the onshoring trend in the November 12, 2020 Morning Briefing, followed by the February 11, 2021 Morning Briefing. Here’s our latest look at recent announcements by companies planning to build manufacturing plants in the US:

(1) Solar industry shines. Italian utility Enel was the latest company to announce plans to build a solar photovoltaic cell and panel manufacturing plant in the US. The company noted that “tailwinds from the Inflation Reduction Act have served as a catalyst for our solar manufacturing ambitions in the US,” a November 17 Reuters article reported. The act offers tax credits for US-made solar products. Construction on Enel’s plant is expected to begin in H1-2023, though its location hasn’t been announced. The factory is expected to create 1,500 jobs by 2025.

Enel’s news follows First Solar’s announcement in August that it will build a $1 billion solar panel factory in Alabama. It’s spending an additional $185 million to expand existing facilities in Ohio. “Some 90% of panels installed in the United States are made overseas, but imports have been constrained by pandemic-related supply chain disruptions, tariff threats and increased border scrutiny to block supplies linked to forced labor,” an August 30 Reuters article reported. US developers have opted for First Solar’s products because they don’t require polysilicon, a raw material primarily made in China. First Solar’s share price is up 85.7% ytd through Tuesday’s close compared to the S&P 500’s 17.0% ytd decline.

(2) Batteries are electrifying. Freyr Battery and Koch Strategic Platforms announced on October 12 a joint venture to develop 50 gigawatts of battery cell manufacturing capacity for producing batteries for electricity storage and for EVs at a US location that will be announced next year.

New battery plants are popping up all around the country. SK Innovation, which is building two plants in Georgia, is planning to build a third plant near Savannah via a joint venture with Hyundai Motor Group. Panasonic Holdings and LG Chem have also announced plans to build new battery plants in the US. Manufacturing batteries in America became more alluring after the Inflation Reduction Act required automakers to source a certain percentage of critical minerals for their EV batteries from the US or a US free-trade partner to qualify for tax credits, a November 29 Reuters article explained.

(3) More US semiconductor plants. Micron Technology was among the most recent companies to announce plans to build up to four semiconductor plants in the US. The company will spend up to $100 billion on the plants in Syracuse’s northern suburbs, creating up to 9,000 jobs over the next 20 years. The plant is expected to bring another 40,000 supply-chain and construction jobs to the region, an October 7 Syracuse.com article reported.

Micron received state and local incentives worth at least $6 billion over 20 years and presumably will take advantage of funding from the CHIPS Act, which provides $52 billion in incentives for companies to produce semiconductors in the US. Intel, Taiwan Semiconductor Manufacturing, and Samsung also are building new fabs in the US. All this is moderately ironic given the glut of semiconductors that currently exists.

(4) Cable needed. Corning announced in August plans to build a new optical cable manufacturing plant in Arizona. That followed news in September 2021 that it plans to build an optical cable plant in North Carolina. The company has invested more than $500 million since 2020 to double its supply capacity. It has a ready buyer in AT&T, which continues to roll out fiber-based broadband to homes, an August 30 Reuters article reported.

These efforts are also encouraged by government largess. The $1 trillion Infrastructure Investment and Jobs Act passed in November 2021 includes $42.5 billion of grants to states to expand broadband infrastructure using materials manufactured in the US.

Technology: Coal Today, Diamond Tomorrow? The S&P 500 Technology sector is ending the year on a sour note, down dramatically ytd and failing to rebound as sharply as other sectors from the market’s September low. The jump in interest rates and slower spending on tech as the economy cools have packed a punch. But as the calendar turns to 2023, it may also be an area still ripe with opportunities, especially if the high point in interest rates is behind us. Here’s a look at where things stand:

(1) Tough year from all angles. First, consider the performance derby of the S&P 500 and its 11 sectors ytd through Tuesday’s close; Tech comes in third from last: Energy (63.3%), Consumer Staples (-1.8), Utilities (-3.2), Health Care (-3.9), Industrials (-5.6), Financials (-8.8), Materials (-10.9), S&P 500 (-17.0), Real Estate (-26.0), Information Technology (-26.1), Consumer Discretionary (-32.0), and Communication Services (-38.4) (Fig. 2).

The Tech sector remains a laggard measured from the S&P 500’s recent low on September 30 through Tuesday’s close: Energy (25.0%), Industrials (20.6), Materials (18.6), Financials (17.5), Consumer Staples (13.5), Health Care (11.9), S&P 500 (10.4), Information Technology (8.6), Real Estate (6.3), Utilities (5.9), Communication Services (1.7), and Consumer Discretionary (-2.4) (Table 1).

Within the Tech sector, the Application Software and Semiconductors industries have fallen the most sharply ytd, by 35.7% and 35.4% respectively. Here’s how the other tech industries have fared ytd: Home Entertainment Software (0.3), Communications Equipment (-19.9), IT Consulting & Other Services (-20.4), Technology Hardware, Storage & Peripherals (-20.9), Semiconductor Equipment (-24.5), and Systems Software (-27.9) (Fig. 3).

(2) Negative news flow. Business in some of the growthiest areas of the Technology sector has slowed, and the Q3 earnings season has been a tough one. CrowdStrike shares fell 14.8% Wednesday after the cybersecurity company forecast Q4 revenue of $628.2 million, missing analysts’ average estimate of $634.8 million. Shares of cloud computing company NetApp fell 5.8% Wednesday after the company targeted earnings per share of $5.30-$5.50 for its April-ending fiscal year, below the analysts’ consensus of $6.76 a share. Sales from Amazon’s cloud business grew 27% last quarter, a deceleration from the 33% growth enjoyed in Q2.

(3) A look at 2023. The S&P 500 Technology sector’s revenue and earnings are expected to slow sharply next year. Revenue is forecast to increase only 2.5% in 2023, far below the 10.6% revenue growth expected this year and the 17.2% jump in 2021 (Fig. 4). Likewise, earnings for the sector is targeted to inch up 1.0% next year, a sharp slowdown from the 9.1% earnings growth forecasted for this year and the 37.0% growth enjoyed in 2021 (Fig. 5). Analysts began paring their estimates this summer, and they have yet to slow down (Fig. 6).

While earnings growth is slowing, many tech industries are expected to post earnings in 2023 that grow faster than the 3.8% earnings growth forecast for the S&P 500 companies collectively. The Application Software industry is a standout, forecast to grow earnings 13.8% in 2023, a bit above this year’s forecast for 11.4% growth and on par with the 12.4% growth produced in 2021 (Fig. 7). Meanwhile, the Application Software industry’s forward P/E has dropped sharply from a peak of 53.0 in November 2021 to a recent 27.5 (Fig. 8).

Here are the other S&P 500 Information Technology industries that are forecast to grow earnings faster than the S&P 500 in 2023: Data Processing & Outsourced Services (11.7%), Internet Services & Infrastructure (10.5), Communications Equipment (7.7), IT Consulting & Other Services (7.0), Technology Distributors (6.4), Electronic Components (5.9), Electronic Equipment & Instruments (5.5), and Systems Software (5.4).

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2024 Is Coming!

November 30 (Wednesday)

Strategy: Looking Forward to 2024. In Monday’s Morning Briefing, we wrote that 2023 is coming. We compared our economic outlook to that of the consensus, as we perceive it, for next year. The main difference is that we are expecting a soft landing rather than a hard landing. In any event, 2024 will be increasingly relevant to the performance of the stock market next year. That’s because investors and analysts look forward by 12 months when they invest in and analyze stocks.

We all know that the stock market equation is P = P/E × E. Joe and I believe that the stock market discounts analysts’ consensus expectations for S&P 500 forward operating earnings (E), which is the time-weighted average of their current expectations for the current year and the coming year. The data are available weekly from I/B/E/S data by Refinitiv. We also reckon that the P/E based on forward earnings reflects the valuation multiple that investors are willing to pay for the analysts’ forward earnings expectations. (Joe and I wrote a detailed 2020 primer on this subject, S&P 500 Earnings, Valuation, and the Pandemic.)

In this context, let’s have a look at the outlook for the stock market equation not only for 2023, but also for 2024 since the market will be giving more weight to 2024 and less weight to 2023 as next year progresses. Consider the following:

(1) S&P 500 quarterly, annual, and forward consensus earnings expectations. During the latest earnings reporting season, for Q3-2022, industry analysts lowered their earnings estimates for Q4-2022 and all four quarters of next year (Fig. 1 and Fig. 2). However, over the past two weeks through the November 24 week, they’ve stopped cutting estimates for next year’s four quarters.

The same can be said about their earnings-per-share estimates for all of 2022 (the consensus is $220.33 currently) and for all of 2024 ($253.30 currently) (Fig. 3). As a result, forward earnings per share edged up over the past two weeks to $230.20, which is now down 4.1% from its record high of $239.93 during the June 23 week.

We take some comfort in these recent developments because we are not expecting a plunge in forward earnings as typically occurs during a hard landing (Fig. 4).

(2) Weekly vs quarterly S&P 500 fundamentals. As we have often noted before, the weekly forward metrics for S&P 500 forward revenues, earnings, and the profit margin closely track their actual reported counterparts (Fig. 5). They are showing that forward revenues might have peaked at a record high during the week of October 13, falling 1.1% through the November 17 week. Forward earnings is down 4.1% from its record high during the June 23 week through the November 24 week, as noted above. We can use these two series to calculate the forward profit margin, which fell from a record high of 13.4% during the week of June 2 to an 18-month low of 12.7% during the November 17 week.

In our opinion, these recent developments are consistent with our soft-landing outlook (so far). In a hard landing, there would be much more downside in forward revenues and the profit margin, and therefore in earnings. That’s not our most likely forecast—we assign it an admittedly high 40% subjective probability, with the other 60% assigned to a soft landing.

(3) Our 2023 and 2024 forecasts vs the consensus for earnings. Supporting our perception that a hard-landing scenario is the consensus outlook is the recent weakness in analysts’ consensus revenue estimates for the coming two years (Fig. 6). Analysts tend to be optimistic. They don’t turn pessimistic until they receive heads-up recession warnings from the companies they follow.

As of the November 17 week, the analysts were estimating that S&P 500 revenues will increase 11.6% this year, 2.6% next year, and 4.3% in 2024. We are currently projecting increases of 11.6%, 4.3%, and 2.7%. Their estimate for next year seems low for investors to use considering that inflation will remain above the Fed’s 2.0% through next year. Then again, the analysts may be going over to the dark side and incorporating a hard(er) landing into their estimates than we are.

We are lowering our S&P 500 earnings estimates to reflect the pressure on the profit margin that started earlier this year (Fig. 7). We are now projecting margins of 12.3% this year, the same for next year, and back up to 13.3% in 2024. The analysts have been shaving their estimates steadily since mid-June, and their current margin forecasts—imputed from their revenues and earnings estimates as of the November 17 week—are now 12.5%, 12.7%, and 13.3% for 2022, 2023, and 2024.

Our latest operating earnings-per-share estimates for these three years are $215, $225, and $250 (Fig. 8). Our 2022 estimate is unchanged, but 2023 is down from our previous estimate of $235. The analysts’ latest consensus estimates are $220, $231, and $253.

(4) Our 2023 and 2024 S&P 500 targets. When we forecast our S&P 500 price index target ranges for the three years, we start by projecting where the forward earnings series is likely to be at the year-ends. Remember that forward earnings at year-ends is the same as the analysts’ consensus projections for the following year. We are projecting forward earnings per share of $225, $250, and $270 for the current and next two years (Fig. 9). While $270 might seem awfully high right now, that’s our projection for what analysts will expect at the end of 2024 that 2025 earnings will be. After all, 2025 is coming too.

Now all that’s left to do is to project the forward P/E ranges for this year (15.0-18.0), next year (15.0-17.0), and 2024 (16.0-18.0) (Fig. 10). Our projections are consistent with a soft-landing scenario, not a hard-landing one.

Now here are our projections for the S&P 500 price ranges for the current and coming two years: 3642-4305, 4080-4845, and 4320-4860 (Fig. 11).

The bottom line is that even with our relatively optimistic economic and earnings outlook, it’s hard to see the S&P 500 rising well into record territory over the next two years. That’s mostly because the valuation multiple was so elevated at 21.5 when the S&P 500 rose to a record high of 4796.56 on January 3 of this year.

For a handy compilation of all the above, see YRI S&P 500 Earnings Forecast.

US Economy: The Yield Curve One More Time. Everyone seems to be obsessed with the inversion of the yield curve. We are too. It is still widely believed that such inversions are uncannily accurate predictors of imminent recessions. But that’s not exactly the case, Melissa and I concluded in our 2019 study The Yield Curve: What Is It Really Predicting?: “In our opinion, the yield curve, first and foremost, predicts the Fed policy cycle rather than the business cycle. Our research confirms this conclusion, as does a recent Fed study. More specifically, inverted yield curves don’t cause recessions. Instead, they provide a useful market signal that monetary policy is too tight and risks triggering a financial crisis, which can quickly turn into a credit crunch causing a recession.”

In other words, the yield curve predicts the impact of the Fed’s policy cycle on the financial and credit cycle, and then on the business cycle. So what is it doing now? It doesn’t seem to be predicting a credit crunch. Despite a bunch of financial crises in cryptocurrencies and the ARK, meme, and SPAC stocks, the credit system in general and the banking system in particular remain remarkably resilient. For the reasons we discussed in yesterday’s Morning Briefing, we believe that the US economy is also resilient and can continue to grow notwithstanding the Fed’s very aggressive monetary policy tightening cycle (so far). While we do see a soft landing for the economy next year, we don’t see a hard landing, which apparently is the consensus view.

So what is the inverted yield curve really predicting this time if not a credit crunch and a recession? We won’t leave you in suspense: In our opinion, it may be anticipating that inflation might moderate surprisingly quickly without a recession in 2023. If so, then it may also be predicting that the yields on both the 2-year Treasury note and the 10-year Treasury bond are peaking. Consider the following:

(1) Fed cycle. The Fed cycle can be easily depicted on a chart showing periods when the Fed raised the federal funds rate followed by periods when it lowered the rate (Fig. 12).

(2) Financial and credit cycle. Since 1960, more often than not, the end of the Fed’s monetary policy tightening cycle coincided (i.e., caused) financial crises, which quickly morphed into economy-wide credit crunches (Fig. 13).

(3) Business cycle. Most of those credit crises triggered recessions, causing the Fed to start a monetary easing cycle (Fig. 14).

(4) Yield curve and interest-rate cycle. The yield curve, based on the yield spread between the 10-year Treasury bond and the 2-year Treasury note, has had a tendency to invert at the end of monetary tightening cycles and the beginning of easing ones (Fig. 15).

The 2-year Treasury note is a leading indicator for the federal funds rate (Fig. 16). During monetary policy tightening cycles, it tends to rise faster than the 10-year yield (Fig. 17). Data available since 1976 show that when the 2-year yield rises to match or slightly exceed the 10-year yield, the Fed’s monetary tightening policy cycle is almost over.

Based on this past performance, we conclude that both the 2-year and 10-year yields might have peaked in late October. If that development can’t be attributed to an impending credit crunch and recession, then that leaves only peaking inflation as the explanation for why this is happening.

Of course, this optimistic analysis could be obliterated should inflation remain persistently high or move even higher. In this scenario, the Fed’s monetary policy tightening cycle would persist, sending both 2-year and 10-year yields higher. Stay tuned.

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Anxious Index

November 29 (Tuesday)

Monday’s Webchat. Monday’s live webchat covered lots of ground. The only problem is that the charts weren’t showing on some participants’ computer screens. So I re-recorded it with the charts showing this time. Please find the replay here.

US Economy I: Anxious Index Is Anxious About 2023. Yesterday’s Morning Briefing was titled “2023 Is Coming!” It mostly compared our economic outlook for next year to our perception of the consensus outlook for 2023. The major difference is that the consensus is expecting a hard-landing economic recession, while we are expecting a soft landing. Real GDP is more likely to be up than down next year, but the growth rate is likely to be relatively slow.

Our contrarian instincts give us more confidence in our “growth recession,” or “mid-cycle slowdown,” scenario. A recession next year would be the most widely anticipated downturn on record. Consider the following:

(1) Philly Fed’s Anxious Index. The Philadelphia Federal Reserve Bank’s Survey of Professional Forecasters, which started during Q4-1968, includes the Anxious Index, which is the probability of a decline in real GDP (Fig. 1). The survey asks panelists to estimate the probability that real GDP will decline in the quarter in which the survey is taken and in each of the following four quarters. The Anxious Index shows the probability of a decline in real GDP in the quarter after a survey is taken. For example, the survey taken in Q4-2022 yielded an Anxious Index reading of 47.2%, which means that forecasters believe there is a 47.2% chance that real GDP will decline in Q1-2023. That reading is the highest since Q2-2009. The probability of a recession over the next four quarters was 43.5%, the highest on record (Fig. 2).

The Philly Fed notes: “The index often goes up just before recessions begin. For example, the first quarter survey of 2001 (taken in February) reported a 32 percent anxious index; the National Bureau of Economic Research subsequently declared the start of a recession in March 2001. The anxious index peaks during recessions, then declines when recovery seems near. For example, the index fell to 14 percent in the second quarter of 2002, when economic indicators began improving.”

(2) WSJ’s recession probability survey. The Wall Street Journal has conducted quarterly surveys of economists—in January, April, July, and October—since April 2021. From the mid-1980s through 2002, the survey was conducted twice a year. From 2003 through March 2021, its frequency was monthly. The panel includes more than 70 academic, business, and financial economists, and the makeup of the panel has evolved over time. The name and affiliation of each economist, as well as their latest indicator forecasts, are included in the Excel spreadsheet available with each survey.

According to the latest WSJ survey during October: “On average, economists put the probability of a recession in the next 12 months at 63%, up from 49% in July’s survey. It is the first time the survey pegged the probability above 50% since July 2020, in the wake of the last short but sharp recession. Their forecasts for 2023 are increasingly gloomy. Economists now expect gross domestic product to contract in the first two quarters of the year, a downgrade from the last quarterly survey, whereby they penciled in mild growth. On average, the economists now predict GDP will contract at a 0.2% annual rate in the first quarter of 2023 and shrink 0.1% in the second quarter. In July’s survey, they expected a 0.8% growth rate in the first quarter and 1% growth in the second. … Economists’ average forecasts suggest that they expect a recession to be relatively short-lived. Of the economists who see a greater than 50% chance of a recession in the next year, their average expectation for the length of a recession was eight months. The average postwar recession lasted 10.2 months.” (The survey of 66 economists was conducted on October 7–11.)

(3) Misery Index. The Misery Index is the sum of the unemployment rate and the yearly percent change in the Consumer Price Index (Fig. 3). It was relatively high, at 11.4%, during October because inflation has soared over the past year. The unemployment rate tends to be at cyclical lows just before recessions, as it is now. The Misery Index tends to rise during recessions and to peak around the end of recessions. It has a similar relationship to bear markets in the S&P 500 (Fig. 4). It may have peaked in June, confirming our view that the latest bear-market bottom might have been made on October 12.

US Economy II: The Brief Case for a Soft Landing, Again. As we explained in the Monday, November 21 Morning Briefing, this time may be different—i.e., a recession might not be a foregone conclusion—if the economy turns out to be more resilient to the Fed’s monetary policy tightening cycle than in the past. That optimistic view is certainly contrary to the prediction of the Index of Leading Economic Indicators, which has been falling since February through October (Fig. 5). It is also contrary to the inversion of the 10-year-versus-2-year yield-curve spread since the summer (Fig. 6). Consider the following this-time-is-different points:

(1) No credit crunch so far. In the past, inverted yield curves tended to predict financial crises, which triggered widespread credit crunches, which caused recessions (Fig. 7). This time, the financial crises have occurred in cryptocurrencies and in the ARK, meme, and SPAC stocks. Yet the credit system remains resilient, as evidenced by the small increase in the allowance for loan and lease losses at commercial banks (Fig. 8). Commercial bank loans rose $1.3 trillion y/y to a record $11.9 trillion through the November 16 week (Fig. 9).

(2) Ample liquidity. A few economists are ringing the alarm bells about the 1.5% decline in M2 since it peaked at a record high of $21.7 trillion during March through October (Fig. 10). Nevertheless, we estimate that it is currently at least $2 trillion above its pre-pandemic trendline. Demand deposits in M2 are up a staggering $3.5 trillion since February 2020 (just before the pandemic lockdowns) to $5.1 trillion in October (Fig. 11).

The y/y change in M2 has been closely tracking the 12-month sum of the personal saving rate (Fig. 12). The recent weakness in both reflects the excess liquidity accumulated by consumers since the start of the pandemic.

(3) Consumer incomes are growing. The labor market remains tight. Payroll employment is up 4.1 million ytd through October to a record high (Fig. 13). Average hourly earnings for all private-sector workers rose 5.0% y/y through September, while the PCED inflation rate was 6.2%, showing that inflation-adjusted wages have been stagnating for the past year (Fig. 14). But we expect that price inflation will soon moderate and fall below wage inflation, boosting real wages. Revolving credit is up $152.4 billion y/y through September, and there is plenty of excess saving, as noted above.

Except for autos, most of the pent-up demand for consumer goods has been satisfied. While consumer spending on goods in real GDP has been essentially flat, it remains above its pre-pandemic trendline (Fig. 15). Consumers clearly have pivoted to spending more on services.

(4) Housing’s mixed message. There is a credit crunch in the single-family housing market, as evidenced by the freefall in mortgage applications to purchase a new or existing home (Fig. 16). Housing affordability has collapsed this year as mortgage rates soared and home prices remained near record highs because of scarce inventory of homes for sale. However, the multi-family housing sector remains strong as developers scramble to meet booming demand for rental apartments. Multi-family residential construction accounts for about 50% of total residential construction.

(5) Capital spending. As we reviewed at the beginning of last week, industrial production of business equipment remained strong during October, with output of industrial and technology equipment leading the way higher (Fig. 17). Output of business computers and communication equipment both rose to record highs (Fig. 18).

(6) Fiscal stimulus. There’s certainly lots of economic stimulus in the fiscal policy pipeline. In July 2022, Congress passed the CHIPS Act of 2022 to strengthen domestic semiconductor manufacturing, design, and research; fortify the economy and national security; and reinforce America’s chip supply chains. The act invests $280 billion in the chip sector and includes semiconductor manufacturing grants, research investments, and an investment tax credit for chip manufacturing.

With the signing of the Infrastructure Investment and Jobs Act on November 15, 2021 and the Inflation Reduction Act this August, congressional lawmakers capped a historically productive year when it comes to transportation policy. The two landmark bills will invest nearly $700 billion in infrastructure, research activities, and related programs that either directly touch the transportation industry or promise to benefit it. In addition, all that federal spending likely will attract even more commitments from states, localities, and the private sector.

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2023 Is Coming!

November 28 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webcasts are available here.

US Economy I: The Consensus Forecast & Ours. What is the consensus economic and financial outlook for 2023? The most widely anticipated recession of all times didn’t occur in 2022, as was widely feared. So now it is widely expected to occur in 2023—if not during the first half of the year, then certainly by the second half. If so, the economic downturn should help to moderate inflation next year.

In this scenario, the Fed should be done tightening early next year, as anticipated by the inversion of the yield curve since this past summer, which also implies that the 10-year Treasury bond yield might have peaked at 4.25% on October 24 (Fig. 1). When the yield on the 2-year Treasury note equals or exceeds the 10-year Treasury bond yield, both tend to be close to their cyclical peaks (Fig. 2). Also anticipating the nearing of the end of the Fed’s monetary policy tightening cycle is the trade-weighted dollar, which peaked on October 19 (Fig. 3).

This is a bittersweet scenario for the stock market. There should be less downward pressure on valuation multiples attributable to rising inflation and interest rates as both move lower in the 2023 consensus forecast. But a recession next year would continue to depress corporate earnings, which have been weighed down by narrowing profit margins since the summer of this year, while revenues rose to record highs, boosted by inflation. In a recession, margins would continue to shrink as revenues fall too. In other words, the bear market in the S&P 500 may not have ended on October 12 of this year if there is still more downside in store for forward earnings and forward valuation multiples (Fig. 4).

Our outlook for 2023 is sweeter than the consensus. It coincides with all the major “talking points” of the consensus with one important exception: Debbie, Joe, and I aren’t expecting a recession. We continue to anticipate a soft landing rather than a hard landing. We see recessionary forces attributable to the tightening of Fed policy rolling through various sectors of the economy in a way that doesn’t add up to a broad-based recession. We’ve also described this phenomenon as a “growth recession” and as a “mid-cycle slowdown.”

That’s consistent with our view that the bear market in stocks ended on October 12, but it doesn’t imply a rip-roaring bull market in 2023. That’s because the bear market has been mostly about the downward rerating of the stock market’s overall valuation multiple from overvalued territory to fairly valued rather than undervalued territory. In addition, there may be more downside in forward earnings during a rolling recession and not much likelihood of a V-shaped rebound in earnings, especially since profit margins remain near record highs.

US Economy II: Inflation Will Make or Break 2023. In our opinion, inflation is the one key variable that clearly will determine the economic and financial outcome in 2023. If it moderates without a hard landing of the economy, as we expect, then 2023 will be a better year all around than 2022. If it has peaked but remains persistently high, the Fed will have no choice but to continue tightening until a broad-based recession ensues.

Consider these most recent relevant developments:

(1) National supply-chain index. Supply-chain disruptions contributed to the surge in goods inflation during the second half of 2021 and the first half of 2022. But these problems have been mostly fixed. Slowing demand for goods has also helped to moderate goods inflation significantly in recent months.

The Global Supply Chain Pressure Index (GSCPI) compiled by the Federal Reserve Bank of New York (FRB-NY) peaked at 4.30 during December 2021 (Fig. 5). It was down to 1.00 during October. The latest FRB-NY analysis of that data concluded: “The GSCPI’s year-to-date movements suggest that global supply chain pressures are falling back in line with historical levels.”

(2) Regional supply chains.We now have November supply-chain indicators for regional business surveys conducted by four of the five Federal Reserve district banks (Fig. 6). New York delivery times was the only positive reading, at 2.9, while Richmond’s backlog of orders was -25.0, Kansas City’s backlog of orders was -25.0, and Philly’s unfilled orders was -22.9. Collectively, those four readings for November confirm the FRB-NY’s conclusion for the October reading of their series. In fact, they strongly suggest that supply-chain pressures have fallen well below normal historical levels!

We also have eight of the 10 prices-paid and prices-received indexes from four of the five regional business surveys through November. Five of the available eight ticked up but remained on downward trends (Fig. 7).

(3) Goods inflation. The CPI for goods peaked at 14.2% y/y in March before falling to 8.6% in October (Fig. 8). That drop was led by a plunge in the CPI durable goods inflation rate from a peak of 18.7% in February to 4.8% in October. We think that this inflation rate could turn slightly negative in 2023 since durable goods prices were mostly deflating, rather than inflating, from the mid-1990s until the end of 2020.

The CPI nondurable goods inflation rate is mostly determined by food and energy commodity prices. Both peaked during the summer but have stabilized in recent weeks. Weakness in the global economy should weigh on these prices over the next few months.

(4) Services inflation. There is no compelling sign of a peak yet in the CPI services inflation rate (Fig. 9). That’s mostly because rent inflation continues to move higher in the CPI, with rent of primary residence up 7.5% during October (Fig. 10). Meanwhile, the Zillow Rent Index peaked at 17.1% y/y in February before falling to 9.6% in October, suggesting that rent inflation in the CPI might start to moderate during the spring of next year.

US Economy III: The Great Landing Debate. Now let’s consider some of the recent developments in the great debate between soft-landing prognosticators and their hard-landing opponents:

(1) GDP. Some pessimistically inclined forecasters declared victory because they deemed that the economy fell into a technical recession during the first half of this year, when real GDP edged down 1.6% and 0.6% (saar) during Q1 and Q2. However, it then rebounded by 2.6% during Q3, and the Atlanta Fed’s GDPNow tracking model showed a prospective Q4 increase of 4.3% as of November 23.

Consumer spending in real GDP increased during the first three quarters of 2022 (by 1.3%, 2.0%, and 1.4%) and is currently on track to increase 4.8% during Q4, according to the GDPNow model.

(2) Coincident vs Leading Economic Indicators. While we are all debating whether the economic landing will be hard or soft, the overall economy as measured by GDP is showing no signs of landing; it is still flying! Indeed, the Index of Coincident Economic Indicators rose 1.9% ytd to a record high through October, led by a 4.1 million increase in payroll employment to a record high of 153.3 million.

Then again, supporting the hard-landing camp is the Index of Leading Economic Indicators (LEI). It peaked during February and has fallen every month through October, signaling a recession next spring. We hate to fight the LEI, but that’s not our forecast.

By the way, in my 2018 book Predicting the Markets, I observed: “When the models fail to work (as most do sooner or later), they are sent back to the garage for a tune-up, if not a major overhaul. A good example of this is the ‘comprehensive revision’ of the Index of Leading Economic Indicators (LEI) during January 2012. The redesign replaced a few old components with new ones to keep the index working as advertised, i.e., as a leading indicator of economic activity.”

(3) Purchasing managers. Supporting the pessimistic outlook of the LEI, November’s flash estimates for the M-PMI and NM-PMI both were relatively weak, falling to 47.6 and 46.1 (Fig. 11 and Fig. 12). The former suggests that the ISM’s “official” M-PMI dropped below 50.0 for the first time since May 2020. That’s consistent with November’s readings of the four available regional business surveys.

However, unlike its M-PMI counterparts, the flash NM-PMI hasn’t been a reliable indicator of the official NM-PMI, which likely remained above 50.0 during November.

The weakness of the official M-PMI relative to the official NM-PMI is consistent with the pivot by consumers to spending more on services than on goods, as evident in consumption of goods in real GDP (down 0.4% y/y through Q3) versus services (up 3.2%) (Fig. 13). It is also consistent with our soft-landing scenario.

(4) Housing market. There’s no doubt that a recession is rolling through the single-family housing market. However, it has been partially offset by strength in the multi-family housing market, as we discussed in last Monday’s Morning Briefing.

But what about the unexpected 7.5% m/m increase in new home sales in October after they had plunged 11.0% in September? The series is based on contract signing, which may have been boosted by builder incentives and a low supply of previously owned homes for sale.

Apparently, many new homebuyers are having second thoughts. According to the homebuilder survey by John Burns Real Estate Consulting—with a sample size of roughly 20% of all new home sales—the cancellation rate spiked to 25.6% in October, up from 7.9% in October 2021 and from 10.9% in October 2019.

The traffic of prospective home buyers index compiled by the National Association of Home Builders dropped to 20 in November, down from 69 in January and the lowest since April 2020, when this activity was hit hard by lockdown restrictions (Fig. 14).

(5) Rail strike. About 30% of the nation’s freight, when measured by weight and distance traveled, moves by rail, and there just isn’t enough capacity on trucks or other modes to move those goods if the trains grind to a halt. That’s a possibility after rank-and-file members of four rail unions rejected an earlier tentative deal, which included a solid pay increase but didn’t meet workers’ demands for better working conditions. A strike could totally upend supply chains, boost inflation, and send the economy hurtling into a recession.

We expect a last-minute deal before the strike deadline on November 28, December 5, or December 9 depending on three scenarios for rail strike preparations. Some industry groups have urged Congress, which has authority under the Railway Labor Act, to act to prevent a strike. (See November 17 CNBC article “STATE OF FREIGHT: With U.S. economy at risk, here’s how a national rail strike could start in December.”)

US Economy IV: Will the Fed Stop Slamming the Brakes? The S&P 500 is up 4.4% from its Tuesday, November 1 close. That’s impressive considering that it dropped 3.5% on the following Wednesday and Thursday mostly because of the very hawkish tone of Fed Chair Jerome Powell’s press conference on Wednesday afternoon.

Perhaps that’s because Powell’s hawkishness was offset by the somewhat more dovish tone of the FOMC statement. Melissa and I discussed this divergence in our November 7 Morning Briefing titled “Powell Is From Mars, Brainard Is From Venus.”

The minutes of the November 1-2 FOMC minutes were released on Wednesday, November 23. They confirmed that the committee on balance was more from Venus (i.e., more dovish than Powell) than from Mars (i.e., hawkish like Powell). The minutes stated that “a substantial majority of participants judged that a slowing in the pace” of federal funds rate hikes “would likely soon be appropriate.”

Traders now are pricing in more than a 75% chance that the Fed will raise rates by 50bps at its December 14 meeting rather than by 75bps, according to futures contracts on the CME. While most economists are expecting a recession next year, Wall Street is growing more confident (as we have been) that the Fed might be able to pull off a soft landing after all.

The S&P 500, DJIA, and Nasdaq rose 12.6%, 17.6%, and 7.8% from October 12 through Friday’s close. Since the January 3 record high in the S&P 500, they are down 16.1%, 6.1%, and 29.1%.

By the way, November’s CPI will be released on December 13, the same day that the FOMC starts its two-day meeting. On December 2, November’s employment report will be released, which might also influence the committee’s 50bps-vs-75bps debate. And a crippling nationwide railroad strike might start before the FOMC meets. In addition, Congress is unlikely to raise the federal debt ceiling during the lame-duck session, increasing the risk of a highly partisan, market-rattling fiscal confrontation next year. The Santa Claus rally may face more turbulence than usual this year. However, we are still targeting 4305 as the year-end level for the S&P 500.

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Thanksgiving In The Twilight Zone

November 21 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here. The next webinar will be on November 28.

Giving Thanks I: 365 Days A Year. Yardeni Research will be celebrating Thanksgiving for the rest of the week with our families and friends. So we will be back on Monday, November 28. We reckon that the world would be a better place if we spent more than just one day giving thanks. We should probably do so all year long. We certainly are thankful for your friendship and support for our research service every day of the year.

Giving Thanks II: No Recession Yet. Let’s be thankful that the US economy continues to grow and that employment is still expanding. The most widely anticipated recession of all times didn’t happen in 2022. Maybe it won’t happen in 2023 either. If inflation peaked during the summer and continues to moderate as we expect, then Fed policymakers may be getting closer to the so-called “terminal rate” for the federal funds rate.

The economy has been in The Twilight Zone since the start of the pandemic. We first made that observation in our April 27, 2020 Morning Briefing titled “The Twilight Zone: Where Is Everybody?” The TV series was created by Rod Serling and broadcast from 1959 to 1964. Each episode presented a stand-alone story in which characters find themselves dealing with often disturbing or unusual experiences. These surreal events were described as “entering the Twilight Zone,” often with a surprise ending and a moral.

That fairly well sums up our collective experience since Covid upended our lives. It is still doing so. Consider the following:

(1) Consumers aren’t in the mood for a recession. It’s hard to have a recession without consumers retrenching. Why should they? They still have plenty of excess savings left over from the pandemic. We reckon it is around $1.1 trillion, measured as the spread between the 24-month sum of personal saving and annualized monthly personal saving (Fig. 1). In addition, payroll employment is up 4.1 million ytd through October to a record high (Fig. 2). Our Earned Income Proxy for private wages and salaries in personal income suggests that real income rose to another record high in October despite high price inflation (Fig. 3). Consumers are boosting their purchasing power with their credit cards. Revolving credit card debt is up $120 billion ytd to a record $1.2 trillion during September (Fig. 4).

The Consumer Sentiment Index dropped from 59.9 in October to 54.7 during the first half of November (Fig. 5). Consumers remain depressed, yet they are going shopping. Apparently, it makes them feel better! It releases dopamine in their brains. The pandemic seems to have led lots of folks to realize that life is short. Some seem to have concluded that the meaning of life is shopping, dining out, and traveling while you still can do so!

The latest estimate for real GDP growth in the Atlanta Fed’s GDPNow model during Q4 was 4.2% on November 17. After last Wednesday’s retail sales report showed a solid 1.3% m/m gain in October, the nowcast of Q4 real personal consumption expenditures growth increased from 4.2% to 4.8%. Inflation-adjusted retail sales rose 0.8% m/m during October. This measure—excluding building materials and food services, which closely tracks real personal consumption expenditures on goods—was up 0.7% m/m last month (Fig. 6).

N.B.: Keep in mind that October’s retail sales were probably boosted by $5 billion in inflation relief money to over 9 million Californians during the month.

(2) Housing: Multi-family boom vs single-family bust. Single-family housing activity is falling into a recession. Single-family housing starts fell 29.5% ytd through October (Fig. 7). Housing downturns have been major contributors to most recessions in the past. This time, though, strength in multi-family starts is offsetting some of the weakness in single-family starts. Single-family starts has accounted for only 51% of residential construction put in place over the past 10 years, down from close to 70% prior to the Great Financial Crisis (Fig. 8).

The pandemic caused single-family home prices to soar. However, the inflationary consequences of the pandemic forced the Fed to raise interest rates, sending mortgage rates soaring. As a result, many households can no longer afford to buy a home and must rent, which is driving up rents and the construction of rental apartment buildings (Fig. 9 and Fig. 10).

There’s certainly no recession in construction industry employment, which rose 3.6% y/y through October to 7.7 million, matching its highest level on record. Thursday’s industrial production report for October showed that output of construction supplies has been flat since the start of the year, consistent with our observation that strength in the multi-family residential sector is offsetting weakness in the single-family housing industry.

(3) No recession in auto production. In the past, rapidly tightening credit conditions would have sent not only housing into a recession but autos as well. Last week, the Fed reported October’s industrial production, which fell 0.1% m/m during October (Fig. 11). However, manufacturing output rose 0.1% m/m, led by a 3.4% increase in auto assemblies (Fig. 12).

In 2021 and early 2022, the supply of autos was weighed down by parts shortages. Those problems seem to have been resolved recently, and now there is enough pent-up demand to offset the depressing impact of tighter credit conditions in the auto market.

(4) Capital spending going strong. October’s production report also showed strength in the output of capital goods. Industrial production of business equipment rose 7.6% y/y to the highest reading since December 2018 (Fig. 13).

Leading the way higher is output of industrial equipment, undoubtedly boosted by onshoring and infrastructure spending. Also strong have been industrial production of computers (13.8% y/y) and communications equipment (17.9% y/y). Both were at record highs during October. Output of semiconductors has weakened this year but remains on a solid upward trend (Fig. 14).

Production of defense and space equipment has been robust too (Fig. 15). It is up 6.1% y/y to a new record high. Output of aerospace and miscellaneous transport equipment isn’t at a record high, but it is heading in that direction with a y/y gain of 11.3% (Fig. 16).

(5) Coincident & leading economic indicators mixed. Confirming the current strength of the economy was October’s 0.2% increase in the Index of Coincident Economic Indicators (CEI) to a new record high (Fig. 17 and Fig. 18). That’s consistent with real GDP growth of around 2.0% y/y.

The bad news is that the Index of Leading Economic Indicators (LEI) peaked at a record high during February and is down 3.8% over the past eight months through October. It has had a good track record of calling the past seven recessions before the pandemic lockdown. On average, it has peaked 14 months prior to the peak in the CEI. That would put the start of the next recession around March or next year. That’s the LEI model’s forecast, not ours.

Previously, we observed that the S&P 500 is one of the 10 components of the LEI. On average, it anticipated the past 11 recessions prior to the pandemic by five months. It peaked in January this year, so it’s been a bad call on the economy so far.

(6) Regional business surveys. So far, we have three of the five business surveys conducted by the Fed’s district banks—for New York, Philadelphia, and Kansas City—for November. The average of their general business indexes tends to be highly correlated with the national M-PMI, which fell to 50.2 in October (Fig. 19). The average of the three surveys suggests that the M-PMI fell below 50.0 during November. Keep in mind that it is readings below 48.7, not 50.0, that are associated with recessions.

The good news is that the three regional business surveys suggest that supply chains are no longer experiencing disruptions. The series tracking both unfilled orders and delivery times are down sharply since the start of this year (Fig. 20). This development should continue to relieve inflationary pressures.

Giving Thanks III: Fossil Fuels Fueling Growth. Climate activists believed that if governments were to impose regulations that limit fossil fuel production, fossil fuel prices would rise, encouraging more usage of renewable energy sources. But government support would be needed to make renewable sources cost competitive. That reality combined with geopolitical developments have made the transition from fossil to renewable fuels far less smooth than climate activists had assumed.

Here in the US, notwithstanding the Biden administration’s commitment to the transition, the fossil fuel industry has kept America not only energy independent but also exporting more fuel to our allies in Europe, who have been scrambling to replace their imports of Russian fossil fuels because of the Ukraine war. Consider the following:

(1) US petroleum production. US crude oil field production was 12.0 million barrels per day (mbd) during September, still below the record high of 13.0mbd during November 2019 (Fig. 21). However, natural gas liquids production rose to 6.0mbd during September. It has been trending higher since 2008, when it was about a third as much. Meanwhile, production of biofuels plus processing gains has remained steady around 2.1mbd. Add them all together, and US petroleum production was 20.2mbd during September, almost matching the pre-pandemic record high.

Weekly data show that during the November 11 week, the US had net imports of -1.9mbd, while petroleum products supplied (which actually is a measure of usage) was 20.9mbd (Fig. 22). This implies that US petroleum production rose to a record 22.7mbd during the latest week.

The US first turned into a net exporter of petroleum during late 2019.

(2) US natural gas production. The US turned into a net exporter of natural gas for the first time during October 2017 (Fig. 23 and Fig. 24).

Prior to the Ukraine war, Russia supplied up to 40% of Europe’s gas. American liquid natural gas suppliers, which tend to have more flexible contracts than those in other countries, have responded quickly to Europe’s needs. This year, shipments to Europe from the US have more than doubled. “The price of a shipload of L.N.G., which might have sold for $20 million two years ago, soared to perhaps $200 million last summer, and is now about half that, with winter fast approaching,” according to a November 16 NYT report.

The story notes: “Now, around 40 tankers with chilled gas worth billions have been sitting off the coasts of Europe and Asia, anticipating that if they wait until the weather turns colder before unloading their fuel, they will be paid higher prices.”

Europeans should give thanks to Americans for producing plenty of natural gas.

Strategy: Trader’s Corner. Here is Joe Feshbach’s latest call on the market: “On Wednesday of last week, we had one of those crazy-high put/call ratios, which halted the big decline in the Nasdaq the next day. Unfortunately, the ratio didn’t remain high and quickly returned to neutral. Furthermore, the breadth problem I’ve been referring to, especially on Nasdaq, remains. I continue to believe this trading range will continue, thus being more friendly to trading types. Investors should really try to avoid buying the momentum on big up days and concentrate more on accumulating stocks on the ugly days. While charts on the dollar and oil have peaked, providing a market floor, the internals are just not there yet for meaningful upside.”

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On Consumers, Chips & The Oceans

November 17 (Thursday)

Consumer Discretionary: Feeling the Pinch. Mixed messages about consumer spending hit the stock market this week. Walmart’s better-than-expected Q3 earnings report on Tuesday sent the shares rallying that day (by 6.5% versus a 0.9% gain for the S&P 500); but on the conference call, management gave a blunt and gloomy description of consumer spending. “[T]he consumer is stressed,” said CEO Doug McMillon. The strength of consumers’ strong balance sheets, boosted by stimulus payments, is “not going to last forever. And so, that’s why we take a rather cautious view on the consumer.”

Yesterday, Target announced results that missed expectations, and its management also sounded gloomy, sending its shares down 13.1% on Wednesday (versus a 0.8% decline for the S&P 500 that day). But the October retail sales report’s 1.3% m/m increase and 8.3% y/y surge were better than expected. Consumers are spending, it appears—just not on general merchandise, sporting goods, hobbies, musical instruments, or books.

Let’s take a look at the retail environment Walmart and Target described and consider October’s retail sales report as well as other data related to the consumer’s financial well-being:

(1) Gaining market share. Bad times are good times at Walmart. More than 50% of US sales are grocery items, and the company gains market share as consumers trade down to the retailer’s less-expensive merchandise. Its market-share gains were raised repeatedly in the company’s conference call. “Customers that came to us less frequently in the past are now shopping with us more often, including higher-income customers,” said McMillon. “Living with high prices through this year has [had] a cumulative impact on our customers, especially those that are most budget conscious. And so, we’re focused on bringing our costs and prices down as quickly as possible by item and category. Regardless of income levels, families are more price conscious now, so it’s as important as ever that we earn their trust with value.”

John David Rainey, Walmart’s CFO, said: The “macro backdrop remains challenging, as persistent inflation is impacting the consumer and our business.” He later added: “High fuel prices and mid-teens food inflation have forced consumers to manage household budgets more tightly, making frequent trade-offs and biasing spending toward everyday essentials.” Rainey noted that the company continues to gain market share in its grocery business from households across demographics, with nearly three-quarters of the share gain coming from households with annual income greater than $100,000.

Walmart increased its fiscal 2023 (ending January) guidance to reflect Q3’s surprisingly good results, but it didn’t boost the assumptions it had for Q4. “Despite a good start to Q4, our guidance assumes that the consumer could slow spending, especially in general merchandise categories, given persistent inflation pressures in food and consumables,” said Rainey. General merchandise prices and transportation costs have started to fall, but dry groceries prices and wages have risen and are sticky.

(2) Missing the Target. For the second consecutive quarter, Target missed analysts’ estimates. Its total revenue grew 3.4% to $26.5 billion, and comparable-store sales rose 2.7%; but adjusted Q3 earnings per share dropped 49.1% y/y. Inventory climbed 14.4%, while company’s operating margin fell to 3.9% compared to 7.8% in Q3-2021.

Target isn’t anticipating any improvement in the current quarter. “Based on softening sales and profit trends that emerged late in the third quarter and persisted into November,” the company forecasts a low-single-digit decline in comparable sales and an operating margin of 3%, plus or minus a large margin, in Q4.

“Clearly, it’s an environment where consumers have been stressed,” said Target CEO Brian Cornell according to a November 16 WSJ article. “We know they are spending more dollars on food and beverage and household essentials, and as they are shopping for discretionary categories, they are looking for promotions.” Target gets about a quarter of its sales from grocery items.

(3) Spending on food & cars. October’s retail sales report showed surprising strength in consumer spending across a wide swath of categories. It may have received a boost from one-time tax refunds in California and a second Prime Day held by Amazon in October. Some m/m results that stood out: gasoline stations (4.1%), food services & drinking places (1.6), food & beverage (in stores) (1.4), motor vehicle & parts (1.3), non-store retailers (1.2), furniture & home furnishing (1.1), building material and garden equipment & supplies (1.1), health & personal care stores (0.5), and miscellaneous store retailers (0.3).

Categories that missed the m/m improvement mark include: electronics & appliance (-0.3%), sporting goods, hobby, musical instrument & books (-0.3), general merchandise (-0.2), and clothing & clothing accessories (0.0) (Fig. 1, Fig. 2, and Fig. 3). Once spending on autos, gas, and food is taken out of the equation and inflation is factored in, retail sales aren’t as positive as the headline result would suggest (Fig. 4).

(4) Where’s the pain? Most consumers still have jobs, with the October unemployment rate of 3.7% remaining near historical lows (Fig. 5). However, layoffs in the tech industry have surged, consumer prices continue to climb, and consumers’ paychecks, when adjusted for inflation, are flat at best. Average hourly earnings adjusted for inflation for all workers held steady in September at $26.16, but that’s down from a peak of $27.22 in April 2020 (Fig. 6). While consumer price inflation in October rose less than analysts expected, sparking a sharp stock market rally, prices were still up 7.7% y/y last month (Fig. 7).

The strain on consumers’ budgets is starting to show up on their balance sheets. The personal savings rate fell sharply to 3.1% in September, well off the pandemic panic high of 33.8% (Fig. 8). Meanwhile, the amount of revolving debt that consumers have borrowed has increased to a record high of $1.2 trillion as of September, up 15.1% y/y. Total consumer debt, including mortgage, auto, and credit card debt, increased in the Q3 at the fastest pace in 15 years. So it’s not surprising that consumers have grown gloomier about the current economic environment and about the future as well (Fig. 9).

While the current environment is less than rosy, several factors could bode well for improved consumer spending in 2023. Peak inflation and peak interest rates may be in the rear-view mirror, and gasoline prices have started to fall. If the employment picture remains strong, consumers might open their wallets a little wider after the new year.

Semiconductors: More Mixed Messages. The semiconductor industry also received a mixed bag of news this week. On the positive side of the ledger, Berkshire Hathaway purchased 60 million shares of Taiwan Semiconductor Manufacturing for roughly $4.1 billion. It’s unknown whether the investment was made by Warren Buffett or one of Berkshire’s other portfolio managers; nonetheless, shares of Taiwan Semi soared 10.5% on the news on Tuesday. Berkshire is scooping up shares that were down almost 50% ytd at their lows in October and November.

But just as the party got started, Micron Technology reminded us why semiconductor stocks are near their ytd lows—demand is weak. The company announced on Wednesday plans to cut production of wafers used in semiconductors by about 20% compared to last quarter due to softening demand.

“Micron said the outlook for calendar year 2023 has continued to weaken. The company now expects supply growth for its DRAM memory chips to fall next year and to see an increase of a single-digit percent for its NAND flash chips,” a November 16 WSJ article reported. Micron shares fell 6.7% Wednesday and are down 36.8% ytd. But that’s an improvement from September, when shares were down 47.5% ytd.

Financial estimates for the S&P 500 Semiconductors industry continue to drop like a stone. The industry’s revenue for 2023 is expected to drop 4.6%, and its earnings are forecast to decline 11.1% (Fig. 10 and Fig. 11). The industry’s forward P/E has fallen to 16.7, down from 25.0 a year ago. In past recessions, however, the P/E actually jumped sharply as earnings all but disappeared (Fig. 12). Perhaps the crew at Berkshire is betting that the economy can skirt by without a recession?

Disruptive Technologies: Tech Saves the Oceans. Pollution, overfishing, and rising water temperatures are putting stress on the oceans, but entrepreneurs are working on solutions. Here are some of the ways they hope to restore the high seas:

(1) AI helps revive seagrass beds. Tidal, one of Alphabet’s moonshot companies, is using cameras and artificial intelligence (AI) to help it preserve and restore the world’s seagrass beds, which absorb and store carbon dioxide. The company originally used its technology in aquaculture to help fish farmers understand the health of their fish and optimize their operations.

Seagrass provides food and a habitat for marine life, filters pollution, and protects coastlines. To create food, it uses photosynthesis, absorbing sunlight, water, and carbon dioxide in the ocean. Tidal hopes to map seagrass beds and then develop models and algorithms that estimate how much carbon the seagrass absorbs. With the data in hand, projects to restore seagrass could apply for carbon credits that can be sold and traded in carbon marketplaces, providing a new funding source for seagrass bed renewal projects around the world.

“The team envisions creating autonomous versions of its tools, possibly in the form of swimming robots equipped with its cameras, that can remotely monitor coastlines and estimate the growth or loss of biomass,” a November 9 MIT Technology Review article reported. The vast amounts of data collected by those cameras could then be analyzed by Alphabet’s AI.

There are critics. The National Academies has warned that seagrass and other coastal renovation projects are hard to scale up because of space limitations: They can be implemented only on shorelines’ narrow bands of undeveloped land, where they compete with human activity. Also it’s tough to measure the net amount of carbon that seagrass removes from the ocean given that some of the carbon it puts into the seafloor escapes back into the ocean and the atmosphere. There’s additional concern about striking the proper balance between competing shoreline-use priorities: Should restoring the seagrass beds trump permitting economic activity to support local communities?

Tidal believes its tools could also be used for other environmental ends, such as growing more seaweed or restoring mangrove forests; the company tackled seagrass first because it’s fast growing.

(2) 3D printing coral reefs. The world’s coral reefs have been dying off due to pollution, acidification of the waters, and warming water temperatures. Corals do grow, but very slowly. Scientists at the King Abdullah University of Science & Technology are hoping to speed that up by giving coral a skeletal base on which to grow, made of a calcium carbonate ink they developed for 3D printing, a November 1, 2021 press release reported. Coral micro fragments attached to the printed skeleton can grow more quickly because they don’t need to build a limestone structure underneath.

The 3D printer can print out a mold of a coral reef that is subsequently filled with calcium carbonate ink to recreate a coral. While this process is quick, the size of the mold—and therefore the size of the coral skeleton made—is limited. An alternative process uses the calcium carbonate ink directly printed into the shape of a coral skeleton. The process is slower, but the structure can be bigger and is more customizable.

The National Oceanic and Atmospheric Administration (NOAA) has also embraced 3D printing to make coral research equipment less expensively. At NOAA’s Reef Lab, scientists experiment with water temperature and other variables to learn which corals are the most resilient to the expected effects of climate change. “3D printing allowed us to maintain the complexity of the research we wanted to carry out and do it for the fraction of the cost,” a NOAA scientist said in a September 13 Engineering.com article.

(3) Ocean cleanup accelerates. The Ocean Cleanup, a Netherlands-based not-for-profit foundation, aims to rid the world’s oceans of plastic by stopping the flow of plastic from rivers into the oceans and by cleaning up large areas of plastic waste already afloat. The company estimates that 1,000 rivers around the world emit nearly 80% of the world’s river plastic flowing into the ocean. Because rivers are so varied, they’ve come up with multiple plastic-collection solutions. For example, the Interceptor is a solar-powered catamaran that uses a conveyor belt to collect garbage floating in rivers. The company has deployed its systems on rivers in Vietnam, Indonesia, Jamaica, and Malaysia, among other countries.

The Ocean Cleanup is more widely known for the system it developed to scoop garbage out of the ocean using two slow moving boats, each holding one end of a net that is open at the bottom allowing fish to escape. It has progressively developed larger nets that scoop up more garbage in a single haul. The more efficient the hauling process, the lower its cost per kilogram of plastic removed and the fewer CO2-spewing boats needed. The company’s software estimates where there’s a high density of plastic waste, and its drones pinpoint the specific spots to target. The Ocean Cleanup says it has removed 1.8 million kilograms of trash from waters and hopes to remove 90% of the world’s floating plastic by 2040.

The company is currently focused on the Great Pacific Garbage Patch (GPGP), which is located between California and Hawaii and is twice the size of Texas. It plans to move beyond the GPGP to four other large ocean garbage hot spots that together contain more than 5 trillion pieces of plastic litter (see video). It also aims to offset all of its carbon emissions and is working with Maersk to experiment with low-carbon fuels in the boats.

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On Inflation & Financial Stability

November 16 (Wednesday)

Strategy: More Peak Inflation Euphoria. Last Thursday’s lower-than-expected CPI inflation rate for October was greeted with a huge rally by stock and bond investors. They continued to discount the possibility that inflation has peaked and is heading lower following yesterday’s PPI report for October. As a result, they seem to be concluding that the Fed’s monetary policy tightening cycle will be peaking sooner rather than later, with a terminal federal funds rate just below 5.00% rather than above that level. Indeed, the two-year US Treasury note yield is down from 4.73% on November 3 to 4.35% yesterday. In addition, they seem to be signaling that the 10-year US Treasury bond yield, which closed at 3.76% yesterday, might have peaked at 4.25% on October 24.

We don’t have a problem with any of that since it has been our forecast in recent months and supports our forecast that the bear market in the S&P 500 bottomed on October 12 at 3577. Admittedly, during the summer, we argued that the June 16 low of 3666 might have been the bottom. Our October 31, 2022 Morning Briefing was titled “Bear Bottoms.” We wrote: “The stock market has been working on forming a bottom since September, finding support around the June 16 low of 3666…” We predicted that the October 12 bottom would hold “if inflation shows clear signs of moderating in coming months, as we continue to expect.”

Our October 18 Morning Briefing was titled “Going Fishing.” We were fishing for reasons to call the bottoms in bond and stock prices. We observed that when the yield curve inverts, it’s time to anticipate a peak in the 10-year US Treasury bond yield, which we predicted would be 4.00%-4.25% in early November. We concluded that the June 16 low might provide support for the S&P 500 after all and that a year-end rally could push it back up to the August 16 high of 4305. So far, so good, with the S&P 500 closing at 3991 yesterday.

Inflation: Ups & Downs. We certainly aren’t out of the inflation woods yet, but we do seem to be heading in the right direction to get out of this dark forest, as we wrote in yesterday’s Morning Briefing. Let’s review the latest batch of inflation indicators, starting with two disappointing ones:

(1) Inflation expectations uptick. On Monday, the Federal Reserve Bank of New York released its October survey of inflation expectations of Americans. It headed in the wrong direction, rising from 5.4% during September to 5.9% during October for the one-year ahead series (Fig. 1). The three-year ahead series also up-ticked for the second month, from 2.8% in August to 3.1% last month.

(2) New York price indexes uptick. Yesterday, the NY Fed also released its November regional business survey. The good news is that the general business conditions index edged up to 4.5 and the employment index remained solid at 12.2. However, the new orders index edged down to -3.3.

More troubling is that both the NY regional prices-paid and prices-received indexes, which have been mostly falling in recent months, both edged up during November, remaining relatively high (Fig. 2).

(3) Peaking PPI. The good news yesterday, of course, was October’s PPI. The PPI final demand rose 8.0% y/y (Fig. 3). That’s down from a record high of 11.7% during March and the lowest since July 2021. The PPI final goods demand has dropped from a record high of 17.6% during June to 10.5% in October. The PPI final services demand is down from a 9.4% peak during March to 6.3% last month.

Among services, it’s still troubling to see that the PPI final demand for transportation and warehousing services was so high at 16.1% last month, though that is down from a peak of 23.4% during May (Fig. 4).

The PPI final demand for trade services is a measure of business markups. It is down from a peak of 18.9% y/y during March to 11.1%. That’s still high and suggests that profit margins are not getting significantly squeezed.

The PPI final demand includes indexes for personal consumption expenditures with and without food and energy (Fig. 5 and Fig. 6). Neither includes rent. They look like they peaked earlier this year, but they remained well above the Fed’s 2.0% inflation target, at 7.2% and 5.8% during October. Fed officials can rightly say that there’s a way to go to get inflation down closer to 2.0%. The question is whether they’ve already done enough given the long lags between changes in monetary policy and their impacts on the economy. We think so.

Financial Stability I: The Cover Curse. Bloomberg BusinessWeek “asked the finest finance writer around, Matt Levine of Bloomberg Opinion, to write a cover-to-cover issue” of the magazine, “something a single author has done only one other time in the magazine’s 93-year history.” The resulting cover-to-cover article is titled “The Crypto Story,” which appears on the front cover in gold lettering on a stark white background. It is a well- balanced guide to the crypto world, dated October 25.

The BusinessWeek article once again demonstrates what I call “the curse of the front-cover story”—i.e., once journalists hit on a big cover-worthy theme, all the good or bad news has been discounted by investors and speculators, and now it’s time to head in the other direction. That’s especially so when the topic fills up an entire issue. Bitcoin closed at $20,305 on October 25. It was down to $16,625 as of late yesterday afternoon.

Earlier last week, crypto exchange FTX had to pause customer withdrawal requests of about $5 billion. FTX lent about $10 billion of customers’ funds to Alameda Research for trading purposes. FTX Chief Executive Sam Bankman-Fried is the founder and majority owner of both firms. According to CoinDesk, he ran a cabal of roommates in the Bahamas. “All 10 are, or used to be, paired up in romantic relationships with each other. That includes Alameda CEO Caroline Ellison, whose firm played a central role in the company’s collapse—and who, at times, has dated Bankman-Fried.” His aspiration to become a multibillionaire was motivated by his self-proclaimed commitment to charitable giving. That included being the second biggest donor to the Democratic party!

Here is what I wrote in our May 11, 2021 Morning Briefing about cryptocurrencies: “I had been thinking of cryptocurrencies as ‘digital tulips,’ reminiscent of the 17th century tulip mania in Amsterdam that drove up tulip prices beyond reason. The difference is that cryptocurrencies are traded 24-by-7 around the world. On second thought, they might be more like a financial virus that won’t stop until enough speculators have been infected that herd immunity is achieved.” Or perhaps, cryptocurrencies are the dotcoms of the 2020s.

The Fed’s May 6, 2021 Financial Stability Report (FSR) mentioned cryptocurrencies just once—as the ninth-greatest risk to US financial stability as determined by a survey of wide-ranging viewpoints.

Here is an important excerpt on cryptocurrencies from the Fed’s most recent November 4, 2022 FSR: “The turmoil in the digital assets ecosystem did not have notable effects on the traditional financial system because the digital assets ecosystem does not provide significant financial services and its interconnections with the broader financial system are limited.”

This is just one of many speculative bubbles that have burst since early last year (e.g., ARK, SPACs, meme stocks) without causing a credit crunch or a recession, which is consistent with our rolling recession scenario.

Financial Stability II: The Banks Are Alright. So far, there are no signs that the recent bursting of any of the speculative bubbles is stressing out the US financial system in general or the banking system. Consider the following:

(1) Credit spread. The yield spread between the high-yield corporate bond composite and the 10-year US Treasury has widened from 279bps at the start of this year to 485bps on Monday (Fig. 7). However, it isn’t spiking higher the way it did during previous credit crunches.

(2) Bank loans. Loans on the balance sheets of all commercial banks in the US are up $1.0 trillion so far this year to a record high of $11.8 trillion during the November 2 week (Fig. 8).

(3) Loan loss provisions. Melissa and I track the Fed’s weekly data on provisions for loan losses at all commercial banks in the US (Fig. 9). This year, they bottomed during the June 8 week and are up just $10.8 billion to $167.3 billion through the week of November 2.

Financial Stability III: The Fed’s Worry & Not-To-Worry List. The Fed warned in its November 2022 FSR (linked above) that rising volatility in the financial markets, diminishing government bond liquidity, and geopolitical tensions threaten the risk of a global economic recession. Tightening by global central bankers combined could further strain the financial system, the report said. But the banking system is more resilient than it was during the global financial crisis. Here’s more:

(1) Liquidity a concern. “Today’s environment of rapid synchronous global monetary policy tightening, elevated inflation, and high uncertainty associated with the pandemic and the war raises the risk that a shock could lead to the amplification of vulnerabilities, for instance due to strained liquidity in core financial markets or hidden leverage,” Fed Vice Chair Lael Brainard said in a statement accompanying the report.

The Fed’s FSR reports include a survey of the risk assessments of various market participants. None of the Fed’s survey respondents in May indicated that liquidity strains and volatility were a concern. However, in November, more than half of contacts perceived these areas as a risk. “Liquidity metrics, such as market depth, suggest that Treasury market liquidity has remained below historical norms,” the Fed report observed. “Low liquidity amplifies the volatility of asset prices and may ultimately impair market functioning.”

(2) Geopolitical tensions. Consequences of Russia’s invasion of Ukraine, stresses in China, the strength of the dollar, and other developments abroad could affect US financial stability, the report said. In particular, relations between China and Taiwan were seen as a growing risk to the global economic outlook. The risks from Russia’s war on Ukraine were seen as declining, but the energy outcomes from the war are still a significant worry.

(3) Stretched home price valuations. The FSR implied, but did not say outright, that housing prices may have further to fall. Although year-over-year house price increases have decelerated, a model-based measure highlighted in the report pointed to stretched house price valuations. In any event, the report did not anticipate a 2008-style calamity in the housing market.

(4) Households and businesses servicing their debts. Notwithstanding the housing market’s troubles, mortgage delinquency rates have remained historically low. Also, the banking system remains stable, and the level of household debt is not concerning. Brainard stated: “Over the period, household and business indebtedness has remained generally stable, and on aggregate households and businesses have maintained the ability to cover debt servicing, despite rising interest rates.”

Shadow banking, or bank lending to nonbank financial institutions, has reached “new highs.” And not a whole lot is known about “some parts of the nonbank financial sector, where hidden pockets of leverage could amplify adverse shocks.” However, regulatory changes after the last financial crisis increased the resiliency and ability of banks and broker dealers to absorb losses.

(5) Leveraged loans stable. Investors’ appetites for risky debt has weakened so far this year amid market volatility. Institutional leveraged loan issuance fell back to its historical average. Default rates on leveraged loans remained near historically low levels but slightly edged up. The credit quality of leveraged loans could be pressured by rising interest rates, as these loans feature floating rates. In addition, the net issuance of high-yield and unrated bonds has remained negative so far this year.

(6) Reasonable valuations. Asset valuations have come down in riskier segments of the market as the Fed has increased interest rates. “Higher interest rates and a weaker outlook for the economy led prices of financial assets to fall amid heightened volatility, but real estate prices remained elevated. Measures of equity prices relative to expected earnings declined. Risk premiums in equity and corporate bond markets were near the middle of their historical distributions,” the report said.

(7) Pivoting opinions. In late October, on Bloomberg TV, Mohamed El-Erian made an interesting point: “If [the Fed] pivot[s], it will be because of financial stability. It’s not going to be because they have decided to not look at inflation anymore.” Earlier in the month, former Fed Chairman Ben Bernanke said that the Fed should not use its interest-rate policy to “fine-tune” financial stability risks because “I don’t think we understand that well enough, except in perhaps extreme conditions.” Instead, he said that financial regulations should be the primary financial stability risk prevention mechanism.

In terms of liquidity, Treasury Secretary Janet Yellen said in October that “we do not have a problem at this point … It’s not unexpected that in a world of increased volatility that liquidity should diminish somewhat or the cost of transacting might rise a little.” An interagency group is working on studying possible reforms to the Treasury market, which could be vulnerable to breakdowns like the one that occurred in March 2020, the WSJ reported.

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Where Inflation Is Plummeting & Soaring

November 15 (Tuesday)

US Inflation: Colder & Hotter. Inflation is following our script, more or less. Earlier this year, we expected that the headline PCED would range between 6%-7% during H1-2022 and that it would peak during the summer, falling to 4%-5% by H2-2022 (Fig. 1). In our forecast, it would continue to decline to 3%-4% in 2023.

How is that working out so far? So-so. Here is an update:

(1) Forecast. The headline PCED inflation rate peaked at 7.0% during June. It was down to 6.2% in September. October’s headline CPI suggests that the headline PCED might have fallen below 6% that month but remained above our 4%-5% target range for the second half of this year (Fig. 2). Nevertheless, we are sticking with our forecast, for now.

(2) Nondurable goods. One of the basic premises of our forecast has been that food and energy prices would stop soaring and start weighing on the nondurable components of the two measures of consumer inflation (Fig. 3). After all, food and energy prices are mostly determined in commodity markets where “high prices are the best cure for high prices,” to paraphrase the age-old adage.

The CPI energy inflation rate peaked at 41.6% y/y during June and fell to 17.6% during October. The CPI food inflation rate edged down to 10.9% from its recent peak of 11.4% during August. The SPGS commodity indexes for both energy and agriculture and livestock peaked during the summer (Fig. 4). Food and energy account for 13.7% and 8.1% of the headline CPI, respectively, and for 51.1% and 16.4% of its nondurable goods component.

By the way, apparel accounts for 2.5% of the CPI and 9.2% of nondurables. Its inflation rate peaked at 6.8% y/y during March and was down to 4.1% during October (Fig. 5). It is likely to continue to moderate since retailers are reporting that their inventories are bulging because they ordered more goods than consumers wanted or needed after their post-lockdown buying binge during 2020 and 2021.

(3) Durable goods. Another basic premise of our inflation outlook has been that durable goods inflation would drop as rapidly as it soared during the first half of this year. Again, that’s supported by retailers’ reporting that they must slash their prices to clear bloated inventories of both nondurable and durable merchandise.

That’s working out just as we expected. The lockdown and subsequent social restrictions, as well as the relief checks sent by the federal government to millions of Americans, boosted the personal income and personal saving of consumers. The result was a demand shock in the goods market that triggered a supply shock (i.e., supply-chain disruptions) that caused the CPI durable good inflation rate to soar from 3.7% y/y during March 2021 (when the third and final round of checks was disbursed) to a peak of 18.7% during February this year, the highest since the early 1940s (Fig. 6).

Retailers and importers couldn’t keep up with demand and ordered more goods from domestic and foreign manufacturers. However, starting this summer, Americans satisfied their pent-up demand for goods and pivoted to spending more on services now that these industries were no longer capacity constrained by government social distancing restrictions. The inflation rates for used cars and trucks, furniture and bedding, and household appliances have tumbled in recent months (Fig. 7). The CPI durables inflation rate was back down to 4.8% y/y during October.

From the mid-1990s until just before the pandemic, durable goods prices tended to fall on a y/y basis because of productivity gains, cheap imports, and the commoditization of many durable goods products. We expect history soon to repeat itself in this segment of consumer prices.

(4) Services. Just as unintended inventories of goods started to pile up, putting downward pressure on durable goods inflation, services inflation started to take off—literally, as airfares soared from -4.6% in October 2021 to 42.9% in September and held there in October (Fig. 8). Lodging away from home, on the other hand, peaked at 25.1% in February and March and was back down to 5.9% in October.

Another major source of inflationary pressure in services has been transportation services, which includes airfares and accounts for 6.0% of the CPI and 9.9% of services (Fig. 9). It was up 15.2% y/y through October.

Of course, the overall CPI services inflation rate was also driven higher by rent of primary residence and owners’ equivalent rate, as housing affordability plunged because of rapidly rising home prices since the end of the lockdowns and soaring mortgage rates this year (Fig. 10). The former accounts for 7.4% and the latter 24.0% of the headline CPI, 9.5% and 30.7% of the core CPI, and 12.2% and 39.5% of CPI services—which soared 7.2% y/y through October, up from 3.6% a year ago (Fig. 11).

Global Central Banks I: ECB in the Danger Zone. Higher energy costs are feeding through to more and more sectors of the economy, said Christine Lagarde, the head of the European Central Bank (ECB), in a November 1 interview. Indeed, headline inflation topped historical readings at 10.7% in the Eurozone, with the core also at a record 5.0% during October (Fig. 12). Here’s more:

(1) Not done yet. That’s why “we decided to raise our interest rates for the third time in a row” during the last ECB meeting, Lagarde continued. She added: “Since July we have raised interest rates by 200 basis points—the fastest increase in the history of the euro. But we are not done yet.” That’s all consistent with what we had expected based on commentary from central bankers, as we detailed in our October 26 Morning Briefing.

(2) Support for some. The bank is concerned about the potential for consumers and companies to start expecting higher inflation rates in the future, a “dangerous” development. However, the risk that some households might be vulnerable to increasing debt-servicing costs needs to be addressed by country-specific policies, Lagarde observed, nodding to the ECB’s recently announced policy tool for financially unstable countries. The ECB’s biannual Financial Stability Review, coming out later this month, will provide a more detailed picture of how this tool will work. So far, we do know that countries deemed to have a lack of fiscal discipline will not receive this support.

(3) Looking ahead. Lagarde reiterated that the ECB foresees “inflation at 8.1% this year, 5.5% next year and 2.3% in 2024. Growth is expected to slow to 0.9% next year and to reach 1.9% in 2024.” The risks to the downside have increased since the ECB made its baseline projections in September, she said.

(4) Discord on the board. Other ECB board members do not seem to be in favor of raising rates as aggressively as Lagarde implied. In a speech yesterday, ECB board member Fabio Panetta said that monetary policy should not “ignore the risks of overtightening.”

Global Central Banks II: BOJ in the Twilight Zone. The Bank of Japan (BOJ) remains an outlier when it comes to global monetary policy. Japan’s September inflation rate of 3.0% was the highest reading that the country has seen in a more than a decade. The rate is comfortably above the BOJ’s inflation target of 2.0%. Compared to inflation in Europe and the US, however, Japan’s inflation rate looks almost measly (Fig. 13).

That partly explains why the bank isn’t tightening while most other global central banks are doing so. At its October meeting, the BOJ decided to hold its key short-term interest rate at -0.1%. It continued to pledge to hold 10-year Japanese government bond yields around 0.0% and said it would take additional easing measures if needed. Here’s more:

(1) Wages wanted too. BOJ Governor Haruhiko Kuroda recently reiterated that the bank aims to achieve its 2% inflation target accompanied by wage increases, according to an article in yesterday’s WSJ. Real wages in Japan have been on a downtrend since 2013 (Fig. 14).

(2) Easing resource prices. Additionally, Kuroda recently said that there are some signs of local inflation easing, reducing pressure on the bank to tighten its ultra-loose monetary policy. At a news conference, Kuroda explained his thinking: “Recent price increases are due mostly to the rise in import costs and their pass-through to consumer prices. But resource prices have already started falling.” The government’s currency interventions have helped to slow the decline in the yen in recent months, he added.

(3) Projections heading down. In the BOJ’s quarterly outlook report, the board edged up its 2022 inflation forecast to 2.9%, from 2.3% back in July, due to rises in prices energy, food, and durable goods. Looking further ahead, the CPI is expected to drop below the bank’s target to 1.5% for fiscal 2023 and fiscal 2024. The board also cut its 2022 GDP growth forecast to 2.0% from 2.4% due to slowdowns in overseas economies and the effects of the spread of Covid-19 this summer. For 2023, the bank cut slightly its GDP outlook to 1.9% from 2.0%.

Global Central Banks III: PBOC in the Red Zone. In a recent note to employees, the People’s Bank of China (PBOC) pledged to keep the currency stable and to maintain the “reasonable” growth of money supply and credit, reported Bloomberg on November 11. Support will be increased for struggling sectors of the Chinese economy, the bank wrote.

The statement followed the release of data that showed China’s credit growth slowed in October on the backs of Covid closures and a weak property sector. Central bank governor Yi Gang said earlier this month that he hoped the property market could achieve a “soft landing.” Yesterday, Bloomberg reported that Chinese authorities have issued a 16-point plan to boost the real estate market and a 20-point plan to reduce the negative economic and health consequences of Covid.

Officials say that policymakers are sticking to China’s “three red lines” policies. Introduced in August 2020, these financial regulatory guidelines relate to keeping liabilities to assets, debt to equity, and cash reserves within “healthy” boundaries. Their primary intent is to promote the financial stability of the highly indebted property-development sector in China. Since December 2021, however, larger institutions have been excluded from the rules to encourage mergers and acquisitions among less stable firms in an effort to mitigate some of the pressure of bad loans.

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On Earnings & Inflation

November 14 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy I: A Brief History of Earnings Recessions. One of our accounts recently asked us if a corporate earnings recession is possible without having an economic recession. Can a soft landing in the economy still result in a hard landing for earnings?

Normally, an economic recession will cause corporate revenues to fall along with nominal GDP. During recessions, profit margins get squeezed as unit costs increase relative to unit revenues. This one-two punch sends earnings into a recession. Arithmetically, it’s possible that nominal revenues could continue to grow, especially during a period of high inflation, even as the profit margin gets squeezed so significantly that profits fall. To some extent, that describes the current situation. Revenues are growing along with nominal GDP, boosted by inflation. Profit margins are narrowing. And earnings are weakening, though they are doing so still more in line with a soft landing than a hard one.

Joe and I have been closely monitoring this scenario for the S&P 500. Let’s analyze the available data:

(1) Revenues & nominal GDP. We have S&P 500 aggregate revenues data since Q1-1992 through Q3-2022 (Fig. 1). This series is highly correlated with total nominal GDP. It is also highly correlated with nominal GDP of just goods and business sales of goods. So far, there is no recession in any of these series. Nor is there a recession in either inflation-adjusted S&P 500 revenues or in real GDP (Fig. 2).

(2) Earnings. While the revenues data compiled by S&P covers only the latest three recessions, the data provider does have a series for reported S&P 500 earnings per share starting in 1935 and covering 14 economic recessions (Fig. 3). Each economic recession was associated with an earnings recession. However, there have been mid-cycle slowdowns and declines in reported earnings per share without economic recessions. We can spot them in the early 1950s, the mid-1960s, the mid-1980s, and the mid-2010s. Almost all past bear markets in stocks were associated with both economic recessions and recessions in reported earnings (Fig. 4). The one exception was the bear market in 1987. And the jury is out on whether the current bear market will be associated with a soft or hard landing (or no landing at all!).

(3) Profit margins. Most past bear markets in stocks were associated with a decline in revenues and a decline in the profit margin. Again, the S&P data are limited because they start only in 1992. However, a useful profit margin proxy that starts in 1948 is the ratio of after-tax corporate profits in the National Income and Product Accounts divided by nominal GDP. It correlates well with the S&P 500 profit margin using either reported or operating margins (Fig. 5 and Fig. 6). The proxy has a cyclical pattern that tends to peak at the tail end of business cycles, i.e., during the booms that typically precede busts. It takes a dive and usually bottoms near the end of recessions.

(4) The future. So where do we go from here? Joe and I are able to anticipate the quarterly data on S&P 500 revenues, earnings, and the profit margin by tracking the weekly series on S&P 500 forward revenues per share, forward earnings per share, and the forward profit margin (Fig. 7). Again, we are limited by the data’s start date, though forward earnings is available since 1979 and encompasses six recessions (Fig. 8). (FYI: “Forward” earnings and revenues are the time-weighted average of analysts’ consensus estimates for this year and next; we calculate the forward profit margin from forward earnings and revenues.)

As we’ve recently observed, there is no recession in S&P 500 forward revenues so far through the November 3 week, though the series may have just started to peak. Forward earnings peaked at a record high during the June 16 week and was down 4.1% through the November 3 week. It’s the drop in the forward profit margin from a record high of 13.4% during the June 9 week to 12.7% during the November 3 week that has weighed most on earnings.

So again, where do we go from here? In a soft-landing scenario, earnings may continue to be depressed by a falling profit margin, but revenues should hold up enough to result in a mid-cycle slowdown like the previous ones identified above. In a hard-landing scenario, both revenues and margins would cause a sharp drop in earnings.

(5) Shades of gray. Of course, there are lots of shades of gray. If the dollar is finally peaking, that should ease the pressure on the profit margin. On the other hand, interest costs are likely to squeeze margins. Chronic labor shortages are causing significant turnover in the labor market, which is driving up wages and weighing on productivity. The question is whether business managers will conclude that they must automate to boost their productivity and their profit margins. Onshoring should reduce costs over the long run but may boost them in the short run.

Strategy II: Q3 Results. Joe reports that S&P and I/B/ES have compiled Q3’s data for S&P 500 revenues per share, operating earnings per share, and the operating profit margin. There are no surprises since Joe tracks the results daily during earnings reporting seasons. Nevertheless, let’s review Q3’s numbers:

(1) Q3 revenues. S&P 500 revenues rose 11.6% y/y during Q3 to a record high (Fig. 9). Growth was boosted by inflation. However, inflation-adjusted revenues increased 4.2% y/y during Q3, to a level just shy of its record high during Q4-2021 (Fig. 10).

All in all, that’s an impressive performance considering that global economic growth slowed during the quarter and the dollar continued to soar. Aggregate revenues received a big boost from the S&P 500 Energy sector. Aggregate revenues rose 10.5% and 7.8% y/y with and without Energy (Fig. 11).

(2) Q3 earnings. Despite the solid increase in revenues per share, S&P 500 operating earnings per share according to I/B/E/S rose just 3.7% y/y during Q3 (Fig. 12). They are looking toppy, having edged down during Q3 (Fig. 13). According to S&P’s data, S&P 500 aggregate earnings fell 2.5% and 11.2% y/y during Q3 with and without Energy (Fig. 14). The latter growth rate has been negative during the first three quarters of this year.

(3) Q3 profit margin. The operating profit margin of the S&P 500 remained relatively high at 12.7% during Q3 (Fig. 15). It is down from its record high of 13.7% during Q2-2021.

(4) S&P, I/B/E/S, and write-offs. By the way, S&P and I/B/E/S each have their own polling services. S&P adheres to a stricter in-house definition of operating earnings, while I/B/E/S follows a consensus “majority rule” when deciding how to present a company’s consensus forecast. The industry analysts polled by I/B/E/S typically follow companies on an adjusted earnings basis (i.e., EBBS or earnings excluding bad stuff, a.k.a. write-offs), which is higher than S&P’s earnings series (Fig. 16).

For 2022, the major difference occurred during Q2 when Berkshire Hathaway had a particularly large “mark to market” accounting loss that was not recognized by I/B/E/S. This accounts for a major part of the $15 difference between S&P’s and I/B/E/S’s 2022 estimate, which puts I/B/E/S at a slight y/y gain and S&P at a y/y decline.

There’s another minor difference between the two services’ data. S&P’s number, which it calls “Basic EPS,” is slightly higher than I/B/E/S’s “Diluted EPS.” During Q2, the difference between the two was 1.0%.

We generally use the I/B/E/S data for quarterly operating earnings, especially because we use the data services’ measure of forward earnings. In our opinion, the stock market discounts majority-rule operating earnings over the coming 12 months.

US Inflation: Peaking Euphoria. It was a moonshot for the stock market on Thursday following the release of a better-than-expected CPI report. The S&P 500 jumped 5.5%, and the Nasdaq soared 7.4%. The market might also have responded to news that Russia’s military commanders announced another significant withdrawal, this time from Kherson in southern Ukraine, on Wednesday. Also on Wednesday, the Atlanta Fed’s GDPNow tracking model reported that Q4 is up 4.0% (saar) so far. There were lots of earnings disappointments last week, but company managements are responding quickly to their misses by cutting their costs.

In any event, the big story was that the headline CPI inflation rate rose 7.7%. That was below the 8.0% that was widely expected. Consider the following:

(1) Monthly changes. Among the major CPI components that dropped m/m during October were utility piped natural gas services (-4.6%), used cars and trucks (-2.4), apparel (-0.7), and medical care services (-0.6).

(2) Annual changes. The headline CPI peaked this year at 9.1% y/y in June, falling to 7.7% in October. The core CPI peaked this year at 6.6% in September and fell to 6.3% last month. Core goods peaked at 12.3% in February and is now down to 5.1% (Fig. 17). On the other hand, services excluding energy has yet to peak, holding at 6.7% during October.

(3) Durable goods. We’ve been expecting that the durable goods CPI inflation rate would come down the soonest and the most this year. So far, so good: It peaked at 18.7% y/y in February (Fig. 18). It was down to 4.8% during October. The annualized three-month inflation rate was down to -1.2%, auguring for further declines in this CPI component’s inflation rate.

(4) Nondurable goods. Harder to predict is the nondurable goods component of the CPI because it is dominated by food and energy prices, which tend to be volatile (Fig. 19). However, their annualized three-month inflation rates—at 8.8% and -21.4%—are below their annual inflation rates of 10.9% and 17.6%.

(5) Services. There’s no peak yet in either owners’ equivalent rent (OER) or rent of primary residence (Fig. 20). We all know why rent inflation is among the stickiest components of the CPI and why OER is a flawed measure.

We all just learned that the CPI services component includes a component that is even funkier than OER. It is health insurance. On a m/m basis, it was rising by 2.0% or over for the past seven months through September (Fig. 21). In October, it dropped 4.0%. (See “Inflation Doves Want It Both Ways With Latest CPI Quirk” in the November 10 Washington Post.)

Strategy III: Trader’s Corner. Here is Joe Feshbach’s latest call on the market: “Thursday’s huge rally came off two monster high put/call ratios in a row. Tuesday’s ratio was the highest I've ever seen. So the bearish bets built up big time in the short term. While the momentum from Thursday should carry the market a little higher, I do not believe this is the start of something big from here. First of all, 1000+ DJIA point moves in a single day are not characteristic of bull markets. Furthermore, market breadth continues to underperform price moves in the major averages as well as the put call ratio quickly showing widespread acceptance of the rally on Thursday and Friday. I believe the most likely scenario to develop here is a trading range market.”

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On Transports, Oil & Climate Change

November 10 (Thursday)

Industrials: Transports Driving Higher. Until yesterday’s selloff, transportation stocks had been rallying in recent weeks, confirming the uptrend that the S&P 500 and Dow Jones Industrial Average indexes both had enjoyed. Since bottoming on October 12, the S&P 500 index has risen 7.0% and the S&P 500 Transportation index has added 8.7% through Tuesday’s close (Fig. 1). Likewise, the Dow Jones Industrial Average (DJIA) has jumped 15.4% since its low on September 26, and the Dow Jones Transportation Average (DJTA) has also climbed 15.4% from its low on September 30 through Tuesday’s close (Fig. 2). Dow Theory apostles take comfort when the DJTA confirms the direction of the DJIA.

The transports and the broader indexes have moved in lockstep, both downwards and upwards, for most of this year. The question is whether the 20.6% ytd loss in the S&P 500 Transports adequately reflects the tough fundamentals that many industries in the index face. The amount of stuff that needs shipping has declined as imports have slowed and business inventories are high; meanwhile, labor and fuel costs are taking a bite out of profits.

Here are the S&P 500 Transport industries’ performances, ytd and from their lows during 2022: Airlines (-12.7%, 21.6%), Railroads (-19.7, 11.0), Trucking (-17.0, 21.1), Transportation Composite (-20.6, 9.5), and Air Freight & Logistics (-25.0, 6.4) (Fig. 3).

Forward earnings for the S&P 500 Transports has dropped 5.5% from its record high during the July 7 week, which is ominous because it often leads the S&P 500’s forward earnings, which is down 4.2% from its June 16 record (Fig. 4). (FYI: Forward earnings are the time-weighted average of analysts’ consensus operating earnings-per-share estimates for this year and next.)

Let’s take a look at some industry fundamentals to help us assess whether the S&P 500 Transports’ recent upward stock price trend might continue or be derailed by lower earnings:

(1) Less to ship. After surging in 2020 and 2021, inbound and outbound West Coast Port container traffic, using a 12-month sum, has slowed sharply. The number of containers shipped was 12.5 million in September, down from 13.3 million at its peak in June 2021 (Fig. 5). Slowing exports reflect the sluggish economy in China and Europe, while imports have fallen from their peak as US companies find themselves with excess inventories and the economy decelerates (Fig. 6).

(2) Prices & earnings soften. In the trucking industry, the amount being hauled continues to climb, but prices in the spot market are falling. The ATA Truck Tonnage Index climbed 5.7% y/y in September to its highest level since August 2019 (Fig. 7). The seasonally adjusted index may not reflect the slowdown experienced in most transportation areas because it’s dominated by contract freight as opposed to freight hauled in the spot market, the association’s press release states. Presumably, the contract freight market reacts more slowly to changes in the economy than the spot market. It’s also notable that the not seasonally adjusted index in September was 3.8% below August’s level.

Meanwhile, the price of truck transportation as measured by the Producer Price Index rose 16.3% in September, a large jump but less than the 24.9% gain enjoyed in May 2022 (Fig. 8). Going forward, prices may continue to decelerate because prices in the spot market have fallen by almost 25% y/y in September, according to data from DAT Solutions quoted in an October 29 WSJ article.

Analysts aren’t very optimistic about 2023, when they expect the S&P 500 Trucking industry to post a 0.1% decline in revenues and a 2.2% decline in earnings (Fig. 9). Net earnings revisions were negative in October for the first time in more than a year, and the industry’s forward P/E has come down sharply, from 31.2 in November 2021 to a recent 20.2 (Fig. 10).

Railcar loadings also have slowed from their 2021 surge (Fig. 11). Rail shipment of intermodal containers has dropped dramatically, to the lowest levels in more than 20 years (Fig. 12). The amount of lumber and wood products shipped by rail also has fallen, in step with the drop in housing construction, and the amounts of chemicals and petroleum products, metals, and metal products shipped by rail have fallen as well. Conversely, rail shipments of coal and automobiles have increased (Fig. 13).

Like the truckers, railroad operators are expected to post meager earnings growth next year, 2.0%, as revenue is forecasted to be flattish, but the profit margin is expected to rise 0.4ppt to 28.0% from 27.6% in 2022 (Fig. 14 and Fig. 15). The S&P 500 Railroads industry’s forward P/E has shrunk as well, to 15.8, down from the April 2021 peak of 23.3 (Fig. 16).

(3) Rough seas ahead? Forward earnings for the S&P 500 Air Freight & Logistics industry is dreary too, and historically it’s been a good indicator of where the S&P 500’s forward earnings is headed (Fig. 17). Forward earnings for the S&P 500 Air Freight & Logistics industry has tumbled 14.3% from the June 30 record high compared to a 4.2% drop for the S&P 500.

Expeditors International of Washington reported Q3 earnings on Tuesday that beat expectations, sending its shares up 9.1% during Tuesday’s trading session; but the report’s details don’t bode well for the broader economy. Airfreight tonnage volume fell 13%, and ocean container volume dropped 10% in the quarter, according to the company’s November 8 press release. Expeditors also highlighted reductions in buy and sell rates, a “rebalancing” of capacity in the logistics freight markets, and high energy prices.

“[We] believe that inflation, high energy costs, and government fiscal and monetary measures will continue to exert pressure on global supply chains. Additionally, many shippers are now looking to shrink retail inventories that were overstocked earlier in the year in reaction to Covid-related supply chain disruptions,” CEO Jeffrey Musser said in the press release. He also forecast that decelerating demand and an overall decline in rates “are likely to continue for the remainder of 2022 and into 2023.” A shift toward slowing volumes and falling rates is occurring.

The sentiment from FedEx management was also gloomy when it warned on Tuesday that US package volumes in the current quarter are below its projections. The e-commerce boom inflated by the pandemic-related surge in shopping from home is now deflating, FedEx CFO Michael Lenz said at the Baird Global Industrial Conference, according to a November 8 Reuters article. The company expected consumers to shift their spending away from big-ticket purchases, but the “commencement and the speed and the depth of that shift was beyond what we certainly had anticipated.” The company has responded by cutting costs—including reducing vendors, deferring some projects, reducing flights, and parking planes.

(4) Travelers save the day. The S&P 500 Airlines industry stock price index has outperformed other transport industries in recent weeks. Airline traffic has rebounded to 90%-100% of 2019’s traffic levels. But costs and fuel expense have risen as well. Consumers’ wanderlust is expected to continue into 2023, when analysts are calling for the industry’s still improving earnings to nearly double y/y as they recover from losses during the Covid years (Fig. 18).

Energy: China Drives Prices. A tug of war is playing out in the oil markets. On one side is China, stubbornly adhering to its zero Covid policy and self-inflicting damage on its economy. On the other side of the equation is Russia, threatening to end oil sales to Europe if Western nations place price caps on its oil exports.

This week, the downward pull of China is winning. The price of West Texas Intermediate crude oil is $85.56 a barrel, down 7.6% over the past three trading days. China’s new Covid cases jumped above 8,000 on Wednesday, up from a more normal level of about 1,000 new cases a day last month, a November 9 South China Morning Post article reported. Granted, these are extremely small case counts given the country’s population of more than 1.4 billion, but zero Covid policies require quarantines and lockdowns nonetheless.

Case counts have jumped in Guangzhou, Beijing, Inner Mongolia, Xinjiang, and other cities and regions. In Guangzhou, a city with 18 million people, 30,000 people were moved into centralized quarantine, and daily testing is required for anyone who visited a high-risk area. Door-to-door testing was done in one area of the city by 2,500 medical workers. Travel has ground to a halt.

The price of oil might have fallen even further were it not for the restrictions that western governments are expected to place on the transport and purchase of Russian oil beginning on December 5. The European Union (EU) is expected to ban most imports of Russian oil and bar companies from insuring or financing Russian oil anywhere in the world. The US and its allies are expected to allow Russian oil shipments if the crude is priced below a preset “capped” price that has yet to be determined. And finally, on February 5, the EU will impose restrictions on Russian refined fuels and impose a price cap on them as well.

The goal of these new rules is to limit Russia’s profits from the sale of oil. The cap is reportedly in the $60-per-barrel area. Russia has said it won’t sell its oil under the price cap. It might develop ways to deliver its oil outside of the traditional G7 channels, perhaps using a “shadow” tanker fleet that doesn’t require the insurance or ships provided by western European companies. Alternatively, Russia claims that it won’t sell its oil in the market at all. It’s a pretty dangerous game of chicken that we’ll be watching.

Disruptive Technologies: COP27 and Carbon Trading. The environment is in the headlines this week, as world leaders are meeting in Egypt for the 27th Conference of the Parties to the United Nations Framework Convention on Climate Change (COP27).

Much has changed since last year’s gathering. Most notably, the Ukraine war has turned natural gas supplied by Russia into a political pawn that the country has withheld from Europe for opposing the war. The elevated price of natural gas has increased Europeans’ use of coal and even wood to generate electricity and heat. As a result, European emissions of carbon dioxide have increased over the first nine months of this year by 4.2% y/y—not a move in the right direction.

Here’s more important news from COP27:

(1) No shows. As notable as the list of attending countries is the list of non-attendees. China’s newly reelected President Xi Jinping is a no-show, yet China is the world’s top emitter of CO2. China suspended climate talks with the US after House Speaker Nancy Pelosi (D-CA) visited Taiwan. US climate envoy John Kerry did speak with his Chinese counterpart during the COP27 conference, though formal discussions have yet to be reestablished. China’s stance is that the US would need to rethink its posture on Taiwan for official talks to restart. Also notably absent was Russian President Vladimir Putin, for obvious reasons.

(2) Greenwashing. Companies, countries, and organizations making big empty promises have been called out by a new UN report. Companies claiming to be “net zero” shouldn’t also continue to build or invest in new fossil fuel assets, a November 8 FT article reported, and their decarbonization plans shouldn’t support new coal, oil, or gas supplies. For example, Glasgow Financial Alliance for Net Zero (GFANZ) should not permit investors like BlackRock and Vanguard to join because they invest in fossil fuels. The net-zero target must cover all of a company’s emissions across businesses and supply chains.

Additionally, the UN report encourages companies to prioritize emissions cuts, not just CO2 removals, and discourages the buying of cheap carbon credits to avoid actually reducing their emissions.

Kerry is working on a plan that would give regional or state governments carbon credits if they reduced their power sectors’ CO2 emissions. The governments then could sell the carbon credits to companies looking to offset their CO2 emissions. While voluntary, the program theoretically would help governments fund the transition to greener energy.

(3) Developing nations want funds. Leaders from developing nations want developed nations and oil companies to fund their transition to green energy.

“The oil and gas industry continues to earn almost $3 billion daily in profits,” said Gaston Browne, Antigua’s prime minister, speaking on behalf of the Alliance of Small Island States, according to a November 8 Reuters article. “It is about time that these companies are made to pay a global carbon tax on their profits as a source of funding for loss and damage.”

(4) Falling carbon prices. The price of carbon credits in the EU has been all over the map this year. After the invasion of Ukraine, the price crashed 35% from €95 to €55 in March. The price surged again to almost €100 in August, only to fall again and trade recently around €76.

Carbon credit prices have fallen presumably because Europeans have used less energy as the price of natural gas surged due to Russia cutting off natural gas supplies to Europe. The spike in energy prices prompted industrial and retail users to conserve as much energy as possible. The price of carbon credits also softened in anticipation of the continent’s likely recession and due to the EU’s plans to sell an increased number of carbon credits in upcoming years to raise €20 billion to help fund its transition away from Russian fossil fuels.

Supporting the price are more buyers of carbon credits looking to offset the increased use of coal to generate electricity. And while there have been warm days during the fall, the anticipation of winter weather may send carbon credit prices higher once again.

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On Political Cycles, Earnings Estimates & Fiscal Fatigue

November 09 (Wednesday)

Strategy I: The Next Political Cycle. Joe and I previously observed that the stock market has a strong tendency to perform well following midterm elections irrespective of the actual election outcome. Since 1942, during each of the 3-month, 6-month, and 12-month periods following each of the 20 midterm elections, the S&P 500 was up on average by 7.6%, 14.1%, and 14.9%. Of the 60 observations, only three of them were negative (Fig. 1 and Fig. 2). But none of the 20 observed 12-month changes were negative!

However, there are too many factors that influence the stock market to show conclusively better performance under divided than unified governments. Nevertheless, it is widely believed that political gridlock is bullish for stocks in the US. The market is happiest when our constitutional system of checks and balances is working. Therefore, a divided government is preferable to a unified government when one party controls the White House and both houses of Congress. That all makes sense. However, gridlock may not be bullish this time if the government can’t function because of extreme partisanship. We do expect nasty fights over the federal debt ceiling, for example.

By the way, in addition to the bullish midterm cycle, there is also the bullish third-year presidential cycle. The average return of the S&P 500 during the first, second, third, and fourth years of presidential terms (including both first- and second-term presidents from Roosevelt through Biden) was 6.7%, 4.3%, 13.5%, and 7.4%. The third year of presidential terms tends to be the best of the four-year cycle (Fig. 3, Fig. 4, Fig. 5, and Fig. 6).

None of these political cycles will matter if inflation doesn’t moderate significantly in coming months. In this scenario, the Fed will be forced to raise interest rates higher for longer. The result could very well be a hard landing of the economy. That would certainly bring inflation down. But it would also push stocks deeper down into bear market territory.

Strategy II: Earnings Estimates Are Fading. Industry analysts have yet to get the recession memo. They are still estimating that S&P 500 revenues are growing. However, they’ve been reading the memo about the squeeze on profit margins from rising costs. As a result, many of them have been reducing their estimates for the profit margins of the S&P 500 companies they cover, as we can tell by deriving margin estimates from their revenues and earnings estimates. Let’s update the data we’ve been following to keep track of these developments:

(1) Forward revenues. The weekly forward revenues per share of the S&P 500 dipped recently but remains on an upward trend through the last week of October (Fig. 7). This weekly series is a very good coincident indicator of actual S&P 500 quarterly revenues per share, so we use it to track the latter. There’s no recession in the weekly series so far, which has been boosted by inflation, of course. It is up 10.7% y/y.

(2) Forward operating profit margin. The forward profit margin of the S&P 500 companies peaked at a record high of 13.4% during the June 9 week. It’s been falling since then, down to a 17-month low of 12.8% during the October 27 week. It too closely tracks the S&P 500’s actual quarterly profit margin. Based on the last two recessions, there is plenty of downside for the profit margin in a hard-landing scenario and less so in a soft-landing scenario.

(3) Forward earnings. The S&P 500’s forward earnings per share peaked at a record high of $238 during the June 16 week. This series, which tracks the quarterly operating earnings per share of the S&P 500, is down 3.6% since then through the October 27 week. During the recessions of the Great Financial Crisis and the Great Virus Crisis, forward earnings dropped 39% and 21% from peak to trough.

(4) Quarterly earnings estimates. With over 88% of S&P 500 companies finished reporting revenues and earnings for Q3, revenues are ahead of the consensus forecast by just 2.2%, and earnings have exceeded estimates by only 3.7%. At the same point during the Q2 season, revenues were 2.7% above forecast and earnings had beaten estimates by 6.1%.

For the 437 companies that have reported Q3 earnings through mid-day Tuesday, the aggregate y/y revenue and earnings growth rates have slowed from their Q2-2021 to Q2-2022 readings. The 437 reporters so far collectively has a y/y revenue gain of 12.0% but an earnings gain of only 5.2%, as higher costs are pressuring profit margins. Excluding Energy, S&P 500 revenue growth falls to 8.7% y/y from 12.0% and earnings growth drops to -3.2% from 5.2%.

Industry analysts have been cutting their Q3 earnings expectations since the start of the Q2 earnings reporting season, as companies have been providing cautious guidance and continue to do so. As a result, the typical upward hook in actual earnings results is much more muted than usual during the current earnings season (Fig. 8). Meanwhile, the analysts continue to chop their expectations for Q4-2022 and all four quarters of next year (Fig. 9).

(5) Annual earnings estimates. While S&P 500 forward revenues per share has been climbing all year, the analysts’ consensus estimates for revenues per share have flattened out for both 2022 and 2023 since August and June, respectively (Fig. 10).

The consensus earnings-per-share estimates for 2022, 2023, and 2024 have been falling since mid-year (Fig. 11). Here are the latest readings for them through the November 3 week: $220, $233, and $253. The latest reading for forward earnings is $231. With the S&P 500 currently around 3850, that implies that the forward P/E is around 16.6. That’s more consistent with a soft landing than a hard-landing scenario.

(6) S&P 500 sectors. A look at the 11 sectors of the S&P 500 shows that their forward revenues are still rising in record territory for Consumer Staples, Energy, Financials, Health Care, and Utilities (Fig. 12). Stalling or heading downwards in recent weeks have been Communication Services, Consumer Discretionary, Industrials, Information Technology, Materials, and Real Estate.

In recent weeks, forward profit margins have stalled at relatively high levels for Energy, Financials, Industrials, and Real Estate (Fig. 13). They are falling among the other sectors.

On balance, slowing forward revenues growth and mostly flat and modestly falling forward profit margins are weighing on forward earnings (Fig. 14).

US Fiscal Policy: Biden’s Contribution to Inflation. The Fed’s latest Minutes doesn’t mention the word “fiscal” even once. This is curious because the Fed’s monetary policy mission to lower inflation runs counter to recent years’ fiscal policy, the effect of which has been to boost inflation. So one would think the Fed would have an opinion on fiscal policy.

In any event, the one Fed governor who has mentioned fiscal policy in recent months is Fed Governor Lael Brainard. Interestingly, Brainard’s take on monetary policy runs counter to Fed Chair Powell’s, as we discussed in Monday’s Morning Briefing. She is not as hawkish as he is.

Brainard may be right that a gentler approach to tightening ahead is best. That’s not only because of the lagging effect that monetary policy has on inflation but also because fiscal policy is likely to become less stimulative and thus less inflationary over the coming months.

During President Joe Biden’s tenure so far, about $4.8 trillion in excessively stimulative fiscal spending has poured into various sectors of the economy. The most significant tranche of spending released immediate funds in an indiscriminate manner to a large swath of the US adult population. Stimulus funds have acted like a jolt of espresso to household wealth and consumer spending, adding to the inflationary environment that the Fed now is trying to tame. Now that much of those funds already have been spent down by consumers, the US government is likely to run out of fiscal fuel while monetary policy is tightening. That’s especially likely if the midterm elections result in more political gridlock.

Below, we examine the inflationary effects of Biden’s big spending. It may very well lead to fiscal fatigue even as the stimulus wears off. Consider the following:

(1) Spending under Biden. The Committee for a Responsible Federal Budget (CFRB) has a helpful infographic on all the spending passed under Biden. It shows clearly that the spending, without much in the way of offsets, has added significantly to the deficit. Of the $4.8 trillion net deficit increase, the American Rescue Plan (ARP) enacted in March 2021 contributed the most, $1.9 trillion. Yet another significant spending bill passed into law under Biden was the Bipartisan Infrastructure Law, enacted in November 2021 and totaling $370 billion. Its purpose is to rebuild America’s roads, bridges, tunnels, and other key transportation infrastructure.

The fiscal 2022 Omnibus bill also added $625 billion in discretionary spending to the budget to keep up with inflation. And net interest associated with the ARP is estimated to cost $700 billion. It all adds up to almost $5 trillion according to the CFRB.

For perspective, President Trump’s additions to the debt added a historic $7 trillion. But $4 trillion of that was emergency spending related to Covid. Some say that Biden’s nearly $2 trillion ARP represents emergency rescue spending as well; but we don’t deem it as necessary as the Trump Covid outlay, since it added to the national debt at a time when the US economy already was coming out of Covid and growing. But the ARP certainly stimulated inflation.

(2) American Rescue Plan inflates inflation. Quick bursts of $1,400 were distributed to Americans with the government’s third round of stimulus checks from the ARP in March 2021. At the time, annual inflation was just under 2.0%. Fast forward a year and a half to September 2022, and we see the highest inflationary increase in nearly 40 years (Fig. 15). Estimates from various university, Fed, and International Monetary Fund researchers (see here, here, and here) suggest that the ARP added around 3-4ppts to inflation.

Of the ARP’s grand total $1.85 trillion, $900 billion of it was spent in 2021, with an immediate $400 billion injection directly into Americans’ bank accounts. That jolted the already inflationary environment created by pandemic-related supply-chain difficulties and the Ukraine war. A case in point: Immediately after Americans received the stimulus checks, demand for new and used cars surged, overwhelming the short supply, and catapulted the CPI for those items (Fig. 16).

Was the ARP worth spiking inflation for? Sure, the spending came at a time of uncertainty when variants of Covid were spreading. But ARP also came at a time when millions of Americans who were out of work during the pandemic found employment.

(3) Student debt relief adds to inflation. Biden’s student debt relief, enacted in several parts from April to August 2022, also freed up income that would have been used to pay down debt and increased household wealth by $20,000 for the biggest beneficiaries ($10,000 in debt cancelation and $10,000 in grants). Others received an extension on a pandemic-related repayment pause. In total, CFRB reports that the act canceled about one-third of all federal student debt.

While Biden’s student debt aid did not add as much to inflation as ARP, according to estimates, the bump was still meaningful. Economist Jason Furman estimated that the Fed would need to raise interest rates by up to 75bps to counteract the debt from an inflationary perspective.

Counterarguments to the inflationary aspects of the student loan cancelation and relief were outlined in a recent article in The Atlantic. They say that much of the debt would have gone unpaid anyway and went to Americans under financial stress—but also acknowledge that only about 11% of debt was in default or arrears when the bill passed.

(4) There’s still lots of excess saving. The Fed’s study of excess savings data shows how much additional household savings was accumulated during the pandemic beyond what would have been saved under normal conditions (i.e., absent federal aid and assuming consistent spending patterns) (Fig. 17). By Q3-2021, the Fed estimates that the stock of excess household savings amounted to about $2.3 trillion, after which it began to decline as spending picked up and fiscal support diminished. However, the stock of excess savings was still high, at about $1.7 trillion, by mid-2022.

The bottom line is that fiscal supports to Americans were inflationary and have not yet run out. But political gridlock suggests that as the fiscal high wears off, there won’t be another round of fiscal extravaganzas.

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On Labor, Productivity & Wages

November 08 (Tuesday)

YRI Monday Webcast. Replays of the Monday webcasts are available here.

US Labor Market I: Pandemonium. Everything has been topsy-turvy since the pandemic. There was a terrible recession during 2020 that lasted only two months. There was a V-shaped recovery from Q2-2020 through Q4-2021 (Fig. 1). Real GDP soared 15.1% over that period. It fully recovered by Q1-2021, just three quarters after it troughed. The headline PCED inflation rate soared from just under 2.0% y/y during February 2021 to a peak of 7.0% during June 2022, the highest reading since December 1981 (Fig. 2). The 2-year US Treasury yield soared from around 0.25% during H1-2021 to 4.66% currently (Fig. 3). The 30-year mortgage rate soared from 3.32% at the start of this year to 7.33% on Friday (Fig. 4).

Just as tumultuous has been the US labor market, which took longer to recover than did GDP but now it remains surprisingly strong. The Fed’s main goal during the pandemic was to lower the unemployment rate. It succeeded all too well, as the jobless rate fell to a recent low of 3.5% during July and September of this year, but inflation soared (Fig. 5). The jobless rate edged up to 3.7% during October.

Now, according to September’s FOMC Summary of Economic Projections, the Fed’s goal is to increase the jobless rate to 4.4% during 2023 and 2024 in order to lower the headline PCED inflation rate to 2.8% next year and 2.3% in 2024. During his November 2 press conference, Fed Chair Jerome Powell warned that it might take higher interest rates than the FOMC had previously expected to achieve all that. If so, then we will see that reflected in December’s SEP.

Consider the following recent strong developments in the labor market that are challenging the Fed’s goal:

(1) Coincident indicators. Payroll employment is one of the four components of the Index of Coincident Economic Indicators (CEI), which rose to a new record high during September. It probably did so again during October, as payroll employment rose to a new record high that month.

Another one of the four components of the CEI is industrial production. Friday’s employment report showed that aggregate weekly hours in manufacturing rose 0.2% m/m during October, suggesting that industrial production continued to expand in October (Fig. 6).

We’ve found that payroll employment in truck transportation and in temporary help services are highly correlated with the Index of Leading Economic Indicators (Fig. 7 and Fig. 8). Both measures rose to new record highs during October. By the way, payroll employment in information industries rose last month to the highest level since April 2006 despite recent layoff announcements among technology companies.

(2) Divergent trends. Payroll employment rose 4.1 million during the first 10 months of this year to a new record high (Fig. 9). Over the same period, the gains in household employment (2.6 million) and the labor force (2.4 million) have slowed, and both remain just below their pre-pandemic record high levels. The payroll measure tallies the number of jobs, while the household measure counts the number of workers. The latter shows that the number of workers with full-time positions increased by 2.0 million since the start of this year, while the number with part-time jobs has increased by 713,000 so far this year (Fig. 10).

(3) JOLTS turnover. The pandemonium in the labor market is easiest to see in the JOLTS data. During September, there were still 10.7 million job openings, or 1.8 open positions for every unemployed worker. This series is highly correlated with the percent of small business owners with job openings and with the jobs-plentiful series that is included in the consumer confidence survey (Fig. 11 and Fig. 12). Both are available through October and suggest that the JOLTS series fell in October but remains very high.

There are numerous reasons for the imbalance between the demand and the supply of labor. The labor force is growing more slowly along with the working-age population. Older Baby Boom workers are retiring. The younger workers who’ve been entering the labor force in recent years seem to have less allegiance to their employers and are more easily persuaded to quit for greener pastures than are older workers. Some might prefer a couple of part-time jobs to the commitment of full-time employment.

Whatever might be the explanation, a near record 33.5% of all payroll employees quit their jobs over the past 12 months through September (Fig. 13). Over this same period, total separations and total hires accounted for 47.0% and 50.7% of payrolls (Fig. 14). That’s an extraordinary amount of turnover!

(4) Productivity. All the post-pandemic turnover in the labor force has weighed heavily on productivity, especially during the first three quarters of 2022. It’s hard to maintain productivity growth when lots of employees are quitting and being replaced with new workers who must be trained to do their jobs.

Nonfarm business productivity rose just 0.3% (saar) during Q3 after falling 4.1% during Q2 and 5.9% during Q1 (Fig. 15). Hourly compensation moderated a bit to 3.8%, so unit labor costs rose 3.5%. However, those are annualized quarterly increases. On a y/y basis, unit labor costs still rose 6.1%, which boosted the CPI inflation rate to 8.2% through September (Fig. 16).

So what about our Roaring 2020s productivity-boom scenario? We still have seven years for this to happen. We still believe that a major productivity growth cycle started during Q4-2015, when the annualized 20-quarter percent change in productivity bottomed at 0.4% (Fig. 17). It recently peaked at 2.5% during Q2-2021 and fell to 1.6% during Q3-2022.

We expect that businesses increasingly will respond to the shortage of labor by using productivity-enhancing technologies like robotics and artificial intelligence. We expect to see the productivity cycle peak around 4.0% during the second half of this decade.

US Labor Market II: Wage Inflation Moderating or Not? Now let’s focus on the wage component of the wage-price-rent spiral. Friday’s employment report did show some moderation in the pace of wage inflation as measured by average hourly earnings (AHE) for all workers. However, the rapid pace of quitting to get better pay by switching jobs probably must subside for wage inflation to continue moderating. Consider the following:

(1) AHE rose 4.7% y/y during October, while its annualized 3-month inflation rate fell to 3.8% (Fig. 18). That suggests that inflationary wage pressures are easing.

(2) The Atlanta Fed’s median wage growth tracker shows that pay rose 6.4% through September, with job switchers seeing pay increases of 7.9% and job stayers receiving 5.3% increases (Fig. 19).

ADP has started to post similar data, which show that the median percent change in annual pay through October rose 15.2% for job changers and 7.7% for job stayers.

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Powell Is From Mars, Brainard Is From Venus

November 07 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy I: Midterms. The Republicans are likely to win a majority in the House and maybe even in the Senate as a result of Tuesday’s congressional midterm elections. The clear winner would be our constitutional system of checks and balances, otherwise known as “gridlock.” The Democrats are warning the voters that such an outcome would be “a threat to our democracy.” The Republicans are countering that the Democrats are the ones posing the greatest threat to our democracy. Hopefully, the electorate will remain calm but be motivated to vote to demonstrate to both sides that our democracy remains very much intact. So go vote on Tuesday.

The stock market might have started to vote early in anticipation of the midterms. The S&P 500 is up 5.4% since it bottomed on October 12 (Fig. 1). The jury is out, but Joe and I think the bear market in the S&P 500 might have hit its ultimate bottom on that day, when it closed at 3577, down 25.4% from its record high on January 3.

Recognizing that “it ain’t over ’til it’s over,” as Yogi Berra once observed, let’s say that the latest bear market lasted 282 days (Fig. 2). That compares favorably with the average bear market: Since 1929, the prior 22 bear markets (including the brief 2020 pandemic selloff) lasted 341 days on average, with the S&P 500 falling 36.6% on average (Table 1). Those were mostly associated with hard landings in the economy, of course.

We are expecting a soft landing for the economy this time, which is why we think that the bear market might have bottomed. We are still assigning a 60% probability to this scenario and a 40% probability to a hard-landing one.

In addition, we’ve noted that the stock market has a strong tendency to perform well following midterm elections. Since 1942, during each of the 3-month, 6-month, and 12-month periods following each of the 20 midterms, the S&P 500 was up on average by 7.6%, 14.1%, and 14.9% (Fig. 3 and Fig. 4). That’s irrespective of the actual election outcome.

By our count, during periods of a unified government, when one party controlled the White House and both houses of Congress, the S&P 500 rose on average 9.5% per year under Democrat administrations and 13.0% under Republican ones since 1933 (Fig. 5). During periods of a divided government, the S&P 500 rose 7.5% per year. Since 1933, there have been three instances when the Republicans ruled the unified government and seven instances when the Democrats did. Altogether, the government was unified under Republicans for 8 years, unified under Democrats for 36 years, and divided for 46 years.

By the way, the amount of federal debt outstanding has risen during periods of both unified and divided government (Fig. 6). The two parties may fight over federal spending and taxation issues, but they can always agree on paying for budget deficits by issuing more debt. Enabling their fiscal excesses in recent years has been the ultra-easy monetary policies of the Federal Reserve. However, the excessively stimulative mix of fiscal and monetary policies in response to the pandemic caused inflation to soar, forcing the Fed to raise interest rates significantly.

As a result, the 12-month sum of the net interest paid by the federal government has jumped from $384 billion just before the pandemic in February 2020 to a record high of $475 billion during September (Fig. 7). We calculate that the federal government is currently paying about 2.0% interest on its debt. That average interest rate can only go up from here. At 3.0% or 4.0%, the net interest cost would rise to $729 billion or $972 billion (Fig. 8).

Helping to offset that rapidly rising cost is inflation, which is boosting federal tax revenues (Fig. 9). The 12-month sum of federal government receipts has increased by $1.35 trillion since February 2020 to a record $4.90 trillion through September of this year.

The liberal-leaning media is warning that if the Republicans win a majority in either the House or the Senate or both, the result is likely to be chaos. For example, on October 10, MSNBC’s Steve Benen, a producer for The Rachel Maddow Show, warned “Republicans aren’t thinking about governing, per se. Rather, GOP leaders are likely to focus on gridlock, impeachment crusades, and extensive hearings into assorted conspiracy theories.” The conservative-leaning The Washington Times reported on October 10 that “Republican Senate candidate Blake Masters said if Arizona voters elect him, he is prepared to shut down the government to force President Biden to reverse course on his border policies.”

Gridlock is likely to be less bullish for stocks if it exacerbates the extreme partisanship that is increasingly dividing our country. Nevertheless, we have often observed that it’s amazing how well the US economy and stock market perform over time despite Washington’s meddling and madness.

Strategy II: Powell & the Others. The S&P 500 fell 3.5% over the course of Wednesday and Thursday last week, mostly following Fed Chair Jerome Powell’s hawkish press conference on Wednesday afternoon. It then rose 1.4% on Friday to close at 3770, still above the June 16 low of 3666 and the October 12 low of 3577.

Powell’s presser reflected the peak pessimism and hawkishness he has shown so far. He seems to have joined the hard-landing camp, concluding that the only way to bring inflation down is with a recession. When asked about whether the path to a soft landing has narrowed, he said “to the extent [interest] rates have to go higher and stay higher for longer [it] becomes harder to see the path, [so] it's narrowed.”

During his presser, Powell presented his one-man “dot plot,” implying that the median forecast for the federal funds rate in September’s FOMC Summary of Economic Projections (SEP) will be revised up in December’s SEP. (See also the actual dot plot, Figure 2 here.) He said, “[W]e think we have a ways to go, we have some ground to cover with interest rates … before we get to that level of interest rates that we think is sufficiently restrictive.” He added, “[W]e still have some ways to go, and incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected.” The phrase “ways to go” appeared four times in Powell’s presser.

Melissa and I think that Powell’s hawkishness may not reflect the views of other Fed officials. Consider the following:

(1) Powell’s hawkishness contrasted with the more nuanced language in the FOMC’s statement: “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

(2) That language is nearly identical to language that Fed Vice Chair Lael Brainard used in talking about tightening monetary policy in an October 10 speech: “We are starting to see the effects in some areas, but it will take some time for the cumulative tightening to transmit throughout the economy and to bring inflation down.” At the end, she reiterated: “It will take time for the cumulative effect of tighter monetary policy to work through the economy broadly and to bring inflation down.”

She also mentioned the lags between monetary policy and the economy that the FOMC statement referred to: “The transmission of tighter policy is most evident in highly interest-sensitive sectors like housing, where mortgage rates have more than doubled year to date and house price appreciation has fallen sharply over recent months and is on track to soon be flat. In other sectors, lags in transmission mean that policy actions to date will have their full effect on activity in coming quarters, and the effect on price setting may take longer.”

(3) The FOMC’s latest blackout period (prohibiting public statements) ended on Friday. We’ve been expecting that after it ends, other Fed officials will start pushing back against Powell’s extreme hawkishness. Sure enough, the pushback began on Friday: In an interview with Federal Reserve Bank of Boston President Susan Collins, the WSJ’s ace Fed watcher Nick Timiraos found that she’s optimistic about a soft landing. She said, “We’re going to have to tighten further and then hold for some time. I am optimistic that there is a pathway that would not require a significant slowdown.” She agrees with Powell that the FOMC still has “a ways to go” in tightening monetary policy but favors smaller rate hikes.

Inflation I: More News Ahead. The outlook for almost everything on the economic and financial fronts depends on the course of inflation. If it shows more signs of moderating soon, then a soft landing will be more likely. In this scenario, interest rates will peak sooner rather than later, and the stock market may have bottomed already on October 12. If inflation remains higher for longer, then so will interest rates, raising the odds of a hard landing and a continuation of the bear market in stocks.

The Santa Claus rally should get a big lift from the midterm elections. However, that won’t happen if Fed Chair Powell feels compelled to play the part of the Grinch That Stole Christmas because inflation remains troublesome.

The next BIG NUMBER on the inflation front is October’s CPI, which will be released on Thursday. Before it comes out, October’s survey of small business owners will be released on Tuesday. In recent months through September, there have been significant drops in the percent of these business owners planning to raise their average selling prices (Fig. 10). Let’s see what we know so far about October’s consumer prices:

(1) Goods. The inflation rate of the goods CPI component on a y/y basis is highly correlated with the M-PMI’s prices-paid index, pushed forward by three months (Fig. 11). The former was up 9.5% during September but has been looking toppy in recent months; its relationship with the latter suggests that it should fall close to zero by early next year.

We know that the national pump price of a gallon of gasoline ticked up during October (Fig. 12). The price of natural gas eased last month. The soaring price of diesel fuel could boost the prices of goods as a result of higher transportation costs. On the other hand, the wholesale price of used cars fell 10.4% y/y during October.

(2) Services. There’s also a correlation between the services CPI inflation rate and the NM-PMI’s prices-paid index, but it isn’t as tight as the one between the goods CPI component and the M-PMI prices-paid index (Fig. 13). The services CPI inflation rate rose to 7.4% during September, the highest since August 1982; the NM-PMI (pushed ahead by 12 months) suggests that the CPI services inflation rate won’t peak until early next year and won’t fall until next summer. We also know that the rent inflation component of the services CPI probably won’t even peak until next summer.

October’s employment reports showed that wage inflation, as measured using average hourly earnings on a y/y basis, seems to have peaked for both goods-producing and services-providing industries, but both remain relatively high, at 4.4% and 4.8% last month (Fig. 14 and Fig. 15). The annualized three-month rates through October were 4.1% and 3.8%, respectively, suggesting further moderation in the y/y measures in coming months.

Inflation II: A Fed Head from Venus vs Mars. During 2020 and 2021, Fed Chair Jerome Powell seemed to reside on Venus, where he did all he could to provide the maximum level of employment that is “broad-based” and “inclusive” to the Earth’s inhabitants. At the start of 2022, Powell moved to Mars to fight the “persistent” inflation that resulted here on Earth because of his Venusian policies.

Meanwhile, Fed Vice Chair Lael Brainard continues to live on Venus, as we suggested above. Powell wants “to keep at it” because the Fed has “a ways to go” to bring inflation down. Brainard believes that the Fed may have done enough (or soon will do so) to bring inflation down considering that the impact of “cumulative tightening” on the economy operates with “lags.”

We agree with Brainard. In her speech cited above, she made the following nuanced and reasonable points about inflation:

(1) “Strong wage growth along with high rental and housing costs mean that inflation from core services is expected to ease only slowly from currently elevated levels. In contrast, core goods have been expected to return to something closer to the pre-pandemic trend of modest disinflation as a result of demand rotation away from goods to services, coupled with the healing of supply chains and declining core import prices. Disinflation in core goods would help to offset the inflationary pressures in services.”

(2) “So there is ample room for margin recompression to help reduce goods inflation as demand cools, supply constraints ease, and inventories increase.”

(3) “Despite the higher prices for a broad set of goods and services, market- and survey-based measures of longer-term inflation expectations are within ranges consistent with expectations that inflation will return to 2 percent over the medium term.”

(4) “The combined effect of concurrent global tightening is larger than the sum of its parts. The Federal Reserve takes into account the spillovers of higher interest rates, a stronger dollar, and weaker demand from foreign economies into the United States, as well as in the reverse direction.”

Movie. “Don’t Worry Darling” (+ +) (link) is a film that Mark Zuckerberg should see and study. It’s about the dark downside of virtual reality. It might convince him to get out of this dream world that can easily turn into a world of nightmares, as it has so far for his company, Meta. Life is idyllic in a 1950s-styled neighborhood of the company town of Victory, California. The men go to their top-secret jobs every morning at Victor Headquarters, while their wives clean the house, socialize with the other wives, and make dinner. But something is not quite right, as two of the wives soon discover. The film is a genre film that channels such classics as “The Stepford Wives,” “Get Out,” “Pleasantville,” and “The Truman Show.” Florence Pugh shines as one of the wives. The cinematography and production design are great too.

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On Powell, China, Consumers & AI

November 03 (Thursday)

The Fed: What Powell Said. During his press conference yesterday, Fed Chair Jerome Powell continued to read from the Volcker 2.0 script. His punchline appeared in his prepared remarks: “[W]e still have some ways to go, and incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected.”

During the Q&A portion of his presser, Powell repeated “some ways to go” several times to describe the Fed’s path for tightening monetary policy. He also reiterated that the terminal federal funds rate is likely to be higher than suggested by September’s FOMC Summary of Economic Projections, which showed a median forecast of 4.6% next year.

He didn’t rule out smaller rate hikes than the latest 75bps hike, but he did rule out any easing, saying, “The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done.” That statement seemed to rule out any pause in rate-hiking anytime soon. The Fed’s goal is to “moderate demand so that it comes into better alignment with supply” to bring inflation down to 2.0%. In his Q&A, Powell clearly stated that he isn’t convinced that the federal funds rate is restrictive enough yet to do the job.

Stocks sank on Powell’s unwavering hawkishness. Nevertheless, we still believe that the S&P 500 bottomed on October 12. We expect that other Fed officials soon will be speaking publicly in less hawkish terms, effectively toning down Powell’s hawkishness. We also expect that a red wave in the midterm congressional elections will boost the stock market. Additionally, we think that the inflation indicators to be released over the rest of the year should show more signs of moderating, which likewise should buoy the market.

China: Looking for a Reason To Bounce. China continues to be plagued by new Covid-19 cases and a zero Covid policy that’s causing economic havoc. Defaults by its overleveraged developers are piling up and depressing the country’s real estate market. Chinese stocks have fallen so far for so long that just a hint that the country might end its zero Covid policy from an unsubstantiated source sent shares rallying recently—until the rumor was debunked.

Here's a quick update on the status of Covid and real estate developers in China as well as a look at what actual developments could send shares sustainably higher:

(1) Covid continues. New daily cases of Covid in China have risen slightly, bouncing around 2,000, and the country’s zero Covid policy has forced many cities to shut down. The cities of Urumqi and Xining have been under lockdown since August, prompting online complaints by citizens. In Urumqi, more than 210 infections were reported on Saturday, an October 31 South China Morning Post (SCMP) article reported.

In Zhengzhou, a Foxconn Technology Group iPhone assembly plant was operating under strict Covid controls, with daily testing and a ban on dining in the cafeterias after a “small number” of the 300,000 employees on the campus came down with Covid. After some viral social media clips showed workers fleeing the plant on foot with their luggage (in China, factory workers often bunk at work), the factory said it would arrange safe transportation for those who wanted to leave and a clean environment for those who wanted to stay, an October 30 SCMP article reported. The plant is offering to quadruple daily bonuses to entice workers to stay at the factory through November. The city around the plant is locked down as well.

After one visitor tested positive for Covid, the Shanghai Disney Resort was closed. Nomura estimates that there were lockdowns and restrictions in 28 Chinese cities last week, affecting almost 208 million people and 8.5% of China’s GDP, a November 1 Reuters article reported.

There are a few signs that the government will slightly ease the zero Covid policy. Next month, priority travelers entering China reportedly will be able to quarantine for just seven days instead of ten under the current policy. There are also reports that the number of international flights will double this winter.

As of mid-October, 90% of Chinese were fully vaccinated, but only 57% had received a booster shot. The country recently introduced a new, inhaled vaccine produced by Chinese company CanSino Biologics that will be used as a booster. It’s hoped that the inhaled booster will attract those who are fearful of injections.

(2) Real estate still sliding. Covid-19 shutdowns and distressed developers have resulted in real estate prices that continue to drop. In Shanghai, some landlords are offering discounts of up to 20% on high-end rental properties as expats and high-income workers have left the city because of the constant threat of Covid shutdowns.

The average monthly home rent in Shanghai fell 5.6% m/m in September to $14.20 per square meter. Prices may continue to drop because the inventory has climbed to 52,600 flats available for lease, an October 30 SCMP article reported.

The distress among Chinese developers continues, with the WSJ reporting on November 1 that the price of dollar-denominated bonds sold by developers has fallen to new lows. Bonds sold by China Evergrande Group, CIFI Holdings Group, and Country Garden, for example, are trading below 10 cents on the dollar. On Tuesday, CIFI became the latest developer to suspend payments on its offshore debt.

New home sales in China continue to suffer as well, as confidence in the developers and the entire real estate sector has deteriorated. New home sales in China’s 100 largest cities fell 28.4% y/y in October to $76.7 billion, the WSJ noted.

(3) Economic activity slows. Covid, a declining real estate sector, and falling exports have hurt Chinese economic activity. The Caixin/S&P Global manufacturing purchasing managers’ index rose slightly to 49.2 in October from 48.1 in September but remained below the 50.0 mark, signifying a slowing of manufacturing activity. The components of the October index were all below 50.0: new orders (48.1), employment (48.3), and output (49.6) (Fig. 1). The country’s bank loans have also fallen to $30.3 trillion, down from their peak in March of $31.7 trillion (Fig. 2).

The China MSCI stock price index continues to reflect country’s woes, having fallen 39.0% ytd (Fig. 3). But the market has sold off so sharply that it seems ready to bounce at the first indication that anything is about to improve. That became evident earlier this week when Chinese stocks rallied on an unverified social media post claiming that a committee was being formed to determine how to end zero Covid. Chinese shares fell back after Chinese Foreign Ministry spokesman put a pin in the rumor, saying that he’s not aware of such a committee, a November 1 Bloomberg article reported.

Investors looking for a reason to buy Chinese stocks might want to consider the price of copper, which often foretells economic activity, particularly in China where it’s used in construction. The price of copper has been moving sideways after falling sharply in the first half of 2022 (Fig. 4). In addition, the yuan has fallen by 13% since its peak in early 2022, which should help the country’s substantial export business (Fig. 5). And if the government ever announced a looser Covid policy or a large restructuring fund to help clean up its real estate problem, Chinese shares very likely would head higher.

Consumer Discretionary: Buying Services. The notion that consumers have been spending more on services and less on stuff was borne out by last week’s economic data releases, and now it’s been confirmed by many of the Q3 corporate earnings reports.

Real personal consumption expenditures rose 1.9% y/y through September, with spending on services jumping by 3.1%, while spending on goods fell 0.5% (Fig. 6). We need look no further than the recent earnings reports of Amazon, Uber, and Airbnb to see the impacts of this shift:

(1) No more stuff needed. Amazon warned last week that sales in the current quarter will miss analysts’ expectations. The company forecast Q4 sales of $140.0 billion to $148.0 billion, a y/y increase of 2%-8%. Analysts were expecting a result closer to $155 billion. The company’s shares have fallen 12.8% since last week’s earnings news, and they’re 41.9% lower ytd through Tuesday’s close.

Amazon executives said foreign exchange rates would hurt sales by 4.6ppts and noted that consumers’ budgets are tight, hurt by high inflation. The company plans to prepare for a period of slower growth by cutting costs. Amazon’s disappointing results could also be the result of stiff competition from the likes of Walmart and Target, a October 28 WSJ article reported. It added that consumers may be more willing to return to brick-and-mortar stores this holiday than they were last year, when Covid was more prevalent. And consumers may spend more on experiences this holiday season instead of buying more stuff if current trends hold through Q4.

(2) Consumers are out and about. After two years of being cooped up, consumers are hitting the road, many in Ubers. The company reported Q3 revenue that jumped 72% y/y to $8.3 billion. But management expects growth to slow from here, as y/y comparisons get tougher. The slowdown is apparent in Uber’s gross bookings, which are expected to grow 16%-20% in Q4 versus 26% growth during Q3 and 56% in Q4-2021.

Investors were still pleased with the forecast, sending Uber shares up 12.0% after the results were announced on Tuesday. Consumers haven’t reduced or stopped taking Uber rides even though inflation is straining budgets. Nationwide, prices for a standard Uber or Lyft ride were 36% higher y/y in September, according to YipitData quoted in a November 1 WSJ article. Uber executives do think that tighter consumer budgets prompted more drivers to join Uber last quarter. As a result, the number of active ride-share drivers in Q3 equaled the number of drivers in 2019.

(3) Consumers go on vacation. Airbnb reported record revenue of $2.9 billion in Q3, up 29% y/y, or 36% y/y excluding the impact of foreign exchange. Results were boosted by more bookings in cities, stronger cross-border travel, and longer stays. The nights and experiences booked in the quarter grew 25% y/y and the value of those nights and experiences grew 31% to $15.6 billion. The company generated almost a billion dollars of free cash flow in the quarter.

Based on its bookings for future stays, Airbnb expects revenue growth to continue and forecasts Q4 revenue of $1.80 billion to $1.88 billion, the midpoint of which is slightly below the analysts’ consensus forecast of $1.87 billion. The y/y Q4 revenue growth forecasted—17%-23%, or 23%-29% excluding the impact of foreign exchange—is slower than Q3’s actual revenue growth.

In the wake of the earnings news, Airbnb shares fell 5.4% in after-market trading on Tuesday, and they’re down 34.5% ytd through Tuesday’s close. The big questions surrounding the company are whether business will slow as more people return to working in offices, instead of in rented condos on the beach, and whether the economy will enter a recession, which presumably also would slow business.

So far, however, Airbnb management isn’t seeing either negative scenario. “Even with more companies requiring employees to return to the office, nights booked from long-term stays remained stable from a year ago at 20% of total gross nights booked,” the company wrote in its quarterly letter.

Disruptive Technologies: AI Gaining Momentum. Programs using artificial intelligence (AI) have gotten smarter, moving beyond recognizing images or patterns in data to creating pictures and text in what’s become known as “generative AI.” Large companies are paying attention, and M&A activity is robust. Some believe that as AI evolves, it will lead to a new surge in corporate productivity. Here’s a look at the rapidly developing area:

(1) AI companies getting acquired. Large, established companies are actively investing in startups specializing in various areas of AI. Google, Microsoft, and Deloitte are either negotiating or have completed an investment in AI startups recently.

Alphabet’s Google is in talks to invest at least $200 million into AI startup Cohere. “Founded in 2019, Cohere creates natural language processing software that developers can then use to build AI applications for businesses, including tools for chatbots and other features that can understand human speech and text,” an October 21 WSJ article reported. Google’s cloud division supplies the computing power needed for Cohere to train its software models. Cohere has also held talks with Nvidia about the chipmaker making an investment.

Deloitte US last month acquired SFL Scientific, a consulting firm focused on AI strategy and data science, for an undisclosed amount, an October 5 article on Consulting.us reported. The company helps businesses evaluate areas for AI investment and identify how AI can transform their businesses. The firm addresses more than 20 industries and has more than 60 employees. It joins the much larger Deloitte Global AI and analytics business, which has more than 27,000 practitioners focused on AI strategy, data and analytics modernization, cloud machine learning, and intelligent automation.

Meanwhile, Microsoft reportedly is considering adding to the $1 billion investment it made in OpenAI in 2019, an October 20 WSJ article reported. The two companies have preexisting relationships. Microsoft has integrated OpenAI’s Dall-E2, which allows users to generate art from strings of text, into Microsoft Design, a new graphic design app, and into the image creator for Bing. And OpenAI uses Microsoft’s Azure as its exclusive cloud provider.

(2) AI getting creative. Like Dall-E2, Stable Diffusion creates images from text, and it was integrated into Adobe’s Photoshop. We experimented with Craiyon, an AI program available for free on the web. Type in “dog juggling popcorn,” and back comes nine moderately different pictures of said request. You can also request the style in which you’d like the picture created. Warhol and Picasso must be turning in their graves. Pretty amazing stuff.

AI-created video has also arrived. Meta’s Make-A-Video and Google’s Phenaki are AI programs that generate video from a string of words. Google is using LaMDA to build an AI writing tool, Wordcraft, that can be used to generate ideas for a piece of fiction or suggest ways to improve upon the writing. “Google describes it as a sort of ‘text editor with purpose’ built into a web-based word processor. Users can prompt Wordcraft to rewrite phrases or direct it to make a sentence funnier. It can also describe objects if asked or generate prompts. In a nutshell, it’s sort of like wrapping an editor and writing partner into a single AI tool,” a November 2 article in The Verge reported.

(3) AI to boost productivity? Stanford University’s Erik Brynjolfsson believes that AI is about to drive a boom in productivity. Companies may have needed to change their business processes, workflows, data infrastructure, and workers to use AI and run machine-learning models in their operations. These efforts, he notes, can be costly and mean that there’s no return on investment during initial stages of adoption.

But when these changes reach their turning point, they result in sudden increases in productivity, something he describes as a “J-curve.” Brynjolfsson believes that we’re near the bottom of the AI J-curve and turning up, implying that productivity improvements should be forthcoming, a January 31 TechTalks article states.

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On Powell, Inflation & Home Prices

November 02 (Wednesday)

The Fed: What Will Powell Say? This afternoon, the FOMC is widely expected to increase the federal funds rate by 75bps to a range of 3.75%-4.00%. There is much less certainty about what Fed Chair Jerome Powell will say at his press conference at 2:30 p.m. after the meeting. The bulls, including yours truly, are hoping to hear that after another rate hike of 75bps next month to 4.50%-4.75%, the Fed is likely to pause rate-hiking to assess the economic impact of raising the federal funds rate by a whopping 450bps during the 10 months since March of this year. That’s probably asking for more than Powell is likely to deliver.

More likely, Powell will say that inflation remains persistent. It seems to be moderating in the goods sector, though food inflation remains troublesome as does energy inflation. If the Russians terminate their agreement with Ukraine over grain shipments, that could push global grain prices higher. The drought in the US could continue to put upward pressure on US food prices (Fig. 1). A shortage of diesel fuel in the US could boost its price significantly, raising the costs of transporting food and lots of other goods (Fig. 2). Powell may not get that far down into the weeds, but he certainly will mention that the inflation pandemic has spread more broadly into services prices, not just rents (Fig. 3).

Nevertheless, Powell is likely to acknowledge that the federal funds rate at 3.75%-4.00% is more restrictive and getting closer to the median forecast of 4.40% shown in September’s FOMC Summary of Economic Projections. A 50bps rate hike in December would match this forecast. A 75bps hike would frontload the committee’s 4.60% projection for 2023.

Powell undoubtedly will reiterate that the Fed remains data dependent. Any pause in rate-hiking won’t last very long if inflation remains stubbornly high. In any event, any pause at a sufficiently restrictive level will be maintained for quite a while even while inflation subsides. The FOMC wants to be certain that inflation has been subdued before lowering interest rates again.

While there is more talk about a 5.00% (or higher) terminal federal funds rate, the 2-year US Treasury note yield remains around 4.50% (Fig. 4). Also suggesting that the federal funds rate will be sufficiently restrictive just below 5.00% is the ongoing inversion of the 10-year versus 2-year Treasury yield spread (Fig. 5).

Inflation: Not There Yet. Now let’s drill down into the latest batch of inflation data to assess whether we need to change our inflation forecast. We’ve been expecting the headline PCED inflation rate to moderate from a range of 6%-7% during the first half of this year to 4%-5% during the second half of this year and 3%-4% next year (Fig. 6). The FOMC’s projection is that the headline PCED will end up this year at 5.4% and next year at 2.8%. We may be too optimistic about the rest of this year, while the Fed is probably too optimistic about next year.

In any case, inflation remains persistently high. It might have peaked at 7.0% y/y during June, but it was 6.2% during September. So it remains in the 6.0%-7.0% range. The core PCED peaked this year at 5.4% during February and March, but it was still 5.1% during September, basically fluctuating around 5.0% since the start of this year. Let’s see where inflation is moderating and where it isn’t:

(1) Commodity prices. Both the CRB all commodities index and the CRB raw industrials spot price index have been falling since they peaked this summer (Fig. 7). The S&P-GS commodity index also peaked this summer; it has stopped falling recently, as both its agricultural & livestock and energy indexes have edged up (Fig. 8 and Fig. 9). The US national pump price of gasoline also edged up during October, as the crack spread has widened again (Fig. 10 and Fig. 11). On the other hand, natural gas prices have been coming down.

(2) Business surveys. The prices-paid index included in October’s survey of manufacturing purchasing managers (the M-PMI) dropped to 46.6 during October (Fig. 12). That’s down from a recent peak of 87.1 during March 2022 and the first reading below 50.0 since the pandemic lockdown ended.

Less encouraging is the average of the prices-paid indexes of the regional business surveys conducted by five of the 12 Federal Reserve Banks. It has declined sharply this year but remained elevated in October. The same can be said about the average of the regional prices-received indexes (Fig. 13).

(3) PCED nondurable goods accounts for 21.5% of the headline PCED. Food and energy account for 11.8% and 55.9% of this component. As of September, the headline and core nondurable goods inflation rates rose 9.5% and 3.8% y/y (Fig. 14).

Food inflation might have peaked during August at 12.3% y/y; it edged down to 11.9% in September (Fig. 15). Energy inflation peaked at 43.6% during June and fell to 20.3% in September.

(4) PCED durable goods accounts for 12.5% of the PCED. This category was inflated by the demand shock for goods following the end of the pandemic lockdowns. It overwhelmed the supply chains, resulting in shortages and rapidly rising prices. The PCED durable goods inflation rate peaked at 10.6% y/y during February 2022 (Fig. 16). It was down to 5.7% during September. On a three-month annualized basis, it was only 2.8% through September (Fig. 17).

Housing-related durable goods inflation rates are moderating because new and existing home sales are in a recession. Used car prices turned negative on a y/y basis during October, falling 10.4% (Fig. 18).

(5) PCED services accounts for 66.0% of the PCED. Rent of primary residence and owners’ equivalent rent account for 5.4% and 16.7% of the services PCED. Both inflation rates continued to move higher during September, to 7.2% and 6.7%. Their comparable three-month annualized rates were even higher at 9.2% and 8.7%. As is widely recognized, the rent component reflects all currently active leases. The Zillow observed rent index, reflecting new leases, peaked at 17.1% y/y during February. It is down to 10.7% as of September (Fig. 19).

There are lots of other services components with smaller weights than rent in the PCED, and they are also showing more signs of inflating than disinflating: motor vehicle maintenance (11.1% y/y), motor vehicle insurance (3.9), airline fares (32.9), pet services including veterinary (11.0), day care & preschool (5.1), and delivery services (16.4).

(6) Bottom line. Inflation may have peaked, but it remains too high. Progress has been made in bringing down goods inflation, though food inflation remains troublesome. The problem is that the inflation in services is no longer just about the funky measure of owners’ equivalent rent. We will wait until October’s CPI is released on November 10 to reassess our outlook for inflation.

The question is whether a persistently high federal funds rate of 4.50%-5.00% will be restrictive enough to bring inflation down in 2023. We think it could bring inflation down to our target range of 3.0%-4.0%. We doubt it will bring inflation down below 3.0% as the FOMC projected in September.

US Housing: Now & Then. With mortgage rates rising to the highest levels since the early 2000s, it is no surprise that home prices are starting to fall. The question is: How low will housing prices go? Most housing market analysts are not expecting a crash as was seen during 2007 when the housing bubble burst. Melissa and I agree. Consider the following:

(1) This time is different. Mortgage rates are causing prices to drop this time around. Last time, mortgage rates were on the way down when home prices dropped. The 2007-09 housing crisis instead was driven by poor lending standards, which led to lots of foreclosures. Now lending standards are much tighter, and household balance sheets are strong.

(2) Mortgage rates weighing on home prices. The S&P/Case-Shiller US National Home Price Index (HPI), released last week, showed that home prices fell 1.1% m/m in August, the biggest monthly decline since 2010. But on a y/y basis, the HPI was 13.0% higher than in August 2021, down from July’s 15.6% increase (Fig. 20). During August 2021, the index was 19.9% above the prior year. Since then, the 30-year fixed mortgage rate has risen from 2.87% to 5.50% through this August. The latest mortgage rate was above 7.0% this October, the highest in 20 years (Fig. 21).

(3) More downside. Pending and existing home sales are at their lowest levels since June 2010 and September 2012, respectively, excluding a brief drop at the start of the pandemic (Fig. 22). Traffic of prospective homebuyers fell 64% from January of this year through October to the slowest pace since the lockdown recession (Fig. 23).

(4) Supply shortage persists. Supply dynamics continue to favor higher prices despite the rise in mortgage rates. Housing prices are still expected to be up 11% for 2022, followed by 2% in 2023, according to the National Association of Realtors’ (NAR) most recent forecast. “Inventory will remain tight in the coming months and even for the next couple of years,” Lawrence Yun, NAR’s Chief Economist, recently said. “Some homeowners are unwilling to trade up or trade down after locking in historically low mortgage rates in recent years, increasing the need for more new-home construction to boost supply.”

The months’ supply of existing homes on the market remained puny at 3.2 months during September 2022 (Fig. 24). Back in 2010, the supply was over 10 months. Compared to existing homes, there is a notable divergence in the supply of new homes, which are up to around nine months from a pandemic low near three months. However, the market is much more heavily weighted toward existing homes, with 1.3 million existing homes currently available for sale versus 462,000 new homes (Fig. 25).

(5) Lending standards/foreclosures. Foreclosures are near record lows, so they’re unlikely to pressure housing prices downward as happened during the GFC (Fig. 26). High prices—buoyed by inventory shortages and a pandemic-driven surge in demand for suburban homes—are unlikely to pop owing to nonpayment of mortgages by distressed homeowners because there’s not much evidence of their financial stress.

During the GFC, many buyers lacking evidence of sufficient income were approved for mortgages, artificially propping up home prices. That would be highly unlikely to happen today. Data from the Federal Reserve Bank of New York recently showed that the typical credit score for newly originated mortgage debt during Q2 was above 700 (Fig. 27). The share of mortgage balances 90+ days past due remained at 0.5%, near a historical low, Fed data show (Fig. 28).

(6) Demographics. Millennial homebuyers would likely swoop into the market en masse if home prices fell further from here (assuming that mortgage rates don’t rise too much further), providing a floor of sorts. Millennials finally are aging into the housing market—buying their first homes but later in life than their Baby Boom parents did; that’s primarily because many have had difficulty saving for a down payment while burdened with huge student loan debt.

Millennials’ main hurdles to homeownership now are affordability and qualifying for a loan. But they do now make up the largest share of home buyers, at 43%, according to the NAR’s 2022 Home Buyers and Sellers Generational Trends report.

Gen Zers, right behind Millennials in age, also have begun to enter the housing market, currently composing 2% of home buyers.

(7) Institutional investors. Not only Millennials but institutional investors as well would swoop in to provide a floor for housing prices if they began to tank—as these investors did for the asset fire sales during the GFC. That’s especially true as institutional ownership represents a growing, though small, share of the real estate market.

(8) Money supply. By the way, in recent years, a close correlation between the monetary aggregate M2 and the S&P/Case-Shiller Home Price Index has emerged (Fig. 29). The monetary aggregate represents the liquid dollars floating around and available to buy up other assets. M2 would have to fall a lot further for the correlation to imply declining housing prices too, all else being equal, because currently there’s still a lot of money in circulation chasing scarce housing assets.

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Back To The Old Normal?

November 01 (Tuesday)

US Economy I: Orlando. It’s good to be back on the road again. I get to visit with our accounts in person, and I also get to see how the economy is doing based on conversations I have with “the locals.” I was in Orlando over the weekend speaking at the MoneyShow conference. The city is growing rapidly, as New Yorkers have been pouring into Mickey’s and Minnie’s neighborhood. Housing and road construction are booming.

I flew into JetBlue’s new terminal at Orlando International Airport. A sign indicated that it was built partly with funds provided by last year’s Bipartisan Infrastructure Law, which included approximately $1.2 trillion in spending, with $550 billion being newly authorized spending on top of what Congress was planning to authorize regularly.

US Economy II: New Normal, R.I.P. The New Normal is dead. So is TINA (i.e., “there is no alternative” to stocks). So is disinflation. May they all rest in peace. They were alive and well from the Great Financial Crisis (GFC) through the Great Virus Crisis (GVC). Following the GFC, the Fed and other central banks feared deflation. They were frustrated that despite their unconventional ultra-easy monetary policies, they weren’t able sustainably to raise their inflation rates to their 2% targets.

So those unconventional policies—including zero-interest-rate and negative-interest-rate policies (ZIRP and NIRP) and the expansion of their balance sheets with quantitative easing (QE)—became all too conventional. Their response to the GVC was to triple and quadruple down on their QE bond purchases. Fiscal authorities, especially in the US, widened their budget deficits dramatically by providing all sorts of pandemic relief programs. Advocates of this monetary and fiscal extravaganza justified it with Modern Monetary Theory. Others called it a necessary provision of “helicopter money” to avert an economic and financial meltdown.

The result of all the helicopter money was a demand shock that caused a supply shock in global commodity and goods markets. Inflation soared. Supply chains were disrupted as the demand for goods well exceeded what could be manufactured and delivered by factories, shippers, wholesalers, and retailers around the world. Russia’s invasion of Ukraine exacerbated supply-chain disruptions and inflationary pressures, especially in grain, oil, and natural gas commodity markets.

The Fed and other central banks responded by raising their official interest rates and signaling that more hikes and more quantitative tightening to fight inflation lay ahead, which caused interest rates to soar even faster and higher than the official rates. That seems to have caused goods inflation to peak and moderate; but meanwhile, the inflation pandemic has spread to services.

So the New Normal is over. It’s looking more like the Old Normal business cycle is back, with central banks responding to higher inflation by tightening their monetary policies until they cause a recession, which should bring down inflation.

US Economy III: An Odd Old Normal. Debbie and I aren’t convinced that the US economy is about to follow the Old Normal script of the classic business cycle, however. The script it’s been following since the start of the pandemic is quite an odd one. During 2020, the economy fell into a deep lockdown recession that lasted only two months, i.e., March and April. Then only three quarters after real GDP bottomed during Q2-2020, it had fully recovered. Inflation, as noted above, made a remarkable comeback since March 2021, when the headline PCED rose above 2.0% for the first time since fall 2018, peaking at 7.0% this June, the highest since December 1981.

Let’s have a closer look at how GDP has been performing so far this year and assess the outlook for the economy in 2023:

(1) Real GDP. Real GDP fell during the first two quarters of this year as follows: Q1 (-1.6%) and Q2 (-0.6%). That led to a widespread view that the economy had experienced a “technical recession,” defined as two consecutive down quarters in real GDP. But then it rose 2.6% during Q3 (Fig. 1). However, it is up just 0.1% from Q4-2021 through Q3 of this year and 1.8% y/y (Fig. 2).

That’s consistent with our view that the economy is in a “growth recession,” a.k.a. a “soft landing,” “rolling recession” or “mid-cycle slowdown.” It’s not experiencing a hard landing now nor do we expect it to do so in 2023.

(2) Net exports. The pandemic has caused pandemonium in all of our personal and working lives. It certainly had a dramatic impact on the economy in 2020 and 2021. This year, much of Q1’s weakness in real GDP was attributable to an unusually large widening of the deficit in net exports of goods and services, which was fully reversed during Q3 (Fig. 3). Apparently, US retailers responded to the demand shock by ordering lots more goods from overseas that finally made it through the jammed ports during Q1, and now they are stuck with more merchandise than consumers want to buy after their buying binge of the previous two years.

(3) Consumers. There’s no recession in consumer spending. On an inflation-adjusted basis, it rose 1.3%, 2.0%, and 1.4% during the first three quarters of this year. That’s even though inflation has eroded the purchasing power of personal income. Over the past 12 months through September, real disposable income is down 2.9% (Fig. 4).

However, consumers have been able to boost their spending thanks to the excess saving they accumulated during the GVC, which we reckon is at least $1 trillion. That’s allowed them to reduce their personal saving rate to boost their consumption (Fig. 5).

So real personal consumption expenditures rose 1.9% y/y through September, led by a 3.1% increase in services, while goods fell 0.5% (Fig. 6). After satisfying much of their pent-up demand for goods, consumers have been spending more on services. In the real GDP accounts, consumer spending on goods is down 2.4% from its record high during Q2-2021, while outlays on services rose 3.2% y/y to a record high during Q3 (Fig. 7).

(4) Autos. Personal consumption expenditures on motor vehicles and parts in the real GDP accounts peaked at a record high during Q2-2021 (Fig. 8). It was down 16.2% through Q3. There is probably still lots of pent-up demand for cars and light trucks as a result of supply shortages over the past year, but quite a bit of that is likely to be stymied by the tightening of lending conditions in the auto market. In the past, falling auto demand was a major contributor to recessions. This time, it might have a smaller impact.

(5) Housing. In the past, the housing industry was also a major contributor to recessions. This time, strength in multi-family housing construction should offset some of the weakness in single-family housing starts, which peaked at 1.22 million units (saar) during November 2021, well below the 1.82 million units record high during January 2006 (Fig. 9 and Fig. 10). Like autos, there is plenty of pent-up demand and migratory demand (as in Orlando), but rapidly tightening lending conditions have seriously depressed affordability.

By the way, also included in the residential component of real GDP are improvements of residential structures and brokers’ commissions (Fig. 11). They peaked during Q4-2020 and Q1-2021, respectively, and are contributing to the decline in residential investment.

(6) Capital spending. Capital spending in real GDP rose to a record high during Q3. It did so even though nonresidential investment in structures has dropped 26.9% from Q4-2019 (just before the pandemic) through Q3 (Fig. 12). Meanwhile, investment in equipment and intellectual property products both rose to new highs during Q3.

The weakness in structures has been widespread (Fig. 13). So this segment of capital spending is already in a recession. Meanwhile, real outlays on industrial, information processing, and transportation equipment remain relatively strong (Fig. 14). Leading intellectual property products to new record highs have been software and research & development (Fig. 15).

(7) Inventories. Inventory investment turns negative during recessions, clearing the decks for a big recovery in real GDP when production ramps up to meet rebounding demand and to restock inventories. During the first three quarters, inventory investment has been positive but falling. That has weighed on GDP growth (Fig. 16). Inventory investment may continue to weigh on economic growth, especially if it turns negative in coming quarters.

The inventories of manufacturing firms and auto retailers seem to be in line with their businesses (Fig. 17). Wholesalers and nonauto retailers seem to have piled up some unintended inventories over the past four quarters and are scrambling to sell surplus goods by discounting their prices.

(8) Government. The federal, state, and local governments all are likely to be stimulating the economy with funds already allocated by Congress for infrastructure spending. In addition, many states are sitting on large budget surpluses. A few of them are dropping some of it as helicopter money into the checking accounts of their taxpayers.

An October 18 Pew report on states’ fiscal health observes: “Rainy day funds in most states and collectively are projected to have reached new highs by the end of fiscal year 2022, building on record gains the year before. Over the last two fiscal years, higher-than-forecasted revenue and other temporary factors have helped spur widespread growth in rainy day funds, which are an essential fiscal tool that helps states weather the ups and downs of the business cycle.”

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Bear Bottoms

October 31 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy I: So Far, So Good. The S&P 500 rose 4.0% last week and 2.5% just on Friday to close at 3901. It is up 9.1% since it bottomed at 3577 on a closing basis on October 12. If that was the bear market’s bottom, then it lasted 282 days (since the January 3 record high) and trimmed the index by 25.4% (Fig. 1 and Fig. 2).

The index is now 18.7% below its January 3 record high of 4796. It jumped easily above its 50-day moving average on Friday. It is likely to retest its 200-day moving average, which was 4098 on Friday. Joe and I are still expecting it to revisit its August 16 high of 4305 by the end of this year. The Santa Claus rally might have started already, and Santa’s sled is likely to be supercharged by the congressional midterm elections, as we first discussed in our October 19 Morning Briefing and explored further on October 24.

The bear market in the S&P 500 has been entirely attributable to a 30% plunge in the S&P 500’s forward P/E from 21.5 on January 3 to 15.1 on October 12 (Fig. 3). We continue to believe, as we’ve been writing, that the 15.0 level should hold as long as the economic outlook is for a soft landing rather than a hard one. The forward earnings of the S&P 500 increased 4.6% since the first week of January through the third week of October (Fig. 4). This weekly proxy for earnings peaked during the June 23 week, falling 1.8% through the October 20 week. (FYI: “Forward P/E” is the multiple using “forward earnings,” which is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for this year and next.)

Admittedly, during the summer, we had thought that the June 16 low of 3666 was the bottom of the current bear market in the S&P 500. In our opinion, that level has provided some good support during the most recent selloff, which was triggered by more hawkish talk by Fed officials.

Fortunately, Fed officials haven’t been talking this week because their blackout period started on October 22 prior to their FOMC meeting on Tuesday and Wednesday of this coming week.

However, we will hear from Fed Chair Jerome Powell at his press conference on Wednesday. He should be a bit less hawkish than he was following the 75bps rate hike on September 21. At that point, he said this (emphasis ours): “[T]oday … we’ve just moved, I think, probably, into the very lowest level of what might be restrictive, and, certainly, in my view and the view of the Committee, there’s a way to go.” That certainly freaked out the bond and stock markets until recently.

On Wednesday, the FOMC is expected to announce another 75bps hike to a range of 3.75%-4.00%. That would make the fourth consecutive hike of that magnitude. Powell will have to acknowledge that the federal funds rate is now further into restrictive territory and will be even more so come the FOMC’s December meeting, when the rate is widely expected to be raised by 50bps to 75bps.

Keep in mind that September’s FOMC Summary of Economic Projections showed that the committee’s median forecast for the federal funds rate was 4.4% by the end of this year and 4.6% by the end of next year. The committee believed that would be restrictive enough to lower the PCED inflation rate from 5.4% this year to 2.8% next year.

Strategy II: Has the S&P 500 Discounted a Hard Landing? One of our accounts recently asked us to assess the extent to which the stock market has discounted a garden-variety recession. That’s an interesting question. Joe and I have been thinking and writing about this question all year.

Our current assessment is that the market has discounted a rolling recession, a.k.a. a “soft landing,” “growth recession,” or “mid-cycle slowdown.” We give this soft-landing scenario a 60% subjective probability; the remaining 40% we assign to the hard-landing one. We think investors have discounted the former but remain nervous about the latter.

The stock market has been working on forming a bottom since September, finding support around the June 16 low of 3666, as we noted above. That bottom should hold if real GDP growth, on a y/y basis, hovers between 0.5% and 1.5% through the first half of next year and then recovers to more normal growth during the second half of next year, as discussed below. In addition, it should hold if the Fed delivers two more hikes in the federal funds rate by the end of this year (as is widely expected) and then pauses rate-hiking during the first few months of next year. Furthermore, the bottom should hold if inflation shows clear signs of moderating in coming months, as we continue to expect.

Let’s examine the extent to which the stock market is discounting a soft landing or a hard landing. Since we think that it has mostly discounted the former, we reckon that the latter could send the S&P 500 down by another 10%-15% from its most recent bottom on October 14. Consider the following:

(1) LEI. The Index of Leading Economic Indicators (LEI) peaked at a record high during February and is down 2.9% through September (Fig. 5). As we’ve previously observed, the LEI has a good record of calling recessions. It peaked on average by 13.7 months before the previous seven business cycle peaks (prior to the pandemic). So the next business cycle peak is likely to occur next year around March or April and will be followed by the next recession, according to the LEI model. That could happen if the Fed is forced to resume tightening after a brief pause because inflation remains persistently high. That’s not our most likely scenario.

(2) S&P 500. The S&P 500 is one of the 10 components of the LEI (Fig. 6). According to the S&P 500, the latest recession should have started already around May of this year. While the LEI is only available since January 1959, the S&P 500 is available starting in 1928. Since the end of WWII, the S&P 500 has peaked on average by five months before the past 11 business cycle peaks (prior to the pandemic).

By the way, with only one exception, the S&P 500 has bottomed near the ends of previous recessions, not before they’d even started! The one exception was the Tech Wreck bear market during the early 2000s, when the S&P 500 didn’t bottom until 11 months after the recession back then had ended.

The current recession is the most widely anticipated downturn that hasn’t happened—so far. If it does happen, there is likely to be more downside for earnings and the valuation multiple, sending the S&P 500 still lower. Again, that’s not our most likely scenario.

(3) History. The current bear market started on January 3 of this year. Let’s say that it lasted 282 days, ending on October 12, when the S&P 500 was down 25.4%. That compares favorably with the average bear market: Since 1929, the prior 22 bear markets (including the brief 2020 pandemic selloff) lasted 341 days on average, with the S&P 500 falling 36.6% on average (Table 1). Those were mostly hard landings, of course.

(4) Forward earnings. As noted above, S&P 500 forward earnings rose to a record high during the June 23 week and has been relatively flat below that peak since then. The S&P 500 is determined by its forward earnings multiplied by its forward P/E. The former is determined by industry analysts, while the latter is determined by investors. So far, forward earnings has been moving sideways, rather than diving as it invariably does during recessions as analysts—who rarely see recessions coming—scramble to slash their earnings estimates.

During the October 20 week, industry analysts did continue to shave their earnings-per-share estimates for the next five quarters from Q4-2022 through Q4-2023 (Fig. 7 and Fig. 8). Nevertheless, their annual estimate for 2023 at $238.78 remained above their forward earnings of $235.58. Very soon, at the start of the new year, forward earnings will be giving increasingly more weight to the analysts’ estimate for 2024, which is currently $258.03 (Fig. 9).

(5) Forward P/E. The bears correctly observe that it would be very unusual to see the next bull market start at a forward P/E of around 15.0, which is the historical average of the P/E ratio (using reported earnings from 1935-1978 and forward earnings since 1979) (Fig. 10). Since the bears expect a hard landing, they conclude that the latest bear market hasn’t bottomed yet. It will do so only after analysts are forced by the coming recession to slash their estimates for S&P 500 revenues, profit margins, and earnings. Along the way, investors are likely to respond by further lowering the P/E multiple they are willing to pay for falling earnings. In this scenario, the P/E could fall much lower, especially if inflation remains stubbornly high during the recession, as happened during the Great Inflation of the 1970s. Again, that’s the bears’ scenario, not ours.

(6) Sentiment. Also supporting our view that the bear bottom has occurred is the extreme bearish readings in various surveys of investors’ sentiment. For example, this year, Investors Intelligence Bull-Bear Ratio has been below 1.00 for 17 of the 26 weeks since early May (Fig. 11). It can stay this low for quite some time during bear markets. But it tends to be a very good contrarian “buy” indicator for long-term investors.

Strategy III: Less Mega in MegaCap-8. So far this year through Friday, the performance derby shows that the eight very high-capitalization stocks known as the “MegaCap-8” (-33.4%) collectively has underperformed the S&P 500 (-18.2%) and the DJIA-30 (-9.6%). The MegaCap-8 still accounts for 21.5% of the market capitalization of the S&P 500, but that’s down from a record 26.4% during the week of November 19, 2021 (Fig. 12). It still accounts for 48.0% of the market cap of S&P 500 Growth, down from the peak of 50.9% during the February 25 week. Here are a few more pertinent updates on the MegaCap-8:

(1) Market cap. Since the S&P 500 peaked at a record high on January 3, the market cap of the MegaCap-8 is down 33.4%, or $4.0 trillion, through Friday’s close (Fig. 13). Their float-adjusted market-cap decline of $3.3 trillion accounted for 44% of the $7.5 trillion drop in the S&P 500’s market cap over the same period.

Here are the percentage and dollar declines (in billions) of the individual MegaCap-8 stocks ytd: Meta (-71.5%, -$669 billion), Nvidia (-53.2, -391), Netflix (-50.7, -135), Amazon (-37.7, -638), Alphabet (-35.1, -674), Tesla (-32.0, -340), Microsoft (-30.4, -767), and Apple (-14.1, -410) (Fig. 14).

(2) Valuation. At 24.7, the forward P/E of the MegaCap-8 was still relatively high at the end of last week (Fig. 15).

(3) DJIA. The DJIA-30 includes just one MegaCap-8, namely Microsoft. This concentrated portfolio is down just 9.6% ytd. It jumped 14.4% this month through Friday, representing its best October performance ever, going back to 1921, and its best month overall since a 14.4% gain in January 1976.

Strategy IV: Trading Corner. Here is Joe Feshbach’s latest call on the market: “Previously, I said this rally should take the S&P 500 up to the 3850-3900 range, and we’re right at the upper range. However, the short-term charts still look a little higher to me. The S&P 500 took out its previous high of 3886, while the Nasdaq has not. The Nasdaq should exceed 11682 before any short-term peak is reached, in my opinion. The put/call ratio has been just okay, but did have a huge day on the Meta shellacking, while breadth has improved but is still nothing to celebrate. So while the market should climb higher over the short term, I don’t think there is significant upside at this point, and most likely a trading range will ensue.”

Movie. “All Quiet on the Western Front” (+ + +) (link) is a German production on Netflix of the Erich Maria Remarque’s book of the same name about the horrors experienced by a young German soldier fighting in the trenches during World War I. There is no glory in this anti-war movie. Wars have horrible consequences. The WSJ review observed that “the military high command on both sides … had 20th-century armaments and 19th-century thinking.” Unfortunately, we are seeing a similar disaster today in real time playing out in Ukraine. The weapons are much more destructive today and the thinking is just as primitive. The acting and the cinematography are superb.

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China and Semiconductors

October 27 (Thursday)

China: What Does Joe Know? On October 7, the US Department of Commerce announced serious restrictions on the sale of sophisticated semiconductors and semiconductor equipment to China. The decision will hurt the revenues of US-based semiconductor and semiconductor equipment makers that sell these high-end products into Chinese markets. In its press release, the agency explained that the restricted chips and equipment were being used by the People’s Republic of China to “produce advanced military systems including weapons of mass destruction; improve the speed and accuracy of its military decision making, planning and logistics, as well as of its autonomous military systems; and commit human rights abuses.”

The new rules “represent a shift in US policy, which is to keep China as far behind the US and other countries as possible in advanced computing technology and not just a generation or two behind,” Byron Callan at Capital Alpha Partners explained in a recent note. “The timing suggests heightened US concern over China’s advances in military related high technology.”

So here’s a look at some of China’s advancements in military technology that may have President Joe Biden’s administration worried:

(1) China 2027. Shortly after Chinese President Xi Jinping entered office in 2012, he laid out plans to build a strong army. In 2020, he went a step further, unveiling plans to build a “fully modernized army” by 2027, the 100th anniversary of the People’s Liberation Army. The goal: to have a military that’s on par with the US military. The plan includes developing advanced weapons; incorporating smart technologies like artificial intelligence (AI); and modernizing military theories, formations, personnel, and strategic management, a December 1, 2020 South China Morning Post (SCMP) article explained.

The country has opened its wallet to achieve its military goals. The amount it spends on defense has more than doubled over the past decade to $229.5 billion in 2022 from $103.1 billion in 2012. Western research shops believe official estimates underestimate the actual spending. The nation also has adopted a policy whereby the spending and the products produced by government entities and the private sector often are indistinguishable. Technological advances made in private companies can be conscripted by the government, which means that there are far more dollars actually being used to advance military technology in China than the official government budget reflects.

(2) Progress in the air. In 2017, China’s military introduced the J-20, a stealth fighter jet comparable to the US F-22. Now the country is working on flying an unmanned, stealth military drone on either side of the J-20. The J-20 would be flown by the pilot and carry a second passenger—a “weapons officer”—to control the drones. These stealth drones theoretically could fly deep into hostile territory and conduct precision-strike missions.

“In tomorrow’s battlefield, joint cooperation between the piloted fifth-generation aircraft and stealthy drones will make up a powerful, stealthy air-combat squadron, connecting and communicating by information link that is supported by big data,” Beijing-based defense expert Wei Dongxu said, according to a October 20 SCMP article. The concept copies the Next Generation Air Dominance initiative outlined by the US military. The drones carry “smart ammunition” with self-navigation capability.

Recent reports claim that former Western military pilots are training pilots in China. A South African company, Test Flying Academy of South Africa, has been recruiting pilots from Britain, Australia, and New Zealand to work for it in China, an October 19 Reuters article reported. One US pilot suspected of working with the Chinese is Daniel Edmund Duggan, who had been in the US military for a decade before moving first to Australia and then to China in 2014. His LinkedIn profile said he’d been working in Qingdao, China since 2017 as the managing director of an aviation consultancy company focused on the Chinese aviation industry, an October 25 Reuters article reported. The company was dissolved in 2020. Duggan was arrested in Australia; he now faces extradition to the US.

(3) Progress at sea & with AI. Earlier this year, The People’s Liberation Army Navy (PLAN) launched the first aircraft carrier designed and built in China. The PLAN has about 355 ships, including submarines, and the US estimates the figure will grow to 420 ships in 2025 and 460 by 2030, a June 17 Associated Press article reported.

Like the US military, the Chinese military is exploring ways to use AI to make operations more efficient and more deadly. AI is being used to determine maintenance and repair schedules, detect leaks, and automate ordering. It’s used in war game simulators to train officers and study the outcome of theoretical conflicts. Military intelligence, surveillance, and reconnaissance are using AI to aid with “geospatial imagery analysis, media analysis and intel acquisition,” according to a February 21 article originally in Analytics India Magazine and republished by Georgetown University. More ominously, AI is being used in autonomous amphibious vehicles for automated target recognition.

There are fears that systems using AI could misinterpret something as an attack and mistakenly launch a counterattack. The US Department of Defense attempted twice to begin a dialog with its Chinese counterparts about AI risk reduction, and both times the Chinese military refused to put the subject on the agenda, according to a May 20 commentary by AI expert Gregory Allen of the Center for Strategic & International Studies.

(4) Ahead in hypersonic missiles. China appears well ahead of the US in the development of hypersonic missiles. Last year, the country tested a nuclear-capable hypersonic missile that circled the globe before missing its target. The missiles are designed to be launched via a rocket into space, then orbit the Earth using their own energy. The missiles fly at five times the speed of sound, which is slower than a ballistic missile; but they are maneuverable, making them difficult to track and destroy.

The missile launches “stunned the Pentagon and US intelligence because China managed to demonstrate a brand-new weapons capability … [which] appeared to ‘defy the laws of physics,’” an October 20, 2021 FT article reported. The Chinese foreign ministry denied that it was a supersonic weapon at the time. The tests came after satellite images showed China “was building several hundred silos to house intercontinental ballistic missiles.”

The Chinese hypersonic missiles reportedly were developed using US software designed for computer simulations of hypersonic weapons by companies that had received funding from the Pentagon, according to a recent Washington Post report. The paper also claims that a Chinese semiconductor company uses US electronic design automation software to design microchips for supercomputers that run hypersonic weapons simulations. The chips are manufactured in Taiwan, according to an October 19 Asia Times article. In August, the US moved to ban the export of this software to China.

Meanwhile, the US is playing catchup. Raytheon Technologies announced that it was awarded $1 billion to develop the Hypersonic Attack Cruise Missile for the US Air Force. In its Q3 earnings conference call on Tuesday, Raytheon said the “first-of-its-kind” missile can travel at hypersonic speeds of Mach 5 or greater. The company also said its “R&D completed the systems requirement review for the hypersonic glide phase interceptor program prototype. This is designed to protect the United States from increasing hypersonic missile threats.”

Semiconductors I: CEOs Awfully Quiet. US CEOs of semiconductor chip and equipment companies have been quite subdued in the face of the US government’s massive policy change. Perhaps they realize that here isn’t much upside to fighting the US government and are concerned about appearing unpatriotic. Perhaps, knowing how important semiconductors are, they’ve been wondering what took the US so long to put restrictions in place. Or perhaps they suspected this was coming when the US Congress this summer passed the Chips and Science Act, which provides $53 billion of funding, some of which will be given to companies building semiconductor factories in the US.

Here's what companies have been saying about the hit to their bottom lines since the government made its announcement:

(1) Intel comments. Intel’s sales in China last year were north of $21 billion—or about 27% of total sales. However, often the chips sold to Chinese electronics manufacturers were put in laptops, desktops, and other equipment that was ultimately sold in other countries. Despite the large potential impact, Intel’s CEO Pat Gelsinger seemed resigned to the US restrictions. “I viewed this geopolitically as inevitable,” he said in an October 24 WSJ article. He believes the location of semiconductor factories will be more important geopolitically over the next five decades than oil was over the past 50 years.

(2) Applied Materials & Nvidia. Intel isn’t the only firm feeling the impact. China represents 22% of sales at Applied Materials, and the US restrictions mean that sales in its fiscal Q4 (ending October 30) will be about $400 million, or 6%, lower than its previous fiscal Q4 sales estimate. The company lowered its adjusted earnings-per-share guidance for its fiscal Q4 to $1.54-$1.78 from $1.82-$2.18 but didn’t comment on the new export rules.

Nvidia will also see next quarter’s sales fall by $400 million, about 7%, because it won’t be able to sell two of its fastest GPUs for machine learning systems to China, an October 22 FT article reported. Nvidia’s CEO Jensen Huang noted a September 21 Reuters article that the chips affected by the export restrictions are part of Nvidia’s much larger product lineups that can still be sold to China. And Nvidia will seek licenses to sell even restricted chips to Chinese customers.

(3) Lam and ASM. Sales to China are 31% of Lam Research’s revenue. The company said the restrictions would cut as much as $2.5 billion, or about 15%, from 2023 sales, the FT article reported. Conversely, Micron Technologies could benefit, as it had been facing competition from China’s YMTC.

ASM International, a Dutch semiconductor equipment company, expects US restrictions to affect more than 40% of its sales in China, which equals roughly 6.4% of the company’s total revenue. The company went on to forecast flat q/q sales for the October quarter, an October 25 Reuters article reported.

Dutch competitor ASML Holding has said that demand was strong enough that any equipment that couldn’t be sold to Chinese buyers could be sold elsewhere.

Semiconductors II: Analysts Cutting Estimates. On top of the bad news about US restrictions on semi sales into China, there’s mounting evidence that the semiconductor cycle has taken a turn for the worse.

Texas Instruments, which sells basic chips that likely won’t be affected by the new government export regulations, warned on Tuesday that it was seeing rising order cancellations and lower order rates. It experienced the expected weakness in personal electronics and warned that the weakness was expanding to other industrial sectors outside of autos, an October 26 Barron’s article reported.

Likewise, memory chip manufacturer SK Hynix reported a 67% y/y decline in Q3 net profit. It expects further declines next year and warns of a softer market for corporate servers.

Semiconductor stocks continue to have a tough year as the industry flounders. The S&P 500 Semiconductor industry’s stock price index has fallen 41.7% ytd through Tuesday’s close, and the S&P 500 Semiconductor Equipment index is 36.2% lower ytd. Both indexes are trailing far behind the S&P 500’s 19.0% ytd decline and the S&P 500 Information Technology sector’s 26.3% drop.

As for performances this month to date (through Tuesday’s close), the S&P 500 Semiconductor index has risen 5.4%, and the S&P 500 Semiconductor Equipment index has climbed 2.3%, while the S&P 500 rose 7.7%, and the S&P 500 Information Technology sector added 8.2% (Fig. 1 and Fig. 2).

Analysts have been cutting their earnings estimates in the semi space, but it looks like estimates need to head even lower. The S&P 500 Semiconductors industry’s earnings for this year are expected to rise 0.9% and then fall 4.0% in 2023 (Fig. 3). On July 1, the earnings estimate for 2023 was 8.4%. The industry’s forward P/E has shrunk to 14.4 from 24.5 at the start of this year (Fig. 4).

Analysts still expect the S&P 500 Semiconductor Equipment industry to grow earnings by 16.8% this year and 2.9% in 2023 (Fig. 5). The estimate for 2023 has been reduced from 18.0%, where it stood on July 1. The industry’s forward P/E has fallen to 13.4 from 21.7 at the start of 2021 (Fig. 6).

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ECB On Thursday, Inflation On Friday

October 26 (Wednesday)

Inflation I: Getting Ahead of It. The ECB meets on Thursday and is expected to raise the central bank’s official interest rate again by 75bps. The Fed meets November 1-2 and is expected to do the same.

The FOMC is likely to provide some guidance for the December 13-14 meeting of the FOMC following the November meeting. Two important economic indicators that may influence that guidance will come out on Friday.

Q3’s Employment Cost Index (ECI) is likely to signal a peak in wage inflation, though not a convincing one. A surprise is more likely to be on the upside than the downside given the strength of the labor market. September’s PCED will be released along with personal income. Like for the month’s CPI, the PCED headline inflation rate should be down, while the core is up, but less so partly because rent has a lower weight in the PCED than in the CPI. Let’s get ahead of these numbers:

(1) ECI. The Fed pays close attention to the ECI because it shows the underlying trend of inflation in the labor market. Labor costs tend to be marked up into selling prices. The ECI for private industry includes wages, salaries, and benefits (Fig. 1). It was up 5.5% y/y during Q2, the highest reading since Q2-1984. It is a less volatile measure of the underlying trend in compensation costs than is the broader but more volatile hourly compensation measure that comes out on a quarterly basis along with nonfarm business productivity.

The ECI’s wages and salaries component was up 5.7% y/y during Q2. It tends to closely track the monthly series for the average hourly earnings (AHE) of all private-sector workers, also on a y/y basis. The latter might have peaked this year at 5.6% during March; it was down to 5.0% during September.

The ECI for benefits rose 5.3% y/y during Q2, the highest since Q1-2005. It’s hard to tell whether this ECI component has peaked.

Debbie and I will also focus on the performance of Q3’s ECI in goods-producing versus service-providing industries (Fig. 2). During Q2, the former rose 4.7%, while the latter increased 5.8%. The current concern among Fed officials and investors is that while goods inflation is showing signs of peaking and moderating, inflation seems to be spreading in services. A related concern is that labor costs are more likely to be passed through to selling prices in services than in goods.

In addition to the possible (maybe?) peak in the AHE measure of wage inflation, the Atlanta Fed medium wage growth tracker might have peaked during June at 7.4% (Fig. 3). It was down to 6.5% during September. Another possible sign of a peak in the ECI wages and salaries inflation rate is the apparent peak in the quits rate, which tends lead the ECI inflation rate by nine months (Fig. 4).

(2) PCED. The Fed also pays close attention to the PCED. It is one of the five macroeconomic variables that the FOMC forecasts in its quarterly Summary of Economic Projections. During September, the committee projected that the headline PCED inflation rate will be 5.4% this year, 2.8% next year, and 2.3% in 2024. We say: “Good luck with that!” Nevertheless, our forecast is also relatively optimistic, with this rate likely to fall to 4%-5% during H2-2022 and 3%-4% in 2023 and in 2024 (Fig. 5).

The headline PCED inflation rate was 6.2% during August. It might have peaked this year during June at 7.0%. The core PCED inflation rate was 4.9% during August. It might have peaked at 5.4% during February and March. The headline and core CPI inflation rates were significantly higher in September at 8.2% and 6.6% (Fig. 6). Friday’s core PCED inflation rate during September is expected to be up 0.5% m/m and 5.2% y/y.

(3) PCED vs CPI. As we’ve previous discussed, the core CPI inflation rate tends consistently to exceed the core PCED inflation rate (Fig. 7). The food and energy components tend to be identical.

Over the past 12 months through August, the durable goods components of the CPI and PCED are up 7.8% y/y and 5.3% (Fig. 8). No one item stands out as a consistent source of the divergence. The CPI tends to be a fixed basket of goods and services and may not reflect substitution into discounted goods as well as the PCED does.

The CPI reflects the out-of-pocket expenses of urban consumers for medical care services, while the PCED also reflects government-subsidized prices for hospital stays and physician services. The same can be said about health care insurance that’s subsidized by employers. So over the past 12 months through August, here are the CPI and PCED inflation rates for medical care services (5.6%, 2.5%), hospitals (4.1, 3.0), physician services (1.1, 0.4), and health care insurance (24.2, 1.3) (Fig. 9). Here are September’s CPI inflation rates for medical care services (6.5), hospitals (3.9), physician services (1.8), and health insurance (28.2). Odds are that the comparable PCED components will be up less, especially the one for health insurance.

Rent has a bigger weight in the core CPI than in the core PCED. The weights for rent of primary residence and owners’ equivalent rent are 9.3% and 30.5% in the core CPI. They are 4.0% and 12.6% in the core PCED. During September, rent inflation in the CPI was 7.2% for tenants and 6.7% for owners (Fig. 10 and Fig. 11). They tend to be identical to their comparable PCED components but have higher weights.

Inflation II: A Closer Look at CPI Services. Last year, Fed officials believed that the rebound in inflation was transitory. That was because it was mostly attributed to the temporary impact of the pandemic on goods prices. It depressed them at first, but then boosted them. So Fed officials blamed rising inflation on the so-called “base effect.” They also believed that supply-chain disruptions were mostly attributable to the pandemic and therefore would abate, also bringing down inflation, particularly for goods.

This year, they’ve concluded that inflation is more persistent and more pernicious than they had thought because it has spread from goods (where it is moderating) to services (where it is accelerating). Within services, they’ve observed that inflation has spread beyond rent to service industries where it might be harder to subdue. Let’s drill down:

(1) Services less energy accounts for 56.8% of the headline CPI. Most of that is attributable to shelter, which accounts for 32.4% of the headline CPI. Here are the weights of the five other major components of CPI services and their y/y inflation rates during September: medical care services (6.9 weight, 6.5 inflation), transportation services (5.9, 14.6), recreation services (3.1, 4.1), education & communication services (5.3, 1.4), and other personal services (1.4, 5.9) (Fig. 12).

(2) Fed officials and investors were freaked out when the core CPI inflation rate jumped to 6.6% y/y during September, the highest reading since August 1982. That was mostly attributable to big m/m and y/y increases in components with small weights in the index: health insurance (0.9 weight, 2.1 m/m, 28.2 y/y), car & truck rental (0.1, 2.5, -1.4), motor vehicle maintenance (1.1, 1.9, 11.1), motor vehicle insurance (2.4, 1.6, 10.3), airline fares (0.6, 0.8, 42.9), pet services including veterinary (0.5, 1.6. 11.0), day care & preschool (0.6, 2.0, 5.1), and delivery services (0.01, 2.9, 16.4) (Fig. 13 and Fig. 14).

European Central Bank: ‘Whatever It Takes,’ Part Deux. Ahead of their next meeting on October 27, the 25-member Governing Council of the ECB is getting set to fight inflation. They are expected to frontload their monetary tightening aggressively without a pause. Council members also are warning fiscal policymakers not to fight them with too much fiscal stimulus. The ECB is expected to begin shrinking its balance sheet sometime in 2023.

For now, the ECB’s central bankers are turning a blind eye to slowing growth in the Eurozone. Echoing the infamous words of former ECB President Mario Draghi, ECB Vice President Luis de Guindos said in October that the bank “will do whatever it takes” to bring down inflation (Draghi, however, used the phrase in talking about supporting the euro). De Guindos recently called reducing inflation “the main contribution we can have to improve the economic situation,” according to Bloomberg.

That’s even though ECB Bank President Christine Lagarde is forecasting a technical recession for the Eurozone this winter, when Europe’s energy crisis could worsen. But she has reiterated the bank’s commitment to lowering inflation with interest-rate hikes nonetheless.

For the first time in 11 years, ECB bankers raised their key interest rate this year—by 50 basis points on July 21 and 75bps on September 8 to 0.75% (Fig. 15). The financial markets see this deposit rate continuing to rise without a pause, to about 2.00% by year-end and about 3.00% by next spring. Eurozone inflation, however, is still well above the ECB’s 2% target, now approaching 10% (Fig. 16). In addition, the bankers are discussing reducing the ECB’s €5 trillion of securities held for monetary purposes,” built up during the pandemic-led recession, but not until interest rates rise further (Fig. 17).

While Fed officials often signal their future moves in interviews and speeches, that’s less common across the pond. But ECB policymakers are prepared to be “more readable” to the markets, Austria’s central bank chief recently said, according to CNBC. Here are some indications of their hawkishness revealed in lots of recent public comments:

(1) Inflation takes priority over growth. “Those who thought inflation was dead now know better,” said Joachim Nagel, the head of Germany’s Bundesbank central bank. “Now the beast has woken up from its slumber ... it’s up to monetary policymakers to tame it again,” he recently told students at Harvard University. “The data unequivocally points to a robust rate move,” he said in October according to Reuters.

Similarly, Irish central bank chief Gabriel Makhlouf said this month that the bank wishes to avoid “expectations of higher inflation” becoming embedded, according to Bloomberg.

In January, Croatian national bank governor Boris Vujcic will become the 26th member of the ECB’s Governing Council when his nation adopts the euro. Last month, he likened double-digit inflation to a disease: “As we learned in Croatia over the last decades, when inflation is high, when it nears double-digit levels, it can become a disease in itself,” Vujcic said according to a September 26 Bloomberg article. He added: “Paying much attention to lower growth now, at the expense of fighting inflation, is often luring. But letting inflation become entrenched always has a higher cost than a temporary decline in GDP.”

(2) No gradualism anticipated here. “Until early this year, I was in favour of gradualism but for now, there is a stronger case for frontloading and determined action,” Finnish central bank chief Olli Rehn told Reuters at the end of September. Rehn also told Reuters that ECB rates could reach a level that no longer stimulates the economy before Christmas. “There is a case for taking a decision on another significant rate hike, be it 75 or 50 basis points or something else,” he said.

Latvian central bank chief Martins Kazaks told Reuters on October 13 that the ECB should lift its 0.75% deposit rate by 75 basis points at the October meeting and make another large hike in December. Bloomberg wrote on October 16: “Belgian central bank Governor Pierre Wunsch said last week that a deposit rate of 3% … isn’t unreasonable, given the outlook for consumer-price growth that’s already five times the 2% target.”

(3) No pause after neutral. Officials recently voiced similar views on how far they’ll go with rate hikes after reaching a neutral rate. “We won’t stop at the neutral rate, we need to keep powering through,” Peter Kazimir, Slovakia’s central bank chief, told Reuters. “I’m of the opinion that we will have to go above the neutral level in order to calm inflation pressures, which are currently in the pipeline,” Bostjan Vasle, Slovenia’s central bank governor said.

“I do not expect policy rate hikes to come to an abrupt end,” Dutch central bank chief Klaas Knot said this month. However, he added: “The farther we hike and the closer we get to restoring a credible prospect of inflation moving back to target, the smaller rate steps will likely become.”

“Given the current trend, I don’t see any need to pause after [removing accommodation],” Latvia’s Kazaks also said in October, according to Reuters. “The pace could slow down somewhat, and I would say that we start to use a wider set of instruments.”

(4) Fiscal policy excesses will not be accommodated. Lagarde told members of the European Parliament during a recent hearing in Brussels that the ECB would not use its tools to help countries that apply untargeted fiscal stimulus that would further fuel inflation, opposing the ECB’s efforts to contain it.

The ECB’s Transmission Protection Instrument recently was announced as a mechanism to buy the bonds of fragile Eurozone countries while not adding to the ECB’s overall bond portfolio. “It’s (used in) a situation where ... there are disorderly market dynamics that are not justified by fundamentals or by economic policy errors that will have been made,” Lagarde said.

France’s central bank governor Francois Villeroy de Galhau said in October that Europe’s energy subsidies could reduce the current rate of inflation but also could lead to higher readings and complicate the task of monetary policy. “Fiscal policy must not add to inflationary pressures and that’s a fine line to walk,” Latvia’s Kazaks has added to the discussion, according to Reuters.

(5) Rates to go up before balance sheet comes down. “[W]e should have an orderly use of our palette of instruments: first, interest rate hikes,” France’s de Galhau said in an October speech at Columbia University. “Once we will have reached neutral territory with our policy rate, it makes sense to consider the roll-off of asset purchases by limiting reinvestments,” the Netherlands’ Knot said on October 15, reported Reuters.

“A tentative conclusion about the impact of balance sheet actions on financial conditions in a normalisation phase is that the signalling channel will be weaker for a given adjustment to the size and composition of our balance sheet,” the ECB’s Philip Lane said on October 12, according to Reuters. Translation: The ECB’s primary approach to combating inflation will be to raise interest rates before reducing the balance sheet.

Lagarde also recently said that the bank would be reviewing the terms of extending its long-term bank lending operations “in due course.” Some say that more restrictive policies could be applied to this lending, perhaps with shrinking the balance sheet in mind.

Whether recession descends on Europe or not, one thing is clear: The ECB is planning to fly with the hawks.

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Your Wish Is Our Command

October 25 (Tuesday)

On Request. On Friday, we sent you a brief review of our research services titled “Getting the Most From Yardeni Research.” We wrote: “We get some of our best research ideas from our accounts. If you ask us a question, don’t be surprised if we provide our answer the following day in the Morning Briefing!” I also field questions during my Monday morning webcasts. But there are always a few more questions than our 30 minutes of time allows. In recent days, a bit of a backlog has accumulated. The following is a catch-up on these requests.

Energy: Will Santa Slip in the Oil Patch? Debbie and I are fielding more questions about the prospects for gasoline prices after the midterm elections and near the end of November, when the Biden administration’s release of oil from the Strategic Petroleum Reserve (SPR) is set to end. The fear is that the pump price will go up a lot, depressing consumers’ confidence and eroding their purchasing power. Soaring interest rates already have increased the risk of a recession. A renewed surge in fuel prices might very well push the economy over the edge. That’s a valid concern.

While another jump in petroleum prices would be good for the S&P 500 Energy sector, it would be bad news for the rest of the stock market, as seen during the first half of this year. Even now through Friday’s close, the only S&P 500 sector with a gain so far this year is Energy. Here is the ytd performance derby of the 11 sectors of the S&P 500 through Friday: Energy (57.9%), Health Care (-10.3), Consumer Staples (-10.7), Utilities (-11.6), Industrials (-16.2), Financials (-17.7), Materials (-20.1), S&P 500 (-21.3), Information Technology (-28.7), Consumer Discretionary (-30.2), Real Estate (-33.1), Communication Services (-36.6). (See Table 1.)

Will the economy and the traditional year-end Santa Claus rally slip in the oil patch? As we’ve been observing lately, the stock market has had a remarkably consistent record of rallying in the months after every one of the 20 midterm elections since 1942. Will this record get tarred after the latest midterm election? We don’t think so.

Consider the following:

(1) On March 31 of this year, the Biden administration announced the US will release 1 million barrels per day (mbd) of oil from the SPR for six months. So the program will terminate at the end of November just after the midterm elections.

The national retail pump price of a gallon of gasoline was $3.38 at the start of this year (Fig. 1). The Russians invaded Ukraine on February 23. The price of gasoline rose to $4.33 during the last week of March. It peaked at $5.11 during the June 13 week. It dropped to the year’s low of $3.77 during the September 19 week. It edged up to $3.99 during the latest week of October 17. We don’t expect it will surge once the SPR draw is over.

(2) The price of gasoline accounts for only 4.24% of the CPI and 2.73% of the PCED. Nevertheless, its rapid rise earlier this year was a major contributor to the jump in overall consumer inflation (Fig. 2). It also had a significant impact on consumers’ purchasing power. During June, gasoline consumption totaled a record $541 billion (saar), up $159 billion from $382 at the start of this year (Fig. 3). The average US household spent an average of $2,988 on gasoline at a seasonally adjusted annual rate at the start of the year. That average rose to $4,223 during June (Fig. 4).

Another surge in gasoline prices would exacerbate inflation, possibly forcing the Fed to keep tightening monetary policy and eroding the purchasing power of consumers at the same time.

(3) Here’s why we don’t expect a rebound in gasoline prices: The US uses about 20.0mbd of petroleum products. The extra 1.0mbd from the SPR amounts to just 5% of daily US usage and about 1% of daily global oil production. So it is unlikely that dipping into the SPR contributed much to the drop in gasoline prices. Indeed, a July 26 analysis by the US Treasury Department estimated that “President Biden’s historic SPR release, in coordination with IEA partners, lowered the price of gasoline by 17 cents to 42 cents per gallon, with an alternate approach suggesting a point estimate of 38 cents per gallon.”

We’ve previously observed that the best cure for high gasoline prices is high gasoline prices. Sure enough, consumers responded to the high price in early July—i.e., just as the summer driving season was revving up—by reducing their usage of gasoline by around 1.0mbd through August (Fig. 5). During the October 14 week, they used 8.8mbd of gasoline, or about 400,000 barrels per day less than at the same time last year.

(4) The big story in the oil patch is that US crude oil and petroleum product exports rose to a record 10.2mbd during the October 14 week (Fig. 6). Exports increasingly have been exceeding US imports, which have been declining in recent weeks to 7.8mbd. As a result, net imports fell to a record -2.4mbd. If we subtract this amount from US petroleum products supplied (which is actually a measure of consumption), we see that the US is producing 2.4mbd more than it’s using, which equals net exports (Fig. 7).

The actual data compiled by the US Energy Department showed that during August, US production (including crude oil field production, natural gas liquids, biofuels, and processing gain) totaled 20.2mbd, slightly exceeding the 20.1mbd of products supplied (Fig. 8).

(5) On October 11, JPMorgan CEO Jamie Dimon said that the US should pump more oil amid the world's energy crisis, just days after OPEC+ agreed to a production cut that is equivalent to 2% of the global supply. In a CNBC interview, he said that “America is the swing producer, not Saudi Arabia.” We agree.

(6) Will we know whether the end of the SPR drawdown will boost gasoline prices when the program terminates at the end of November? Maybe not given President Biden’s October 19 announcement that an additional 15 million barrels will be sold from the SPR in December and that the administration also will purchase oil to refill the SPR—now at its lowest level in nearly 40 years—when prices fall to $70 a barrel (Fig. 9). “Refilling the reserve at $70 a barrel is a good price for companies. And it’s a good price for the taxpayers. And it’s critical to our national security,” Biden said. Needless to say, Biden’s recent comments about his SPR policy are contradictory and confusing.

Recession: Rolling vs Rampant. Yesterday, we observed that the Index of Leading Economic Indicators peaked at a record high during February and fell 2.9% over the past seven months through September. It has been a reliable harbinger of recessions before. So have inverted yield curves, i.e., when the 2-year Treasury yield exceeds the 10-year yield, which has been the case since July. Jamie Dimon, Jeff Bezos, Stan Druckenmiller, and Leon Cooperman are warning about a recession in 2023.

We’ve observed that if a recession is coming, it will be the most widely anticipated downturn ever. Widespread preparation for it minimizes the chances of it, by reducing the shock effects seen when recessions catch people by surprise.

Not surprisingly, we’ve received emails from some skeptics. We counter by observing that the economy is already in a rolling recession, a.k.a. a growth recession or a soft landing. Consider the following:

(1) Housing. The single-family housing bust is well underway and is likely to bottom by the middle of next year given how quickly mortgage applications and single-family housing starts are falling, down 40.8% and 26.4% ytd (Fig. 10). On the other hand, multi-family starts remains strong and may remain so given the increase in rents and the unaffordability of homes for purchase.

(2) Autos. The auto industry’s recovery from its supply-chain disruptions is likely to be thwarted by rapidly tightening credit conditions for auto loans. Last year and early this year, a shortage of auto parts reduced the industry’s output. US motor vehicle sales fell to 12.7 million units (saar) during December 2021, down from 16.5 million units at the end of 2020. They’ve remained below 14.0 million units (saar) since May (Fig. 11).

At the end of September, Cox Automotive, which provides digital and software solutions for automotive dealers, reported in a press release that “new-vehicle sales are down more than 10% versus 2021 and are on course to finish at the lowest level in a decade.” Cox lowered its full-year sales forecast to 13.7 million units. The press release reported that sales have been “held in check by high prices, tight inventory, and softening demand.”

Higher interest rates are beginning to directly impact the new-vehicle market, knocking some buyers to the sidelines. Subprime buyers accounted for roughly 14% of the new-vehicle market in 2019. Now, subprime buyers account for just 5%, and deep subprime buyers have all but disappeared. However, there is still lots of pent-up demand for autos among high-income buyers who can pay cash or secure better loan rates.

(3) Retailers, ports, and truckers. Retailers have been scrambling for months to discount merchandise to reduce bloated inventories. Consumers aren’t buying PCs and large flat-screen TVs now because they did so en masse during the pandemic. That’s depressing consumer electronic sales and the demand for semiconductors.

The 12-month sum of inbound container traffic at the West Coast ports fell in September to the slowest pace since April 2021 (Fig. 12). This suggests that retailers have trimmed their orders for imported goods. On the other hand, the American Trucking Association truck tonnage index rose 5.4% y/y during September (Fig. 13). The trucking business continues to do well, as evidenced by the 10.5% ytd rise through September in medium-weight and heavy truck sales to 504,000 units (saar) (Fig. 14).

Of course, some of the weakness in consumers’ demand for goods is attributable to their spending more on services, which took longer to become readily available than did goods following the pandemic lockdowns and restrictions. This was clearly evident in September’s M-PMI, which was down to 50.9, while the NM-PMI remained elevated at 56.7 (Fig. 15).

(4) Manufacturing & onshoring. Another source of economic growth is likely to be the ongoing onshoring of supply chains. The semiconductor industry has received substantial financial support from Washington to bring production to the US from overseas. The government’s recent restrictions on US semiconductor sales and related activity in China should also spur onshoring.

Over the past 24 months through August, US new orders for industrial, metalworking, and materials-handling machinery is up 63% compared to a 22% increase in new orders for construction, farm, and mining machinery (Fig. 16). We think that the strength in the former reflects onshoring activity.

(5) Bottom line. All of the above adds up to a rolling recession rather than a rampant one, in our opinion. Nevertheless, we aren’t dismissing the risks of a severe economic downturn. As we wrote in our October 4 Morning Briefing, looking into 2023, we assign a 60% subjective probability to a soft landing and 40% to a hard landing.

The Dollar: How Much Stronger? How Much Longer? We don’t usually get many questions about the foreign-exchange value of the US dollar. Recently, we have been getting more than usual since the dollar has been soaring all year.

The JP Morgan trade-weighted dollar is up 14% y/y through Friday’s close (Fig. 17). The main concern, of course, is that the strong dollar is weighing on the corporate profits of companies with sales overseas. A company with 50% of its sales and earnings abroad would see a 12% drop in those earnings in dollars and a 6% drop in total earnings compared to a year ago given the current strength of the dollar.

A stronger dollar also tends to weigh on commodity producers headquartered in the US. That’s because their overseas sales and earnings are worth less in dollars, and because higher dollar prices for commodities priced in dollars depress demand for them. That’s why a strong (weak) dollar tends to coincide with weak (strong) commodity prices.

Much of the dollar’s strength this year reflects the more hawkish stance of US monetary policymakers to inflation than their counterparts in most other countries, especially in Europe and Japan. The dollar should peak once the Fed either pauses or terminates the current round of monetary policy tightening.

When that happens, companies with lots of overseas exposure, particularly commodity producers, should get boosts to their earnings and to their stock prices, at least relative to what they’ve been like during this strong-dollar period.

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The Great Monetary Policy Reversal

October 24 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy: From Unconventional Back to Conventional. The bearish case for stocks hasn’t changed all year. It continues to hinge on the fact that the widely unexpected rebound in inflation over the past year has forced the major central banks to pivot sharply from their unconventional ultra-easy monetary policies after the Great Financial Crisis (GFC)—which were aimed at averting deflation—to conventional tight monetary policies aimed at bringing inflation down.

Looking ahead, the bearish script suggests that prospects for stocks remain bearish because the abrupt monetary policy reversal is likely to cause a recession, which will continue to depress valuation multiples and earnings too. In this scenario, the “bubbles in everything” will continue to burst, and there will be lots more collateral damage to the global economy and financial markets, as occurred during the GFC.

In the US, the bullish case looking forward is that “this too shall pass,” and indeed is passing. In other words, most if not all of the bubbles have burst already, so not much more collateral damage lies ahead. The Fed is likely to raise the federal funds rate two more times before the end of this year and then pause next year. Monetary policy has turned restrictive enough to moderate inflation without causing a recession. So corporate earnings are more likely to move sideways than take a dive. The same goes for valuation multiples. Moreover, US financial markets continue to benefit from “TINAC,” i.e., the very sound investment rationale that “there is no alternative country” to serve as a safe haven for global investors during these challenging times around the world.

The bullish scenario isn’t as bullish as the bearish one is bearish, but it is certainly much more upbeat. Now consider the following:

(1) The bearish case. According to the bearish narrative, the bull market from 2009 through 2021 was primarily attributable to the ultra-easy monetary policies of the Fed and the other major central banks. These policies were largely justified by the deflationary forces unleashed by the GFC. The result was that all the major central banks undershot their 2.0% inflation targets. That was their excuse for implementing so-called unconventional monetary policies including zero-interest-rate policies (ZIRP), negative-interest-rate policies (NIRP), yield-curve-control policies, and quantitative easing (QE).

Just when it seemed that these unconventional policies had become the new normal, inflation soared around the world over the past year, and now all the major central banks are scrambling to subdue inflation rates well exceeding their 2.0% targets. In the US, the headline PCED inflation rate rose above 2.0% in March 2021 and is now at 6.2% (Fig. 1). In the Eurozone, the headline CPI inflation rate jumped above 2.0% in July 2021 and is now at a record-high 9.9% (Fig. 2). In Japan, the headline CPI rose above 2.0% in April 2022 and is now 3.0% (Fig. 3).

So the Fed and the European Central Bank (ECB) are raising their interest rates and implementing quantitative tightening (QT). The shock of this Great Monetary Policy Reversal (GMPR) has sent interest rates soaring and stock prices plummeting around the world.

The bears’ favorite chart shows the relationship between the S&P 500 and the size of the Fed’s balance sheet. The former rose 609% from March 9, 2009 through January 3, 2022 (Fig. 4). Over this same period, the Fed’s assets rose 1,005% from $760 billion in March 2009 to $8.4 trillion in January 2022.

On January 5, 2022, the Fed released the minutes of its December 14-15, 2021 FOMC meeting. It included a long section titled “Discussion of Policy Normalization Considerations.” The committee reviewed previous episodes of hiking the federal funds rate and considered “the appropriate size and composition of the Federal Reserve’s balance sheet in the longer run.” The word “runoff” in connection with the size of the balance sheet appeared 10 times in the minutes. For example: “Many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode.”

The Fed’s QT program began in June of this year and started accelerating in September. At the current runoff pace of $95 billion per month, the Fed’s asset holdings would drop $2.8 trillion from a record high of $8.5 trillion during May 2022 to $5.7 trillion by the end of 2024. The bears reckon that will continue to send stock prices lower. They might be right. But keep in mind that the forward P/E of the S&P 500 has already dropped from 21.5 on January 3 of this year to 15.9 on Friday (Fig. 5). So it has already discounted quite a bit of the Fed’s pivot from accommodative to restrictive monetary policy.

(2) The bullish case. Currently, the bullish case for stocks in the US is that a soft landing of the economy is more likely than a hard landing. Debbie and I have been making the case for a rolling recession, a.k.a. a growth recession or a mid-cycle slowdown. In this scenario, there shouldn’t be much more downside in the S&P 500’s forward P/E, and its forward earnings per share is more likely to move sideways than to take a dive as it always does during hard landings. (FYI: The “forward P/E” is the P/E multiple using forward earnings as the denominator; “forward earnings” we derive by time-weighting analysts’ consensus operating earnings-per-share estimates for this year and next.)

Of course, this rolling recession scenario is valid only in conjunction with a rolling inflation scenario, which we also believe is unfolding. That is, inflation seems to be rolling out of goods and into services currently. Next, it must roll out of services—or else, if it fails to do so, the Fed would have no choice but to resume tightening until a recession finally breaks the back of inflation completely. That’s the bear’s base case, of course.

The bullish case rests on a happy development: the return of the old normal (growing) economy, with inflation settling down to 3%-4% and conventional monetary policies resuming. An even happier development would be that employers increasingly respond to chronic labor shortages by boosting productivity, allowing wages to rise faster than prices, thus increasing the purchasing power and living standards of workers and boosting economic growth. In this scenario, inflation-adjusted average hourly earnings, which has been flat for the past year through August, resumes its historical 1.2% annual growth path since December 1994 (Fig. 6).

Needless to say, the bullish case is very much the minority view for now. The spread between the percentages of bulls and bears is currently -9.0ppts according to Investor Intelligence’s survey and -33.6 according to AAII’s (Fig. 7). There are only 31.3% bulls in the former and 22.6% in the latter.

Favoring the bulls over the rest of this year is the prospect of a traditional Santa Claus rally, which is even more likely to happen following midterm elections, as we showed in last Wednesday’s Morning Briefing. Since 1928, the S&P 500 fell 1.1% on average during September, by far the worst performance of any month. Octobers, Novembers, and Decembers were up 0.5%, 0.6%, and 1.4% on average. This Santa Claus rally phenomenon tends to be even more likely following midterm elections. Since 1942, during each of the 3-month, 6-month, and 12-month periods following each of the 20 midterm elections, the S&P 500 was up on average by 7.6%, 14.1%, and 14.9% (Fig. 8 and Fig. 9).

By the way, our friend Matt Miller, the political economist at Capital Group, reviewed the outlook for the upcoming midterm election in an October 20 article titled “U.S. midterm elections: Will the House flip?” He concluded: “I still expect the GOP to win the House. That’s been my position since early in President Biden’s term—even before inflation rose to 40-year highs and Americans started worrying about a potential recession. The Senate, meanwhile, remains a toss-up that I think could go either way as races tighten in a number of key states.” He observed that the Republicans must flip just five seats to win a majority in the House. Typically, during the first midterm of a presidency, the opposition party wins many more than that, he noted.

(3) Looking forward. Last Thursday, September’s Index of Leading Economic Indicators (LEI) and Index of Coincident Economic Indicators (CEI) were released. There’s a recession coming according to the LEI, while the economy continues to grow solidly according to the CEI. The former peaked at a record high during February and fell 2.9% over the past seven months through September (Fig. 10).

During the past seven business cycles (before the pandemic), the LEI peaked 13.7 months on average before the peak in the CEI. The CEI rose to yet another record high last month and is up 2.3% y/y, confirming that real GDP is still growing on a y/y basis (Fig. 11). Indeed, the Federal Reserve Bank of Atlanta’s GDPNow model shows that real GDP is currently tracking at 2.9% (saar) for Q3. It still looks like a rolling recession to us with recessions rolling through housing, autos, retailing, and goods manufacturing industries.

By the way, the S&P 500 is one of the 10 components of the LEI (Fig. 12). During the past 11 business cycles before the pandemic, it peaked five months before the CEI peaked. It peaked 10 months ago, yet the economy is still growing.

S&P 500’s forward revenues, earnings, and profit margin are confirming that economic growth is slowing but not diving into a recession (Fig. 13). Forward revenues continues to rise into record-high territory though at a slower pace in recent weeks. It’s hard to tell whether that’s because inflation is cooling or unit growth is weakening or both. Forward earnings peaked at a record high of $239.93 per share during the June 23 week and was down 1.6% to $236.16 during the October 13 week. The forward profit margin is down to 12.9% from a record high of 13.4% during the June 9 week.

The Fed: Volcker 1.5. Melissa and I have been referring to Fed Chair Jerome Powell’s ultra-hawkish pivot in his August 26 Jackson Hole speech as “Volker 2.0.” He mentioned former Fed Chair Paul Volcker’s experience with taming inflation during the late 1970s. The lesson Powell drew from that episode is that “[r]estoring price stability will likely require maintaining a restrictive policy stance for some time.” So the implication was that the Fed would continue to raise interest rates until they were restrictive enough to subdue inflation and then would keep rates there for a while. Subsequently, numerous Fed officials depressed investors by repeating the Fed’s new party line: “We are going to raise interest rates until we see the inflation is clearly coming down.”

On Friday, the Fed might have started to dial back that widely expected scenario a bit to “Volcker 1.5.” That day, the S&P 500 rallied 2.37% to 3,752.75 as the 2-year US Treasury note yield fell to 4.50% from 4.61% on Thursday. The happy day’s performance was sparked by Friday’s WSJ article titled “Fed Set to Raise Rates by 0.75 Point and Debate Size of Future Hikes” by the Journal's ace Fed watcher, Nick Timiraos.

Nick’s article suggested that some Fed officials are realizing that the party line might be excessively hawkish. The markets had been discounting that the FOMC would hike the federal funds rate two more times by 75bps at each of the FOMC’s last two meetings this year with more rate hikes next year. Nick’s article indicated that some Fed officials wanted to discuss a 50bps hike during December, rather than 75bps one, and a pause early next year.

Indeed, on Friday afternoon, San Francisco Federal Reserve President Mary Daly said, “I hear a lot of concern right now that we are just going to go for broke. But that's actually not how we, I, think about policy at all.” She said, “We have to make sure we are doing everything in our power not to overtighten.” She added, “The time is now to start planning for stepping down.”

Powell freaked the markets during his September 21 press conference when he said: “Clearly, today … we’ve just moved, I think, probably, into the very lowest level of what might be restrictive, and, certainly, in my view and the view of the Committee, there’s a ways to go.” He was speaking just after the Fed had raised the federal funds rate by 75bps to 3.00%-3.25%.

Let’s review by how much interest rates have soared so far this year to date (i.e., over the past 41 weeks through Friday).

(1) Federal funds rate. Since the start of this year through Friday, the federal funds rate is up 300bps, the most over a 41-week period since August 1981 (Fig. 14).

(2) Two-year and 10-year US Treasury yields. Over this same period, the 2-year and 10-year Treasury yields are up 369bps and 248bps, the most since September 1981 and October 1987 (Fig. 15).

(3) Thirty-year mortgage rate. The 30-year fixed mortgage rate is up 387bps since the start of this year, the most since September 1981 (Fig. 16).

(4) High-yield corporate bond composite. Since the start of this year, the US high-yield corporate bond yield is up 509bps, the most since April 2009 (Fig. 17).

(5) Trade-weighted dollar. Finally, the trade-weighted dollar is up 13.4% y/y (Fig. 18). That’s that biggest gain since September 2015. It’s another indication of the remarkably rapid pivot in monetary policy from an accommodative stance to a restrictive one.

(6) Bottom line. It seems to us that monetary policy is well above the “very lowest level of what might be restrictive.”

Movie. “Eiffel” (+) (link) is a very interesting docudrama about Gustave Eiffel. He was a remarkable French engineer. After he finished his work on the Statue of Liberty, the French government commissioned him to design something spectacular for the 1889 Paris World Fair. The result was the 300-meters-tall Eiffel Tower, which was completed in just over two years. The movie includes a romantic subplot that is pure fiction and doesn’t add much to the story.

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On China, Banks & Solar

October 20 (Thursday)

China: What Xi Isn’t Saying. At the 20th National Congress of the Chinese Communist Party this week, what President Xi Jinping didn’t say is perhaps more important than what he did. Xi rattled off the expected banalities during his nearly two-hour speech. His zero Covid policy will continue, economic growth and self-reliance remain priorities, as does reunification with Taiwan. Battling poverty, enhancing ecological conservation, safeguarding national security, and modernizing the military all are Party goals. What Xi didn’t say: China’s economy is a mess.

Real estate debt totaling in the billions of dollars needs to be restructured so it doesn’t weigh on economic growth for years. Yet Xi’s speech failed to include a large, cohesive plan to address the problem. Foreign companies are decamping for countries that don’t face US tariffs, Covid lockdowns, and scattered water and energy shortages. Chinese youth unemployment is at 18.7%. And it’s a safe bet that economic growth has slowed far below the country’s 5.5% y/y GDP target.

Here are some excerpts from the English translation of Xi’s speech and some details that he left out for obvious reasons:

(1) Economic growth. Xi touted the progress that the Chinese economy has made during the years he has led the nation. “In the past decade, China's GDP has grown from 54 trillion yuan to 114 trillion yuan to account for 18.5 percent of the world economy, up 7.2 percentage points. China has remained the world's second largest economy, and its per capita GDP has risen from 39,800 yuan to 81,000 yuan. It ranks first in the world in terms of grain output, and it has ensured food and energy security for its more than 1.4 billion people. The number of permanent urban residents has grown by 11.6 percentage points to account for 64.7 percent of the population.”

What Xi failed to mention was that Q2 real GDP fell 2.6% (not annualized), as much of the economy was shut down due to Covid (Fig. 1). Q3 GDP was expected by some to grow roughly 3%, but given that the data release expected on Tuesday was postponed, we presume the result was far lower than the estimate. The 13.7% drop in the CRB Raw industrials spot index this year and the 64% drop in the Drewry benchmark for shipping container prices also imply that all’s not well (Fig. 2). As does the 32.7% ytd decline in the China MSCI share price index (Fig. 3).

(2) International heft. Xi boasted about China’s relationships with other countries. He specifically noted: “As a collaborative endeavor, the Belt and Road Initiative has been welcomed by the international community both as a public good and a cooperation platform.”

Xi’s speech didn’t note that many countries that borrowed money under the Belt and Road Initiative are now struggling to repay China about $1 trillion of debt. Some have called the program China’s “debt-trap diplomacy.”

Xi also opted to exclude to China’s failure to warn the world that its people were coming down with a new disease, Covid-19. Instead, he said: “We have demonstrated China's sense of duty as a responsible major country, actively participating in the reform and development of the global governance system and engaging in all-around international cooperation in the fight against Covid-19. All this has seen us win widespread international recognition. China's international influence, appeal, and power to shape have risen markedly.”

(3) Keeping the peace. Xi noted the Party’s accomplishments in maintaining peace within the country’s borders. “We have effectively contained ethnic separatists, religious extremists, and violent terrorists and secured important progress in the campaigns to combat and root out organized crime,” he said.

No reference was made of China’s treatment of the Uyghurs and members of other Muslim communities who are incarcerated in the Xinjiang region. China committed “serious human rights violations” in their treatment of these minorities, an August 31 UN report noted.

(4) Protector of the environment. In a number of areas, Xi waxed poetic about the country’s devotion to preserving the environment. At one point he said: “China is committed to sustainable development and to the principles of prioritizing resource conservation and environmental protection and letting nature restore itself. We will protect nature and the environment as we do our own lives.” The country’s goals include establishing “eco-friendly ways of work and life; steadily lower carbon emissions after reaching a peak; fundamentally improve the environment; largely accomplish the goal of building a Beautiful China.”

While the country has rolled out solar panels and wind turbines to generate green energy, it is still tied to using coal and other CO2-producing fuels. China has produced 2.93 billion tons of coal from January to August, an 11% y/y increase, as it aims to avoid the power outages it suffered through last year, an October 12 Global Times article reported. The country’s coal imports dropped 14.9% to 168.0 million tons. The country had the highest CO2 emissions in the world in 2020, 11.7 billion tons, followed by the US, which emitted 4.5 billion tons, World Population Review has reported.

(5) Boosting business. Xi’s speech emphasized the Party’s support for businesses. We will “encourage entrepreneurship and move faster to help Chinese companies become world-class outfits. We will support the development of micro, small, and medium enterprises.” (Ask former Ant Group investor Jack Ma if he felt that support.) Of course, Xi has actually come down hard against entrepreneurs. Government regulation and supervision of business has increased significantly in recent years under Xi.

(6) Supporting workers. Xi spent a chunk of his presentation on how the Party will help workers. He said: “We will ensure more pay for more work and encourage people to achieve prosperity through hard work. We will promote equality of opportunity, increase the incomes of low-income earners, and expand the size of the middle-income group. … We will protect lawful income, adjust excessive income, and prohibit illicit income. … We need to intensify efforts to implement the employment-first policy and improve related mechanisms to promote high-quality and full employment. We will refine the public services system for employment and the system of providing employment support for key groups and do more to help those in difficulty find employment and meet their basic needs. ... We will further improve the multi-tiered social security system that covers the entire population in urban and rural areas and see that it is fair, unified, reliable, well-regulated, and sustainable.”

Xi also gave a shoutout to China’s youth: “A nation will prosper only when its young people thrive. China's young people of today are living in a remarkable time. They have an incomparably broad stage on which to display their full talents, and they have incomparably bright prospects of realizing their dreams.” The 18.7% unemployment rate among those aged 16 to 24 years old in August was left out of the speech (Fig. 4).

(7) Taiwan. Xi reiterated the Party’s focus on reunification with Taiwan, stating that the plan is to establish in Taiwan the same one-country, two-systems framework used in Hong Kong and Macau. “Resolving the Taiwan question and realizing China's complete reunification is, for the Party, a historic mission and an unshakable commitment. It is also a shared aspiration of all the sons and daughters of the Chinese nation and a natural requirement for realizing the rejuvenation of the Chinese nation.”

And just in case the politicians in Washington DC weren’t paying attention, Xi added: “Taiwan is China's Taiwan. Resolving the Taiwan question is a matter for the Chinese, a matter that must be resolved by the Chinese. We will continue to strive for peaceful reunification with the greatest sincerity and the utmost effort, but we will never promise to renounce the use of force, and we reserve the option of taking all measures necessary. This is directed solely at interference by outside forces and the few separatists seeking ‘Taiwan independence’ and their separatist activities; it is by no means targeted at our Taiwan compatriots. The wheels of history are rolling on toward China's reunification and the rejuvenation of the Chinese nation. Complete reunification of our country must be realized, and it can, without doubt, be realized!”

Taiwan’s presidential office, not surprisingly, is opposed to Xi’s plan for the island nation, and its response to Xi’s speech underscored Taiwan’s commitment to independence, democracy, and freedom.

Financials: An Eye on Leveraged Loans. The big banks’ Q3 earnings reports have been pleasantly surprising. Net interest income rose sharply y/y in the quarter, as the Federal Reserve has raised interest rates while banks have kept the interest they pay on deposits extraordinarily low. Some managements started increasing loan loss reserves in Q3, but the banks’ writeoffs and defaults so far have remained minimal.

But these are early days in the higher-interest-rate environment. The Fed has indicated that it’s not done raising rates. Companies with low credit ratings and floating-rate debt are just starting to feel the pinch of higher interest expense.

And there’s a lot of floating rate debt out there. Last year, leveraged loan issuance totaled $615 billion, 22% higher than the previous record year’s issuance, a January 3 S&P Global report noted. As a result, the total amount of leveraged loans outstanding rose to a record $1.4 trillion in 2021. But then this year, leveraged loan issuance dropped sharply to $195 billion in H1-2022, down from $495 billion in H1-2021.

Last year, bankers sliced and diced some of the leveraged loans and packaged them into a record amount of collateralized loan obligations (a.k.a. CLOs). Exchange traded funds (ETFs) were created to buy leveraged loans and articles written about them had headlines like: “Opportunity Beckons with Leveraged Loan ETFs.”

So far, leveraged loans are holding their own as their interest rates float and adjust to the current rate environment, unlike fixed-rate high-yield bonds. Some of the leveraged loan ETFs tracked online have fallen 3.8% to 6.8% ytd, which isn’t bad compared to high-yield bond ETFs, which have dropped more than twice as much, by 13%-15% ytd.

But if interest rates remain high and the economy weakens, some leveraged companies are bound to find that they can’t make their new, higher interest payments. Default rates for US leveraged loans could rise to 9% next year if the Fed “stays on its aggressive monetary-policy path,” according to a UBS Group analyst quoted in an October 14 Bloomberg article.

At Citigroup, markdowns and losses on leveraged loans totaled $110 million in Q3. And US banks as a whole wrote down $1 billion of leveraged and bridge loans in Q2, with some of that pain caused by write-downs on loans funding the leveraged buyout of Citrix Systems. We’ll keep an eye on this space.

Disruptive Technologies: Solar’s Slow But Steady Progress. The promise of solar panels on every roof hasn’t become a reality, but progress toward it is being made. Most recently, Tesla received some positive press when its solar roof on a Florida home in the path of Hurricane Ian remained intact and the accompanying Tesla Powerwall, which was covered by floodwaters, continued to work.

Solar panels remain pricey, but scientists are working on ways to bring the cost down. Here’s a look at some recent advancements:

(1) Swapping silver for copper. Australian startup SunDrive swapped out the expensive silver used in most solar cells for less expensive and more abundant copper, while maintaining the cells’ energy efficiency. The company believes it will be able to make further improvements to the cells, boosting their efficiency beyond their current 26.4%.

“Copper is around 100 times cheaper per kilogram and around 1,000 times more abundant than silver. And aside from the abundancy and cost benefits of copper, we have found we can improve the efficiency above and beyond what is attainable with silver,” SunDrive co-founder Vince Allen told PV Magazine in a September 5 article. The company, which has received funding from Blackbird, Grok Ventures, Main Sequence, and Virescent Ventures, counts Tesla Chair Robyn Denholm as one of its board members.

(2) Printing out solar panels. Scientists at Australia’s University of Newcastle have developed paper-thin solar panels that can be printed out in a sheet and rolled up because they are so flexible. They were used to power a Tesla that was driven around the perimeter of Australia. Eighteen solar sheets measuring 20 meters by 1 meter were laid out on the ground every day of the trip and required 10 hours of sunlight to power the next day’s drive.

While expecting drivers to lay huge panels out in the sun for a day before using their cars isn’t practical, the concept of thin, rollable panels holds promise. The solar cells’ efficiency is expected to increase, so the surface area needed to charge a car can shrink, making the panels more manageable. But in their current state, the solar cells are more likely to be used on commercial factory roofs and other large-scale installations.

It’s exciting to think that these solar cells could be incorporated into the coating of cars or used on the side of buildings. And because they are manufactured using conventional, 2D printers that might otherwise produce newspapers or packaging, the solar panels are cheap and fast to make, a September 2 article on the University’s website stated. The printer used in the University’s lab was previously used to manufacture wine labels.

Another advantage is that the printed panels are made primarily of PET, a material that can be recycled, unlike traditional silicon panels.

(3) Solar on cars. Aptera is designing a two-seater car that looks like an egg with a tail. But what makes it exciting are the lightweight solar panels that cover the roof and sides. The solar panels can bend in two different directions and are strong enough to survive rain, snow, and hail. They’re being designed to last more than 15 years without yellowing or aging, and they’re 50% lighter than the competition’s products.

The solar cells available on the market today are about 24% efficient, and cells that are 30% efficient are coming in the near future, an October 10 CleanTechnica article reported. “At 40% efficiency (something that’s in active development), the power you can get from a car’s surface will double. If they can get as far as 90% efficiency (a real possibility) a vehicle like the Aptera could add 120 miles of range on a good day.” Traditional auto manufacturers will add solar panels to their cars when they can add 40-50 miles to an electric car’s range per day, the article speculates.

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On Mid-Terms, Earnings & Commodities

October 19 (Wednesday)

Strategy I: ‘Bear Market Killer.’ In a recent TD Ameritrade interview, Paul Schatz, the Chief Investment Officer of Heritage Capital, observed, “October is known as the ‘bear killer’, especially in 1974, 1990, 1998, and 2002. Mid-term [election] years usually see major bottoms in the fourth quarter. … Stocks will bottom and interest rates will peak long before the Federal Reserve finishes hiking.”

A September 23 post on TheStreet reported, “According to the Stock Trader’s Almanac … September is the worst month for stocks. … Since 1950, October has been the 7th worst month for returns. However, returns are substantially better than usual in mid-term election years, with the S&P 500 and NASDAQ returning 2.7% and 3.1% on average. Between 1999 and 2003, Octobers were big winners during the Internet bust when high-valuation stocks were similarly entrenched in a vicious bear market. The Stock Trader’s Almanac writes that October ‘turned the tide in 12 post-WWII bear markets: 1946, 1957, 1960, 1962, 1966, 1974, 1987, 1990, 1998, 2001, 2002, and 2011.’

“October also ends the Almanac’s ‘worst six months of the year,’ setting the stage for historically stronger returns. According to the Almanac, November is NASDAQ’s best month of the year during mid-term election years, returning 3.5% since 1971. Furthermore, the six months from November through April have generated an average return of 7.5% on the Dow Jones Industrial Average, versus a 0.8% average gain from May through October. Since many bear markets have coincidentally ended in October, it’s called a ‘bear killer.’”

Now consider our numbers:

(1) Joe observes that since 1928, the S&P 500 fell 1.1% on average during September, by far the worst performance of any month. October, November, and December were up 0.5%, 0.6%, and 1.4% on average (Fig. 1). Yes, Virginia, there really is a Santa Claus rally. Apparently, it tends to be even more likely during mid-term election years.

(2) Joe observes that since 1942, during each of the 3-month, 6-month, and 12-month periods following each of the 20 mid-term elections the S&P 500 was up on average by 7.6%, 14.1%, and 14.9% (Fig. 2 and Fig. 3). I asked him to double-check his numbers, and they checked out!

Strategy II: Earnings Season Has Started. Wouldn’t you know it? Stock prices have rallied the past four days through Tuesday even though the Q3 earnings reporting season has started out poorly. Consider the following:

(1) Below, Joe reports that the Q3 earnings reporting season is off to the weakest start since Q1-2020. For the 45 companies that have reported Q3 earnings through mid-day Tuesday, the aggregate earnings growth rate dropped to -1.7% y/y.

Of course, this figure will change significantly as more Q3 results are reported in the coming weeks, particularly from nonfinancial firms with greater exposure to the strong dollar. While we expect y/y growth rates to remain positive in Q3, we think the revenue and earnings surprises will deteriorate q/q due to the slowing economy, missed deliveries, higher costs, and currency translation.

(2) Nevertheless, investors mostly liked what they heard on the big banks’ earnings calls, which have been leading the market higher since Thursday through Tuesday. The banks’ net interest income levels have been boosted by jumps in their net interest margin and record loans on their balance sheets (Fig. 4, Fig. 5, and Fig. 6). Furthermore, they’ve been reporting that the economy in general and the consumer in particular both are in good shape. The big banks just started to increase their allowances for loan losses in early October (i.e., the start of Q4) but not by much (Fig. 7).

(3) Here’s the performance derby of the S&P 500 and its 11 sectors over the past three trading days—i.e., Thursday’s big reversal day move to the upside, Friday’s downside move, and Monday’s upside movie: Financials (4.9%), Communication Services (3.6), Information Technology (3.3), Health Care (3.2), Utilities (3.2), Real Estate (3.1), S&P 500 (2.8), Industrials (2.2), Materials (1.9), Energy (1.4), Consumer Discretionary (1.2), and Consumer Staples (0.9) (Table 1).

Of the top 10 S&P 500 industry performers, seven are in the S&P 500 Financials sector: Diversified Banks (10.7%), Asset Management & Custody Banks (5.8), Life & Health Insurance (5.0), Multi-Sector Holdings (4.9), Reinsurance (4.9), Regional Banks (4.8), and Multi-line Insurance (4.8).

Strategy III: Looking Forward. It’s too early in the earnings season to see how Q3 results will impact industry analysts’ expectations for the final quarter of this year and all four quarters of next year. Nevertheless, we know that analysts collectively continued to lower their expectations for Q3 and Q4 of this year and all four quarters of next year during the October 13 week (Fig. 8 and Fig. 9).

Here are the analysts’ consensus 2022, 2023, and 2024 earnings-per-share estimates for the S&P 500 companies collectively as of the October 13 week: $222, $239, and $259 (Fig. 10). The forward earnings we derive by time-weighting their consensus estimates for the current year and next one is down to $236 from a record high of $239.93 during the June 23 week. The comparable y/y growth rates are 9.0%, 7.0%, and 9.0% (Fig. 11).

By the way, for most of the S&P 500’s sectors—all but Energy, Real Estate, and Utilities—industry analysts have been lowering their 2022 and 2023 earnings estimates (Fig. 12). Both years’ revenues expectations have been cut recently for the Consumer Discretionary, Industrials, Information Technology, and Real Estate sectors (Fig. 13). The analysts’ profit margin expectations (which we calculate from their revenue and earnings estimates) also have been cut for both years, especially for Communication Services, Consumer Discretionary, Consumer Staples, Health Care, Industrials, Information Technology, and even Utilities (Fig. 14).

Commodities I: Summits & the Pits. At his coronation this week as China’s president-for-life, Xi Jinping declared that economic growth is no longer the number-one priority of the Chinese Communist Party. European Union (EU) leaders are holding a summit on Tuesday, as we write this, to discuss proposals for solving their energy crisis. Both events could have significant recessionary impacts on the global economy, especially commodity markets, if China and the EU fail to overcome the challenges their economies face. Consider the following:

(1) China. On Sunday, China’s Communist Party Congress opened with a speech by President Xi on his vision for his country’s economy, covered by CNN. Xi’s continued dedication to the authoritarian zero-Covid movement, the country’s attempts to deleverage itself with tight business regulations, and comments about the nation’s future geopolitical aims regarding Taiwan and the possibility of invasion all affect commodities markets.

Xi’s commitments to authority, self-reliance, and security come at the expense of restoring China’s flailing economy, where growth has stalled and the housing market is a mess. The International Monetary Fund has downgraded China’s GDP growth outlook largely owing to the drag exerted by China’s zero-Covid policy. China’s economic slowdown is likely to further put the brakes on its raw materials boom.

The country has delayed the release of its Q3 GDP data, originally scheduled for Wednesday, until after the summit. Data on steel and energy output, property investment, and retail sales also were expected along with the release. No news is probably bad news, because usually good news isn’t hidden.

(2) Europe. EU leaders are currently considering draft proposals for dealing with their energy crisis. The package of proposals seen by Reuters states that as a “last resort,” the EU could set a temporary maximum price on a European gas trading benchmark. Most EU countries are looking for a gas price cap but disagree on how to implement one. Germany and the Netherlands say that a cap could leave struggling EU countries to obtain supply from global markets as a replacement for Russian fuel. In other words, a cap does not look likely for now.

Other measures in the EU’s package are aimed at mitigating the impact of high prices on consumers and businesses. By January 31, “trading venues must impose upper and lower price limits each day that front-month energy derivatives must trade within, as a way of limiting large price swings. EU energy regulators would also be charged with developing a new liquefied natural gas price benchmark by the end of March, and Brussels will launch a ‘tool’ for EU countries to start jointly buying gas, according to the draft,” Reuters wrote.

It seems that EU leaders aren’t doing much to actually solve their energy crisis by producing more of it in their neighborhoods.

Commodities II: Jitters in the Pits. The global economic slowdown, led by China and Europe, is pushing the CRB Raw Industrials Spot Price Index lower. Its latest reading was 561.21 as of Monday, which was 18.5% below its record high on April 4 (Fig. 15).

If China’s leaders somehow miraculously turn out a believable positive economic growth story, it’s possible that commodities prices would react favorably. But we expect them mostly to remain in the pits. That is, except for gas prices that have been energized by the crisis in Europe. Here are some related recent developments:

(1) Natural gas. Russian President Vladimir Putin recently warned of a “terror” risk to global energy infrastructure in a thinly veiled direct threat to global energy markets. Russian supplies to Europe have been severely strained by suspiciously damaged energy pipeline infrastructure. Benchmark natural gas prices have slumped from a peak but remain elevated (Fig. 16).

(2) Metals. The London Metal Exchange recently floated with clients the prospect of banning deliveries of Russian metal. The Biden administration also is considering a possible prohibition on Russian aluminum imports. That could be a positive for US metals producers but could also strain global supplies, elevating prices.

But softening global demand due to the weakening global economy is pressuring metals prices downward. The metals component of the CRB Raw Industrials Spot Price Index dropped 34.0% from its recent record on April 4 (Fig. 17).

Steel and copper prices, known to be heavily under the influence of China demand, both recently have fallen (Fig. 18).

(3) Soybeans. Poor weather impacting yields and lessening demand from China could continue to pressure the market for soybeans (Fig. 19). China remains the largest purchaser of US soybeans despite import tariffs on American goods. But China forecasts that soybean imports will decline as it weans itself from dependence on other countries for this and other commodities.

“The China Soybean Industry Association (CSIA) predicted that soybean imports in October may fall to a two-year low of about 5 million tons as the nation aims to reduce reliance on imports to stabilize supplies and prices amid falling US soybean exports,” according to Nasdaq.

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Going Fishing

October 18 (Tuesday)

Strategy I: Fishing (& Wishing) for a Top in the Treasury Bond Yield. Forecasting the cyclical peak in the 10-year US Treasury bond yield is easy. The hard part is getting it right.

We know that historically when the yield spread between the 10-year bond and 2-year note has been inverted, we were approaching a peak in the bond yield (Fig. 1 and Fig. 2). That’s because an inverted yield curve signals that the Fed’s monetary tightening policy is increasing the risk of a financial crisis that might trigger a credit crunch and a recession (Fig. 3 and Fig. 4). In other words, tightening monetary policy increases the chances that something will break in the financial system, slamming the brakes on economic growth, which forces the Fed to ease and causes the 10-year bond yield to fall (Fig. 5).

The daily 10-year versus 2-year yield spread has been inverted since July 8 (Fig. 6). Since then, the 10-year bond yield has risen from 3.01% to 4.00%, while the 2-year note yield has risen from 3.03% to 4.48% (Fig. 7). We know that the 2-year tends to anticipate the terminal federal funds rate (FFR) during monetary tightening cycles (Fig. 8).

So all we have to do is to forecast the terminal FFR. That forecast will tell us when the 2-year yield has peaked. Then all we must do is add the (negative) yield-curve spread to the peak 2-year yield to derive the peak level of the 10-year yield.

Let’s assume, as we do now, that the Fed will hike the FFR two more times, by 75bps at each of the November 1-2 and December 13-14 FOMC meetings. That would put the FFR at 4.50%-4.75%, which is our forecast and probably the current consensus forecast as well. The 2-year yield is currently around 4.40%. So it is very close to our forecast of the terminal rate.

This suggests to us that the 10-year bond yield should peak at 4.00%-4.25% assuming that the yield-curve spread remains around the current -50bps. The bond yield most likely will peak following November’s 75bps hike in the FFR. It might do so anticipating that the December hike will be the terminal one.

Strategy II: Fishing (& Wishing) for a Bottom in the S&P 500. The interest-rate outlook above is consistent with the likely scenario for the FFR as outlined in an October 14 Reuters interview with St. Louis Fed President James Bullard.

As we observed in yesterday’s Morning Briefing, Bullard said that he favors “frontloading” hikes in the FFR, with a wait-and-see stance on 2023. In other words, he suggested that the Fed should go ahead with the widely expected 75bps hike in the rate at the November 1-2 meeting of the FOMC and another 75bps hike at the December 13-14 meeting. That would bring the FFR target range up to 4.50%-4.75%. But then Bullard went on to imply that the Fed should pause for a while.

Joe and I think that’s one reason that stocks rallied on Monday. Another reason, of course, is that Bank of America reported better-than-expected Q3 earnings. The net interest margins of the S&P 500 Financials (particularly the money center and regional banks) have widened significantly this year.

We are thinking that instead of a V-shaped capitulation bottom, the S&P 500 may very well remain in a volatile trading range around the June 16 low of 3666 for a while longer before moving back toward the August 16 high of 4305 over the rest of this year.

US Labor Market I: Fishing for a Bottom in Labor Supply. Sure, Covid caused many workers to leave the workforce owing to health concerns or for caregiving purposes. But it’s not the only reason for the depressed US labor-force participation rate. Now that the pandemic has abated, life has normalized, but labor-force participation hasn’t. In September, the participation rate was merely 62.3%, over a full percentage point below the level just before the pandemic, in February 2020, of 63.4% (Fig. 9).

One of the main reasons for the lack of a post-pandemic snapback in labor-force participation is that the long expected tsunami of Baby Boomer retirements is here (Boomers, born between 1946 and 1964, are now 58 to 76 years old). Accordingly, the number of people who are not working—and are not looking to—has increased even though job openings are plentiful. The historically low unemployment rate of 3.5% excludes these NILFs (i.e., not-in-the-labor-force) from its in-the-labor-force denominator. Job openings exceeded the number of unemployed workers in the US from the start of 2018 through the start of the pandemic, and since July 2021 (Fig. 10).

Here’s a deeper look at factors that have been driving up the ranks of NILFs and weighing down the labor-force participation rate:

(1) Age distribution. The age distribution of a population can profoundly influence its percentage of NILFs. The participation rate of the prime-working-age population, 25- to 54-year-olds, has recovered from its pandemic-depressed lows (Fig. 11). That’s not the case, however, for the over-65 cohort (Fig. 12). Many Boomers retired during the pandemic. Just as Boomers’ outsized impact has been skewing the overall population older, it’s been weighing on the overall labor-force participation rate.

(2) Pandemic retirements. About 2.5 million people retired earlier than normal during the pandemic, found the St. Louis Fed. Fear of Covid complications among older people was one big reason. Another reason was that rising asset prices during the pandemic provided many people with sufficient nest eggs to retire, many of them without even collecting Social Security benefits yet (delaying claims increases the benefit amount up until the maximum collection age of 70). Remarkably, Social Security claims remained flat amid this wave of retirements. This raises the possibility that some retirees will reenter the labor force as a result of this year’s negative wealth effect on their portfolios.

(3) Declining population. Nevertheless, continuing retirements are likely to put additional downward pressure on labor-force participation rates over the next decade. Low labor-force participation compounded by the low growth rate of the working-age population is contributing to labor shortages. The size of the labor force equals the size of the population age 16 and older multiplied by their labor-force participation rate. Kansas City Fed researchers decomposed changes in population size and changes in participation rates. They found that population growth helped offset declining labor-force participation in most states between December 2019 and December 2021. But lower birth rates and lower migration trends (as discussed below) also contribute to declining population growth rates and the declining labor force.

(4) NILF newbies. Prime-working-age women (aged 25 to 64) faced a slightly larger drop in the labor-force participation rate during 2020, a 1.7ppt decrease compared to a 1.6ppt decline for men (Fig. 13). As many children returned to in-person learning at the start of the 2021-22 school year, the female participation rate rebounded. The current prime-working-age female participation rate is 72.2%, 0.5ppt from its the February 2020 level of 72.7%. The rate for men is 0.4ppt below its pre-pandemic level of 84.9%.

What’s been keeping some pandemic-era NILF newbies out of the labor force still? Federal stimulus funds sent to households aimed at boosting economic recovery could have influenced many NILFs to drop out of the labor force. These transfers, the Richmond Fed found, are estimated to account for almost 20% of the shortfall in the labor-force participation rate between February 2020 and August 2021. But the labor-force participation rate is expected to increase as many spend down their stimulus funds.

Disability spurred by long-Covid could explain why some prime-working-age NILFs have remained out of the labor force. A July 2022 Census Bureau survey found that 16.3 million people (around 8%) of working-age Americans currently have long-Covid. Of those, 2-4 million are out of work due to long-Covid. Some of their ranks, however, may be offset by previous NILFs now able to rejoin the workforce thanks to the growing remote work trend.

Labor Market II: Fishing for More Explanations for Labor Shortages. Here's a closer look at changes in the nature of the labor market since the pandemic:

(1) Lower paying jobs seeing most labor shortages. Baby Boomers presumably are mostly retiring from higher paying jobs that require more experience. So many younger folks have had the opportunity to hop into those higher paying positions, leaving a shortage of lower paid labor. Foreign-born workers, discussed below, typically would fill such a gap, but they also have been in short supply. The shortage has been felt especially by employers in lower paying, immigrant-reliant industries such as construction, hospitality, and other services.

(2) Shortage of teachers is notable too. Interestingly, educators retired in large numbers during the pandemic. The teaching workforce is now suffering from an incredible labor shortage. According to the U.S. Bureau of Labor Statistics, there were approximately 10.6 million educators working in public education in January 2020. As of February 2022, there were 10.0 million, a net loss of around 600,000, according to the National Education Association.

Some educators were motivated to retire by early retirement packages and others by fear of working in schools during the pandemic. The teacher shortage soon could get worse, as more than half of teachers are over 40. To address the shortage, some state governments are making it easier for retired school staff to return to work, according to edsource.org.

(3) Inflation may drive some out of retirement. Determining who is retired versus out of work can be tricky. A May article in the Washington Post noted that an estimated 1.5 million retirees have reentered the labor market over the past year, according to an Indeed economist. That means the economy has made up much of the excess loss of retirees since February 2020.

Some returning workers cite difficulty dealing with rising costs on a fixed income as the reason. Some are going back to work until they’re eligible for Medicare due to the high cost of private healthcare premiums. A survey from the Nationwide Retirement Institute found that some 13% of Gen Xers and Baby Boomers say they have postponed or considered delaying plans to leave the workforce due to soaring costs.

Vanguard research observes: “Except for pensioners, those who retired earlier than expected would have had to amass financial assets equal to as much as 10 times their annual income to confidently meet living expenses through at least age 84.” That suggests that some retirees may be returning to the workforce for one reason or another. But even if that were the case for many, the trend wouldn’t halt the inevitable Boomer-induced labor-force drain, just delay it.

(4) Immigration problem could be labor-force solution. “If retiring baby boomers are creating a labor shortage—immigration could be the solution” was the title of a September article in Fast Company. A July 2021 Peter G. Peterson blog noted that foreign born workers made up nearly one-fifth of the US labor force.

Tighter immigration policies and travel restrictions stemming from the Covid-19 pandemic reduced net international immigration to the US from 2016 to 2021, found the Kansas City Fed in a study. As of June, there were about 1.7 million fewer working-age immigrants living in the US than there would have been had immigration continued at its pre-2020 pace, according to an economist quoted in an October Bloomberg article.

More temporary workers are coming to the US, according to a Pew Research Center analysis cited in the article. But the number of workers still doesn’t match the level prior to the pandemic. Moody’s Analytics has shown that for every 1% increase in the population made of immigrants, GDP rises 1.15%, the article observed.

(5) Age wave and inflation. By the way, the formerly accepted notion that elderly populations tend to drive inflation down may be challenged in the coming years (Fig. 14). Recent research from the International Monetary Fund found that when there are high concentrations of dependent populations relative to the working-age cohort, there is a tendency toward consumption, which inflates inflation. BCA Research also recently highlighted how Baby Boomers control more than half of US household wealth and increasingly will have an outsized influence on consumption over output. That’s all according to a September article in Forbes.

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Mostly All About Inflation

October 17 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy: Sizzle to Fizzle in Two Days. It’s still a bear market. Financial market sentiment is still all about hotter-than-expected inflation and the Fed’s increasingly hawkish approach to the problem.

Extremely bearish sentiment often gives way to rallies, but the recent rallies haven’t lasted very long. From a fundamental perspective, even the S&P 500’s industry analysts—who collectively tend to have an optimistic bias—are finally reducing their earnings estimates for 2022 and 2023, resulting in a flattening of forward earnings. Forward revenues, derived from their consensus revenue estimates for the index, is still rising in record-high territory, driven higher by inflation. But the analysts collectively are shaving their profit margin expectations, according to the forward profit margin we calculate from their consensus earnings and revenue estimates.

In the fixed-income markets, the two-year Treasury note yield—which tends to reflect investors’ expectations for the terminal federal funds rate (FFR)—continues to rise. That’s pulling the 10-year Treasury note yield higher, but not as fast. So the yield curve is getting more inverted, signaling a rising risk of a financial crisis, which could turn into a credit crunch and a recession. All these unhappy developments are weighing on the S&P 500’s forward P/E, which has been leading the bear market so far this year.

Since all the above is all about inflation, let’s review the latest PPI and CPI reports released last week. Debbie and I must warn you that we will be looking for signs that it has peaked now that the markets are challenging that hypothesis. But before we go there, let’s have a closer look at the numbers and details behind the picture we just painted of the financial markets:

(1) Anatomy of a bear market in stocks. The S&P 500 sizzled on Thursday following the release of September’s hot CPI inflation report. At first, it dropped 2.4% from Wednesday’s close. But then it rebounded remarkably by 5.6% and closed up 2.6% for the day. In our October 13 QuickTakes, we explained: “It’s possible that prior to the widely feared CPI report, investors hedged their portfolios and scrambled to cover their shorts when the market dropped on the bad news. That forced unhedged shorts to cover too resulting in a reversal day.”

However, on Friday, the S&P 500 closed down 2.4% when interest rates moved higher in reaction to the previous day’s bad inflation news. The index is down 25.3% from its record high on January 3 (Fig. 1). It is 13.5% and 8.8% below its 200-day and 50-day moving averages.

The internal damage among the 11 sectors of the S&P 500 is particularly intense among the cyclical ones. Here is their performance derby since January 3 through Friday’s close: Energy (41.7%), Health Care (-11.5), Utilities (-12.5), Consumer Staples (-12.6), Industrials (-19.3), Financials (-21.8), Materials (-23.7), S&P 500 (-25.3), Information Technology (-33.7), Real Estate (-34.3), Consumer Discretionary (-35.7), and Communication Services (-40.0). (See Table 1 and Fig. 2.)

As noted above, while S&P 500 forward revenues per share continues to be boosted by inflation to new highs (albeit at a slower pace in recent weeks), forward earnings per share peaked at its record high during the June 23 week and since then has stalled just below that level at around $237 (Fig. 3). The forward profit margin peaked at a record 13.4% during the June 9 week, edging down to 13.0% during the October 6 week.

So far, the bear market has been all about the plunge in the S&P 500’s forward P/E. It has dropped 30% from 21.5 on January 3 to 15.1 on Friday (Fig. 4). This severe rerating of the valuation multiple is all about inflation turning out to be more persistent (i.e., higher for longer) than widely expected at the end of last year. As a result, interest rates have been rising all year.

(2) Anatomy of a bear market in bonds. On Friday, the 10-year Treasury bond yield rose to 4.00%, the highest reading since April 5, 2010 (Fig. 5). The 2-year Treasury note yield rose to 4.48%, up from 4.30% a week ago, as investors continued to anticipate a higher terminal FFR level. The FOMC is widely expected to raise the rate by 75bps on November 2 to a range of 3.75%-4.00% and by 50bps on December 14 to 4.25%-4.50%.

The widening inverted yield-curve spread between the 2-year and 10-year notes suggests that investors are increasingly concerned that the Fed’s monetary tightening might soon trigger financial instability, i.e., a financial crisis that leads to a widespread credit crunch and a recession (Fig. 6).

(3) Anatomy of Bullard’s frontal lobe. In a Friday, October 14 Reuters interview, St. Louis Fed President James Bullard said that he favors “frontloading” hikes in the FFR, with a wait-and-see stance on 2023. In other words, he suggested that the Fed should go ahead with the widely expected 75bps hike in the rate at the November 1-2 meeting of the FOMC and another 75bps hike at the December 13-14 meeting. That would bring the FFR target range up to 4.50%-4.75%. But then Bullard went on to imply that the Fed should pause for a while.

In the interview, Bullard commented on September’s CPI, which was released on Thursday, saying that it showed inflation had become “pernicious” and difficult to stop, and therefore “it makes sense that we’re still moving quickly.” Bullard tends to be among the most hawkish of the hawks on the FOMC. And he often tends to provide an accurate early read on changes in the committee’s thinking and stance.

Bullard didn’t rule out raising the FFR above 5.00% next year if “inflation doesn’t come down the way we’re hoping in the first half of 2023 and we continue to get hot inflation reports.” He didn’t rule out a soft landing of the economy and said that the inversion of the yield curve might be attributable to an inflation premium. He posited that after “the transition,” the economy “could grow just as fast at the higher interest rates.” He downplayed the risk of a financial crisis like those of 2008 or early 2020: “I don’t think we’re in a situation where global markets are facing a lot of stress of that type.”

Bullard’s outlook jibes with our rolling recession outlook. We also agree with him that the new normal, coming out of this mess, may very well be the old normal of economic growth with higher interest rates. We are just waiting for him also to acknowledge that the Fed might have to learn to live with inflation rates closer to 3.0% y/y than to 2.0%.

(4) Feshbach’s call. Joe Feshbach is neutral about the short-term trading prospects for the S&P 500. He wasn’t surprised by Friday’s downward reversal of Thursday’s upside reversal. “The part that doesn’t fit and makes me uncomfortable is that breadth continues to be just awful, continually outperforming on the downside and underperforming on the upside.” He was quite surprised that the put-call ratios both Thursday and Friday were among the lowest readings in weeks: “It’s as if investors are too optimistic about the upside and not sufficiently pessimistic about the downside.” So Feshbach is in a wait-and see trading mode currently.

US Economy: Rolling Along Slowly. Last week, Debbie and I reiterated our rolling recession scenario for the economy. We also suggested that inflation might be following a similar rolling script.

Currently, we think that the single-family housing market and auto sales are in recessions because of the Fed’s tightening. Retailers also are experiencing a recession. They’ve had to discount prices to reduce their bulging inventories of goods, because consumers had satisfied their post-lockdown pent-up demand for goods while previously ordered ones arrived en masse as supply-chain problems abated. Consumers also satisfied their pent-up demand for PCs and TVs, built up during the first two years of the pandemic. So the semiconductor industry is in a recession.

The bottom line is that the unit sales of many goods producers and distributors have been weakening since the beginning of the year. Here are the ytd changes in real business sales from December through July: total (-0.8%), manufacturing shipments (-3.2), wholesale sales (-0.5), and retail sales (1.1) (Fig. 7 and Fig 8). In current dollars, September’s retail sales was virtually unchanged m/m and rose just 0.1% m/m excluding gasoline (Fig. 9).

Meanwhile, the energy sector is booming and scrambling to export more natural gas to Europe. The services economy is also prospering, as evidenced by the strength of September’s NM-PMI. As we noted in last Wednesday’s Morning Briefing, September’s MasterCard SpendingPulse found relative weakness in housing-related retail sales. Furniture & furnishings and hardware retailers had small gains of 1.4% and 1.7%, respectively. On the other hand, “experiential” spending is strong. In September, spending at restaurants rose 10.9% y/y and spending on airlines and lodging likewise experienced double-digit y/y growth, of 56.4% and 38.1%.

US Inflation: Rolling Along Too. Excessively stimulative fiscal and monetary policies during 2020 and 2021, in response to the pandemic, caused a demand shock, especially for goods during 2021 and early 2022. As a result, global supply chains were overwhelmed, causing a supply shock that resulted in rapidly rising prices, especially for durable goods. The Ukraine war put more upward pressure on goods prices, particularly for energy and food.

Now those goods-specific inflationary pressures seem to be abating, but inflation has rebounded in the services sector. Underlying demographically driven labor shortages were exacerbated by the pandemic and government programs aimed at helping the unemployed. That resulted in an increase in wage inflation. As a result of record quits, the turnover in the labor market has increased greatly, which has weighed on productivity.

Let’s review the latest developments in this rolling inflation scenario:

(1) Goods & services. We can see that inflation has been rolling out of goods and into services in the core CPI (excluding energy and food) (Fig. 10). On a y/y basis, the former rose from 1.7% in January 2021 to a peak of 12.4% in February 2022. It was back down to 6.7% by September. The core services CPI was 1.3% at the start of last year and rose to 6.7% in September of this year, the hottest reading since August 1982. There’s no peak yet in the services CPI inflation rate.

(2) Goods. Among nondurable goods in the CPI, energy inflation seems to have peaked on a y/y basis during June at 41.6%. It was down to 19.8% in September. Food inflation hasn’t peaked yet. It rose to 11.2% during September (Fig. 11). The most significant peaks have been made in durable goods inflation (Fig. 12). The CPI index for this category peaked at 18.7% y/y in February and fell to 7.1% in September. The three-month annualized rate through September was down to 2.7%.

By the way, both the headline and core PPIs show recent clear peaks in their y/y inflation rates for finished goods, intermediate goods, and crude goods (Fig. 13).

(3) Services. Among the biggest jumps in CPI services prices recently has been health insurance, which soared 28.2% y/y through September (Fig. 14). Its three-month annualized inflation rate was almost as bad at 27.6%. The only good news is that this item was up only 1.3% y/y in August’s PCED inflation. That’s because the PCED reflects the fact that this item tends to be paid for by businesses rather than consumers.

Needless to say, because we and others have said it before, the rent component of the CPI has been sticking out like an increasingly large sore thumb in the inflation picture (Fig. 15). It’s misleading partly because it includes so-called “owners’ equivalent rent.” Further confusing the picture, rent has a bigger weight in the CPI than in the PCED.

One cause for stratospheric rent inflation that a smart fellow at one of our accounts recently pointed out to us is that many landlords were stymied from raising their rents by government-imposed moratoriums during the pandemic and are now raising them to make up for lost revenue.

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On Semis, Valuation & Energy

October 13 (Thursday)

Semiconductors: A No-Good, Very Bad Year. The S&P 500 Semiconductors and the S&P 500 Semiconductor Equipment stock price indexes have had a horrible year, sharply underperforming the S&P 500 index. The industries are being weighed down by their typical challenges—oversupply, weak prices, and slowing computer sales—on top of the Biden administration’s ban on the sale of high-end chips and manufacturing equipment to China.

Here's how the S&P 500 Semiconductors, S&P 500 Semiconductor Equipment, and S&P 500 indexes performed on Tuesday (-1.4%, -4.2%, -0.7%), over the past week (-10.3, -14.7, -5.3), and ytd (-46.4, -42.6, -24.7) (Fig. 1 and Fig. 2).

Unfortunately, analysts’ collective net earnings revisions for the S&P 500 Semiconductors industry just started turning negative in July, for the first time in almost two years (-15.3% in September, -14.2% in August, and -0.9% in July) (Fig. 3). After the downward revisions, analysts still call for earnings growth this year—of 2.4%—followed by a 2.7% earnings decline in 2023 (Fig. 4).

Analysts started trimming earnings estimates for the S&P 500 Semiconductor Equipment industry in April, and estimates have weakened further for most months since, May being the exception (-9.3% in September, -9.4% in August, and -2.6% in July) (Fig. 5). Nonetheless, they still expect earnings to grow by 18.4% this year and 10.8% in 2023 (Fig. 6). The downward revisions probably aren’t finished until earnings drop sharply in both industries, as they did in 2000, 2009, and 2018 (Fig. 7 and Fig. 8).

During these industries’ two sharp earnings drops in 2001 and 2009, their P/Es soared—to 100.7 and 74.4, respectively, for the S&P 500 Semiconductors index and to 137.5 and into the stratosphere for the S&P 500 Semiconductor Equipment index. If the current environment is anything similar, the selloff in the industries’ stock price indexes may continue until their P/Es climb far above the current levels of 15.4 (for Semiconductors) and 14.2 (for Semiconductor Equipment) (Fig. 9 and Fig. 10).

Here's a look at some of the news affecting the industry:

(1) Industry slowdown continues. Global semiconductor sales rose by 0.1% y/y in August, but these sales’ three-month moving average declined by 8.3% y/y that month. Here’s how the three-month moving average fared geographically: Europe (2.8%), Japan (-2.0), Americas (-6.6), Asia Pacific/All Other (-11.2), and China (-11.7) (Fig. 11).

The slowdown can be partially attributed to less demand for new computers after the surge in demand from pandemic-related work-from-home arrangements. Worldwide PC sales fell 19.5% in Q3 y/y, according to a Gartner press release. Q3 sales fell 17.3% in the US and -26.4% in Europe, the Middle East, and Asia. The drop-off of PC sales is what reportedly led Intel to plan a major headcount reduction, which may number in the thousands and will be announced as early as this month, an October 12 Bloomberg article reported.

Falling prices are also weighing on the industry. “The average contract prices for the two major types of memory, called DRAM and NAND flash, dropped by 15% and 28%, respectively, from the prior quarter during the July-to-September period,” an October 7 WSJ article reported. The article’s data comes from TrendForce, a market research shop that believes that the double-digit declines should end by spring and that prices should be flattish by year-end 2023.

(2) Politics takes a toll. The Biden administration announced on Friday that it plans to limit the sale of chips used in artificial intelligence and supercomputing, as well as the sale of chipmaking equipment, to China. Other countries are expected to announce similar restrictions.

“The US measures seek to stop China’s drive to develop its own chip industry and advance its military capabilities. The impact could extend well beyond semiconductors and into industries that rely on high-end computing, from electric vehicles and aerospace to gadgets like smartphones,” an October 11 Bloomberg article reported.

US semiconductor equipment suppliers reacted this week by pulling out staff based in China’s leading memory chip manufacturer, state-owned Yangtze Memory Technologies. They also stopped support of equipment that was already installed at the Chinese company and ended the installation of new tools, the WSJ reported yesterday. Semiconductor equipment manufacturer Applied Materials’ press release on Wednesday said the export curbs could cut its Q4 and Q1 revenue forecast by $500 million, at the midpoint of its estimate, and potentially by more than $1 billion.

Strategy: A P/E Reset. Perhaps the only upside of the market downdraft is the resetting of forward P/E multiples. The S&P 500 forward P/E has shrunk to 16.2 from 20.4 a year ago. The index’s price has declined 17.1% y/y through Friday’s close. If we pretend that the forward P/E was unchanged y/y, the index price would have risen by 9.7%, the same amount as the gain in forward earnings. Likewise, if forward earnings had been unchanged, the price index would have fallen 26.8% solely due to the meltdown in the forward P/E (Fig. 12). (FYI: Forward earnings is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for this year and next; forward P/E is the multiple based on forward earnings.)

Now let’s drill down to the sectors and industries of the S&P 500:

(1) Sectors. Joe reports that the forward P/Es of all 11 S&P 500 sectors have fallen over the past 12 months, some more sharply than others. Here’s where the forward P/Es stood as of October 6 and where they were a year prior: Real Estate (32.8 as of October 6, 48.2 one year ago), Consumer Discretionary (23.2, 28.6), Information Technology (19.7, 25.1), Consumer Staples (19.2, 19.9), Utilities (18.4, 19.0), S&P 500 (16.2, 20.4), Industrials (16.0, 20.3), Health Care (15.7, 16.3), Communication Services (14.0, 21.1), Materials (13.6, 15.8), Financials (11.5, 14.6), and Energy (8.6, 13.1) (Table 1).

(2) Industries. Drilling down to the industry level, we find that those S&P 500 industries that suffered the greatest P/Es declines over the past year did so for a mixed bag of reasons, including higher forward earnings as a result of rebounding business after Covid shutdowns (e.g., Airlines and Hotels) and very high P/Es before the market sold off (Application Software and Movies & Entertainment).

(3) Falling P/Es. Here are the 10 S&P 500 industries that have seen their forward P/Es shrink by the greatest percentages over the past year along with their forward P/Es as of October 6 and one year ago: Airlines (8.7, 32.2), Hotel & Resort REITs (19.3, 68.0), Hotels (17.9, 45.6), Oil & Gas Refining & Marketing (7.3, 17.8), Cable & Satellite (8.4, 17.2), Movies & Entertainment (20.4, 41.3), Health Care Supplies (19.1, 37.1), Industrial REITs (33.0, 60.0), Publishing (16.9, 30.5), and Application Software (26.9, 46.7).

(4) Rising P/Es. One small group of industries enjoyed expanding forward P/Es over the past year. This group includes cyclical industries with earnings estimates that have declined sharply (sending their P/Es higher) and defensive industries that have traded up because they’re expected to withstand an economic downturn better than cyclical areas.

Here are the 10 S&P 500 industries with forward P/Es that have increased by the greatest percentage over the past year along with their current and year-ago forward P/Es: Copper (15.2, 9.2), Health Care Distributors (13.3, 10.2), Gold (19.8, 15.5), Biotechnology (12.9, 10.2), Steel (7.8, 6.2), Managed Health Care (19.0, 16.6), Internet & Direct Marketing Retail (56.0, 51.0), Health Care Services (11.5, 10.6), Gas Utilities (17.8, 16.5), and Brewers (11.9, 11.1).

(5) Different strokes. After selling off for almost a year, some industries typically considered safe havens are looking expensive, while the multiples of some growth industries have become much more reasonable. While the S&P 500 Personal Products industry’s forward P/E has fallen to 28.8 from 40.3 a year ago, its forward earnings growth rate is 7.8%. Water Utilities has a forward P/E of 28.7 and a forward earnings growth rate of 8.9%, while Hypermarkets & Super Centers has a forward P/E of 25.9 and a forward earnings growth rate of 8.1%. Each of these industries’ forward P/E is more than three times its forward earnings growth rate.

Meanwhile, some growth industries have forward P/E multiples that are about twice their expected forward earnings growth: Application Software (forward P/E of 26.9, forward earnings growth of 14.3%), Systems Software (22.8, 12.3%), and Internet Services & Infrastructure (20.2, 9.9%).

Energy: Sliding Demand. President Joe Biden was understandably upset when Saudi Arabia and OPEC+ decided on October 5 to cut oil production by 2 million barrels a day (mbd). Prior to the meeting, the price of Brent crude oil futures had fallen to the low- to mid-$80s from their peak of $123.58 on June 8. Since the announcement, the price of Brent futures rose to $97.92, before dropping back down to $94.29 on Tuesday (Fig. 13). Anything that boosts the price of oil not only hurts Western economies but also boosts Russia’s oil-related revenues, padding its war coffers.

So far, the impact of the supply cut hasn’t been dramatic because of the global economic slowdown. A strong dollar and more Covid-related shutdowns in China haven’t helped the oil market either. And looking out into the future, the growing adoption of hybrid and electric vehicles may curb demand for black gold.

Let’s turn to some of the moving parts affecting the price of oil:

(1) Fears of global economic slowdown. It’s not often that the whole world’s economy faces a synchronized economic slowdown, but that’s what appears to be occurring. In Europe, high natural gas and electricity prices are crushing consumer demand and boosting corporations’ expenses. And missteps by the UK government’s new leaders have spooked that country’s financial markets, sending interest rates and inflation spiraling higher. The latest reading of German industrial output fell by 0.8% m/m in August.

In Asia, China’s economy continues to be dragged down by real estate developers defaulting on their debt. The latest defaults occurred on Monday as payments were missed on $225 million of trust borrowings owed by units of China SCE Group Holdings and Shimao Group Holdings, an October 10 Bloomberg article reported. SCE is ranked 27th nationwide in sales.

Widespread lockdowns due to a very small number of Covid cases has also hurt the Chinese economy. Cases jumped to 2,089 on October 10—the highest since August 20—after domestic travel increased during “Golden Week” earlier this month, an October 11 Reuters article relayed. Increased testing and targeted lockdowns reportedly are occurring. Nomura estimates that 36 cities are under various degrees of lockdown or control, affecting 196.9 million people.

The preventative steps are being taken days before the Communist Party Congress starts on Sunday. The latest dour economic reading arrived earlier this week: The Caixin China General services purchasing managers index fell to 49.3 in September, down sharply from 55.0 in August.

Earlier this week, the International Monetary Fund lowered its 2023 estimate for global economic growth by 0.2ppt to 2.7%. That’s slower than the 3.2% growth expected this year and the 6.0% growth the global economy produced in 2021. OPEC also lowered its global economic growth forecast for 2022 to 2.7%, down from its prior forecast of 3.1%. Its forecast for 2023 economic growth was also lowered to 2.5% from 3.1%. “OPEC also lowered its oil-demand growth forecasts by 460,000 barrels a day to 2.64 million barrels a day for 2022. For 2023, the Vienna-based group lowered its forecast by 360,000 barrels a day to 2.34 million barrels a day,” a WSJ article reported yesterday.

(2) Strong dollar packs a punch. The strong US dollar may also be weighing on the price of crude oil, which is largely traded in dollars. The greenback is up 16.5% from its 2021 low (Fig. 14). The higher the dollar, the more expensive it is for other countries to buy oil, and that hurts demand.

(3) EVs starting to pinch? Global sales of passenger electric vehicles (EVs)—both battery electric vehicles (BEV) and plugin hybrid electric vehicles (PHEV)—continue to grow and take market share. In August, 847,580 EVs were registered, up 60% y/y, an October 3 InsideEVs article reported. Market share increased to 15% of new vehicles registered, which includes 11% for BEVs and 4% for PHEVs. (Excluding China, PHEV sales fell 9%.)

The International Energy Agency’s 2022 outlook estimated that the global EV fleet in 2030 would displace about 3.4mbd of diesel and gasoline, assuming that EVs reach just over 20% of sales in 2030. If EV sales represent more than 30% cars sold globally, they could displace about 4.6mbd, up from about 0.3mbd in 2021. The impact on the market will also depend on whether the demand for crude oil-based fuels by industrial users remains flat, increases, or decreases.

In the US, roughly 45% of US crude oil is turned into gasoline and used by cars, according to US Energy Information Administration data. The impact of EVs on fuel demand has caught the attention of some state finance departments that collect gasoline taxes. Fuel taxes provide roughly 40% of the revenue that states use to fund transportation spending, and much of it could disappear in the coming decades, according to an October 3 report by Pew Charitable Trusts.

West Virginia’s Department of Transportation in 2021 estimated that fuel tax revenue could fall by 11%-20% from 2021 through 2030 and by 31%-52% from 2031 through 2050 as more EVs hit the road and the fuel efficiency of cars with internal combustion engines improves. States will need other revenue sources, which might include a mileage-based tax, a new real estate or sales tax, or a general transportation fee.

A 2021 report by the Connecticut Office of Policy and Management noted that revenue from the state’s motor fuels tax was growing until 2020, when Covid hit and consumption fell. In early 2022, consumption remained below pre-pandemic levels and was not expected to recover over the next five years. But even apart from the pandemic, the state had assumed that the growth in motor fuels consumption would drop either because gas prices jumped or because “alternatively-powered vehicles” would increasingly be used. The state estimates that the motor fuels tax will recover to $490.2 million in fiscal 2023 and gradually decline to $485.3 million in fiscal 2026.

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The Most Widely Anticipated Recession In History

October 12 (Wednesday)

US Economy I: The Recession Is Coming! Debbie and I have said it before: “The next recession may be the most anticipated recession of all times.” We have a reason to say it again: Jamie Dimon, the CEO of JPMorgan Chase yesterday said a recession is coming.

Dimon acknowledged that the US economy is “actually doing well,” but he thinks it could be in a recession within six to nine months. Among Dimon’s major concerns are inflation, interest rates, quantitative tightening, and Russia’s war in Ukraine. “These are very, very serious things which I think are likely to push the US … in[to] some kind of recession,” Dimon said. He added that Europe is already in a recession.

Those are all valid points. Here’s our assessment of the economy’s recession prospects:

(1) Rolling recession adds up to growth recession. We agree that the US economy is actually doing well even though we think it has been in a “rolling recession,” hitting different industries at different times, since the start of this year. So rather than a hard landing, we think we are already experiencing a soft landing, a.k.a. a “growth recession.”

The rolling recession is rolling through the single-family housing industry. It is rolling through the retailing industry that is scrambling to discount merchandise to clear unintended bloated inventories. It is rolling through the auto industry, which finally seems to have the parts needed to boost production; but the jump in interest rates is depressing the demand for auto loans and autos.

Dimon undoubtedly can see the weakness in both mortgage demand and auto loans. An index of mortgage applications for new purchases is down 37% y/y through the September 30 week to the lowest since October 2015 (Fig. 1). Single-family housing starts are down 23% since February through August (Fig. 2). September’s auto sales were relatively weak at 13.7 million units (saar), down 10% from January’s 15.2 million units, even though the auto industry’s supply-chain problems are abating by most accounts (Fig. 3). The weakness in auto sales is occurring for domestic autos and light trucks as well as imports (Fig. 4).

Dimon undoubtedly also sees that demand for commercial and industrial (C&I) loans is booming. Indeed, total C&I loans rose 14.6% y/y through the September 28 week (Fig. 5). The sum of C&I loans and nonfinancial commercial paper is up $290 billion ytd through the end of September (Fig. 6). This series is highly correlated (not surprisingly) with the value of business inventories, which rose to a record high partly as a result of unintended accumulation and rapidly rising prices.

(2) Our new growth recession forecast. There was no growth in real GDP during the first half of this year, confirming the notion of a growth recession. Growth was actually down slightly during Q1 and Q2. So far, Q3’s growth isn’t following anyone’s recessionary script.

The Atlanta Fed’s GDPNow tracking model’s latest estimate is that real GDP was up 2.9% (saar) during the quarter. We are raising our Q3 forecast for real GDP from 1.5% to 2.5% and lowering our Q4 one from 1.5% to 1.0%. We are lowering our 2023 GDP growth rate projection from 2.5% to 1.5% (Fig. 7). So we think that the growth recession could linger well into 2023.

(3) Consumers are still consuming. So far, consumers haven’t read the recession memo. They are spending freely, according to MasterCard SpendingPulse, which found that retail sales grew by double digits, both online and offline, in September 2022. Excluding autos, off-line retail sales increased 11% y/y, and e-commerce sales rose 10.7% y/y. (The data are based on in-store and online retail sales across all forms of payment and are not adjusted for inflation.)

Not surprisingly, MasterCard’s data show relative weakness in housing-related retail sales. Furniture & furnishings and hardware retailers had small gains of 1.4% and 1.7%, respectively.

On the other hand, “experiential” spending is strong. In September, spending at restaurants rose 10.9% y/y, and spending on airlines and lodging also experienced double-digit y/y growth of 56.4% and 38.1%. (See the October 7 CSA article titled “Mastercard: September U.S. retail sales sizzle.”)

US Economy II: Small Business Owners Remain Depressed. Yesterday, the National Federation of Independent Business (NFIB) released its September survey of small business owners. They are about as depressed as they have ever been. That’s not because their sales are terrible. Rather, they can’t find enough workers to expand their businesses. So they’ve had to raise both the wages they pay and the prices they charge. However, September’s survey suggested that inflationary pressures are moderating. Consider the following:

(1) Depressed outlook. The NFIB index of the outlook for general business fell to a record low of -61 during June (Fig. 8). It was back up to -44 during September, which was still well below the previous troughs in this series that started in 1974. Inflation is the number one problem faced by 30% of small business owners, according to the latest survey (Fig. 9). It peaked at 37% during July, but these readings are in line with similar ones during the Great Inflation of the 1970s.

(2) Raising prices. Small business owners are contributing to the inflationary pressures. The percentage of them raising prices in September was 51%, down from a recent peak of 66% (Fig. 10). Somewhat more encouraging is that the percentage planning to raise their prices fell from a recent peak of 54% during November to 31% in September.

(3) Tight labor market. In recent months, nearly 50% of small business owners said that they have job openings, holding near last September’s and this May’s record high of 51.0% going back to the start of the series in 1974. This series is highly inversely correlated with the unemployment rate (Fig. 11). On a three-month-average basis, 23% of them plan to raise worker compensation, down from a record high of 32% the last three months of 2021 (Fig. 12). That suggests that the y/y increases in both the Employment Cost Index and average hourly earnings may be peaking (Fig. 13).

Strategy: The Latest Earnings Season. We are still forecasting S&P 500 operating earnings per share of $215 this year and $235 next year. Given our new prolonged growth recession forecast, we most likely will lower those numbers by $5-$10 each. But first, we will wait to see how the current earnings reporting season, for Q3, unfolds. We aren’t the only ones cutting earnings estimates. Consider the following:

(1) Quarterly earnings. Industry analysts collectively have continued to lower their earnings estimates for the S&P 500 too. During the October 6 week, they shaved their earnings estimates for Q3 and Q4 this year and for every quarter of next year (Fig. 14 and Fig. 15). Nevertheless, they are currently projecting that Q3 earnings will be up 2.9% y/y (Fig. 16). But that’s down from their projected growth rate of 7.0% at the beginning of this year. They are currently estimating that Q4 earnings will be up 6.7% y/y, but that’s down from 14.2% at the start of this year.

Here are the analysts’ current consensus estimates for the quarterly y/y growth rates in 2023: Q1 (4.1%), Q2 (2.2), Q3 (9.2), and Q4 (9.2) (Fig. 17).

(2) Annual earnings. During the October 6 week, analysts were estimating the following annual earnings and growth rates: 2022 ($223.34, 7.1%), 2023 ($240.97, 7.9%), and 2024 ($260.52, 8.1%) (Fig. 18).

(3) Forward revenues, earnings, and profit margin. During the September 29 week, S&P 500 forward earnings rose to yet another record high (Fig. 19). However, forward earnings peaked at a record $239.93 during the June 23 week. It has been drifting lower, reaching $236.90 during the October 6 week, the lowest reading since August 11.

The forward profit margin peaked at a record 13.4% during the June 9 week. It was down to 13.0% during the September 29 week.

(4) NERI. The net earnings revision index of the S&P 500 was -9.7% during September, down from -9.0% in August and the worst reading since July 2020 (Fig. 20).

(5) Q3 earnings season by sectors. Here are the currently projected Q3 y/y earnings growth rates for the S&P 500 and its 11 sectors: Energy (121.0%), Industrials (26.3), Consumer Discretionary (13.5), Real Estate (11.0), S&P 500 (2.9), Materials (-2.1), Consumer Staples (-2.4), Information Technology (-3.5), Health Care (-4.2), Utilities (-7.4), Financials (-10.5), and Communication Services (-16.1).

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More Inflation (News) Is Coming

October 11 (Tuesday)

US Inflation I: Moving Markets & Fed Policy. The stock market’s performance this year has been mostly driven by the CPI inflation news releases and perceptions of how the Fed will respond to the news. Almost all the releases caused the S&P 500 to drop so far this year (Fig. 1). Here’s a quick recap of events:

(1) The CPI releases for June (on July 13) and July (on August 10) didn’t interfere with the rally from June 16 to August 16, which turned out to be a bear-market rally on the hope (we shared) that the sharp drop in gasoline prices during July and August might lead to a moderation of inflation broadly (Fig. 2). That hope was dashed when August’s CPI was released on September 13. It suggested that inflation might be broadening notwithstanding the drop in gasoline prices and declines in some durable goods prices.

(2) Fed Chair Jerome Powell announced his latest pivot toward a more hawkish stance on August 26, after July’s CPI release and before August’s. Powell morphed into a “Volcker 2.0” hawk, seeming to channel his 1970s era predecessor Paul Volcker.

(3) The September 13 CPI release came out during the Fed’s blackout period prior to the September 20-21 meeting of the FOMC. As soon as the blackout period ended on September 22, a chorus of Fed officials started chanting the Fed’s new party line: Inflation is too high, and interest rates must be raised until it shows clear signs of subsiding toward 2.0%. They’ve all joined Powell’s Volcker 2.0 campaign without any dissenters so far.

(4) In the past, the Fed’s preferred inflation measure was the core PCED. But now, the headline PCED rate is more important to the Fed since food and energy prices have been rising rapidly and Fed officials recognize that we all need food and fuel. Their prices can have a significant impact on inflationary expectations, consumer confidence, and actual purchasing power. However, the financial markets seem to be giving more attention to the CPI because it is released before the PCED inflation rate.

US Inflation II: The PPI Measure of Consumer Prices. September’s CPI is coming. It will be released on Thursday. The day before, on Wednesday, September’s PPI will be released. Here are the consensus forecasts that the markets are anticipating for each:

(1) The headline and core PPIs are expected to be up 0.2% and 0.3% m/m, and 8.4% and 7.3% y/y. (On a y/y basis, they peaked at 11.7% and 9.7% during March.)

(2) The headline and core CPIs are expected to be up 0.2% and 0.5% m/m, and 8.1% and 6.5% y/y. (On a y/y basis, they peaked at 9.1% during June and 6.5% during March.)

The PPI includes an index for personal consumption expenditures (PPI-PCE). Its y/y inflation rate closely tracked both the CPI and PCED inflation rates prior to 2021 (Fig. 3). The same can be said about the core inflation rates of all three (Fig. 4). The headline measures of all three peaked during March and continued to decline in August. The core rates of the CPI and PCED moved higher in August, but the core PPI for personal consumption continued to fall sharply.

We will be watching September’s PPI-PCE as an indicator of the CPI and PCED. The big difference between the PPI-PCE and the CPI and PCED is that the former does not include rent, which pushed August’s CPI inflation rate for services above that for the services component of the other two measures (Fig. 5). (As discussed below, rent has a much bigger weight in the CPI than in the PCED.)

US Inflation III: The CPI for Better or Worse. Thursday’s CPI release is likely to move the markets, as the previous releases this year did. This time, it will come out well before the FOMC’s blackout period from October 22 to November 3. So the “Federal Open Mouth Committee” will have plenty of time to opine about the latest CPI before the FOMC’s next meeting on November 1-2. The release is coming out at the beginning of the Q3 earnings reporting season. It might even have some influence on the mid-term congressional elections on November 8.

What do we know so far? Consider the following:

(1) Food and fuel. The S&P Goldman Sachs Commodity Index peaked during the summer and continued to fall through September (Fig. 6). The same can be said for both the index’s agricultural & livestock and energy sub-indexes (Fig. 7). The four-week average of the national pump price of gasoline was $3.82 per gallon at the end of September, down 5.2% from the end of August (Fig. 8). These developments confirm that September’s headline CPI should increase by less than the core CPI.

(2) Consumer durable goods. Both the CPI and PCED durable goods inflation rates peaked during February at 18.7% and 10.6% respectively (Fig. 9). They were down to 7.8% and 5.3% in August. We know that the Manheim Index of wholesale used car prices has plunged from 46.6% y/y at the end of last year to -0.1% during September (Fig. 10). Meanwhile, the three-month annualized inflation rates for these four durable goods were below their y/y rates as follow: new cars (8.1%, 10.9%), used cars & trucks (4.4, 7.8), furniture & bedding (10.1, 12.8), major household appliances (-14.2, 2.2) (Fig. 11).

(3) Services excluding rent & medical. A similar analysis shows that the three-month annualized inflation rates were below the y/y rate for the following services: lodging away from home (-21.6%, 4.1%), airfares (-54.8, 33.4), car & truck rental (-47.6, -6.2) (Fig. 12).

(4) Medical services. Inflation in the medical services component of the CPI tends to exceed that of the PCED (Fig. 13). That’s because hospital fees and health insurance are inflated in the CPI by the out-of-pocket expenses of urban consumers. They don’t reflect that some of these expenses are subsidized or capped by the government (for hospital stays) and employers (for health insurance premiums). The PCED does so. The CPI medical services inflation rate was boosted by a 24.3% y/y increase in health insurance in the CPI through August versus a 1.3% increase for this item in the PCED.

(5) Rent. The 800-pound gorilla in the CPI inflation rate is rent. Rent has a bigger weight in the core CPI than in the core PCED. The weights for rent of primary residence and owners’ equivalent rent are 9.3% and 30.5% in the core CPI. They are 4.0% and 12.6% in the core PCED.

Here are August’s three-month annualized and y/y inflation rates for the CPI’s rent of primary residence (8.9%, 6.7%) and owners’ equivalent rent (8.2, 6.3) (Fig. 14). Unfortunately, rent inflation isn’t likely to cool off for a while because it is based on the rent levels reflected in all existing leases rather than just in newly signed ones. Rents in new leases rose sharply over the past year, but are showing signs of peaking in recent months, according to Zillow (Fig. 15). Indeed, Zillow’s rent index peaked at 17.2% during February and fell to 12.3% in August. That’s still high, but it is heading down quickly.

(6) The pipelines. In our opinion, inflation is moderating in the inflation pipeline while the Fed is tightening based on the gush of price increases currently coming out of that pipeline. The Fed could overdo it, as Fed Chair Jerome Powell acknowledged at his July 27 press conference; he said that the interest-rate hikes have been large and quick, so “it’s likely that their full effect has not been felt by the economy. So there’s probably some additional tightening, significant additional tightening, in the pipeline.” He said that before he morphed into the Volcker 2.0 super-hero on August 26 at Jackson Hole, as we discussed in yesterday’s Morning Briefing.

US Inflation IV: Less Inflation in Supply Chains. The Federal Reserve Bank of New York compiles a monthly Global Supply Chain Pressure Index (GSCPI) (Fig. 16). Global supply-chain pressures decreased in September, marking a fifth consecutive month of easing. The September decline was quite broad based. The GSCPI’s ytd movements suggest that global supply-chain pressures are beginning to fall back in line with historical levels. Here is a description of what is reflected in the index:

“The GSCPI integrates a number of commonly used metrics with the aim of providing a comprehensive summary of potential supply chain disruptions. Global transportation costs are measured by employing data from the Baltic Dry Index (BDI) and the Harpex index, as well as airfreight cost indices from the U.S. Bureau of Labor Statistics. The GSCPI also uses several supply chain-related components from Purchasing Managers’ Index (PMI) surveys, focusing on manufacturing firms across seven interconnected economies: China, the euro area, Japan, South Korea, Taiwan, the United Kingdom, and the United States.”

US Inflation V: Now & Then. The prices-paid index in the M-PMI survey peaked at a near record high of 92.1 during June 2021 (Fig. 17). It plunged to 51.7 in September, the lowest reading since June 2020. The prices-paid index in the NM-PMI survey isn’t down as dramatically so far. It peaked at a record 84.6 during April and fell to 68.7 during September.

It's interesting to compare the performance of the M-PMI now and during the Great Inflation of the 1970s (which started in 1965 with President Johnson’s guns-and-butter policies). The data are available since 1948 and show that this index always fell well below 50.0 during recessions (Fig. 18). But it also did so during the mid-cycle slowdowns in the mid-1980s, mid-1990s, and mid-2010s. During the Great Inflation, the M-PMI’s prices-paid index stayed stubbornly high except during the two recessions of that period (Fig. 19).

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Volcker 2.0 vs Bernanke 2.0?

October 10 (Monday)

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The Fed I: Powell’s Volcker 2.0 Pivot. I published my book Fed Watching for Fun & Profit in early 2020, near the middle of Fed Chair Jerome Powell’s first term. The chapter on our current Fed chair is titled “Jerome Powell: Pragmatic Pivoter.” He has continued to pivot since then.

Under Powell’s leadership, the FOMC turned “woke” in 2020. The committee’s August 2020 Statement on Longer-Run Goals and Monetary Policy Strategy broke with historical precedent by prioritizing “inclusive” maximum employment over its stated 2.0% inflation target. Also in that statement, the Fed embraced flexible average inflation targeting, indicating that it now would tolerate inflation overshoots to compensate for prior inflation shortfalls.

By maintaining ultra-easy monetary policies through the first few months of this year, the Fed succeeded in lowering the unemployment rate to a recent low of 3.5% during July. In addition, the ratio of job openings to unemployed workers rose to a record 2.0 during March. The result has been a significant increase in wage inflation, which has spiraled into price and rent inflation, thus eroding the purchasing power of all workers (Fig. 1). That has been the unintended consequence of the Fed’s wokeness!

As inflation moved higher in 2021, Powell and his colleagues initially characterized it as “transitory.” The rebound in inflation from H2-2021 through H1-2022 forced Powell to turn less woke and to refocus on bringing inflation down. In his congressional testimony on November 30, 2021, Powell pivoted by conceding that inflation isn’t transitory but persistent.

The minutes of the FOMC’s December 14-15, 2021 meeting were released on January 5. The word “transitory,” which had previously described the Fed’s outlook for inflation, was mentioned once: “As elevated inflation had persisted for longer than they had previously anticipated, members agreed that it was appropriate to remove the reference to ‘transitory’ factors affecting inflation in the post-meeting statement and instead note that supply and demand imbalances have continued to contribute to elevated inflation.”

This year, Powell continued to pivot:

(1) Powell before Jackson Hole. The FOMC started hiking the federal funds rate by 25bps at the March 15-16 meeting of the committee. That was followed up with a 50bps hike at the May 3-4 meeting and 75bps at the June 14-15 meeting to a range of 1.50%-1.75%. At his July 27 presser, Powell was still a dovish hawk. He characterized the new range for the federal funds rate of 2.25%-2.50% (up 75bps) as “right in the range of what we think is neutral.” Decisions on further rate hikes would be made “meeting by meeting.” Yet he stated that “another unusually large increase could be appropriate” in September. (Sure enough, the Fed hiked again by 75bps to 3.00%-3.25% in late September.)

Yet at the July presser, Powell acknowledged that the rate hikes so far this year (as of late July) have been large and quick, so “it’s likely that their full effect has not been felt by the economy. So there’s probably some additional tightening, significant additional tightening, in the pipeline.”

Powell said “we’re not trying to have a recession. And we don’t have to. We think there’s a path for us to be able to bring inflation down while sustaining a strong labor market.” He acknowledged that the path for doing so “has narrowed.”

Nevertheless, the financial markets (rightly) concluded that the Fed might do another 75bps in early September and then (wrongly) concluded that the Fed might pause.

(2) Powell at Jackson Hole. Along the way, in his short, August 26 speech at Jackson Hole, Powell morphed into a “Volcker 2.0” hawk, seeming to channel his 1970s era predecessor Paul Volcker. He no longer talked about a painless path forward. Instead, he said that restoring price stability will “bring some pain” and require higher interest rates, slower growth, and “softer labor market conditions.”

Powell reiterated that another 75bps hike might be coming in early September and that the Fed wouldn’t pause, though it might be “appropriate to slow the pace of increases.” Indeed, he said that “with inflation running far above 2 percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.” On the contrary, he said, “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”

Powell even mentioned Paul Volcker by name, saying that the former Fed chair once said that the Fed’s job “must be to break the grip of inflationary expectations.” Powell agreed, saying, “[W]e must keep at it until the job is done.” By the way, Volcker’s 2018 autobiography is titled “Keeping At It: The Quest for Sound Money and Good Government.”

(3) Powell after Jackson Hole. At his September 21 presser, Powell mentioned the words “pain” or “painful” seven times. He did so in the context that bringing inflation down with tight monetary policy might cause a recession, but the pain will only be worse later if the Fed doesn’t step on the monetary brakes now. His other remarks were uniformly just as hawkish.

Powell mentioned the word “restrictive” 12 times in that September presser, in the context that, at 3.00%-3.25%, the federal funds rate is “probably into the very lowest level of what might be restrictive.” He warned that “there’s a ways to go.” He stated that the FOMC needs “to move our policy rate to a restrictive level that’s restrictive enough to bring inflation down to 2%, where we have confidence of that.” He said that once the federal funds rate is at a restrictive level, the FOMC will have “to keep it there for some time.” Channeling Volcker again, Powell mentioned “keep” or “keep at it” in the context of staying the tightening course a total of six times at his presser.

Since Powell’s September 21 presser, the other Fed officials on the FOMC all have turned into a chorus of Powell’s Mini-Me disciples. They have been chanting the Fed’s party line: Inflation is too high, and the Fed must continue to raise interest rates to bring it down.

(4) Powell’s terminal range. Since his July presser, Powell has been saying that the Fed’s forward guidance on the outlook for the federal funds rate can be found in the Summary of Economic Projections (SEP). At the September meeting of the FOMC, the committee’s median federal funds rate forecast for 2023, according to the SEP, was raised to 4.60% from 3.80% in July’s SEP. This implies that the committee expects to raise the federal funds rate to a terminal range of 4.50%-4.75% next year, up from the current actual range of 3.00%-3.25%. (Two more 75bps rate hikes would get it there fast.) The latest SEP showed that for next year, three groups of six of the committee’s participants projected a federal funds rate next year of 4.25%-4.50%, 4.50%-4.75%, and 4.75%-5.00%. One participant was at 3.75%-4.00%.

The Fed II: Powell’s Bernanke 2.0 Risk. Powell & Co.’s embrace of Volcker 2.0 is raising the risk that they will trigger Bernanke 2.0, i.e., another Great Financial Crisis. Something is likely to break if they persist in raising interest rates willy-nilly without pausing to assess how the 300bps increase in the federal funds rate since March is affecting the economy and financial markets, including global capital and forex markets. Instead, they seem intent on a fourth consecutive 75bps hike in the federal funds rate to 3.75%-4.00% at the November 1-2 FOMC meeting. And still more after that, as we just discussed above.

Consider the following:

(1) Housing market. In our October 6 QuickTakes, we observed that monetary policy has already had an extremely restrictive impact on the mortgage market, pushing the housing market into a severe recession. Mortgage applications to purchase a home have been plummeting (Fig. 2). They are down 37% from the same week one year ago to the lowest since October 2015. New plus existing single-family home sales have been heading south fast (Fig. 3). They are down 17% y/y through August. Single-family housing starts are down 15% y/y.

(2) Wealth effect. Much of Americans’ wealth resides in home equity and financial market portfolios, both of which have taken big hits this year. Under Powell, the median price of a single-family home (based on the 12-month average) soared 54% from $249,675 during February 2018 to $384,240 during August 2022 (Fig. 4). On a 24-month basis, the pace of appreciation of of the actual median price peaked at a record 44.9% during May (Fig. 5). That pace fell to 25.9% during August. This price undoubtedly is heading for a big fall in coming months.

There already has been a significant negative wealth effect in stock and bond portfolios so far in 2022. The iShares 20+Year Treasury Bond ETF is down a whopping 31.9% since the end of last year. The market capitalization of the S&P 1500 is down 24.4% from a record $44.2 trillion on January 3 to $33.4 trillion on Friday (Fig. 6).

(3) The dollar. The US dollar index (DXY) is up 17.2% since the start of this year. In a September 30 speech titled “Global Financial Stability Considerations for Monetary Policy in a High-Inflation Environment,” Fed Vice Chair Lael Brainard indicated that at least she is aware that the 300bps increase in the federal funds rate since March (“a rapid pace by historical standards”) could exacerbate “financial vulnerabilities.” She noted that emerging economies with depreciating currencies and “currency mismatches between their assets and liabilities” might be prone to financial instability.

Nevertheless, Brainard concluded her speech on a hawkish note: “Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target. For these reasons, we are committed to avoiding pulling back prematurely.”

The Fed III: Waller Weighs In. A similarly hawkish viewpoint was provided by Fed Governor Christopher Waller in a Thursday, October 6 speech titled “The Economic Outlook with a Look at the Housing Market.” He downplayed the risks of financial instability caused by the Fed’s tightening of monetary conditions, saying, “I’ve read some speculation recently that financial stability concerns could possibly lead the FOMC to slow rate increases or halt them earlier than expected. Let me be clear that this is not something I’m considering or believe to be a very likely development.” In fact, he concluded: “I believe we have tools in place to address any financial stability concerns and should not be looking to monetary policy for this purpose. The focus of monetary policy needs to be fighting inflation.”

Most of Waller’s speech focused on the impact of the housing market on the rent component of the inflation rate. He observed: “The combination of high monthly inflation and a large weight in measuring overall prices means that shelter inflation is a key driver of overall inflation.”

Waller predicted that even though mortgage rates have increased from less than 3% at the end of last year to nearly 7% recently, the housing market correction “could be fairly mild.” But he acknowledged that “I cannot dismiss the possibility of a much larger drop in demand and house prices before the market normalizes.”

US Economy: No Recession In The Labor Market. In his Jackson Hole speech, Powell observed: “The labor market is particularly strong, but it is clearly out of balance, with demand for workers substantially exceeding the supply of available workers.” He elaborated on that theme at his September 21 presser:

“Despite the slowdown in growth, the labor market has remained extremely tight, with the unemployment rate near a 50-year low, job vacancies near historical highs, and wage growth elevated. Job gains have been robust, with employment rising by an average of 378,000 jobs per month over the last three months. The labor market continues to be out of balance, with demand for workers substantially exceeding the supply of available workers. … FOMC participants expect supply and demand conditions in the labor market to come into better balance over time, easing the upward pressure on wages and prices.”

In this past week’s batch of labor market indicators, the only sign of weakness was the drop in job openings from a record high of 11.9 million during March to 10.1 million in August, but that still exceeded the number of unemployed workers by 4.1 million (Fig. 7). Initial unemployment claims remained very low at 219,000 during the October 1 week (Fig. 8).

September’s employment report showed that our Earned Income Proxy (EIP) for private-sector wages and salaries in personal income rose 0.5% m/m, with aggregate weekly hours up 0.2% to a record high of 4.5 billion and average hourly earnings (AHE) up 0.3% (Fig. 9 and Fig. 10).

Most of the purchasing power of that increase was eroded by price inflation. On a y/y basis, our EIP is up 8.7% through September, while the PCED was up 6.2% through August.

The AHE measure of wage inflation for all workers seems to be peaking, falling from a recent high of 5.6% during March to 5.0% in September (Fig. 11). It rose 4.4% at a three-month annualized rate through September (Fig. 12).

Movie. “Operation Mincemeat” (+ +) (link) is a very interesting film based on a book about a British operation during WWII to trick Nazi Germany into believing that the Allies would be invading Greece rather than Sicily. Winston Churchill signed off on the plan partly because it was so absurd that he thought it might work. Ian Fleming makes an appearance in the film as a British operative involved in the deception, which probably inspired him to write James Bond novels. The romantic sub-plot is a bit of a distraction from the compelling story about the successful espionage operations.

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On Earnings, JOLTS & Housing

October 06 (Thursday)

Strategy: Flat Earnings Society. We are expecting a growth recession in S&P 500 earnings because we believe that the economy has been in a growth recession since the start of this year. If economic growth is close to zero, S&P 500 forward earnings should be flat. That seems to have been the case since late June. Consider the following:

(1) Revenues, profit margin & earnings. Interestingly, so far, there is no sign of a recession in S&P 500 forward revenues per share, which rose to yet another record high during the September 22 week (Fig. 1). This weekly series closely tracks actual quarterly S&P 500 revenues per share, which likewise rose to a record high during Q2-2022. Revenues are getting a big boost from rapidly rising prices.

The weekly S&P 500 forward profit margin, which closely tracks the comparable quarterly series, peaked at a record high of 13.4% during the June 9 week. It edged down to a 14-month low of 13.0% during the September 22 week. S&P 500 forward earnings peaked at a record $239.93 per share during the June 23 week. It’s been relatively flat since then at around $237 per share through the September 29 week.

(2) Inflation-adjusted revenues & earnings. Even on an inflation-adjusted basis, monthly S&P 500 forward revenues rose to a new record high during August (Fig. 2). While nominal forward revenues is up 11.6% y/y, real forward revenues is still up 3.7% (Fig. 3). However, this growth rate is likely to fall closer to zero. That’s because it is highly correlated with the national M-PMI, which fell to 50.9 during September, the lowest reading since May 2020 (Fig. 4).

On an inflation-adjusted basis, forward earnings peaked at a record high during May (Fig. 5). It was down 1.5% through August. This series tends to be a good coincident indicator of the business cycle: If forward earnings is peaking, that could be an early sign of an impending hard-landing recession; if it simply stops climbing, that might signal a growth recession. The latter has occurred during past mid-cycle slowdowns of the US economy, and we think it is happening again.

(3) Quarterly & annual consensus earnings forecasts. How can it be that forward earnings isn’t falling along with analysts’ consensus earnings expectations for the last two quarters of this year and each of next year’s four quarters (Fig. 6 and Fig. 7)? They dropped during the September 22 week in response to FedEx’s warning of recessionary forces in the US and abroad. They edged down during the September 29 week.

Of course, the recent downward revisions in the coming six quarters are reflected in the analysts’ 2022 and 2023 earnings estimates at $223.72 and $241.83 during the September 29 week (Fig. 8). Forward earnings is the time-weighted average of the two and was $237.30 that week. It is converging toward the 2023 estimate at the end of this year, and will start giving weight to the 2024 estimate, which is currently $260.93, at the beginning of next year.

(4) Our forecasts & theirs. We are expecting S&P 500 revenues per share to rise to $1,750 and $1,875 this year and next, up 11.6% and 7.1% (Fig. 9). The analysts’ consensus rose to $1,745.49 and $1,817.95 during the September 22 week. On the other hand, we expect that analysts will continue to lower their S&P 500 earnings estimates to our estimates of $215 and $235 for this year and next year (Fig. 10). That would be consistent with our flattish outlook for S&P 500 forward earnings (and actual earnings during the second half of this year and first half of next year) (Fig. 11).

US Employment: Churn To Earn (More). The labor market is remarkably dynamic. The pace of both hirings and quits is truly remarkable. Many people are quitting their old jobs to take new ones that pay more. The problem they face is that price inflation has been eroding most, if not all, of their wage gains. All that churning may also be weighing on productivity. Consider the following remarkable turnover in the labor market:

(1) Working. During the 12 months through August, payroll employment rose 5.8 million according to the monthly employment report (Fig. 12). That was only 3.8% of total payrolls during August (Fig. 13).

(2) Hiring. Over this same period, according to the JOLTS report, hiring totaled a whopping 78.0 million, or 51.1% of August’s payrolls (Fig. 14 and Fig. 15). That’s right: Half of payroll employment was attributable to newly hired workers, i.e., hired over the past 12 months!

(3) Quitting. Over this same period, separations totaled 72.2 million (47.3% of payroll employment), consisting of 51.5 million quits (33.7% of payrolls) and 16.5 million layoffs (16.5% of payrolls) (Fig. 16 and Fig. 17). That’s right: A third of all workers quit their jobs over the past 12 months!

(4) Job openings. All this churning can partly explain why there are 1.7 job openings for every unemployed worker. Jobs open when workers quit. But the rapid pace of hiring suggests that jobs get filled quickly after opening.

(5) Switching. Some of this incredible churning in the labor market undoubtedly reflects workers’ perceptions that the labor market is tight and that they can get paid more by switching jobs. They are right, according to the Atlanta Fed’s wage growth tracker (WGT). During August, the wages of job switchers rose 8.4% y/y, while the wages of job stayers rose 5.6% (Fig. 18).

(6) Eroding. Meanwhile, the PCED inflation rate was 6.2% y/y through August. So in real terms, the WGT rose just 2.2% for switchers and fell 0.6% for stayers (Fig. 19).

US Housing I: Reversal Of Fortune. No longer are buyers lining up around the block at open houses. Homebuyer enthusiasm has been curbed by the Fed’s aggressive interest rate hikes and quantitative tightening, driving up mortgage rates thus reducing affordability. But buyers aren’t just wary of committing to higher mortgage payments than they can afford; they’re also wary of purchasing a home poised to depreciate.

Depreciation is a real threat because sellers have been dropping home prices to attract reluctant buyers. In many US regions, home prices are flat with year-ago levels; and in some, they’re down. In August, Realtor.com found that about 20% of sellers had dropped their asking price, noted CNBC, versus just 11% a year earlier. Redfin found that the average home sold for less than its list price for the first time in over 17 months during the four-week period ended August 28.

Affordability challenges dampen not only demand by causing buyer hesitancy; they also dampen supply by making sellers reluctant to list their home at a time of falling prices. As a result, Melissa and I expect continued affordability challenges to drive a further pullback in housing activity.

But notably, we don’t expect home prices to freefall, as occurred during the Great Financial Crisis (GFC), because today’s market is supported by more stringent lending standards, a persistent shortage of housing (since even before the pandemic), and the heightened importance of home in people’s lives since the pandemic—especially when home doubles as a workplace.

(FYI: More than 60% of the increase in home prices from the start of the pandemic to November 2021 is attributable to the rise in work from home during the pandemic, according to San Francisco Federal Reserve Bank researchers. It’s a trend that persists, with 30% of work still being done from home as of last month.)

How slow has housing activity gotten? One of the ugliest charts on the block right now shows the index for traffic of prospective buyers of new homes. It has continued to plunge from 71 at the start of this year to 31 during September (Fig. 20). Just as ugly is the chart showing the sharp declines so far this year in the Housing Market Index (for new homes) and the Pending Home Sales Index (for existing homes) (Fig. 21).

Consider the following:

(1) Rising mortgage rates are busting the boom. The single largest driver of the housing market right now is mortgage rates. Interest rates on a 30-year fixed mortgage crossed the threshold of 7.0% on September 30, the highest in the history of the data going back to 2004 (Fig. 22).

Mortgage rates took a momentary reprieve in July. After rising to 6.11% on June 21, rates fell back down to 5.26% on August 1 when the market briefly hoped for a less hawkish Fed. Rates could rise even further to 8.0% should an aggressive Fed not relent in the rate-hiking cycle. Currently, rates on a 30-year fixed-rate mortgage are at 6.86% as of Tuesday.

Mortgage applications for new purchases fell dramatically by 17% ytd through September 30 (Fig. 23). Since very few borrowers would benefit from refinancing, applications for these types of transactions fell 84% y/y during the last week of September—to its lowest reading since September 2000.

(2) Buyers are affordability challenged. Homebuyers today are looking at much different monthly mortgage payments than they were just a few months ago. For a $400,000 home, the monthly mortgage payment would now be hundreds of dollars more than it was in January. Prices for existing single-family homes have come down some, yet still are 45% higher than they were pre-pandemic. Through July, the National Association of Realtors’ (NAR) Housing Affordability Index, which is based on a 30-year fixed-rate mortgage, dropped to the lowest seen since July 2006 (Fig. 24).

Although mortgage rates have pressured home sellers to cut prices, home prices still are significantly higher than they were last year and before the pandemic. August’s median existing housing prices (including houses, condos, and co-ops) fell 5.9% during the two months through August from June’s record high $413,800, according to the NAR (Fig. 25). It was the largest two-month fall since September 2013. The y/y rate of increase slowed to 8% from 25% a year earlier (although it did remain an increase). Over the latest 24 months through May, the median existing single-family home price increased by 45%, slowing to 26% in August.

(3) Prices decelerate with declining affordability. Home prices cooled in July at the fastest pace ever as measured by the Case-Shiller Index (Fig. 26). From June to July, the national composite saw its first month-to-month price decline since February 2012. Because of a lag in how the index captures price data relative to when deals are done, July’s reading might have been skewed upwards by temporarily lower mortgage rates.

(4) Sales soften as the Fed marches on. The NAR Pending Home Sales Index dramatically dropped through August from the record during mid-2020 when the Covid lockdowns were lifted. The index tends to be a leading indicator for existing home sales. Many sales agreements on existing home sales under contract were undone because mortgage rates had skyrocketed.

The recent weakness in sales largely reflects the surge in mortgage rates since the start of the year combined with the jump in home prices since the end of the lockdown recession in 2020. Total existing home sales (including single family homes and condominiums) plunged 26% since January to 4.8 million units (saar) during August, the slowest pace since May 2020 (Fig. 27). New home sales peaked at 1.04 million units (saar) during August 2020 and fell 34% to 685,000 units during August of this year (Fig. 28).

(5) Thank goodness for tighter lending standards. Fortunately, mortgage lending standards have been tightened significantly since the GFC. During Q2-2022, the percent of mortgages delinquent by 90 days or more remained at a record low of 0.5% (Fig. 29). The similar delinquency rate for home equity loans was 0.9%. Both were well below the delinquency rates on auto loans (3.9%), student loans (4.6%), and credit cards (8.0%).

US Housing II: Homebuilders Are Flipping Out. The National Association of Homebuilders’ latest survey of homebuilders reports weak traffic in many markets owing to the affordability challenges discussed above. The median yearly percent change in 12-month moving average of single-family prices for new homes fell 17.1% through August (Fig. 30). To bolster sales, more than a half of homebuilders have been offering incentives like home price cuts, help with closing costs, and free amenities, Robert Dietz of the National Association of Homebuilders recently said. Such incentives combined with elevated costs for labor and materials have pressured homebuilders’ margins.

No wonder homebuilder sentiment is down. According to the National Association of Homebuilders Index, homebuilder sentiment fell 3 points in September to 46 (below 50 indicates negative sentiment) (Fig. 31). Given the weak margin prospects for new builds, it’s not surprising that big homebuilders, including Lennar and KB, recently have announced dropping pending deals for new lots.

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On Central Bankers, Stocks & Batteries

October 05 (Wednesday)

Strategy I: Central Bankers Blink. Government officials and central bankers around the world have been talking tough about squashing inflation and squeezing the excesses out of their economies. But the financial markets have other ideas. Recent market actions in the UK and China have forced authorities to backpedal on their plans. And even in the US, the markets have started to behave as if a monetary policy U-turn is imminent.

Here's a look at how financial markets have been calling the shots:

(1) Getting closer to peak fed funds rate. US central bankers may want to raise the federal funds rate by at least another 75bps in coming months, but the bond and currency markets may be saying rates have moved high enough already. The 10-year Treasury bond yield has fallen to 3.62%, down from its recent high of 3.97% on September 27 (Fig. 1). The two-year Treasury note yield has fallen a bit to 4.10%, down from a peak of 4.30% also on September 27. And the US dollar has eased 1.5% to 134.69 since hitting a peak on September 28 of 136.74 (Fig. 2).

High interest rates have already broken the housing market. The interest rate on a 30-year mortgage was 6.85% on Monday, down a bit from Friday’s record high 7.10%, going back to 2004 (Fig. 3). And the spread between the 30-year mortgage and the 10-year Treasury bond has blown out to 318 bps, a level last seen in 2020 during the Covid shutdown and in 2008 during the housing crisis (Fig. 4). Existing home sales have slowed sharply. In August, 4.80 million homes were sold, down from a recent peak of 6.49 million in January. And pending home sales, which have followed a similar pattern, show no signs that the slowdown is over (Fig. 5).

Recent days have brought several weak economic releases and disappointing earnings reports. On Monday, the ISM manufacturing purchasing managers index fell to 50.9 in September, lower than expected and down from 52.8 in August and 63.7 at its peak in 2021 (Fig. 6). That was followed yesterday by news that US job openings fell by 10% m/m to 10.1 million in August, though job openings still far exceed the number of unemployed people. Disappointing earnings news from Micron Technology, Nike, CarMax, and Carnival added to the impression that the economy is slowing down sharply enough that the Fed’s tightening work might be done or at least close to done.

There’s also been growing concern about the strength of Credit Suisse Group, as its shares have fallen to single digits. The investment bank, which has a new CFO and CEO, is expected to sell stock to fund a pending restructuring and to pay legal costs; the details of the restructuring are scheduled to be announced on October 27.

(2) China faces its property problems. With the 20th National Congress of the Chinese Communist Party approaching this month, it’s not surprising that the Chinese government has begun to address the downturn in its property sector more aggressively. Many one-off financing programs have been announced at the local and national levels to boost demand for residential real estate. It remains to be seen whether these programs will increase would-be home buyers’ confidence in real estate companies after so many have defaulted and failed to deliver paid-for apartments.

It’s quite an about-face from the situation in 2020, when Chinese leaders began tightening the funding available to real estate buyers and developers. But with almost 20 Chinese real estate developers in default on their debt and dragging down the economy, Chinese leaders have finally blinked.

A Bloomberg report on Monday described one of the largest programs to date: “[T]he People’s Bank of China and the China Banking and Insurance Regulatory commission told the [country’s] six largest banks to each offer at least [$14.1 billion] of financing support, including mortgages, loans to developers, and purchases of their bonds.”

Additionally, the People’s Bank of China (PBOC) is allowing local governments to reduce the mortgage rates for first-time home buyers in cities where new home prices fell from June through August m/m and y/y, a September 30 South China Morning Post article reported. Buyers in 23 of the 70 largest Chinese cities could qualify.

The PBOC announced on Friday that it will “lower the interest rate for housing provident fund loans by 0.15 percentage points for first-time homebuyers starting from October, the first cut in such loans since 2015,” an October 2 FT article reported. The interest rate on loans maturing in more than five years will be lowered to 3.1%.

China’s Ministry of Finance announced on Friday that individuals who buy new homes within one year of selling their previous homes will be eligible to receive a refund on income taxes. The banking and insurance regulator and the PBOC “relaxed” a floor on mortgage interest rates for some first-time homebuyers. Banks can offer cheaper loans to support demand based on the banks’ profitability.

The moves have yet to spark a stock market rally, however, with the China MSCI stock price index up marginally on Tuesday from a new low this year on Monday, bringing its ytd decline to 30.9% (Fig. 7).

(3) UK backpedals. New UK Prime Minister Liz Truss and her Chancellor Kwasi Kwarteng might have wanted to boost the sluggish UK economy by cutting income taxes on the wealthy, but the financial markets would have none of it. The tax cuts were in addition to other tax cuts and government support to offset the spike in energy bills. And all of this was going to be funded by borrowing funds.

The market reacted violently, with bond yields surging to almost 5.00%. The abrupt move in interest rates prompted some banks to stop making new mortgage loans and resulted in losses at pension funds with liability-driven investment strategies.

Officials’ retreat from the plan was swift. The Bank of England suspended its quantitative tightening plan last Wednesday and instead announced plans to buy long-term bonds “at whatever scale necessary.” Then on Monday, Truss and Kwasi ditched their plans to cut taxes on the wealthy. The UK MSCI stock price index has risen 2.8% so far this week through Tuesday’s close (Fig. 8). And the 10-year UK bond yield has fallen back to 3.86% (Fig. 9).

Strategy II: Examining The Rallies. The financial market’s sharp rally in reaction to the slightest hint that monetary tightening may be about to pause or even end has been impressive. Monday and Tuesday’s gains in the S&P 500 amounted to 205 points, or 5.7%.

We wondered whether the same industries outperformed during this rally as during the rally from June 16 to August 16. The upshot: Some of the outperforming industries were the same and some weren’t. Here’s a closer look:

(1) Energy jumps now, but not last summer. The S&P 500 rallied by 2.6% Monday, and the top-performing sector was Energy, as rumors of OPEC’s plan to cut production circulated. That’s very different from last summer’s rally, when the S&P 500 gained 17.4% and the worst performing S&P 500 sectors were Energy and Materials.

Here’s the performance derby for the S&P 500 sectors’ performance on Monday and during last summer’s rally: Energy (5.8%, -0.8%), Materials (3.4, 9.2), Information Technology (3.1, 22.8), Industrials (3.1, 17.5), Utilities (3.0, 18.9), Communication Services (3.0, 12.9), Financials (2.8, 16.4), S&P 500 (2.6, 17.4), Health Care (2.1, 12.0), Real Estate (1.9, 18.0), Consumer Staples (1.7, 12.1), and Consumer Discretionary (0.2, 29.4) (Table 1 and Table 2).

Here are some of the top performing industries in the Energy sector on Monday, along with their performances that day and during last summer’s rally: Oil & Gas Exploration & Production (7.3%, -3.7%), Oil & Gas Equipment & Services (6.7, -11.9), and Integrated Oil & Gas (5.3, 1.1).

(2) Outperformers in both time periods. A few industries were top performers both on Monday and during last summer’s rally. To derive this exclusive list, we took the top 10 performing industries on Monday and dropped from the list those that did not also outperform the S&P 500 during the summer rally. Then we took the top 10 performing industries during the summer rally and excluded those that weren’t also outperformers of the S&P 500 on Monday.

Here’s this rarefied group: Steel (6.9% Monday, 26.7% during last summer’s rally), Auto Parts & Equipment (5.7, 24.2), Health Care Facilities (5.1, 21.5), Semiconductor Equipment (4.9, 26.5), Trucking (4.7, 29.1), Homebuilding (4.6, 28.5), Independent Power Producers (4.2, 32.3), Real Estate Services (4.1, 28.1), Casinos & Gaming (3.4, 30.7), Technology Hardware Storage & Peripherals (3.1, 32.0).

Using the same methodology for the worst performing industries of both rallies, we learned that only three industries were among the worst performers both on Monday and during last summer’s rally. They are Food Retail (0.0%, -1.5%), Pharmaceuticals (0.4, 3.6), and Reinsurance (1.3, 4.6).

(3) Tesla’s not helping. Another big difference between Monday’s rally and last summer’s rally is the performance of the Consumer Discretionary sector. On Monday, it was the worst performing S&P 500 sector (0.2%), dragged down by the sharp selloff in Tesla shares and the underperformance of Amazon shares. During last summer’s rally, Consumer Discretionary was the best performing sector, up 29.4%.

Tesla is a member of the Auto Manufacturers industry, which turned in the strongest performance this summer (42.6%) but the worst performance on Monday (-7.4%). Likewise, the second-best performing industry last summer was Internet & Direct Marketing Retail (39.5%), home to Amazon. But on Monday, that industry underperformed the S&P 500, gaining only 2.5%. Finally, the Movies & Entertainment industry, home of Netflix, was the fifth best performing industry last summer, gaining 31.2%, and on Monday it gained 2.6%, which only matched the S&P 500’s performance.

Disruptive Technologies: Building Better Batteries. Most electric vehicles (EVs) drive for 250-350 miles on one charge, but scientists are hopeful that the range can be extended if solid-state EV batteries are developed.

Today’s EV batteries have two poles separated by a liquid. When batteries charge, lithium ions move from one pole (the cathode) to another pole (the anode). After many charges, dendrites (small spikes) grow on the lithium anode, eventually piercing the barrier separating the two poles. As a result, the battery dies or catches fire. Some scientists are working to develop solid-state batteries to avoid such suboptimal results. Others are experimenting with different metals, like zinc and iron, to develop longer-lasting, less expensive batteries. Here are some of their advancements:

(1) Solid improvement. Adden Energy hopes to commercialize solid-state battery technology that it has licensed from Harvard University. The company contends that its solid-state battery charges in only three minutes in the laboratory and can last for 5,000-10,000 charging cycles, a vast improvement over the typical 2,000-3,000 charge lifecycles of today’s batteries. Adden hopes to develop the materials into a vehicle battery within the next three to five years.

Adden, which was started by Harvard researchers, has raised $5.2 million in seed funding, a September 13 article on electrive.com reported. We first wrote about the Harvard solid-state battery development in the May 20, 2021 Morning Briefing.

(2) OneD gets GM nod. General Motors recently participated in a $25 million series C funding round for OneD Battery Sciences and announced plans to jointly develop OneD’s battery technology. OneD boosts the amount of energy a battery can hold by adding “more silicon onto the anode battery cells by fusing silicon nanowires into EV-grade graphite. Silicon can store 10 times more energy than graphite,” a September 29 GM press release stated.

Using silicon allows for faster charging and greater power. Increasing the battery’s density could make car batteries lighter, smaller, and more efficient. By reducing the graphite and increasing silicon, the cost of the battery falls and its carbon footprint is reduced. If the technology proves itself, it could be used in GM’s Ultium battery cells.

Earlier this year, GM launched its Wallace Battery Cell Innovation Center to focus on the development and production of batteries. In addition, the company has one Ultium battery factory running in Ohio, two under construction, and another in the planning stage.

(3) Considering iron. Form Energy is trying to replace the costly lithium used in batteries with less expensive and more abundant iron. It believes iron batteries will hold more energy and last longer than their lithium ion counterparts. The startup is raising $450 million from investors that include ArcelorMittal, TPG, and Bill Gates’ Breakthrough Energy Ventures, an October 4 WSJ article reported. It plans to use the funds to build its first big manufacturing plant.

Form Energy’s iron battery, which uses a water-based electrolyte, takes in oxygen and converts iron pellets to rust. When it discharges energy, the rust is turned back into iron and oxygen is expelled. Form Energy isn’t the first to try to develop a battery using iron. Past hurdles have included corrosion that occurs faster than expected and shortens the life of the battery. In addition, the batteries need to be larger to hold the same amount of energy a lithium ion battery can hold.

Lithium ion batteries can hold 100 watt hours of electricity per kilogram, while iron air batteries only hold 40 watt hours per kilogram, a March 12 Popular Science article explained. Lithium’s ability to hold more energy per kilogram enabled the evolution of cell phones that fit into our pockets. But that doesn’t mean iron batteries couldn’t be deployed when size isn’t an issue, such as when building large arrays of batteries to store utility-scale wind or solar energy.

(4) Air out of the balloon. Some of the stock market’s excitement about solid-state batteries has been squashed. QuantumScape uses a ceramic divider that it says will improve a solid-state battery’s density. The company, which went public after merging with a SPAC (special purpose acquisition corporation), saw its share price soar as high as $131 in December 2020 before falling into the $40s the following January and down to $9 as of Monday’s close. Volkswagen Group of America Investments owns a 20% stake in the company, according QuantumScape’s last annual report.

Solid Power, another solid-state battery company, hasn’t had much better luck in the stock market. It too went public via a SPAC merger, in December 2021. Its shares, which traded as high as $13.04 that month, closed Monday at $5.39. It counts Ford, BMW, and SK Innovation as investors.

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On Valuation, Liquidity & Inflation

October 04 (Tuesday)

Strategy I: The Valuation Question. The air continued to come out of valuation multiples last week, as inflation remains persistent and interest rates remain elevated.

There’s an inverse correlation between the S&P 500’s P/E and the CPI inflation rate on a y/y basis (Fig. 1). We have quarterly data starting in 1936 for the P/E based on four-quarter trailing earnings and based on monthly forward earnings since January 1979. The CPI inflation rate is available monthly over this period. During periods of falling and low inflation, our composite P/E tends to rise and exceed its historical average of 15.0 (Fig. 2). During periods of rising and high inflation, the P/E tends to fall below its historical average.

On Friday, the forward P/E was 15.1, the lowest since April 1, 2020 but about at its historical average (Fig. 3).

The composite P/E is also inversely correlated with the 10-year bond yield based on data available since 1953 (Fig. 4). The correlation isn’t as tight as with the inflation rate. The S&P 500 forward P/E peaked last year at 22.7 on January 8. So its drop since then to 15.1 certainly can be explained by the jump in both inflation and interest rates since then.

The question is whether the P/E will hold at its historical average or fall below it. The answer depends on whether the US economy is heading into a hard-landing recession. If it is, then the forward earnings of the S&P 500 will fall along with both forward revenues and the profit margin. In this scenario, the forward P/E would likely fall below 15.0 on its way to the high single digits, as happened during previous recessions.

In our “growth recession” scenario, the PCED inflation rate continues to moderate from 6%-7% during H1-2022 to 4%-5% during H2-2022 and 3%-4% next year and the Fed hikes the federal funds rate two more times, by 75bps at the next FOMC meeting on November 1-2 and by 50bps at the following one on December 13-14. So the terminal federal funds rate range would be 4.25%-4.50%. The 10-year bond yield would peak around 4.00%-4.25%. In this scenario, the S&P 500 forward P/E would remain at or above 15.0, while both forward earnings and the S&P 500 price index would move sideways for a while before resuming their uptrends in 2023.

Our current subjective probability for this scenario is 60%. The odds of an inflationary boom are zero. So the remaining 40% is our subjective probability of a hard-landing recession.

Now let’s review the latest valuation metrics:

(1) MegaCaps, LargeCaps, and SMidCaps. At the end of last week, the forward P/Es of the S&P 500/400/600 fell to 15.1, 11.1 and 10.6. The latter two valuation multiples are back down to levels seen during past recessions. The spread between the S&P 500’s forward P/E and those of the SMidCaps (SmallCaps and LargeCaps collectively) has been 5.0 points since late last year (Fig. 5 and Fig. 6). That’s the highest since 2000.

The valuation multiple of the LargeCaps has been boosted by the forward P/E of the eight very high-capitalization stocks collectively dubbed the “MegaCap-8” (Fig. 7). The latter has also weighed on the former, as it has dropped from a record high of 38.5 on August 28, 2020 to 22.8 this past Friday. The MegaCap-8 has accounted for around 25% of the market cap of the S&P 500 since mid-2020 (Fig. 8). They accounted for 23.1% this past Friday, when the S&P 500 forward P/E was 15.1, or 13.8 without the MegaCap-8 (Fig. 9).

(2) MegaCaps, Growth, and Value. The MegaCap-8 has accounted for about 50% of the market cap of the S&P 500 Growth index for the past year. The latter’s forward P/E fell to 18.9 on Friday from 28.3 at the start of the year (Fig. 10). The S&P 500 Value’s forward P/E fell to 13.0 on Friday, the lowest since April 7, 2020.

(3) Foreign P/Es. Previously, we’ve observed that the forward P/E of the S&P 500 Value tends to closely track the comparable valuation multiple of the All Country World ex-US MSCI index (Fig. 11). The latter fell to 10.6 on Friday, the lowest since March 23, 2020. Here are the forward P/Es of some of the major MSCI indexes on Friday: US (15.6), Japan (11.6), EMU (10.2), Emerging Markets (10.1), and UK (8.7) (Fig. 12). All remain above their pandemic lows in early 2020, except for the UK’s 11-year low.

(4) Buffett ratios. The bottom line on valuations based on forward P/Es is that they seem reasonable, on balance, if the economy has a soft landing rather than a hard one. Of course, the valuation of the MegaCap-8 remains relatively rich.

On the other hand, Buffett ratios suggest that stocks remain somewhat overvalued. The ratio of the S&P 500 market cap to actual quarterly revenues, which peaked at a record 2.79 during Q3-2021, fell to 2.33 during Q2-2022 (Fig. 13). The comparable weekly series of the S&P 500 stock price index to the forward revenues of the index was down to 2.10 during the week of September 22. Both readings still exceed the 2.00 peak during the tech bubble in the late 1990s.

(5) Real yield. Another bearish valuation metric is the real earnings yield, which is S&P 500 reported earnings as a percent of the quarterly average S&P 500 index minus the CPI inflation rate (on a y/y basis using quarterly data based on three-month averages). It was solidly negative at -4.49% during Q2 (Fig. 14). In the past, it often bottomed near the end of bear markets.

(6) Dividend yield. During Q3-2022, the S&P 500 dividend yield was 1.82%. That’s well below the latest yield on three-month Treasury bills (3.46%), two-year Treasury notes (4.12%), and 10-year Treasury bonds (3.67%). If the dividend yield rose to match any of those levels, the stock market would be much lower (Fig. 15).

Strategy II: The Liquidity Question. Providing quite a bit of support to valuation multiples is the enormous amount of liquidity in the financial markets. Consider the following:

(1) Saving. As Debbie and I noted yesterday, consumers accumulated $2.2 trillion in personal saving over the 31 months from February 2020 (when the pandemic started) through August of this year (Fig. 16). As a result, they’ve reduced their personal saving rate over the past 12 months. We reckon that they still have about $1 trillion of excess saving.

(2) M2 & demand deposits. Another measure of liquidity is M2. It has flattened out over the past six months through August, but it remains almost $2 trillion above its pre-pandemic trend line (Fig. 17). The demand deposit component of M2 rose to a record-high $5.2 trillion in August. It too remains about $2 trillion above its pre-pandemic trend line.

(3) Distribution of liquidity. According to the Fed’s Distributional Financial Accounts, over the past 11 quarters (from Q4-2019 through Q2-2022), checkable deposits and currency of households rose $4.7 trillion to $15.3 trillion, with the bulk of that increase held by households in the top 10% wealth percentile (Fig. 18).

(4) Equity mutual funds. Equity mutual funds have been sitting on more cash than usual. Morningstar reports that cash was at 2.84% at the end of July, up from 1.29% at the end of 2021. “Of the 415 U.S. equity funds covered by Morningstar, 63% have increased their cash allocation since the end of last year. In July 2022, equity funds reported their highest average cash level since March 2020, and before that since February 2016.”

US Inflation: The CPI Vs PCED Question. The headline CPI inflation rate tends to exceed the comparable PCED inflation rate (Fig. 19). That’s even clearer when we compare their core inflation readings because food and energy inflation rates are almost identical in the two (Fig. 20 and Fig. 21).

The big difference between the two is in durable goods, medical care services (including hospitals, physicians, and health insurance), and the weight of rent of shelter:

(1) CPI vs PCED. Over the past 12 months through August, the headline CPI and PCED are up 8.3% and 6.2%). Their core rates are up 6.3% and 4.9%.

(2) Durable goods. Over the past 12 months through August, the durable goods component of the CPI and PCED are up 7.8% y/y and 5.3% (Fig. 22). No one item within the category stands out as a consistent source of the divergence. The CPI tends to be a fixed basket of goods and services and may not reflect substitution into discounted goods as well as the PCED.

(3) Medical care services. The CPI reflects out-of-pocket expenses of urban consumers for medical care services, while the PCED also reflects government-subsidized prices for hospital stays and physician services. The same can be said for health care insurance, which is subsidized by employers.

So over the past 12 months through August, here are the CPI and PCED inflation rates for medical care services (5.6%, 2.5%), hospitals (4.1, 3.0), physician services (1.1, 0.4), and health care insurance (24.2, 1.3) (Fig. 23).

(4) Rent. Rent has a bigger weight in the core CPI than in the core PCED. The weights for rent of primary residence and owners’ equivalent rent are 9.3% and 30.5% in the core CPI. They are 4.0% and 12.6% in the core PCED.

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On Volcker 2.0, Recession & Inflation

October 03 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy: The Volcker 2.0 Question. On Friday, the S&P 500 fell below the June 16 low of 3666 to a new low of 3585. It is down 25.2% since January 3 of this year. Over this period, the index’s forward P/E fell from 21.5 to 15.1, the lowest since late March 2020. Last week’s batch of economic indicators suggests that economic growth is better than widely expected, while inflation is worse—as discussed below.

This has increased the odds that inflation will remain persistent and that the Fed will persist with “Volcker 2.0,” i.e., raising interest rates until they cause a recession to bring inflation down as former Fed chair Paul Volcker did during the late 1970s.

Indeed, on Friday, Fed Vice Chair Lael Brainard reiterated the hawkish party line that Fed officials have espoused since Fed Chair Jerome Powell’s hawkish speech at Jackson Hole on August 26. She did so in a speech titled “Global Financial Stability Considerations for Monetary Policy in a High-Inflation Environment.” She said: “Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target. For these reasons, we are committed to avoiding pulling back prematurely.”

Bearishness about the outlook for both bonds and stocks is mounting rapidly. There’s more chatter that the terminal rate of the federal funds rate during the current monetary tightening cycle will be closer to 5.00% than to 4.00%. Brainard corroborated those concerns, saying: “In the United States, the Federal Reserve has increased the federal funds rate target range by 300 basis points in the past seven months—a rapid pace by historical standards—and the Federal Open Market Committee’s most recent Summary of Economic Projections indicates additional increases through the end of this year and into next year.” She also noted that starting last month, QT2 is now on pace to reduce the Fed’s balance sheet by $95 billion per month.

The 2-year versus 10-year yield curve remains inverted, but that doesn’t mean that the 10-year yield can’t continue to rise above 4.00% if the 2-year jumps closer to 5.00% in anticipation of this as the terminal federal funds rate.

In the stock market, the Q3 earnings reporting season is about to start. There have already been a few significant negative preannouncements and news items from Ford, FedEx, Nike, Apple, and Micron. This increases the odds that there is more downside risk for both our earnings and valuation forecasts. We are still expecting S&P 500 forward earnings to flatten around the current level of $235 per share, however, and the forward P/E to hold at 15.0.

Nevertheless, the bearish opera ain’t necessarily over until the Fed lady sings a happier tune.

US Economy I: The Great Recession Question. There was no recession during Q3, according to the latest estimate of the Atlanta Fed’s GDPNow tracking model. In fact, its estimate of Q3’s real GDP growth increased from 0.3% (saar) on September 27 to 1.6% on September 28 to 2.4% on Friday, following the release of August’s personal income data that morning.

The Bureau of Economic Analysis will release its preliminary estimate of Q3’s real GDP growth on October 27, just a few days before Halloween. It’s not likely to be too spooky given the latest GDPNow tracking estimate. However, there is still a bunch of economic indicators coming out before then that will be fed into the Atlanta Fed’s tracking model.

The latest upward revision was attributable to upward revisions in personal consumption expenditures (from 0.4% to 1.0%) and capital equipment spending (from 0.9% to 4.6%). The weakest component of Q3’s real GDP remains residential investment (still down 25.5%). A recession is clearly rolling through the housing industry.

Of course, the main driver of our economy is consumer spending, which accounted for 68% of nominal GDP during Q2. Let’s have a closer look at Friday’s Personal Income & Consumption report to assess how consumers are faring:

(1) Income & taxes. Nominal personal income rose 3.9% y/y to a record high through August (excluding the Covid-related volatility) (Fig. 1). However, the personal consumption expenditures deflator rose 6.2% over the same period (Fig. 2). So real personal income fell 2.3%. Inflation has been eroding the purchasing power of consumers.

Also weighing on purchasing power have been federal, state, and local government taxes, which have been boosted by inflated nominal incomes (Fig. 3). Nominal and real current personal taxes in personal income are up 20.1% and 13.0%, respectively, over the past 12 months through August.

As a result, nominal disposable personal income continues to rise along with hourly wages and payroll employment to new highs. However, on an inflation-adjusted basis, it fell 4.5% y/y through August (Fig. 4).

(2) Consumption. Nevertheless, consumer spending is still growing. It was up 8.2% y/y through August in current dollars and 1.8% on an inflation-adjusted basis (Fig. 5). In real terms, consumer spending is down 0.4% y/y for goods and up 3.0% for services.

Consumers went on a buying binge for goods after the lockdown recession of 2020, while their spending on services was limited by ongoing capacity restrictions in many services industries. As businesses reopened, consumers pivoted toward buying services since much of their pent-up demand for goods had been satisfied.

(3) Saving & government transfers. During 2020 and the first half of 2021, personal saving soared because consumers couldn’t spend much during the lockdowns and were limited in what they could spend on services after the lockdown restrictions were eased. They also received three rounds of pandemic support payments from the government, which boosted both personal consumption and saving (Fig. 6). Over the past 31 months (from February 2020 through August this year), personal saving totaled $2.2 trillion, well above the comparable amount through January 2020, i.e., just before the pandemic spread (Fig. 7). We estimate that at least $1.0 trillion in excess saving has been accumulated since the start of the pandemic.

That’s allowed consumers on balance to reduce their monthly saving in recent months to the slowest pace in 13 years, thus boosting their purchasing power. Interestingly, personal saving per household peaked at a record high $28,075 (using the 12-month average of saar data) during March 2021 and fell to $8,625 during August of this year to the lowest since June 2017, before the pandemic (Fig. 8).

(4) California. By the way, starting next month, eligible California residents will receive “inflation relief” tax-refund payments totaling $9.5 billion—a plan approved owing to the state’s 2022-23 state budget surplus. Payments ranging from $200 to $1,050 will hit the bank accounts of more than 20 million Californians over the next few months. (See the September 15 Patch article, “CA Giving Away $9.5B Next Month: What To Know.”)

(5) Answer to the recession question. On balance, Debbie and I conclude that the economy has been in a growth recession since the start of this year that should continue through H2-2022. We are hearing more chatter about a hard-landing recession in 2023. That outlook is supported by the decline in the Index of Leading Economic Indicators over the past six months. However, that’s not our view, currently.

The risk of a hard landing has certainly increased since the Fed turned more hawkish this summer. If we turn more pessimistic about the economic outlook, then we will most likely forecast that the growth recession will continue through H1-2023.

US Economy II: The Great Inflation Question. Inflation probably peaked during H1-2022, but it remained elevated after the peak, according to August’s PCED released on Friday in the Personal Income & Consumption report. On a y/y basis, the headline PCED inflation rate edged down from 6.4% in July to 6.2% in August, while the core rate ticked up from 4.7% to 4.9%. The headline rate peaked at 7.0% during June of this year, while the core rate peaked at 5.4% during February and March.

Let’s have a closer look at the latest inflation readings:

(1) Nondurable goods accounts for 21.5% of the PCED. Food and energy account for 55.4% of this category. Weakening global economic activity continues to weigh on oil prices. In the US, consumers have reduced their gasoline usage by about 1 million barrels per day in recent weeks compared to the same time last year (Fig. 9). The price of gasoline has been falling since early July and continued to fall in September (Fig. 10).

While energy price inflation seems to be peaking, the same cannot be said of food price inflation in the PCED (Fig. 11). Then again, grain and livestock commodity price inflation peaked during June (Fig. 12).

(2) Durable goods accounts for 12.6% of the PCED. Of the three major components of consumer prices, the most peakish looking chart is for durable goods inflation (Fig. 13). All the major subcomponents are showing easing inflationary pressures, especially used car & truck prices and household appliances. Retailers are reporting bloated inventories of goods, requiring them to cut the prices of both the durable and nondurable goods they carry. The housing recession is depressing the demand for housing-related goods.

(3) Services accounts for 65.9% of the PCED. Since the start of this year, we’d been expecting that durable goods inflation would come down almost as rapidly as it went up. We also had expected that the rent component would become an increasingly significant inflation issue for the consumer price measures.

Sure enough, the rent of primary residence and owners’ equivalent rent components of the PCED rose 6.7% y/y and 6.3% through August (Fig. 14). A year ago, those inflation rates were 2.1% and 2.5%. The comparable three-month annualized increases were even more alarming at 8.9% and 8.2% as of August. The rent is still too d@mn high, though the Zillow Rent Index certainly looks peakish, having dropped from a recent high of 17.2% y/y during February to 12.3% in August.

Also contributing more to recent consumer inflation readings have been health insurance (up 24.3% in the CPI, but 1.3% in PCED) and electricity (up 15.8% in both) (Fig. 15 and Fig. 16).

(4) Answer to the inflation question. We were disappointed by August’s PCED report. We still think that inflation has peaked; but it’s not dropping as rapidly as we had anticipated.

We’d been expecting that by now enough progress would have been made in bringing down the consumer inflation rates excluding rent that Fed officials could at least pause their rate hiking—with rent excluded because it’s a weird component of both the CPI and PCED, as we’ve previously discussed.

Movie. “Blonde” (+) (link) is a very painful movie to watch about Marilyn Monroe’s often painful life. It isn’t really a docudrama since quite a bit of it isn’t historically accurate. It’s been at the top of Netflix’s movie chart but has been widely criticized as “sexist” and “cruel” even though it received a 14-minute standing ovation at the Venice Film Festival. It’s worth seeing just for the remarkable performance of Ana de Armas as Marilyn. However, she had to cry during almost every scene. The film in many ways is an American tragedy about an iconic personality.

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Troubled Times In The UK & China

September 29 (Thursday)

UK: Pounded. The UK is spending a lot of money that it doesn’t have, and Bond Vigilantes—already on alert due to high inflation—aren’t going to stand for it. In early September, new Prime Minister Liz Truss announced a plan to spend billions to subsidize citizens’ energy bills. Then last week, the UK Chancellor Kwasi Kwarteng proposed a plan to boost the economy by cutting taxes and borrowing heaps of debt. This flies in the face of the Bank of England’s (BOE) efforts to tame inflation, which has soared due to painfully high energy prices.

The mixed messages resulted in a sharp bond market selloff that forced the BOE to react on Wednesday. It’s a tough way to start a new administration. Let’s take a look:

(1) The tax-cut plan. UK Chancellor Kwarteng laid out a plan to boost economic growth by cutting taxes and borrowing £45 billion, which equals 1.5% of GDP, by 2026-27. The move could push the UK’s public borrowing to more than £190 billion, the third highest since the second World War. And it’s occurring as interest rates have jumped, making the borrowing more expensive.

Under the proposal, taxes on the highest earners will drop to 40% from 45%, and the cap on bankers’ bonuses will be removed. Homebuyers will start paying a tax when purchasing a £250,000 home, up from a £125,000 home. And 40 new investment zones will be created in which businesses will pay low taxes.

(2) The energy-cap plan. Earlier this month, Prime Minister Truss unveiled her £150 billion package to limit consumers’ and businesses’ exposure to the jump in energy prices. The average annual household energy bill will be limited to £2,500 over the next two years, a September 8 FT article explained. In addition, an energy bill discount will be retained and green levies eliminated, which will reduce annual bills to roughly £1,950 (the actual amount households pay will fluctuate based on usage). Without these measures, the average household bills were expected to rise to £3,500 in October and climb as high as £6,000 next year.

Businesses and public institutions will also receive support under Truss’s plan but only for six months. After that period, support will go to vulnerable industries, which will be identified in the future.

Truss also announced a £40 billion liquidity facility to help energy companies handle the market’s volatility and avoid a potential cash flow crisis. Electricity generators have to post much more collateral to hedge future production. Truss also plans to encourage fracking and provide more licenses for oil and gas projects in the North Sea.

(3) The market’s reaction. Investors have given the new fiscal plan a swift thumbs down. Investors fear that the large spending package will exacerbate already high inflation levels. The UK CPI was at 9.8% in August, while the core CPI had climbed to 6.2% (Fig. 1).

At its lowest point on Wednesday, the pound relative to the dollar fell 3% from Thursday’s close (before the UK chancellor’s plan was announced) and 21% from this year’s high in early January to 1.090 (Fig. 2). The yield on the 10-year government bond jumped to a high of 4.48% on Tuesday, up from 3.50% on Thursday and its low of 0.97% this year (Fig. 3). And the UK MSCI stock price index fell 3.1% ytd through Wednesday’s close (Fig. 4).

The jump in interest rates was so dramatic that some British banks have stopped offering new home mortgage loans or have reduced the loans they offered, opting to wait until the market settles down before returning to the market.

(4) The pivot. The BOE responded to the market turmoil by pivoting on Wednesday. The central bank suspended its quantitative tightening plan and announced plans to buy long-term bonds instead. The BOE’s quantitative tightening plan, which was slated to start next week, involved selling almost $900 billion of government bond holdings to reduce UK inflation. Post-pivot, the BOE plans to buy long-term bonds through mid-October. The central bank said that it would make purchases at “whatever scale is necessary” and that the UK Treasury would fund any losses.

The International Monetary Fund frowned on the UK’s fiscal plans, saying that large, untargeted fiscal packages are not recommended during times of high inflation. Likewise, Moody’s said the tax cuts were a credit negative and likely to hurt economic growth.

UK 30-year bond yields, which were just south of 5% prior to the announcement, fell to 3.93% on Wednesday, their biggest drop on record, according to a FT article yesterday. The pound, however, continued its decline, trading around 1.090 against the dollar. Now the questions are whether the BOE will need to raise interest rates to defend the pound and by how much. Already this year, the central bank has raised its base rate to 2.25% from 0.10% (Fig. 5).

China: The Great Restructuring. China has a debt problem. Domestically, indebted real estate companies have built ghost towns of empty residential towers, leaving their buyers trapped by the mortgage debt they’ve incurred to pay for these unfinished units. Internationally, the Chinese government has lent money to projects in emerging market countries that are going belly up, their forecasted cash flows having failed to materialize. Restructuring China’s debt is bound to be slow and painful, as nearly all debt restructurings are.

China’s real estate sector is dragging down the country’s economic growth, as are the country’s restrictive Covid policies. Chinese industrial profits have fallen 2.1% y/y during the first eight months of 2022, and the World Bank lowered its forecast for China’s economic growth in 2022 earlier this week to 2.8% from 4.3% back in June.

China’s deteriorating economic picture has its central bankers cutting interest rates when their counterparts the world over are raising interest rates, and that’s putting pressure on the yuan. Let’s look at some of the recent news contributing to the situation:

(1) Debt at home. China’s leveraged real estate sector continues to restructure billions of dollars of debt and look for new sources of capital to finish half-built buildings. Sunac China, which has defaulted on its dollar bonds, is seeking to extend by six months its repayment on almost $560 million of domestic debt. It would be the third extension of the debt’s maturity date, Reuters reported this week.

Meanwhile, China Evergrande Group, which has more than $300 billion of debt, announced that Shenzhen Longgang Ancheng Investment Operation would be brought in to help with project construction at four developments in Shenzhen, a September 27 Reuters article reported.

There are new funds being raised to invest in distressed properties. China Construction Bank is setting up a $6 billion fund to buy properties from developers to turn them into rental properties. Meanwhile, it was reported this summer that China was raising a $44 billion real estate fund to support the sector. But so far, there’s no indication that the worst has passed. Average new home prices in 70 Chinese cities fell 2.1% m/m in August, which follows a 1.7% m/m price decline in July.

(2) Debt abroad. “Debt-trap diplomacy” is what detractors call China’s Belt and Road policy. The country spent roughly $1 trillion on projects in 150 countries scattered throughout Asia, Africa, and Latin America. Many of the projects were extremely leveraged. For every $1 of aid China provided, it lent out $9 of debt, while similar US-subsidized projects were funded with $9 of aid for every $1 of debt, a September 26 WSJ article reported. Now China has to determine what to do with projects that aren’t throwing off enough cash to service the debt.

In many cases the solution will involve extending maturities, reducing interest payments, forgiving debt or some combination of the above. Chinese creditors Export Import Bank of China and the China International Development Cooperation Agency have suspended more than $1.3 billion in debt service in 23 countries under the G20 program, including 16 African nations, according to Johns Hopkins School of Advanced International Studies research quoted in a September 27 South China Morning Post article. These Chinese creditors suspended debt service in Kenya ($378 million), Zambia ($110 million), Tajikistan ($40 million), and Maldives ($25 million).

Earlier this month, China restructured $3.2 billion of private debt owed by Ecuador. The China Development Bank extended the maturities on $1.4 billion of debt to 2027, and the Export-Import Bank of China pushed out the maturities on $1.8 billion of loans to 2032. Amortization payments on those loans were reduced, and the total relief granted to Ecuador was pegged at $1.4 billion, according to a September 19 Reuters article.

Zambia is negotiating the restructuring of $17 billion of external debt, $6 billion of which is owed to Chinese lenders. Chinese lenders are also the largest creditors to Sri Lanka, which defaulted on $47 billion of external debt last year. Laos appears likely to require debt restructuring soon; about half of its $14.5 billion of foreign debt is owed to China. And Pakistan owes $30 billion, or about 30% of its foreign debt, to China.

China hasn’t joined the Paris Club, a group of 22 nations that helps nations pay off loans, as membership requires greater transparency than China is willing to provide. China tends to favor extending maturity dates on debt over forgiving debt, as typically occurs in Paris Club restructurings. However, a September 26 WSJ article reported that Chinese policymakers are hashing out a more conservative lending program, internally dubbed “Belt and Road 2.0,” and that they’re increasingly open to renegotiating debt even if that means accepting losses, “something they had been previously unwilling to do.”

(3) Covid cases continue. Covid-19 cases continue to pop up in China. On Sunday, China reported 999 new Covid cases, on par with the 936 new cases reported on Saturday. Citizens are getting tired of the government’s zero-Covid policy lockdowns, which have been a drag on economic growth.

A “snap” lockdown of Shenzhen after 10 new Covid cases were reported prompted dozens of people to protest, chanting “lift the Covid lockdown.” Citizens may use public transportation and enter restaurants and hospitals only if they’ve tested negative on a PCR Covid test within the past 24 hours, a September 27 article in Channel News Asia reported.

Conversely, Hong Kong has lifted some of its Covid-19 controls, including the requirement that incoming travelers quarantine in a hotel upon arrival; they still must take Covid tests for a week and abstain from visiting restaurants and bars for three days. Likewise, Macau plans to ease Covid restrictions, making it easier for citizens to travel to the city, in November.

(4) Yuan falling fast. The yuan has fallen 12% against the dollar since peaking at the end of February (Fig. 6). The currency, which hit a 14-year low on Wednesday, has come under pressure as the Federal Reserve has increased US interest rates, strengthening the dollar, while the People’s Bank of China (PBOC) has cut interest rates and bank reserve requirements, most recently in August (Fig. 7).

The PBOC has tried to stem the decline of the yuan by introducing policies that increase the cost of shorting the currency. Specifically, the central bank has “[lowered] the amount of foreign exchange financial institutions must hold as reserves and reinstated risk-reserve requirements on currencies purchased through forwards,” September 27 Reuters article reported.

The China MSCI share price index has maintained a downward path this year. It has fallen 28.3% ytd and 53.6% from its February 17, 2021 record high (Fig. 8). Revenues for companies in the China MSCI index are expected to rise 10.9% this year and 7.2% in 2023 (Fig. 9). Earnings are also expected to climb, by 9.5% this year and 15.5% in 2023, though net earnings revisions have been decidedly negative over the past year (Fig. 10 and Fig. 11).

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Recessions Here & There

September 28 (Wednesday)

Strategy: Powell’s One-Two Punch. Fed Chair Jerome Powell’s surprisingly hawkish press conference on Wednesday, September 21 obviously caused investors to turn more bearish. The S&P 500 fell 5.2% from September 20 through September 26 (Fig. 1). Over this same period, the 10-year US Treasury bond yield jumped 31bps to 3.88% (Fig. 2).

We will soon see whether the industry analysts who cover the S&P 500 companies might also have been paying attention to Powell’s warning that the economy could experience some “pain” while the Fed is fighting inflation. Analysts usually don’t pay much attention to macroeconomic developments unless they clearly increase the odds of an imminent recession.

But the analysts certainly responded to FedEx’s recent warning. The package delivery giant delivered a terrible preannouncement about its fiscal Q1 (ended August) on Thursday evening, September 15. FedEx said that it expects Q1 earnings, excluding some items, to be $3.44 per share, or roughly 33% below the analysts’ consensus estimate of $5.10. In addition, FedEx withdrew its earnings forecast for 2023, saying that macroeconomic trends have “significantly worsened,” both internationally and in the US, and are likely to deteriorate further, fueling fears of a broad-based earnings decline.

In this light, consider the following:

(1) Annual earnings forecasts. During the week of September 22, the analysts lowered their S&P 500 operating earnings estimates for Q3- and Q4-2022 and each of next year’s quarters (Fig. 3 and Fig. 4). Their consensus estimates now are $223.83 per share this year and $242.22 per share next year (Fig. 5).

(2) Forward earnings. The forward earnings of the S&P 500 fell to $237.27 per share during the September 22 week, down 1.1% from its record high during the June 23 week. It remains consistent with our mostly sideways earnings forecast, which is consistent with our growth recession economic forecast. Forward earnings would be much lower in a hard-landing scenario.

(3) Forward P/E. The forward P/E of the S&P 500 also took it on the chin. It was 16.2 on September 20 and fell to 15.4 on September 26 (Fig. 6).

US Economy: In A Growth Recession. The latest batch of US economic indicators is consistent with our growth recession forecast. Consider the following:

(1) GDP. After the release of August’s new home sales and durable goods orders, the Atlanta Fed’s GDPNow tracking model showed a Q3 increase of only 0.3% (saar) yesterday, unchanged from the September 20 estimate. The weakest component is residential investment (down 25.5%).

(2) New home sales. New home sales jumped 28.8% m/m during August, but the supply of new homes for sale rose to 461,000 units, the highest since March 2008 (Fig. 7). The rebound in sales is likely an aberration caused by a dip in mortgage rates earlier in the summer. Since then, they’ve continued to soar closer to 7.00%, more than double the year-ago rate.

(3) Orders for non-defense capital goods excluding aircraft. This closely watched proxy for business spending plans surged 1.3% last month. That was the biggest gain since January. Data for July were revised higher to show these so-called core capital goods orders gaining 0.7% instead of 0.3% as previously reported. The data are not adjusted for inflation, so the jump in spending may reflect higher prices.

(4) Regional business surveys. The business surveys conducted by five Federal Reserve Banks showed some upticks during September, but the average composite index (-5.5) and average new orders index (-8.5) both remained in negative territory (Fig. 8). The average employment index remained high at 9.3, but it has been declining since the start of this year.

The regional averages of the prices-received (35.0) and prices-paid (50.2) indexes remained elevated in September, but they also have been declining sharply since the start of the year (Fig. 9).

The regional average of unfilled orders or delivery times fell to -13.0, the lowest reading since May 2020 (Fig. 10). That’s down from a record high of 28.2 during May 2021. We think this strongly confirms that supply-chain disruptions have mostly abated.

(5) Consumer confidence. Consumer confidence rebounded slightly during the two months through September from July’s depressed reading, which was the lowest since February 2021 (Fig. 11). The labor market remains tight, with 49.4% of respondents agreeing that “jobs are plentiful” in September (Fig. 12). It’s hard to envision a hard landing for the economy anytime soon given this and other strong readings on the labor market.

Europe I: Heading Toward Recession. Germany is Europe’s largest economy. The German economy is facing recession, and almost all major sectors (i.e., manufacturing, services, trade, and construction) are in the red, the Ifo surveys head Klaus Wohlrabe told Reuters on Monday. The reading of the Ifo Institute's business climate indicator for September slipped to 84.3, down from an upwardly revised mark of 88.6 in August (Fig. 13). It is the lowest reading since May 2020, when the index touched 80.2. Ifo added that companies’ pessimism for the coming months has increased “significantly.”

European businesses and households will have to survive this winter without any significant Russian gas flows. The Nord Stream gas pipeline system that delivers Russian gas to Europe has been out of action for several weeks. But any hope that the Kremlin might have turned the taps back on at some point were dashed yesterday when the system was damaged by a suspected act of sabotage.

Europe II: The Sound Of Fiscal Spending. EU member countries’ fiscal policies are guided by a set of rules called “The Stability and Growth Pact.” They stipulate that member states must keep their government deficits below 3% of GDP and public debt levels below 60% of GDP. However, the rules have been suspended since May 2020, with an escape clause triggered first by the exceptional circumstances of the pandemic, then by Russia’s invasion of Ukraine. In May, the European Commission postponed their reinstatement for yet another year to allow member governments the fiscal latitude to invest in the green and digital transitions.

“We collectively face a mountain of investments,” EU Economy Commissioner Paolo Gentilioni explained, according to a May 23 article in Euractiv.

EU governments soon will be crafting their 2024 budgets and need a guidebook to follow. Next month, detailed reform proposals for the EU’s fiscal rulebook are expected. Melissa and I expect the outcome to promote much more public and private investment, particularly given the region’s push to transform its energy and digital landscapes. Here’s more:

(1) The hills are alive with debt. So far, the EU has followed the Stability and Growth Pact’s fiscal reform rules. Yet the policy pact has not resulted in policy instruments orchestrating much growth or stability, as an FT article recently pointed out. Public and private investment in the EU has fallen over the past decade.

Stability has come to mean limiting public borrowing. Previous macroeconomic government rules called for deficits and public debt levels below 3% and 60% of GDP, respectively. But these rules haven’t been very effective in promoting macroprudential stability, as exemplified by the recent public debt crises in Spain and Ireland. Member states are fragmented in terms of their indebtedness—some are highly indebted, while others, the more fiscally conservative, are less so. Such fragmentation has the potential to destabilize the entire region’s financial system.

(2) These are a few of Europe’s new favorite investments. Russian President Vladimir Putin’s moves to deprive Europe of gas are driving initiatives to increase energy security in Europe. Europe’s governments are actively pursuing heavy centralized investments in public goods to support energy, defense, and basic utilities.

(3) So long, farewell, austerity. Even Germany, typically the most austere in the region, recently has stressed the need for public investments. Commentary from the German government on the EU’s work-in-progress reforms stated: “Higher levels of public investment would have a long-term impact on growth and would facilitate the transformation towards climate neutral economies.”

German leaders are arguing for the expansion of the investment clause outside of economic crisis times. Similarly, a unique position statement between the Dutch and Spanish called for a roadmap to revise the EU’s fiscal framework to focus more on “high-quality” investments.

(4) Climbing every mountain. The French and Italian governments also have called for more fiscal wiggle room for member states. Others have pushed back, calling for more prudence in fiscal matters, including Austria, Sweden, and Latvia, wrote the FT. But to us it seems that the call for public investment in Europe is getting louder.

(5) How do you solve a problem like Lagarde? That’s even while the head of the European Central Bank (ECB) has demanded for inflation’s sake that any fiscal stimulus be targeted and limited in scope so as not to counteract the impacts of the bank’s tightening moves. ECB President Christine Lagarde may want to head for the hills after the details for the new EU fiscal rule book comes out.

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Powell’s Latest Pivot Shocks Markets

September 27 (Tuesday)

Video Webcast. You can find a replay of our Monday morning webcast here.

Strategy: Revisiting Our Forecasts. The bad news is that everyone is pessimistic and bearish, and rightly so following Fed Chair Jerome Powell’s latest pivot. Last Wednesday, September 21, at his post-FOMC press conference, Powell essentially embraced his 1970s era predecessor Paul Volcker’s approach to dealing with inflation, as we discussed in yesterday’s Morning Briefing.

Powell said that he will continue to raise interest rates rapidly until he is convinced that they are restrictive enough to bring the inflation rate back down to 2.0%. He is no longer talking about pausing along the way to assess whether the latest hike is doing the job; he’ll keep raising rates until he sees the job getting done—however long that takes, so he said. Powell has indicated that he understands that he might cause a recession along the way, but he reckons that the pain of allowing inflation to remain high exceeds the pain of causing a recession sooner rather than later.

Now let’s consider the following related developments and revisit our forecasts in light of Powell’s increasing hawkishness:

(1) Foul mood, the dollar & commodity prices. Like the bad news, the good news is also that everyone is pessimistic and bearish, as Debbie, Joe, and I reviewed in yesterday’s Morning Briefing. For contrarians, the widespread foul mood creates buying opportunities. More fundamentally, the good news on the inflation front is that the dollar is soaring to new highs and commodity prices are tumbling, suggesting that the Fed’s tougher monetary stance may bring inflation down rapidly.

The JP Morgan trade-weighted dollar is up 11% ytd and 13% y/y (Fig. 1). The CRB all commodities price index is down 13% from its record high on May 4 through Friday of last week (Fig. 2). On Friday, the nearby futures price of a barrel of Brent crude oil was down to $86.15 from a recent peak of $123.58 (Fig. 3). Here are the futures prices for 3, 6, 12, and 24 months ahead: $83.61, $80.37, $76.87, and $72.26.

(2) Inflation forecasts. Debbie and I believe that the headline PCED inflation rate peaked at 6.8% y/y during June of this year and that the core rate peaked during February at 5.3% (Fig. 4). Their readings during July were 6.3% and 4.6%. We still expect to see both ranging between 4.0%-5.0% over the rest of this year and 3.0%-4.0% next year. In other words, we are not changing our outlook for inflation.

The FOMC’s latest Summary of Economic Projections (SEP) shows the following medians for the headline and core PCED inflation rates: 2022 (5.2%, 4.5%), 2023 (2.8, 3.1), and 2024 (2.3, 2.3). We doubt that inflation will come down as quickly as the SEP forecasts imply.

(3) Interest-rate forecasts. Melissa and I expect that the FOMC will vote to hike the federal funds rate by another 75bps to a range of 3.75%-4.00% at its November 1-2 meeting. That might very well do the trick—i.e., end the tightening round. The top end of this range is still below the 4.4% and 4.6% median forecasts for 2022 and 2023 shown in the FOMC’s latest SEP. But it is close enough.

The two-year Treasury note yield rose to 4.31% yesterday. It tends to be a good leading indicator of the federal funds rate over the next 3-6 months (Fig. 5). It also tends to overshoot the peaks in the federal funds, i.e., the “terminal” federal funds rates at the end of monetary policy tightening cycles. The nearby federal funds rate future was 3.76% on Friday. Here are the federal funds rate futures for 3, 6, and 12 months ahead: 3.75%, 4.56%, and 4.67% (Fig. 6).

We now expect the 10-year Treasury bond yield will peak before the end of this year at 4.00%-4.25%. Admittedly, this yield has been rising faster than we’ve been raising our forecasts. Ever since the pandemic, the current business and investment cycles in many ways have resembled a video about the 1970s on fast-forward.

(4) S&P 500 forecasts. Joe and I have been projecting that the S&P 500 would trade over the rest of this year in a range between its August 16 high of 4035 and June 16 low of 3666. Yesterday, it closed at a new bear-market low of 3655. The next major support level might be at 3386, which was the February 19, 2020 record high just before the pandemic (Fig. 7).

Notwithstanding Powell’s hawkishness, we aren’t ready to change our growth recession forecast for the economy. So we aren’t ready to change our forecast of a flat outlook for S&P 500 forward earnings around $235.00 per share for the rest of this year (Fig. 8). At year-end, this would also be analysts’ consensus expectations for 2023. That’s consistent with our forecast that the growth recession of H1-2022 will continue in H2-2022. In a hard-landing scenario, forward earnings would be much lower. Using our $235-per-share estimate, here are the forward P/Es at S&P 500 levels of 4035 (17.2), 3666 (15.6), 3386 (14.4), and 2237 (9.5).

The forward P/E was down to 15.5 on Friday. We’ve been estimating a range of 15.5-18.0 for the forward P/E over the rest of this year (Fig. 9). If forward earnings is $235, the S&P 500’s range for the rest of this year would be 3642-4230 (Fig. 10).

(5) Feshbach’s trading strategy. Our friend Joe Feshbach, trading strategist extraordinaire, thinks that the market is getting close to a significant trading bottom even if it drops below the June 16 low. He likes the jump in the CBOT’s equity put/call ratio to 1.02 on Friday, the highest reading since March 16, 2020 (Fig. 11). He also likes that sentiment indicators turned so bearish again so quickly.

We would add that the rally from June 16 through August 16 corrected an oversold market, which is now just about as oversold as it was before the recent rally, with only 13.5% of the S&P 500 companies trading above their 200-day moving averages (Fig. 12). And Investors Intelligence’s Bull/Bear Ratio was back below 1.00 last week, a bullish contrarian sign—for long-term investors, not short-term traders (Fig. 13).

The Fed: Pragmatic (Serial) Pivoter. In my 2020 book Fed Watching For Fun & Profit, the chapter on our current Fed chair is titled “Jerome Powell: The Pragmatic Pivoter.” When I have some time, I’ll update it to reflect his pivots during the summer of 2020, the fall of 2021, and the summer of 2022. He has become a serial pivoter. Here is a brief review of his most recent pivots:

(1) Summer 2020. Under Powell’s leadership, the FOMC turned “woke” in 2020. The committee's August 2020 Statement on Longer-Run Goals and Monetary Policy Strategy broke with historical precedent by prioritizing “inclusive” maximum employment over its stated 2.0% inflation target. Also in that statement, the Fed embraced flexible average inflation targeting, indicating that it now would tolerate inflation overshoots to compensate for prior inflation shortfalls.

By maintaining ultra-easy monetary policies through the first half of this year, the Fed succeeded in lowering the unemployment rate to a recent low of 3.5% during July. In addition, the ratio of job openings to unemployed workers rose to a record 2.0 during March. The result has been a significant increase in wage inflation, which has spiraled into price inflation, thus eroding the purchasing power of all workers. That has been the unintended consequence of the Fed’s wokeness!

Ironically, only six months after the August statement was issued, the PCED inflation rate jumped above 2.0% during March 2021 and never looked back (Fig. 14). The Fed’s new policy caused the PCED inflation rate to jump from its “disappointing” 1.3% annual uptrend that it had maintained since the statement was first issued in January 2012 to its 2.0% “desired” path by April 2022 (Fig. 15).

(2) Fall 2021. The rebound in inflation from H2-2021 through H1-2022 forced Powell to turn less woke and to refocus on bringing inflation down. In congressional testimony on November 30, 2021, Powell pivoted by conceding that inflation isn’t transitory, but persistent.

The minutes of the FOMC’s December 14-15, 2021 meeting were released on January 5. The word “transitory,” which had previously described the Fed’s outlook for inflation, was mentioned once: “As elevated inflation had persisted for longer than they had previously anticipated, members agreed that it was appropriate to remove the reference to ‘transitory’ factors affecting inflation in the post-meeting statement and instead note that supply and demand imbalances have continued to contribute to elevated inflation.”

(3) Summer 2022. Powell seemed to be pivoting back toward a more dovish stance at the end of July. Stock prices rallied following his July 27 press conference after he said that the federal funds rate was now at “neutral.” He said so right after the FOMC had voted to raise it by 75bps to a range of 2.25%-2.50%. Stock and bond market investors concluded that the Fed was getting closer to a restrictive level of the federal funds rate, implying that the Fed’s monetary tightening cycle might end sooner rather than later and at a lower terminal rate.

Powell scrambled to convince the markets that he was really very hawkish. In his short speech at Jackson Hole on August 26, Powell buried the notion that the Fed might lower interest rates next year. He said, “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”

Powell channeled his inner Volcker by saying: “As former Chairman Paul Volcker put it at the height of the Great Inflation in 1979, ‘Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.’”

In his September 21 presser, Powell characterized the latest federal funds rate range of 3.00%-3.25% as “probably into the very lowest level of what might be restrictive.” Undoubtedly, this won’t be his last pivot.

(By the way, an exclusive free download of my book is available here.)

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‘Keeping At It’

September 26 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. This week’s webcast will be prerecorded and available here.

Sentiment: The Lower Depths. The Lower Depths is a play by Russian author Maxim Gorky written in 1902. It was criticized for its pessimism, but is a classic of Russian social realism.

The play’s pessimistic mood certainly resonates today given the lower depths that President Vladimir Putin has taken his country by starting a war with Ukraine. The war has resulted in an energy crisis in Europe, where pessimism also is widespread. Here in the US too, pessimism is widespread, because inflation has remained high and the Fed has turned increasingly hawkish since late August. That’s when Fed officials first indicated that they are willing to risk a recession if that’s what it takes to subdue inflation. Consider the following:

(1) Consumer and business confidence. The Consumer Sentiment Index rebounded during the first half of September but remained near the lows of the Great Financial Crisis and the Volcker recessions of the early 1980s (Fig. 1). It’s also well below the lockdown recession low.

The CEO Outlook index dropped in Q3 to 84.2, down from its recent peak of 123.5 during Q4-2021 (Fig. 2). The Small Business Optimism Index edged up in August but remained near the lockdown recession low (Fig. 3).

(2) Investor sentiment. Investors Intelligence Bull/Bear Ratio dropped back below 1.00 last week (Fig. 4). The CBOT Put/Call Ratio jumped to 1.02 on Friday, the highest reading since the lockdown recession of 2020 (Fig. 5).

(3) Stock market. The S&P 500 is down 14.2% since its most recent peak on August 16 through Friday (Fig. 6). It closed at 3693 after falling intraday just below the June 16 low of 3666. The DJIA briefly flirted with a bear market on Friday but closed at a 22-month low of 29590 and down 19.6% from its record high on January 4. The S&P 500 is down 23.0% since it peaked at a record high on January 3.

The S&P 500’s forward P/E was back down to 15.5 on Friday, the lowest since June 20 (Fig. 7). It is inversely correlated with the 10-year TIPS yield, which has soared from a recent low of 0.09% on August 1, 2022 to 1.32% on Friday.

The reversal in breadth measures has been breathtaking. The percent of S&P 500 companies trading above their 50-day moving averages plunged from 92.9% on August 12 to 2.8% on Friday (Fig. 8).

(4) The Fed’s talking heads. From a contrarian perspective, such widespread pessimism is creating buying opportunities. Admittedly, though, it is getting harder to be optimistic about the economy. It is also getting harder to be bullish on stocks when the Fed is turning more hawkish on monetary policy. Now that the FOMC’s blackout period is over, we can look forward to all the Fed’s talking heads talking up their more “restrictive” stance, as already explained to us all by Fed Chair Jerome Powell last Wednesday.

The Fed I: Powell Channels Volcker. It seems that Powell recently read former Fed Chair Paul Volcker’s autobiography, Keeping At It (2018). Amazon’s summary states: “As chairman of the Federal Reserve (1979-1987), Paul Volcker slayed the inflation dragon that was consuming the American economy and restored the world’s faith in central bankers.”

At his press conference last Wednesday, Powell mentioned “keep” or “keep at it” in the context of staying the tightening course a total of six times:

(1) “We will keep at it until we are confident the job is done.”

(2) “The FOMC is strongly resolved to bring inflation down to 2%, and we will keep at it until the job is done.”

(3) “We want to act aggressively now and get this job done and keep at it until it’s done.”

(4) “And in light of the high inflation we’re seeing, we think we’ll need to … bring our funds rate to a restrictive level and to keep it there for some time.”

(5) “So, what that tells us is that we need to continue, and we can keep doing these, and—[as] we did today—do another large increase as we approach the level that we think we need to get to, and we’re still discovering what that level is.”

(6) “And we have to get back to that [i.e., 2% inflation rate] and keep it for another long period of time … [T]he record shows that if you postpone that, the delay is only likely to lead to more pain.”

In Friday’s QuickTakes, we noted that Powell mentioned the words “pain” or “painful” seven times in his presser. He did so in the context that bringing inflation down with tight monetary policy might cause a recession, but the pain will only be worse later if the Fed doesn’t step on the monetary brakes now.

Furthermore, Powell mentioned the word “restrictive” 12 times in his presser, in the context that, at 3.00%-3.25%, the federal funds rate is “probably into the very lowest level of what might be restrictive.” He warned that “there’s a ways to go.” He stated that the FOMC needs “to move our policy rate to a restrictive level that’s restrictive enough to bring inflation down to 2%, where we have confidence of that.” He said that once the federal funds rate is at a restrictive level, the FOMC will have “to keep it there for some time.”

During his previous presser, on July 27, Powell mentioned the word “restrictive” just three times, and he stated (once) that restrictive monetary policy would mean a federal funds rate “somewhere in the range of 3 to 3½ percent” by year-end.

By the way, at that July press conference, Powell sounded relatively dovish: “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.” Likewise, at his June presser, Powell said, “Clearly, today’s 75 basis point increase [in the federal funds rate] is an unusually large one, and I do not expect moves of this size to be common.”

But the FOMC raised the federal funds rate by 75bps at the June, July, and September meetings of the committee, to 3.00%-3.25%. Another 75bps hike at the November meeting would take the range up to 3.75%-4.00%.

Powell now has completely crossed over to the dark side.

The Fed II: What About QT2? During Powell’s prepared remarks at his latest presser, he said, “[W]e are continuing the process of significantly reducing the size of our balance sheet.” He didn’t acknowledge that QT2 has already had a very restrictive impact on the housing market by widening the spread between the mortgage rate and the 10-year US Treasury yield. Consider the following:

(1) Mortgage rate. The mortgage rate has risen from 3.32% at the start of this year to 6.67% on Thursday (Fig. 9 and Fig. 10). It rose faster than the 10-year Treasury bond yield because Fed officials have said that the Fed should get out of the mortgage market by getting rid of all its mortgage-backed securities over time. Under QT2, the Fed projects that its holdings of mortgage-backed securities will fall from $2.7 trillion at the start of June to $1.7 trillion by the end of 2024 (Fig. 11).

(2) Housing indicators. The four-week average of weekly mortgage applications is down 31% since the start of this year through the September 16 week (Fig. 12). The sum of new and existing single-family home sales plunged 27% from 6.58 million units (saar) during January to 4.83 million units during July.

(3) Treasury yield. Under QT2, the Fed is also planning to reduce its holdings of US Treasury securities from $5.8 trillion at the start of June to $4.0 trillion by the end of 2024 (Fig. 13). It increased the pace of running off maturing securities from $22.7 billion per month from June through August to an estimated $34 billion during September. That has certainly contributed to the rebound in the 10-year Treasury yield from a recent low of 2.60% during August 1st to 3.69% on Friday (Fig. 14).

(4) Treasury market. Keep in mind that before QT2, QE4Ever started on March 23, 2020 and lasted through May 2022. Over this period, the Fed’s holdings of Treasuries increased $3.3 trillion, which financed 58% of the $5.7 trillion cumulative federal budget deficits back then. Over the past 12 months through August, the Fed’s holdings of Treasuries increased by $0.4 trillion, the lowest since February 2020 (Fig. 15).

The 12-month federal budget deficit was $1.0 trillion through August, down sharply from a record $4.1 trillion through March 2021. On a consolidated basis, the Treasury and the Fed had a deficit of $650 billion over the past 12 months through August (Fig. 16). Last week, we noted that over the past 12 months through July, the Treasury International Capital report showed net foreign capital inflows into US Treasury notes and bonds totaled $634.5 billion. Their net purchases of Treasury bills was only $1.5 billion.

US Economy: Growth Recession Update. Following the release of August’s housing starts last Tuesday, the Atlanta Fed’s GDPNow tracking model’s estimate for Q3-2022 real GDP growth was reduced from 0.5% (saar) to 0.3%. That result would follow modest declines in real GDP of -1.6% during Q1 and -0.6% during Q2. The model’s estimate for Q3 residential investment in real GDP was lowered from -20.8% to -24.5%, following -16.2% during Q2, which was mostly attributable to declines in spending on home improvements and reduced real estate commissions.

It all still adds up to a growth recession (a.k.a. a soft landing, rolling recession, or mid-cycle slowdown) rather than an outright old-fashioned recession. So far. By the end of last week, following Powell’s hawkish presser, fears of a hard landing increased significantly, as reflected by the 4.6% drop in the S&P 500 last week.

Even as Powell was heightening recession fears during his latest presser, he also observed that “people have savings on their balance sheet from the period when they couldn't spend and where they were getting government transfers.” He said that these excess savings could “support growth.” He also noted “that the states are very flush with cash.” He concluded, “[S]o there's good reason to think that this will continue to be a reasonably strong economy.”

The latest economic readings still are consistent with our growth recession scenario. The latest housing indicators show that the industry is experiencing a hard landing. August’s Index of Leading Economic Indicators was down for the sixth month in a row.

On the side of strength, however, the Index of Coincident Economic Indicators rose to a new record high during August, led by a solid increase in payroll employment. Initial unemployment claims remained low at 213,000 during the September 17 week. Continuing claims fell 22,000 to only 1.379 million during the September 10 week. S&P Global’s Flash US Manufacturing PMI edged up in September to 51.8 from 51.5 in August. The S&P Global Flash US Services Business Activity Index was 49.2 in September, up notably from 43.7 in August, signaling a much slower decline in output.

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Consumers, Lithium & Waves

September 22 (Thursday)

Consumer Discretionary: So Bad It’s Tempting? The S&P 500 Consumer Discretionary sector has underperformed the broader stock market for much of the year, down 23.5% ytd through Tuesday’s close versus the S&P 500’s 19.1% ytd decline. But an interesting thing has happened since the S&P 500 bottomed on June 16: Consumer Discretionary has outperformed all other sectors.

Here's the performance derby for the S&P 500 and its 11 sectors from the June 16 low through Tuesday’s close: Consumer Discretionary (17.1%), Utilities (13.7), Financials (6.8), S&P 500 (5.2), Information Technology (4.9), Health Care (4.5), Industrials (4.1), Consumer Staples (3.7), Real Estate (1.1), Energy (0.8), Materials (-3.0), and Communication Services (-3.9) (Table 1).

Among the Consumer Discretionary sector’s industries, three have outperformed the sector’s strong performance since June 16. Automobile Manufacturers posted the most dramatic outperformance, rising 41.4%, followed by Casinos & Gaming (23.7%) and Internet & Direct Marketing Retail (17.7).

Let’s consider what investors might see in this very economically sensitive sector at this time of economic uncertainty:

(1) Employment’s still strong. Despite all the worry about interest rates and economic growth abroad, the US labor market remains exceptionally strong. The August unemployment rate came in at 3.7%, only 1.2ppts above its all-time low of 2.5% posted in May and June 1953 (Fig. 1).

(2) Prices lower at the pump. Gasoline prices have come down sharply in recent weeks. Since peaking at $5.11 during the June 13 week, the price of a gallon of gasoline has fallen 26% to $3.77 (Fig. 2). That certainly helps when it comes time to fill up the tank.

(3) Interest rates close to a top? The Federal Reserve has been busy this year. It boosted the fed funds rate by 75bps to a range of 3.00%-3.25% on Wednesday, marking the fifth consecutive FOMC meeting that resulted in an increased fed funds target and the third consecutive increase of that size. The Fed has raised the fed funds rate by a total of 300bps during the current tightening cycle. The two-year Treasury yield has hit 4.02%, and the 10-year Treasury yield has jumped to 3.51% (Fig. 3). Given the sharp slowdown in the housing industry and surge in interest rates, investors may be presuming that, even though Powell & Co. indicate that they could raise fed funds as high as 4.6% next year, the FOMC may stop raising rates far sooner.

We do see a possible yellow flag for the sector: Americans have been taken aback by the pace at which grocery bills have been rising. The food inflation rate in August’s CPI was 11.6% on a three-month-change basis and 11.4% on a yearly basis (Fig. 4). Prices are expected to remain elevated, as drought has affected crops in the US and South America and war has created uncertainty about supply from the Ukraine. We’ll be watching food inflation to see if it saps consumers’ purchasing power.

Materials: Lithium Keeps Rising. Fears of a global recession have hurt the prices of most metals and materials. One notable exception is the price of lithium. It’s up 119% ytd thanks to the expected surge in demand for lithium batteries used to power electric cars and provide backup storage for utilities using solar and wind power (Fig. 5). Large and small companies around the world are hoping to open new mines and to build processing plants for the mineral. But they’ve faced outcry from environmentalists and “NIMBYs” (“not in my backyarders”). Mining is a dirty business, and lithium mining is no exception.

Let’s take a look at what’s happening with metals prices, the obstacles new lithium mines will need to overcome, and some of the funding out of Washington, DC that’s attracting old and new companies alike:

(1) A metals meltdown. Concern about a global economic slowdown has weighed on the prices of materials in general and of metals specifically. The price of US Midwest domestic hot rolled coil steel has tumbled to $798 per ton from a recent peak of $1,541 at the end of March (Fig. 6). Copper has fallen to $3.55 per pound from its record high of $4.93 in early March (Fig. 7). And the amount fetched for aluminum has dropped to $2,245 per metric tonne from its record high of $3,984 in early March (Fig. 8).

Not surprisingly, the stock price indexes of most industries in the S&P 500 Materials sector reflect metals’ sliding prices. Only Fertilizers & Agricultural Chemicals is up on a ytd basis (by 28.8%), while the rest are down: Steel (-0.6%), Diversified Chemicals (-5.3), Industrial Gases (-18.9), Materials sector (-20.0), Construction Materials (-23.0), Copper (-28.8), Specialty Chemicals (-30.0), and Gold (-31.0) (Fig. 9).

Earnings forecasts for the S&P 500 Materials sector have melted down as well. While earnings are expected to grow 16.7% this year, they’re forecasted to fall 7.5% in 2023, and revisions have been decidedly negative for the past six months (Fig. 10). Given all this negativity, the 119% ytd jump in the price of lithium is all the more impressive.

(2) Objections to lithium mines. Demand for electric vehicles (EVs) is expected to grow rapidly around the world, driving global demand for lithium up six-fold by 2030 from about 350,000 tons in 2020, according to a March 28 Associated Press article. But supply may not keep pace with demand in part because the dirty process of mining invites opposition from environmentalists. The lofty price of lithium is telling us that proposed mining projects aren’t going to get done in the numbers necessary to fulfill demand.

Environmentalists stymied BYD’s attempts to set up a mining operation in Chile, which has among the largest lithium deposits and existing mining operations. Protesters worried about the environmental impact and the percentage of profits Chile would receive from the mine.

The US has about 4% of the world’s lithium reserves, but it produces only 2% of the world’s supply, or roughly 5,000 tons a year, primarily from Nevada’s Silver Peak mine, owned by Albemarle. One US mine under development—and the closest to production—is in Thacker Pass, NV. Owner Lithium Americas (11% owned by Chinese company Ganfeng Lithium) hopes to start construction late this year on a facility expected to produce 66,000 tons a year of lithium carbonate once operational. Native American tribes are opposed to the mine, however, saying it’s on sacred lands and could pollute the region.

The project will include a chemical processing plant, waste dumps, and an open-pit mine that could be 370 feet deep, a May 6, 2021 NYT article explained. The company has said the mine will consume 3,224 gallons of water per minute, and locals worry it will cause the water table to drop. There’s also concern that the mining could pollute the water with metals like arsenic. “The lithium will be extracted by mixing clay dug out from the mountainside with as much as 5,800 tons a day of sulfuric acid. This whole process will also create 354 million cubic yards of mining waste that will be loaded with discharge from the sulfuric acid treatment, and may contain modestly radioactive uranium, permit documents disclose,” the NYT reported. That’s certainly not what EV drivers think about as they make their auto purchase.

California Governor Gavin Newsom, a Democrat, has called California the “Saudi Arabia of lithium.” There are fewer objections to the lithium mining projects proposed for an area around the state’s Salton Sea, a lake that sits atop underground volcanos called the “Salton Buttes.” CalEnergy and Energy Source long have tapped the Buttes for geothermal heat to produce electricity. Now three companies—Berkshire Hathaway Energy Renewables, Controlled Thermal Resources, and Materials Research—plan to separate out the lithium from the heated brine water expelled by two geothermal plants before it’s injected back into the earth. This is considered the greenest way to extract lithium. The project aims to be operational in 2023. GM is backing another such project on the Salton Sea that targets 2024 for lithium production.

(3) Lithium refiners needed too. After lithium is extracted from the earth, it needs to be processed to be used by battery manufacturers. Most lithium is processed in China. Tesla is considering building a lithium hydroxide refinery facility near Corpus Christi, TX. If the plan is approved with the tax relief Tesla requested, the company would invest $365 million, break ground in Q4, and aim for production by year-end 2024, according to a September 12 article on Electrive.com.

Piedmont Lithium wants to develop an open-pit mining project for the Kings Mountain area west of Charlotte, NC as well as a lithium hydroxide processing plant in Tennessee. The Tennessee plant would cost $600 million to develop and produce 20,000 metric tonnes a year of lithium hydroxide starting in 2025, a September 2 article in Mining Technology reported.

(4) A hand from Uncle Sam. The US government has lined up funding to expand US lithium production in an effort to reduce the US’s lithium dependence on China. The Biden administration’s Bipartisan Infrastructure Law provides $3.1 billion in funding to make more batteries and components in America and build out domestic supply chains. It’s part of the administration’s goal to have EVs make up half of all car sales in the US by 2030.

But just as the government giveth, it taketh away. The Inflation Reduction Act makes it tougher to receive a rebate for purchasing an EV. For buyers to qualify for incentives, the EV purchased must have been made with source materials from North America or a country with which the US has a trade agreement. And that includes the lithium used in batteries.

The Act also provides $7 billion in funding to strengthen the US battery supply chain. Included in that funding is $3.2 billion to support battery manufacturing, processing, and recycling. Separately, the Inflation Reduction Act provides a 10% tax write-off of operational costs for US companies producing critical minerals.

The expected demand and federal funding up for grabs have spawned a slew of startup would-be lithium miners and suppliers to lithium miners. Rover Metals, Lilac Solutions, Standard Lithium, and Patriot Battery Metals are among those vying to become the Exxon of Lithium.

Disruptive Technologies: Catching A Wave. Humans have harnessed the energy of the sun, wind, and rivers. Next up: Companies are attempting to turn the motion of waves in the ocean into electricity that can be used on land. Doing so is difficult, because the motion of waves isn’t linear but oscillating, ocean water is corrosive, conditions on the sea can be brutal, and costs are problematic. Costs need to drop from about $0.60-$1.00 per kilowatt hour to about $0.06 for ocean energy to be competitive with inland competitors.

Nonetheless, small companies are building platforms and buoys to learn which technologies are most efficient. And US government funding has become more plentiful with the passage of the Inflation Reduction Act. A September 7 CNBC article described some of the technologies being explored. Here’s a quick look:

(1) Bobbing below the surface. CalWave has a large, block-like device that rises and falls with the waves under the surface of the water. Inside the block are dampers that convert the waves’ motion into torque, which drives a generator to produce electricity that’s sent back to the shore via an underwater cable.

(2) Two bobbing devices. Oscilla Power has one large, block-like device that floats on the ocean’s surface and is connected to a large ring-shaped item below the surface. “The difference in motion between the float and the ring generates force on the connecting lines, which is used to rotate a gearbox to drive a generator,” the CNBC article explained.

(3) Floaters near shore. Eco Wave Power has developed floating devices that attach to piers or jetties, but all the machinery that converts the wave energy into electricity is located on land. This dramatically decreases the costs of installation, operation, and maintenance. The company’s product is being used in Gibraltar, and there are plans to deploy it in Israel and the Port of Los Angeles.

(4) A windmill below the waves. UK-based Sustainable Marine has built platforms that float on the ocean’s surface while the motion of the ocean turns turbines below the surface. The electricity they generate is sent back to the shore via an undersea cable. The platforms are being tested off Canada’s Nova Scotia. It will be interesting to see whether marine life is affected.

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On Earnings & Central Banks

September 21 (Wednesday)

Strategy: Flat Earnings Society. In yesterday’s Morning Briefing, Joe and I explained that our rolling recession scenario suggests that S&P 500 forward earnings will be basically flat this year compared to last year. Forward earnings is the time-weighted average of industry analysts’ consensus earnings forecasts for the current year and the coming year. So for example, at the end of each year, it is identical to consensus expectations for the coming year. At mid-year, it is equal to 50% of the current year’s estimate and 50% of the coming year’s estimate. And so on and so forth.

Last year, forward earnings peaked at a record $223.04 per share during the year’s final week (Fig. 1). With so many people expecting a recession this year and next year, our prediction that forward earnings will be flat around that level through the end of this year and early next year is practically as fringe as the Flat Earth Society’s beliefs. In a recession, forward earnings typically takes a dive as both forward revenues and forward profit margins drop (Fig. 2).

As we noted yesterday, the cycle in S&P 500 forward earnings is highly correlated with the Index of Coincident Economic Indicators (CEI) (Fig. 3). The former is also highly correlated with the Index of Leading Economic Indicators (LEI). We’ve found that forward earnings acts more like a leading indicator during economic expansions but more like a coincident one during recessions. In any event, forward earnings is available weekly with a one-week lag, while both the CEI and LEI are monthly and available with a one-month lag—so forward earnings is very useful to have.

Let’s put the latest numbers in perspective:

(1) Looking forward. This year, S&P 500 forward earnings rose to a record high of $239.93 per share during the June 23 week (Fig. 4). It was down slightly to $238.23 during the September 15 week, not much above where it was at the end of last year. Industry analysts lowered their quarterly earnings forecasts for Q3-2022, Q4-2022, and all four quarters of next year during the latest earnings reporting season (Fig. 5 and Fig. 6).

Yet forward earnings have held up relatively well because this time-weighted average is giving more and more weight to next year’s earnings estimate, which remains above this year’s estimate. During the September 15 week, the former for 2022 was $225.34, while the latter for 2023 was $243.46. As we approach year-end, this year’s earnings will matter less and less, while next year’s earnings will matter more and more.

(2) Revenues rising, margins falling. As noted above, during economic expansions, S&P 500 forward earnings can serve as a very good leading indicator of actual earnings over the coming year, and during recessions it makes a good coincident indicator of actual earnings. The same can be said about S&P 500 forward revenues vis-à-vis actual revenues and the forward profit margin vis-à-vis actual margins (Fig. 7).

The latest data through the September 15 week show that forward revenues remained close to its week-earlier record high. However, the forward profit margin peaked at a record 13.4% during the June 9 week, slipping slightly to 13.1% during the September 15 week. Inflation continues to boost revenues. Apparently, companies are finding it harder to pass their rising costs through to their selling prices, as evidenced by the weakness in the profit margin recently.

(3) Homing in on the ranges. We think it all adds up to a flattish outlook for forward earnings, consistent with our view that the stock market should be range bound with the S&P 500 between the June 16 low of 3666 and the August 16 high of 4305. That’s the technical range we can see on a chart of the S&P 500.

Based on our forward earnings forecast of $235 per share at the end of this year and our target forward P/E range of 15.5-18.0, the arithmetic range for the S&P 500 is 3642-4230, which is consistent with the technical range (Fig. 8 and Fig. 9). Next year, our range is 4080-4845 based on forward earnings of $255 and a forward P/E range of 16.0-19.0.

(4) Let’s get real. The official CEI is based on four economic indicators measured in real terms. Above, we compared forward earnings to both the CEI and LEI. Let’s do the same with monthly forward earnings divided by the CPI (Fig. 10 and Fig. 11). The conclusion is the same as using nominal forward earnings. The inflation-adjusted series is more like an LEI during recoveries and expansions, and more like a CEI during recessions. Real forward earnings peaked during May and has fallen each month since then through August.

(5) Slicing & dicing. Finally, let’s have a quick look at the forward revenues, forward earnings, and forward profit margin of the 11 sectors of the S&P 500 (Fig. 12, Fig. 13, and Fig. 14).

We see that consensus forward revenues estimates for 2022 and 2023 are mostly rising with the notable exceptions of those for the Communication Services, Information Technology, Materials, and Real Estate sectors.

We see that forward earnings are flattening for all but the Energy, Real Estate, and Utilities sectors. Forward profit margins have been falling since the start of this year for all but Energy, Industrials, and Real Estate.

ECB: Whatever It Takes, Part Deux. Fed Chair Jerome Powell is not the only central bank chief on a mission to subdue inflation. European Central Bank (ECB) President Christine Lagarde is too. After raising the ECB’s key interest rate by 75bps the week before last, Lagarde said: “[W]e are so far away from the rate that will help us return inflation to 2%.”

Financial markets anticipate another 75bps hike at the ECB’s October meeting as the ECB normalizes monetary policy to lower inflation. ECB Vice-President Luis de Guindos all but confirmed investors’ interest-rate expectations in an interview. His message was that more hikes are coming. And that’s with or without natural gas flowing into Europe from Russia.

(Breaking news: Lagarde further justified the ECB’s thinking in a speech yesterday.  “[W]e need to normalize policy, and be ready to adjust rates by as much as necessary to reach our inflation target in the medium term,” she said, adding, “[M]oving faster [than 25 basis points] at the start of the hiking cycle clearly conveys our commitment to bring down inflation to our medium-term target.”)

Consider more of what Guindos said:

(1) Inflation. Reducing inflation might be painful over the next few years, but the Eurozone’s inflation level, running 9.1% y/y at its latest read, is already causing pain. ECB officials project that it will remain above their 2.0% target for quite a while. In 2024, under the baseline scenario, the ECB projects inflation averaging 2.3%. In the downside scenario, the ECB projects inflation averaging 2.7% in 2024.

(2) Uncertainty. Regarding the European gas crisis brought on by Russia’s war on Ukraine, “uncertainty is very high” because the war is still evolving: “We will be data-dependent and follow a meeting-by-meeting approach to set interest rates. … [But] more hikes might come in the next few months.”

(3) Normalizing. Back in December, the ECB started normalizing monetary policy when the bank set an end date for its pandemic emergency purchase programme (PEPP) and the asset purchase programme (APP). But the bank’s projections over the last year have underestimated inflation, putting ECB behind on raising rates—which has “happened not only at the ECB, but also in other international institutions.”

(4) Russia. The ECB Vice-President said, “everyone has to understand” that the “slowdown of the economy is not going to take care of inflation on its own.” In other words, the ECB will continue normalizing policy even if the gas crisis turns worse. “What we want to avoid is the sort of situation that we had in the 1970s, which also started with an energy shock followed by second-round effects that made things much worse.”

(5) Fiscal. Lagarde has called on governments not to adopt measures that will fuel inflation. But many Eurozone countries are taking fiscal measures to aid households and businesses, as energy prices and inflation remain high. So the bank may be fighting not only inflation but also fiscal policy.

(6) Fragmentation. The ECB has prepared for the risk that some countries will need different monetary policy treatment than others. To address yield curves rising above the norm in certain countries, the ECB decided to flexibly reinvest redemptions under the PEPP and introduced the transmission protection instrument. But so far, the bank has not seen much fragmentation among countries in this respect.

(7) Banks. Higher interest rates will both boost European banks’ profitability as well as raise their funding costs. The prospect of a dramatic economic slowdown could give rise to asset impairment and more defaults. Nevertheless, the capital and liquidity positions of European banks is solid.

(8) Euro. Negatively impacting the cost of energy in Europe, the depreciation of the euro could escalate inflationary pressures. But if the euro stopped depreciating, this could support the fight against inflation.

BOJ: Last Man Standing. By the end of its two-day meeting on Thursday, Bank of Japan (BOJ) Governor Haruhiko Kuroda and his board are anticipated to maintain negative interest rates, even as their global counterparts move to fight inflation. After the value of the yen came close to 24-year lows against the dollar last week, Kuroda indicated that direct intervention is on the table and could come swiftly and without warning, a Monday Bloomberg article observed. Here’s more of what Bloomberg reported that Kuroda said:

(1) To stop the yen’s recent slide, it would take massive interest-rate hikes that would break the economy. Even after its near low against the dollar, the BOJ continues to believe that a weak yen is positive for the economy so long as it’s stable, according to people familiar with the matter.

(2) Japan is missing the robust wage growth that would indicate the sustainable inflation rates needed to justify interest-rate rises to normalize policy. So rates will stay “at their present or lower levels.” The bank is expected to maintain its Yield Curve Control policy too, but for how long is questionable.

(3) Currently, the BOJ is holding short-term interest rates at -0.10% while enforcing a 0.25% cap on 10-year government debt. In the midst of the recent global bond selloff, the central bank had to spend 1.4 trillion yen ($9.8 billion) over just two days to buy bonds in order to defend yields.

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How’s Business?

September 20 (Tuesday)

Strategy: Rolling Recession & Flat Earnings. Debbie and I continue to watch numerous economic indicators so that we can regularly update our answer to the oft-posed question by investors, “How’s business?” The answer today is that it is not so good but not so bad either. That’s consistent with our rolling recession scenario for the economy.

In the past, many recessions that were attributable to tighter monetary policy tended to be hardest on the interest-rate-sensitive sectors, particularly autos and housing. That’s where the biggest job losses occurred, and they quickly spread to most manufacturing businesses as goods producers scrambled to reduce their unintended inventory buildups and cut their capital spending. The services economy tended to hold up relatively well, and so did employment in most services industries.

The recession during 2001 hit technology industries hard when the sector’s speculative bubble burst. The recession that occurred during the Great Financial Crisis depressed the housing, autos, and the banking industries when the subprime-lending bubble burst. So it weighed on employment not only in goods-producing industries but also in financial and real estate services.

The lockdown recession of 2020 didn’t last very long in goods-producing industries because the lockdowns were lifted after only two months; but many services were forced by social-distancing regulations to curtail business. Manufacturers and distributors of consumer durable goods and the housing industry recovered very quickly and experienced remarkable booms in demand. But employment in the services economy remained depressed during the recovery.

The overall economy has been experiencing a growth recession so far this year, as real GDP edged down 1.6% and 0.6% (saar) during Q1 and Q2. The latest estimate from the Atlanta Fed’s GDPNow tracking model shows real GDP growing just 0.5% during Q3. We’ve been characterizing the current economic experience as a “rolling recession,” depressing different industries at different times without resulting in an official broad-based recession. (The GDPNow forecast will be updated this morning.)

The bottom line for the bottom line of corporate income statements is that earnings are likely to flatten rather than take a dive in our rolling recession scenario. Overall revenues may continue to grow, boosted by inflation, but profit margins will be squeezed. That should flatten earnings like a pancake.

The main rationale for our rolling recession forecast is that this time is different compared to previous monetary policy tightening cycles. In the past, these cycles ended when they triggered a financial crisis that quickly turned into a broad credit crunch, depressing most businesses—especially goods-producing ones—and causing an economy-wide recession.

Before we analyze the latest developments in various key industries, let’s review the relationship between S&P 500 earnings and key macroeconomic variables:

(1) Actual quarterly & weekly forward revenues. S&P 500 revenues per share rose to a record high during Q2 (Fig. 1). Forward revenues per share—which is the time-weighted average of industry analysts’ revenues-per-share estimates for this year and next year—is a great weekly coincident indicator of the actual quarterly revenues series. It rose to a record high during the September 8 week.

(2) Aggregate revenues & business sales. S&P 500 aggregate revenues includes the revenues of companies that produce both goods and services. Nevertheless, it is highly correlated with the monthly series on manufacturing and trade sales, which includes only goods producers and distributors (both wholesale and retail) (Fig. 2). Both series also are highly correlated with nominal GDP of goods. The growth rates of all three on a y/y basis are very close (Fig. 3 and Fig. 4).

During Q2, nominal GDP of goods was up 11.3% y/y, while S&P 500 aggregate revenues was up 11.9%. During July, business sales of goods was up 12.5% y/y. The bad news is that inflation-adjusted business sales fell 1.5% y/y through June, while the price deflator for this category was up 16.2% (Fig. 5 and Fig. 6).

Here are June’s y/y percent changes in real business sales and their deflators for manufacturing (-2.4%, 18.4%), wholesale sales (1.8, 17.5), and retail sales (-4.1, 11.1) (Fig. 7 and Fig. 8).

(3) Actual per-share revenues, earnings, and the profit margin. During Q2-2022, revenues per share rose 12.2% y/y, while operating earnings per share increased 9.8% (Fig. 9). Both set record highs, as the profit margin was 13.4% versus a record-high 13.7% a year ago (Fig. 10).

(4) Actual quarterly earnings & weekly forward earnings. S&P 500 forward earnings tends to be a good leading indicator of the S&P 500 companies’ actual quarterly earnings, on an operating basis (Fig. 11). Forward earnings peaked at a record high of $239.93 during the June 23 week. It has edged down 0.7% since then through the September 15 week.

(5) Bottom line on the bottom line. Our rolling recession scenario implies that both forward weekly and actual quarterly operating earnings will stall at their recent record highs through the end of this year, and maybe through the first half of next year. If we were forecasting an outright recession for the economy, we would be much more bearish on earnings and the stock market; but we aren’t doing so at this time. Instead, we are forecasting that earnings will be $215 per share this year, up only 3.1% from 2021 (Fig. 12). Next year, we are forecasting $235 per share, up 9.3% from this year.

(6) Top down. From a top-down macroeconomic perspective, we’ve noted that S&P 500 forward earnings, on a monthly basis, closely tracks the Index of Coincident Economic Indicators (CEI) (Fig. 13 and Fig. 14). The CEI was up 2.1% y/y through July. In our rolling recession (a.k.a. growth recession) scenario, the CEI flattens around its current record high, as do S&P 500 forward and actual operating earnings.

US Economy: Rolling Along. Our business is a very simple one. Most of the variables we care about and need to forecast can go only up, down, or sideways. Forecasting the stock market is even easier. All we must do to forecast the S&P 500 stock price index is to forecast two variables, i.e., forward earnings for the S&P 500 companies as estimated by industry analysts and the forward P/E that investors will pay for those earnings. Forecasting these two variables is very easy to do. Getting them right is the hard part.

Today, we are working on getting the forward earnings piece right by getting our economic forecast right, particularly for the CEI. Let’s examine the latest relevant indicators and assess whether they are likely to go up, down, or sideways:

(1) Coincident Economic Indicators. The CEI includes four economic indicators: payroll employment, real personal income less transfer payments, real manufacturing & trade sales, and industrial production (Fig. 15):

Payroll employment rose to a record high during August and is likely to continue to move higher in coming months since there are still lots of job openings. That’s positive for personal income.

On an inflation-adjusted basis, however, wages and salaries in personal income have stalled as rapidly rising prices have continued to erode the purchasing power of rising wages.

Price inflation is boosting business sales of goods (and S&P 500 revenues), as we noted above, but these sales have stalled in real terms.

Industrial production edged down 0.2% during August after reaching a new record high in July and is likely to flatten out for a while, as unintended inventories have been increasing relative to sales (Fig. 16 and Fig. 17).

As for the composite CEI, it rose 0.3% in July, to a new record high, and we project that it will remain around the high over the rest of this year.

(2) Housing. The major single-family housing indicators all have been going south as the mortgage rate has been on a due-north course since the start of this year. Since the start of this year, new and existing single-family home sales are down 38.5% and 25.0% through July.

Housing-related retail sales also are depressed. Real construction spending on home improvements is down 4.7% ytd through Q2. On the other hand, multi-family building permits and starts remain strong.

(3) Auto sales and production. Auto sales have been weak since last summer, mostly because production has been hampered by parts shortages. In other words, the auto industry has been in a recession already, attributable to supply-chain disruptions. But there is plenty of pent-up demand that should boost sales as production ramps up.

(4) Government spending. The pandemic unleashed a torrent of federal legislation to boost fiscal spending in coming months and years on public infrastructure, green projects, semiconductor factories, and grants to fund state and local government spending. In addition, federal defense spending on weapons is likely to boom as inventories (depleted by the Ukraine war) are replenished.

(5) Business spending. Capital spending indicators have been weakening in some areas as economic growth has stalled. However, the “onshoring” of supply chains is likely to boost capital spending. So is a spending boom in the energy sector, particularly on LNG production and export facilities.

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On Blackouts & Liquidity

September 19 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Monetary Policy I: Blackout Period. The FOMC meets on Tuesday and Wednesday. On Wednesday at 2:00 pm, the committee will release its brief statement summarizing its monetary policy response to the latest developments in the economy. The committee will also release its quarterly update of the Summary of Economic Projections (SEP) detailing the “economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, under their individual assumptions of projected appropriate monetary policy.”

Melissa and I often have referred to the Federal Open Market Committee as the “Federal Open Mouth Committee.” Its members like to talk in public all too often, sharing their views about the economy and monetary policy. Fortunately, we get a break during the blackout period stretching from 10 days before to one day after FOMC meetings. The latest blackout period started September 10 and lasts through September 22.

In fact, the Fed chair gets to break the FOMC’s silence with his/her press conference immediately after the committee’s eight meetings per year. Fed Chair Jerome Powell has been the most publicly loquacious of all the Fed chairs. Whereas Ben Bernanke in April 2011 instituted the practice of holding press conferences following four of the eight FOMC meetings each year, Powell in 2019 increased the frequency to after every FOMC meeting. That’s too often, in our opinion. But it does provide Fed watchers, such as yours truly, more to watch and comment on—such as the following observations:

(1) Leaks. Following the release of May’s CPI shocker on Friday, June 10, we concluded that the FOMC was more likely to raise the federal funds rate by 75bps than by 50bps on June 15. Our expectation was confirmed on Monday, June 13, by a WSJ article by Nick Timiraos titled “Fed Likely to Consider 0.75-Percentage-Point Rate Rise This Week.” Nick is the Journal’s ace Fed watcher. In the past, Fed chairs have often provided the financial markets with a heads-up by leaking their latest views to the WSJ—so there are ways around the blackout period. Sure enough, the federal funds rate was raised by 75bps on June 15 and again by 75bps at the July 27 FOMC meeting to a range of 2.25%-2.50%.

(2) Projections. August’s higher-than-expected core CPI inflation rate was released on September 13, i.e., during the latest blackout period. Fed officials are probably beside themselves trying to refrain from commenting on this development, but they’ll have to hold their tongues until Friday, September 23. However, Wednesday’s SEP is likely to show that the FOMC’s median projections for the federal funds rate in 2022, 2023, and 2024 have been raised since June’s SEP. It is widely expected that the FOMC will vote to hike the federal funds rate by 75bps on Wednesday. We are expecting a 100bps hike to 3.25%-3.50%.

We keep track of the changes in the SEP in our FOMC Economic Projections. June’s SEP showed a median of 3.4% for this year, which is likely to be raised. So is June’s 3.8% for next year, most likely to 4.2%.

The question is whether a more hawkish SEP outlook for the federal funds rate will change the committee’s outlook for the economy and inflation. The median projected change for real GDP was cut significantly in June to 1.7% during 2022 from 2.8% in March, and to 1.7% during 2023 from 2.2% in March. We doubt that committee members will lower their relatively low projections during June any further. On the other hand, we won’t be surprised if they raise their consensus estimate of the headline PCED inflation rate for 2022 from 4.3% closer to 5.0%, as inflation continues to be more persistent and higher than they expected. Nevertheless, the committee might stick with next year’s median projection of 2.7% for the headline PCED to signal that they will do whatever it takes to lower inflation.

(3) Guidance. At his July 27 press conference, Powell made clear that he would no longer provide forward guidance about monetary policy. Then he proceeded to provide some of it by saying that if the financial markets wanted guidance, it was right there in the FOMC’s June SEP. He elaborated as follows:

“I think the Committee broadly feels that we need to get policy to at least … a moderately restrictive level. And maybe the best data point for that would be what we wrote down in our SEP at the … June meeting. So I think the median [federal funds rate] for the end of this year … would’ve been between 3¼ and 3½ [percent]. And then, people wrote down 50 basis points higher than that for 2023. So … even though that’s now six weeks old … that’s the most recent reading. Of course, we’ll update that reading at the … September meeting in eight weeks. So that’s how we’re thinking about it.”

(4) Channeling Volcker. In his short but effective speech at Jackson Hole on August 26, Powell recalled that “the successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.”

Powell channeled his inner Volcker by saying: “As former Chairman Paul Volcker put it at the height of the Great Inflation in 1979, ‘Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.’”

That wasn’t the first time that Powell has invoked the wisdom of Volcker. On April 21, in pre-recorded remarks at a special briefing of the Volcker Alliance and Penn Institute for Urban Research, Powell called former Fed boss Paul Volcker, who battled high inflation in the 1970s and 1980s, “the greatest economic public servant” of the era. Volcker raised interest rates to a record 20% in the 1980s in response to the nation’s double-digit inflation. Volcker had known that to save the economy, he needed to stay that controversial course and couldn’t be swayed by political opinion. Back then, we wrote: “Powell’s Volcker Moment may have arrived.”

Monetary Policy II: Terminal Federal Funds Rate. So where is the Fed going? And what are the implications for interest rates? As noted above, the FOMC will update its median projections for the federal funds rate in September’s SEP, which will be released on Wednesday. Powell’s guidance is that we should use that as the Fed’s guidance for the federal funds rate. We expect it will suggest that the terminal federal funds rate during the current monetary tightening cycle will be 4.25%-4.50%.

We can also turn to the financial markets for guidance on the direction of the federal funds rate. Consider the following:

(1) New range. The federal funds target range is currently 2.25%-2.50%. If the Fed hikes by 100bps, as we expect, the range will be 3.25%-3.50%, implying that the terminal rate would require the Fed to raise the federal funds rate by another 100bps to 4.25%-4.50%, either in one shot or incrementally. That scenario is likely to be the one shown by the forthcoming SEP (Fig. 1).

(2) Futures. Weekly data based on the average of daily federal funds rate futures currently show that the 3-month, 6-month, and 12-month futures rates were 3.75%, 4.33%, and 4.26% (Fig. 2). That’s certainly consistent with the SEP’s likely scenario.

(3) Two-year yield. Our favorite market indicator of the outlook for the federal funds rate is simply the two-year Treasury note yield. It tends to be a very good leading indicator for the federal funds rate when it is rising and a coincident indicator of the federal funds rate when it is falling (Fig. 3 and Fig. 4). On Friday, this yield was 3.85%, little changed from Thursday’s 3.87%—which was the highest since October 31, 2007—and up 364bps from a year ago. That’s among the most aggressive hikes in the two-year yield since Volcker was the Fed chair.

(4) Yield curve. The yield-curve spread between the 10-year and two-year US Treasury securities has narrowed since the start of this year and turned negative over the past 11 weeks (Fig. 5). It has done so as the former rose faster than the latter. That implies that fixed-income investors are betting that the Fed’s monetary tightening cycle is likely to end sooner rather than later because interest rates have been raised to levels that are likely to trigger a financial crisis, which could quickly morph into an economy-wide credit crunch and recession (Fig. 6).

(5) High-yield corporate yield. Notwithstanding the warning signal emitted by the yield-curve spread, there’s no recession signal coming out of the high-yield bond market. The yield spread between the high-yield corporate composite and the 10-year US Treasury has widened from 279bps at the start of this year to 519bps on September 16 (Fig. 7). But that’s a relatively modest widening compared with the widenings that occurred during the previous two recessions. By the way, this spread is highly correlated with the S&P 500’s VIX, which also has remained remarkably subdued so far this year (Fig. 8).

Be warned: The yield spread between the high-yield corporate composite and the 10-year Treasury tends to be a coincident indicator of the business cycle, unlike the Treasury yield-curve spread, which tends to be a coincident indicator. By the time the former signals a recession, we’re usually in the thick of it.

(6) Mortgage rates. There is a distress signal emanating from the mortgage market. At the end of last week, the 30-year mortgage rate rose to 6.36%, the highest since November 2008, up 304bps since the start of this year (Fig. 9). Over that period, the 10-year Treasury yield rose 182bps, and the spread between the mortgage rate and the Treasury yield widened by 122bps to 291bps (Fig. 10). The rolling recession is already rolling through (and roiling) the housing market.

US Economy: Plenty Of Liquidity. As noted above, the yield-curve spread is signaling that a credit crisis is becoming more likely as the Fed continues to tighten. In the past, such crises quickly turned into economy-wide credit crunches and recessions. That’s not our forecast. This time is different because the financial system in general and the banking system in particular are in much better shape than during previous tightening cycles. So we expect that the current rolling recession will continue through the end of this year without turning into an official recession. Consider the following:

(1) Lots of excess saving. Consumers saved a lot during the pandemic. That has allowed them to dip into those savings and to reduce their current rate of saving to boost their purchasing power. Over the past 24 months through July, they saved $1.9 trillion, or roughly twice as much as they saved on a comparable basis before the pandemic (Fig. 11). During July, the personal saving rate held at 5.0%, the lowest since August 2009.

(2) Corporate debt refinanced. Over the past 24 months through July, nonfinancial corporations raised $1.8 trillion (gross) in the corporate bond market (Fig. 12). Over the past eight quarters through Q2-2022, their net borrowing in the corporate bond market was $131 billion (Fig. 13). So they refinanced $1.7 trillion of their bond debt at or near record low interest rates!

(3) Better capitalized financials. During August, commercial banks in the US had a near record $2.2 trillion in capital, measured as assets minus liabilities, according to data provided by the Federal Reserve Board (Fig. 14). The ratio of this capital proxy to banks’ loans and leases was 18.7% during August, up from 11.3% during November 2008 (Fig. 15). Banks are much better capitalized now than they were during the Great Financial Crisis (GFC).

(The Fed warns: “This balancing item is not intended as a measure of equity capital for use in capital adequacy analysis.”)

Soaring loan losses caused the earnings of the S&P 500 Financials sector to crater during the Great Financial Crisis (Fig. 16). That forced them to slash their lending activities. That’s not likely to happen this time. Indeed, loans and leases at the banks rose $1,156 billion y/y to a record-high $11.6 trillion during the September 7 week.

(4) Less leveraged real estate. The Fed’s quarterly Financial Accounts of the United States shows that during Q2-2022, household real estate was valued at a record $41.2 trillion with owners’ equity at a record $29.0 trillion and home mortgages at a record $12.2 trillion (Fig. 17). Owners’ equity accounted for 70.5% of the value of homes, the highest since Q4-1984, while mortgages accounted for 29.5% of home values, the lowest since Q4-1984 (Fig. 18).

We conclude that falling home prices certainly will reduce the net worth of households. But they aren’t likely to trigger the credit calamity that occurred during the GFC.

(5) Huge capital inflows. Last (for now) but not least, money from overseas is pouring into the US capital markets, which foreign investors regard as a haven in a world that’s increasingly unsafe for them. Their mantra is “TINAC: There is no alternative country!”

The US Treasury International Capital System (TICS) reported on Friday that private net capital inflows totaled $1.5 trillion over the past 12 months through July, near recent record inflows (Fig. 19). Over this same period, foreigners’ net purchases of US bonds totaled $880.4 billion, while their net equity purchases were -$248.2 billion. The bond purchases included $634.5 billion in US Treasuries, $121.0 billion in agency bonds, and $125.0 in corporate bonds. (See our Treasury International Capital System.)

Movie. “Five Days at Memorial” (+ + +) (link) is a remarkable TV miniseries docudrama about the struggle of doctors, nurses, and staff at Memorial Hospital in New Orleans to care for their patients during Hurricane Katrina, when the facility was without power for five days with very little food or water in oppressive heat. It quickly turns into a life-and-death dilemma for several of the patients, especially once everyone is ordered to evacuate the hospital with several patients not able to do so. The situation raises lots of ethical questions that aren’t easy to answer during such an emergency, especially when the government fails to do its number-one job of protecting its citizens. The cast is superb, and the story is all the more incredible because it’s true.

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MegaCap-8, Strikes & Hydrogen

September 15 (Thursday)

Technology: MegaCap-8 Leading Tech Lower. The elevated inflation readings in Tuesday’s CPI report caused continued MegaCap-8 stock price deflation. The specter of harsher-than-expected Fed tightening is no friend to these high-valuation tech stocks. Once high-flying market leaders, the MegaCap 8—i.e., Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Netflix, Nvidia, and Tesla—collectively has fallen far harder than the broader market in recent days.

Collectively, the MegaCap-8 lost 6.1% on Tuesday and 27.2% ytd through Tuesday’s close—greater than the comparable declines experienced by the S&P 500 (-4.3%, -17.5%, respectively) and the S&P 500 Technology sector (-5.3%, -24.5%) (Fig. 1 and Fig. 2). Individually, only two of the eight outperformed the S&P 500 over one or both of those time spans, Tesla by just hairs and Apple only ytd: Netflix (-7.8%, -63.8%), Nvidia (-9.6, -55.4), Meta Platforms (-9.4, -54.5), Alphabet (-5.9, -27.2), Microsoft (-5.4, -25.1), Amazon (-7.0, -23.9), Tesla (-4.2, -17.1), and Apple (-5.9, -13.4).

Despite its decline over the past year, the MegaCap-8 still makes up 23.1% of the S&P 500’s market capitalization as of Tuesday’s close. That’s down from a peak of 26.4% on November 19, 2021. It’s particularly tough for Growth style investors to avoid these large-cap stocks, which represent nearly half of the S&P 500 Growth index’s market capitalization (Fig. 3).

While each of the MegaCap-8 members has taken it on the chin, the ytd performances of Meta Platforms, Netflix, and Nvidia stocks have been particularly devastating. Earnings forecasts for those companies have been sharply pared back after various Q2 missteps: Meta Platforms’ advertising revenue declined, Netflix shed subscribers, and Nvidia’s earnings growth was hurt by the drop in semiconductor chip sales for gaming PCs.

Analysts’ expectations for the group of eight have become more realistic in the wake of dour earnings news and the stock market selloff. Analysts project long-term (typically three to five years) earnings growth for the MegaCap-8 collectively of 18.6%, down from the peak 38.9% that analysts forecast on April 26, 2019 (Fig. 4). Here’s the long-term earnings growth analysts expect today and what they expected in 2019: Tesla (52.3%, 65.4%), Amazon (33.3, 94.0), Nvidia (23.4, 6.7), Microsoft (15.2, 15.0), Alphabet (13.7, 17.6), Apple (8.8, 13.0) Netflix (7.7, 49.0), and Meta (4.9, 19.1) (Fig. 5).

As forward earnings expectations deflated, so too did forward P/Es (i.e., the share price divided by forward earnings, which is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for this year and next). Following Tuesday’s selloff, the MegaCap-8’s forward P/E is 25.2, down from a peak of 38.5 on August 28, 2020. The S&P 500’s forward P/E of 16.9 as of last Friday declines 1.9 points to 15.0 when these eight stocks are excluded (Fig. 6). During August 2020, the MegCap-8 had added 3.0 points to the S&P 500’s P/E of 22.9. Sometimes, the forward P/E has fallen in recent years because the company started to produce earnings, as was the case with Tesla. But in other situations, the P/E shrank because the stock price fell sharply, as was the case with Netflix and Meta. In nearly all cases, their forward revenue and earnings growth expectations have slowed considerably.

Here are the forward P/Es for the MegaCap-8 members today and on August 28, 2020 when the MegaCap-8 forward P/E peaked: Amazon (72.0, 85.1), Tesla (53.9, 163.2), Nvidia (31.9, 51.7), Microsoft (23.8, 34.7), Apple (23.9, 32.6), Netflix (20.6, 66.1), Alphabet (14.3, 31.2), and Meta (14.3, 31.1) (Fig. 7).

In the couple of years prior to the peaks—i.e., from 2017 through 2019—the MegaCap-8’s collective forward P/E bounced around 24. If valuations revert to that level from 25.2 on Tuesday, the group’s shares would have a bit further to fall, but the distance from that possible foothold is narrower than it’s been for the past two years, since the start of 2020, when the forward P/E was bouncing around 31 (Fig. 8).

US Economy: Keeping An Eye On Labor. With the unemployment rate near historical lows and inflation running hot, unions are pushing for higher wages and better benefits. Railroad conductors across the country, teachers in Seattle, and nurses in Minnesota are on strike or threatening to strike. Tuesday’s report on consumer prices strengthened their requests for higher wages, with headline CPI rising 8.3% y/y in August and the core CPI increasing 6.3% (Fig. 9).

On the other hand, some companies whose employees aren’t represented by unions have started announcing layoffs. That’s particularly true among tech and fintech companies that aren’t profitable and looking to reduce costs. Most recently, software developer Twilio announced plans to cut about 11% of its workers. Job reductions are also occurring at Goldman Sachs, which is facing slow investment banking activity; Best Buy, which warned that electronics sales have faltered; and Ford, which is restructuring its shop to focus on electric vehicles.

Here’s a look at some of recent actions announced or threatened by unions:

(1) Off the rails. Railroads could stop rolling down the tracks on Friday if management and two unions, representing 57,000 conductors and engineers, can’t reach an agreement on attendance policies. The railroads already have reached contract agreements with 10 other unions; but if the two recalcitrant unions go on strike, the other rail workers are expected to stay off the job as well.

The situation is becoming a political mess. After two years of unsuccessful negotiations, President Joe Biden appointed an emergency board in July to mediate. A White House panel recommended a 25% wage increase for workers between 2020 and 2025. Workers would receive a 14% wage increase immediately and five annual increases of $1,000, two of which would be made retroactively, a September 12 WSJ article reported.

In calls on Monday, President Biden pressed both sides to make a deal. And it's expected that the President and/or Congress would act quickly to end any strike that is declared. The railroads move about 30% of America’s goods transported, as measured by ton miles (the length and weight freight travels), and a stoppage would severely disrupt the country’s supply chain.

The potential for a strike is looking serious enough that contingency plans are being made. Amtrack, which runs on some freight lines, canceled some long-distance routes on Monday so passengers in transit wouldn’t be stuck if a strike occurs. White House aides are looking at how essential products—like chlorine for wastewater treatment and coal for utility plants—that normally are carried by rail can be delivered if there’s a strike, a September 13 Washington Post article reported. And some railroads have suspended transporting hazardous material shipments in preparation for a lockout.

(2) Unhealthy relations. About 15,000 nurses in 15 hospitals located in and around two Minnesota cities held a three-day strike that began on Monday in a push for higher wages and better staffing. Hospitals have offered a 10%-12% wage increase over three years, but the nurses want a wage increase of more than 30%, a September 12 ABC News article reported. “Hospital leaders called their wage demands unaffordable, noting that Allina and Fairview hospitals have posted operating losses and that the cost of such sharp wage increases would be passed along to patients,” the article noted. The nurses’ union declined to participate in mediation.

In Wisconsin, a separate group of nurses was expected to go on strike Tuesday before an agreement was reached with University of Wisconsin Hospitals and Clinics Authority. Nurses wanted the hospital to recognize their union—representing an estimated 2,600 of the 3,400 nurses the health care system employs—a September 12 Milwaukee Journal Sentinel article reported. Wisconsin has a law that eliminates most collective bargaining for public employees, but the nurses contend that UW Health is exempt. Hospital officials disagree. Now it’s up to the Wisconsin Employment Relations Commission to rule on the matter.

(3) School’s out. Classes started late in the Seattle area because 6,000 teachers and other school professionals were on strike. A tentative three-year contract was agreed upon late Monday night and now awaits union members’ vote.

The teachers are asking for improved staffing ratios in special education, greater mental health and behavioral resources, and higher wages. A summary of the new agreement showed union members would receive a 7% pay raise this year, 4% in year two, and 3% in year three. The raises could be higher if the state-funded adjustment is higher than what’s in the contract.

(4) UPS unions eye 2023. Contract negotiations between UPS and the Teamsters Union are expected to begin in the spring, prior to the contract’s expiration on August 1, 2023. The union’s president won his position by promising to take a harder line, leading some labor experts to predict a coming strike, a September 6 CNN article reported.

If the approximately 350,000 UPS drivers and package sorters in the union do strike, it will be the largest strike against a single business in US history. The average pay for delivery drivers is $95,000 a year, in addition to benefits that include a traditional pension plan. The majority of the workers who voted on their 2018 contract voted against it. But not enough workers voted to trigger a strike.

“Do our members wake up every day wanting a strike. I’d say no. But are they fed up? Yes, they’re fed up,” Union President Sean O’Brien told CNN. “Whether or not there is a strike, that’s totally up to the company. We’re going to utilize as much leverage as we can to get our members the contract they deserve.” Them’s fighting words.

Disruptive Technologies: Harnessing Hydrogen. Even before Russia choked off natural gas supplies to Europe, hydrogen was getting second and third looks by folks wanting a clean fuel source to power industrial processes. Hydrogen is one of the most abundant elements on Earth and burns cleanly. Yes, the gas is challenging to store. But NASA uses molecular hydrogen to send vehicles into space because it produces more energy for its weight than gasoline or coal. That’s what makes it a good fuel source for energy-intensive industrial processes and moving large items like trains and ships.

Here’s a rundown of some of the latest users and producers of hydrogen:

(1) Using hydrogen on the high seas. Zero Emission Industries has developed hydrogen fuel cells to power large ships. Its first vessel, the Sea Change, is being used as a ferry to transport passengers along the San Francisco waterfront. Zero Emission recently received funding led by Chevron New Energies and Crowley. The company believes its hydrogen-based fuel cells can be used to power cruise ships, yachts, tugboats, port equipment, and container ships, among other things.

The Sea Change went into service this year, but it follows in the wake of a hydrogen-fueled ferry in Norway. The MF Hydra was built for Norled at Westcon Yards and designed by LMG Marin.

(2) Using hydrogen to roll down the tracks. Fourteen hydrogen-powered trains have begun operating in Germany. Built by Alstom, the trains use Cummins fuel cell systems and can operate all day on one hydrogen tank before being fueled overnight at the Linde hydrogen filling station, an August 26 article in PV Magazine reported. Another 27 trains are on order for use in the Frankfurt area.

(3) Using hydrogen in recycling plants. UK-based Romco Metals plans to expand its metals recycling operation in Africa and is working on a project to create green hydrogen to power the furnaces, a September 13 Reuters article reported. The company would use solar power to split water into its hydrogen and oxygen components.

(4) Making hydrogen in Germany. It took about one year for Siemens Smart Infrastructure to build one of Germany’s largest green hydrogen generation plants, Fuel Cells Works reported on September 14. Green hydrogen is generated through electrolysis using renewable power sources. The plant can generate up to 1,350 tons of green hydrogen annually using solar and wind power. The hydrogen can be used to power local glass and ceramics businesses, automotive suppliers, and a local sawmill. It can also be used in vehicles. The hydrogen will be transported by trucks to companies within a 200-kilometer radius of the plant. By 2030, 10 million tons of green hydrogen will be produced in the EU, the article states.

(5) Making hydrogen in Scotland. Scottish Power is building a green hydrogen plant in Suffolk that’s expected to generate 100 megawatts of power by 2026, according to an August 26 article on the AZoCleantech site. The hydrogen produced is to be used to power trains, trucks, and ships. Scottish Power is also building a smaller plant near Glasgow that will be powered by an offshore windfarm. It’s expected to generate enough hydrogen to power 1,300 trucks.

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Corporate Finance Review

September 14 (Wednesday)

On The Road. I read about August’s bearish CPI report on my smartphone as my wife drove us in a rental car from Salzburg to Vienna’s airport Tuesday afternoon to catch a flight back home from our European vacation. I came to the same conclusions as almost everyone else did: The FOMC now is more likely to hike the federal funds rate range by 100bps, to 3.25%-3.50%, than by 75bps at its September 20-21 meeting. That assessment was confirmed by the two-year US Treasury note yield, which jumped from 3.62% on Monday to 3.76% after the CPI report was released. We agree with the market’s perception that 3.75%-4.00% should turn out to be the peak in the federal funds rate. We are likely to see the Fed get there sooner rather than later as a result of the CPI report.

After the report, the yield-curve spread between the 10-year bond and the two-year note widened to -30bps, suggesting that a recession is coming. Debbie and I continue to believe that a “rolling recession,” hitting different sectors of the economy at different times, is more likely than an economy-wide “official recession.” Inverted yield curves tend to predict financial crises that turn into economy-wide credit crunches, which cause recessions. We don’t expect a credit crunch this time for reasons we have discussed before. Below, Melissa reviews the corporate sector’s financial condition and concludes that it remains in very good shape.

In our scenario, we still expect that the S&P 500 will be range bound between the June 16 low of 3666 and the August 16 high of 4305, probably through the end of the year, before rising to a new record high by the end of next year. We expect the 10-year yield to remain around 3.50%.

Corporate Finance I: Profits & Cash Flow. Corporate profits and cash flow reached new highs during Q2. Profit margins were at or near record highs despite rapidly rising costs, which firms so far have been mostly able to pass on to customers. Corporate balance sheets, like their income statements, are also in good shape. A great deal of corporate debt was refinanced at record-low interest rates during 2020 and 2021, and the pace of borrowing is beginning to slow.

The main concern facing most businesses in America is a chronic shortage of labor. Businesses are responding by spending more on capital equipment and technologies to boost productivity, as we discussed in Monday’s Morning Briefing. They are also doing that to bring their supply chains closer to home, as global challenges have forced managements to move away from just-in-time to just-in-case supply-chain management.

From time to time, Melissa and I review the latest developments in corporate finance from a macroeconomic perspective. Here is Melissa’s update starting with profits and cash flow:

(1) Corporate profits. According to the National Income and Product Accounts (NIPA), pre-tax corporate book profits (i.e., as reported to the IRS) during Q2-2022 rose to a new record high of $3.4 trillion (Fig. 1).

Pre-tax corporate profits from current production includes the Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj), which restate the historical-cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current-cost measures used in GDP (Fig. 2). We sometimes refer to this concept as “cash-flow profits.” This measure also reached a new record of $3.0 trillion (saar) on a pre-tax basis during Q2.

(2) Corporate tax rate. Corporate profit taxes totaled $427.5 billion (saar) during Q2, which was near the recent peak during Q4 and the previous two peaks (Fig. 3). This series includes US federal taxes and taxes collected by other domestic and foreign taxing authorities. Yet the effective corporate tax rate was 13.2%, near recent record lows and well below the federal statutory rate of 21.0% (Fig. 4).

Some of the discrepancy between the two rates is attributable to S corporations. Their profits are included in NIPA’s measure of total corporate profits, but their owners pay taxes on the dividends they receive. These taxes are included in personal income taxes, not corporate profits taxes.

Nevertheless, the effective tax rate for the S&P 500 companies, all of which are C corporations, was 18.4% during Q2, also well below the federal statutory rate.

(3) Dividends. During Q2, dividend payments from corporations remained at its previous record high of $1.5 trillion (saar) (Fig. 5). NIPA includes an almost identical series in personal income. Dividends paid by the S&P 500 rose to a record $600.0 billion at an annual rate during Q2.

We have previously estimated that the S&P 500 companies account for about 35% of corporate dividends and other C corporations account for 25%, while S corporations account for the remaining 40% of dividends, based on 2017 data (the latest available). The dividend payout ratio of all corporations has fluctuated around 60% in recent years (Fig. 6). The payout ratio for the S&P 500 has fluctuated around 40%.

(4) Cash flow. Undistributed corporate profits is equal to after-tax profits from current production less dividends (Fig. 7). It remained at a record high of $1.1 trillion (saar) during Q2. It tends to fluctuate much more than dividends do over the course of a business cycle.

Corporate cash flow rose to a record $3.4 trillion during Q2 (Fig. 8). It is equal to undistributed profits plus consumption of fixed capital, or economic depreciation, which totaled $2.3 trillion through Q2. That’s roughly the same as tax-reported depreciation.

Depreciation is the decline in the value of fixed assets due to physical deterioration, normal obsolescence, or accidental damage. In business accounting, tax-reported depreciation is generally measured at the historical cost of the asset, whereas NIPA’s economic measure of depreciation is measured at the asset’s current cost. We like to think of tax-reported depreciation as a huge and legitimate tax-shelter. Depreciation is a substantial cost of doing business that warrants sheltering from taxation, to ensure that companies have enough cash flow to replace worn, obsolete, and damaged plant and equipment.

(5) Profit margin. The NIPA data are often used to calculate a corporate profit margin series that divides after-tax corporate book profit by nominal GDP (Fig. 9). Joe and I prefer the one for the S&P 500. However, it only starts during Q1-1993 and currently is available only through Q1. The NIPA series starts in 1948. The two series are reasonably well correlated but sometimes have diverged. The NIPA series reached a new high of 12.1% during Q2. The S&P 500 margin peaked at a record 13.7% during Q2-2021 and edged down to 12.8% during Q4-2021, but then picked up again to 13.4% during Q2.

(6) Forward profit margins. There’s a much better fit between the S&P 500’s quarterly profits margin and the index’s weekly forward profit margin (Fig. 10). The weekly proxy for the quarterly series shows that it may just be starting to pull back from record-high territory. It was 13.1% during the September 1 week.

Digging into the forward profit margins, industry analysts have been shaving their profit margin estimates for nine of the 11 sectors in the S&P 500 (Fig. 11). Only Energy and Real Estate margins have been revised higher. We aren’t expecting margin estimates to fall much further this year as long as there’s no economy-wide recession.

Corporate Finance II: Buybacks. Progressive economists and politicians frequently rail against corporate dividends and buybacks, claiming that they have accounted for roughly all after-tax corporate profits in recent years, leaving no money for capital spending or better pay for workers. But that stance ignores that dividend payments always come out of after-tax profits, and the payout ratio has been relatively stable over time. Most corporations need to pay a growing, predictable, and competitive dividend return to attract stock investors.

As Joe and I have explained in the past, share buybacks are paid for out of corporate cash flow and/or bond issuance. So they should be compared to cash flow, which includes undistributed profits. Comparing them to profits, as progressive politicians tend to do, does not make sense from a corporate finance perspective. It makes sense only from a political perspective—i.e., as a way to press a progressive political agenda.

Surely, it’s a perspective that helped to pass the excise tax on stock buybacks by corporations included in the Biden administration’s Inflation Reduction Act of 2022. Because it is only a 1% tax, it likely won’t have much impact on corporations’ share repurchase, investment, or spending plans for now. But now that we have the first instance of this tax, the excise tax rate has the potential to go higher, driving up corporations’ effective tax rates.

In any event, most buybacks (as much as two-thirds) are made to reduce a corporation’s share count and thereby counteract the dilution of earnings per share that results from stock compensation. When that’s the case, the buyback is accounted for as a stock compensation expense, requiring no financing out of cash flow or bond issuance! (We’ve discussed this often in the past; see our May 20, 2019 Topical Study titled Stock Buybacks: The True Story.) The only good news is that buybacks related to employee stock compensation plans are exempt from the new tax.

We should have Q2 data on buybacks shortly; but for now, let’s update our previous Q4-2021 analysis with the latest data from Q1-2022:

(1) Aggregate vs per-share earnings growth. Our observation that buybacks counteract dilution effects helps to explain why the spread between the y/y growth rates of S&P 500 earnings in the aggregate and on a per-share basis remains relatively and consistently small, with the two not diverging much despite the hundreds of billions spent on buybacks every year (Fig. 12).

In recent years, from 2012 through 2019, the spread between the y/y growth rates of S&P 500 operating earnings per share and operating earnings in aggregate averaged just 1.2% (Fig. 13). During 2020 and 2021, aggregate earnings rose faster than per-share earnings. In 2021, the difference between the two was 2.9ppts, even though buybacks totaled a record $881.7 billion!

(2) Buybacks in perspective. On balance, buybacks reduced the share count of the S&P 500 by only 8.6% over the period from Q1-2011 through Q1-2022, or less than 1.0% per year (Fig. 14). Over this same period, buybacks totaled $6.7 trillion (Fig. 15). That may seem like a lot of money, but it isn’t relative to corporate cash flow and especially relative to the labor compensation that much of it represents. As mentioned above, a significant portion of buybacks is necessary to avoid the share dilution that results from compensating employees with stock.

(3) Sectors’ share count. The S&P 500 basic share count peaked at 316 billion during Q2-2011 and fell 8.6% through Q1-2022 to 289 billion. Here are the latest percent changes in the share counts since Q1-2011 for the S&P 500 and its 11 sectors: S&P 500 (-8.6%), Communication Services (14.7), Consumer Discretionary (-6.2), Consumer Staples (-12.6), Energy (7.7), Financials (-16.6), Health Care (-7.5), Industrials (-12.4), Information Technology (-23.9), Materials (14.7), Real Estate (56.7), and Utilities (26.7) (Fig. 16).

Corporate Finance III: Capital Spending & Worker Compensation. Contrary to the claim of progressives that buybacks and dividend payouts are occurring at the expense of spending more on workers and on productivity-enhancing investments, there is plenty of cash flow left for funding these things. Capital spending has been on the same solid uptrend for many years, rising to another record high at the end of last year (Fig. 17). During Q2, the cash flow of nonfinancial corporations (NFCs) was $2.8 trillion (saar), well exceeding NFCs’ capital spending of $2.9 trillion (saar) (Fig. 18).

Furthermore, inflation-adjusted compensation per employee (using the household measure of employment) has been trending solidly upward for many years. It fell only slightly from a recent peak during the pandemic (when expanded benefits were extended) and returned to historical norms through July (Fig. 19).

Corporate Finance IV: Securities Issuance & M&A. The Fed’s Financial Accounts of the United States includes lots of data tracking the activities of NFCs in the capital markets. Here’s an update through Q1-2022:

(1) Equities. The four-quarter sum of NFCs’ gross equity issuance cooled slightly through Q1-2022, though remained near record territory, totaling $456.0 billion, including initial public offerings (IPOs), seasoned equity offerings (SEOs), and private equity (PE) (Fig. 20). Equity retirements totaled a record $1.3 trillion. Of that, stock repurchases accounted for a record $714.1 billion and M&A-related equity retirements accounted for $547.9 billion (Fig. 21).

Net issuance, which is the difference between gross issuance and retirements, totaled -$819 billion in the four quarters ending Q2-2022, the lowest on record (Fig. 22). It’s important to note that the Fed’s accounts do not include employee stock plans. So it’s impossible to assess how much of the repurchases reduced the share count or offset stock issuance by such plans.

(2) Mergers & acquisitions. M&A activity in the US slipped to an eight-quarter low of $463.86 billion during Q2-2022 (Fig. 23). The Russian invasion of Ukraine and rising interest rates likely put some deals on hold. We still expect that this year’s M&A activity in the US will remain around last year’s record $2.6 trillion pace.

It’s worth noting that August has seen the best monthly deal activity since 2021, according to data compiled by Bloomberg, which attributed the big causes for previous delays or terminations of pending transactions to stock market volatility and financing disruptions, which deal makers now have a better handle on.

(3) Bonds. During the pandemic-challenged 24 months through June 2021, NFCs raised a record gross $2.5 trillion in the bond market (Fig. 24). That figure dramatically came off record highs to $1.8 trillion in the 24 months through July. Net borrowing was $0.1 trillion over the eight quarters through Q2. These numbers imply that a record level of bonds was refinanced at the record-low yields of the past two years, and that the pace of borrowing is beginning to taper off with interest rates on the rise (Fig. 25).

Corporate Finance V: Balance Sheets. Finally, the Fed’s data show that NFCs’ short-term debt divided by their credit market debt is relatively low around 30%-35% as of Q2-2018 (Fig. 26). Slightly concerning is that their liquid assets divided by their short-term liabilities recently has declined during the H1-2022 (Fig. 27). Yet we attribute that to the fact that the Fed includes stocks held by corporations in the measure of liquid assets.

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Keeping Up With The Joneses

September 13 (Tuesday)

US Consumers I: How Are They Doing? There has been a huge debate in the US about whether the economy is in a recession or will soon be in one. Everyone seems to agree that there was a “technical” recession during the first half of this year because real GDP fell 1.6% (saar) during Q1 and 0.6% during Q2. Since those are minor declines, the presumed recession could easily vanish once the data are revised. Indeed, the preliminary estimate for Q2 was revised from -0.9% to -0.6%. As we noted in the August 29 Morning Briefing, the gap between gross domestic income and gross domestic product has widened over the past seven quarters through Q2-2022 by more than ever before, also raising the possibility that the latter will be revised upward.

Now let’s focus on the outlook for consumer spending, since it is the main driver of GDP in America:

(1) Consumer spending holding up. Consumer spending accounted for 68.0% of nominal GDP in the US during Q2 (Fig. 1). That’s up from 58.5% during Q1-1967. It’s hard to have a recession in the US unless consumers retrench. In the past, that’s happened whenever they were losing jobs. During the first eight months of this year, payroll employment rose 3.5 million to a record 152.7 million (Fig. 2). As a result, consumer spending held up quite well during the first half of this year, rising 1.8% and 1.5% during the first two quarters (both q/q, saar).

(2) Consumers are depressed. Nevertheless, rising inflation has been depressing the Consumer Sentiment Index (CSI), while solid employment gains have been boosting the Consumer Confidence Index (CCI). Over the years, Debbie and I observed that the CSI is more sensitive to inflation, while the CCI is more sensitive to employment. That’s why we like to average the two to derive our Consumer Optimism Index (COI) (Fig. 3).

The COI rebounded smartly last year through June to 107.2, but then it declined as bad news on inflation had a negative impact on all consumers, while the good news on jobs impacted mostly the newly employed. It fell to this year’s low of 73.4 during July. It edged back up to 80.7 during August.

(3) Inflation has been depressing purchasing power. Rising inflation depresses consumers because it reduces the purchasing power of their incomes. Core personal income (excluding government social benefits to persons) rose 7.6% y/y through July but only 1.2% when adjusted for inflation (Fig. 4). Disposable income (DPI)—which is personal income including benefits and less taxes—was up 2.3% y/y through July but down 3.7% after adjusting for inflation (Fig. 5).

Average hourly earnings (AHE), a measure of hourly wages, is up 6.0% y/y through July but flat on an inflation-adjusted basis (Fig. 6).

It’s no wonder that the CSI, CCI, and COI all show that consumers are very depressed. So how did consumers manage to increase their real outlays on goods and services during the first half of this year and by 2.2% y/y through July (Fig. 7)?

(4) Excess saving and saving less. Consumers saved a lot during the pandemic. That has allowed them to dip into those savings and to reduce their current rate of saving to boost their purchasing power. Over the past 24 months through July, they saved $1.9 trillion, or roughly twice as much as they saved on a comparable basis before the pandemic (Fig. 8). During July, they lowered their pace of saving to $0.9 trillion (saar), the lowest since December 2016. That’s not likely to be sustainable.

(5) The future of purchasing power. So what will keep consumers spending? Job gains are likely to remain strong given that job openings well exceed the number of unemployed workers. The labor force participation rate might continue to rebound. It was 62.4% in August, still below the 63.4% reading during January and February 2020, just before the pandemic. Most importantly, we think is that wage inflation may be starting to outpace price inflation, boosting the purchasing power of households. Admittedly, that forecast is supported by just two data points, both during July: AHE rose 0.5% m/m, while the PCED edged down 0.1%.

US Consumers II: How Do They Allocate Their Budgets? We’ve previously observed that American consumers are born to shop. They do so when they are happy, and many do so even more when they are depressed, for the dopamine that shopping releases in their brains. It makes them feel good. When faced with rapidly rising prices, consumers seem to reason that they’d better buy before prices go even higher. However, they must have enough purchasing power to do so. So far, so good, as suggested by our analysis above.

What do they buy? It must be much more than groceries and gasoline, which aren’t likely to release much if any dopamine. Let’s examine the budget of the average household in America (“the Joneses”) with two different but related sets of data. The first set is average spending per household (in current dollars and at an annual rate), available through July. The second set is the shares of various spending categories as percentages of DPI. Let’s take a look:

(1) Income, taxes, and saving. During June, there were a record 128.1 million households in America. The Joneses had personal income of $169,770 during June and disposable income of $145,240, after paying $24,530 in taxes (Fig. 9 and Fig. 10).

The 12-month average of annualized personal saving per household spiked to a record-high $27,600 during March 2021 as a result of the lockdown recession and three rounds of government pandemic support checks (Fig. 11). It was down to $10,000 during June, the lowest since February 2020, just before the lockdowns. For all households, personal saving accounted for 7.8% of DPI. So personal consumption accounted for 92.2% of DPI. (The savings rate is 100 minus the consumption rate.)

(2) Major consumption categories. Total consumption per household rose to a record-high $134,000 during June (Fig. 12). Here are the amounts and DPI budget shares of the three major categories of consumption: durable goods ($16,700 in June, 11.6% in July), nondurable goods ($30,000, 20.4%), and services ($87,300, 60.2%).

(3) Durable goods. From the Great Financial Crisis in late 2008 through just before the start of the Great Virus Crisis, the share of DPI spent on durable goods was remarkably flat around 9.5% (Fig. 13). Once the lockdowns were gradually lifted, the demand for consumer durable goods soared along with their prices, especially relative to services, which took longer to reopen. As a result, the share of DPI spent on durable goods shot up to 11.6% over the past year through July.

Here’s what the Joneses spent on various durable goods during June (on average and at a seasonally adjusted annual rate): used cars & light trucks ($1,900), new cars & light trucks ($3,000), furniture & furnishings ($2,500), household appliances ($600), and recreational goods and vehicles ($4,750).

(4) Nondurable goods. There was a significant downtrend in the share of DPI spent on nondurables from 35.6% at the start of the data in 1959 to 18.3% at the end of 2019, just before the pandemic. The same can be said for the share of outlays on food and energy, which fell from 28.7% in 1959 to 14.9% at the end of 2019 (Fig. 14). It jumped to 16.8% for these essentials as their prices rose faster than most other prices during July of this year.

During June, the Joneses spent a record $18,100 on food, with $10,200 in groceries “purchased for off-premises” consumption (i.e., at home) and $7,900 for purchased meals and beverages (at restaurants and included as services in the government’s accounts). They spent $4,300 on gasoline and other energy goods. The Joneses purchased a record $3,900 in clothing and footwear and $5,000 in pharmaceutical and other medical products.

(5) Services. During July, Americans spent more on health care services than they did on rent. That might not surprise anyone, but notably rent includes both tenant rent and imputed owners’ equivalent rent (OER). That last category is a figment of the imagination of the government’s bean counters, who need to assign a charge to homeowners for housing services they receive from themselves. According to them, a homeowner is both a renter and a landlord.

So here are the DPI shares of some of the major categories in services as of July: OER (10.4%), tenant rent (3.3), household utilities (2.3), health care services (14.4), transportation services (2.9), recreation services (3.1), food services and accommodations (6.5), financial services and insurance (6.8), other services (7.4).

Here is what the Joneses spent on these categories during June: OER ($15,000), tenant rent ($4,800), household utilities ($3,350), health care services ($20,900), transportation services ($4,225), recreation services ($4,500), food services and accommodations ($9,400), financial services and insurance ($10,000), other services ($10,650).

US Consumers III: Are They Better Off Or Worse Off? The analysis above was based on consumer income and spending data in current dollars. The shares of DPI does adjust for inflation, since the numerator reflects the prices of the spending categories while the denominator reflects the overall consumer price level (i.e., the PCED).

To get a better idea of whether the standard of living of the Joneses has been increasing or decreasing over time, we divide inflation-adjusted total personal income, disposable income, and consumption by the number of households (Fig. 15). All three series have been on solid upward trends since 1968. The first two have been declining over the past year as inflation reduced the purchasing power of consumer incomes. Nevertheless, average real consumption per household was little changed during June from April’s record high of $109,025.

We conclude that the Joneses have never been better off based on inflation-adjusted consumption per household. We recognize that this flies in the face of conventional wisdom, especially on the left side of the political spectrum. Progressives will quickly note that the rich are skewing the income data since they are based on means rather than medians. Maybe so, but average real consumption per household surely isn’t biased by the rich. That’s because there aren’t enough of them to make much of a difference to this average and because they don’t consume much more of the categories reviewed above than the rest of us do.

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What’s The Matter With Productivity?

September 12 (Monday)

YRI Monday Webcast. Dr. Ed is on vacation. Join his webcast next Monday at 11 a.m. EST. Replays of past Monday webinars are available here.

On The Road. My wife and I are sightseeing in Budapest, Bratislava, and Salzburg. In Hungary and Slovakia, we heard about the tidal wave of refugees from Ukraine earlier this year. We were also told that many of them moved on to some of the bigger and more prosperous countries in Europe, presumably with more supportive social welfare programs. Our tour guides said that the end of communism in their countries in the early 1990s was at first a terrible shock to their economies, causing widespread unemployment. But then Western business interests started investing in their countries. So now they are experiencing better economic times and are greatly enjoying their freedom from communism. Under communism, everybody worked, but nothing worked, we were often told. Both Budapest and Bratislava are very beautiful cities on the Danube River.

Productivity I: Pandemic Shock. Debbie and I continue to believe that chronic labor shortages are likely to force businesses to spend more on technology and capital equipment to boost productivity, subduing inflation. That’s the key driver of our “Roaring 2020s” scenario. How’s it working out so far? Not so well: The pandemic made a mess of the first three years of the decade; as a result, the past year has looked more like the Great Inflation of the 1970s on fast-forward than like our happier scenario. The good news is that we still have seven more years before the end of the 2020s, and we are sticking by it for the rest of the decade.

Let’s review quickly how the pandemic derailed the happier scenario. Labor shortages were exacerbated by the pandemic because of lockdowns and the slow reopening of many businesses. The pandemic also contributed to supply-chain disruptions and parts shortages. Productivity rose rapidly during the lockdowns as employment fell faster than economic output dropped. During the post-lockdown recovery, many workers left jobs and stayed home for various reasons related to the pandemic. For example, many parents had to stay home to provide childcare because the schools were closed and offered only remote learning. As companies scrambled to reopen, many had to increase their wages to keep and attract workers. As a result, many workers quit their jobs for more pay at another job.

For now, the tight labor market is contributing to the wage-price-rent spiral that has spiraled seemingly out of control over the past 12 to 18 months. Wages have risen rapidly. However, real wages have stagnated because prices have risen as fast as wages. The fact that real wages have been flat confirms that productivity has failed to move higher. Nevertheless, the recent data hold a glimmer of hope that real wages are starting to move higher again along with productivity. Let’s have a look at the data that are most relevant to our discussion:

(1) Chronic labor shortages. Just before the pandemic started, the unemployment rate fell to 3.5% during January and February 2020 (Fig. 1). That was the lowest reading since 1969. As a result of the lockdowns, the unemployment rate soared to a post-WWII record-high 14.7% during April 2020. Remarkably, it was back down to 3.7% during August.

The labor force participation rate (i.e., the labor force as a percentage of the civilian working-age population) hasn’t fully recovered from the pandemic. It was 62.4% during August, a full point below the 63.4% during the first two months of 2020 (Fig. 2). The unemployment rate would have risen much higher if the labor force hadn’t dropped by 8.2 million workers from January through April 2020.

The labor force has recovered to a new record high, hitting 164.7 million in August, which is only 113,000 above its previous record high right before the pandemic. The growth rate in the 12-month average of the civilian working-age population was just 0.8% y/y in August (Fig. 3 and Fig. 4). The rebound in the labor force participation rate from 61.7% a year ago boosted the growth rate of the labor force to 1.6% in August.

Nevertheless, it’s clear that the demand for labor well exceeds the supply of labor. July's JOLTS report showed that there were 11.2 million job openings for 5.7 million of the unemployed (Fig. 5). In addition, the Consumer Confidence Index (CCI) rebounded slightly from July's low, as only 11.4% of CCI survey respondents said jobs are hard to get (Fig. 6). The percent of small business owners saying they have job openings has hovered near 50% for the past 12 months through August.

(2) Productivity hits the skids. During Q2-2022, nonfarm business (NFB) productivity fell 2.4% y/y, the lowest growth rate since the start of the data in 1948 (Fig. 7). That’s partly because productivity jumped by 1.9% y/y during Q4-2021. And that’s because real NFB output, which closely tracks real GDP, rose faster than hours worked right after the pandemic; but it has slowed in recent quarters relative to hours worked (Fig. 8). We expect that productivity growth will recover over the rest of this year and through next year as NFB output outpaces hours worked.

(3) The big picture. The growth rate of productivity is very volatile on both a q/q and y/y basis. That’s why Debbie and I keep track of the average annual growth rate of productivity over 20-quarter periods (Fig. 9). That data series clearly shows the productivity cycles since 1952. The current cycle bottomed at 0.5% during Q4-2015 and rose to a recent peak of 2.0% during Q2-2021. The big drops in productivity during H1-2022 depressed the 20-quarter average to 1.3%.

Nevertheless, we think that the current cycle will boost productivity to 3.5%-4.0% once our Roaring 2020s scenario gets going over the rest of the decade. That might sound like a stretch, but it is consistent with the peaks of the past three cycles in productivity growth. We certainly don’t expect a repeat of the collapse in productivity growth that occurred during the Great Inflation of the 1970s.

(4) The real Phillips curve. During the 1970s, the labor force grew rapidly as the Baby Boom generation started to enter the labor market. Tight monetary policies back then depressed the economy and pushed the unemployment rate higher.

Historically, we’ve found that a high (low) unemployment rate is associated with weak (strong) productivity growth (Fig. 10). Nominal wages do rise at a faster pace in tight labor markets, but so does productivity, which is the ultimate determinant of real wages. This is confirmed by the average annual growth rate of inflation-adjusted hourly compensation over 20-quarter periods, which tracks the comparable growth rate in productivity (Fig. 11). As goes productivity, so goes real hourly compensation.

The macro-economic textbooks all discuss the Phillips curve, which posits that there is an inverse relationship between the unemployment rate and wage inflation. Phillips curve discussions almost always fail to incorporate the inverse relationship between unemployment and real hourly compensation. The latter tends to grow faster (slower) when the labor market is tight and productivity is growing faster (slower) (Fig. 12).

(5) Inflationary consequences. The pandemic has scrambled the economy. The labor market is very tight as a result of the excessively stimulative fiscal and monetary policy responses to counter the depressing impact of it on the economy. Wages have increased at a faster pace, but the result has been a wage-price spiral with inflation-adjusted wages stagnating for the past year (Fig. 13). Inflation-adjusted wages (using average hourly earnings for production and nonsupervisory workers) was flat over the 12 months through July. Real hourly pay should resume its annualized average 1.2% growth trend (which started around 1994) as the pandemic’s adverse impact on productivity dissipates.

The wage-price spiral is a wage-price-productivity spiral, as we saw during the 1970s. Productivity growth collapsed back then. The labor market wasn’t tight, but it was significantly unionized. So the decade’s food and energy price shocks were almost immediately passed through to wages by cost-of-living adjustments in union contracts.

This time, the pandemic exacerbated the underlying chronic labor shortage and temporarily (in our opinion) depressed productivity, sending prices and wages soaring together.

There is a very strong correlation between the inflation rate of the implicit price deflator of the nonfarm business sector and the inflation rate of unit labor costs in the sector, i.e., the ratio of hourly compensation to productivity (Fig. 14). This relationship is more significant than that of the Phillips curve—in that sense, it’s the “real Phillips curve.”

Productivity II: The Manufacturing Problem. It is widely believed that services is the economic sector with the worst productivity performance. That’s not correct. The biggest problem has been in manufacturing. It started at the end of 2001, when China joined the World Trade Organization (WTO). Prior to that event, manufacturing productivity almost always grew faster than nonfarm business productivity (Fig. 15). Since then, manufacturing productivity growth has dropped significantly. Since 2014, it has stayed mostly below zero and below the growth rate of the broader measure of productivity.

From 1948 through the end of 2001, manufacturing production and capacity expanded at an average annual rate of about 4.0% (Fig. 16). Ever since China joined the WTO, manufacturing production and capacity both have been flatlining.

The obvious explanation for the stalling since 2001 of US manufacturing capacity—and subsequently US productivity—is that lots of manufacturing capacity was moved to China after the country joined the WTO in late 2001.

Now the escalating Cold War between the US and China may very well cause more US companies to move their production out of China and back to the US. The Chinese government’s increasing hostility toward capitalism (i.e., property rights and the sanctity of contracts protected by the rule of law) and terrible handling of the Covid pandemic also are likely to stimulate more onshoring by US firms.

There isn’t any evidence of this happening yet in the monthly manufacturing capacity data, which remain at the same levels as when China entered the WTO. Nevertheless, some indicators suggest that manufacturers and other businesses in America are expanding their capacity domestically and spending more on technology and capital equipment to boost their productivity:

(1) Technology. Over the past seven quarters through Q2-2022, technology has been around a record 52% of total capital spending (in current dollars) (Fig. 17).

(2) Capital equipment. Over the past 24 months through July, new orders for industrial, metalworking, and material handling equipment soared by 67% (Fig. 18). Some of that increase reflected higher prices; but even so, the real increase undoubtedly has been significant.

(3) Factories. Construction put in place for both manufacturing and commercial structures rose to record highs during July (Fig. 19).

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Bad Times In Europe & China

September 08 (Thursday)

Europe: Gas Crisis. On Friday, Russia extended its suspension of natural gas deliveries to Germany through Nord Stream I indefinitely, in reaction to the G-7’s plan to cap oil prices. The move sent energy prices surging in Europe once again. The Dutch month-ahead wholesale natural gas price was up 30% in early trading on Monday. But it’s notable that even after the recent pop, the Dutch gas price remains 29% off its August 26 peak (Fig. 1). Likewise, even as OPEC announced a 100,000 bpd cut to production on Monday, the price of Brent crude oil futures remains 27% below its 2022 peak of $127.98 per barrel (Fig. 2).

Governments have scrambled in recent days to engineer plans to help their citizens pay to stay warm and keep the lights on this winter. They are also coming to the rescue of utilities facing margin calls as the market moves violently. Here’s a roundup of the latest moves:

(1) New British PM goes to work. New British Prime Minister Liz Truss hadn’t yet stepped foot into 10 Downing Street when her plan to help British citizens afford energy was floated in the news.

A typical British household’s gas and electricity bill is expected to rise from £1,971 to £3,549 in October. The government is expected to subsidize bills over £2,500, a September 6 BBC article reported. The news agency didn’t know how long the government will provide support, but the total package is expected to cost about £100 billion; the exact tally depends on gas and electricity prices this winter and how much additional support is offered to the most vulnerable citizens. The plan’s details are expected to be released today. The price tag could also rise when the government announces how it plans to support businesses, many of which have fixed-rate deals that expire this October.

The government is expected to borrow to pay for the plan. There’s some concern about the UK’s debt levels since it already borrowed £60 billion to £70 billion to fund the Covid furlough plan, and it’s expected to borrow more to fund tax cuts and increased defense spending. The British pound has fallen to its lowest level against the dollar since 1985 (Fig. 3).

(2) Third time’s a charm? Germany said on Sunday that it will spend at least €65 billion ($64.7 billion) on a package of payments to the most vulnerable citizens and tax breaks to energy-intensive businesses. This is the country’s third round of support related to the energy crisis.

The government will make one-off payments to pensioners, people on benefits, and students, and the country will cap energy bills, said German Chancellor Olaf Scholz according to a September 5 BBC article. The country also plans to give tax breaks to about 9,000 energy-intensive businesses valued at €1.7 billion. These plans would be funded in part by a windfall tax on energy companies and implementing a 15% global minimum corporate tax.

Including this new package of subsidies and payments, Germany will have spent about €100 billion to give its citizens relief from surging energy prices. That follows the €300 billion the country spent on Covid relief.

Germany’s gas storage has reached 85% of capacity on Saturday, a month earlier than expected thanks in part to corporations’ consumption reductions. The country also announced intentions to keep two nuclear plants open in reserve mode beyond their scheduled closures around year-end. Germany uses the euro, which has dropped to a 20-year low against the dollar (Fig. 4).

(3) Countries funding utilities’ margin calls. EU energy ministers are set to meet on Friday to discuss how to “ease the burden of energy prices across the bloc,” the September 5 BBC article reported. Price caps on imported gas and emergency liquidity support for energy market participants are on the agenda, a September 4 Reuters article stated.

European power producers are facing a major cash crunch as margin calls on their hedges are forcing them to pony up more cash. The September 4 Reuters article explained: “Utilities sell most of their power a few years in advance to guarantee a certain price, in an arrangement which requires them to deposit a ‘minimum margin’ into an account as a safety net in case they default before the power is produced and actually enters the market.

“A margin call occurs if the funds in the account fall below the minimum margin requirement for a trade, forcing the company to secure it with more cash. Soaring European power prices in recent months have triggered margin calls, putting a liquidity squeeze on market participants.” Norway’s Equinor ASA told Bloomberg on Tuesday that margin calls for European energy trading totaled at least $1.5 trillion and warned that cash shortages at the utilities could lead to a “Lehman Brothers” moment.

Countries have rushed to provide support. Germany has earmarked €7 billion in loans for companies, including utilities, that face liquidity issues. Germany’s Uniper SE last week requested another €4 billion of funding in addition to the €9 billion it had previously received, the Bloomberg article noted. Austria provided a €2 billion credit facility to cover the trading positions of Vienna’s municipal power utility.

Switzerland’s largest renewable electricity producer, Axpo, and Finnish utility, Fortum, said Tuesday that they’ve been granted new state-backed credit lines totaling €33 billion. And Centrica, owner of British Gas, is in negotiations with bankers to line up additional credit lines. Also, the EU is considering offering pan-European credit-line support for energy market players facing margin calls, the September 4 Reuters article explained.

(4) Companies take it on the chin. Companies across the continent are feeling the pinch of higher energy prices. Dutch bakery owners will have to shut their doors if prices stay this high for much longer, reported a September 6 Reuters article. Many bakers have power contracts that are set to expire. Their monthly bills could jump from €3,000 to €30,000. That’s a lot of dough.

Dutch online grocery delivery company Picnic is halting deliveries of frozen foods, like frozen pizzas, meals, and ice cream. It’s no longer economical to buy dry ice because high energy prices have hurt their dry ice supplier so much, the Reuters article reported.

Energy-intensive smelters continue to shut down. The latest moves come from Slovenia’s Talum, which is cutting production to a fifth of capacity, and Alcoa, which is closing one of its lines in its Lista plant in Norway, a September 1 Reuters article reported. Almost 1 million tonnes of European primary aluminum capacity has been closed so far. However, reduced production in Europe and the US has been more than offset by increased production in China, Reuters noted. And that helps to explain why the price of aluminum has fallen 19% ytd (Fig. 5).

China I: Covid Strikes Again. Chinese officials undoubtedly want to put on a good show when the Chinese Communist Party meets in Beijing on October 16. They don’t want Covid cases to distract from the party’s shindig. So let’s shine a light on what Chinese leaders would like everyone to ignore.

China only has 1,695 Covid cases as of October 6, but officials have shut down cities and encouraged citizens not to travel during the upcoming holiday weekend. It all seems so 2020.

At least 34 cities are partially or completely locked down, including Tibet’s Lhasa, Qinghai’s Xining, Xinjiang’s Urumqi, Henan’s Shijiazhuang, Guizhou’s Guiyang and Heilongjiang’s Harbin, according to a September 6 Asia Times article. It explains that many cities have adopted a “silent management mode” policy, which requires daily Covid tests, avoiding leaving home except for essential activities, and refraining from gatherings.

Shenzhen, which had 36 Covid cases on Monday, adopted the silent management mode. It closed its entertainment premises, encouraged workers to work from home, and halted restaurant dining and most subway lines. One girl tested positive in Shanghai on Tuesday. But instead of locking down the whole city, the government responded just by requiring residents in two districts to complete two Covid tests in three days.

Chengdu, a city with 21.2 million residents in southwestern China, has been locked down since last Thursday, a September 7 Reuters article reported. There was outrage over pictures showing people forced to stay in their residences even as the city was being hit by a 6.8 magnitude earthquake on Monday. Authorities subsequently said that residents under Covid lockdown may leave their homes during emergencies such as earthquakes.

Beijing had 14 locally transmitted cases reported on Tuesday. In Yizhuang, an economic and technological development zone outside Beijing, Communist Party officials and residents were told not to leave unnecessarily during the mid-autumn festival or the week-long holiday in early October, in an effort to “create a safe and stable social environment for the party congress.” Chinese officials undoubtedly have been concerned as they’ve watched new Covid cases in Hong Kong recently surge past 10,000 a day.

China II: UN Confirms Human Rights Violations. A United Nations’ August 31 report concludes that there were “serious human rights violations” in the Xinjiang Uyghur Autonomous Region (XUAR) from 2017 to 2019 related to the government’s counter terrorism and counter extremism policies affecting Uyghur and other predominantly Muslim communities. The Chinese government “indicates” that all the detainment centers used in its counter-terrorism program are closed and no longer in use. But the UN hasn’t been given access to the region to confirm the assertion.

The UN report recommends that: 1) China release people held in violation of their human rights and amend its policies; 2) businesses determine whether the companies they do business with are respecting human rights; 3) surveillance and security companies assess whether their products and services could contribute to human rights abuses; and 4) the international community support efforts to promote human rights in the XUAR region, refrain from returning members of the Uyghur and Muslim minorities to China, and provide them with medical and psychological support.

While calling out China’s human rights violations is important, the report’s recommendations lack any enforcement or punishment mechanism. That said, let’s dive into its findings:

(1) Some background. XUAR is China’s largest region, covering one sixth of the country and home to 25.9 million people. In 1953, the region’s population was 75% Uyghurs and 7% Han, China’s predominant ethnic group. Today, XUAR’s population is 45% Uyghur and 42% Han, presumably because of government incentives to encourage Han migration into the area and potentially because of government policies that have limited Uyghur childbirth.

In 2018, the UN Committee on the Elimination of Racial Discrimination estimated that the number of people detained in the XUAR region ranged from tens of thousands to over a million; some researchers put the figure closer to 10%-20% of the area’s adult Uyghur population, which at the high end is roughly 2 million people. The Chinese government has declined to release any data.

In addition to finding documents describing Chinese policies in the region, the UN interviewed 40 individuals with direct knowledge of what was occurring, both detainees and workers.

(2) Training or detention. In 2018, China acknowledged the existence of Vocational Education and Training Centers (VETCs). The following year, China said that it had established the centers to “eradicate the breeding ground and conditions for the spread of terrorism and religious extremism.” The centers are residential, and individuals are given a choice between going there or to a prison. Interviewed detainees said they were not allowed to leave the facilities, which were staffed by armed guards. To visiting foreign delegations, one former detainee was instructed to say that everything was fine and that they were allowed to return home at night. They stayed in the centers anywhere from 2-18 months.

People were “referred” to VETCs for reasons as innocuous as having too many children, being an unsafe person, being born in certain years, wearing a veil or beard, having applied for a passport but not having left the country, being an ex-convict, having foreign connections, attempting to cancel their Chinese citizenship, having dual registration in a neighboring country, having downloaded WhatsApp, and simply to fulfill a quota.

Detainees were not told what their offenses were but were asked to choose them from a list. One interviewee said, “I was not told what I was there for and how long I would be there. I was asked to confess a crime, but I did not know what I was supposed to confess to.” They did not appear to have access to lawyers.

At the centers, detainees were tortured, interrogated, indoctrinated in political teachings, and “rehabilitated” in a program based on self-criticism. They were denied food, forbidden to speak their own language or pray, and administered injections or pills that made them drowsy. Blood samples were collected regularly. Women reported instances of rape. Families often were not told where their relatives were being held, and a registry of thousands of missing people in Xinjiang has been created by exiled family members.

(3) Religious restrictions & surveillance. Separately, the report found increasing restrictions on Muslim religious practices in the region. Islamic religious sites have been destroyed, and the Uyghur language is prohibited. The UN has not been given access to the region to investigate these reports.

The government also has installed a large surveillance system across the region developed with the help of private technology companies. It includes using biometric data collection, including iris scans and facial imagery, a large network of surveillance cameras, and broad access to “personal communication devices and financial histories.” The system informs authorities when Islamic religious materials are downloaded and when residents communicate with people abroad. Both actions could trigger government detainment.

The report noted that the birth rate for Uyghurs dropped sharply from 2016 to 2018, far more sharply than births declined in China overall. There was also a sharp rise in sterilizations and IUD placements in XUAR in 2017 and 2018. In 2018, 243 per 100,000 inhabitants of XUAR were sterilized compared to 32.1 per 100,000 in China as a whole. These data suggest what interviewees confirmed: Minority women were subjected to forced abortions, sterilizations, and IUD placements after families reached permitted numbers of children. Women spoke of harsh punishment, including internment, for violating family planning policy.

The report also notes indications that the government has forced minorities to work and linked those work programs to the VETC system.

It’s almost assured that this report will not be on the agenda when the Chinese Communist Party meets on October 16.

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Can TINAC Survive A Global Recession?

September 07 (Wednesday)

Global Economy I: Bad News. Over the long US weekend, the odds of a global recession increased significantly. Europe is facing soaring power costs and rationing as Russia continues to reduce its exports of natural gas to the region. China’s haphazard “zero Covid” policy is depressing the country’s economy, as is the country’s ongoing property market debacle. OPEC+ reduced its production target minimally for October, signaling that the cartel is more concerned about propping up oil prices than it is about a global recession that would reduce oil prices along with oil demand.

Consider the following:

(1) Europe. Russia cut its main natural gas pipeline to Europe on Monday. The September 5 WSJ observed: “The cutoff, which the Kremlin blamed Monday on Western sanctions and said would be long-lasting, realizes the worst-case scenario Europe had been girding for since Russia invaded Ukraine in February.” Electricity prices are soaring in the region.

After the financial markets closed last week, Russia’s state-controlled Gazprom announced the shutdown of the Nord Stream pipeline to Germany. Kremlin spokesman Dmitry Peskov said Monday that problems pumping gas “arose due to the sanctions imposed against our country and against a number of companies by Western states, including Germany and Great Britain.” He added, “We insist that the collective West, in this case the European Union, Canada, Great Britain, are to blame for the situation having reached the point where it is now.” Gazprom said the Nord Stream closure would last indefinitely.

Until recently, Nord Stream was the main transit route for Russian gas, which met about 40% of the European demand before Russia invaded Ukraine.

(2) China. The latest result of China’s “zero Covid” policy is that some 60 million people across China are facing partial or full lockdowns, according to Chinese media, from Chengdu to the southern economic powerhouse of Shenzhen to the oil-producing city of Daqing near Russia. The number of infections remains relatively small, with about 1,500 new cases on Sunday.

The September 5 NYT reported, “Nearly three years of on-and-off lockdowns have lashed the economy, sending unemployment soaring, especially among young people. The country is increasingly isolated, as the rest of the world largely abandons Covid restrictions. New subvariants are ever more transmissible. And the seemingly endless restrictions leave more ordinary Chinese people wearier by the day.”

The lockdowns are only exacerbating the woes in China’s property market. Country Garden Holdings, ranked for years as China’s top real estate developer by contracted sales, reported a 96% drop in H1-2022 profits. The company’s home sales are down by one third versus the previous year. The Guangdong-based company stated that the property market has slid rapidly into “severe depression.” The August 30 WSJ reported that more than 30 Chinese real-estate companies—including China Evergrande Group and Sunac China Holdings Ltd.—have defaulted on their international debt. Many privately run developers this month issued profit warnings; some said they expect a greater-than-90% decrease in net profit, and a few expect to post losses.

(3) OPEC+. On Monday, OPEC+ announced a small oil production cut of 100,000 barrels per day to bolster prices. Just last month, OPEC+ decided to raise oil output by the same target of 100,000 barrels per day. It’s literally a drop in the bucket. However, under the circumstances, the political message is clear: The cartel isn’t ready to help the global economy weather the geopolitical storm coming out of Russia by allowing weakening oil demand to lower oil prices.

Last week, the G-7 countries agreed to cap Russian oil prices to reduce funds flowing into Moscow’s war chest and bring down the cost of oil for consumers. However, neither India nor China is likely to participate in the sanction since they’re reportedly purchasing Russian barrels at a discount already.

Global Economy II: Weak Data. We’ve been monitoring global economic indicators for signs of weakness. Here are some of the latest ones:

(1) Global purchasing managers indexes. During August, the global composite PMI edged down to 49.3, the first reading below the 50.0 demarcation between contraction and expansion since June 2020 (Fig. 1). The global composite PMI for manufacturing edged down to 50.3, while the comparable non-manufacturing index fell to 49.2. We expect these indicators to fall solidly below 50.0 in coming months. The only strong reading was 54.9 for the non-manufacturing sector of emerging economies.

The M-PMIs and NM-PMIs for the Eurozone and the United Kingdom were all around 50.0 plus/minus 2.0 during August (Fig. 2 and Fig. 3). The trend in all of them has been downwards since the start of this year.

In the US, August’s M-PMI compiled by ISM was 52.8, a bit better than the 51.5 provided by S&P Global (Fig. 4). There was a significant divergence between August’s NM-PMIs reported by ISM (56.9) and those reported by S&P Global (43.7) (Fig. 5).

(2) European consumer confidence and retail sales. The consumer confidence component of the Eurozone’s economic sentiment indicator edged up to -24.9 in August from -27.0 in July, the lowest reading since the start of the data in January 1985 (Fig. 6). Soaring energy bills are clearly depressing consumer confidence in the region. This is only just starting to weigh on the volume of retail sales (excluding autos and motorcycles), which in July was basically flat m/m and down 0.9% y/y (Fig. 7).

(3) German new orders. In Germany, new factory orders fell 1.1% m/m in July, led by a 16.9% plunge in consumer goods orders (Fig. 8). Germany’s passenger car production remains extremely depressed at 3.1 million over the past 12 months through July (Fig. 9). That may reflect parts shortages from suppliers in Ukraine and Russia.

(4) Commodity prices. Our trusty CRB all commodities and raw industrial spot price indexes are down 10% and 11%, respectively, through Friday from their recent peaks during early June (Fig. 10). They confirm the weakening of the global economy, as does the price of copper, which is down 25% since early June through Friday (Fig. 11).

Global Economy III: TINAC In A World Of Hurt. Joe and I continue to recommend overweighting the US in global equity portfolios. During the previous bull market, we often explained why we preferred a Stay Home investment strategy over the alternative Go Global one. We’ve remained in the Stay Home camp post-bull market, but we have rebranded the rationale as “TINAC,” i.e., “there is no alternative country.” We’ve done so for all the reasons discussed above.

In the past, global economic booms and busts tended to be synchronized. The economies of the US, Europe, Japan, Australia, Canada, and the major emerging market countries tended to cycle in unison. We think that the US can skirt a global recession led by Europe and China later this year and early next year. Instead, the US should continue to experience a rolling recession, as we discussed in the Morning Briefings dated September 6 (“Back To The Old Normal?”) and August 30 (“Anatomy Of A Rolling Recession”).

Consider the following:

(1) The currency markets seem to agree with us. The JP Morgan trade-weighted dollar is up 9% ytd and 11% y/y (Fig. 12). Contributing to that strength is the perception that the US economy is in better shape and can handle geopolitical stresses much better than all the other major economies. Getting whacked are the euro, pound, and yen (Fig. 13, Fig. 14, and Fig. 15). The Emerging Markets MSCI currency index is also falling (Fig. 16).

(2) While forward P/Es are cheaper overseas, the ratios of the US MSCI stock price index relative to the All Country World ex-US MSCI stock price index—in both US dollars and local currencies—remain on the uptrends they’ve held since the start of the previous bull market in early 2009 (Fig. 17).

Strategy: Q2 Operating Earnings Confusion. There was a confusing divergence in the S&P 500’s y/y operating EPS growth rates for Q2 as calculated by I/B/E/S and by S&P. S&P 500 earnings rose 9.8% y/y in Q2 according to I/B/E/S but fell 9.8% y/y according to S&P (Fig. 18).

I asked Joe to explain the major difference:

I/B/E/S bases its operating earnings actual figure on how the majority of analysts present their forecasts, while S&P adheres to a more rigid definition that does not consider analysts’ majority rule. As a result of this different methodology, S&P’s Q2 actual included the mark-to-market writedowns, or paper losses, in Berkshire Hathaway’s equity investments. I/B/E/S’ actual matched the analysts’ consensus and did not include the writedown. The company is the sixth largest in the S&P 500 by market cap, which helps explain the impact; it’s included in the S&P 500 Financials sector.

For the S&P 500, I/B/E/S’ Q2 operating EPS actual figure of $57.94 was 23.4% higher than S&P’s $46.97. That was the biggest divergence between the two actuals since Q1-2010, when the Energy sector took significant writedowns in the value of oil & gas. Also during Q2, I/B/E/S’s actual of $10.20 for the Financials sector was 195.7% higher than S&P’s $3.45. That was the highest on record for the sector since operating EPS comparisons began in Q4-2009 (Fig. 19).

Here are Q2-2022’s y/y operating earnings growth rates for the S&P 500 and its sectors according to I/B/E/S and S&P: Energy (294.3% according to I/B/E/S, 347.5% according to S&P), Industrials (31.9, 21.5), Materials (16.1, 15.3), Real Estate (13.6, -10.8), Health Care (7.6, 6.0), Information Technology (3.1 ,-3.1), Consumer Staples (2.1 ,-9.5), S&P 500 (9.8, -9.8), Utilities (-3.9, -0.3), Consumer Discretionary (-15.3, -21.8), Communication Services (-18.4, -17.5), and Financials (-20.7, -78.3).

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Back To The Old Normal?

September 06 (Tuesday)

YRI Weekly Webcast. Join Dr. Ed’s live Q&A webinar today at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the weekly webinars are available here.

US Economy I: Interesting Times For Interest Rates. Before Fed Chair Jerome Powell’s Jackson Hole speech on Friday, August 26, Melissa and I expected that the Fed would raise the federal funds rate by 75 bps at the September 21 meeting of the FOMC. We also thought that the Fed might then pause for a few months to assess whether monetary policy is restrictive enough to bring inflation down while avoiding a recession.

Other Fed watchers ventured further during the weeks before Powell’s August 26 speech and after his press conference on July 27: There was lots of chatter that the Fed would finish its tightening this year and would pivot early next year by lowering interest rates. Accordingly, the S&P 500 rallied 9.8% from July 26 (the day before the presser) through August 16. The 10-year US Treasury bond yield remained flat around 2.80% over this period. The 2-year Treasury note rose a bit from 3.05% to 3.24%. However, we could not find anything in Powell’s July presser that would lead to that wishful conclusion by the nattering nabobs of positivism (to paraphrase former Vice President Spiro Agnew).

In his presser, Powell made it clear that he would no longer provide forward guidance about monetary policy. Then he proceeded to provide some of it by saying that if the financial markets wanted guidance, it was right there in the FOMC’s June Summary of Economic Projections (SEP). He elaborated as follows:

“I think the Committee broadly feels that we need to get policy to at least … a moderately restrictive level. And maybe the best data point for that would be what we wrote down in our SEP at the … June meeting. So I think the median [federal funds rate] for the end of this year … would’ve been between 3¼ and 3½ [percent]. And, then, people wrote down 50 basis points higher than that for 2023. So … even though that’s now six weeks old … that’s the most recent reading. Of course, we’ll update that reading at the … September meeting in eight weeks. So that’s how we’re thinking about it.”

In his short speech at Jackson Hole, Powell not only reiterated that indirect guidance but also buried the notion that the Fed might lower interest rates next year. He said, “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.” He then reminded us all once again that “the June SEP showed the median federal funds rate running slightly below 4 percent through the end of 2023.”

In his speech, Powell recalled that “the successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation and start the process of getting inflation down to the low and stable levels that were the norm until the spring of last year. Our aim is to avoid that outcome by acting with resolve now.”

This raises the question: How will the FOMC recognize when the federal funds rate is restrictive enough to bring inflation down? They should be looking for clues in yield-curve spreads. The yield-curve spread between the 10-year US Treasury and the federal funds rate is one of the 10 components of the Index of Leading Economic Indicators (Fig. 1). It narrowed by 85 bps to 31 bps on July 28, just after the Fed hiked the federal funds rate by 75 bps. Another hike of that magnitude would put the spread just below zero. The yield-curve spread between the 10-year and 2-year has been below zero since July 8. It was -28 bps on Friday, suggesting that a federal funds rate of 3.25%-3.50% would be restrictive if the bond yield remains around 3.00%.

In the good old days of the Old Normal (the period following the Great Inflation of the 1970s and before the Great Financial Crisis of 2008), the US economy had no problems growing when the federal funds rate and the 10-year US Treasury bond yield were around 3.00%-4.00% (Fig. 2).

What if that happens again? Wouldn’t it be swell if the Fed truly normalized monetary policy and we found that the economy can do just fine with a federal funds rate of 3.00%-4.00%? It has happened before, and it can happen again.

US Economy II: Immaculate Disinflation? Of course, a return to the Old Normal requires that inflation shows more signs of moderating and does so without the economy falling into a significant recession. Is immaculate disinflation possible? History shows that inflation rarely falls on its own without a recession (Fig. 3).

But we don’t think history necessarily has to repeat itself (despite how often it rhymes). While the inflation rate tends to peak before recessions, the yield-curve spread tends to turn negative at about the same time as recessions, signaling that monetary policy is getting restrictive enough to trigger a financial crisis—which usually has taken the form of a widespread credit crunch and recession (Fig. 4).

What seems to be different this time (so far) is that the credit system is less vulnerable to a credit crunch than it was in the past. The result is what we now have: a rolling recession hitting different sectors of the economy at different times; we expect it to bring inflation down without precipitating an economy-wide downturn. In his July 27 presser, Powell said that the Fed might succeed in going down that path. In his August 26 speech, he suggested that it was less likely than he had thought only a month previously.

Now, consider the following related developments:

(1) We think that the headline CPI and PCED inflation rates did peak at 9.1% and 6.8% during June (Fig. 5). Excluding food and energy prices, the core CPI peaked at 6.5% during March, and the core PCED inflation rate peaked at 5.3% during February (Fig. 6).

(2) Food in the CPI rose 10.9% y/y during July, the highest since May 1979 (Fig. 7). The S&P GSCI index for agricultural and livestock commodities is down 17.6% since it peaked on May 17 through Friday’s close (Fig. 8).

(3) The pump price of a gallon of gasoline fell 13.6% from the last week of July through the last week of August, using the four-week moving average of the price (Fig. 9). Americans have responded to recent high prices by reducing their consumption of gasoline by 654,000 barrels a day compared to a year ago (Fig. 10).

(4) The wholesale price of used cars fell 3.6% m/m during August, suggesting that the CPI for used cars fell last month (Fig. 11).

(5) Lots of other CPI components have shown signs of moderating over the past couple of months, including appliances, clothing, furniture, airfares, lodging away from home, and car rentals.

Rent stands out as the one major component of the CPI that is likely to remain troublesome. Nevertheless, the markets should welcome August’s CPI when it is released on September 13.

US Economy III: Getting A Lead On Leading Indicators. There’s no recession in the latest estimate of the Atlanta Fed’s GDPNow model. On September 1, Q3’s real GDP was running at 2.6% (saar). That was up from 1.6% on August 26. That was also before Friday’s employment report. The latest estimate shows that real personal consumption expenditures and gross private domestic investment are growing at annual rates of 3.1% and -3.5% during Q3, up from the previous estimates of 2.0% and -5.4%.

We are projecting 1.5% growth for the current quarter’s real GDP. Let’s drill down to some of the key recently released components of the Coincident Economic Indicators (CEI) and the Leading Economic Indicators (LEI) to see what’s growing and what’s not doing so:

(1) Consumer income and spending. Payroll employment is one of the four components of the CEI. It rose 0.2% during August (Fig. 12). That’s a solid increase. However, the average weekly hours of all employees in the private sector fell 0.3% last month (Fig. 13).

The product of these two variables is aggregate hours worked per week, which was flat during August (Fig. 14). We multiply this product by average hourly earnings, which rose 0.3% during August, to derive our Earned Income Proxy (EIP) for private wages and salaries in personal income (Fig. 15). It rose just 0.3% during August, which might show a weaker gain after adjusting for inflation, though August’s CPI (to be reported on September 13) might be flat or even slightly negative, as discussed above.

We aren’t sure why the GDPNow model showed a faster pace of consumer spending in the latest estimate. August’s motor vehicle sales, released on Friday, were little changed from July’s, at 13.4 million (saar) (Fig. 16). The sales slump is certainly almost all about the shortage of parts constraining assemblies rather than weak demand. However, a slump is a slump, so we conclude that a recession is rolling through the auto industry.

By the way, the expectations component of the Consumer Optimism Index (which averages the Consumer Sentiment Index and the Consumer Confidence Index) edged up from 56.5 during July to 66.6 during August. That’s still quite depressed. This is yet another component of the LEI.

(2) Residential investment. A recession is clearly rolling through the housing industry. Residential investment in real GDP fell 16.2% (saar) during Q2. Interestingly, that was mostly attributable to a 40.5% drop in real estate brokers’ commissions and an 11.4% decline in spending on home improvements (Fig. 17).

The plunge in single-family housing starts during the past five months through July will weigh on Q3’s real residential investment (Fig. 18). Multi-family housing starts are likely to remain elevated, but with neither a positive nor negative contribution to real GDP (Fig. 19).

Building permits is a component of the LEI (Fig. 20). Data through July show continued weakness in single-family permits and resilience in multi-family permits.

(3) Nonresidential investment. While residential investment is experiencing a recession, the outlook for construction spending on nonresidential structures and public infrastructure remains mostly positive (Fig. 21). In the former, construction put in place is at or near recent record highs for commercial, health care, and manufacturing structures. Relatively weak is construction put in place for amusement & recreation, communication, lodging, power, and transportation.

In the public sector, construction is booming for sewage & waste disposal, water supply, and health care. Relatively weak is public spending on education, transportation, and power.

(4) Production. Aggregate weekly hours in manufacturing was flat during August (Fig. 22). That suggests industrial production was relatively weak last month, which was confirmed by Friday’s M-PMI report. The M-PMI’s new orders index, which is in the LEI, edged up in August. Industrial production is one of the four components of the CEI.

Movie. “Candy” (+ + +) (link) is a TV mini-series docudrama about Candy Montgomery, a 1980s housewife and mother. She had it all, including a loving husband with a good job at Texas Instruments, two well behaved children, a nice house in a Texas suburb, and plenty of friends. But one day, something snapped, and she crossed a moral line. In many ways, this mini-series is like a typical crime show such as Dateline on NBC. The differences are the compelling and quirky performance of Jessica Biel as Candy and the suspenseful editing.

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China, Earnings & FedNow

September 01 (Thursday)

China: Time To Think Big. China’s real estate market has crumbled over the past year, and so far the Chinese government has taken only incremental steps to staunch the bleeding. Until they open the floodgates, this drain on economic growth isn’t going away. More than 30 developers have defaulted on their dollar-denominated debt. On Tuesday, Country Garden, considered among the strongest developers, reported that profits fell 96% y/y in H1-2022. And in more than 100 cities, people have stopped paying their mortgages on homes under construction or have threatened to do so.

Banks have started to show the impact, reporting large jumps in non-performing loans. China Construction Bank and Bank of China reported a 68% and a 20% increase in bad real estate debt during H2, an August 30 Reuters article reported. Nonetheless, the banks reported a net profit for the period. An S&P Global Ratings exec quoted in the article estimates that Chinese banks’ nonperforming ratio in the property development sector will rise to around 5.5%-5.6% by year-end, more than double the year-earlier 2.6%. Regional banks could be even more exposed to nonperforming real estate loans than their national counterparts.

A real estate debacle isn’t the only headwind China faces. It’s still selectively locking down neighborhoods when Covid cases spike. Record heat and drought have forced the country to shut industrial plants in hard hit areas to preserve electricity for air conditioning. And the country is owed $1 trillion by struggling countries around the world who participated in China’s Belt and Road initiative. In all, China’s debt is expected to reach 275% of its GDP, according to an estimate by China’s director of the National Institution for Finance and Development. The country’s leverage vastly overshadows even the US’s sizable debt load, which equals 98% of GDP.

With the country’s Q2 GDP having risen only 0.4%, China has been announcing new programs in rapid succession to bolster the economy in advance of the National Congress of the Chinese Communist Party on October 16 (Fig. 1). So far, the financial markets have only yawned in response. The China MSCI share price index has fallen 19.8% ytd through Tuesday’s close, and the Shanghai-Shenzhen 300 is down 17.5% over the same period (Fig. 2 and Fig. 3).

Here’s a look at some of the economy-boosting steps the country has taken so far:

(1) Lower rates. Last week, China made buying a home more affordable by lowering the five-year loan prime rate (LPR)—a benchmark Chinese banks use when extending mortgages—by 0.15ppts to 4.3%, an August 22 FT article reported. This was the second time the rate was lowered in 2022, and one more cut is expected this year. The rate on the country’s one-year loan prime rate was also cut, by 0.05ppts, to 3.65%; many commercial loans in China are based on this rate.

(2) Debt guarantees. The Chinese government is offering full guarantees on the domestic, yuan-denominated bond sales of six private Chinese developers: CIFI Holdings Group, Country Garden, Gemdale, Longfor, Seazen Group, and Sino-Ocean, an August 24 WSJ article reported. The guarantees don’t apply to their dollar-denominated debt. These companies have been hurt by the downturn, but they are presumably the strongest developers in the market and are being helped by the government to ensure they survive the harsh property downturn. Shares of these developers rallied on news of the government guarantees.

The bond guarantees may open up a can of worms, however. By default, they reveal which developers the Chinese government doesn’t believe are worth saving and may lead to even greater stress on those developers without government-guaranteed debt.

(3) New cash. The People’s Bank of China will issue about Rmb200 billion of low-interest loans to state commercial banks. It’s hoped that the banks will leverage the funds to provide Rnb1 trillion of loans to refinance stalled real estate projects, a July 27 FT article reported. Beijing-based Everbright Bank estimates that Chinese developers have suspended construction on as many as 8 million homes that require Rmb2 trillion ($292 billion) to complete. The problem is that many projects already have too much debt and may have zero or negative value. They need new equity or a restructuring, not more debt.

Separately, Beijing has provided Rmb300 billion ($44 billion) to state-controlled banks in an effort to boost infrastructure projects and economic growth, an August 25 WSJ article reported. Beijing approved another Rmb200 billion ($29 billion) in new debt for power generation companies hurt by the extreme heat and drought and another Rmb20 billion to fight the drought and help in the nation’s rice harvest.

(4) Local government support. Local government financial vehicles (a.k.a. LGFVs) have been raising funds from retail investors to back infrastructure projects, a July 16 FT article reported. In many cases, they are doing so because banks and institutional investors are no longer willing to lend to them. The practice is raising the question of whether the local governments in this situation are overleveraged and about to face a problem.

Beijing has sent high-ranking officials across the country “to demand local governments do more to stabilize growth, a rare move that may indicate the economy is in worse shape than official figures suggest,” an August 29 South China Morning Post article noted.

Some areas have lowered housing down payments and eased some home-purchasing restrictions. The Zhengzhou city government set up a property relief fund to help developers finish their projects after residents who bought apartments threatened to stop making their mortgage payments.

Earnings: Analysts Fear Not. Although the S&P 500 is down 16.4% ytd through Tuesday’s close, earnings for the companies in the index collectively will rise 9.6% this year and 7.2% in 2023 if analysts’ estimates are on target. Next year’s growth forecast certainly isn’t heroic, but it’s reassuring to know that it’s in positive territory and has been revised downward only modestly since January 27, when it stood at 10.2% growth (Fig. 4).

Here are the growth rates implied by analysts’ 2023 consensus earnings estimates for the S&P 500 and its sectors: Consumer Discretionary (36.2%), Industrials (17.3), Financials (13.3), Communication Services (12.9), Information Technology (7.7), S&P 500 (7.2), Utilities (6.1), Consumer Staples (5.9), Real Estate (0.1), Health Care (-0.5), Materials (-7.8), and Energy (-13.3) (Table 1). Let’s take a look at how these estimates have moved this year:

(1) Thank Amazon. While the S&P 500 Consumer Discretionary sector’s 2022 earnings estimates have been trimmed since the start of the year, its 2023 estimates have been revised steadily upward (Fig. 5). The sector’s anticipated improvement in 2023 owes much to Amazon, a member of the Internet & Direct Marketing Retail industry. Analysts forecast that earnings for the Internet & Direct Marketing Retail industry will rise more than 3,000% next year after declining a projected 96.5% this year (Fig. 6).

Amazon is expected to earn $0.10 a share this year, down from $3.24 in 2021. The company hit a rough patch this year: It built too much real estate, felt the impacts of higher fuel expenses and a strong dollar, and saw online product sales slow as consumers opted to spend more on services and less on stuff once Covid cases dropped sharply. Next year, however, the company is expected to return to form and earn $2.30 a share.

The Consumer Discretionary sector’s earnings are also helped next year by the Hotels, Resorts & Casinos industry, which is recovering from losses suffered during the Covid lockdowns. The Auto Parts & Equipment industry’s earnings also are forecast to climb in 2023, by 39.6%, giving the Consumer Discretionary sector a boost.

(2) A tip of the hat to Boeing too. The Industrials sector’s earnings forecasts for both this year and next have held relatively steady since the start of this year. The sector’s earnings are expected to soar 34.4% this year and 17.3% in 2023 (Fig. 7). Propelling such growth prospects are the following industries’ expected earnings growth this year and next: Airlines (returning to a profit, 198.2%), Aerospace & Defense (30.0, 34.9), and Industrial Conglomerates (9.3, 20.0).

Boeing’s earnings are expected to take flight now that deliveries of its 787 Dreamliner have resumed. The company’s earnings—which contribute to those of the Aerospace & Defense industry—are expected to recover to $4.92 a share in 2023 from a $1.36 per-share loss this year.

The earnings of Boeing and other defense contractors also stand to benefit from the US Defense Department’s need to replenish munitions and equipment being sent to Ukraine. Lockheed Martin’s earnings are forecast to jump from $21.75 a share in 2022 to $28.11 in 2023; Raytheon Technologies’ earnings are forecast to surge 19.4% in 2023; and General Dynamics’ earnings are slated to jump 15.9% next year.

And General Electric’s expected 68.4% jump in 2023 earnings boosts the Industrial Conglomerates industry’s projected earnings growth.

(3) Steady 2023 expectations. Even though the Financials sector’s 2022 earnings growth forecast has declined gradually to -12.6%, its 2023 estimates have been relatively unscathed at 13.3% (Fig. 8). A similar pattern appears in the Communication Services sector: Its 2022 earnings growth has been slashed to a decline of 11.2%, but its 2023 earnings are expected to grow 12.9%, down slightly since the start of 2022 (Fig. 9).

(4) No good news in ’22 or ’23. Analysts have been slashing their 2022 and 2023 earnings estimates for the Consumer Staples, Health Care, and Technology sectors in recent months. Now they expect Consumer Staples’ earnings to grow 3.3% this year and 5.9% next, down from 6.3% and 7.9% expected at the start of 2022 (Fig. 10). Estimated 2022 earnings for the Health Care sector have dropped from a high of 8.4% on February 17 to a recent 4.9%. The 2023 estimate fell sharply in late 2021 and has been largely unchanged so far this year at -0.5% (Fig. 11). Earnings projections for the Technology sector both this year and next have been dropping since late April. At their peak in mid-May, Tech earnings for 2022 were expected to grow 13.4%; now just 10.0% growth is expected (Fig. 12). At their peak in late March, Tech earnings for 2023 were expected to grow 12.3%; that’s been trimmed to 7.7%.

(5) Tough 2023 expected. While analysts following Energy sector companies have been boosting their 2022 earnings estimates, they’ve been cutting their 2023 growth estimates. Next year’s forecast now calls for earnings to drop 13.3% versus -4.2% expected at the start of the year (Fig. 13). The same pattern—i.e., raised sights for this year and lowered sights for next—has been occurring for the Real Estate, Materials, and Utilities sectors (Fig. 14, Fig. 15, and Fig. 16).

Disruptive Technologies: Fed Catches Up, With FedNow. When Jackie and her husband bought their first home years ago, what was expected to be a simple transaction took a nightmarish turn, as the funds got stuck in limbo. “We’d transferred the money from a savings account into a checking account the day before,” she recounts, “and the transaction hadn’t yet settled. After much panic and many phone calls, the branch manager solved the problem, and we vowed to name our first child after her.”

Soon, such experiences will happen much less often because the Federal Reserve has announced that FedNow, its instant payment service, will launch for individuals and businesses perhaps as early as May 2023. Transfers will occur instantly, 24 hours a day, seven days a week, all year long between accounts at participating banks. It’s a move that helps the US catch up to other countries, like China and India, where real-time transactions are the norm.

Here are some of Jackie’s observations about the new platform:

(1) Who gets to play. FedNow will be open to those who have an account with a participating bank. The more banking institutions that join, the more successful FedNow will be. Joining will require institutions to upgrade their systems to connect with the Fed’s payments infrastructure.

“The time is now for all key stakeholders—financial institutions, core service providers, software companies, and application developers—to devote the resources necessary to support instant payments. This means upgrading back-office processes, evaluating accounting procedures to accommodate a seven-business-day week, arranging liquidity providers, deploying a new customer-facing application, and promoting instant payments for key use cases to customers,” said Fed Vice Chair Lael Brainard in an August 29 speech.

FedNow competes with Real Time Payments (RTP), an existing system created by and largely used by large banks. Zelle runs on the RTP system. Smaller banks and thrifts encouraged the Fed to set up its own system so that they wouldn’t be subject to RTP’s rules and fees.

Notably, the FedNow system isn’t open directly to retailers or fintech companies despite their requests to be allowed in. Fintech companies and retailers will need to access the system through a bank; only banks will benefit from direct access to the Fed system, as is the case now.

(2) Consumers benefit. FedNow will allow consumers to access the cash from their paychecks immediately upon deposit and eliminate high-interest payday loans. It may also eliminate or limit consumers’ need to use a bank debit card, which often have fees. The instant transfer of funds may also reduce consumers’ overdraft and late fees. Gig workers, like freelancers and Uber drivers, who can receive payments directly and instantly should also benefit from FedNow.

It remains to be seen whether the Fed can develop an app that’s consumer friendly. One flier we saw explained that “all” that’s needed for a person-to-person instant transfer is the routing number of the payment recipient’s financial institution and his/her account number. Those aren’t numbers that most people have memorized, but maybe it will be in the future.

(3) Companies and banks benefit too. FedNow instant payments could result in improved working capital for businesses. It could also reduce cash and check volumes, which would reduce banks’ costs, a PWC primer noted. And it would reduce the amount of funds banks owe each other, thereby reducing risk in the overall banking system.

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Earnings Matter

August 31 (Wednesday)

Strategy: The Earnings Growth Cycle. We all know that the earnings growth cycle peaked during Q2-2021, when the y/y growth rates of S&P 500 revenues and earnings peaked at 21.8% and 88.5% (Fig. 1 and Fig. 2). Naturally, both growth rates were lower, at 12.1% and 9.5%, one year later, i.e., in Q2-2022. The pressing questions now are: Will they soon turn negative? And if so, how negative?

The answers depend on the outlook for the business cycle, of course. We think that the current growth recession will continue through the second half of this year. Debbie and I are forecasting that real GDP, which fell 1.0% (saar) during H1-2022, will edge up by only 1.5% during H2-2022 (Fig. 3). We see the headline PCED inflation rate falling from 6.3% y/y in July to 4.0%-5.0% during the second half of this year and 3.0%-4.0% during 2023 (Fig. 4).

As we discussed in yesterday’s Morning Briefing, we think that the economy is experiencing a rolling recession that is weakening different sectors of the economy at different times. In the past, most traditional recessions were caused by tight monetary policy that triggered a financial crisis, which caused a widespread credit crunch and a full-blown recession. Inverted yield curves tended to anticipate that chain of events. This time we believe there is ample liquidity in the financial system to avert a financial crisis that could morph into a credit crunch.

In our economic scenario, earnings growth does turn negative but not by much and not for long. Consider the following:

(1) Earnings forecasts: ours & theirs. We are anticipating that earnings growth will be -5.4% y/y and -3.8% during Q3 and Q4. For the entire year, we are predicting earnings of $215 per share, which would be a flattish 3.1% increase from 2021 (Fig. 5). Next year, we are projecting a 9.3% increase in earnings per share to $235. The consensus estimates of industry analysts during the August 25 week were $225 and $244 this year and next year. In other words, their latest projections show no downturn during the second half of this year. (See Table 1 in YRI S&P 500 Earnings Forecast.)

The analysts’ earnings estimates for this year and next year peaked at the end of June and have been converging toward our estimates since then. During the Q2 earnings reporting season, the actual result beat the consensus estimate for S&P 500 earnings at the start of the season by 4.4% (Fig. 6). Nevertheless, company managements provided cautious guidance for the rest of this year and all of next year. So the analysts shaved their estimates for the remaining two quarters of this year and all four quarters of next year (Fig. 7).

The good news is that now that the earnings season is over, analysts seem to have stopped shaving their estimates for the next six quarters. As a result, their earnings estimates for 2022 and 2023—as well as forward earnings, which we derive by time-weighting their annual estimates—stopped falling during the August 25 week (Fig. 8). Let’s see what happens during the Q3 earnings season, which starts in early October (just before Halloween).

(2) Revisions. So we are clearly past the peak in the earnings growth cycle. The question is: How close are we to the bottom? In our outlook, earnings should start growing again during Q1-2023. For now, we can see that analysts are revising their estimates downward, which is what happens past the peak on the way to a trough in the earnings cycle. So for example, the S&P 500’s net revenues revisions index (NRRI) was -5.1% during August, the first negative reading since July 2020 (Fig. 9). The net earnings revisions index (NERI) was -9.0% during August, following a -1.9% reading during July, which was the first negative reading since July 2020 (Fig. 10).

Furthermore, our forward earnings breadth index (FEBI) for the S&P 500 fell to 60.8% during the August 26 week, down from last year’s peak of 89.8% during the June 4 week and the lowest reading since July 24, 2020 (Fig. 11). During the past three recessions, FEBI fell below 50.0%.

(3) Macro picture. Interestingly, the national manufacturing purchasing managers index (M-PMI) is highly correlated with the y/y percent change in the S&P 500 (Fig. 12). That’s because the M-PMI is also highly correlated with the growth cycles of both S&P 500 revenues and earnings, as well as with both NRRI and NERI (Fig. 13, Fig. 14, Fig. 15, and Fig. 16).

We will get August’s reading for the M-PMI on Thursday. Based on the five regional business surveys we track, we expect that it fell from 52.8 in July to just below the 50.0 level, indicating an economic contraction, in August (Fig. 17). The question is: Will that mark the bottoms in the M-PMI and the S&P 500’s earnings growth cycles? Probably not, but we are getting closer to those bottoms, in our opinion.

Autos I: Not There Yet. In the past, auto market recessions have coincided with rising interest rates. This time, autos sales and production are depressed because of supply-chain problems and parts shortages, especially related to semiconductor parts. Sales and production have recovered some from levels during the thick of the pandemic, however. With the inventory shortages, customers are having to order a vehicle and wait months for delivery, often paying above sticker price.

Inventory levels are still well below demand levels, which continue to be elevated by pent-up demand as buyers have held onto their older models waiting for new car prices to fall. Before delving into some of the global auto industry’s market dynamics, let’s look at a few big-picture indicators for the domestic auto market:

(1) Softish auto sales. Domestic auto & light-truck sales plunged during September 2021 to a recent low of 8.9 million units (saar) because of supply disruptions (Fig. 18). Sales then recovered to a recent high of 11.5 million units during January. But sales since then have stalled around 10.5 million units, as shortages have persisted. (August data will be released tomorrow afternoon.)

(2) High auto prices. It has not been easy to afford a used car, let alone a new one, these days. Average estimated transaction prices for new vehicles have increased to about $48,000 from near $37,000 in early 2019, according to Cox Automotive’s July industry report. But used auto price inflation has cooled recently as the availability of new cars has picked up. The CPI inflation rate for used autos has come back to Earth after rising at a rate just above 40% y/y during mid-2021 and then again early this year, falling to 6.6% through July (Fig. 19). New-car price CPI inflation has continued to rise during the pandemic years, to 12.6% y/y through July; this compares with a normal y/y rate near zero from at least 2012 through 2019.

(3) Low inventories. But demand still well exceeds supply, as reflected in rising prices for new vehicles and the industry’s inventory-to-sales ratio, which remained around half a month’s supply during H1 (Fig. 20). In the past, auto dealers typically had 2.5 months’ worth of inventory on their lots.

(4) Production pending. Cars don’t last forever, and owners holding onto old ones will have to replace them at some point. Manufacturers are ramping up production as recent supply-chain difficulties are now abating. Domestic motor vehicle output dropped sharply from a July 2020 peak of 11.9 million units (saar) to a September 2021 low of 7.7 million units (Fig. 21). It was back up at 11.0 million units during July.

(5) More borrowing. Folks who are purchasing vehicles are borrowing more to do so as auto prices have surged (Fig. 22). Eventually, rising interest rates could bring demand and supply for autos into better balance, driving prices down. For now, borrowers are proving able to carry the more expensive debt at higher loan values, as shown by auto loan delinquency rates that are near historical lows according to the New York Fed’s Q2 Household Debt and Credit report.

Autos II: What’s Plaguing Production? Globally, auto parts shortages have continued to plague auto manufacturers following the pandemic. Production has improved around the world but remains depressed relative to where it was before the virus lockdowns hit supply chains. Here are a few reasons why:

(1) China’s plagues. Persistent authoritarian lockdowns on the Chinese people after most countries have eased Covid lockdowns have continued to pressure global auto supply chains. Also, China’s Sichuan region recently experienced a severe drought that’s led to production cuts and plant closures for auto parts and semiconductors.

(2) Russia-Ukraine war. Russia’s war on Ukraine certainly has not helped European auto production, especially as those two nations produce critical materials for auto production.

(3) Semis dysfunctional. Since the onset of the pandemic, the semiconductors supply chain has been strained. Even now that supply is flowing more normally for some types of semiconductors, getting the right product mix and kits remains challenging for auto manufacturers. Chips used in crypto mining rigs, PCs, and smartphones are starting to look oversupplied, but those are not the chips that automakers need to build cars, Wolf Street pointed out in a recent note.

Autos III: EVs Ruling The Road. Under the hood of the auto market, a divergent trend is evident: The shortages are much more prevalent among fuel-efficient cars than gas-guzzling ones. Electric vehicles (EVs) are leading segment sales by far, according to the Cox report cited above (see page 8 chart!). Among EV brands, Teslas led sales ytd through July; gas-guzzlers like Rams and Dodges saw sales fall. Many more days’ supply of Rams and Dodges are available than of Subarus.

The vehicles with the largest y/y price increases through July are alternative-fuel cars, while those with the smallest price increases are pickup trucks, research dated August 9 from iseecars.com found. Fiscal policy is providing incentives for purchasing “greener” autos. Here are a few of the latest updates:

(1) US funds EV manufacturing. Signed into law in August, the Biden administration’s Inflation Reduction Act will provide $20 billion in loans and $2 billion in grants to auto manufacturers to retool and build green friendly auto plants in the US.

Likewise, the Chips & Science Act will provide $50 billion toward the construction of semiconductor chip manufacturing, research and development, and workforce development.

(2) California cans gas cars. California has adopted regulations that are taking the gas out of the market for ICE (internal combustion engine) vehicles and putting the pedal to the metal for EV models. It’s leading among states in the transition to fuel-efficient vehicles, having passed a law banning the sale of new gas-powered cars by 2035.

(3) Pump prices driving EV sales. Russia’s war on Ukraine has wreaked havoc for the energy markets, increasing the cost to drive gas-powered cars. Frustrated by high gas prices, many consumers are opting for fuel-efficient vehicles.

(4) But are EVs ready for prime time? While EVs may be catching on, they’re also catching fire. Reports have it that hundreds of vehicles have caught fire this year in the world’s largest EV market, China. That’s way up from last year’s number of such incidents. The car fires are largely due to fires at EV charging stations. EVs have a way to go before they can be truly sustainable rides.

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Anatomy Of A Rolling Recession

August 30 (Tuesday)

US Economy I: Powell’s New Path. It was a cold morning in Jackson Hole, Wyoming this past Friday. I joined the Bloomberg Surveillance team on a Zoom interview at 8:00 a.m. EST. They were sitting outdoors with the Grand Teton mountains behind them. It was still dark in their time zone, so the mountains weren’t visible just yet. But it was easy to see that they were shivering in the cold. Co-host Lisa Abramowicz said it was 39 degrees.

That morning at 10 a.m. EST, the financial markets were hit by a cold blast when Fed Chair Jerome Powell gave the opening remarks at the Kansas City Fed’s annual conference at Jackson Hole. Delivering a carefully scripted eight-minute speech, he sounded more hawkish than the markets had expected. Less than a month earlier, at his July 27 press conference, Powell seemed to pivot toward a more dovish stance. He obviously concluded that he needed to walk that back. So he turned the other way, stressing that the Fed’s top priority is to bring inflation back down by pushing interest rates up quickly, even if doing so risks causing a recession.

Powell no longer claimed that the Fed had a path to bring inflation down without causing a recession, as he had at the end of July. Instead, he acknowledged that there will be some pain: “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

Powell channeled his inner Volcker by saying: “As former Chairman Paul Volcker put it at the height of the Great Inflation in 1979, ‘Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.’”

The Fed chair’s short speech managed to wipe out $1.2 trillion of the market capitalization of the S&P 500 stock price index, which fell 3.4% on Friday. He clearly felt that he needed to set the record straight by talking much more hawkishly than he had at his July presser.

Ironically, Powell established the precedent of holding a presser after every FOMC meeting instead of on a quarterly basis, starting in January 2019. Back then, he explained, “Having twice as many press conferences does not signal anything about the timing or pace of future interest rate changes. This is only about improving communication.” It’s not clear to Melissa and me that communication has improved. Volcker rarely talked to the press but got his intentions across loud and clear.

By the way, before 1982, the Kansas City Fed’s symposium was held in different towns in the district. It was a low-key, academic sort of event. Fed Chair Paul Volcker was invited in 1982 to enhance the gathering’s stature. To convince him to come, Jackson Hole was picked because it has lots of good fly fishing, which Volcker enjoyed greatly. Volcker accepted the invitation, and tradition has kept the conference at Jackson Hole ever since.

US Economy II: The Path Forward. So is the only path forward a painful one, as Powell suggested? Is a recession inevitable now that Powell may be channeling his inner Volcker? Debbie and I still don’t expect that any economic downturn over the rest of this year and/or next year will be severe enough to qualify it as an official recession, i.e., meeting the criteria of the Dating Committee of the National Bureau of Economic Research.

We believe that the economy has been in a “rolling recession” since the start of this year that may continue through the end of this year. The idea is that different economic sectors experience downturns at different times, resulting in a “growth recession” for the broad economy with no significant contraction of GDP—thus skirting a broad-based official recession.

During the first half of this year, real GDP fell slightly led by a recession in the housing industry, a shortage of new autos, and weakness in capital spending on structures. During the second half of the year, housing will still weigh on economic growth, and retailers’ unintended inventory building is already forcing them to cut their prices to clear the excess merchandise. Consider the following:

(1) Residential investment. Among the most interest-rate sensitive sectors of the economy is housing. The 30-year mortgage rate soared 262bps from 3.29% at the start of the year to 5.91% on Friday (Fig. 1). It did so because the 10-year US Treasury yield jumped 152bps and the spread between the mortgage rate and the bond yield widened by 110bps to 287bps over this period (Fig. 2).

This spread widened as fixed-income traders and investors anticipated that the Fed would start reducing its portfolio of mortgage-backed securities during H2-2022 once it had implemented its QT2 program.

Residential investment in real GDP fell 16.2% (saar) during Q2 (Fig. 3). That’s not surprising since this series is mostly determined by housing starts, which dropped from 1.67 million units (saar) in January to 1.45 million units in July led by a plunge in single-family starts (Fig. 4). Multi-family housing starts remained strong during July at 530,000 units because rapidly rising rents are providing a big incentive to develop such properties.

By the way, according to the Bureau of Economic Analysis (BEA), the decrease in residential fixed investment was actually led by a decrease in “other” structures, specifically real estate brokers’ commissions! This suggests that there is more weakness ahead in residential investment to reflect the recent drop in housing starts.

(2) Motor vehicles. In the past, rising interest rates depressed auto sales and production. This time, auto production has been depressed by shortages of parts. Domestic motor vehicle output dropped sharply from a July 2020 peak of 11.9 million units (saar) to a September 2021 low of 7.7 million units (Fig. 5). It was back up at 11.0 million units during July. Demand still well exceeds supply, as reflected in rapidly rising motor vehicle prices and the industry’s inventory-to-sales ratio, which has remained around half a month’s supply since the start of this year through June (Fig. 6). In the past, auto dealers typically had 2.5 months’ worth of inventory on their lots.

(3) Capital spending on structures. Capital spending on nonresidential structures dropped 13.2% (saar) in Q2 to the lowest level since Q2-2011 (Fig. 7). The weakness was widespread, with declines in commercial and health, power and communications, and manufacturing structures (Fig. 8). Some of that weakness was offset by strength in mining exploration, shafts, and wells structures.

During Q2, capital spending on nonresidential equipment edged down 2.7% (saar) from Q1’s record high. The same can be said about information processing equipment and industrial equipment (Fig. 9). Spending on transportation equipment ticked higher during Q2 after falling sharply during the previous three quarters.

We construct current and future capital spending indexes based on the regional business surveys conducted by Fed district banks. The current capital spending measure is based on three of the regional banks, while future capital spending covers five banks (Fig. 10). Both are down from their peaks early this year but remained relatively high during August, improving over the past two months.

A major driver of capital spending is corporate profits. Yesterday, we observed that S&P 500 aggregate earnings rose to a record high during Q2. And so did the broadest measure of profits in the National Income & Product Accounts.

(4) Inventories. During Q4-2021 and Q1-2022, inflation-adjusted inventories piled up among wholesalers and non-auto retailers (Fig. 11). Major retailers are dealing with a glut of goods they need to clear out. A lot of items, especially summer items, have been on sale and will continue to go on sale. Consumers are paring back their spending on a lot of discretionary goods, like apparel or a new TV. Instead, they’re focused on filling up their car with gasoline and buying groceries. They are also spending more on services.

(5) Consumer spending. Personal consumption expenditures rose during Q1 and Q2 by 1.8% (saar) and 1.5%, respectively. There’s no recession in consumer spending, though both growth rates are relatively low. The Q2 pace reflected an increase in spending on services (led by food services and accommodations as well as “other” services) that was partly offset by a decrease in goods (led by food and beverages) (Fig. 12).

Consumers’ purchasing power has been eroded by rapidly rising prices (Fig. 13). As a result, consumers have tapped into the excess saving they accumulated during the pandemic. That’s not sustainable. However, we expect that price inflation will moderate faster than wage inflation during H2-2022 and in 2023, resulting in rising purchasing power for consumers.

(6) Government spending. In the real GDP accounts for Q2, federal government spending declined by 3.9% (saar), while state & local government spending fell 0.6% (Fig. 14).

The decrease in federal government spending reflected a decrease in nondefense spending that was partly offset by an increase in defense spending. The decrease in nondefense spending reflected the sale of crude oil from the Strategic Petroleum Reserve, which results in a corresponding decrease in consumption expenditures. Because the oil sold by the government enters private inventories, there is no direct net effect on GDP. The decrease in state and local government spending was led by a decrease in investment in structures.

This year, the Biden administration has succeeded in passing bills through Congress that entail spending lots of money on public infrastructure, semiconductor manufacturing capacity, and all sorts of “green” projects.

(7) Trade. Jackie, Melissa, and I believe that Europe is the most at risk of falling into a recession later this year and early next year because of the energy crisis resulting from the Ukraine war. In retaliation for imposing sanctions on Russia, the Kremlin is likely to shut off the natural gas that the country exports to Europe.

US exports to Europe account for around 23.5% of total US merchandise exports (Fig. 15). China’s exports to the European Union account for 15.6% of that country’s exports currently.

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Powell’s Latest Pivot Won’t Be His Last

August 29 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

The Fed: Powell Channels Volcker. In my book Fed Watching for Fun & Profit, Chapter 8 is titled “Jerome Powell: The Pragmatic Pivoter.” Our current Fed chair continues to pivot since I published that book in early 2020.

Back on August 27, 2020, Powell pivoted by turning very dovish in his speech at the Fed’s annual Jackson Hole conference when he announced that the Fed’s revised Statement on the Longer-Run Goals and Monetary Policy Strategy prioritized “maximum employment” as “a broad-based and inclusive goal.” He pivoted again late last year and early this year when he morphed from a dove to a hawk because inflation turned out to be more persistent than he and his colleagues on the FOMC had expected.

Powell seemed to be pivoting back toward a more dovish stance at the end of last month. Stock prices rallied following his July 27 press conference after he said that the federal funds rate was now at “neutral.” He said so right after the FOMC had voted to raise it by 75bps to a range of 2.25%-2.50%. Stock and bond market investors concluded that the Fed was getting closer to a restrictive level of the federal funds rate, implying that the Fed’s monetary tightening cycle might end sooner rather than later and at a lower terminal rate.

Indeed, many Fed watchers (including us) concluded that the Fed might hike one more time at the September 21 FOMC meeting and then pause for a while. Some even chattered about the Fed possibly lowering interest rates in early 2023; that was a very optimistic and unrealistic interpretation of Powell’s comment that “[a]s the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.”

Reflecting the optimism, the S&P 500—which had closed at 3921.05 the day before Powell’s July 27 presser—rallied 9.8% to a recent high of 4305.20 on August 16, putting it up 17.4% from the June 16 low of 3666.77.

After Powell’s speech at Jackson Hole on Friday, the S&P 500 got crushed, closing down 3.4% for the day at 4057.66. That put it 10.7% above the June 16 low, but down 15.4% from the record high on January 3 (Fig. 1). The index failed to rise above its 200-day moving average (dma) early this past week and finished the week just 1.2% above its 50-dma.

Melissa and I sent you a QuickTakes on Friday morning after Powell’s short speech at Jackson Hole. We noted that it was hawkish from start to finish, leaving no room for an optimistic spin, unlike his presser. In effect, Powell had pivoted once again, but toward an even more hawkish stance! Consider the following:

(1) Forget about rate cuts. Powell immediately demolished any expectations of rate cuts by saying, “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance.” He reiterated: “Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.” He reminded all of us that the FOMC’s latest Summary of Economic Projections “showed the median federal funds rate running slightly below 4 percent through the end of 2023.”

(2) Forget about a pause. This time, Powell did not opine on whether the federal funds rate is at neutral currently. Instead, he said, “In current circumstances, with inflation running far above 2 percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.”

(3) Forget about a painless path. In his presser, Powell talked about a narrowing “path” for the Fed to restore price stability without causing a recession. In his speech on Friday, he acknowledged that the path ahead is likely to be painful:

“Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

(4) Favoring frontloading. In addition, Powell sided with St. Louis Fed President James Bullard, who recently advocated frontloading rate hikes. Powell said: “History shows that the employment costs of bringing down inflation are likely to increase with delay, as high inflation becomes more entrenched in wage and price setting. ... Our aim is to avoid that outcome by acting with resolve now.”

(5) Channeling Volcker. Just to make sure we all got the message, Powell said, “As former Chairman Paul Volcker put it at the height of the Great Inflation in 1979, ‘Inflation feeds in part on itself, so part of the job of returning to a more stable and more productive economy must be to break the grip of inflationary expectations.’” Powell is apparently channeling his inner Volcker.

Powell concluded: “We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”

(6) Anticipating his next pivot. It’s conceivable that Powell and his colleagues will be emboldened to hike the federal funds rate by a full percentage point (to 3.25%-3.50%) at the September 21 meeting of the FOMC rather than by a measly 75bps given his hawkishness.

The 2-year US Treasury note yield tends to be a leading indicator of the federal funds rate (Fig. 2). It rose to 3.37% on Friday. At the same time, the yield-curve spread between the 10-year and 2-year Treasuries remained solidly negative at -29bps. Negative yield-curve spreads have a history of signaling that tighter monetary policies tend to cause financial crises that turn into credit crunches, which cause recessions.

In his speech, Powell failed to acknowledge that the Fed’s rate increases during the first seven months of this year combined with a strong dollar and now with a ramping up of QT2 starting in September might already be working to slow the economy and to moderate inflation. So he may soon regret having pivoted toward a more hawkish stance at Jackson Hole, which soon may force him to pivot yet again toward a more dovish one.

(7) Data dependent. In his presser, Powell mentioned the word “data” 16 times in the context of their importance in determining the course of monetary policy. He observed that while the latest batch has been mixed, “our economy continues to show strong underlying momentum.” He also noted: “Our decision at the September meeting will depend on the totality of the incoming data and the evolving outlook.”

Before that next meeting, August’s national M-PMI and NM-PMI (compiled by the Institute for Supply Management) will be released on September 1 and 6, respectively. As we discussed in a recent QuickTakes, they are likely to be weak, as suggested by the flash estimates provided by S&P Global (Fig. 3 and Fig. 4). The four available regional business surveys conducted by the Fed’s district banks during August likewise suggest that the M-PMI composite index and its new orders sub-index will be weak, with readings below 50.0 (Fig. 5).

August’s employment report will be released on September 2. It is likely to confirm that payroll employment remains strong. However, there hasn’t been much growth in either the household measure of employment or in the civilian labor force so far this year (Fig. 6). August’s wage inflation data will be included in the employment report, and it is likely to remain elevated.

Perhaps the most important data release next month will be August’s CPI report on September 13. It might very well show that price inflation is abating faster than widely expected. Durable goods inflation in the CPI has dropped sharply from a peak of 18.7% y/y during February to 7.9% during July (Fig. 7). We think it will fall to zero by the end of this year. The price of gasoline soared during the first six months of this year, inflating the CPI for nondurable goods (Fig. 8). It fell sharply during July and continued to do so through the August 22 week.

(8) Complimentary download. You can download a free copy of Dr. Ed’s Fed Watching for Fun & Profit here.

US Economy I: The Great Discrepancy. Debbie and I expect that when the Bureau of Economic Analysis (BEA) gets around to its next “benchmark” revision of real GDP, it will be revised up. We won’t be surprised if the so-called “technical recession” during the first half of this year turns out to be a figment of the preliminary estimates. Consider the following:

(1) Nominal values. There has been an unprecedented widening divergence between gross domestic income (GDI) and gross domestic product (GDP) (Fig. 9 and Fig.10). In current dollars, it has widened from below zero during Q3-2020 to $1.0 trillion, or 3.9% of nominal GDP, during Q2-2022.

(2) Real values. On an inflation-adjusted basis, GDI was also 3.9% higher than GDP during Q2 (Fig. 11). That’s the widest discrepancy on record since 1948! Here are the annualized growth rates for real GDI versus real GDP for Q1 (1.8%, -1.6%) and Q2 (1.4, -0.6).

(3) Income = spending. GDI is the total income received by all sectors of the economy. It includes the sum of all wages, profits, and taxes, minus subsidies. Since all income is derived from production, the GDI of a country should exactly equal its GDP. That’s in theory. In practice, the two indicators don’t always match because the government can’t measure the economy perfectly. However, they’ve never diverged by so much for so long. GDI tends to be a more accurate measure because the BEA has more timely and comprehensive data on the components of national income.

(4) Next revision. The BEA will release results from the 2022 annual update of the National Income and Product Accounts (NIPA) on September 29, 2022. This update will present revised statistics for GDP, GDP by Industry, and GDI that cover the Q1-2017 through Q1-2022.

(5) Our forecast. Real GDP dropped by only 1.6% during Q1 and 0.6% during Q2—and both are seasonally adjusted annual rates (saar). It won’t take significant upward revisions to move the GDP growth needle above zero for either or both. The Atlanta Fed’s GDPNow model estimated that Q3’s real GDP is tracking at 1.6%.

We are currently projecting that real GDP will increase at a 1.5% annual rate during H2-2022 and at a 2.5% rate during 2023.

US Economy II: Lots Of Profits. Joe reports that Q2 data are now available for S&P 500 revenues and operating earnings per share. Both rose to new record highs, with the former up 12.1% y/y and the latter up 9.5% y/y (Fig. 12, Fig. 13, and Fig. 14). The profit margin remained near recent record highs at 13.4% (Fig. 15). On balance, the S&P 500 companies have been able to offset rapidly rising costs by rapidly raising their prices.

Last week, the BEA reported Q2 data for profits in the NIPA. There was lots of good news:

(1) After-tax book profits rose to a record $3.0 trillion (Fig. 16). S&P 500 reported net income, which tends to account for about half of NIPA profits, remained basically unchanged in Q2 on an aggregate basis in record-high territory.

(2) The NIPA measure of the corporate profit margin rose to a record 12.1% during Q2, while the S&P 500 margin remained in record-high territory at 13.4% (Fig. 17).

(3) NIPA’s corporate profits from current production adjusts book profits (which is based on the historical cost basis used in profits tax accounting) for inventory withdrawals and depreciation to the current-cost measures used in GDP. On this basis, after-tax profits also rose to a new record high ($2.6 trillion, saar), as did dividends ($1.5 trillion) and undistributed profits ($1.1 trillion) (Fig. 18). The bottom line is that corporate cash flow rose to a record $3.4 trillion during Q2 (Fig. 19).

Movie. “Blackbird” (+ +) (link) is a disturbing TV series docudrama about Larry Hall, a serial killer who is in prison but might be set free on appeal because the evidence used to incarcerate him wasn’t sufficiently compelling. So the FBI cuts a deal with another prisoner to befriend Hall and get him to provide incriminating details about his murder spree. The acting is top-notch; Paul Walter Hauser does a great job of playing creepy Larry.

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Industrials, Russia & Robots

August 25 (Thursday)

Industrials: Hurt by Mother Nature & Natural Gas. Mother Nature must have a dry sense of humor because extreme temperatures are evaporating rivers in Asia, Europe, and the US. Droughts are making hydroelectricity production and river shipping less feasible and more expensive. The situation is forcing some energy-intensive industrial plants to shut down in China and in Europe. The calendar says the Dog Days of Summer are almost over, but the frequency with which droughts have been occurring casts long shadows of doubt.

Here’s a look at how industrial businesses have been impacted around the world:

(1) China: Damaged by Drought. China’s 65-day heatwave is its longest since records began in 1961. Rainfall in Sichuan province in Southwest China declined by 40%-50% y/y in July and August, an August 20 South China Morning Post (SCMP) article reported. As a result, the Yangtze River has shrunk to barely half of its normal width in some places. That has curtailed the region’s ability to produce hydroelectricity, which represents about 80% of its power supply, with coal-fired plants accounting for the remainder.

Sichuan has a large number of hydroelectric power plants and typically exports the excess electricity the plants generate. The province lacks the infrastructure to import electricity when needed and lacks enough coal-fired electricity production to compensate. Moreover, there’s concern that the areas to which Sichuan exports electricity could face shutdowns of their own due to a lack of electricity.

Sichuan has activated its highest emergency response and ordered industrial production halts to ensure enough power for residential air conditioning. A shutdown of industrial plants that was expected to last six days was extended to 10 days, an August 23 Asia Times article reported.

Companies that have needed to cut production and/or close plants in the Sichuan region include automaker Toyota Motor, battery manufacturer Contemporary Amperex Technology, polysilicon supplier Tongwei, and lithium producer Yahua Industrial, according to an August 18 Quartz article. Electronics manufacturer Foxconn and BOE Technology Group, a supplier of LCD and OLED screens for Apple, were also affected, an August 23 Asia Times article stated, as were auto parts and semiconductor manufacturers.

Sichuan province represents only about 4% of China’s industrial production, but its plant closures could generate ripple effects. Tesla and SAIC Motor told Shanghai city government officials that supply-chain disruptions due to the Sichuan energy crunch have impacted production in their Shanghai factories, an August 22 CNN article reported. Expect more supply-chain knots if rain doesn’t solve the problem soon.

(2) Europe: Drought and Natural Gas Crisis. Europe is also experiencing historically dry conditions, with 47% of Europe under a drought warning and 17% under a drought alert, the EU’s August drought report noted. A shrinking Rhine River in Germany has limited coal shipments to electric plants. Uniper, one of Germany’s largest energy producers, said two of its plants that use coal to generate electricity may see “irregular” operation until early September due to “insecure” coal supplies, an August 23 article in the Business Standard reported.

In France nuclear production has been reduced because the Rhone and Garonne rivers’ temperatures were too high to cool the plants. In addition, the amount of hydroelectric power produced in France and Italy has dropped sharply as rivers and reservoirs have shrunk.

More than 100 French municipalities have drinking water delivered by truck and fires across Europe have consumed more than 60,000 hectares of land since the beginning of this year, double what burned in 2021 and more than four times the average of the past decade. The heat and drought is also hurting crops. Current yield forecasts for grain maize, soybeans, and sunflowers in the EU are 16%, 15%, and 12% below the five-year average.

Russia is making the situation even more untenable by limiting the Russian natural gas flowing into Europe. Flows via the Nord Stream 1 pipeline, which have been 20% of normal, will be cut off entirely for three days at the end of the month, purportedly to conduct unscheduled maintenance. The news unnerved commodity markets, sending the price of natural gas up to $9.19 per MMBtu in the US (Fig.1).

Some energy-intensive industrial plants are closing because of escalating energy prices. Norsk Hydro plans to close an aluminum smelter in Slovkia. Budel, one of Europe’s largest zinc smelters, will halt production next month too, and others are operating at less than full capacity. “The region had already lost about half of its zinc and aluminum smelting capacity during the past year, mainly as producers dialed back output. Hydro and others are now moving to shut down plants entirely,” an August 17 Bloomberg article reported.

The price of zinc has jumped 21% after hitting a low on July 15, 2022 (Fig.2), while the price of aluminum is 5% above its July 15 low (Fig.3).

The European economy has not been unscathed. S&P Global’s purchasing managers index for the Eurozone fell to 49.2 in August, down from 49.9 in July (Fig.4). Eurozone manufacturing PMI fell to 49.7, a 26-month low. Meanwhile, Eurozone services barely expanded at 50.2, down from 51.2 in July. New orders fell and factories reported a glut of inventories.

Here’s the August PMI flash estimates (total, manufacturing, nonmanufacturing) for some of the largest European nations: Germany (47.6, 49.8, 48.2), France (49.8, 49.0, 51.0), United Kingdom (50.9, 46.0, 52.5). Data for Italy (47.7, 48.5, 48.4) and Spain (52.7, 48.7, 53.8) is only available for July (Fig. 5, Fig. 6, Fig.7, Fig.8, and Fig.9).

The good news is that for most of Europe “normal” weather conditions are expected to return from August to October. It should alleviate the drought, though not entirely reverse the impact of the dry weather.

Russia: Another Opinion. In last Thursday’s Morning Briefing we concluded that while Russia’s economy was shrinking, the damage from Western sanctions wasn’t as bad as initially expected because the price of oil has soared and Asian countries have proved willing to buy the commodity from Russia.

An eagle-eyed reader pointed out a July 20 study by Yale University professors with a different opinion: “Business Retreats and Sanctions are Crippling the Russian Economy.”

The difference between our conclusion last week and the Yale study may be a matter of timing. High commodity prices are helping Russia’s economy today. Russia’s inability to buy western goods to replace and repair computers, cell phones, and assorted factory parts may drag down the Russian economy more than expected next year.

Here are some of the highlights from the Yale report:

(1) Russia needs Europe. The Yale study argues that Russia is far more dependent on Europe as a customer for its natural gas than Europe is dependent on Russia as a provider of natural gas. Russia sells 83% of its natural gas to Europe, while Europe gets only 46% of its natural gas from Russia. The International Energy Agency has a plan for the EU to reduce its reliance on Russian natural gas that includes importing natural gas from other countries, increasing the use of renewables and coal, and increasing natural gas in storage.

Russia can’t easily replace European buyers of natural gas with Asian buyers because the infrastructure doesn’t exist. To replace Europe, Russia would have to build a major pipeline across unforgiving territory to China. Alternatively, it would need to build many liquified natural gas (LNG) plants. Both solutions are costly and take time to complete. It’s also unlikely that Russia has the expertise required and China has yet to open its wallet to help Russia. The two countries have historically bickered over the price of natural gas, with China desiring a lower price that’s equivalent to what the country pays for coal.

Meanwhile, Russia’s state-run gas company Gazprom eliminated its dividend in June for the first time since 1998, indicating the stress the company is under given sales to the West have shrunk dramatically. Company officials said the dividend was cut so Gazprom could focus on Russian regional gasification, prepare for the heating season and pay increased taxes, a June 30 Reuters article reported.

While the authors are correct that many LNG sellers are willing to provide Europe with natural gas, Europe will also need to build new LNG plants to make receiving the LNG possible. And while the authors may be correct in the long run, Europeans today are worried about whether there will be enough natural gas to provide air conditioning this summer and heat this winter.

(2) Russia needs Western oil customers. Western companies that have left Russia due to sanctions have taken their technology and know-how with them. The Russian Ministry of Finance forecasts that Russia could see its oil production fall by 9%-17% this year due to Western sanctions and departing international oil companies. If sanctions remain in place, Russia could see its oil production capacity decrease to about 6mbd by the end of the decade, down from the 11.3mbd it produced in January.

The authors also doubt that China and India will be able to absorb the 6mbd of oil that Russia previously sold to the West. They point to a July 18 Bloomberg article that states Chinese and Indian purchases of Russian oil are down some 30% from their post invasion peaks. In addition, the oil sold to Asia is being priced roughly $35 less than the Brent crude benchmark. However, the same article notes that the jump in the price of oil means that the revenue Russia is receiving from oil sales is still about 25% higher than prior to its invasion of Ukraine. So, even if Russia sells half as much oil next year than it did in 2021, as long as the price of oil is twice as high the country will benefit.

(3) Russia needs imports. Russia would like to believe it can operate independently of Western countries, but 20% of Russian GDP came from imports. The percentage is even higher in specific areas. Imports were 75% of nonfood consumer goods sold and 86% of telecommunications equipment. The authors estimate that Russian imports fell by upwards of 50% in the initial months after the invasion due to sanctions. Even China’s exports to Russia fell by 50% to under $4 billion from the start of this year to April.

Russian companies are left scrambling to find alternative sources for the imported products they need. One survey noted that 81% of Russian manufacturers “could not find any Russian versions of imported products they need. and more than half were “highly dissatisfied” with the quality of homegrown products. …In short, Russia needs global markets far more than the rest of the world needs Russian markets.”

There are tales of Russian airlines using parts from grounded aircraft to keep other planes flying. Russian military equipment reportedly has semiconductors that were taken out of dishwashers and refrigerators. Auto sales have fallen from about 100,000 a month prior to the invasion to only 27,000 in June due to a lack of supply, soaring prices, and falling consumer sentiment. And the lack of available goods has sent inflation soaring. Here we agree with the authors. The inability to import Western goods seems to be Russia’s Achilles heel.

Disruptive Technologies: Robotic Update. In Q1, North American companies bought the most robots ever: 11,595 robots (up 28% y/y) worth $646 million (up 43% y/y), according to a June 6 Association for Advancing Automation press release. Given this surge of spending, we thought we’d update how companies are using robots today and what scientist are working on for the future.

(1) A Tesla teaser. Tesla is expected to unveil Optimus, a humanoid robot prototype, on September 30 during Tesla AI Day #2. The company recently released a picture that appears to be Optimus’s “hands” making a heart sign, an August 4 Electrek article reported.

Elon Musk has said creating Optimus is a company priority. The humanoid robot business could become bigger than Tesla’s auto business, helping to solve the labor shortage and reduce costs. Initially Optimus would perform simple, repetitive tasks in manufacturing. But, as the robot improves, it will “be able to perform a wider range of tasks that would make it useful for both commercial and consumer applications,” the article stated. Tesla aims for produce Optimus in 2023.

Japanese startup Jinki Ittai has introduced a giant humanoid robot that looks like a transformer from the movies and is controlled by a human wearing a VR headset. The company envisions the robot being used in construction, fixing power lines, or replacing road signs, an August 8 TechEBlog article stated. The robot is expected to enter production in 2024.

(2) The perfect pizza. Italian chefs beware. Picnic Works’ pizza-making robot presses the dough, adds sauce, cheese and toppings, and then puts the pie on a conveyor belt to deliver it to the oven, an August 19 article in Nation’s Restaurant News reported. Working with Picnic Works equipment, PizzaHQ can make 1,500 pizzas a day. Now that’s a lot of dough. (Couldn’t resist!)

Robots are also the chefs in Stellar Pizza’s automated pizza trucks. They make the pizzas, but right now humans are putting the pie into the oven, slicing, and boxing the pizza. Stellar Pizza is looking to automate those processes too. Stellar Pizza’s founder Benson Tsai, a former SpaceX engineer, estimates the robots can reduce costs by 16-20% per truck by reducing labor.

(3) Making smarter robots. The Boston Dynamics AI Institute was launched with $400 million of funding to create more intelligent robots. Boston Dynamics founder Marc Raibert heads the institute and wants robots to be able to look at the world and understand what they’re seeing.

“I’d like to make a robot that you can take into a factory, where it watches a person doing a job and figures out how to do that job itself,” he said in a recent IEEE Spectrum interview cited in an August 22 MindMatters article. The institute will also focus on ethical issues surrounding robots, including the use of robots in the military and threat of killer robots taking over the world.

The weaponization of robots is not theoretical. Russian engineers have created a robotic dog that carries and fires weapons, an August 15 Newsweek article reported. It can also deliver medications and survey war torn areas. The US military also has a robotic dog. The Portland Air National guard is using one for security and surveillance and a Florida police department is using a robotic dog in situations that involve threat to human life.

(4) Softer robots. Hong Kong University and Lawrence Berkeley National Laboratory scientists have created Aquabots, soft robots made primarily of liquids. The fluidity of these structures enable them to change shape and enter narrow spaces. They envision using Aquabots inside our bodies, perhaps delivering drugs to specific locations, biologically engineering human tissue, or performing the functions of specific biological systems, an August 22 article in ELE Times reported.

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Will Inflation Persist?

August 24 (Wednesday)

Inflation: What Could Go Right. It’s showtime for inflation. The rally in stock prices since June 16 was largely attributable to investors’ expectations that inflation might be peaking. If that’s so, then the Fed’s monetary policy tightening cycle will end sooner rather than later at a lower terminal federal funds rate than otherwise.

In this relatively upbeat scenario, the economy should continue to grow slowly overall, with any recession rolling through different sectors at different times, as occurred during the first half of this year. This scenario might mean that the S&P 500’s latest bear market ended when its price index bottomed on June 16 at 3666.77 and its forward P/E bottomed at 15.3.

So it is also showtime for our inflation forecast. We’ve been predicting that the headline PCED inflation rate would peak during the first half of this year between 6%-7% and fall to 4%-5% during the second half of this year and to 3%-4% next year (Fig. 1). The headline PCED inflation rate rose to 6.8% during June, the highest since January 1982. The core PCED inflation rate rose to 5.3% during February this year and fell to 4.8% during June.

We’ll all be looking for confirmation that inflation has peaked in the major inflation indicators that will be released in coming weeks. The next big one will be August’s CPI to be released on September 13. So far this year, the headline CPI inflation rate rose to 9.1% during June and fell to 8.5% during July, while the core CPI inflation rate rose to 6.5% during March and fell to 5.9% during June and July (Fig. 2).

There already are some indicators that can give us a glimpse of what to expect for August’s CPI. Let’s have a look at them:

(1) Regional business surveys. Three of the five regional business surveys are now available through August. They are conducted by the Federal Reserve district banks of New York, Philadelphia, and Richmond. The average of their prices-paid and prices-received indexes clearly peaked earlier this year, but they remained above their previous cyclical peaks (Fig. 3).

The average of the three regional prices-paid indexes suggests that August’s national M-PMI prices-paid index continued to fall but also remained high (Fig. 4).

(2) Supply chains. The three regional business surveys include indexes for delivery times and unfilled orders (Fig. 5). The average of these indexes fell from 19.9 in March to -8.9 in August, suggesting that the supply-chain disruptions are easing either because the chains have been fixed, demand has fallen, or both  (Fig. 6). Whatever the cause, this development should reduce inflationary pressures. The average of the regional surveys is highly correlated with the national M-PMI’s supplier deliveries index.

(3) Food and energy commodities. The major contributors to headline CPI inflation have been food and energy prices, which rose 10.9% y/y and 32.9% y/y through July (Fig. 7). There are some signs of relief on both fronts. The S&P Goldman Sachs Commodity Price Indexes for both agricultural and energy commodities are down 18% and 20% from their peaks in May and June, respectively, through Monday (Fig. 8). The GSCI Grain Index is down 26% since it peaked in May (Fig. 9).

The CPI food inflation index for the US is highly correlated with the yearly percent change in the UN world food index, which has dropped from a recent peak of 39.7% in May 2021 to 13.1% in July (Fig. 10).

On the energy front, the CPI gasoline index is derived from a weekly data series on the national retail pump price (Fig. 11). Both fell sharply during July. The four-week average of the pump price continued to decline through the August 22 week.

The bad news on the energy front is that natural gas prices have soared in recent days as the energy crisis in Europe has worsened.

(4) Durable goods prices. The CPI for durable goods peaked at 18.7% y/y in February; it fell to 7.9% in July (Fig. 12). Consumers have been pivoting away from buying goods toward purchasing services, resulting in unintended inventories for retailers, forcing them to cut their prices.

The rate of price increases for housing-related durable goods has been moderating also as a result of the housing recession. And the rate of price inflation for used cars has moderated in recent months, though remains high for new cars.

(5) Services. In the services sector, even though Americans have been traveling more, the inflation rates for lodging away from home, airfares, and car & truck rentals have moderated greatly from much higher inflation rates earlier this year (Fig. 13).

The rent components of the CPI are likely to remain troublesome over the rest of the year. Both rent of primary residence and owners’ equivalent rent (OER) have seen their three-month annualized inflation rates exceed the y/y rate since early 2021 (Fig. 14). Both have large weights in the CPI.

The current weights of the OER and tenant rent components of the headline CPI are 24% and 7%, respectively, and those of the headline PCED are 11% and 4%. The combined weights for tenant rent and OER are unrealistically high in the CPI at 31% but about right in the PCED at 15%.

OER is a bizarre concept reflecting how much homeowners would have to pay themselves in rent if they were their own landlords. The good news is that median existing home prices, which tend to lead the OER inflation rate, have been falling (Fig. 15).

US Fiscal Policy I: Inflation Redux Act. President Joe Biden’s Inflation Reduction Act of 2022 (the Act) is better described as the “wannabe Build Back Better (BBB)” act. It won’t substantially reduce inflation as an August 15 White House briefing claimed. But it may be a “breakthrough” on climate policy, as the nonprofit Wilderness Society has proclaimed.

The Act is a scaled-back version of part of the climate-focused BBB agenda proposed by Biden early in his administration—although supporter Democratic Senator Joe Manchin (WV) might not agree. Manchin staunchly opposed the BBB, finding it to be too spending-heavy and potentially inflationary, and he recently called the BBB “dead,” apparently to bury his former reactions and to disassociate the two acts.

To appease Manchin, the Act includes plenty of new “pay-fors” that offset its incremental spending on climate. However, the “inflation reduction” branding seems more like an attempt to justify special interest funding (backed by elite lobbyists, including Bill Gates), even though the Act really has little to do with inflation.

Let’s have a quick look at the Act by the numbers from a big-picture perspective, then outline some of the major provisions and how they could impact inflation:

(1) Big picture: Major components. In a one-pager summarizing the Act’s major components, the Senate conveniently did not outline the spending timing. The summary does show that an incremental $400+ billion would be offset by $700+ billion in additional revenues from increased taxes and drug price reform. But any offsetting effects won’t be seen until well into the 10-year budget window ending in 2031. Not until 2027 does the Act result in net reductions to the deficit, a Penn Wharton Budget Model (PWBM) analysis showed. Before that, the Act adds to the deficit, meaning that it could be inflationary over the near term!

(2) Inflation impact: Statistically zero. Even after the full effects of the Act are seen a decade from now, PWBM concluded that any impact on inflation is “not statistically different from zero.”

Similarly, Moody’s expects that the Act “will modestly reduce inflation over the 10-year budget horizon,” giving the economy a “nudge” in the right direction. By Q4-2031, the CPI will be just 0.33% lower because of the legislation, Moody’s found.

Also, the Congressional Budget Office (CBO) has estimated that the Act will have a “negligible effect on inflation” in 2022. In years beyond, inflation could be somewhere between 0.1ppt lower and 0.1ppt higher than now as a result of the Act, the CBO said.

US Fiscal Policy II: The Act’s Provisions. Let’s go over some of the Inflation Reduction Act of 2022’s major provisions and examine the potential for them actually to raise inflation, rather than lower it as misleadingly implied by the name of the Act:

(1) Climate and energy provisions (-$385 billion addition to deficit). This provision includes numerous investments in climate advancements, including tax credits for households to offset energy costs, investments in clean energy production, and tax credits for reducing carbon emissions. Putting aside the Act’s climate benefits, are not such measures textbook-inflationary? Public investments require public workers and resources, and mandating the reduction of carbon emissions will increase production costs for manufacturers.

(2) Prescription drug pricing reforms (+$229 billion budget reduction). This provision permits Medicare to negotiate certain prescription drug prices to lower the price for beneficiaries. Sure, bringing down healthcare costs is helpful for family budgets. But the money that people would have spent on drugs will likely be spent elsewhere, so this provision won’t be broadly disinflationary. It is also worth noting that prescription drugs have low weights in both the CPI and PCED, so even big changes in drug prices would impact overall inflation only marginally.

(3) Minimum tax on corporations’ book income (+$199 billion budget reduction). A new tax rate of 15% will be applied to corporations with at least $1 billion in income. Individual and household tax rates will not be directly impacted. This component of the Act obviously “pays for” the climate provisions along with the drug reform. But affected corporations may well pass on their increased costs to the consumer by raising prices.

By the way, stock buybacks by corporations also will face a 1% excise tax.

(4) IRS funding (+$146 billion). The Internal Revenue Service will receive funding to substantially increase its employee base, largely focused on increasing audits to target tax evaders. Again, this provision directly will raise revenues and reduce the budget deficit, offsetting the climate investments. But the added costs to businesses (particularly smaller ones) from increased audits (and possibly higher tax bills) could limit their capacity expansion plans, constraining supply and thereby worsening inflation.

Other less significant provisions total +$73 billion.

(FYI: We don’t ascribe much merit to the Joint Committee on Taxation’s report indicating that the Act would increase taxes at nearly every income level given the opinion of several outside evaluators, including the Tax Policy Center, faulting the analysis for overlooking important components of the Act.)

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Raging Debate

August 23 (Tuesday)

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Strategy I: The Tug-Of-War Continues. The latest bear market started on January 3, 2022, when the S&P 500 peaked at a record-high 4796.56. That’s undisputable. But whether the bear market ended on June 16 at a closing low of 3666.77 is a question of great dispute. The bulls, including Joe and me, think so. The bears believe that the bear market isn’t over and that new lows are ahead.

The bears were on the defensive from Thursday, June 16 through Tuesday, August 16; over those two months, the S&P 500 rallied 17.4% to 4305. But the rally wasn’t robust enough to breach the index’s 200-day moving average, which was 4306 on Friday (Fig. 1). The S&P 500 stock price index relative to its 200-dma bottomed at a 26-month low of  -17.1% on June 16 and rose to -0.2% on August 16 (Fig. 2). It closed at -3.8% on Monday.

Now let’s review why the bulls enjoyed such a good bull run from mid-June through mid-August and then consider why the bears might have a good bear run for a few weeks:

(1) There were mounting signs this summer that inflation might be peaking and doing so within the context of a soft, rather than hard, landing of the economy. The major commodity price indexes peaked in mid-June, led by energy (especially gasoline) and agricultural (especially grain) commodities (Fig. 3 and Fig. 4). An easing of price inflation would lift consumers’ purchasing power at a time that payroll employment has been rising; it jumped by 926,000 during June and July.

(2) During the Q2 earnings reporting season, the results turned out to be better than expected. With 95% of the S&P 500 companies reporting, Q2 earnings growth for the companies that have reported is 10.6% y/y, twice as fast as was expected at the start of the earnings reporting season (Fig. 5 and Fig. 6).

(3) At his press conference on July 27, Fed Chair Jerome Powell said that the federal funds rate, which had just been raised 75bps to 2.25%-2.50% by the FOMC, was now at neutral, suggesting that the monetary tightening cycle might be over sooner rather than later. Both stock and bond prices rallied. The foreign-exchange value of the dollar remained strong, suggesting that foreign investors were purchasing dollars to buy US securities (Fig. 7).

(4) Sentiment was extremely bearish in mid-June, suggesting that sellers had mostly capitulated (Fig. 8). Back then, the bull/bear ratio, a contrary indicator, had bottomed at 0.60, representing the fewest bulls relative to bears since early March 2009.

Now the bulls are likely to be on the defensive for a while. Consider the following:

(1) From a technical perspective, the bears gained ground in their tug-of-war with the bulls when the S&P 500 failed to rise above its 200-dma last week.

(2) During the recent bear market, investors slashed the valuation multiples that they were willing to pay for analysts’ consensus earnings expectations, which were rising to record highs. Perversely, the latest rally occurred as analysts finally started to cut their earnings estimates. They’ve been doing so since late June, lowering estimates for the remaining two quarters of this year and all four quarters of next year (Fig. 9 and Fig. 10).

(3) “Don’t fight the Fed” has been good advice for investors to follow over the years. Arguably, they’ve been doing just that from mid-June through mid-August. Since Powell’s presser, several Fed officials continued to squawk hawkishly. They’ve been pushing back on the idea that the Fed may soon slow the pace of interest-rate increases and start cutting rates early next year.

Most recently, in an August 19 WSJ interview, Federal Reserve Bank of St. Louis President James Bullard said he expects the economy to be “stronger in the second half than we were in the first half.” On inflation, he said: “[I]t’s far too high.” He wants to raise the federal funds rate quickly to a level “that’ll put significant downward pressure on inflation.” He favors a 75bps hike at the September meeting of the FOMC. He said that “the idea that inflation has peaked is a hope” rather than a reality.

(4) In our opinion, the financial markets have discounted a 75bps rate hike in the federal funds rate to a range of 3.00%-3.25% at the September meeting of the FOMC. So there may be a debate within the FOMC between those (like Bullard) who want to front-load future rate increases and those (like Powell, perhaps) who would prefer to pause rate hiking for a while.

July’s CPI, which will be released on September 13, may resolve the debate in favor of the more hawkish FOMC members even if it shows insufficient further moderation of inflation to justify a pause. The bears are expecting to hear more squawking hawks on the committee in coming months. Then again, in our opinion, the inflation news may continue to show that inflation is heading lower, as the bulls expect.

(5) When he was asked about quantitative tightening, Bullard noted that he wants to see how QT2 works over the next six months before evaluating how it’s going. He wasn’t asked and didn’t volunteer whether QT2 is equivalent to a significant rate hike, which might reduce the terminal federal funds rate for the current tightening monetary policy cycle.

(6) Winter is coming, and Europe is getting closer to a severe recession resulting from an energy crisis as Russia cuts off natural gas supplies to the region. European gas prices soared on Monday after Russia’s state-owned energy giant Gazprom said it would shut down the Nord Stream 1 pipeline for three days at the end of the month.

The unscheduled maintenance work on the pipeline, which runs from Russia to Germany via the Baltic Sea, is heightening fears of a total shutdown. A severe recession in Europe might not cause a recession in the US, but it certainly would depress the earnings of many US corporations that do business in the region. It would strengthen the US dollar further, which would also depress earnings of US companies with sales in Europe.

Strategy II: The Ugliest Chart Of Them All. We’ve saved the worst for last. It’s probably the most oft-shown and most compelling chart included in the PowerPoint presentations of the bears to make their case. It shows the S&P 500 stock price index versus the Fed’s holdings of US Treasuries, agency debt, and mortgage-backed securities (Fig. 11).

Joe and I added a dotted line to track the Fed’s QT2, which ramps up in September and will reduce the Fed’s holdings by $95 billion per month, on average.

We certainly agree that all the QE programs that expanded the Fed’s holdings of securities contributed to the bull market from 2009 through 2021. But they weren’t its only support. The S&P 500 always rises along with earnings during economic expansions, and the economy was mostly expanding over this period (except for a severe but short-lived recession in early 2020).

The fourth round of QE undoubtedly boosted the S&P 500’s valuation multiple (Fig. 12). But the forward P/E has already corrected significantly, falling from 22.5 at the beginning of 2021 to a low of 15.3 on June 16, and back up to 17.5 on Friday.

The question is whether there will be enough other buyers of Treasuries, agencies, and mortgage-backed securities to offset the Fed’s QT2. Keep in mind that before QT2’s $95 billion-per-month paring of the Fed’s balance sheet, QE4Ever expanded it by $4.7 trillion from February 2020 through May 2022.

Who might fill the void in the bond markets left by the Fed? Consider the following:

(1) US Treasury. The good news is that the federal government’s budget deficit has been shrinking significantly as pandemic-related outlays have decreased while tax revenues have been boosted by inflation (Fig. 13 and Fig. 14). Over the past 12 months through July, the deficit is down to $1.0 trillion from $2.9 trillion a year ago on the same basis.

(2) Commercial banks. So far this year, commercial banks have seen their deposits increase by $172 billion through the August 10 week, while their collective loan portfolio has expanded by $786 billion (Fig. 15). They’ve stopped accumulating securities and have sold $84 billion ytd.

(3) Bond funds. Bond mutual funds and bond ETFs have purchased just $87.4 billion of these securities over the 12 months through June, down from a comparable record high of $1.1 trillion during April 2021 (Fig. 16). As it turns out, there was an alternative to stocks, namely bonds, but they incurred huge capital losses over the past 12 months as yields soared. So it may take some time to bring investors back to the bond market at scale.

(4) Foreign investors. The most aggressive buyers of bonds in the US capital markets have been foreign investors. Over the past 12 months through June, they purchased $840.9 billion in the US bond market, led by $618.8 billion in Treasury notes and bonds (Fig. 17 and Fig. 18).

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Searching For Godot

August 22 (Monday)

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US Economy I: Recessions, Bananas & Godot. What if the most widely anticipated recession in history doesn’t happen—at least not over the rest of this year or all next year? What if it already happened during the first half of this year and is over already? It is widely believed that the two small quarterly declines in real GDP during the first half of this year was a “technical” recession only—i.e., so mild that it might not enter the record books as an official recession.

The Biden administration, which seems to be channeling the Carter administration, has rejected claims that the US is in a recession. On July 28, the GDP report for Q2 showed a 0.9% (saar) decline following Q1’s 1.6% drop. Treasury Secretary Janet Yellen, speaking to reporters after the report, said “most economists and most Americans have a similar definition of recession—substantial job losses and mass layoffs, businesses shutting down, private sector activity slowing considerably, family budgets under immense strain. In sum, a broad-based weakening of our economy. That is not what we're seeing right now.” Administration officials clearly don’t want to hear the “R” word.

“Between 1973 and 1975, we had the deepest banana that we had in 35 years, and yet inflation dipped only very briefly,” the economist Alfred Kahn, who headed the Carter administration’s task force to fight inflation, once said. He substituted “banana” for the word “recession.” The reason, he amiably explained, was that references to recessions seemed to make people nervous and irritable. Of course, one of the people made the most irritable was his boss, President Jimmy Carter.

Rather than talking about bananas, Debbie and I prefer to channel playwright Samuel Beckett, who wrote Waiting for Godot. In the absurdist play, two characters, Vladimir (Didi) and Estragon (Gogo), engage in various discussions and encounters while anxiously awaiting, for some unexplained reason, the titular Godot, who never arrives. Notwithstanding the technical recession during H1-2022, an official recession—anxiously awaited all year—might still be a no-show when the curtain closes on 2022 and again on 2023.

The August 17 estimate for Q3’s real GDP growth from the Atlanta Fed’s GDPNow tracking model was 1.6%, down from the previous estimate of 1.8%. It followed the release of July’s retail sales report from the US Census Bureau; Q3’s real personal consumption expenditures growth of 2.7% was revised down to 2.4%.

Last week, we assigned a 60% probability to a slow-growth scenario, 35% to a recession, and 5% to an inflationary boom. Of course, we all could “talk ourselves into” a recession, expecting it with such certainty that our economic behavior is altered. Reduced economic activity could result from such “talk,” but so could increased caution, which likely would diminish the excesses that typically cause or worsen recessions. So any recession that occurs is more likely to be a soft landing rather than a hard landing—i.e., a mild recession rather than a bad one. It could even be a “rolling recession” hitting different sectors of the economy at different times, resulting in a shallow but protracted “growth recession.”

US Economy II: Rolling Recession. In this context, let’s look at the latest data and clues around the world for signs of Godot:

(1) Leading & coincident indicators. On Thursday, the Conference Board released July’s Index of Coincident Economic Indicators (CEI). It rose to a new record high (Fig. 1). Peaks and troughs in the CEI have coincided with the business cycle’s peaks and troughs, suggesting that this is the main indicator used by the Dating Committee of the National Bureau of Economic Research to call the beginning and end of recessions. So there’s no recession evident from the CEI so far.

On the other hand, the Index of Leading Economic Indicators (LEI) fell during July for the fifth consecutive month. It peaked at a record high during February and is down 2.3% since then. The Conference Board projects that the economy will not expand during Q3 and could slip into a mild recession by the end of this year or early next year.

There have been a few similar mid-cycle slowdowns in the LEI that didn’t lead recessions. In any event, our hunch is that the LEI could be signaling a rolling recession that might not make it into the record books.

(2) Manufacturing. So far, we have two of the five regional business conditions survey results for August conducted by the Federal Reserve district banks. The New York and Philadelphia districts’ surveys tend to come out before those of Dallas, Kansas City, and Richmond. The average general business conditions index composed of the first two tends to track that of the last three, as well as the national M-PMI (Fig. 2 and Fig. 3). Interestingly, the former is less volatile than the latter.

The NY-Philly average index fell to -12.6 during August, the lowest reading since May 2020. It suggests that August’s M-PMI is likely to fall from 52.8 in July to just below 50.0. It also suggests that the growth rate of manufacturing production is likely to weaken in coming months (Fig. 4).

(3) Housing. In the US economy, the housing sector is clearly in a recession. Not only are new and existing home sales depressed, but so are housing-related retail sales. On the other hand, multi-family housing construction is likely to remain robust.

The sum of new and existing home sales has dropped 21.7% since January to 5.15 million units (saar) during June (Fig. 5). As a result of soaring home prices and mortgage rates, the housing affordability index calculated by the National Association of Realtors plunged from 141.5 in January to 98.5 in June (Fig. 6).

(4) Autos. In the past, housing and auto recessions tended to coincide since both industries are interest-rate sensitive. This time, the auto industry may be spared since it’s now recovering from a recession that started about a year ago as supply-chain problems depressed motor vehicle production. Accordingly, there’s lots of pent-up demand for autos right now.

Meanwhile, the output of US-made motor vehicles has rebounded from last year’s low of 7.7 million units (saar) during September to 11.0 million units during July, led by light trucks (Fig. 7). That improvement undoubtedly reflects fewer supply-chain problems and lots of pent-up demand. In any event, the domestic auto inventory-to-sales ratio was just 0.6 months’ supply during June (Fig. 8). Prior to the pandemic, the normal ratio was around 2.5 months’ supply.

(5) Capital spending. Capital spending growth is likely to slow along with corporate profits, but neither of their growth rates is likely to turn negative as typically occurs during recessions. Companies must spend more on technology and capital equipment to boost productivity to deal with the structural shortages of labor.

The Business Roundtable’s CEO outlook index closely tracks the y/y growth rate in capital spending in real GDP (Fig. 9). The index peaked most recently in Q4-2021 at 123.5 and fell to 95.6 in Q2-2022, which is still a relatively high reading. The growth rate of real capital spending peaked most recently in Q2-2021 at 13.3%. It was down to 3.5% in Q2-2022.

The regional business conditions surveys discussed above also track current and future capital spending. They’ve both declined from last year’s cyclical peaks but remained relatively high in July (Fig. 10).

(6) Energy. Fossil fuel companies that have been cutting their capital budgets are likely to boost them again soon, as the Biden administration has conceded that the hoped-for transition to cleaner energy was too hasty.

On Friday, FOX Business reported that “[w]hile the Inflation Reduction Act signed by President Joe Biden last Tuesday includes several green energy provisions opposed by the fossil fuel industry, it also orders the Department of the Interior (DOI) to take a series of steps to boost fossil fuel production on federal lands and waters. The legislation specifically requires the DOI to reinstate Lease Sale 257, a massive offshore oil and gas sale spanning 80.8 million acres across the Gulf of Mexico, within 30 days of enactment.”

(7) Government spending. The Biden administration has succeeded in pushing lots of spending bills through Congress, including for public infrastructure, new semiconductor production capacity, and plenty of “green” projects. This suggests that construction spending on public projects, which currently equals what Americans spend on their home improvements, is likely to start soaring over the next couple of years (Fig. 11).

Industrial production of defense and space equipment rose to a record high during July (Fig. 12). Government defense spending is bound to boost such production given rising tensions between the US and its allies on one side and Russia and China on the other side.

(8) Trade. A recession could roll through America’s export sector early next year if Europe falls into a deep recession because of the energy crisis attributable to Russia’s invasion of Ukraine.

US exports and imports have been strong, though a surge in imports during Q1 accounts for much of that quarter’s decline in real GDP. The US exported a record 9.5 million barrels per day of crude oil and petroleum products during June. US natural gas exports are also soaring, especially to Europe, which may be facing a recession caused by an energy crisis this coming winter. That would weaken the pace of other US exports to the region in general, though US exports of fossil fuels are likely to be strong.

Strategy: The Cruelest Month. The poet T.S. Elliott claimed that “April is the cruelest month” in his poem The Waste Land. In our business, September has often tended to be the cruelest month of the year (Fig. 13). Will it be so again this year? Consider the following chronology:

(1) Friday, August 26. The September curse could start on Friday when Fed Chair Jerome Powell speaks at the annual Jackson Hole conference hosted by the Federal Reserve Bank of Kansas City. The title of the symposium this year is “Reassessing Constraints on the Economy and Policy.” Powell might be more hawkish than market participants expect. He is likely to say that inflation does seem to be peaking, but it remains too high. He’ll undoubtedly reiterate that the Fed’s top priority is to bring inflation down.

(2) Thursday, September 1. We think August’s M-PMI could drop below the 50.0 mark—indicating contraction—based on what we know from the index averaging the NY and Philly business conditions results for August. That might heighten recession fears again. However, keep in mind that according to the M-PMI press release, it is readings below 42.5 that are associated with recessions.

(3) Tuesday, September 13. August’s CPI will be released. Inflationary pressures probably continued to subside for nondurables (particularly energy) and durable goods (particularly used cars and housing-related good). However, rent inflation is likely to remain a persistent and pesky problem.

(4) Wednesday, September 21. The FOMC’s statement will be released at 2:00 p.m. along with the committee’s latest quarterly Summary of Economic Projections (SEP). Powell’s press conference will take place at 2:30 p.m. Melissa and I expect that the Fed will hike the federal funds rate by 75bps and that Powell will signal that the Fed might pause raising interest rates for the rest of the year, which could lift stock prices. The SEP will indicate whether the FOMC is turning even more hawkish or less so.

(5) Wild card. At the beginning of September, the Fed will increase the pace at which it shrinks its balance sheet to $95 billion per month. No one really knows how this will impact the capital markets. It could put upward pressure on bond yields, which might be offset by continued inflows into the US bond market from abroad.

But the planned balance-sheet reductions scare many of the investors who’ve seen the chart showing the S&P 500 rising along with the Fed’s balance sheet since 2009 (Fig. 14). They are afraid that the Fed’s QT2 could push stock prices much lower.

We aren’t spooked. We note that stock prices rose 18.3% during QT1 from October 1, 2017 through July 31, 2019. In addition, there is still plenty of liquidity left over from QE4Ever and all the helicopter money distributed by the US Treasury’s pandemic support checks. In addition, global investors have been purchasing plenty of dollars to buy US securities, a theme we dub “TINAC”—the widely held view that effectively “there is no alternative country” for investing right now.

Then again, there is a remarkably close correlation between the NY-Philly composite business conditions index and the y/y percent change in the S&P 500, which was -10.4% during July (Fig. 15).

Movie. “The Offer” (+ + +) (link) is a wonderful Paramount+ mini-series about the making of “The Godfather.” In an 1889 essay, Oscar Wilde wrote, “Life imitates Art far more than Art imitates Life.” That certainly applies to this mini-series. The cast of characters involved in making the movie is just as colorful as the cast in the movie. The real-life plot behind the production of one of the greatest movies of all times is even more interesting than that of the movie. Both are full of intrigue and violence, but the live version is much funnier than the artsy one. The dialogue and acting are top notch all around too.

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Consumers, Russia & The Metaverse

August 18 (Thursday)

Consumer Discretionary: Less Spent On Gas, More Spent On Stuff. Consumer spending continues to shift in correlation with how much consumers have to spend on gasoline. In July, the news was good: Consumers had more money to spend on things and experiences because the price of gasoline peaked during the June 13 week and has been falling ever since (Fig. 1).

July’s retail sales excluding gasoline and auto sales increased 0.7% m/m (Fig. 2). When gas and auto sales were included, July’s retail sales were flat m/m.

Spending at gasoline stations fell 1.8% m/m, and auto sales dropped 1.6%. That left consumers with more money to spend at non-store retailers (2.7% m/m) and at stores selling building materials, garden equipment, and supplies (1.5), miscellaneous items (1.5), health & personal care items (0.4), electronics & appliances (0.4), food and beverages (0.2), furniture and home furnishings (0.2), and sporting goods, hobbies, musical instruments, and books (0.1).

The large jump in spending at online retailers likely reflects the change in Amazon’s Prime Day timing to July this year from June last year. The segment’s sales were up 20.2% y/y in July. Outside of gas and autos, the only other areas to post m/m declines last month were stores selling clothing and accessories (-0.6%) and general merchandise (-0.7) (Fig. 3, Fig. 4, and Fig. 5).

Target warned investors in June that its Q2 results wouldn’t meet expectations because consumer spending patterns had changed, and the retailer was stuck with excessive inventory. Most of that inventory now has been cleared out, and consumers are buying essentials and store brands, while also looking forward to celebrating the holidays, management said on the earnings conference call. Here’s a quick rundown of what Target execs have been seeing:

(1) Sharp decline in results. There’s no sugar-coating it: The need to run sales to move inventory hurt Target’s bottom line. Revenue increased 3.5% y/y in Q2 to $26 billion. However, the quarter’s gross margin dropped 8.9 percentage points y/y to 21.5, its operating margin shrank to 1.2%, and earnings dropped to $183 million from $1.8 billion a year ago.

(2) Consumers prefer staples. Target spent the last few weeks reducing the discretionary items it carries in inventory and has on order. Instead, it’s been stocking up on items in food and beverage, beauty, essentials (which includes the pets and health care categories), seasonal items, and fashion-forward items.

The company’s Q2 same-store sales increased 2.6% y/y, and here’s how certain categories fared: food and beverage (low double-digit increase), beauty (high single-digit increase), essentials (mid-single-digit increase), hardlines (down slightly), home (low single-digit decline), and apparel (low single-digit decline).

A pinched consumer has Target focused on offering customers savings. “Given the ongoing pressure our guests are facing from inflation, we’re leaning into value. This means we’re focused on providing great everyday pricing and strong opening price points across every category, including in our own brands,” said CEO Brian Cornell according to the conference call transcript. Consumers are “responding” to Target’s 12 private label brands, each of which generate more than $1 billion in revenue.

That said, Target’s management believes consumers are entering H2 ready to open their wallets for the holidays. The company will still be clearing out some remaining inventory in Q3; but in Q4, it faces easier comparisons to Q4-2021, when high costs were incurred. As a result, management didn’t change its earlier guidance for low- to mid-single digit revenue growth for fiscal 2022 (ending January 2023) and an operating margin rate of around 6% in the second half of the year.

(3) Supply chain improving. Target’s COO John Mulligan believes the supply chain is much improved compared to last year but still not normal. “There are early signs that both costs and volatility may have peaked. More specifically, lead times in global shipping have begun to decline. Spot rates to move shipping containers have fallen somewhat. And in light of the reduction in petroleum prices we’ve seen recently, fuel surcharges have been easing compared with the peak rates we saw earlier in the second quarter.”

Target continues to request delivery of inventory earlier than it has historically. As a result, the company has “secured temporary capacity to store and stage shipping containers near the ports.” Having the inventory in the country earlier should reduce the company’s reliance on air freight.

Russia: Saved By Pricey Oil. When Russia went to war with Ukraine on February 24, the EU, UK, and US imposed hefty economic sanctions that they hoped would limit Russia’s ability to fund the war. Almost six months later, the war continues unabated, as do the sanctions.

The Central Bank of the Russian Federation’s assets have been frozen, Russian banks were kicked out of the Swift messaging system, and more than 1,000 Russian business leaders and politicians have been sanctioned. The US, UK, and EU have banned the export of goods that could be used by the Russian military, Russian flights have been banned, and many international companies have ended their business operations in the country. The US has banned all oil and gas imports from Russia, and the EU has said it will ban all imports of oil brought in by sea from Russia by the end of this year.

Economists polled by Reuters thought Russia’s Q2 GDP would fall 7%, but it dropped only 4%. High energy prices and Russia’s oil and gas exports helped to soften the blow. Let’s take a deeper look at what’s driving Russia’s economy:

(1) The oil buffer. Russia is the world’s third-largest oil producer, behind the US and Saudi Arabia, according to the Energy Information Administration’s data. The country’s total oil exports fell to 7.4 mbd in July, down from 8.0 mbd at the start of the year, less of a drop than was expected because the country has successfully rerouted its oil exports, an August report by the International Energy Agency (IEA) stated. Russian crude oil sold to the US, UK, EU, Japan, and Korea has dropped by nearly 2.2 mbd since the war began. But two thirds of those oil flows have been rerouted to India, China, and other markets. The EU embargo on Russian crude and product imports will take full effect in February 2023, and Russia then will have to find a new home for an additional 2.3 mbd of crude oil and crude products.

The price of a barrel of Brent crude oil spiked to $127.98 on March 8, up from $96.84 when the war began. Since the peak, the price has fallen 27.8% to $92.34 (Fig. 6). The IEA report estimates that Russia’s export revenue from oil fell to $19 billion in July, down from $21 billion the prior month, due to lower oil prices and volumes. We’ll be watching to see whether the recent drop in oil prices puts additional pressure on the Russian economy.

(2) Interest rates normalizing. After Russia invaded Ukraine and international sanctions were imposed on Russia, the country’s central bank acted swiftly to prevent an even more dramatic economic meltdown than was occurring. It hiked the country’s key interest rate to 20.0% from 9.5% in hopes of curbing the ruble’s dramatic slide against the dollar (Fig. 7 and Fig. 8). It also hoped to tame inflation, which has spiked to 15.1% as of July (Fig. 9). That’s down slightly from the peak of 17.8% in April. Russia’s central bank forecasts inflation in the ranges of 12%-15% this year and 5%-7% in 2023.

Higher interest rates, increased liquidity, capital controls, and foreign sales of oil and gas have helped to stabilize the ruble, which is 32% higher today than it was on February 23. Russia’s current account surplus more than tripled over the first five months of the year to $110 billion due to oil sales, a June 16 WSJ article reported. The Institute of International Finance estimated that “if commodity prices remain high and Russia’s oil and exports hold up, Moscow could receive more than $300 billion in payments for its energy sales this year—roughly equivalent to the amount of Russia’s foreign reserves frozen by Western sanctions.”

As the economy has stabilized, Russia’s central bank has gradually lowered the country’s key interest rate, most recently in July by 150bps to 8.0%. That’s lower than where it stood just before Russia’s invasion of Ukraine, and the central bank indicated that more rate cuts might be forthcoming. Likewise, the yield on Russia’s 10-year bond has fallen from its recent peak of 13.63% on March 23 to 8.94% yesterday (Fig. 10).

(3) GDP shrinking nonetheless. Surging oil and gas revenue couldn’t prevent Russia’s GDP from declining 4.0% y/y in Q2, a sharp change from the 3.5% y/y increase in Q1. A July 22 Reuters article reported that Russia’s central bank expects the country’s GDP will shrink 4%-6% this year (improved from its late April forecast of a 8%-10% contraction) and 1%-4% next year (a wider range than the 3% shrinkage expected earlier). Likewise, the International Monetary Fund recently upped its estimate for Russia’s GDP this year, by 2.5 percentage points to a 6.0% contraction.

Russian manufacturing output fell 4% q/q during Q2, with production in imports-dependent sectors dropping more than 10%, an August 16 CNBC article reported. Retail sales fell 11% q/q. The country’s economy is somewhat insulated by the fact that the Russian state accounts for more than 60% of GDP, while private enterprise makes up the remainder, the article noted.

(4) Capital punishment. The Ukraine war has been costly for US investors in Russian equities. The US government has banned US citizens from buying Russian shares. US investors who want to sell Russian shares they own must find an overseas buyer. Likewise, MSCI expelled Russia from its indexes on March 9, which means a total loss for holders.

Disruptive Technologies: What’s New In The Metaverse. The number of folks giving concerts in the metaverse continues to grow since we first wrote about Marshmello and Travis Scott performing on Fortnite in 2020. They been followed by Ariana Grande and Grimes, each of whom has given performances in this new virtual concert hall with no capacity constraints.

Snoop Dogg created Snoopverse for The Sandbox and in April released an exclusive music video of his song “House I Built” on the platform. He’s expected to hold a full concert later this year. Warner Music Group has also partnered with Sandbox, where it will create the “first music themed world,” a combination of a musical theme park and a concert venue.

And perhaps the ultimate recognition of this medium: MTV has created a video music award for the best musical performance in the metaverse, an August 12 WSJ article reported. Let’s take a look at some of the other ways creative types are using the metaverse:

(1) Watch the catwalk. Metaverse Fashion Week, held in March, was the first fashion week in the metaverse. Bulova, Tommy Hilfiger, Dolce & Gabbana, and others were hosted on Decentraland. It follows the Fabric of Reality show in 2020 and Gucci’s Garden on Roblox in 2021. Metaverse Fashion Week attracted 108,000 unique attendees and wasn’t the same as a traditional fashion show. Cats replaced models in the Dolce & Gabbana show. Models on the Unxd runway could fly after emerging from blooming lotuses. And an after-party allowed attendees’ avatars to participate in a dance-off, explained a March 29 Vogue Business article.

(2) Meet Paris. Paris Hilton launched Paris World on Roblox last year, and now she’s launching another “land” on The Sandbox. On Sandbox, she’ll create her virtual Malibu mansion, where she can plan social and community events like rooftop parties and glam social experiences. On Roblox’s Paris World, all of Paris’ fans around the world can attend as she DJs, and she envisions being able to sell digital wearables and working with brands in the future to monetize the site.

“At the Neon Carnival we had almost half a million people there and in the real life party there was 5,000. That’s the power of the metaverse where you can have people from all around the world be able to enjoy and experience things that are usually … exclusive events,” she said in an August 10 CNBC interview. Now, that’s hot! (as Paris has been known to say).

(3) Check out some art. Decentraland is holding its third Metaverse Art Week from August 24-28. Dubbed “The World is Made of Code,” the event looks at the relationship between man and nature and how that relates to the metaverse, according to an August 14 item on NFT Evening. It will include exhibitions, art designs, discussion panels, and live performances. OpenSea, SuperRare, Sotheby’s, and creators like Damien Hirst are involved.

Hirst is an artist who in July 2021 created 10,000 individual physical prints, each with multi-colored dots. Each of the prints could be purchased for $2,000, and the buyers had a year to decide if they wanted to keep the physical print or the corresponding NFT. If the NFT is chosen, the physical artwork will be destroyed in September. As of August, 4,851 of the buyers chose the NFT, and 5,149 opted for the physical artwork, an article on MyArtBroker stated. The value of the NFT rose to about $20,000 last year and is now closer to $9,000.

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More On The Bulls Vs Bears Debate

August 17 (Wednesday)

YRI Media. On Monday, the Financial Times posted an op-ed by Dr. Ed titled “Why the Fed might be at ‘neutral’ already on monetary policy.” By the way, you can find exclusive free downloads of Dr. Ed’s Fed Watching for Fun & Profit on our website, along with his other books. You can also tune into replays of his Monday webcasts on our website.

Strategy I: New Bull Or Old Bear? There is a fierce debate going on between the stock market’s bulls and bears. The question under consideration is whether the rally since June 16 is a new bull market or just a rally in the bear market that started on January 3? Over this period, the S&P 500 fell 23.6% from its record high of 4796 to 3666.

Joe and I think a new bull market started on June 16, with the S&P 500 up 17.4% through yesterday’s close of 4305 (Fig. 1 and Fig. 2). The S&P 500 is now only 10.2% below its record high on January 3. It rose above its 50-day moving average (dma) on July 19. It is now less than 1% below its 200-dma.

If the S&P 500 fails to rise meaningfully above its 200-dma, the bears undoubtedly will conclude that the next stop will be a retest of the devilish low, possibly on the way to a new low before the bear market finally ends. They have the calendar on their side because September tends to be the worst month for the stock market. Since 1928, the S&P 500 has dropped 1.0% on average during the month (Fig. 3).

From a fundamental perspective, the bears expect that inflation will remain elevated, forcing the Fed to raise interest rates much higher, causing a severe recession. The bulls, like us, believe that inflation might have peaked in June and that the Fed is likely to pause for a while following one more rate hike of 50bps-75bps in late September. The bears see lots more downside for earnings and valuation multiples. We see flattening corporate earnings through the end of this year and believe that forward valuation multiples bottomed on June 16. In our bullish narrative, the market could move sideways for a while before moving to new record highs next year.

Bear-market rallies tend to occur during long bear markets, which occur during long recessions when investors’ hopes for an end in sight are dashed (Fig. 4 and Fig. 5). Arguably, the S&P 500 discounted a recession during the first half of the year, which so far looks like a short “technical recession,” with real GDP down just 1.6% (saar) and 0.9% during Q1 and Q2. The rally since June 16 will turn out to be a sustainable bull market if inflation is peaking, implying that the Fed is almost done tightening and won’t have to trigger a recession to bring inflation down. If that happy scenario doesn’t play out, the bears will have a field day.

Strategy II: Earnings Up, Down, Or Sideways? Did industry analysts finally get the recession memo? In conference calls with company managements during the Q2 earnings reporting season, they seem to have picked up enough negative guidance to cut their earnings estimates for the rest of this year and all of next year. However, most of the cuts seem to be related to lower estimates for profit margins rather than for revenues. Consider the following:

(1) Earnings. Since the start of the latest earnings season, analysts’ consensus S&P 500 earnings estimates for each of the next six quarters through the end of next year have been reduced (Fig. 6 and Fig. 7). As a result, since the end of June, their estimates for 2022 and 2023 earnings have been coming down (Fig. 8). During the August 11 week, they predicted that S&P 500 operating earnings will be $225.66 this year and $243.81 next year. Joe and I are still projecting $215 and $235. The former would be flat with last year’s result.

(2) Revenues & profit margins. Interestingly, the analysts’ consensus estimates for the revenues of the S&P 500 during 2022 and 2023 edged down during the week of August 4, but both remain on solid uptrends in record-high territory (Fig. 9). So earnings expectations have been coming down along with profit margin estimates. Here are the margin estimates during the start of this year and during the August 4 week: 2022 (13.2%, 12.8%) and 2023 (13.8%, 13.2%).

We conclude that there’s no recession reflected in consensus revenues estimates, but profit margins are getting squeezed by rapidly rising costs, which are getting harder to pass through to selling prices.

(3) Forward earnings. Given our slow-go economic outlook for the rest of this year, we are forecasting that S&P 500 forward earnings per share (the time-weighted average of analysts’ consensus earnings-per-share estimates for this year and next year) will flatten around $235 for the rest of this year before moving higher to $255 next year (Fig. 10). Forward earnings has been falling since it peaked at a record-high $239.93 during the June 23 week (Fig. 11). It edged up during the August 11 week to $236.83.

(4) Earnings metrics. So far, the downdraft in earnings expectations isn’t signaling a recession, as shown by the percent of S&P 500 companies with positive three-month percent changes in forward earnings (Fig. 12). This metric fell from 81.4% at the start of this year to 62.4% during the August 12 week.

In the past, a drop below 50.0% signaled a recession, though that tended to happen after the recession had already started. In other words, as we’ve observed in the past, analysts don’t do a good job of anticipating recessions, because that’s not their job.

Then again, the Net Earnings Revisions Index (NERI) for the S&P 500 turned negative (-1.9%) during July for the first time since July 2020 (Fig. 13). It turned negative during previous recessions, but it has a history of turning negative even during economic expansions because analysts tend to be too bullish during such periods. By the way, NERI is highly correlated with the M-PMI, which may soon signal that a manufacturing recession is underway.

Expecting forward earnings to remain around current levels rather than to drop, as we do, is probably on the optimistic side of investors’ consensus expectations. On the other hand, it’s hard to imagine that the forward P/E of the S&P 500 is about to rebound to where it was—21.4—at the start of this year just before the bear market (Fig. 14). It fell to 15.3 on June 16 and snapped back to 18.1 on Friday. There are plenty of alternative valuation metrics, such as price-to-sales ratios (a.k.a. Buffett ratios) and the real earnings yield, that remain bearish (Fig. 15 and Fig. 16).

Strategy III: The MegaCaps Again. Of course, the MegaCap-8 stocks (namely, Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) are still mega, at least collectively, accounting for 24% of the market capitalization of the S&P 500 and 48% of the market cap of the S&P 500 Growth composite (Fig. 17).

From June 16 through Friday’s close, the market cap of the S&P 500 rose $5.1 trillion (16.3%), while the MegaCap-8’s collective market cap rose $2.0 trillion (25.7%). During the August 4 week, the forward P/Es of the S&P 500 and the S&P 500 excluding the MegaCaps were 17.7 and 15.7 (Fig. 18). The forward P/E of the MegaCaps was 27.8 that week, up from 22.2 during the June 16 week.

The S&P 500 is relatively cheap excluding the MegaCap-8, which aren’t as cheap as they were on June 16 but remain widely and wildly popular investments.

Strategy IV: Attacking & Taxing Buybacks. On August 5, Senate Majority Leader Chuck Schumer (D-NY) said, “I hate stock buybacks. I think they are one of the most self-serving things that corporate America does.” That’s why the Inflation Reduction Act that he pushed through Congress includes a 1% tax on buybacks, excluding buybacks associated with employee stock compensation plans.

Schumer says companies should be investing in worker training, research, modernizing equipment, and other activities rather than buying back their shares. He doesn’t seem to realize that buybacks come out of cash flow, not retained earnings. Many companies are spending their cash in constructive ways but still have enough left to return some of it to shareholders through buybacks.

Congress shouldn’t be meddling in matters of corporate finance. However, Congress has a habit of doing so in all aspects of our lives, especially when it sees a new source to tap for tax revenue. Schumer will be very happy with buybacks if taxing them generates lots of revenues, and will raise the tax to get even more.

US Inflation: Alternative Measures. The bond and stock markets seem to be discounting the possibility that the US economy has hit peak inflation. Like everyone else, we track the CPI and PCED and give more weight to the latter, as does the Fed. However, there are alternative measures that are widely followed. I asked Melissa for an update. Here it is:

The Atlanta Federal Reserve Bank’s (FRB) Underlying Inflation Dashboard shows nine measures of inflation. All nine are in the “red” zone (ranging between 4.3% and 7.0%), significantly exceeding the Fed’s 2.0% target. While the CPI and PCED suggest that inflation is peaking, the other measures mostly aren’t doing so yet.

During July, the official CPI’s headline and core rates were 8.5% and 5.9% y/y, respectively, down from the recent highs of 9.1% (during June) and 6.5% (during March). For June, the PCED headline rate climbed to 6.8%, the highest since January 1982, while the core rate eased from 5.3% during February to 4.8% in June, which was a slight uptick from May’s 4.7%. (Data for July will be released on August 26.) The CPI tends to run a bit hotter than the PCED, mostly because the CPI uses a bigger weight for rents.

Like the CPI and PCED, the alternative inflation measures lurched above 2.0% y/y early in 2021 as excessively stimulative US fiscal and monetary policies caused an inflationary demand shock that overwhelmed global supply chains. But unlike the conventionally used CPI and PCED, the high rates of most alternative measures have yet to show signs of abating, largely because they give more weight to rents. Rent inflation has been soaring owing to current housing market dynamics. (For more on the housing market, see our July 27 Morning Briefing.)

Consider these alternative measures of inflation used by various regional FRBs for more insight:

(1) Sticky vs flexible in Atlanta. The Atlanta FRB breaks down its alternative inflation measures into one of these two categories, namely “sticky” and “flexible.” The items in the Sticky CPI show relatively slow price changes; in July, they rose 5.8% y/y on a headline basis. Conversely, items in the Flexible CPI are prone to rapid price changes; its headline rose 16.3% y/y in July. The Atlanta Fed sticks to the notion that the Sticky CPI may be a better indicator of where inflation is heading.

(2) Sticky easing ahead. If that’s true, then rising inflation is a more persistent problem than the conventional CPI data suggest because the Sticky CPI has continued to rise while the Flexible CPI has eased (Fig. 19). But the categories of prices that have kept the Sticky CPI stuck at elevated rates are important to consider, especially given the effects on some categories of unusual current market dynamics.

(3) Rents are too high. Moving the Sticky CPI higher are rents, which are weighted heavily in this index and have rising inflation rates that show no signs of peaking (Fig. 20). The CPI for Rent of Shelter includes Owner Equivalent Rent (an odd concept that represents what homeowners would pay themselves if they rented their homes from themselves). Rent inflation should cool now that the housing market is in a recession. That should bring home prices down, restoring the affordability of homebuying and reducing rental demand. Household furniture and furnishing prices are weighted heavily in the sticky index, too, and should ease while fewer households are buying homes to decorate (Fig. 21).

(4) Driving the flexible down. Among the heavily weighted flexible price categories are new and used vehicles. They were down 2.8 and 34.6 percentage points, respectively, from their peaks of 13.2% and 41.2%, respectively, during April and February (Fig. 22 and Fig. 23). Prices for new autos likely will drop even further as global supply-chain pressures ease.

(5) Trimmed means in Dallas & Cleveland. For its homegrown trimmed mean inflation rate, the Dallas FRB removes a percentage of weight from the lower and upper tails of the price distribution (Fig. 24). That gives more weight to rent and household furnishings. (See the “Components included and excluded from this month’s Trimmed Mean” spreadsheet on the Dallas FRB’s website.)

The FRB Cleveland’s 16% Trimmed-Mean CPI likewise overweights owner- and tenant-occupied homes and furnishings (see component calculation details here) (Fig. 25).

(6) In conclusion, we’ll monitor the alternative measures of consumer inflation but continue to focus mainly on the CPI and PCED.

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Why Are Oil Prices Falling?

August 16 (Tuesday)

Commodities: Crude Thoughts. Is the price of petroleum products falling because the Biden administration has been releasing crude oil from the US Strategic Petroleum Reserve (SPR)? Or is the drop attributable to less demand in response to high prices? Consider the following:

(1) SPR. At the beginning of April, President Joe Biden announced a “historic” release from the SPR of 1 million barrels a day (mbd) for six months. An April 7 press release by the White House said it would be in coordination with other countries’ release of an additional 60 million barrels onto the market: “Together with the United States’ commitment, this will add a combined global amount of 240 million barrels. It is both the largest release from the United States and the largest release from other IEA [International Energy Agency] countries in history and will support American consumers and the global economy.”

In the US, the SPR was 569 million barrels during the last week of March (Fig. 1 and Fig. 2). It fell by 107 million barrels to 462 million barrels during the August 5 week. The press release implies that the White House intends to reduce the SPR by a total of 180 million barrels by the end of September.

(2) Global demand. On August 9, the IEA estimated that 98.8 mbd of petroleum and liquid fuels was consumed globally in July 2022, an increase of 0.9 mbd from July 2021. The IEA forecast that global consumption of petroleum and liquid fuels will average 99.4 mbd for all of 2022, which is a 2.1 mbd increase from 2021. In addition, the IEA forecast that global consumption of petroleum and liquid fuels will increase by another 2.1 mbd in 2023 to average 101.5 mbd.

In other words, at the consumption rate of 99 mbd worldwide, the release of 240 million barrels over the next six months amounts to a grand total of 2.4 days of extra fuel to run the global economy. Whoop-de-doo!

(3) US inventories. During the August 5 week, US inventories of crude oil & petroleum products totaled 1.19 billion barrels (Fig. 3). So the SPR is currently just 39% as large as US inventories excluding the SPR, which are currently 3.8% below the year-ago level.

(4) US production. High crude oil prices have stimulated more US oil field production, which rose to 12.3 mbd during the August 5 week, the highest pace since the end of March 2020 (Fig. 4). We derive a total imputed US production series by subtracting net imports from total petroleum products supplied (including crude oil), which is also used as a measure of total US demand (Fig. 5).

Our series shows that the US has been petroleum independent since late 2019, when net imports dropped to zero. During the August 5 week, our implied production series was at a recent near-record 21.1 mbd, while products supplied (usage) was 20.1 mbd. The US exported 1.0 mbd more than was imported that week.

(5) US consumption. The data on US petroleum products supplied show that during the August 5 week, it was 400,000 mbd below a year ago (Fig. 6). That was mostly attributable to weaker gasoline usage of 8.9 mbd, which was 500,000 below the year-ago usage. Americans have cut back on their consumption of gasoline in response to high prices.

(6) Prices. The price of a barrel of Brent crude oil peaked this year at $127.98 per barrel on March 8 (Fig. 7). It fell to $94.98 yesterday. The national average retail price of a gallon of gasoline peaked at $5.11 during the June 13 week. It was down to $4.15 during the August 8 week (Fig. 8).

(7) Conclusion. Our analysis of the data strongly suggests that the Biden administration’s release of crude oil from the SPR amounts to a drop in the bucket and doesn’t begin to explain why petroleum prices have been falling. Much more significant reasons are the drop in gasoline usage in the US and the ongoing recovery in US crude oil production. Both have occurred in reaction to high petroleum prices. Probably even more significant has been the drop in China’s oil demand, as the country seems to be slipping into a recession, as we discuss below.

Global Economy: Is Godot Hiding Overseas? Debbie and I have often observed that if the US economy is sinking into a recession or soon will do so, it will be the most widely anticipated recession of all times. It might already have started during the first half of this year since real GDP fell 1.6% during Q1 and 0.9% during Q2. Then again, these declines could easily be revised upward to show that the Bureau of Economic Analysis got the magnitudes right but the signs wrong.

It’s possible that we might all collectively talk ourselves into a recession. It’s also possible that we are all hunkering down just enough that any recession will be mild since there won’t be too many excesses to worsen it. The downturn could be what we called a “rolling recession” during the mid-1980s for the US.

Only yesterday morning, we suggested that waiting for the next recession was like waiting for Godot, who never showed up on stage in the play by Samuel Beckett. But also yesterday morning, we learned that Godot might be hiding in plain sight in China or New York. Before we go there, let’s look at the OECD’s recently released batch of leading economic indicators for July:

(1) Total OECD. The OECD leading indicator has been falling for the past 11 months through July (Fig. 9). It fell below 100.0 in April of this year and was down to 99.2 in July. So far, that’s more of a soft landing than a hard one for the OECD countries. The major economies of Europe (98.9), Japan (100.5), and the US (99.0) are mostly in sync, though Japan does stand out with a reading above 100.0.

(2) BICs. The OECD also compiles leading indicators for Brazil (98.0), China (98.5), and India (100.0) (Fig. 10). Yesterday’s batch of economic indicators for China suggests that the country’s economy might be weakening more rapidly than shown by its OECD leading indicator, as we discuss in the next section.

China Economy: Hitting The Skids? A month ago, on July 14, China announced that its real GDP rose just 0.4% y/y during Q2. That was weaker than the 1.0% consensus forecast. It implied that real GDP plunged 11.0% q/q (saar) (Fig. 11). The bursting of China’s property bubble and its zero Covid restrictions have hammered the economy. July data released yesterday suggest that Q3 could also be a very weak quarter for China’s economy. Consider the following:

(1) Retail sales. Retail sales rose 2.7% y/y in July, and so did the CPI, so real retail sales were unchanged y/y (Fig. 12).

(2) Industrial production. Industrial production, meanwhile, rose only 3.8% y/y in July, marginally slower than June’s 3.9%, while growth in fixed-asset investments slowed to 5.1% y/y.

(3) Social financing. On Friday, we also learned that total social financing, which includes bank loans and is the broadest measure of credit in the economy, was extremely weak in July (Fig. 13 and Fig. 14).

(4) Policy response. The People’s Bank of China cut its one-year rate by 10bps to 2.75% after the country’s sales and production data for July both fell short of expectations. It also trimmed its seven-day reverse repo rate.

(5) Blackouts. Beijing is facing a major energy crisis after sweltering heat led to soaring electricity demand across the country as families fired up air conditioners.

Yesterday, all industrial users of electricity in China’s Sichuan province—including factories producing metals, chemicals, and other industrial products—were told to shut down or curb their output in a bid to ration power consumption and prevent blackouts among residential populations. The entire province spans 485,000 square kilometers, which is nearly twice as big as the UK.

(6) Dr. Copper. The nearby futures price of copper is a very sensitive indicator of global economic activity, particularly in China. It plunged 35.0% from this year’s high of $4.94 on March 4 to this year’s low of $3.21 on June 14. It rose to $3.71 on August 11 but was back down to $3.61 on the disappointing news out of China.

US Economy: New York State Of Mind. Yesterday, we might have spotted Godot in New York. The Federal Reserve Bank of New York released its July regional business survey. It was shockingly weak, as we reviewed in yesterday’s QuickTakes.

The headline general business conditions index plummeted 42.4 points to -31.3. New orders and shipments plunged, and unfilled orders declined. Delivery times held steady for the first time in nearly two years, and inventories edged higher. Labor market indicators pointed to a small increase in employment but a decline in the average workweek. The only good news was that the region’s prices-paid and prices-received indexes declined sharply last month.

We concluded: “Let’s see August’s business survey for the Fed’s Philly district on Thursday before jumping to any conclusions. If it is as bad as the NY one, recession fears could make a fast comeback, which would weigh on stock prices, commodity prices, bond yields, and the dollar.” Let us know if you happen to see Godot anywhere else.

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Waiting For Godot

August 15 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

US Economy I: Is The Recession (Risk) Over Yet? The S&P 500 fell 23.6% from its record high on January 3 through June 16. It did so on fears that the Fed’s increasing hawkishness, sparked when inflation turned out to be persistent rather than transitory, would end in a recession. The S&P 500 is now up 16.7% since June 16 through Friday’s close. Does that mean that investors no longer fear a recession? Apparently so, but Debbie and I think that fears of a recession might make a comeback later this year or early next year. After all, this is the most widely anticipated recession ever, which is why it might be like waiting for Godot!

Consider the following:

(1) A “technical” recession? Everyone not working in the Biden administration seems to agree that the US experienced a “technical” recession during the first half of this year simply because real GDP dropped for two consecutive quarters during Q1 (-1.6%) and Q2 (-0.9%). In last Monday’s Morning Briefing, we explained that there is a good chance that one or both of these quarters will be revised up because the spread between Gross Domestic Income and Gross Domestic Product has been widening significantly in recent quarters, with the former growing faster than the latter (Fig. 1 and Fig. 2).

(2) Coincident indicators. We also explained last Monday that there is no recession evident in the Index of Coincident Economic Indicators (CEI), which rose to a record high in June and probably continued to do so in July (Fig. 3). That’s because payroll employment is one of the four components of the CEI, and it rose every single month during the first seven months of this year by a cumulative 3.3 million to a record 152.5 million during July (Fig. 4).

(By the way, over this same period, the household measure of employment rose by 2.3 million. The household measure counts the number of people with one or more jobs including the self-employed, while the payroll measure counts the number of jobs excluding the self-employed.)

Another component of the CEI is real personal income excluding government transfer payments. From July’s employment report, we know that our Earned Income Proxy (EIP) for private wages and salaries in personal income rose 0.8% m/m and 9.6% y/y during July to a new record high (Fig. 5). However, on an inflation-adjusted basis, it was up just 2.9% y/y through June.

Nevertheless, July’s CPI, which was unchanged during the month, suggests that both our EIP and real private wages and salaries in personal income rose solidly last month. Indeed, a separate Labor Department report last Wednesday showed real average weekly earnings rose 0.5% in July, the first monthly increase since last September and the largest gain since January 2021. This suggests that July’s real retail sales, which will be released on Wednesday, should show a solid gain and boost the real manufacturing and trade component of the CEI.

The fourth component of the CEI is industrial production. From July’s employment report, we know that aggregate weekly hours edged up 0.4% during July, suggesting that industrial production was a positive contributor to the CEI last month (Fig. 6). We will find out on Tuesday what it actually did.

(3) Leading indicators. The bad news is that the Index of Leading Economic Indicators (LEI) peaked at a record high during February and is down 1.9% through June, with four consecutive monthly declines through June. Such weakness in the LEI has been a fairly reliable early warning signal of a recession, with an average lead time of 14 months prior to the past seven business cycle peaks, excluding the peak just before the lockdown recession of 2020. The lead time from the LEI’s peaks and the peaks of subsequent economic activity has been nine to 22 months. This suggests that the next recession might start next spring but could begin as early as the end of this year.

Then again, we might learn that July’s LEI was up but not enough to match February’s peak. After all, the S&P 500 is one of the 10 components of the LEI, and its monthly average of daily data rose 0.3% m/m during July after falling 3.5% in June (Fig. 7). On average, it has peaked five months before the previous 11 business cycle peaks excluding the 2020 pandemic cycle. This time, it peaked on January 3, arguably anticipating the technical recession of H1-2022. If so, then the rally since June 16 may be signaling better times ahead for the economy, unless it turns out to be a bear-market rally.

What else do we know so far about the components of July’s LEI? Initial unemployment claims will likely be a negative contributor. It recently bottomed at 166,000 during the March 19 week and rose to 262,000 during the August 6 week (Fig. 8). We know that the expectations component of the Consumer Sentiment Index, which is included in the LEI, jumped from 47.3 during July—which was the lowest reading since spring 1980—to 54.9 in early August (Fig. 9).

The yield-curve spread between the 10-year US Treasury bond yield and the federal funds rate should be a big negative LEI contributor in either July or August because it narrowed dramatically when the Fed raised the federal funds rate by 75bps on July 27 (Fig. 10).

By the way, a useful leading indicator for this spread is the one between the 10-year and 2-year yields, which turned negative in early July, signaling that a recession is still possible in coming months. Melissa and I believe that the 2-year yield mirrors the market’s prediction for the federal funds rate over the next 12 months. It currently shows a peak rate around 3.25%.

(4) Hawkish Fed heads. Ever since Fed Chair Jerome Powell’s July 27 press conference, Fed officials have been scrambling to clarify his comment that the federal funds rate range of 2.25%-2.50% is “right in the range of what we think is neutral.” He added, “now that we’re at neutral, as the process goes on, at some point, it will be appropriate to slow down” the pace of rate hikes. The financial markets optimistically interpreted that to mean that the Fed may even cut interest rates next year. The other Fed officials have been walking back Powell’s suggestion that the Fed is nearly done tightening and trying to stick a pin in the market’s notion that the Fed may be cutting interest rates next year.

Following last Wednesday’s news of a drop in the CPI inflation rate, Minneapolis Federal Reserve Bank President Neel Kashkari said that despite the “welcome” news in the CPI report, the Fed is “far, far away from declaring victory” on inflation. Kashkari, who has always been among the most dovish Fed officials, said he hasn’t “seen anything that changes” the need to raise the Fed’s policy rate to 3.90% by year-end and to 4.40% by the end of 2023. That probably makes him the most hawkish member of the FOMC.

Kashkari did acknowledge that raising rates so quickly could push the economy into recession, and that a recession could even occur in the “near future.” But most of Kashkari’s 18 colleagues think a little less policy tightening may be enough to bring prices under better control without causing a recession.

Among them is Chicago Fed President Charles Evans. While calling inflation “unacceptably high,” he set his target rate hikes at 3.25%-3.50% this year and 3.75%-4.00% by the end of next year, still somewhat higher than Powell signaled after the Fed’s latest meeting in July.

(5) The Chair’s guidance. Powell did offer a bit of guidance during his July 27 presser. He said, “And I think you can still think of the destination as broadly in line with the June SEP. Because it’s only six weeks old.”

“SEP” stands for the “Summary of Economic Projections,” which shows the consensus forecasts of the FOMC participants for the federal funds rate, the unemployment rate, real GDP, headline PCED inflation, and core PCED inflation. Back in June, they expected the federal funds rate would be raised to 3.40% by the end of this year and 3.80% by the end of next year. (See our FOMC Economic Projections.)

According to the SEP, that’s restrictive enough to bring inflation down but without causing a recession. More specifically, real GDP is expected to grow 1.7% this year and next year, with the unemployment rate rising to only 3.9% next year. The PCED inflation rate is expected to fall from 5.2% this year to 2.6% in 2023 and 2.2% in 2024.

(6) Dr. Copper. The CRB all commodities and raw industrials spot price indexes peaked at record highs on May 4 and April 4, respectively, and are down 8.3% and 11.3% through Friday (Fig. 11). For now, we think that’s a better omen of lower inflation than an imminent recession.

The price of copper is widely watched as an indicator of economic activity. So its plunge during the first half of the year seemed to confirm recession fears (Fig. 12). However, it is a better measure of economic activity in China than in the US. China’s economy was depressed during the first half of this year by renewed pandemic lockdowns and the popping of its property bubble. The price of copper has rallied in recent days.

(7) Money supply and QT. What about M2? It has declined for two of the past three months by a total of $72.4 billion, while the total deposits of all commercial banks has decreased by $146 billion from its record high during the April 13 week through the August 3 week (Fig. 13).

That doesn’t worry us, for now. M2 remains about $2 trillion above its pre-pandemic trend. We might get more concerned if it were to fall too rapidly toward that trend or below it. It is falling because the Fed pivoted from QE to QT (quantitative easing to quantitative tightening) starting in June. Meanwhile, commercial bank loans have been rising in record-high territory recently, with new loans funded by the banks’ sale of securities such as Treasury bonds (Fig. 14).

(8) Recession odds. So what are the recession odds now? They’ve been reduced, in our opinion, by the easing of financial conditions in the capital markets. The labor market remains strong. Consumers still have about $2 trillion in excess savings, and their real wages may be starting to get a lift from lower price inflation. Capital spending is slowing but not falling. Residential investment is in a recession, led by the single-family housing market, while the multi-family sector remains solid. Europe faces an energy crisis this winter but is still growing currently.

So Debbie and I are more sanguine about the economic outlook now than we have been in recent months. We think that economic growth will be weak during H2-2022 but positive around 1.5% (saar). Next year should be a year of recovery (not recession) from this year’s mid-cycle slowdown. Real GDP next year should be up 2.5%.

So here are our new subjective probabilities: We place 60% odds on this slow-go scenario and 35% odds on a recession, more likely next year than this year. We give 5% to a boom scenario. In the recession scenario, inflation remains persistently high, forcing the Fed to raise rates to levels that cause a recession.

US Economy II: Has Inflation Peaked? Of course, notwithstanding the favorable response last week to the apparent peaking in the CPI and PPI inflation rates, the jury is still out on whether they’ve actually peaked. We’ve been predicting that inflation would moderate during H2-2022. So far so good, but we need to see more evidence to know definitively that’s the case.

Movie. “Elvis” (+ + +) (link) is a long movie about the all-too-short life of Elvis Presley and his convoluted relationship with his manager, Colonel Tom Parker. Austin Butler plays Elvis brilliantly. Tom Hanks’ performance as the Colonel is a bit annoying, but that’s the way the Colonel was apparently. During the 1950s, Elvis started a musical revolution by popularizing traditional genres such as blues, country, and bluegrass. His vocal energy and then-scandalous hip swings and body contortions drove his concert audiences into a frenzy. He was without a doubt “The King of Rock & Roll.”

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Health Care, Earnings & Uncle Sam

August 11 (Thursday)

Health Care: Among The Best. The S&P 500 Health Care sector has been holding its own this year to date, despite the bear market from January 3 through June 16. The industry has benefitted from a healthy dose of M&A, with pharmaceutical companies strengthening their drug benches and tech companies eyeing the health care industry’s inefficiencies and demand for cloud services.

Some health care companies have enjoyed the return to normalcy post-Covid, while others have been hurt by it. Now that Covid cases have receded, patients have resumed going to their annual doctor appointments and undergoing non-urgent medical procedures, but they’ve also stopped getting Covid vaccines and using related supplies.

Here’s the share price performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Energy (35.0%), Utilities (4.9), Consumer Staples (-3.9), Health Care (-6.9), Industrials (-9.6), S&P 500 (-13.5), Financials (-13.6), Real Estate (-14.5), Materials (-14.8), Information Technology (-17.4), Consumer Discretionary (-20.5), and Communication Services (-27.4) (Fig. 1).

The Health Care sector has been dragged down by one of its larger industries, Health Care Equipment, which has watched what was a high forward P/E multiple last year melt as interest rates rose this year. Here are how the S&P 500 Heath Care industries’ share prices have performed ytd through Tuesday’s close: Health Care Distributors (24.5%), Managed Health Care (6.8), Health Care Services (2.7), Biotechnology (-0.7), Pharmaceuticals (-1.0), Health Care Sector (-6.9), Health Care Facilities (-17.8), Life Sciences & Tools (-19.0), and Health Care Equipment (-20.3), Health Care Supplies (-45.6) (Fig. 2).

Let’s take a look at some of the recent M&A activity driving health care stocks higher and the Inflation Reduction Act’s future impact on drug manufacturers:

(1) Giants jump in. Amazon, CVS Health, and Oracle each have either announced or completed large health care acquisitions this year that are aimed at using technology to improve health care services.

CVS reportedly plans to bid for Signify Health, according to recent headlines. Signify is a home health care company that uses technology and data to help health plans, employers, and providers offer in-home care. With a market value of $5.2 billion, multiple bidders in addition to CVS are expected. The deal would help CVS offer primary care services at home and potentially in the real estate its drug stores already occupy.

CVS’s urgency to expand into primary care may have increased after Amazon agreed in July to purchase 1Life Healthcare’s subscription health services company One Medical for $3.9 billion. The company has 204 primary care clinics and thousands of caregivers who can provide services to Amazon’s Prime members. That deal followed Amazon’s $753 million acquisition of online pharmacy PillPack in 2018. Amazon also has developed a telehealth service, Amazon Care, which is a 24/7 texting, video, and in-person care service initially offered in 2019 just to Amazon employees and this year opened up to customers nationwide along with Amazon’s network of walk-in clinics.

Oracle’s $28.3 billion acquisition of Cerner, an electronic health records company, closed in June. Oracle intends to offer Cerner customers ways to access information in Oracle’s cloud using a hands-free voice interface. The improved medical information systems will “lower the administrative workload burdening our medical professionals, improve patient privacy and outcomes, and lower overall healthcare costs,” stated Chairman and CTO Larry Ellison.

The Oracle deal followed Microsoft’s March $16 billion purchase of Nuance Communications. Nuance is an artificial intelligence company specializing in voice recognition and related software and services for health care and other industries. The acquisition will capitalize on Microsoft’s cloud services.

CVS shares, which are essentially flat so far this year, reside in the S&P 500 Health Care Services industry, which is up 2.7% ytd (Fig. 3). Earnings estimates for the industry have been revised down sharply this year. Analysts’ consensus earnings estimate for 2022 represented a 4.9% y/y gain when 2021 began, which since has fallen to a 2.5% decline (Fig. 4). Next year’s earnings estimates have been cut also, but the growth implied remains in positive territory at 6.0%. Over the past 20 years, the industry’s forward P/E has contracted from north of 20 to a recent 11.6 (Fig. 5).

(2) Drug M&A happening too. Acquisitions also have heated up in the pharmaceuticals industry, as large drug companies are looking to replace revenue from drugs going off patent and to expand their offerings. Amgen agreed earlier this month to buy ChemoCentryx for $3.7 billion. The company has a treatment for bone disease and potential treatments for inflammatory disorders and immune disorders. Amgen may be looking to offset declining sales of its arthritis drug Enbrel, which meant the company’s total revenue increased by only 1% in Q2, an August 4 Reuters article reported.

Separately, Pfizer has agreed to pay $5.4 billion for Global Blood Therapeutics, which produces drugs to treat sickle-cell disease. The deal follows Pfizer’s April agreement to buy ReViral, a privately held company that develops drugs for respiratory virus. And late last year, the company announced plans to buy Arena Pharmaceuticals for $6.7 billion. Arena’s drug etrasimod is being studied for its use in treating ulcerative colitis, and Pfizer plans to consider its use to treat other immune-inflammatory diseases as well, a December 13 WSJ article reported. Pfizer is well heeled enough to play offense thanks to the success of its Covid-19 vaccines.

ChemoCentryx and Global Blood Therapeutics are too small to be in the S&P 500 Biotechnology index, but they are in the iShares Biotechnology ETF, or the IBB, which has fallen 14.9% ytd. The ETF may have hit bottom on June 16, when it was down 30.7%, as it has rallied since. Conversely, the S&P 500 Biotechnology index is essentially flat so far this year (Fig. 6). After the industry’s earnings rose 39.6% in 2021, they are expected to fall this year and next by -4.0% and -13.8% (Fig. 7). And the industry’s forward P/E has fallen from north of 20 in 2013 and 2014 to a recent 12.4 (Fig. 8).

(3) Drug bill better than feared. The final version of the Inflation Reduction Act, which allows Medicare to negotiate a limited number of drug prices, wasn’t as bad for the industry as earlier iterations of the legislation. In fiscal 2026, Medicare will be able to negotiate the prices of the 10 most used drugs covered under Part D, expanding to 15 Part D drugs in 2027. Newly approved drugs won’t be subject to negotiation for nine to 13 years after their market introduction, an August 8 CNBC article reported.

It’s unknown which drugs will be subject to negotiated prices, but last year the government spent $9.9 billion on blood-clotting treatment Eliquis, $5.4 billion to $5.7 billion on cancer treatment Revlimid (both produced by Bristol-Myers Squibb), and $4.7 billion on the blood clotting drug Xarelto (Johnson & Johnson).

The legislation also caps monthly costs for Medicare recipients’ insulin at $35 a month starting next year. Also next year, drugmakers that raise prices faster than general inflation will have to pay the government in rebates.

With a ytd decline of just 1.0%, the S&P 500 Pharmaceuticals industry index actually has outperformed the broader market so far this year (Fig. 9). But its earnings prospects for next year aren’t great: After climbing by 23.7% in 2021 and an estimated 15.8% in 2022, earnings are expected to drop by 3.0% in 2023 (Fig. 10). At 13.5, the industry’s forward P/E suggests that investors aren’t banking on much positivity.

Earnings: Flipping The Calendar To 2023. While analysts aren’t optimistic about the S&P 500 Health Care sector’s earnings for next year, they are quite enthusiastic about next year’s earnings in other sectors. For estimates to materialize though, the consumer will need to keep spending, traveling, and doing all the things that will help other industries levered to economic growth pick up the pace of earnings growth from the current year’s miserable clip.

Here are analysts’ 2023 earnings estimates for the S&P 500 and its sectors: Consumer Discretionary (35.2%), Industrials (17.5), Financials (13.4), Communication Services (13.4), Information Technology (8.6), Utilities (7.8), S&P 500 (7.6), Consumer Staples (6.3), Real Estate (0.7), Health Care (-0.6), Materials (-8.3), and Energy (-12.7) (Table 1).

Analysts are counting on consumer spending and traveling remaining robust. In 2023, the S&P 500 Hotels industry’s earnings are expected to bounce back from losses this year, rising 555.3%, as the S&P 500 Airlines’ earnings increase an estimated 206.3%, also from losses. Our return to watching the big screen is expected to help the Movies & Entertainment industry grow earnings 43.3% next year after an expected earnings gain of 1.0% this year. The S&P 500 Footwear, Apparel Retail, Apparel & Accessories, and Restaurants industries each are expected to grow earnings by roughly 12.7%-22.0% in 2023.

Given all the uncertainty in the world, it’s not surprising that the S&P 500 Aerospace & Defense industry is expected to grow earnings by 35.7% in 2023. And after this year of monetary tightening, the S&P 500 Financials sector should see earnings grow nicely. Here are the earnings growth rates analysts expect in 2023 by industry: Reinsurance (26.9%), Property & Casualty Insurance (22.7), Multi-Line Insurance (21.4), Investment Banking & Brokerage (16.6), Regional Banks (15.7), Diversified Banks (13.9), Financial Exchanges & Data (12.2), Asset Management & Custody Banks (11.7), and Insurance Brokers (10.9).

At the other end of the spectrum, industries in the S&P 500 Energy sector will be hard pressed to exceed their 2022 earnings next year. The Oil & Gas Refining & Marketing industry is expected to see earnings fall 38.2%, followed by a drop in the earnings of Integrated Oil & Gas (-13.6%), and Oil & Gas Exploration & Production (-6.1).

The Energy sector’s dim hopes of earnings growth combined with the 2023 earnings drops projected for Steel (-59.7%), Copper (-23.9), and Homebuilding (-13.7) underscore the message that all’s not well in the economy, particularly not in the homebuilding industry.

Disruptive Technology l: Uncle Sam Goes Green. The Inflation Reduction Act really has more to do with the environment than it does inflation. A better name might have been “The Save the Planet Act” or “The Going Green Act.” Senate Democrats believe the bill will help the US reduce carbon emissions 40% by 2030. We’ll be interested to see if the government will be able to successfully oversee the spending of this labyrinthian bill.

Here are some of the green things that the act aims to encourage by offering funding or tax breaks:

(1) Capturing carbon. The Inflation Reduction Act extends an existing tax credit for carbon capture projects to those that begin construction prior to 2033. It also lowers the carbon capture thresholds required to qualify for the credit. The actual tax credit for capturing carbon spewed by a plant is increased to $85 per ton, up from the current $50 per ton.

The Act also includes a $180-per-ton tax credit for carbon that’s captured directly from the air, not specifically related to an industrial plant per se. “Because most technologies in today’s market are early stage or experimental in nature, the additional increase in 45Q tax credits for DAC facilities is aimed at creating synthetic economics for these projects to allow them to receive additional capital to help develop DAC technologies at scale and eventually make DAC businesses widespread and profitable,” a paper by law firm McDermott Will & Emery explained.

(2) Reducing emissions. The Inflation Reduction Act establishes several grant programs at the Environmental Protection Agency and other agencies to reduce emissions. A $6 billion Advanced Industrial Facilities Deployment Program is established to reduce emissions from industrial emitters, like chemical, steel, and cement plants. There is also $3 billion in grants to reduce air pollution at ports by encouraging the purchase and use of zero-emission equipment and technology.

A Methane Emissions Reduction Program is established to reduce the leaks from the production and distribution of natural gas. And there’s a $27 billion “clean energy technology accelerator to support deployment of technologies to reduce emissions, especially in disadvantaged communities.”

(3) EV buyers benefit. Under the Inflation Reduction Act, low- to middle-income consumers can receive a $4,000 tax credit when purchasing a used electric vehicle (EV) and get up to $7,500 for a new EV. The Postal Service is given $3 billion to buy zero-emission vehicles as part of a larger $9 billion program that funds the federal purchase of American-made clean energy technologies. And there’s $1 billion for clean heavy-duty vehicles, like busses and garbage trucks. Tax credits and grants also are established to develop and use clean fuels and clean commercial vehicles throughout the transportation sector.

(4) Green manufacturers win. The Act offers production tax credits valued at $30 billion to accelerate US manufacturing of solar panels, wind turbines, batteries, and the minerals used in making those items. It provides another $10 billion in investment tax credit to build manufacturing facilities that produce EVs, wind turbines, and solar panels. Auto manufacturers are given $2 billion in grants to retool existing plants to manufacture “clean vehicles.” They can also receive $20 billion in loans to build new clean vehicle manufacturing plants in the US.

(5) Energy efficiency at home. The Act offers low-income consumers $9 billion in rebates to electrify home appliances and buy energy efficient appliances. It also offers 10 years of consumer tax credits to make homes energy efficient and run on “clean” energy, including heat pumps, solar, and electric HVAC and water heaters. The Act also establishes a $1 billion grant program to make affordable housing more energy efficient.

(6) Green on the grid. The Act provides $30 billion in grants and loans to states and electric utilities to accelerate the transition to “clean” electricity. It encourages the use of renewable energy sources and increasing energy storage. There are also tax credits to keep nuclear power plants running.

(7) Green on the farm and in the lab. More than $20 billion was earmarked to support “climate-smart” agriculture practices. There are also tax credits and grants to support the domestic production of biofuels and the related infrastructure. And finally, the National Laboratories in the Department of Energy will receive $2 billion to accelerate breakthrough energy research.

Disruptive Technology II: Uncle Sam Spending On Chips. In an unusually productive summer for Washington DC, the CHIPS and Science Act was signed into law this week. It provides $50 billion to fund the construction of new semiconductor chip manufacturing facilities, related R&D, and workforce development.

As if on cue, the importance of the Act was emphasized by Chinese war games going on uncomfortably close to Taiwan’s shores. The new law had the desired effect of eliciting promises from manufacturers to build chips in the US of A: Micron will spend $40 billion to build a memory chip plant, Qualcomm and Global Foundries will expand GlobalFoundries’ upstate New York plant, and Intel earlier this year unveiled plans to spend $100 billion on a new chip complex in Ohio.

Ironically, these plans are being announced just as the semiconductor industry appears oversupplied. That said, the plants will take years to come online, and US security demands may make risking an oversupplied market unavoidable.

Like the sprawling Inflation Reduction Act, the $280 billion CHIPS Act doles out dollars like a drunken sailor. There’s $170 billion for scientific research and development. Another $10 billion funds “regional innovation and technology hubs” across the US to bring together state and local governments, universities, labor unions, businesses, and community-based organizations to create regional partnerships to develop the technology, innovation, and manufacturing sectors.

Another $13 billion will be used to fund science, technology, engineering, and mathematics (STEM) education and workforce development from kindergarten through graduate schools. Additional funds will go to NASA with the goal of sending astronauts to Mars, sending the first woman of color to the Moon, and extending US participation in the International Space Station through 2030.

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Earnings & Productivity

August 10 (Wednesday)

Strategy: Analysts Cutting Estimates. Industry analysts have been lowering their 2022 and 2023 earnings estimates for S&P 500 companies since the end of June. While the latest earnings reporting season—which ran from early July until about now—showed that their companies generally performed well during Q2, many managements provided cautious forward guidance during their calls with analysts. Let’s have a closer look:

(1) Q2 results to date. So far, 87% of S&P 500 companies have reported revenues and earnings for Q2-2022. The revenue and earnings surprises are historically strong but near their lowest readings since the pandemic recovery began. Revenues are beating the consensus forecast by 2.8% and earnings by 6.0% (Fig. 1 and Fig. 2).

The 435 companies that have reported Q2 earnings through mid-day Monday have a y/y revenue gain of 15.4% and a y/y earnings gain of 11.2%. These figures are bound to change as more Q2 results are reported in the coming few weeks, particularly from the struggling retailers.

(2) Q2 and the next six quarters. Better-than-expected results by some of the big-cap technology names last week caused Q2’s blended earnings—i.e., including actual results and estimated ones—to jump during the first week of August (Fig. 3). At the end of June, just before earnings season began, analysts expected Q2 earnings to grow by 4.9% y/y. Now the blended growth rate is 8.9%. That’s the good news.

The bad news is that analysts have lowered their estimates for each of the next six quarters (Fig. 4). They’ve been doing so since the start of the current earnings season. So their 2022 and 2023 earnings estimates have been falling. As a result, forward earnings—which is the time-weighted average of analysts’ consensus earnings-per-share estimates for the current year and coming year—peaked at a record high of $239.93 per share during the June 23 week, and is now down 1.3% to $236.74 during the August 4 week (Fig. 5).

(3) Annual growth rate estimates. As of the August 4 week, industry analysts estimated that 2022 and 2023 earnings per share will be $225.50 and $244.36, up 10.1% and 7.7% on a y/y basis (Fig. 6).

(4) Back to the old normal. Industry analysts typically lower their estimates for both revenues and earnings over time because their initial projections are too optimistic. We can see this tendency in the weekly “squiggles” charts for S&P 500 revenues and earnings starting in 2009 (Fig. 7 and Fig. 8).

This time, after slashing their estimates for both revenues and earnings during the lockdown recession in March and April 2020, they scrambled to raise their estimates during the V-shaped economic recovery through the end of last year. Then during the first half of this year, economic growth stalled, yet the analysts continued to raise their estimates to new record highs. Some of that optimistic forecasting reflected higher-than-expected inflation, which boosted revenues estimates. It also boosted earnings estimates, as industry analysts assumed that profit margins would remain high because companies were successfully passing rapidly rising costs through to their selling prices.

(5) Profit margin estimates falling fast. During the current earnings reporting season, company managements have been guiding down analysts’ expectations, particularly for profit margins. We derive the annual consensus estimates of the profit margins of the S&P 500 by dividing analysts’ consensus earnings estimates by their consensus revenues estimates. The 2022 and 2023 profit margin estimates have dropped from 13.2% and 13.8% at the start of this year to 12.8% and 13.3% during the July 28 week (Fig. 9).

(6) Our outlook. In our Sunday, August 7 QuickTakes, we explained why the valuation-led stock market rally since June 16 might sputter for a while. It’s mostly because forward earnings has probably started to flatten in recent weeks as a result of the economy’s current growth recession. In addition, the S&P 500’s forward P/E bottomed at 15.3 on June 16 and rebounded to 17.4 on Friday (Fig. 10). We reckon that the forward P/E will be range-bound between 15.5 and 17.5 for a while, especially if the 10-year US Treasury bond yield sputters around 2.50%-3.00% for a while, as we expect.

(7) Feshbach’s market call. I checked in with our friend Joe Feshbach for his latest assessment of the action in stocks: “The market should continue to move higher. However, new buying should be put on hold. Narrowing breadth and improving sentiment raise the risks of a short-term pullback offering up lower prices.”

US Economy: Why Is Productivity Falling? The pandemic certainly has disrupted and upset almost every aspect of our lives. That might explain the extraordinary drop in productivity during the first half of this year. The pandemic exacerbated pre-existing labor shortage problems. After the pandemic, companies might have concluded that labor shortages would persist and therefore have hoarded scarce workers without having enough for them to do, especially if supply-chain disruptions disrupted operations.

The recent productivity drop certainly challenges our thesis that chronic labor shortages will force companies to increase their capital spending on technology to boost the productivity of the available labor force. That’s our story for the “Roaring 2020s,” and we are sticking to it. We have a few more years before the end of the decade. Meanwhile, let’s review the latest data, which were released yesterday:

(1) Productivity. Nonfarm business productivity fell 4.6% (saar) during Q2 following Q1’s 7.4% plunge. It is a volatile series. Nevertheless, it was down 2.5% y/y through Q2, the weakest reading since the start of the data in 1947 (Fig. 11).

Keep in mind that productivity soared after the lockdown recession of 2020 by 10.3% during Q2 and 6.2% during Q3. The latest reading brings productivity back to where it was during the first half of 2020. So it should resume rising along its pre-pandemic trendline.

(2) Statistical discrepancy. Productivity is the ratio of nonfarm business output and total hours worked by labor. The numerator is based on GDP, which has been rising at a slower pace than gross domestic income. This suggests that GDP might eventually be revised higher, showing that both productivity and overall economic activity have been stronger than the preliminary data show.

(3) Unit labor costs. Then again, unit labor costs (ULC) jumped 9.5% y/y during Q2, the most since Q1-1982, as productivity plunged 2.5% and hourly compensation soared 6.7% (Fig. 12). The CPI inflation rate is highly correlated with ULC inflation, both on a y/y basis (Fig. 13). The former was up 9.1% through June.

US Households I: Golden Age Of Moving Out. Since the beginning of 2020, there’s been a remarkably sharp drop followed by a remarkably quick rebound in the US household headship rate—i.e., the number of households divided by the number of adults in the population. This rebound has contributed to the huge increase in housing demand. Over this period, house prices and rents have soared to record highs.

America quickly lost 1.8 million households during September 2020, when the total fell to 125.5 million (Fig. 14). But by June of this year, the US had regained all the lost households and added 812,000 more! That’s according to recent Census Bureau data.

A few years ago, it was generally expected that household formation would rise moving into the 2020s as many Millennials in their late 20s and early 30s moved out on their own after delaying “adulting.” According to a 2021 report from the National Association of Realtors, the typical first-time home buyer was 33 years old. The pandemic temporarily dented household formation by Millennials, but it has quickly recovered. As the pandemic ended, as employment has increased, and as unmarried singles in the population have continued to rise, roommates have been parting ways.

Looking ahead, an erosion in affordability for both homebuyers and renters and the slowing growth in the population could pressure household formation. Slowing immigration in particular could offset any Millennials-led growth in household formation. That’s important because household formation drives housing demand, rents, and prices! Already, the housing market has begun to turn south and is unlikely to recover in the foreseeable future, as we discussed in our July 27 Morning Briefing.

Here's more:

(1) Living together during the pandemic. Changes in the composition of living arrangements since 2019 show that at the onset of the pandemic, many adults living alone or with roommates abruptly moved in with older family members or with a spouse or partner. Additionally, some who were living with family members delayed moving out due to the health and financial concerns surrounding the pandemic. That’s according to a May FEDS Notes piece written by two of the Fed’s household economists.

(2) Young adults moved in and out. Gradually, the Fed economists wrote, the pandemic-induced changes in living arrangements have receded as the fraction of adults living with their original family and the fraction living with a spouse or partner have returned to pre-pandemic levels. The initial pandemic-onset-induced drop in headship rates was especially sharp for 16- to 30-year-olds who moved in with older relatives, but the trend for that group has retraced some. Older Americans’ headship rates have been relatively resilient.

(3) More separations post-pandemic. In a new development, more adults are living alone and fewer with roommates, boosting the headship rate. Because of the pandemic, people started spending more time at home and together, straining relationships. More than half a million roommate households separated in 2020, but that was below pre-pandemic levels, according to a July analysis of Census data from Apartment List. The percent of single persons in the civilian noninstitutional working-age population continued to rise from pre-pandemic rates above 50.0% after briefly falling below that level during the pandemic (Fig. 15).

Generational trends also may drive the growth in sole-person households. Baby Boomers made up 39% of sole-person households in 2020, and their share is likely to rise because of divorces and deaths of spouses/partners, wrote Freddie Mac in a research note last August.

(4) Employment driving headship. Likely, the ongoing recovery of the labor market has contributed to the rebound in headship rates, as headship is higher among the employed than unemployed, the Fed economists surmised. That’s confirmed by our chart of the total households (as a percent of the working age population) and the Civilian Labor Force Participation Rate, which has dramatically improved, demonstrating labor market tightening, since the onset of the pandemic (Fig. 16). However, these drivers of the headship rate could be outweighed by weakening US population growth.

(5) Population growth slowdown. From 2010 to 2016, the number of adults in the US grew by 2.3 million per year, on average, the FEDS Notes article observed. But since 2016, population growth has slowed—to about 1.5 million in 2021—largely because of reduced immigration (Fig. 17). In recent years, actual immigration growth has come in far below the Census Bureau’s low estimate.

(6) Immigration the underlying offset. Under Census’ low immigration projection, the FEDS Notes piece highlighted, the adult population in 2030 would be about 5.5 million lower than would be expected assuming historically consistent immigration levels—implying roughly 2.75 million fewer households at the current headship rate. The lower headship rate suggests either many more vacant units by then and/or less housing construction, the Fed economists expect.

US Households II: Golden Age for Landlords. The post-pandemic era has been called the “Golden Age” for multifamily housing, and we think that’s true, as we’ve often discussed. Landlords have been a big beneficiary of household formation following the pandemic. Rental vacancy rates hit 5.6% during Q2, the lowest in over 30 years, according to Census Bureau data (Fig. 18). In turn, landlords have been afforded the opportunity to raise rents pretty darn high (Fig. 19). Generational trends also point toward greater growth of renters than homeowners. Consider the following:

(1) Millennials & Boomers living alone. Most younger adults moving out of their parents’ homes after the pandemic are moving into rentals. Mostly that’s because owning a home has become increasingly unaffordable. Seniors living on their own because of recent family circumstances also tend to rent rather than purchase a home. These trends are apparent in the Census data on post-pandemic household formation by renters versus homeowners (Fig. 20 and Fig. 21).

(2) Zoomers want to zoom into homes. Generation Z, colloquially known as “Zoomers,” will be the next generation to age into moving out. Nearly 90% of those born between 1997 and 2012 want to buy a home, and nearly half of them want to do it within the next five years, according to a survey by Rocket Mortgage. But desire and ability are two different things. Millennials think they have it tough, but Gen Zers are facing the steepest housing prices in years, especially relative to their starting incomes, wrote a Gen Zer for Next Advisor. Like Millennials, Gen Zers too are saddled with debt and limited savings. In other words, Gen Zers are likely to be doing Zoom calls out of their rentals as they age in place.

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Around The World

August 09 (Tuesday)

Global Economy I: Our TINAC Thesis & Stay Home Strategy. Our basic premise about the outlook for the global economy through the end of 2023 is that a recession is more likely to occur in Europe and China than in the US. Of course, a global recession that starts abroad could push the US economy into a recession if it is already vulnerable to one. On the other hand, global investors might conclude that the US is the only major safe harbor from storms blowing around the world. If so, then their capital inflows could help to insulate the US economy from a global recession.

Granted, that would be an unusual development since economic booms and busts around the world tend to be synchronized ones. However, the US could buck a global recessionary cycle if enough global investors embrace our “TINAC” thesis—i.e., “there is no alternative country.” Melissa, Jackie, and I believe that TINAC has already been in play so far this year given the strength of the dollar and solid net capital inflows. If TINAC continues to insulate the US from the troubles of the rest of the world, then our “Stay Home” investment strategy should continue to outperform the “Go Global” alternative, as it has since 2009.

Consider the following big picture:

(1) Leading and coincident indicators. This morning, the OECD will release its July leading indicators for its 36 member countries, which tend to have developed economies, along with a few for the big emerging market economies (EMEs) that aren’t OECD members. The series starts in mid-1961.

June data show that the overall index fell from a recent peak of 101.0 in July 2021 to 99.5, the lowest reading since December 2020 (Fig. 1). Dominating the index are the US (99.4), Europe (99.3), and Japan (100.6) (Fig. 2). Generally, the business cycles of these major economies tend to be synchronized, but there have been times when one of the three major economies outperformed or underperformed the other two.

Similar synchronization can be seen among the major and minor European economies (Fig. 3 and Fig. 4). They all have been rolling over during the first six months of this year, with OECD leading indicator index readings either close to 100 or slightly below it. Both Australia (98.3) and Canada (99.6) are also rolling over (Fig. 5). And the same can be said of the BICs: Brazil (98.1), India (100.1), and China (98.3) (Fig. 6). (The BICs are not members of the OECD.)

The bottom line of the OECD data is that the global economy has been weakening during the first six months of this year but hasn’t fallen into a recession so far. Neither the US nor any other major OECD economy stands out from the pack as a leader or a laggard.

(2) Global PMIs. We have access to the JP Morgan global purchasing managers indexes (PMIs) since January 2018 through July of this year (Fig. 7 and Fig. 8). Not surprisingly, the global composite PMI is highly correlated with the OECD’s leading indicator. This global C-PMI has been falling in a sawtooth pattern from a high of 58.5 during May 2021 to 50.8 during July, the lowest since June 2020. So it too is signaling a global slowdown rather than a recession.

The global manufacturing PMI fell to 51.1 in July from 54.3 at the start of the year. The global nonmanufacturing PMI fell to 51.1 in July from 54.7 at the start of this year. All of these readings are consistent with a global slowdown. They might be pointing toward a recession, though certainly not definitively.

(3) Commodity prices. The same can be said about industrial commodity prices, especially the price of copper. Since the start of the year through Friday of last week, the CRB raw industrials spot price index is down 6%, while the nearby futures price of copper is down 20% (Fig. 9). Copper is especially sensitive to housing and auto sales. The world economy may not be in a recession, but housing activity almost certainly is in a recession around the world. Auto sales have been depressed by a shortage of auto inventories because supply-chain disruptions have disrupted auto production.

Interestingly, the CRB raw industrials spot price index tends to track the Emerging Markets MSCI stock price index (in dollars) very closely (Fig. 10). The latter is down 19% since the start of this year through Friday. This relationship suggests that most emerging markets haven’t emerged from their dependence on producing and exporting commodities.

(4) World production and exports. The CPB Netherlands Bureau for Economic Policy compiles monthly indexes of world industrial production and world volume of exports. Both are available from January 1991 through May of this year. The production index peaked at a record high in February of this year (Fig. 11). It is down 2.9% since then through May. The volume of exports reached a new record high in May.

(5) Capital flows. Previously, we observed that US private net capital inflows from overseas totaled a near-recent record high of $1.6 trillion over the 12 months through May, while official net capital flows were -$226 billion (Fig. 12). On balance over this period, private foreigners purchased $797 billion in US bonds, $331 billion in US bank liabilities, and $73 billion in US Treasury bills. They sold $162 billion of US equities. (See our Treasury International Capital System.)

This certainly helps to explain the strength of the US dollar index (ticker symbol DXY), which is up 18% since May of last year.

(6) Staying home. From a valuation perspective, the All Country World (ACW) ex-US MSCI was selling at a 32% discount relative to the US MSCI at the end of July (Fig. 13 and Fig. 14). From 2002 through 2015, the normal discount was 15% on average. The former tends to trade more like the S&P 500 Value index and is currently at a valuation discount of 20% to it rather than the normal discount of 0%-10% (Fig. 15 and Fig. 16).

From a fundamental perspective, both the forward revenues and forward earnings of the US MSCI have been significantly outperforming the comparable stats for the MSCIs of the Emerging Markets, EMU, and the UK (Fig. 17 and Fig. 18). The ratio of the US MSCI’s forward earnings to the ACW ex-US MSCI’s forward earnings has nearly doubled since early 2000 from 3.5 to 6.6 currently (Fig. 19). This certainly explains why the comparable ratios of the two stock price indexes (in both local currencies and in US dollars) remain on their strong uptrends that started in 2009 (Fig. 20). In other words, Stay Home continues to outperform Go Global. We recommend continuing to overweight the US in global portfolios.

Global Economy II: Europe In General, Germany In Particular. Real GDP in the Eurozone rose 2.0% (saar) during Q1 and 2.8% during Q2. At the same time, real GDP fell 1.6% and 0.9% in the US. The difference has mostly been attributed to the fact that the Eurozone economy was reopened from the Covid lockdowns after the US economy was reopened. In any event, it is now widely expected that the Eurozone faces a cold and dark winter because Russia has cut back its deliveries of natural gas to the region.

Germany is the country most dependent on Russian gas and most likely to fall into a severe recession. Consider the following recent economic developments in Germany:

(1) German data have actually been mixed, with manufacturing production up 0.8% m/m in June and manufacturing new orders down 0.4% m/m (Fig. 21). Both are volume rather than value indexes, which explains why German exports have been soaring during the first six months of this year to a new record high in June. The prices of those exports have been soaring.

(2) The Economic Sentiment Indicators for Germany are also mixed. The industrial and services components remained relatively high in July, with readings of 11.1 and 11.7 (Fig. 22). However, the consumer and retail trade components have crashed recently to readings of -25.2 and -18.4.

Global Economy III: EMs In General, China In Particular. Many emerging markets may be at risk of political and social instability, as inflation around the world has significantly boosted the cost of food and fuel. A few benefitted from the jump in commodity prices over the past couple of years, but many of those commodity prices seem to have peaked around mid-June.

China seems to be dodging these global problems. However, it has homegrown problems that are weighing on its economy, including the bursting of the country’s massive housing bubble, the ongoing pandemic-related lockdowns, and a rapidly aging demographic profile.

The country’s saber-rattling about Taiwan runs the risk of triggering a war between China and Taiwan, including whatever allies decide to join the fray directly or indirectly. China also has chosen to take sides with President Vladimir Putin over his war with Ukraine, which could spread to all of Europe.

Currently, the country continues to experience a trade boom, with record exports and a record trade surplus thanks in large measure to American and European consumers (Fig. 23 and Fig. 24). China’s geopolitical aspirations and reckless behavior are jeopardizing trade, one of the few remaining sources of economic growth available to the country.

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No Recession In Labor Market

August 08 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

US Economy I: Lots of Jobs. Friday’s employment report was all good news for consumers and the economy. It was bad news for the fixed-income securities market, since it increases the odds that the Fed will raise the federal funds rate by 75bps rather than 50bps at the next meeting of the FOMC, in late September. It was mixed news for the stock market since it reduces the odds of a recession during the rest of 2022 but increases the odds of one in 2023 if the Fed will have to raise interest rates to levels that cause a recession to bring inflation down.

How does all this change our economic outlook? Not much for now. Consider the following:

(1) GDP vs GDI. Debbie and I believe that what the economy is going through is a mid-cycle slowdown, not a recession. The so called “technical recession” during the first half of this year—with real GDP down slightly during Q1 and Q2—is unlikely to make it into the record books as an “official” recession. Indeed, either one or both quarters’ GDP results could be revised upward to show positive growth, especially because Gross Domestic Income (GDI) has been much stronger than GDP in recent quarters (Fig. 1 and Fig. 2). GDP is based on the demand side of the economy, while GDI is based on the income side and is widely deemed to be a more accurate measure of economic activity.

In any case, we now expect that real GDP will grow around 1.0% (saar) during Q3 and Q4, consistent with our view that the economy is in a “growth recession” this year. Next year should be a recovery year, with real GDP up around 2.5%.

(2) Leading indicators. The Index of Coincident Economic Indicators (CEI) rose to a record high during June, and payroll employment is one of its four components (Fig. 3). Payroll employment jumped 528,000 during July to a new record high. That suggests that the CEI’s other three components also rose in July because they are driven by employment.

Industrial production is also one of the four components of the CEI. Manufacturing output likely rose during July, since the employment report showed that aggregate hours worked in manufacturing rose 0.2% m/m last month after falling 0.1% during May.

Nevertheless, the Index of Leading Economic Indicators has been trending downward through June after peaking in February. So it is still signaling that a recession is likely sometime early next year (Fig. 4). That’s not our forecast currently, but we remain on high alert for compelling signs of a recession.

(3) Inflation eroding purchasing power. July’s strong employment report meant that our Earned Income Proxy (EIP) for private-sector wages and salaries jumped 0.8% in current dollars as aggregate hours worked increased 0.3% and average hourly earnings rose 0.5% (Fig. 5). So why aren’t we more optimistic about the near-term economic outlook given the strength in July’s employment report?

The problem is that inflation has been eroding the purchasing power of nominal wages and salaries. As a result, while our EIP is up 9.8% y/y through June, it is up just 2.9% y/y on an inflation-adjusted basis using the PCED. The good news is that inflation might have moderated during July, led by a drop in gasoline prices, thus leaving consumers with more purchasing power during the month.

(4) Broad-based job gains. Total payroll employment has recovered 22.0 million jobs since bottoming in April 2020, moving above its pre-pandemic level by 32,000 (Fig. 6). The payroll employment diffusion index, which tracks the percentage of industries reporting higher private payrolls, was 68.6% on a one-month basis and 74.4% on a three-month basis (Fig. 7). Industries posting the largest gains during July were leisure & hospitality (96,000), professional & business services (89,000), health care (70,000), construction (32,000), manufacturing (30,000), and transportation (22,500).

The gain in construction jobs is surprising since homebuilders are selling fewer homes. Also surprising is the gain in information technology (13,000), since some tech companies recently announced hiring freezes and layoffs. Not surprising is that warehouse employment fell 1,600, as retailers are slashing their prices to reduce their bloated inventories.

US Economy II: The Fed Isn’t Done. As noted above, Friday’s employment report increased the odds that the Fed will raise the federal funds rate by 75bps rather than 50bps when the FOMC meets in late September. In addition to a strong increase in payrolls, wages continue to spiral higher along with prices. Consider the following:

(1) The spiral. Average hourly earnings for all workers in July increased 0.5% m/m and 5.2% y/y. July’s wage inflation rate remained well below the latest available price inflation data, for June, of 9.1% y/y and 6.8% y/y in the CPI and PCED measures, respectively (Fig. 8). Real wages have been stagnating since early 2021 (Fig. 9). However, the wage-price-rent spiral continues to spiral.

(2) Fed heads. Last week, even before the jobs report was released, a few of the talking Fed heads clearly were on a damage-control campaign to clarify Fed Chair Jerome Powell’s comment at his presser on July 27 that the federal funds rate range of 2.25%-2.50% is “right in the range of what we think is neutral.” He added, “now that we’re at neutral, as the process goes on, at some point, it will be appropriate to slow down” the pace of rate hikes.

Last week, five regional Fed bank officials scrambled to walk back the notion that the Fed was nearly done tightening. San Francisco’s Mary Daly said that the central bank is “nowhere near” being almost done cracking down on inflation. Cleveland’s Loretta Mester said she’s still awaiting persuasive evidence that price pressures are moderating, and Chicago’s Charles Evans said the kind of data that would confirm policymakers are on the right track is a few reports away.

Minneapolis Fed Bank President Neel Kashkari said that the Fed reacted to inflation too slowly last year because policymakers believed higher prices would be transitory. When asked about a potential recession, he said that navigating a soft landing is still possible.

Kashkari also shot down the notion that the Fed could cut interest rates in 2023 to spur economic growth: “Some financial markets are indicating they expect us to cut interest rates next year,” he said. “I don’t want to say it’s impossible, but it seems like that’s a very unlikely scenario right now given what I know about the underlying inflation dynamics. The more likely scenario is we would continue raising (interest rates), and then we would sit there until we have a lot of confidence that inflation is well on its way back down to 2 percent.”

Also on August 3, in a CNBC interview, St. Louis Fed Bank President James Bullard said the Fed might need to keep interest rates “higher for longer” until there’s enough evidence showing that inflation is easing. “We’re going to need to see convincing evidence across the board, headline and other measures of core inflation, all coming down convincingly before we’ll be able to feel like we’re doing enough.”

On Saturday, Fed Governor Michelle Bowman suggested that she would vote for another 75bps rate hike at the next FOMC meeting: “Based on current economic conditions and the outlook I just described, I supported the FOMC’s decision last week to raise the federal funds rate another 75 basis points. I also support the Committee’s view that ‘ongoing increases’ would be appropriate at coming meetings. My view is that similarly-sized increases should be on the table until we see inflation declining in a consistent, meaningful, and lasting way.”

(3) Market reaction. By the end of last week, the 2-year Treasury note yield, which is a good indicator of market expectations for the federal funds rate over the coming year, rose to 3.24% on Friday, up 39 bps from its recent low of 2.85% on July 28 (Fig. 10). The yield-curve spread between the 10-year and 2-year Treasury notes fell to -35bps on Friday—the lowest reading since early September 2000—signaling that if the Fed continues to tighten, a recession is likely (Fig. 11).

US Employment III: Churn To Earn More. The labor market is remarkably dynamic. Over the past 12 months, hirings and quits rose to record highs. Many people are quitting their old jobs to take new ones that pay more. The problem they face is that price inflation has been eroding most, if not all, of their wage gains. Consider the following remarkable turnover in the labor market:

(1) Payrolls. During the 12 months through July, payroll employment rose 6.1 million according to the monthly employment report (Fig. 12). That was only 4.0% of total payrolls during July (Fig. 13).

(2) Hiring. Over this same period, according to the JOLTS report, hiring totaled a whopping 78.3 million, or 51.5% of July’s payrolls (Fig. 14 and Fig. 15). That’s right: Half of payroll employment was attributable to newly hired workers, i.e., hired over the past 12 months!

(3) Quits. Over this same period, separations totaled 72.2 million (47.5%), consisting of 51.4 million quits (33.8%) and 16.4 million layoffs (16.4%) (Fig. 16 and Fig. 17). That’s right: A third of workers quit their jobs over the past 12 months!

(4) Job openings. All this churning can partly explain why there are a near-record 1.8 job openings for every unemployed worker. Jobs open up when workers quit. But the rapid pace of hiring suggests that jobs get filled fairly quickly after opening up.

(5) Switching. Some of this incredible churning in the labor market undoubtedly reflects workers’ perceptions that the labor market is tight and that they can get paid more by switching jobs. They are right, according to the Atlanta Fed’s wage growth tracker (WGT). During June, the wages of job switchers rose 7.9% y/y, while the wages of job stayers rose 6.1% (Fig. 18).

(6) Eroding. Meanwhile, the PCED inflation rate was 6.8% y/y through June. So in real terms, the WGT rose just 1.1% for switchers and fell 0.7% for stayers (Fig. 19).

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Emerging Markets, Oil Refiners & Nuclear Power Plants

August 04 (Thursday)

Emerging Markets: Facing Challenges. Even though the S&P 500 has fallen 14.2% ytd through Tuesday’s close, the US has been one of the safest places in the world to invest so far this year (a theme we call “TINAC,” for “there is no alternative country”). Its currency is strong, the 10-year US Treasury offers a more attractive yield than other developed nations’ benchmark bonds, and today’s global challenges seem more surmountable here than in many other places around the world.

Unfortunately, what has helped the US has hurt many emerging market countries, particularly poor nations that face increasingly expensive dollar-denominated debt repayments and whose citizens can’t afford the higher cost of food and energy. Investors have responded by pulling funds out of the emerging markets in each of the past five months. Outflows from emerging market stock and bond funds hit $9.8 billion in July, bringing the total outflows to almost $40 billion since March, according to an August 3 WSJ article citing Institute of International Finance data.

As a result, the US MSCI, which has lost 15.2% ytd through Tuesday’s close, has outperformed the MSCI All Emerging Markets index, which has fallen 20.1% in dollars and dropped 16.0% in local currencies (Fig. 1).

As for the country-specific emerging market MSCIs, the indexes of those countries that export goods priced in dollars generally have fared better than the rest. The Brazil MSCI index is up 2.7% ytd in dollars and down 3.4% in local currency, outperforming most of its counterparts. The country is a large exporter of soybeans, iron ore, and oil.

The MSCI indexes of countries that benefit from tourism also have outperformed this year, helped by the resumption of international travel. Thailand’s MSCI has fallen 7.5% ytd measured in dollars and is flat ytd in the local currency.

Conversely, other countries—e.g., Sri Lanka—are scrambling to pay for imported goods and meet their dollar-denominated debt payments, as they lack access to dollars. The MSCI of that Asian nation has fallen 68.2% ytd measured in dollars and 43.5% ytd in the local currency.

Let’s take a quick world tour:

(1) Interest rates: High, but not too high. The 10-year US Treasury yield has risen to 2.75%, up from 1.19% a year ago. That’s far more attractive than the yields on other developed countries’ 10-year bonds: UK (1.91%), France (1.43), Sweden (1.38), Germany (0.81), and Japan (0.18) (Fig. 2).

And high US interest rates have helped boost the value of the US dollar relative to other currencies around the world (Fig. 3). However, a surging dollar has made soaring food and oil prices even more expensive to purchase for emerging countries that import those goods.

(2) Uneven economic growth. The manufacturing purchasing managers index (M-PMI) for emerging economies has weakened only modestly over the past two years. After peaking at 53.9 in November 2020, the emerging markets’ M-PMI was 50.8 in July. It’s moderately below the developed markets’ M-PMI of 51.3 (Fig. 4).

But lumping all emerging markets into one basket obscures substantial differences among the economies. European emerging economies have been battered by the war in Ukraine. Here are their July M-PMIs: Kazakhstan (52.8), Turkey (46.9), Czech Republic (46.8), and Poland (42.1) (Fig. 5). The Ukraine war and high-stakes natural gas games with Russia have taken a toll on several developed European countries as well. Here is a handful that have seen their M-PMIs drop below the 50.0 level indicating contraction: France (49.5), Germany (49.3), Greece (49.1), Spain (48.7), Italy (48.5), and Denmark (38.0).

Manufacturing PMIs for Latin American countries vary quite a bit, with Brazil’s M-PMI jumping sharply (54.0) and Columbia’s (49.5) and Mexico’s (48.5) M-PMIs contracting slightly in July (Fig. 6). Brazil benefits from the dollars earned by Petrobras, the state-run oil company, and the country’s miners. Mexico, on the other hand, is expected to be dragged into a recession, due in part to its close economic ties to the US, where demand for goods (including imported ones) seems to be slowing.

Meanwhile, July’s PMIs held up relatively well in most emerging Asian countries: India (56.4), Thailand (52.4), Indonesia (51.3), Vietnam (51.2), Philippines (50.8), Malaysia (50.6), and China (50.4) (Fig. 7).

(3) Descending into turmoil. Some emerging market countries might wish that their worst problem was a PMI below 50.0. Panama and Sri Lanka, for example, suffer from inflation, capital outflows, and civil unrest. Panama’s dollar-denominated market is down 18.4% ytd through Tuesday’s close. Sri Lanka’s has fallen by 43.5% ytd in local currency and by 68.2% ytd in dollars.

Sri Lanka has been plagued by inflation running north of 50% and a lack of foreign currency, which has led to shortages of fuel, food, and other imported goods. Last year, the government prohibited the importing of chemical fertilizer, which led to crop failures among the nation’s farmers. The country then had to buy food from abroad, worsening its financial situation.

Sri Lanka suffers from political instability, as its President fled to Singapore last month. The Prime Minister declared a state of emergency across the country as protesters filled the streets and even stormed the presidential palace. The country failed to make an interest payment on its foreign debt in May, and it owes more than $51 billion to foreign lenders, including $6.5 billion to China.

Protestors are also hitting the streets in Panama. They too are upset about inflation and the prices of food and gasoline, which rose from $3.73 a gallon in January to $5.75 in July, a July 20 FT article stated. Protestors are also upset by politicians who have special advisors being paid for ambiguous services and by a video of “lawmakers celebrating the beginning of the legislative period with $340 bottles of Macallan whisky.”

Argentina, Latin America’s second largest country, has struggled with inflation north of 60%, shrinking currency reserves, a falling currency, and too much debt. The country has a deeply divided government, and the top economic position has changed hands three times over the past month. The cost of Argentina’s imports has surged due to the rising price of energy. Meanwhile, its exports have been hurt by grain exporters who are “hoarding their harvest because they fear an imminent devaluation,” a July 25 FT article reported.

Having watched inflation erode their savings and earnings, Argentinians have been protesting for a minimum living wage. And there are questions about whether the country can live up to a negotiated restructuring of the $44 billion of debt it owes the International Monetary Fund.

Energy: Refiners Reporting Riches. Over the past week, oil refiners reported banner Q2 earnings, boosted by high gasoline prices and a wide crack spread. Valero Energy’s adjusted Q2 earnings was $4.6 billion, or $11.36 a share, up from $260 million, or 63 cents a share in Q2-2021. Marathon Petroleum’s adjusted net income came in at $5.7 billion, or $10.61 a share, up from $437 million, or 67 cents a share in Q2-2021. The company’s refining and marketing margin surged to $37.54, triple the $12.45 margin in the year-ago quarter. Here’s a look at what drove results:

(1) Running full tilt. Refiners ran their operations non-stop to meet demand for gasoline during the summer driving season and for airplane fuel now that travelers have returned to the skies. Valero refinery’s utilization rate increased to 94% in Q2, up from 89% in Q1 and 90% in Q2-2021. Marathon Petroleum’s refineries ran at 100% utilization processing in Q2, up from 94% in Q2-2021. The company expects its utilization rate will return to 94% in Q3 as it performs maintenance in September.

(2) Cash is flowing. The jump in earnings also meant a surge in cash flow for the two refiners. Valero’s business threw off adjusted net cash of $5.2 billion in Q2. Marathon reported EBITDA from continuing operations of $9.1 billion, up from $1.9 billion a year earlier.

Despite the billions of earnings and cash flow generated, capital spent to expand the traditional refining business was relatively minimal. At Valero, $355 million was used to grow the business in Q2, $300 million was used to reduce debt, and about $2.2 billion paid dividends and bought back stock. Cash on the balance sheet rose by $2.8 billion.

The company said on the earnings conference call that it will earmark about $800 million for capital investments to grow the company, and half of that will be put into expanding Valero’s low-carbon fuels business. That leaves only $400 million earmarked for expanding Valero’s traditional refining operations in 2022.

Marathon used $313 million to pay dividends and $3.3 billion to repurchase shares in the quarter. The company spent $546 million on capital expenditures, some of which is earmarked to expand its Galveston Bay refinery capacity by 40,000 a day.

Both companies are spending to build renewable fuel facilities, which can take animal fats, used cooking oil, and corn oil and process them into diesel that can be used in engines on the road today. The renewable diesel produced at the Valero facility claims that it reduces greenhouse gas emissions by up to 80% compared with traditional diesel fuel.

(3) A look at the numbers. At its peak on June 7, the S&P 500 Oil & Gas Refining & Marketing stock price index was up 73.4% from the start of 2022. Since peaking, the index has fallen 20.0%, leaving it up 39.0% ytd through Tuesday’s close (Fig. 8). The shares appear to be following the crack spread of West Texas Intermediate crude oil, which peaked at $69.20 per barrel on April 28 and has since fallen to $39.40 (Fig. 9).

The industry’s revenue climbed 69.8% last year and is expected to grow again by 41.2% this year before falling by 11.0% in 2023, according to analysts’ consensus estimates (Fig. 10). Earnings follow a similar pattern. Analysts expect earnings to soar 400.0% this year, only to fall by 39.7% in 2023 (Fig. 11). The industry’s forward P/E has fallen to only 6.8 from a peak of 170.4 in November 2020, when the industry was barely profitable (Fig. 12).

Disruptive Technologies: Small Nuclear Gets The Nod. The US Nuclear Regulatory Commission plans to certify the small modular reactor (SMR) designed by NuScale Power Corp. Even though it’s far smaller than a traditional nuclear reactor, it is expected to generate nuclear power more easily and safely.

SMRs are “small enough that they can be assembled on a factory floor and then shipped to a site where they will operate, eliminating many of the challenges of on-site construction. In addition they’re structured in a way to allow passive safety, where no operator actions are necessary to shut the reactor down if problems occur,” ARS Technica reported on July 29.

NuScale is working with the Utah Associated Municipal Power Systems to deploy a SMR system in 2029. NuScale also received a $15 million private investment from Nucor, the steel manufacturer, which presumably is looking for ways to produce large amounts of electricity to run its mills without producing CO2. And NuScale completed a reverse merger in May with a special-purpose acquisition company, Spring Valley Acquisition Corp. The new company’s ticker: SMR, of course

We noted in the February 18, 2021 Morning Briefing that Bill Gates has embraced SMRs. He’s an investor in and the chairman of TerraPower, which is building a small nuclear plant in Wyoming that uses molten salt to store energy.

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US Earnings & European Gas

August 03 (Wednesday)

Strategy: Analysts Are Shaving Earnings. Investors spent most of the first six months of this year worrying about a recession and selling stocks. They did so even as industry analysts raised their earnings estimates. Investors, apparently fearing that the analysts might be delusional, slashed the valuation multiples they were willing to pay for analysts’ earnings estimates. Now that analysts finally have started to lower their earnings estimates, investors seem to have concluded that the economic outlook may not be as bad as they feared. So stocks have rebounded sharply since they bottomed on June 16.

Let’s see what analysts have been up to recently:

(1) Earnings. Joe and I shaved our earnings estimates on July 5 (see that day’s Morning Briefing). We reduced our S&P 500 operating earnings-per-share forecast for 2022 by $10 to $215 and for 2023 by $5 to $235 (Fig. 1). Industry analysts also have started shaving recently. Their comparable consensus estimates peaked at $229.57 and $251.99 during the week of June 16. They lowered them to $227.02 and $246.33 during the July 28 week.

(2) Revenues. S&P 500 revenues-per-share data for 2022 and 2023 consensus estimates are available with a one-week lag through the July 21 week. They remain on solid uptrends in record-high territory, though both flattened during the latest week (Fig. 2). We expect that they will continue to rise, boosted by inflation, as they have been doing for the past year. There’s certainly still no sign that analysts are shaving their earnings estimates because they see a recession given their upbeat outlook for revenues.

(3) Margins. The main reason that analysts have been trimming their earnings estimates is that they have lowered their sights for profit margins, which we can tell because we impute the profit margins they expect simply by dividing their consensus earnings estimates by their consensus revenues estimates (Fig. 3). Nevertheless, their latest profit margin estimates, at 12.9% and 13.4% for this year and next year, are higher than our estimates of 12.3% and 12.5%—suggesting that they may have further shaving of margin and earnings estimates to do if our numbers are closer to the mark.

Of course, both their estimates and ours are too optimistic if a severe recession unfolds over the rest of this year and/or next year. During the Great Financial Crisis, the aggregate profit margin for S&P 500 companies fell into the mid-single digits. During the Great Virus Crisis, it fell into the low double digits.

(4) Forward earnings. Our projections for the S&P 500 price index are based on our projections for the forward P/E and forward E—i.e., the time-weighted average of the analysts’ consensus earnings-per-share estimates for this year and next year. We are predicting that forward earnings will be $235 per share at the end of this year. During the July 28 week, it was down to $238.16 from a recent record high of $239.84 during the July 7 week (Fig. 4).

(5) Quarterly earnings estimates. Joe and I also track the weekly series of analysts’ consensus estimates for the quarterly earnings of the S&P 500 companies for the current year and the coming one. Data through the July 28 week show that their estimate at the start of the Q2 earnings season remains close to the mark of around $55 per share for the quarter (Fig. 5).

However, since the annual consensus estimates peaked on June 16, analysts have shaved their Q3 and Q4 estimates by $3.07 altogether. At the same time, they’ve also been shaving their earnings estimates for each of next year’s four quarters by $6.15 altogether (Fig. 6).

(6) Revenues & earnings growth. As noted above, there’s no recession in analysts’ consensus expectations for revenues. They’ve actually raised their expectations for 2022 revenues growth from 7.5% at the start of this year to 12.0% during the July 21 week (Fig. 7). The revenues boost from higher-than-expected inflation was undoubtedly the reason. However, their revenues growth estimate for 2023 is down to 4.2% from 5.3% at the start of this year. Apparently, they expect to see a moderation in inflation since we doubt that they are collectively anticipating a recession next year.

And what are they expecting for earnings growth? During the July 21 week, their earnings projections represented growth rates of 10.6% this year and 8.2% next year, which compares to their 8.7% and 10.1% projections at the start of this year (Fig. 8).

Europe I: Running Out Of Gas. The European Union’s political leaders are accusing Russian President Vladimir Putin of using energy as a weapon of war because he has slowed the flow of Russian natural gas to Europe in what appears to be retaliation for the EU’s war sanctions on his country. EU nations are preparing to reduce their dependence on Russian gas but likely won’t be able to meet their needs this winter if Russia further slows gas flows or cuts them off entirely.

The EU’s precarious gas situation could quickly turn into a crisis and a recession. Before reductions in deliveries to Europe of about 20% of previous capacity, Russia supplied about 40% of Europe’s natural gas.

Here’s a timeline of major recent developments related to the flow of natural gas from Russia to Europe:

(1) On June 24, Politico reported that Russia’s state-run Gazprom has previously stopped or reduced deliveries to 12 EU countries in retaliation for Western sanctions against Russia over the invasion of Ukraine. Deliveries were halted to Poland, Bulgaria, the Netherlands, Finland, and Denmark. To compensate, the impacted countries are relying on alternative sources, including coal and nuclear-powered plants. That was after those Russia-designated “unfriendly countries” refused to pay for deliveries in rubles instead of the contractual euros or dollars.

(2) On July 11, Gazprom closed its critical Nord Stream pipeline gas flow to Europe, claiming force majeure for technical maintenance over a 10-day period. As promised, the energy major reopened the taps on July 21. Even before the maintenance period began, however, Moscow already had reduced the flow of gas through Nord Stream to about 40% of its capacity on June 14, the retroactive effective date of the contract clause. But a spokesperson for Germany’s economic ministry said the reason for the maintenance was a replacement part that was meant to be used only from September onward.

(3) On July 19, Putin said that the Kremlin would keep good on its natural gas commitments to Europe, but at the same time warned of putting a squeeze on capacity due to Western sanctions.

(4) On July 20, the European Commission (EC) released a plan to push governments to prepare for a gas shortage this winter. The EC is aiming to get countries to voluntarily reduce their gas consumption by 15% by early next year. If countries do not abide by the timeline, the EC could force the reductions. Russian gas supplies to Europe in June were less than 30% of the average sent to the EU over the previous five years, the Commission said.

(5) On July 27, gas flows through the pipeline were further reduced to about 20% of the pipeline’s capacity from an already low 40%, again with Gazprom citing maintenance issues. Ukraine President Volodymyr Zelenskyy said the move was equivalent to a “gas war” with Europe. Germany’s economy minister said the maintenance “excuse” was a “farce.” It is unclear whether this will be a temporary supply restriction or Gazprom will continue sending only 20% of supplies.

(6) On Monday, European gas futures jumped after Gazprom announced it had stopped sending natural gas to Latvia. Gazprom said it did so because of a “violation of the conditions for gas withdrawal” with no further details. Latvian officials said Gazprom's move would have little effect given that Latvia has already decided to ban Russian gas imports starting January 1, 2023.

(7) Bloomberg calculations published Monday showed that Gazprom’s daily deliveries were down 22% in July from June. That was the lowest seen since at least 2014 even as daily flows to China set multiple records in July.

Europe II: Winter Of Their Discontent? European officials have said that Russia’s squeeze on Europe’s gas supply will result in a “clear cut” recession for the region. The latest economic indicators are already pointing in that direction. Energy prices are soaring and depressing consumer and business sentiment. Here are the latest updates on the European economy:

(1) Energy leading CPI inflation to record highs. In July, the Eurozone’s flash CPI inflation rate jumped to a record 8.9% y/y (Fig. 9). The flash core rate (excluding food and energy) was 4.0%, also the highest on record looking back to 2000.

(2) Energy prices leading. Not surprisingly, energy prices led the way up for the headline number with a rate of 39.7% y/y, down only slightly from the record rate of 44.3% during March (Fig. 10).

(3) European sentiment souring. In July, the European Economic Sentiment Indicators (ESIs) for both the EU and Eurozone fell just below 100 for the first time since recovering from the pandemic (Fig. 11). So far, Europeans are not nearly as pessimistic about the economy as they were during the pandemic. But they could soon be if limited gas this winter plunges them into the cold and dark.

The overall ESI is derived from the industrial (weight 40%), service (30%), consumer (20%), construction (5%), and retail trade (5%) confidence indicators. Of the components, consumer sentiment fell most dramatically in July (Fig. 12). Consumers are most concerned over the next 12 months about the general economic situation, while their expectations about the job market remain strong (Fig. 13).

(4) Real GDP to weaken. The Eurozone’s ESI does not bode well for real GDP growth, as the former tends to be a leading indicator for the latter. During Q2, the Eurozone’s real GDP rose 4.0% y/y (Fig. 14). The ESI suggests that GDP growth could weaken significantly during the rest of this year and early next year.

(5) European stocks drop. The EMU MSCI index fell 16.2% (in local currency) from its record high on November 17 through Monday’s close (Fig. 15). The index is trading at a low forward P/E multiple of just below 12.0, down from just over 18.0 in mid-2020 when pandemic lockdowns began to lift (Fig. 16).

Forward earnings continued to rise through the July 21 week. Leading the way in earnings growth expectations is the EMU MSCI’s Energy sector, which makes sense given that Europe is becoming much more dependent on domestic energy firms than it was before the war. Forward earnings for most other sectors have either flatlined or edged downward through July 21.

The EMU MSCI sectors’ forward profit margins also remain near recent record highs, led by the Energy sector with a record-high forward profit margin of 9.7%. That suggests that energy firms are having no problems passing the increases from rising costs through to their selling prices. That doesn’t appear to be the case for companies in most other sectors, however, as their forward profit margins recently have turned downward. (See our EMU MSCI Sectors.)

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Valuation, M-PMI & Consumers

August 02 (Tuesday)

Strategy I: Tweaking Our Valuation Multiples. In line with our view that the S&P 500 might have bottomed on June 16 at 3666, Joe and I are raising our target ranges for the index’s forward P/E valuation multiples from 14.0-17.0 to 15.5-18.0 this year and from 15.0-18.0 to 16.0-19.0 next year.

We are sticking with our forward earnings forecasts of $235 per share for year-end 2022 and $255 per share for year-end 2023. As a result, our projected ranges for the S&P 500 stock price index are now 3642-4230 by the end of this year and 4080-4845 by the end of next year. (See our updated YRI S&P 500 Earnings Forecasts.) (FYI: Forward earnings is the time-weighted average of analysts’ consensus earnings-per-share estimates for this year and next.)

Could the S&P 500 rise to a new record high of 4800 by the end of this year, rather than at the end of next year as we expect? These days, anything is possible, we suppose. However, during the July 21 week, forward earnings was $239. We are expecting it to be essentially flat over the remainder of this year assuming, as we do, that the current growth recession continues over the rest of the year.

For the S&P 500 to get to 4800 with our year-end forecast of $235 for forward earnings would require that the forward P/E jumps back to 20.4 from Friday’s level of 17.2. If the current multiple remains unchanged at 17.2 by the end of the year, forward earnings would have to rise to $279 by the end of this year for the S&P 500 to hit 4800.

In other words, a new record high in the S&P 500 by the end of this year seems unlikely to us. It is more likely to happen by the end of next year. But we won’t object if it happens sooner.

Strategy II: Why Equity Investors Care About The M-PMI. Yesterday’s M-PMI report for July was fully consistent with our view that the economy is in a growth recession, supply-chain disruptions are abating, and unintended inventory accumulation is putting downward pressure on prices (Fig. 1). On balance, it was bullish for stocks. Consider the following:

(1) M-PMI and S&P 500. The S&P 500 on a y/y basis closely tracks the M-PMI (Fig. 2). The former was down 10.4% y/y during July. July’s M-PMI reading of 52.8 suggests that the S&P 500 should be up by about as much.

Not surprisingly, the M-PMI is also highly correlated with the y/y growth rate in S&P 500 operating earnings per share (Fig. 3). So far, the former is consistent with a slowdown in the latter rather than a hard landing with negative y/y comparisons.

(2) Production & new orders. The M-PMI production index remained solidly above 50.0 during July at 53.5 (Fig. 4). However, the M-PMI new orders index dipped to 48.0, which is consistent with previous slowdowns rather than recessions.

(3) Supply chains. The M-PMI’s supplier-deliveries and backlog-of-orders components both fell sharply to readings of 55.2 and 51.3, respectively, indicating that supply-chain disruptions are easing (Fig. 5).

(4) Inflation indicator. The M-PMI’s prices-paid index dropped from 87.1 during March to 60.0 during July (Fig. 6). That’s the lowest since August 2020. In the past, similar declines occurred during recessions, identified as such by the Dating Committee of the National Bureau of Economic Research. This time might be different if the current slowdown isn’t bad enough to be counted as an “official recession.”

Consumers I: ‘Inflation Tax’ Flattens Real Incomes. Over the past 12 months through June, personal income less government social benefits to persons, in current dollars, rose $1,346 billion to a record $17.9 trillion (Fig. 7). Over that same period, inflation-adjusted income (on a comparable basis) rose just $184 billion to $14.5 trillion. So in effect, the “inflation tax” reduced the purchasing power of pre-tax personal income by $1,162 billion.

A similar analysis of disposable personal income (DPI) shows that it rose $602 billion in current dollars and fell $498 billion on an inflation-adjusted basis. So the inflation tax reduced the purchasing power of DPI by $1,100 billion (Fig. 8).

In percentage terms on a y/y basis, real personal income with and without government social benefits fell 1.0% and rose 1.3% through June. On a m/m basis, they fell 0.3% and 0.2% during June. Real DPI fell by 0.3% m/m and 3.2% y/y through June. Any way that we slice and dice the data, the inflation tax has dramatically eroded the purchasing power of consumers over the past 12 months.

It’s no wonder that the Consumer Sentiment Index (CSI), the Consumer Confidence Index (CCI), and the Consumer Optimism Index (COI) all show that consumers are very depressed (Fig. 9). The COI, which is the average of the CSI and the CCI, fell in July to the lowest reading since November 2013.

Consumers II: Saving Less To Boost Spending. In an effort to prop up their spending, especially on essentials, consumers have cut back on their saving and increased their borrowing. The personal saving rate fell from 9.5% last June to 5.1% this June (Fig. 10). Over this period, current-dollar personal saving fell $769 billion, while inflation-adjusted personal saving fell $718 billion (Fig. 11).

In current dollars, consumer revolving credit increased $131 billion over the past 12 months through May (Fig. 12). But again, on an inflation-adjusted basis, the real purchasing power of that borrowing increased by only $57 billion.

By saving less and borrowing more, consumers have managed to spend more but at a slower pace than during past periods when inflation wasn’t eroding their purchasing power as much as it is now. Consider the following:

(1) Real consumption. Personal consumption expenditures (PCE) is up 8.4% y/y through June in current dollars but only 1.6% on an inflation-adjusted basis (Fig. 13). In other words, their nominal PCE has increased by $1,334 billion over the past 12 months to $17.1 trillion, but that’s barely allowed them to increase their real spending—because of the inflation tax.

(2) Pivoting from goods to services. Over the past 12 months through June, real PCE on goods fell 3.0%, while real PCE on services rose 4.1%. Following the lockdown recession in early 2020 through mid-2021, consumers splurged on goods while most services were still unavailable. Now they’ve satiated their pent-up demand for goods and reverted to spending more on services.

(3) Budget shares. We can gain some additional insights into consumer spending by examining current-dollar spending categories as a percentage of DPI. Total PCE as a percent of DPI edged up to 92.1% during June, the highest since August 2008 (Fig. 14). This ratio is roughly the mirror image of the personal saving rate. (Personal saving equals DPI less PCE less personal interest payments less personal current transfer payments.)

From 2009 through 2019, consumers consistently spent between 9% and 10% of their DPI on durable goods. During the lockdown recession, this percentage plunged to 6.3%. Since then, it has rebounded to about 11.5%. Odds are that it will decline as the service percentage rises from 60% currently closer to the 62% pre-pandemic reading.

Spending on nondurable goods including groceries and gasoline had been on a downward trend from 1990 through 2019. Rapidly rising prices of food and fuel have forced consumers to spend 17.1% of their DPI on these essentials during June, the highest since March 2013 (Fig. 15). Similar trends have unfolded for the DPI share of clothing and footwear (Fig. 16).

Consumers have managed to pay for more of their essentials mostly by saving less and borrowing more, as noted above. That’s disturbing. Even more disturbing is that many consumers might also be reducing the share of their DPI budgets spent on health care, which was down to 19.4% during June, compared to 21.2% before the pandemic (Fig. 17).

(4) Nota bene. Comparing nominal and real-time series is a bit like comparing apples and oranges because of indexing issues raised by using the price deflator. Nevertheless, the basic conclusions above make sense to us.

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Switching Planets: Investors Now From Venus, Analysts From Mars

August 01 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy I: Trading Places. Since our June 24 QuickTakes, we’ve been making the case that the bear market in the S&P 500 might have ended on June 16, when it was down 23.6% to 3666 from its record high of 4796 on January 3. We wrote: “[S]entiment indicators were so bearish that they were bullish. … On a fundamental basis, we’ve noted that commodity prices are showing signs of peaking, suggesting that inflation may be doing the same. Bond market indicators have also turned more bullish recently. For now, we see the 3666 level as a possible bear-market bottom.”

So far, so good. The S&P 500 is up 12.6% since June 16 through Friday’s close (Fig. 1). It is down only 13.9% from its record high. So far, it has remained in bear-market territory—i.e., with a decline of 20% or more—for only 21 calendar days of the 207 days since its record high. If June 16 marked the bottom, then the index bottomed 164 days into the latest bear market (Fig. 2). Let’s have a closer look at the recent happy developments:

(1) Different planets. Here is the performance derby of the 11 sectors of the S&P 500 since June 16 through Friday’s close and during the bear market from January 3 through June 16 (sorted by the former): Consumer Discretionary (21.8%, -36.4%), Information Technology (17.2, -30.2), Real Estate (14.8, -24.9), Utilities (13.7, -8.3 ), S&P 500 (12.6, -23.6), Industrials (11.8, -18.6), Health Care (10.7, -14.4), Financials (9.6, -22.4), Consumer Staples (8.2, -11.2), Communication Services (6.4, -32.7), Materials (4.7, -16.5), and Energy (1.8, 35.0). (See Table 1 and Table 2.)

That’s quite a reversal of fortune among the 11 sectors of the S&P 500. Similarly, industry analysts and investors seem to have traded places. During the bear market, Joe and I maintained that industry analysts were from Venus, while investors were from Mars. The former didn’t seem to have a care in the world and kept raising their estimates for the revenues and earnings of the S&P 500 companies for 2022 and 2023. At the same time, investors, fearing a recession caused by the Fed’s tightening of monetary policy to fight inflation, slashed the valuation multiples they were willing to pay for what they deemed to be the delusional earnings estimates provided by the analysts.

(2) Analysts from Mars. In the past couple of weeks, we’ve observed that analysts may finally have started to shave their estimates to reflect the mild recession that occurred during the first half of this year, with real GDP falling modestly during Q1 and Q2 (Fig. 3). S&P 500 forward earnings—i.e., the time-weighted average of analysts’ consensus earnings estimates for this year and next year—rose 7.5% since the start of this year to a record high during the week of July 7 as the analysts raised their 2022 and 2023 estimates. They’ve been cutting their annual estimates for the past five weeks through the July 21 week, so forward earnings has flattened around $239 per share.

(3) Investors from Venus. Meanwhile, since June 16, investors seem to have concluded that they might have been too bearish about the outlook for both Fed policy and earnings. The S&P 500’s forward P/E, which started the year at 21.4, bottomed at 15.3 on June 16 and was back up to 17.2 on Friday (Fig. 4).

Previously, we had observed that the June 16 low coincided with the peak of the S&P GSCI commodity price index on June 8 and the peak of the 10-year Treasury bond yield on June 14, at 3.48%. After June’s worse-than-expected CPI came out on July 13, we observed that the market had held up well compared to the dive it took when May’s number was released on June 10. That suggested to us that the market was starting to discount the possibility that June’s CPI might have marked peak inflation, as we discussed in our July 12 QuickTakes titled “Will June’s CPI Inflation Rate Be the Peak?”

(4) Feshbach on the market. I checked in with my friend Joe Feshbach on his latest market call. We seem to be on the same planet lately. In his opinion: “Sentiment indicators proved reliable once again. Nasdaq breadth was a bit shaky Friday, so that could lead to temporary profit-taking. However, the put/call ratios I monitor showed skepticism on the rally, which should be a nice clue that the market will work its way higher after any pullback.”

Strategy II: The Fed Is From Outer Space. In addition to discounting peak inflation, the market seems to have discounted peak Fed hawkishness last week on Wednesday afternoon during Fed Chair Jerome Powell’s press conference right after the FOMC voted to hike the federal funds rate by 75bps to a range of 2.25%-2.50%. Consider the following:

(1) Neutral debate. In his brief prepared remarks, Powell started out saying: “My colleagues and I are strongly committed to bringing inflation back down, and we are moving expeditiously to do so. … It is essential that we bring inflation down to our 2% goal if we are to have a sustained period of strong labor market conditions that benefit all.” He reiterated that the Fed remains on course to “significantly reducing the size of our balance sheet.”

Then, in his unscripted remarks, he responded to a reporter asking “how far into restrictive territory rates may need to go?” He said, “[W]e’ve been saying we would move expeditiously to get to the range of neutral. And I think we’ve done that now. We’re at 2.25 to 2.50, and that’s right in the range of what we think is neutral.” Apparently, his suggestions that the Fed is on the borderline of restrictive territory and therefore closer to being done tightening were all it took to move more investors from Mars to Venus.

On Friday, former Treasury Secretary Lawrence Summers accused Powell of coming from outer space. He said that the Fed is engaging in “wishful thinking” similar to the Fed’s delusion last year that inflation would be transitory. He accused Powell of saying things “that, to be blunt, were analytically indefensible.” He added, “There is no conceivable way that a 2.5% interest rate, in an economy inflating like this, is anywhere near neutral.” Former Federal Reserve Bank of New York President William Dudley said on Wednesday that, given the level of uncertainty, “I’d be a bit more skeptical” in saying policymakers had reached neutral.

(2) Safe passage. Investors were also delighted to hear Powell say, “We’re not trying to have a recession. And we don’t think we have to. We think there’s a path for us to be able to bring inflation down while sustaining a strong labor market ... along with—in all likelihood—some softening in labor market conditions. So … that’s what we’re trying to achieve, and we continue to think that there’s a path to that.”

However, he reiterated that “restoring price stability is just something that we have to do. There isn’t an option to fail to do that.” Investors clearly chose to cherry-pick Powell’s dovish comments and ignore his hawkish ones, now that they are on Venus.

(3) No more guidance. Apparently, investors were also happy that Powell said that the Fed’s decisions going forward will be totally data dependent, and the Fed will no longer provide forward guidance (until further notice): “In terms of September, we’re going to watch the data and the evolving outlook very carefully. … I’m not really going to provide any specific guidance about what that might be. But I mentioned that we might do another unusually large rate increase, but that’s not a decision that we’ve made at all.”

Again, investors chose to interpret that as leading to a happy potential outcome, namely, that the data will show weakening economic activity and peaking inflation, thus bringing the Fed’s monetary policy tightening cycle to an end sooner rather than later.

(4) Playbook from Venus. Powell did offer a bit of guidance. He said, “And I think you can still think of the destination as broadly in line with the June SEP. Because it’s only six weeks old.”

“SEP” stands for the “Summary of Economic Projections,” which shows the consensus forecasts of the FOMC participants for the federal funds rate, the unemployment rate, real GDP, headline PCED inflation, and core PCED inflation. Back in June, they expected the federal funds rate would be raised to 3.40% by the end of this year and 3.80% by the end of next year. (See our FOMC Economic Projections.)

According to the SEP, that’s restrictive enough to bring inflation down but without causing a recession. More specifically, real GDP is expected to grow 1.7% this year and next year, with the unemployment rising to only 3.9% next year. The PCED inflation rate is expected to fall from 5.2% this year to 2.6% in 2023 and 2.2% in 2024.

On Venus, there are only happy endings.

Credit: The Bond Vigilantes Are From Venus Too. Joining stock investors on Venus are the Bond Vigilantes. Consider the following:

(1) Bullish indicators. As noted above, the US Treasury bond yield peaked this year (so far) at 3.49% on June 14, falling to 2.67% on Friday. That’s surprising given that inflation remains so high. But we aren’t surprised. As we’ve pointed out before, the bond yield closely tracks the copper/gold price ratio and the Citigroup Economic Surprise Index (Fig. 5 and Fig. 6). Both remain bullish for the bond market, with the copper/gold price ratio signaling that the yield should be closer to 2.00%.

(2) The dollar, QT2 & the yield curve. As we noted in last Tuesday’s Morning Briefing, the strong dollar combined with the Fed’s intention to proceed with QT2 may be equivalent to a hike in the federal funds rate of at least 100bps. The Fed’s critics seem to overlook this important point. A 2.50% federal funds rate in fact may be at the neutral rate under the circumstances!

This view is corroborated by the inversion of the yield curve. The yield spread between the 10-year and 2-year US Treasury notes turned negative on July 6 and was down to -22bps on Friday (Fig. 7). That certainly is signaling that bond investors believe that interest rates are already high enough to weaken economic growth and bring inflation down.

The 2-year yield—which tends to be an indicator of the market’s expectations for the federal funds rate over the next 12 months—peaked this year at 3.45% on June 14 (Fig. 8). It was down to 2.89% on Friday. It currently implies “one and done,” i.e., that one more federal funds rate hike of 50bps to a range of 2.75%-3.00% in September should be the end of the Fed’s rate hiking.

That may seem absurdly low to the Fed’s critics, but they’ve been ignoring the restrictive impact of the strong dollar and QT2. Fed officials undoubtedly have run their econometric model to determine the equivalence of these restrictive developments to the magnitude of a rate hike. They should share that information with the public.

(3) Flow of funds. The rally in the bond market has been especially impressive given that bond mutual funds experienced net withdrawals of $83.2 billion over the past 12 months through June (Fig. 9). That may be a good contrary indicator given that investors piled into these funds at a record 12-month pace of $766 billion during April 2021, the worst possible time to be buying bonds as it turned out.

Previously, we observed that net capital inflows into the US from abroad added up to $1.3 trillion over the 12 months through May (Fig. 10). Over that same period, private foreigners’ net purchases of US bonds was $796.8 billion (Fig. 11). On the other hand, foreign investors sold $162.4 billion in US equities, on balance, over this same period.

(4) TINAC. The above suggests that global investors have concluded that the US represents a safe haven for their money in a world that’s going mad. Their mantra is “there is no alternative country” (TINAC). That explains why the dollar has been so strong since the start of this year, as they’ve been buying lots of US bonds. Now they may also be buying US stocks. If not, their bond purchases certainly have helped to lower the bond yield here, which seems to be providing support for valuation multiples in the stock market.

Inflation: Hopefully Peaking. So is inflation peaking or not? There are mounting signs that it is peaking, but not enough of them to be certain. It didn’t peak in June, as the headline PCED inflation rate rose to 6.8%, the highest since January 1982 (Fig. 12). The core inflation rate was 4.8%. We are still predicting that the headline rate will moderate to 4%-5% during H2. We should see it get closer to this range when July’s PCED is released on August 26 for the following reasons:

(1) Food & energy. Agricultural commodity prices dropped during July, suggesting some moderation in food inflation, which was 11.2% y/y during June in the PCED (Fig. 13). The same can be said about energy inflation, with the exception of natural gas prices, which moved higher in July. The energy component of the PCED was up a whopping 43.5% y/y during June.

(2) Core inflation. The three-month annualized inflation rates for both durable and nondurable goods (excluding food and energy) moderated significantly through June (Fig. 14). Retailers have been forced to liquidate their bulging inventories by slashing their prices. We also expect to see further weakness in the prices of household furniture and appliances as a result of the housing recession (Fig. 15).

Debbie and I anticipated that some of the progress likely to be made in durable and nondurable goods inflation will be offset by the rent components of the PCED services sector. Sure enough, rent of primary residence and owners’ equivalent rent are rising at faster rates, of 5.8% and 5.4% y/y through June (Fig. 16). The comparable three-month annualized rates are even higher at 7.9% and 7.1%.

(3) Employment costs. In his presser, Fed Chair Powell said that among the more important inflation indicators is the Employment Cost Index (ECI). It came out on Friday, and it showed no signs of peaking. The ECI inflation rate continued to move higher during Q2 with a gain of 5.5% y/y, led by a 5.7% increase in wages and salaries, while benefits rose 5.3% (Fig. 17).

The wage-price-rent spiral was still spiraling through June.

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The Fed, Earnings, Chips & AI

July 2 8 (Thursday)

The Fed: No Surprises From Powell. The S&P 500 soared 2.6% yesterday to close at 4023.61, 9.7% above its June 16 bear-market low of 3666.77. It is still 16.1% below its record high on January 3. Yesterday’s rally was boosted by Fed Chair Jerome Powell’s no-surprises press conference. The Fed hiked the federal funds rate by 75bps as widely expected. Powell reiterated that he believes that the Fed has a path toward moderating inflation without causing a recession.

Joe and I believe that TINAC has been a major contributor to the rebound in the bond and stock markets recently. “TINAC” stands for “there is no alternative country.” As the world seems to be spinning out of control, the US looks like a safe haven for global investors.

That explains the strength of the US dollar. Previously, we’ve observed that monthly net capital inflows data collected by the US Treasury show that foreigners have been big buyers of US fixed-income securities in recent months. That may have helped to stabilize the bond yield around 3.00%, stopping the freefall in valuation multiples in the stock market.

As we note in the next section, the Q2 earnings reporting season so far reflects a slowing economy, but not a recession. Analysts are shaving some earnings estimates, but certainly not slashing them. For now, the market seems to be siding with Powell’s view (and ours) that a soft landing is possible.

Earnings: So Far, So Good. Despite all the handwringing about Fed tightening and high energy prices, analysts continue to call for solid earnings growth this year and next. Their consensus forecasts for S&P 500 companies collectively imply earnings growth of 10.6% this year and 8.2% in 2023 (Fig. 1). Granted, the jump in the S&P 500 Energy sector’s expected earnings for this year has boosted the S&P 500’s projected 2022 earnings growth, but next year the Energy sector will weigh on the broader index’s 2023 earnings growth. Excluding the Energy sector, S&P 500 earnings are expected to grow 4.4% in 2022 and 10.6% in 2023.

Higher interest rates and gasoline prices did take a toll on consumer spending in Q2, based on earnings reports this week from Walmart, McDonald’s, and Shopify. That pressure won’t let up anytime soon given the Fed’s federal funds rate increase yesterday. Conversely, corporations have continued spending on technology, but have pulled back on ad spending, if Microsoft’s earnings report is any indication.

Here’s a quick look at some of the notable Q2 corporate earnings reports from this week:

(1) Consumers hit speed bump. Retailers warned that inflation and higher interest rates had started to affect consumers’ shopping patterns. Walmart’s customers are spending more on necessities like food and less on clothing and electronics because inflation is pinching their pocketbooks, the retailer said as it made a Q2 earnings preannouncement this week that shocked investors.

While Walmart said same-store sales rose 6% in Q2, the shift in consumer spending left the retailer with excess inventory that needed to be aggressively marked down. The retailer lowered its 2022 earnings forecast to a decline of 11%-13%, much greater than the 1% decline it previously signaled. Walmart shares dropped 7.6% on the news Tuesday and are down 15.7% ytd through Tuesday’s close. That’s actually better than the S&P 500 Consumer Discretionary sector’s 31.4% decline ytd.

McDonald’s CEO Chris Kempczinski sounded very gloomy in a conference call, noting that war, inflation, and high interest rates are “contributing to weak consumer sentiment around the world and the possibility of a global recession,” a July 26 CNBC article reported. Lower-income customers are opting for more value offerings, and the company is gaining customers who are trading down from sit-down and fast-casual restaurants. Q2 earnings—excluding charges from the closure of McDonald’s business in Russia and other unusual expenses—came in at $2.55 a share, up 8% y/y.

Shopify warned that 2022’s online sales will “reset to the pre-Covid trend line and is now pressured by persistent high inflation.” While Shopify’s revenue rose 16% y/y, it posted an adjusted loss of three cents a share, missing analysts’ consensus target and below Q2-2021’s adjusted earnings per share of 22 cents. Losses are expected to continue during H2 as well. Shopify, which helps companies set up their e-commerce websites, announced it will cut 1,000 jobs. Its shares have fallen roughly 75% ytd.

(2) Microsoft saves the day. In the current economic environment, all tech is not created equal. The shares of many tech companies that rely on advertising like Snap and Meta Technologies are down sharply ytd, as advertising is often the first thing that customers cut during uncertain economic times. With the consumer facing the pressure of higher gasoline prices, higher interest rates, and higher inflation, tech companies selling online to consumers face headwinds as well.

Microsoft does have consumer exposure through its Xbox gaming business, which saw revenue drop 6% in its fiscal Q4 ended June 30. But Microsoft’s Azure and other cloud services revenue grew 40% y/y. All in, the company reported a 12.4% y/y jump in Q4 revenue, a 7.5% rise in operating income, and a 2.8% jump in earnings per share despite the war in Ukraine, factory shutdowns in China, and the drag of a strong dollar.

Microsoft’s forecast of double-digit currency-adjusted growth in revenue and operating income for fiscal 2023 sent its shares 6.7% higher Wednesday. Despite the current economic turmoil, IT spending will increase because “every business is trying to fortify itself with digital tech to in some sense navigate this macro environment,” said CEO Satya Nadella, a July 26 WSJ article reported.

Technology: Semis Fear Gluts. The S&P 500 Semiconductors industry has had a terrible year, with its stock price index falling 30.8% ytd through Tuesday’s close, almost twice the S&P 500’s 17.7% decline (Fig. 2). Investors are concerned that demand for semiconductors will slow sharply if customers find themselves with excess inventory because they’ve been double-ordering during the recent shortages. There’s also concern that demand could slow if the economy falls into a recession. Already, there are signs that the demand is softening in the consumer technology area, as few consumers need a new computer or phone, having bought new ones during the pandemic.

Despite these fears, demand for chips remains robust in the industrial and automotive segments based on the Q2 earnings calls of NXP Semiconductors and Texas Instruments this week. Let’s take a look at what they had to say and the legislation winding its way through Congress that could encourage more chip manufacturers to build fabs in the US of A:

(1) Semis still selling. Despite the handwringing, global sales of semiconductors continued to rise in May, by 18.0% y/y to $51.8 billion (using a three-month moving average). Sales were up y/y in all geographies: Americas (36.9%), Japan (19.8), Europe (16.1), Asia Pacific/All other (15.8), and China (9.1) (Fig. 3). On a m/m basis, sales were up in most regions: Japan (3.9%), Americas (2.9), China (1.7), Asia Pacific/All Other (1.1), and Europe (-0.7).

Wall Street analysts continue to call for the industry’s revenue and earnings to grow. Revenue is expected to climb 17.4% this year and 5.2% in 2023 (Fig. 4). Even earnings are expected to increase by 13.2% this year and 3.8% in 2023 (Fig. 5).

Despite optimistic expectations, the S&P 500 Semiconductors index’s forward P/E has tumbled from a peak of 25.0 last November to a recent 16.0 (Fig. 6). The last time the industry faced an extended selloff was in 2009, and it didn’t end until analysts started cutting the industry’s earnings forecasts sharply and the index’s forward P/E spiked. In cyclical sectors, the optimal time to buy is often when earnings have fallen sharply and P/Es have jumped.

(2) Inventory worries. NXP Semiconductors batted away concerns about customers’ inventory levels on its Tuesday conference call. It did confirm that demand has slowed for chips used in low-end Android handset markets; but demand remains hot in the auto and industrial segments. Even though NXP has “gradually and incrementally” increased its supply capabilities, it is still only able to meet 80% of demand from customers and requires customers place non-cancelable, non-returnable orders through 2023.

“When looking at customer inventory, we continue to see a dysfunctional supply chain, which struggles to get the right product mix and complete kits to the correct location in the extended automotive and industrial markets,” said CEO Kurt Sievers.

The company, which said it is sold out for 2022, gave Q3 revenue guidance of $3.35 billion to $3.50 billion, a 17%-22% jump y/y and above analysts’ consensus forecast of $3.32 billion. NXP’s own inventory increased to 94 days, up five days sequentially and close to its target of 95 days. The company was optimistic that car production would pick up from depressed levels, and it noted that the number of semiconductors in cars continues to increase.

Texas Instruments (TI), which sells chips into a broader range of end markets than NXP, noted that Q2 revenue was up y/y in automotive (more than 20%), industrial (high-single-digits percentage), communications equipment (about 25%), and enterprise systems (mid-teens percentage). The weakest link was personal electronics, which only grew in the low single digits. TI believes weak demand in the personal electronics category will continue in Q3. Nonetheless, the company is forecasting Q3 revenue of $4.9 billion to $5.3 billion and Q3 earnings per share of $2.23 to $2.51. Both targets are above analysts’ consensus forecasts of $4.94 billion and $2.26, respectively.

TI has seen clear signs that its customers have been building inventory in recent quarters, but whether they will operate with larger inventories going forward or bring inventories back down remains a question. TI continues to build its own inventory levels, which will be easier as three factories come on online, one each in 2022, 2023, and 2025.

(3) Washington spends on chips. On Wednesday, the Senate approved The CHIPS and Science Act of 2022, a $280 billion package of subsidies and funding aimed at boosting US competitiveness in semiconductors and advanced technology, a July 27 WSJ article reported. The bill heads to the House of Representatives, where it’s expected to be approved.

The bill contains funding to encourage companies to build semiconductor plants in the US to reduce America’s dependence on semi production in Taiwan and other countries. Intel, SK Group, and Samsung each have indicated they plan to build plants in the US. The bill also includes funding for scientific research to be conducted primarily by the federal government over the next decade, the WSJ reported.

Disruptive Technologies: AI & Drug Development. Some call it “pharmatech.” Others dub it “digital biology” or “medtech.” Regardless of the name, the use of huge data sets and artificial intelligence (AI) in drug discovery and development has gone mainstream. Started in the labs of leading universities, AI is now used by startup companies that often partner with the industry’s pharmaceutical giants in hopes of developing new drugs faster and more cheaply.

One of the industry’s leaders is DeepMind, a unit of Alphabet focused on AI development. DeepMind has developed AlphaFold, an open-source software program that predicts the structure of existing proteins, can develop new proteins, and can find treatments using proteins. Since AlphaFold’s software became available to the public last year, scientists have been using it in all manner of research.

Alphabet isn’t completely altruistic. Last November, the company announced the creation of a new company, Isomorphic Labs, which plans to use AlphaFold to develop drugs. Like many of the startups in this area, Isomorphic throws together traditional scientists and technology professionals. Its top management team includes a chief science officer, chief technology officer, and a director of machine learning working together to develop drugs.

Here are a few of the industry’s other players and their achievements:

(1) BenevolentAI. BenevolentAI uses AI to develop drugs with a higher probability of clinical success than if it had used traditional drug development methods. The company has an in-house pipeline of more than 20 drugs, with one for atopic dermatitis in phase two trials. The company says its AI tools were used to search through approved drugs to find one that could treat Covid-19. By focusing on drugs that block the viral infection process, it identified baricitinib, an Eli Lilly drug for rheumatoid arthritis that was ultimately approved to treat Covid as well. BenevolentAI is also collaborating with AstraZeneca to develop drugs for idiopathic pulmonary fibrosis and chronic kidney disease.

BenevolentAI went public through a merger with Odyssey Acquisition on April 22, when the shares traded at €9.90, and they’ve fallen to €6.50 as of Tuesday’s close. The deal gave BenevolentAI access to €225 million, a company press release stated.

(2) Owkin. Owkin applies AI to the patient data it gathers from 18 academic medical centers across the world to develop new drugs and aid in the treatment of patients. The privately held French company partnered in June with Bristol-Myers Squibb to design and optimize cardiovascular drug trials in a deal that could be valued at $180 million if certain milestones are met. This follows the $180 million deal Owkin struck with Sanofi to collaborate on cancer research, a June 9 article posted on Fierce Biotech reported. “In a study published in 2020, for example, the firm used two deep learning algorithms to build models for predicting the survival of patients with hepatocellular carcinoma treated by surgical resection.”

(3) Exscientia. Founded in 2012, Exscientia uses AI to design medicines and run experiments rapidly and efficiently. “We trust the algorithms to generate hypothesis, generate ideas and select which molecules we should make and test,” said CEO Andrew Hopkins. The UK-based, publicly traded company has an oncology drug and a psychiatry drug in phase one trials, along with a number of other drugs in earlier stages of development.

Exscienta, which is expected to lose $0.89 a share this year, has a drug discovery deal with Bristol-Myers Squibb that could pay out up to $1.2 billion or more, a May 19, 2021 Fierce Biotech article stated. The company also works with Bayer, Sanofi, Dainippon Sumitomo, and the Gates Foundation and has raised funding from investors that include Softbank, Bristol-Myers Squibb, and BlackRock. Exscientia’s ADRs traded as high as $27.10 on October 1 but since have fallen to $10.05 as of Tuesday’s close.

(4) Insitro & Schrodinger’s. Insitro builds large datasets optimized for machine learning and develops models used in drug development. In 2020, the company entered a five-year collaboration with Bristol-Myers Squibb to develop treatments for amyotrophic lateral sclerosis (ALS) and frontotemporal dementia. Insitro was founded in 2018 by CEO Daphne Koller, who was a Stanford computer science professor, founded the education technology company Coursera, and was the chief computing officer of Calico, an Alphabet healthcare company.

Schrodinger’s software allows customers to simulate physical interactions between chemical compounds and molecular targets, making drug development more efficient, explained a June 13 article posted on TheStreet.com. The publicly traded company had 20 of the largest pharmaceutical companies as customers last year, and it is also developing drugs to create its own pipeline. Schrodinger, which analysts expect will lose $2.02 a share this year and lose $1.47 in 2023, has watched its shares fall from a high of $110.18 on February 2021 to a recent $31.50.

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All About Housing

July 27 (Wednesday)

US Housing I: From Boom To Caboom? The pandemic-induced housing boom is over. Would-be homebuyers no longer are lining up out the door for open houses and jumping into bidding wars within hours of first listing. In fact, one of the ugliest charts on the block right now shows the index for traffic of prospective buyers of new homes. It has plunged from 71 at the start of this year to 37 during July (Fig. 1). Just as ugly is the chart showing the sharp declines so far this year in the Housing Market Index (for new homes) and the Pending Home Sales Index (for existing homes) (Fig. 2).

Until recently, a shortage of housing inventory held back strong sales volume and caused home prices to soar. Now inventory-to-sales ratios are rising, as declining affordability is depressing sales volume from the demand side. Contracts are being canceled mid-deal because buyers who hadn’t locked in their mortgage rates can’t afford the monthly mortgage payments that are so much higher than they expected to pay when they first started looking for a house. Buyers also are wary of purchasing a home that could now depreciate in value. Sellers looking to get out while prices are still elevated and before interest rates rise further have started lowering their listing prices.

Nevertheless, Melissa and I don’t expect a housing crash the likes of the Great Financial Crisis (GFC) saw, even though national measures of home prices are likely to fall in coming months. That’s because demand for housing is likely to remain elevated due to the demographic trends discussed below and because mortgage lending standards were tighter in recent years than the historically lax standards that prevailed in the years before the GFC. Consider the following:

(1) Sales decrease as inventories increase. Total existing home sales (including single-family homes and condominiums) plunged 21% since January to 5.1 million units (saar) during June, the slowest pace since June 2020 (Fig. 3). New home sales peaked at 1.04 million units (saar) during August 2020 and fell 43% to 590,000 units in June of this year (Fig. 4).

The recent weakness in sales largely reflects the surge in mortgage rates since the start of the year combined with the jump in home prices since the end of the lockdown recession in 2020. The inventory-to-sales ratios of both existing and new homes are rising as sales fall.

During June, there were 1.26 million existing homes for sales, well below the record high of 4.04 million during July 2007 (Fig. 5). As a result of this year’s sales drop, the month’s supply of existing homes on the market rose from a record low of 1.6 months during January to 3.0 months during June. During the GFC, readings above 10 months were the new abnormal.

A similar analysis shows that new homes for sale rose 16% from 394,000 units in January to 457,000 units in June, the highest inventory of such housing since spring 2008 (Fig. 6). The months’ supply rose from a record low of 3.3 months during August 2020 to 9.3 months in June, the highest since May 2010.

(2) Pending deals come undone. Pending existing home sales data for June will be out this morning. The National Association of Realtors’ (NAR) Pending Home Sales Index ticked up in May but still was about as low as it was in March 2020, when the Covid lockdowns started (Fig. 7).

The index tends to be a leading indicator for existing home sales. But a wave of cancelations suggests that sales could be weaker than the index suggests. The share of sales agreements on existing homes canceled in June was about 15% of all homes under contract, according to a July 11 report from Redfin. That was the most deals undone since early 2020, when the residential real estate market essentially froze during the lockdown.

(3) Rising rates & prices leaving buyers out in the cold. Mortgage applications for new purchases fell dramatically by 25% ytd through July 15 (Fig. 8). Over the same period, the 30-year mortgage rate shot up from 3.30% to nearly 6.00%.

Remarkably, over the past 24 months through June, the median existing home price is up 42.1% (Fig. 9). Over the 24 months ending May, the median new home price was up 40.2% (Fig. 10). But yesterday, we learned that this price plunged 9.5% m/m during June. So the median price increase over the past 24 months through June is now 18.0%.

Altogether, housing has become much less affordable in recent months. Through May, the NAR’s Housing Affordability Index based on a 30-year fixed rate mortgage dropped to the lowest seen since July 2006 (Fig. 11).

(4) Tighter lending standards. Fortunately, mortgage lending standards have been tightened significantly since the GFC. During Q1-2022, the percent of mortgages delinquent by 90 days or more remained at a record low of 0.5% (Fig. 12). The similar delinquency rate for home equity loans was 0.8%. Both were well below the delinquency rates on auto loans (4.0%), student loans (4.7%), and credit cards (8.4%).

US Housing II: Homebuilders Getting Squeezed. Q2’s real GDP will be released tomorrow. According to the Atlanta Fed’s GDPNow tracking model, it is likely to show a small decline of 1.6% (saar) led by a large 10.1% drop in residential investment, which is highly correlated with both total housing starts and housing completions (Fig. 13 and Fig. 14). Consider the following:

(1) Starts mixed by type. Single-family housing starts can be volatile, but June’s 8.1% drop to 982,000 units (saar) appeared to be a clear weakening of the post-pandemic uptrend in homebuilders’ breaking ground (Fig. 15). Single-family permits, a leading indicator for starts, fell 7.7% in June to 970,000 units (saar) (Fig. 16).

Multi-family starts and permits increased, however. Likely that reflects builders’ recognition of the demand for more affordable units for purchase and for rent, as buyers are priced out of the single-family market.

(2) Homebuilders’ margins at record high. While new home prices have risen significantly, the increase isn’t all going into homebuilders’ margins; much is going to the increased costs of building materials and labor. Global supply-chain disruptions and shortages of building materials along with generally rising prices in the US have led to higher costs to build.

The PPI for final demand in construction rose 19.2% y/y during June (Fig. 17). Homebuilders have gotten a bit of a reprieve in the price of lumber but still may be working to offset the skyrocketing cost of lumber that occurred just a few months ago.

Nevertheless, the forward profit margin of the S&P 500 Homebuilding industry has increased significantly from 8.9% at the start of 2020, just before the pandemic, to a record high of 15.1% recently (Fig. 18). However, both forward revenues and forward earnings seem to have peaked in recent weeks. (See our S&P 500 Industry Briefing: Homebuilding.) June’s drop in the median new home prices suggests that the industry’s profit margin may be about to head south quickly.

US Housing III: Millennials Forming Households. Leading up to the pandemic, the number of households surged; then during the pandemic, it fell as many extended families moved in together to share costs and commiserate during the lockdowns. Following the pandemic, household growth again is on the rise, albeit more slowly than before (Fig. 19).

Prior to the pandemic, many Millennials started purchasing their first homes. But as affordability has become a real challenge for many of them recently, the number of rental households increased from Q3-2021 through Q1-2022, while the number of owner-occupier ones decreased (Fig. 20). These developments are likely to boost multi-family housing starts, while depressing single-family housing starts.

Harvard’s Joint Center for Housing’s recently released “The State of the Nation’s Housing Report 2022” included an interesting section on demographics. Here are a couple of excerpts from the report’s fact sheet:

(1) “Household growth has been strong during the pandemic, increasing by 3.2 million between Q1 2020 and Q1 2022. This has been driven in part by the large millennial generation aging into prime years of household formation. The peak of the millennial generation (born 1985–2004) was age 31 in 2021. As a result, there were 46 million adults aged 25–34 in 2021, a record-high number for the age group most likely to form households.”

(2) “The aging of the baby boom generation is resulting in a meteoric rise in the number of older adult households. The peak of the baby boom generation (born 1946–1964) was age 59 in 2021, and the oldest members of the generation were age 75. The number of householders age 65 and over rose by 10.0 million from 2011 to 2021 and is projected to rise by 1.1 million annually until 2028. This growth in older households will result in a more pressing need for accessible and affordable housing as well as supportive services to meet the changing needs of this demographic.”

US Housing IV: Urban Exodus. Many owner-occupier households have skirted the housing affordability hurdle by moving to cheaper areas. The remote work trend, outlasting the pandemic, has provided workers with the flexibility to live in more affordable areas as well as save time and money on commutes. As a result, mass migration has occurred from urban areas into more rural less expensive ones.

The Harvard housing report observed: “Though overall residential mobility continues to decline, pre-pandemic trends in migration away from large urban areas continued during the pandemic. In total, the core counties of large metro areas lost 1.2 million people to domestic migration last year, while suburban counties of these large metros gained 428,000 people from domestic moves. Counties in small- and medium-sized metros added a net total of 539,000 migrants, and rural nonmetropolitan counties gained 235,000 people from net domestic migration last year—reversing a decade-long trend in net domestic outflows.”

Recently, one of our accounts asked a great question: Is the mass exodus out of the more expensive areas reflected in the latest housing inflation data?

Our answer: Based on the following resources, population size by geographic location is factored into the Consumer Price Index (CPI) for owner-occupied and tenant rent. However, the sample size is constant for a period. The latest data reflect the 2018 geographic CPI pricing areas (based on the 2010 Census population size). So, no, the CPI for rent would not factor in the exodus from more expensive geographies to cheaper ones (by way of weighting the cheaper ones more).

That means that if the geographies were reweighted against the population, it’s possible that the CPI would be lower. But keep in mind that the “cheaper” regions have experienced rental increases following increased housing demand. Also, the fact that the Bureau of Labor Statistics collects “existing” rent information (as opposed to the prices for new listings) for the CPI makes it a lagging indicator, which more than likely means that CPI for rent currently is vastly understated. (See BLS Handbook of Methods and this NBER working paper by economist Larry Summers et al.)

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How Much Rate Hiking Does QT2 Equal?

July 26 (Tuesday)

YRI Webcast. Replays of Dr. Ed’s Monday webcasts are available here.

The Fed I: Waiting For An Answer From Talking Fed Heads. Melissa and I have been wondering how much federal funds rate hiking does the current round of quantitative tightening (QT2) equal? Last week, in the July 20 Morning Briefing, we asked a similar question about the 10% increase in the US dollar index (DXY) since the start of this year.

Let’s just say that each equates to a 50bps rate hike, so collectively they exert the equivalent of 100bps of rate hiking, at least. Now let’s say that absent these two non-rate-related tightening sources, the Fed’s current monetary tightening cycle would take the federal funds rate to a peak of 4.00% from 1.50% currently. Then with these two sources in place, the peak would be only 3.00%.

Fed officials have been remarkably silent on this question. They were much more talkative and informative about similar developments in the past when they were justifying their ultra-easy monetary policies:

(1) William Dudley on QE2. In my 2020 book Fed Watching For Fun & Profit, I wrote: “William Dudley, the president of the Federal Reserve Bank of New York, gave a speech on October 1, 2010 favoring another round of QE with specific numbers: ‘[S]ome simple calculations based on recent experience suggest that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point.’” His basic argument was that despite the downside of additional QE, it was the only tool the Fed had left to meet its congressional mandate to reduce the unemployment rate since the federal funds rate was at the “lower bound.” (Back then in 2010, I argued that if the Fed’s econometric model was calling for a negative official policy rate, then either there was something wrong with the model or the Fed was trying to fix economic problems that could not be fixed with monetary policy.)

(2) Lael Brainard on the strong dollar. As we noted in the July 20 Morning Briefing linked above, on September 12, 2016, Fed Governor Lael Brainard presented a speech titled “The ‘New Normal’ and What It Means for Monetary Policy,” calling for “prudence in the removal of policy accommodation.” She listed several reasons for this, including a very specific estimate of the impact of the strong dollar on the economy. She said, “In particular, estimates from the FRB/US model suggest that the nearly 20 percent appreciation of the dollar from June 2014 to January of this year could be having an effect on US economic activity roughly equivalent to a 200-basis-point increase in the federal funds rate.”

In a December 1, 2015 speech titled “Normalizing Monetary Policy When the Neutral Interest Rate Is Low,” Brainard stated, “According to the Board’s FRB/US model, it would require lowering the path of the federal funds rate by roughly 1 percentage point over the medium term to insulate domestic employment from the 15 percent stronger exchange rate in inflation adjusted terms” that had occurred since June 2014. Again, she called for prudence in normalizing monetary policy: “In effect, this spillover from abroad implies some limitations on the extent to which U.S. monetary conditions can diverge from global conditions.”

(3) Bottom line. We conclude that the peak in the federal funds rate during the current monetary tightening cycle will be lower than otherwise because the combination of QT2 and the strong dollar are equivalent to at least a 100bps increase in the federal funds rate. In addition, the extraordinary jump in both short-term and long-term interest rates in the fixed-income markets has already accomplished much of the tightening for the Fed. The markets have already discounted a peak federal funds rate of 3.00%-3.25%, which is where it will be assuming that the Fed hikes the rate by 75bps on Wednesday and 75bps again at the end of September, as widely expected.

The Fed II: The Markets Have An Answer. The financial markets are currently signaling that the peak in the federal funds rate is likely to be 3.00%, according to the 2-year US Treasury yield, which tends to lead the federal funds rate by about six to 12 months (Fig. 1 and Fig. 2). The 2-year yield peaked at 3.45% on June 14. It was down to 3.04% yesterday. In addition, the yield-curve spread between the 10-year and 2-year Treasury notes turned negative last week, falling to -20bps on Friday (Fig. 3). That signals that bond investors believe that the Fed’s monetary tightening cycle will end sooner rather than later, as the economy slows.

While the Fed has raised the federal funds rate by only 150bps so far during the current monetary policy tightening cycle, the credit markets seem to have discounted the full tightening cycle. In other words, if the Fed proceeds with a 75bps rate hike right after Wednesday’s meeting of the FOMC and follows up with another 75bps at the September meeting of the FOMC, yields might not follow suit since they’ve already anticipated these moves, as noted in the previous section.

In addition, the credit markets seem to have discounted QT2, especially the mortgage market. Consider the following:

(1) Mortgage rates go vertical. Mortgage rates have soared much faster and much higher than can be explained by the actual and expected hikes in the federal funds rate since the start of this year, in our opinion. Soaring mortgage rates combined with record-high home prices have depressed housing, accounting for much of the recent weakness of the economy.

The 30-year fixed-rate mortgage yield jumped from 3.29% at the start of this year to 5.73% on Friday (Fig. 4). Its spread with the 10-year Treasury yield soared from 177bps at the start of the year to 296bps on Friday (Fig. 5). This spread tends to hover between 150bps and 200bps during normal times.

(2) Feddie shutting down mortgage business. The jump in the mortgage yield spread is reminiscent of similar ascents in this yield during the Great Financial Crisis (GFC) and the Great Virus Crisis (GVC). The obvious explanation for this year’s extravaganza is that the December 2021 minutes of the FOMC, released on January 5 of this year, indicated that the Fed was getting closer to ending QE4 and starting QT2. In addition, the minutes signaled that “Feddie” (the distant cousin of Fannie Mae and Freddie Mac since the GFC through the GVC) was getting out of the mortgage financing business:

“Consistent with the previous normalization principles, some participants expressed a preference for the Federal Reserve’s asset holdings to consist primarily of Treasury securities in the longer run. To achieve such a composition, some participants favored reinvesting principal from agency MBS into Treasury securities relatively soon or letting agency MBS run off the balance sheet faster than Treasury securities.”

(3) QT2 unveiled. Following the May 3-4 meeting of the FOMC, the Fed issued a press release titled “Plans for Reducing the Size of the Federal Reserve’s Balance Sheet.” During June through August, the Fed will reduce its balance sheet by running off maturing securities, which will drop its holdings of Treasury securities by $30.0 billion per month and its holdings of agency debt and mortgage-backed securities (MBS) by $17.5 billion per month. So that’s a decline of $142.5 billion over those first three months of QT2.

Starting in September, the runoff will be set at $60 billion for Treasury holdings and $35 billion for agency debt and MBS. That’s $95 billion per month. There’s no amount set or termination date specified for QT2. The press release simply states that “the Committee intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves.”

Assuming that QT2 is terminated at the end of 2024, the Fed’s holdings of securities would decline by $2.7 trillion, to $5.8 trillion from $8.5 trillion in May. Its holdings of Treasuries and MBS would decline by $1.7 trillion and 1.0 trillion, respectively, by the end of 2024 (Fig. 6, Fig. 7, and Fig. 8).

In our opinion, the extraordinary jump in mortgage rates and in the mortgage yield spread since the start of this year can be largely explained by the market’s anticipation of QT2 in addition to the Fed’s rate hiking (Fig. 9 and Fig. 10).

(4) Demand destruction in the housing market. The Fed’s goal is to slow demand relative to supply to bring down inflation. It is doing so in the housing market and in the market for housing-related goods and services. The mortgage index for purchasing homes dropped 22.4% since the start of the year through the July 15 week (Fig. 11). The sum of new plus existing single-family home sales dropped 16.5% during the past four months through May. Housing-related retail sales have weakened in recent months, especially on an inflation-adjusted basis (Fig. 12).

The Fed III: A Fed Study Has An Answer. Last but not least, we found a recent study titled “How Many Rate Hikes Does Quantitative Tightening Equal?” It is by Bin Wei, a research economist and adviser in the Research Department at the Federal Reserve Bank of Atlanta. He summarized his findings as follows: “In this article, I examine the question of how to quantify the equivalence between interest rate hikes and quantitative tightening (QT). Using a simple ‘preferred habit’ model I estimate that a $2.2 trillion passive roll-off of nominal Treasury securities from the Federal Reserve’s balance sheet over three years is equivalent to an increase of 29 basis points in the current federal funds rate at normal times, but 74 basis points during turbulent periods.” (Hat tip to Doug Vogt for sharing that study.)

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Anatomy Of A Mid-Cycle Slowdown

July 25 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy I: Time To Be Less Afraid? Sentiment indicators continue to show that fear is rampant in the equity markets. That’s because there have been lots of fearsome developments since the start of the pandemic, including the global spread of Covid, supply-chain disruptions, Russia’s invasion of Ukraine, the persistence of inflation, and increasingly hawkish central bankers. This litany of woes adds up to increasing risks of a global recession. That’s triggered a significant drop in valuation multiples in global stock markets and fears that the second shoe, i.e., aggregate corporate earnings, is about to drop.

The fears have included apocalyptic ones, mostly associated with the war in Ukraine. At the start of the war, Russian President Vladimir Putin implied that he would not rule out using nuclear tactical missiles. Russia’s blockade of Ukrainian ports on the Black Sea halted the country’s grain exports, causing food prices to soar and raising fears of famine and social upheaval, particularly in Africa. The war also reduced the availability of Russian fertilizer, also heightening the risk of a global food shortage. Now, there is mounting concern that Russia will shut off gas supplies to its customers in Western Europe during the winter with dire consequences for the region’s people and industry. The war has united the NATO nations, but it is also uniting an Axis of Evil including Russia, China, and Iran. And now we have new variants of Covid and even Monkeypox to worry about.

Notwithstanding all that, there is some good news (maybe) on a few of these fronts:

(1) Russian gas. An article posted July 22 by BBC News reported: “Russia has resumed pumping gas to Europe through its biggest pipeline after warnings it could curb or halt supplies altogether. The Nord Stream 1 pipeline restarted following a 10-day maintenance break but at a reduced level. On Wednesday, the European Commission urged countries to cut gas use by 15% over the next seven months in case Russia switched off Europe’s supply. Russia supplied Europe with 40% of its natural gas last year. Germany was the continent’s largest importer in 2020, but has reduced its dependence on Russian gas from 55% to 35%.”

(2) Ukrainian grain. An article posted July 22 by NYT reported: “After three months of talks that often seemed doomed, Russia and Ukraine signed an agreement on Friday to free more than 20 million tons of grain stuck in Ukraine’s blockaded Black Sea ports, a deal with global implications for bringing down high food prices and alleviating shortages and a mounting hunger crisis. Senior United Nations officials said that the first shipments out of Odesa and neighboring ports were only weeks away and could quickly bring five million tons of Ukrainian food to the world market each month, freeing up storage space for Ukraine’s fresh harvests.”

Nevertheless, the article warned: “It remains to be seen whether the deal works as planned. With each side deeply suspicious of the other, there will be plenty of chances for the agreement to break down.” Sure enough, on Saturday, Russian missiles hit Odesa, just one day after Ukraine and Russia agreed on the deal that would allow the resumption of vital grain exports from the region.

(3) Checks and balances. A major contributor to the jump in the inflation rate since March 2021 was the Biden administration’s American Rescue Plan. It provided a third round of Economic Impact Payments, which stimulated a demand shock in the US that overwhelmed global supply chains. Senator Joe Manchin (D-WV) voted for the stimulus package. But now the senator has been accused by many in his party of sabotaging the President’s agenda. Manchin is most concerned about the inflationary consequences of additional government spending. Without his support, the Democrats don’t have the votes they need for the additional spending programs championed by Biden. The Founding Fathers based our government on a constitutional system of checks and balances, which continues to work relatively well.

Strategy II: The Current Earnings Reporting Season. While investors have plenty left to worry about, their main concern currently is focused on the current Q2-2022 earnings reporting season and company managements’ earnings guidance for the rest of the year.

The S&P 500 fell 0.9% on Friday on disappointing earnings news from Snap. Its shares plunged by more than a third on Friday as reports of the social-media company’s weakest-ever quarterly sales growth fanned fresh concerns about a slowdown in the digital advertising industry. The S&P 500 Communication Services sector fell 4.3%, and the Information Technology sector lost 1.4% (Table 1). Nevertheless, the S&P 500 is up 8.0% from its recent bottom of 3666.77 on June 16 through Friday’s close of 3961.63 (Table 2). It is now down 17.4% from its record high on January 3.

The fear is that this rebound is an unsustainable short-covering rally in a bear market because analysts are just starting to reduce their earnings estimates for the rest of this year and next year to reflect weakening economic growth. But Joe and I still think that June 16’s low could turn out to be the low for the latest bear market, a case we made a week ago in the July 18 Morning Briefing. Our basic premise is that inflation is peaking, and so is the 10-year US Treasury bond yield, so there shouldn’t be much more downside risk in valuation multiples.

So what about earnings risk? We believe that the economy is in the midst of a mild recession (a.k.a. a mid-cycle slowdown), which suggests that downward earnings revisions should flatten forward earnings—whereas in a conventional recession, forward earnings would tank. As a result, the S&P 500 could meander in a trading range for several months, say between 3666 and 4150, before moving higher, possibly to a new record high in late 2023. Needless to say, lots could go wrong to subvert this scenario, as we reviewed a week ago. But for now consider the following:

(1) Quarterly consensus estimates for S&P 500. The Q2-2022 earnings reporting season started at the beginning of this month and will end around mid-August. So far, the S&P 500’s blended earnings, combining actual reported results and estimated ones, edged down during the July 14 week but remains relatively flat since the end of the previous earnings season (Fig. 1). However, Q3 and Q4 estimates have been cut slightly over the past four weeks, reflecting weaker guidance. The same can be said about the S&P 400’s and S&P 600’s estimates for the next two quarters. The growth rate of Q2’s S&P 500 earnings is currently expected to be 4.5%, down from the 5.2% estimate during the July 7 week (Fig. 2).

(2) Annual consensus estimates for S&P 500. Analysts’ consensus expectations for S&P 500 revenues during 2023 and 2024 remained on solid uptrends through the July 14 week (Fig. 3). So forward revenues, the time-weighted average of the two, remained near a record high that week. On the other hand, forward earnings may be starting to flatten out after rising to a record high during the June 16 week, as 2023 and 2024 earnings estimates are just starting to look toppy.

The consensus analysts’ data so far suggest that they still aren’t seeing a recession, since their revenues estimates continue to rise. Rather, they are finally seeing reasons to be concerned about profit margins. They’ve been lowering their 2022 and 2023 profit margin estimates since the start of this year and only now is that starting to weigh on the forward profit margin.

(3) Annual consensus estimates for S&P 500 sectors. Joe has put together a handy-dandy chart publication, Revenues, Earnings, & Profit Margin Squiggles. Flipping through it, we see the following ytd percent changes in the forward revenues, forward earnings, and forward profit margins, respectively, of the 11 sectors of the S&P 500 (sorted by magnitude of margins’ percent changes):

Energy (33.5%, 75.4%, 31.4%), Real Estate (5.1, 16.9,11.2), Information Technology (6.9, 7.7, 0.7), Industrials (8.2, 8.6, 0.4), Financials (5.0, 4.6, -0.4), S&P 500 (7.6, 7.7, -0.5), Materials (10.3, 8.2, -1.9), Consumer Staples (5.0, 1.9, -3.0), Health Care (4.5, 0.4, -4.0), Communication Services (4.3, 0.2, -4.0), Utilities (10.0, 4.1, -5.3), and Consumer Discretionary (4.9, -0.6, -5.2). Seven of the sectors are showing margin compression since the start of this year.

(See also Tables 2R and 2E in our Performance Derby: S&P 500 Sectors & Industries Forward Earnings & Revenues and Table 7 in our Performance Derby: S&P 500 Sectors & Industries Forward Profit Margin.)

US Economy: Less Growth, Maybe Less Inflation Too. The S&P 500 composite includes corporations that produce goods and services. The earnings of goods producers tend to fluctuate along with the business cycle, while those of the services producers do so as well but with less amplitude. That explains why the y/y growth rates of S&P 500 revenues per share and operating earnings per share are highly correlated with the M-PMI, the manufacturing purchasing managers index compiled monthly by the Institute for Supply Management (Fig. 4 and Fig. 5). Consider the following:

(1) M-PMI, revenues & earnings. The M-PMI peaked at a cyclical high of 63.7 during March 2021, falling to 53.0 during June. The revenues growth rate peaked at 21.8% during Q2-2021. It was down to 13.6% during Q1-2022, which wasn’t as weak as suggested by the M-PMI because inflation has been boosting revenues over the past year.

S&P 500 operating earnings growth peaked at 88.6% during Q2-2021, much more than suggested by the coincident peak in the M-PMI because profit margins tend to rebound more when the M-PMI is rising than when it is falling. Earnings growth fell to 11.8% y/y during Q1-2022.

(2) Flash PMIs. On Friday, S&P Global released July flash estimates for the US M-PMI and NM-PMI, which is the purchasing managers index of the nonmanufacturing sector (Fig. 6 and Fig. 7). Not surprisingly, they tend to track the ISM’s versions of these two indexes relatively closely.

July’s S&P Global M-PMI for the US edged down from 52.7 in June to 52.3 in July. The drop in the comparable NM-PMI from 52.7 in June to 47.0 in July was surprisingly weak. On balance, Debbie and I believe that these numbers are consistent with our mid-cycle slowdown outlook (with 55% odds of a mild recession and 25% odds of a growth recession, leaving 10% for a boom and 10% for a bust).

(3) Two regional business surveys. Two of the regional business surveys conducted by five of the 12 Federal Reserve district banks are out for July. The average of the NY and Philly surveys’ composite business activity indexes closely tracks the national M-PMI (Fig. 8). It suggests that July’s M-PMI is likely to fall closer to 50.0; we’ll see when it is reported at the start of next month.

Again, that would be consistent with a soft landing of the economy, rather than a hard one. Of course, the M-PMI could fall significantly below 50.0 in a hard landing, but that’s not our most likely outlook.

The same can be said about the two regional surveys’ comparable new orders indexes: July’s two-regions average suggests that the national orders index, which was 49.2 in June, might have been somewhat weaker in July (Fig. 9).

(4) LEI & CEI. The Index of Leading Economic Indicators (LEI) peaked at a record high during February and is now down four months in a row through June (Fig. 10). On average, it has peaked 12 months prior to the peaks of the past eight business cycles. That suggests that the next recession will start early next year.

Again, that’s not our forecast. But it is the forecast of the LEI. Meanwhile, the Index of Coincident Economic Indicators (CEI) rose to a new record high in June. If the LEI proves to be prescient, then the CEI, which peaks when the business cycle peaks (i.e., just before recessions) might do so during February 2023.

(5) Yield curve & credit-quality yield spreads. One of the LEI’s 10 components is the spread between the 10-year Treasury bond yield and the federal funds rate. Perversely, it was one of the four positive contributors to June’s LEI. Most investors have ignored it and focused on the recession signal emitted by the spread between the yields of the 10-year Treasury and 2-year Treasury; that spread has diverged from the official LEI interest-rate spread by falling since the start of the year and turning slightly negative last week (Fig. 11).

We are also keeping a close watch on the yield spread between the high-yield corporate bond composite and the 10-year Treasury bond (Fig. 12). The spread has widened from 283bps at the start of this year to 506bps on Friday. So far, it is signaling that credit conditions have tightened, but not to the extent of previous credit crunches that triggered severe recessions.

(6) Less inflation, maybe. The good news in July’s two regional business surveys is that supply-chain disruptions are abating, as evidenced in recent months by the drops in the NY delivery-time index and the Philly unfilled-orders index (Fig. 13). This undoubtedly also reflects some slowing in demand for goods. The result is that the prices-paid and prices-received indexes in both regions have turned down over the past couple of months from their elevated readings of the past year (Fig. 14).

(7) Bottom line. Debbie and I have found that inflation-adjusted S&P 500 forward earnings is a good coincident indicator of the US economy (Fig. 15 and Fig. 16). It rose to a record high during June, though at a slower pace since the start of this year than during its V-shaped recovery from the pandemic lockdown recession. Its growth rate has slowed to 9.6% y/y through June from a recent peak of 35.2% during May 2021.

In the mid-cycle slowdowns of the mid-1980s, mid-1990s, and mid-2010s, the growth rates of both nominal and real forward earnings dropped to zero, but not much below that before moving higher again.

In our current mid-cycle slowdown outlook, we expect that S&P 500 forward earnings will also flatten out for several months and that the forward P/E bottomed on June 16. In this scenario, the S&P 500 would have bottomed on June 16 at 3666 and remain range bound above that level for a few months, say between 3666 and 4150, until better economic growth boosts forward earnings again.

(8) Feshbach on the market. Finally, I checked in with my friend Joe Feshbach on his latest market call. In his opinion, “The sentiment indicators got to extreme bearish levels and indicate little major downside risk. Even if there is another retest of the low, it should be successful. As I said previously, if I was running a $5 billion fund I’d be increasing exposure to stocks on weakness. The put/call ratio got sloppy on this initial rally phase but started to improve again during the second half of last week. The US dollar is showing signs of topping, which would also be a plus for the stock market.”

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Financials, China & Russian Gas

July 21 (Thursday)

Financials: An Eye on Deposits. Going into the Q2 earnings season, it was fairly clear that banks with large capital markets businesses would face tough y/y comparisons. With the S&P 500 down 20.6% in the first half of 2022, the IPO market slowed to a crawl and even bond underwriting was down sharply y/y. Traditional banking businesses fared better, however, with demand for consumer and commercial loans growing briskly and credit quality remaining strong.

Banks’ next challenge may be navigating the jump in interest rates. So far, consumer deposits largely have stayed put, even though the interest rates offered on bank deposits remain close to zero while the yield on the three-month Treasury bill has risen to 2.51%. Let’s take a look at how higher interest rates are affecting banks’ assets and liabilities:

(1) Deposits rose during Covid. When Covid struck in 2020, the federal government supported US citizens with a flood of free money. Some of that money was spent, but some of it wound up in bank accounts. More deposits came from people who continued to work but were unable to go out and spend because they feared catching the virus. So in 2020, total deposits at banks surged by $2.9 trillion y/y (21.8%), followed by a $1.8 trillion y/y increase in 2021 (11.4%) (Fig. 1).

This year, with Covid-related government financial support ended and consumers able to spend money more freely in a reopened world, the rate of deposit growth has slowed sharply. Only $166 billion of deposits has found its way into banks’ coffers in the first half of this year, and total deposits appears to have plateaued around $18.0 trillion (Fig. 2).

(2) Higher-yielding alternatives now. During the Covid crisis, there were few good alternatives to low-yielding bank deposits because the Federal Reserve lowered interest rates sharply and rapidly when the economy was closed. The federal funds rate was cut to a low of 0.00%-0.25% on March 15, 2020 and stayed there until March 16, 2022 (Fig. 3). Interest rates on Treasuries and other bonds fell in tandem.

But faced with rising inflation, the Fed started raising interest rates this year. The federal funds rate stands now in a range of 1.50%-1.75%, and 12-month federal funds futures have jumped to 3.44% in anticipation of additional interest-rate hikes to come. Treasury bond yields have risen as well. The six-month Treasury bill now yields 3.04%, and the three-year Treasury note yields 2.51% (Fig. 4).

While Treasury yields have risen, the interest being offered on many bank deposits has barely budged. Bank of America (BofA) paid 0.02% on deposits in Q2, unchanged from a year ago, and JPMorgan’s interest bearing deposits sport a 0.2% interest rate. This raises the following question: When will depositors start shifting out of deposits that pay next to nothing into higher-yielding alternatives? And: How high will banks need to raise rates to retain deposits?

(3) Loans on the rise. In 2020 and 2021, banks took funds from surging deposits and invested in Treasuries because there was tepid consumer and commercial loan demand. US Treasury and agency securities held by banks rose from $3.0 trillion at the start of 2020 to a peak of $4.7 trillion at the end of this February (Fig. 5). Since late May 2021, the yearly change in bank purchases of Treasury and agency securities has slowed sharply, from a peak of $982 billion to $401 billion in early July (Fig. 6).

Instead of buying Treasuries and agencies, banks are making more commercial and consumer loans. Commercial & industrial (C&I) loans spiked at the start of the pandemic as companies quickly borrowed funds as a precautionary measure. C&I loans then fell sharply for most of 2021, only to rise again this year. In an indication that the economy may be stronger than expected, C&I loans have risen $207 billion ytd to $2.7 trillion (Fig. 7 and Fig. 8).

Likewise, consumer borrowing has been strong. Consumer credit outstanding was $4.6 trillion as of May, up 7.3% y/y (Fig. 9). Car loans have risen sharply, as have student loans (Fig. 10). After bottoming in January 2021, consumer revolving credit has jumped 14.4% to $1.1 trillion (Fig. 11). And home mortgage debt has increased gradually but consistently throughout the pandemic and this year (Fig. 12).

(4) Improving NIM. As interest rates on loans and Treasuries have increased and interest rates on deposit rates have remained low, banks’ net interest margin (NIM) has improved from historically low levels. The average NIM fell to a low of 2.50% in Q2-2021, and it rose to 2.54% in Q1. A more “normal” NIM is north of 3.0% (Fig. 13).

If NIM continues to improve, the upside opportunity is substantial. At BofA, the net interest yield on loans rose to 1.86% during Q2, up from 1.69% in Q1 and 1.61% in Q2-2021, according to the bank’s earnings press release. As a result, the bank’s net interest income jumped by 22% y/y in Q2, or $2.2 billion, to $12.4 billion due to higher interest rates, lower premium amortization, and loan growth.

The bank calculated that a 100bps parallel shift in the interest-rate yield curve would boost net interest income by $5.0 billion over the next 12 months. The key word in that sentence is “parallel.” It looks like banks may have to raise interest rates on their deposits if consumers ever wake up from their slumber. At BofA, total deposits at the end of Q2 were $1.98 trillion, down from $2.07 trillion in Q1 but up y/y from $1.91 trillion in Q2-2021. The bank attributed the q/q decline to customers paying their taxes, a normal seasonal event.

As the Fed continues to raise interest rates, we’ll be watching to see how banks react and their depositors respond.

China: Ramifications of Siding with Russia. When the Ukraine war broke out, we thought China was more likely to stay neutral or side with its largest trading partners: the European Union (14.9% of Chinese exports) and the US (16.3%) (Fig. 14). While Russia is another authoritarian nation, it purchases only 1.5% of China’s exports. However, China has used the Ukraine war as an opportunity to buy Russian oil on the cheap and encourage the construction of new gas pipelines between the two countries.

China may not have counted on the Ukraine war’s impact on emerging markets. The war sent the prices of food and oil surging, and the Fed’s tightening response to subdue the inflation boosted the dollar’s value. The stronger dollar and higher food and oil prices have hurt overleveraged emerging market nations. Some of those nations have begun restructuring their debt, which is bad news for China and its banking institutions—collectively the world’s largest creditor.

Here’s a look at one of the Ukraine war’s unintended consequences and an update on Covid cases in China:

(1) Debt & dollar headaches. Since the Ukraine war intensified on February 24, the Fed has raised interest rates, and the US trade-weighted dollar has gained 7.4% (Fig. 15). Unfortunately, what benefits the dollar doesn’t benefit emerging market countries that have struggled with rising food and oil prices and owe dollar-denominated debt.

Bonds in more than a dozen countries are trading at distressed levels, the weakest of which will likely default. China, as the biggest bilateral creditor in the world, will get dragged into these restructurings. “Poorest countries face $35 billion in debt-service payments to official and private sector creditors in 2022, with over 40% of the total due to China,” according to the World Bank,” a July 4 Reuters article stated. Due to its Belt and Road Initiative, China is owed $1.5 trillion in debt and trade credits by more than 150 countries, a February 26, 2020 Harvard Business Review (HBR) article estimated.

And the debt is growing quickly. The HBR article states: “For the 50 main developing country recipients, we estimate that the average stock of debt owed to China has increased from less than 1% of debtor country GDP in 2005 to more than 15% in 2017. A dozen of these countries owe debt of at least 20% of their nominal GDP to China (Djibouti, Tonga, Maldives, the Republic of the Congo, Kyrgyzstan, Cambodia, Niger, Laos, Zambia, Samoa, Vanuatu, and Mongolia).”

Chinese lending, which is done mostly by state-controlled agencies and policy banks, was described as “opaque” by Reuters. Countries may be required to keep the loans confidential and give them seniority, which means that other lenders may be providing loans based on inaccurate information. HBR notes that the Chinese loans are typically made at market rates, unlike the subsidized lending and grants provided by other large nations.

(2) China learns to restructure. China is new to the world of restructuring sovereign debt, but it’s going to have to learn the ropes on the fly. Zambia’s debt restructuring is one of the first involving China, and it’s taking longer than expected. It has been two years since Zambia defaulted on $17 billion of external debt, about a third of which is owed to China, a May 31 Reuters article reported. China’s central bank reportedly was willing to move ahead with the restructuring, but the country’s finance ministry was concerned that if it accepted losses on its loans the restructuring would set “a costly precedent” for China’s other debtors.

A June 28 FT article noted that Chinese lenders often are willing to extend maturities or grant payment holidays to debtors, but they don’t like to reduce the amount of debt owed for fear of a “political backlash in Beijing”—which “puts them at odds with commercial creditors such as bondholders.”

Sri Lanka defaulted earlier this year on $12 billion of overseas debt, of which China is owed $6.5 billion. Various Chinese lenders invested in the country’s highways, a port, airport, and coal power plant, an April 28 Reuters article reported. Some critics are blaming the country’s current crisis on the excessive debt that China made available. Treasury Secretary Janet Yellen has said she will push China to restructure loans to countries facing unsustainable debt burdens, a July 14 WSJ article reported.

(3) Covid cases escalating. On another note, China’s Covid-19 cases surged past 1,000 on Wednesday for the first time since May 20, rising from 776 cases a day earlier, a July 20 Reuters article reported. With China’s zero-Covid policy remaining in force, lockdowns are increasing. “About 264 million people in 41 cities are currently under full or partial lockdowns or living under other measures, analysts at Nomura, the Japanese bank, wrote in a note on Monday. Last week, the figure was about 247 million in 31 cities,” a July 19 NYT article reported.

One dramatic situation involved 2,000 tourists visiting Weizhou Island who were caught up in a surprise lockdown after 700 cases were discovered over the past week. There are multiple areas where mass testing is being required, including Shanghai.

Disruptive Technologies: Replacing Russian Gas. Russia’s game of cat and mouse continues, with the European Union’s energy security and Ukraine’s independence at stake. Russian President Vladimir Putin indicated yesterday that Russia would send natural gas through the Nord Stream pipeline to Europe, but he was cagey about the amount. Gazprom, the pipeline’s Russian-controlled majority shareholder, will “fulfill all of its obligations,” said Putin, but natural gas flows may be only 20% of the pipeline’s capacity next week if a turbine being repaired in Canada isn’t returned to Russia soon. The turbine is reportedly in transit back to the pipeline operator. Another turbine requires maintenance on July 26.

Also yesterday, Russia’s foreign minister announced that Moscow’s goals for the Ukraine invasion have moved beyond liberating the eastern Donbas border region. Moscow now also aims to control the provinces of Kherson and Zaporizhzhia in southern Ukraine and a number of other territories. He warned that Russia would go further if the West continues to supply Ukraine with advanced weapons, a July 20 FT article reported.

This is occurring as Europe swelters during a major heatwave that is causing fires across the continent. Yesterday, the EU called upon member nations to cut natural gas use by 15% from August 1 through March 2023 in anticipation of supply disruptions this winter. That’s the equivalent of about 45 billion cubic meters of natural gas. Europe has looked overseas for additional sources of natural gas, and it has plans to increase its reliance on coal- and nuclear-fired power plants.

Meanwhile, entrepreneurs are working on new ways to approach this old problem. Here are some ideas being explored for generating and storing energy:

(1) Solar on balconies. Serial entrepreneurs Karolina Attspodina and Qian Qin have developed a way to put the charming balconies on European buildings to good use. Their company, WeDoSolar, has developed vertical solar panels that weigh 1kg each and plug into a standard power socket. “The WeDoSolar Microinverter then pushes the power into the home grid, allowing the panels to power home appliances ahead of using the normal grid,” a July 18 article in TechCrunch reported. The company claims they will reduce electricity bills by up to 25% per year. An eight-panel set costs €1,299 or it can be rented by electric vehicle owners in exchange for CO2 certificates.

(2) Solar from Africa. Russian natural gas imports could theoretically be replaced by large solar farms in the Sahara desert, a March 22 article by the Institute for Security Studies suggested. Solar farms can be assembled more quickly than liquified natural gas terminals, and they are more environmentally sustainable. Undersea cables would need to be laid to transmit the electricity from Northern Africa to Southern Europe.

Already, Tunisia and Algeria are planning underwater links to Italy and Spain, and Greece and Egypt are in discussions to lay a cable between the two countries. Such a large solar farm would generate so much heat that local temperatures could rise by 1.5 degrees Celsius, the article states. The impact might be minimized by spacing out the solar panels and improving their efficiency. Electricity from such a large project might also be used to desalinize water in North Africa or power green hydrogen projects.

Africa also has hydroelectric power and oil and natural gas resources that Europe may want to consider tapping.

(3) Energy storage in oil wells. The intermittency of solar and wind energy remains a hurdle that has entrepreneurs looking for new ways to store excess energy. Hyperlight Energy plans to solve the problem by storing excess solar energy in existing oil wells. The goal is to “store solar-produced heat in rock formations below the (earth’s) surface, creating a solar-generated geothermal resource in which heat is stored for meaningful durations,” Daniel Codd, a researcher at the University of California, San Diego said in a March 14 IEEE Spectrum article. The stored energy can be used as heat energy or harnessed to produce electricity.

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The Dollar & Earnings

July 20 (Wednesday)

The Dollar I: Above All Else. Since I began my career on Wall Street in 1978, the only time the dollar was discussed much at FOMC meetings was during 2015 and early 2016. The 26% appreciation of the trade-weighted dollar from mid-2014 through early 2017 certainly raised some concerns about its negative impact on exports at a time when the Fed was worrying about the slow pace of economic activity (Fig 1). In addition, the strong dollar weighed on import prices and inflation at a time when the Fed was hoping that its policies would boost inflation toward its 2.0% target.

The Fed began to normalize monetary policy in late 2014 when it terminated QE3 at the end of October and hiked the federal funds rate by 25 basis points during December 2015 (Fig. 2). Meanwhile, the other major central banks continued to pursue their ultra-easy monetary policies. As a result, the dollar soared just as the Fed was achieving its dual mandate, with the unemployment rate down to around 5.0% and core inflation approaching 2.0%. Fed officials mentioned their concerns about the adverse impact of a strong dollar on their dual-mandate mission but expected the impact to be transitory, passing once the dollar had peaked.

On September 12, 2016, Fed Governor Lael Brainard presented a speech titled “The ‘New Normal’ and What It Means for Monetary Policy,” calling for “prudence in the removal of policy accommodation.” She listed several reasons for this, including a very specific estimate of the impact of the strong dollar on the economy. She said, “In particular, estimates from the FRB/US model suggest that the nearly 20 percent appreciation of the dollar from June 2014 to January of this year could be having an effect on US economic activity roughly equivalent to a 200-basis-point increase in the federal funds rate.”

I had been making the same point since late 2015. It was good to see in 2016 a top Fed official acknowledge that the foreign-exchange value of the dollar matters. There was much angst when the dollar continued to move higher through early 2017.

So what about now? Consider the following:

(1) Fed is ahead of the pack. The trade-weighted dollar is up 8% y/y through yesterday. Is that equivalent to a 100bps hike in the federal funds rate? The foreign-exchange value of the dollar was mentioned just once and only in passing during the June 14-15 FOMC meeting, according to the minutes. Melissa and I don’t recall Brainard or any other Fed official raising this issue recently.

A big reason for the dollar’s recent strength is that the Fed has turned more hawkish than the European Central Bank (ECB) since the start of this year. So the euro has plunged 13% y/y through yesterday (Fig. 3). The Fed has already raised the federal funds rate from a range of 0.00%-0.25% to 1.50%-1.75% and is expected to add 75bps to that at the end of this month. The ECB previously flagged that it would just start raising rates by 25bps at its policy meeting this morning to contain record-high inflation. Yesterday, the financial press reported that the ECB might go for a 50bps hike. That would increase the ECB’s deposit facility rate from -0.50% all the way up to 0.00% (Fig. 4).

Meanwhile, the Bank of Japan remains committed to its ultra-easy monetary policy, including pegging the government’s 10-year bond yield at zero. As a result, the yen is down 20% y/y through Monday (Fig. 5).

(2) Quantitative tightening. Fed officials’ muteness on the strong dollar’s economic impact is matched by their silence on another economically important development: They also haven’t quantified the impact of the termination of QE4ever and the start of the latest round of quantitative tightening (QT2). The first round, QT1, started on October 1, 2017 and ended on July 31, 2019 (Fig. 6). The Fed’s balance sheet was pared by $675 billion. That undoubtedly contributed to the economic slowdown that occurred during 2018 and 2019. The Fed terminated QT1 well ahead of normalizing its balance sheet as a result of illiquidity problems in the repo market in late 2019 and the pandemic in early 2020.

No one knows how long QT2 will last. It will take a very long time to reduce the Fed’s mortgage-backed securities portfolio from $2.7 trillion during May back down to zero, which is the intention suggested by some Fed officials. The same can be said about reducing the Fed’s holdings of Treasuries from $5.8 trillion during May to $2.4 trillion, which is where Treasury holdings stood during January 2020 just before the pandemic (Fig. 7, Fig. 8, and Fig. 9).

If the Fed succeeds in reducing its balance sheet by $2.8 trillion to $5.7 trillion by the end of 2024 under QT2, would the tightening impact be comparable to raising the federal funds rate by 100bps, 200bps, 300bps, or more? Fed officials undoubtedly have run their econometric model to come up with some estimates. But they haven’t shared the results with the public.

(3) Double whammy. The 10% appreciation of the dollar and QT2 undoubtedly will lower the federal-funds-rate endpoint of this tightening cycle. But what will that point be? It’s conceivable that two more rate hikes of 75bps each at the next two meetings of the FOMC will be enough given the additional tightening of credit conditions attributable to the strong dollar and to QT2!

The Dollar II: TINAC & TICS. As we observed yesterday, the geopolitical mess around the world continues to favor the US dollar, suggesting increasing net capital inflows from overseas into the US financial markets. That helps to explain the recent peaking of the bond yield, which should provide some support to the valuation multiples of stocks.

There is no end in sight for the Ukraine war. Europeans are preparing for a possible permanent shutoff of Russian gas. China continues to struggle with Covid and a bursting housing bubble. Emerging markets are facing soaring prices for energy and food and shortages of both, which are triggering political instability. So lots of global investors may be concluding that they must overweight US securities in their portfolios since there is no alternative country (TINAC).

Data compiled by the Treasury International Capital System (TICS) show that the US is experiencing massive net capital inflows, which have been boosting the dollar in the face of record current-account deficits. The monthly data show that total net capital inflows added up to $1.3 trillion during the 12 months through May, near the record high of $1.4 trillion during February (Fig. 10). Over this same period, the total private net capital inflows rose to $1.6 trillion, while the total official net capital inflows was -$226 billion (Fig. 11).

Here are the major components of the 12-month private net capital inflows through May: total ($1.6 trillion), all bonds ($797 billion), Treasury bonds ($583 billion), government agency bonds ($104 billion), corporate bonds ($110 billion), equities (-162 billion), Treasury bills ($73 billion), and other negotiable instruments ($336 billion) (Fig. 12).

The Dollar III: Stay Home vs Go Global. So while foreigners have bought lots of dollars over the past year, they invested them in US fixed-income securities and were net sellers of US equities. They were probably turned off by the relatively high forward P/E of the US MSCI stock price index compared to the All Country World (ACW) ex US forward P/E (Fig. 13). The ratio of the two shows that the former has been selling at a 40%-50% premium to the latter (Fig. 14). The current premium is 45%.

The forward P/Es of the major MSCI indexes around the world are much lower currently than those of the comparable US index (Fig. 15). Here were their latest readings during the week of July 7: US (16.5), Japan (12.3), EMU (10.8), Emerging Markets (10.9), and UK (9.5).

This year, through July 18, the US MSCI is down 20.7%, while the ACW ex US is down 12.8%. On the other hand, the ACW ex US is down 20.3% in dollar terms. The upward trends in the ratios of the US MSCI to the ACW ex US MSCI since 2009 in dollars and in local currencies remain intact (Fig. 16). We continue to recommend overweighting a Stay Home rather than Go Global investment strategy since the US still looks like a safe haven given the new world disorder.

The Dollar IV: Weighing on Earnings. Many US companies do lots of business overseas. By investing in these companies, US investors indirectly accrue plenty of exposure to the global economy. Many of these corporations not only export goods and services made in America but also generate profits from their overseas subsidiaries. Accordingly, the foreign-exchange value of the dollar greatly affects the profits of many US companies. Currency impacts are often discussed during quarterly earnings calls held by corporate managements with investors and industry analysts. Available data can provide some perspective:

(1) Revenues from abroad. On average, the S&P 500 companies derive roughly half of their revenues and profits from abroad. In 2016, the actual percentage of S&P 500 companies’ sales from foreign countries was 43% of their total sales, down from 44% in 2015 and 48% in 2014. Importantly, however, S&P 500 foreign sales represent only goods and services produced and sold outside of the United States; they don’t include US-made products that are exported and sold abroad.

(2) Earnings from abroad. Standard & Poor’s provides no comparable figures for the percentage of profits earned overseas by the S&P 500 companies. However, it’s likely to be close to the percentage of revenues from abroad. The National Income and Product Accounts of the United States does have a data series on pretax corporate profits receipts from the rest of the world. It has risen from $3 billion at the start of 1959, accounting for 5.7% of total pretax profits, to $988 billion during Q1-2022, accounting for 34.3% of profits (Fig. 17 and Fig. 18).

If all else were equal, one could expect a straightforward, consistent impact of currency-exchange effects on corporate profits: 10% appreciation (or depreciation) of the dollar should decrease (or increase) S&P 500 profits by 4%, assuming that roughly 40% of the index companies’ earnings come from abroad. But the fact that Standard & Poor’s excludes export revenues in its calculation of revenues from abroad—lumping export sales together with domestic sales—means that all else isn’t equal; there’s more to the story, because export revenues are affected by currency impacts as well. In other words, there is no simple rule of thumb for estimating the impact of a currency’s move on either overall profits or an individual company’s earnings.

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More On Inflation

July 19 (Tuesday)

Inflation I: Wages. Debbie and I have some good news and some bad news on the inflation front. Wage inflation appears to be moderating according to the average hourly earnings (AHE) measure of wages but is still moving higher based on the Atlanta Fed’s wage growth tracker (WGT). Consider the following:

(1) AHE. The AHE is available for all workers since March 2006 and for production and nonsupervisory (PNS) workers since January 1964. This measure reflects not only changes in basic hourly and incentive wage rates but also such variable factors as premium pay for overtime and late-shift work and changes in the output of workers paid on an incentive plan. It also reflects shifts in the number of employees between relatively high-paid and low-paid work and changes in workers’ earnings in individual establishments.

The AHE inflation rate for all workers moderated from a recent peak of 5.6% y/y during March to 5.1% during June (Fig. 1). For PNS workers, who account for 81.5% of payroll employment, it moderated from 6.8% to 6.4% (Fig. 2). Both series have been very volatile since the pandemic. During the lockdowns, more of the lower-wage PNS workers lost their jobs than higher-wage workers, who could work from home. That misleadingly boosted the AHE measure of wage inflation. Then the AHE misleadingly went the other way when the lockdown ended, allowing more of the lower-wage workers to find jobs again.

By now, the AHE measure should be a more accurate measure of underlying wage inflation. If so, then it is showing that wage inflation may be moderating. During June, when the AHE rose 5.1% y/y, it rose 4.2% on a three-month percentage-change basis, suggesting that inflationary pressures are subsiding (Fig. 3). Interestingly, lower-wage workers have been getting bigger wage increases than higher-wage workers, with the former up 6.4% y/y (and 5.8% over the past three months) through June and the latter up 2.5% (but just 0.6% over the past three months) (Fig. 4).

(2) WGT. The WGT series tracks the median wage growth rate, not the median wage. It calculates the wage growth of surveyed people who were working over the course of a year and constructs a distribution of growth rates, which is used to calculate three-month moving-average medians. As a result, the WGT has been less volatile than the AHE measure of wage inflation (Fig. 5).

According to the WGT, wage inflation hasn’t yet slowed down; it rose to 6.7% during June from 6.2% during May. There are also no signs of moderating wage pressures in the WGT’s various components. For example, during June, the WGT for job switchers and job stayers jumped to 7.9% and 6.1%, respectively (Fig. 6). That 1.8ppt differential certainly explains why so many workers have been quitting their jobs for better paying ones (Fig. 7).

According to the WGT, on a 12-month moving average basis through June, wages are up 5.4%. For younger workers, they’re soaring, with gains of 12.5% for 16- to 24-year-olds versus 5.6% for 25- to 54-year-olds and 3.7% for workers 55 and older (Fig. 8). By industry, the 12-month gains are: leisure & hospitality (6.4%), trade & transportation (5.9), manufacturing (5.8), finance & business services (5.5), construction & mining (4.9), education & health (4.9), and public administration (4.6).

(3) Real wages. In a perfect world, wages would be rising at a moderate pace that exceeds price inflation by the growth rate in productivity. During a wage-price spiral, productivity growth suffers as wages and prices spiral higher. So real wages tend to stagnate. That’s what is happening currently: On an inflation-adjusted basis, AHE for all private workers is down -1.0% y/y through May, while AHE for PNS workers is up just 0.1% (Fig. 9 and Fig. 10).

Inflation II: Rents. As we’ve previously discussed, the wage-price spiral is really a wage-price-rent spiral. While there are a few glimmers of moderating wage inflation in the AHE measure, there’s no sign of relief from the uptrend in rent inflation that started during March 2021. Consider the following:

(1) Home prices & rents. The Fed’s ultra-easy monetary policies in response to the pandemic caused home prices to soar, and now rents are soaring. Over the 24 months through May, the median single-family existing home price is up an astonishing 44.5% (Fig. 11).

This year's jump in mortgage rates only exacerbated the affordability problem facing would-be first-time homebuyers, leaving many of them with no choice but to rent. That’s reflected by the jump in the Zillow Observed Rent Index, which was tracking around 3% y/y before the pandemic; it fell close to 0% in late 2020 and early 2021 before shooting up to peak at 17.2% during February 2022 (Fig. 12). It declined slightly to 14.8% in June.

(2) Rent measures. The CPI includes rent of primary residence and owners’ equivalent rent of primary residence (OER). The former measures tenant rents, while the OER measure imputes the rent that homeowners would have to pay to themselves if they were their own landlords. This strange concept makes sense since owner-occupied housing provides a service that is consumed every day, i.e., shelter. On the other hand, when rents go up, tenants have to pay more for rent, while nothing really changes for homeowners—unless higher rents are the result of higher home prices; in that case, they benefit.

Tenant rent in the CPI is based on a sample of all existing leases, not based on new leases. New lease rents will show up in the CPI over the coming 12-24 months depending on the renewal terms of those leases. The Bureau of Labor Statistics uses statistical techniques to infer OER using rental prices for similar units in the area. As a result, the OER inflation rate tends to closely follow the tenant rent inflation rate (Fig. 13).

(3) Rent inflation. Tenant rent inflation in the CPI rose from a 2021 low of 1.8% y/y during March through May to 5.8% during June of this year, the highest since July 1986. The OER measure rose to 5.5% during June, the highest since September 1990.

Economist Larry Summers coauthored a February 2022 study titled “The Coming Rise In Residential Inflation.” It concluded that these rent inflation measures are likely to move close to 7% during 2022, and to remain high during 2023. The authors base that prediction on private-sector data on home prices and rents on new leases. They observe, “Historically, the year-over-year growth in home prices and market rents have been powerful leading indicators for OER inflation and [tenant] rent inflation [in the CPI].”

(4) CPI vs PCED rents. The PCED and CPI inflation rates for tenant and OER rent are nearly identical (Fig. 14 and Fig. 15). However, they have higher weights in the CPI than in the PCED.

Rent of primary residence (a.k.a. tenant rent) and OER account for 7% and 24% of the headline CPI, 9% and 31% of the core CPI, and 12% and 40% of CPI services. So both together account for 31% of the headline CPI, 40% of the core CPI, and 52% of CPI services.

Rent of primary residence and OER account for 4% and 11% of the headline PCED, 5% and 13% of the core PCED, and 6% and 17% of PCED services. So both together account for 15% of the headline PCED, 18% of the core PCED, and 23% of PCED services.

As a result of the different weights, the Summers study concludes that “housing will make a significant contribution to overall inflation in 2022, ranging from one percentage point for headline PCED to 2.6 percentage points for core CPI.”

That all makes sense to us. Nevertheless, we expect to see inflation rates moderating for both nondurable and durable goods during H2. So we are sticking with our forecast that the headline PCED inflation rate will ease from 6%-7% during H1-2022 to 4%-5% during H2-2022 and get down to 3%-4% next year. Our inflation rate projections would be lower but for the upward pressure from the rent components of the consumer price measures.

(5) Rents & wages. The risk for any optimistic outlook on inflation is that the wage-price-rent spiral continues to spiral. The CPI tenant rent component, on a y/y basis, closely tracks the WGT (Fig. 16). If inflation doesn’t cool off during the second half of this year, Fed Chair Jerome Powell may have no choice but to “go Volcker” and push interest rates up to whatever level it takes to cause a recession, as former Fed Chair Paul Volcker did during the 1970s. History shows that recessions do break the back of inflation.

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Bear Market Rally Or A New Bull Market?

July 18 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

Strategy I: Calling Bottoms. Early in my career, when I was at Prudential-Bache Securities, I worked as the firm’s chief economist alongside its chief investment strategist, Greg Smith. On Monday, August 16, 1982, we called the bottom in the stock market, which actually had bottomed four days earlier on Thursday, August 12, it was later determined. On August 17, Solomon Brothers’ renowned chief economist, Henry Kaufman, also turned bullish. My weekly commentary that week was titled “Fed-Led Recovery Now Seems Likely.” (Greg was a great professional mentor and personal friend. Sadly, he passed away earlier this year.)

Five years later, the stock market crash on Black Monday, October 19, 1987 stress-tested the conviction of bulls like Greg and myself. Nevertheless, we spent much of that day reassuring our sales force that this was unlikely to be the beginning of a long-lasting bear market. The bear market ended on December 4 of that year. Fed Chair Alan Greenspan came to the rescue with what came to be known as the “Fed Put.”

In the late 1990s, I was bearish on technology stocks because they seemed overvalued. I was particularly concerned when Greenspan, in his January 28, 1999 congressional testimony, compared investing in tech stocks to playing the lottery. In addition, I expected a recession triggered by the Y2K problem. There was a tech-led bear market from March 24, 2000 to October 9, 2002. There was also a recession at the time that resulted from too much Y2K-related spending on technology; the spending fixed the Y2K problem but also triggered a downturn when tech spending suddenly dropped off at the start of the new millennium.

I didn’t call the stock market bottom that occurred in late 2002, but I did turn increasingly bullish on commodities and on China. I didn’t anticipate the magnitude of the Great Financial Crisis because I didn’t expect that the US government would let Lehman fail. However, I did cut my rating on the S&P 500 Financials from overweight to underweight on June 25, 2007. Lehman was allowed to fail on September 15, 2008, and the Financials led the bear market lower through early March 2009.

On March 16, 2009, I wrote that the devilish intraday low of 666 on the S&P 500 on March 6 might have marked the end of the bear market, which did end on March 9. As a symbolist, I relied on the Da Vinci Code for that insight. As a fundamentalist, I observed that on March 16, the Fed’s first round of quantitative easing was expanded to $1.25 trillion in mortgage-related securities and $300 billion in Treasury bonds. The Fed Put was back, bigger than ever.

At the end of 2019, I anticipated a 10%-20% stock market correction in early 2020. I didn’t expect a pandemic and the resulting lockdowns. But when these events rapidly unfolded in February and March, I argued that it was too late to panic. I expected that the Fed would come to the rescue by slashing interest rates and suggested that the Fed might even purchase corporate bonds. When the Fed announced QE4Ever on March 23, I declared that this gigantic Fed Put made the bottom.

It’s time once again to look for a bottom in the latest bear market. Until recently, I was in the correction camp. My June 14 QuickTakes was titled “It’s Officially a Bear Market.” I conceded the obvious, i.e., that the S&P 500 had entered bear market territory when it was down 21.8% on Monday, June 11 from its record high on January 3.

So where are we now? The bear market low so far was made on June 16, down 23.6% from the January 3 peak. That low was 3666. Is that a freaky Da Vinci Code coincidence or what? The answer will be “yes, it is” if 3666 turns out to be the bear market low. The S&P 500 is up 5.4% since June 16 (Fig. 1 and Fig. 2). That gain could certainly reflect just a short-covering rally in a bear market rather than the beginning of a new bull market. The following two sections examine the alternative scenarios promoted first by the bulls (including us), then by the bears.

Strategy II: It’s A New Bull Market. The central assumption of the bulls is that while the bear market did an excellent job of anticipating the bad news that unfolded during the first half of this year, the stock market now will focus on the likely economic outlook for the remainder of this year—which still may be challenging but no more so than that of the first half of this year, while the outlook for 2023 is likely to be brighter.

So there shouldn’t be much more downside in the S&P 500’s forward P/E, which bottomed at 15.3 on June 16, and was back up to 16.1 on Friday (Fig. 3). The S&P 400 and S&P 600 are especially undervalued relative to the S&P 500 with forward P/Es of 11.6 and 11.4 on Friday. Of course, the bulls also assume that any recession will be a mild one, so there shouldn’t be a lot of downside in the stock market stemming from downward earnings revisions. Consider the following:

(1) Inflation is peaking. The bullish case makes sense only if inflation moderates significantly during H2-2022 as the economy slows modestly—i.e., not enough to fall into a severe recession that forces analysts to slash their earnings estimates. June’s CPI and PPI provided only a few glimmers of hope for inflation optimists like ourselves. The CPI durable goods inflation rate peaked at 18.7% y/y during February, falling to 8.4% during June (Fig. 4).

While the headline PPI for finished goods soared to 18.6% y/y during June, its core rate (excluding food and energy) was unchanged at 8.8%. More encouraging are the sharp declines from January through June in the core rates of the PPI for intermediate goods (from 23.3% to 13.5%) and the PPI for crude goods (from 23.1% to 7.1%) (Fig. 5). Another encouraging sign on the inflation front is that the S&P GSCI Commodity Price Index has dropped 20% since it peaked on June 8 through Friday of last week (Fig. 6).

So far, we have one of the five business surveys conducted by the Federal Reserve’s district banks for July. The New York delivery index has dropped sharply since the start of this year (from 23.1 to 8.7), suggesting that supply-chain disruptions are abating quickly (Fig. 7). Over the same period, the prices received index fell (from 44.6 to 31.3), and so did the prices paid index (from 80.2 to 64.3).

(2) Fed tightening will be over soon. The FOMC is on course to raise the federal funds rate by 75bps at the July 26-27 meeting of the committee and is likely to do so again at the September 20-21 meeting. That would bring the federal funds rate range up to 3.00%-3.25%, a level that probably has been discounted by the financial markets. That should be enough to weaken demand (which is already slowing), contributing to the moderation in inflation expected by equity bulls.

Previously, in our June 28 Morning Briefing, Melissa and I argued that the Fed’s quantitative tightening (QT) may be equivalent to at least a 50bps-100bps increase in the federal funds rate. We concluded, “In other words, while QT has been widely feared by investors as additional monetary tightening, it might very well lower the peak federal funds rate during the current monetary tightening cycle!” We also observed, “The S&P 500 was quite volatile during the previous QT period, which included a taper tantrum during the last three months of 2018. But it managed to rise 18.3% nonetheless over the QT period” (Fig. 8 and Fig. 9).

(3) Mid-cycle slowdown underway. In our July 5 Morning Briefing, Debbie and I raised our odds of a mild recession from 45% to 55% with real GDP already down about 1.5% (saar) during H1-2022 and another 2.0% decline likely during H2-2022, followed by a solid recovery in 2023. Last week, we distributed the remaining odds with 35% to a growth recession (i.e., no growth in real GDP), 10% to a boom, and 10% to a bust. So our economic outlook with an 80% subjective probability is comparable to the mid-cycle slowdowns that occurred in the mid-1980s, the mid-1990s, and the mid-2010s, when the y/y growth rate in S&P 500 forward earnings fell to zero for a short spell without a recession, but also without a bear market (Fig. 10 and Fig. 11).

This scenario for the economy was supported on Friday with the release of June’s retail sales and industrial production reports. As we noted in the July 15 QuickTakes, inflation-adjusted retail sales fell 0.3% m/m during June following a 1.1% decline in May (Fig. 12). Manufacturing output fell 0.5% m/m during May and again in June (Fig. 13). Both series are reflected in the Index of Coincident Economic Indicators.

The S&P 500, which is one of the 10 components of the Index of Leading Economic Indicators, rallied 1.9% on Friday’s news. It was down just 0.9% last week despite higher-than-expected CPI and PPI reports for June on Wednesday and Thursday. In our opinion, if the mid-cycle slowdown (i.e., either a growth recession or a mild downturn) scenario gains credibility, that would increase the odds that the bear market bottom occurred on June 16. Confirming this outlook are the recent peaks in commodity prices (May 4) and the bond yield (June 14).

(4) TINAC. The geopolitical mess around the world continues to favor the US dollar, suggesting increasing net capital inflows from overseas into the US financial markets. That helps to explain the recent peaking of the bond yield, which should provide some support to the valuation multiples of stocks.

There is no end in sight for the Ukraine war. Europeans are preparing for a possible permanent shutoff of Russian gas. China continues to struggle with Covid and a bursting housing bubble. Emerging markets are facing soaring prices for energy and food and shortages of both, which are triggering political instability. So lots of global investors may be concluding that they must overweight the US in their portfolios since there is no alternative country (TINAC).

(5) Too many bears. Last week’s muted response to the latest unpleasant surprises in June’s CPI and PPI inflation rates suggests that lots of investors already bailed out of the stock market during the first half of the year. Sentiment remains very bearish, which is bullish from a contrarian perspective. The Investors Intelligence Bull/Bear Ratio was 0.89 during the July 12 week, the 11th consecutive weekly reading below 1.00. During past bear markets, such readings persisted as stock prices continued to fall, but such negative sentiment set the stage for sharp rebounds during the ensuing bull markets (Fig. 14).

Strategy III: It’s A Bear Market Rally. The stock market’s rally since June 16 has been led by the sectors that were the biggest losers during the bear market so far from January 3 through June 16. Here is the performance derby of the 11 sectors of the S&P 500 from January 3 through June 16 and since then through Friday’s close: Health Care (-14.4%, 8.9%), Consumer Discretionary (-36.4%, 8.0), Information Technology (-30.2, 7.6), Utilities (-8.3, 7.3), Real Estate (-24.9, 6.3), Consumer Staples (-11.2, 6.1), S&P 500 (-23.6, 5.4), Communication Services (-32.7, 5.0), Financials (-22.4, 3.5), Industrials (-18.6, 1.6), Materials (-16.5, -3.4), and Energy (35.0, -10.9). (See Table 1 and Table 2.)

So it’s possible that the rebound is a short-covering rally that won’t last much longer. In addition, stocks are certainly cheaper than they were at the start of the year, thus attracting value buyers. However, stock owners might still regret their purchases no matter when they were made if the following occur:

(1) Protracted inflation. Inflation was widely deemed to be transitory last year. But by the end of 2021, everyone agreed that it had turned into a more persistent problem. Now the fear is that it might be even more protracted than expected. Some question whether the Fed’s tightening will have much impact on inflation for a couple of reasons. One is that the inflation problem seems to have a significant supply-side component that tightening doesn’t address. Specifically, the Ukraine war continues to put upward pressure on energy and food prices, and some pandemic-related supply-chain problems remain challenging. Another reason is that price increases continue to spiral into wages and rents, a spiral that’s difficult to halt.

(2) Fed’s ‘Volcker Moment 2.0.’ Previously, I’ve noted lots of similarities between now and the Great Inflation of the 1970s. However, I’ve also noted that watching recent developments has been like watching That ’70s Show on fast-forward. If the analogy proves valid, then the surge in inflation over the past year might soon convince Fed Chair Jerome Powell that inflation is becoming a more pernicious and protracted problem. He might have no choice but to find his inner Paul Volcker, raising interest rates much faster and much higher to break the back of inflation as his predecessor of the 1970s did. That would also cause a severe recession, sending the S&P 500 below the June 16 bottom, with possible support at 3386, which was the record high on February 19, just before the pandemic started.

(3) A severe European recession ahead. Jackie, Melissa, and I have become increasingly concerned about the vulnerability of European nations should Russia shut off natural gas to the region in retaliation for their support of Ukraine. That would trigger a brutal recession and winter in Europe with consequences that could depress the US economy significantly. We aren’t alone with this concern. The euro has dropped 11% since Russia invaded Ukraine on February 24 of this year. For more on this, see the July 14 Morning Briefing titled “Europe Sans Gaz (ESG).”

(4) Earnings shoes starting to drop. The bears, particularly those who see a deep and long recession ahead, contend that there is still much more downside ahead for stocks since industry analysts are only now starting to cut their earnings estimates for this year and next year. That means that there is also more downside for the stock market’s valuation multiple.

Industry analysts might have just started to shave their S&P 500 earnings estimates for 2022 and 2023 during the July 7 week (Fig. 15). They are likely to continue to do so over the remainder of this year. During the July 7 week, they projected S&P 500 earnings per share of $229 this year and $250 next year. We are forecasting $215 this year, which would be unchanged from last year and consistent with a growth recession outlook. We are predicting $235 for next year, a 9.0% y/y gain. In a deep and long recession, earnings would likely fall below $200 both this year and next year.

Strategy IV: It’s Neither Of The Above. Whether 3666 or some other lower number turns out to be the low, that number won’t necessarily mark the beginning of a bull market. After all, the stock market can drift sideways for a while. That’s what it did during the Great Inflation of the 1970s.

Now fast-forwarding past this scenario, we see a possibility that a new bull market may be underway in a few months, with the S&P 500 first meandering in a trading range north of 3666 over the next few months and then rising again, making it to new record highs by late 2023.

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Europe Sans Gaz (ESG)

July 14 (Thursday)

Energy: European Crisis Ahead? An energy crisis in Europe this winter isn’t a forgone conclusion, but things aren’t looking good. Towns in Germany plan to set up warming centers for people who can’t afford to heat their homes. Cities have proactively started conserving energy in public facilities, a July 12 article in The Local reported. German residents are buying anything that heats without using natural gas, so wood-burning ovens and heat pumps have become hot commodities, a July 10 article in The Guardian reported.

The latest reason to worry emerged on Monday when Russia shut down the Nord Stream 1 natural gas pipeline to Germany for maintenance. Industry watchers fear Russia will keep the taps closed to retaliate against the West for its economic sanctions against Russia because of the Ukraine war.

Let’s look at how Europe is positioned during this period of energy uncertainty:

(1) Prices on the rise. The US is blessed with the ability to produce more natural gas than it needs: 34.6 trillion cubic feet of production versus 30.8 trillion cubic feet of consumption, based on the 12-month sum through April (Fig. 1). Over the same period, the US had net exports of 4.0 trillion cubic feet of natural gas.

Limited capacity to turn natural gas into liquified natural gas (LNG) has kept the vast preponderance of the US’s natural gas at home. An explosion at the Freeport LNG terminal in Texas on June 8 took a fifth of US export capacity offline, and it’s not expected to resume until October at the earliest. Historically, the terminal’s exports headed to Asia, but higher prices in Europe recently have lured shipments to Europe’s shores. With the Freeport LNG plant off line, more natural gas remains in the US, so the price of natural gas fell sharply from north of $9 mmBTU prior to the explosion to $6.16 mmBTU on Tuesday (Fig. 2).

The lower price of US natural gas does not mean that all’s well in the world. The Freeport plant’s explosion—and dwindling supplies from Russia—have sent natural gas prices up to $51 mmBTU in Europe. That’s better than this spring, when prices topped $70, but far above the $7-$9 the price that natural gas fetched in “normal” times before the Ukraine war and Covid.

In addition, spot prices at dates further out the natural gas futures curve have been on the rise, which is sure to affect companies looking to hedge their natural gas exposure. “Back in March, a German manufacturer could lock in gas prices for all of 2023 at about 80 euros per megawatt hour; now, it has to pay a record high 145 euros to hedge the same price risk,” a July 11 Bloomberg opinion piece noted.

As European nations have scrambled to buy LNG, the price of LNG in East Asia has risen to $38.43/mmBTU as of last week, up from $13.17 a year ago, according to EIA data. And as US capacity increases to export LNG in coming years, the US price for natural gas will probably rise as well.

(2) Russia squeezes tight. Last year, the EU imported about 140 billion cubic metres (bcm) of natural gas from Russia via pipelines, or about 40% of the EU’s natural gas needs. Among EU nations, Germany is the biggest purchaser of natural gas, consuming 100 bcm of natural gas last year.

More than half of Germany’s gas, about 55 bcm, is purchased from Russia and flows through the Nord Stream 1 pipeline. In June, Russia reduced the flow of natural gas to only 40% of the pipeline’s capacity. Russia said the reduction occurred because a turbine was being fixed by Germany’s Siemens Energy in Canada. Under sanctions, the turbine should not have been returned to Russia. But Canada made an exception and will allow the return of the repaired turbine to Russia because doing so supports Europe’s ability to access reliable and affordable energy.

The situation grew more tenuous on Monday when Russia stopped the flow of ALL natural gas through the pipeline to do routine maintenance. The pipeline is expected to reopen on July 21. Officials who are concerned that Russia won’t restart gas flows through the pipeline will be watching this date very, very closely. If Russia doesn’t restart Nord Stream 1, Germany will likely need to institute natural gas rationing to ensure sufficient supplies this winter.

(3) Planning for winter. Germany’s natural gas storage facilities were 52% full in mid-June, a June 16 Reuters article reported. The country’s goal is to have them 80% full by October and 90% full by November to prepare for winter. The longer Nord Stream 1 stays shut, the less likely reaching those goals becomes.

Germany doesn’t have any LNG terminals, but plans to bring in four floating terminals, two of which should operate this year. It also plans to build traditional LNG facilities over the next three to five years. Taken together, the country will develop LNG importing capacity of 68 bcm, more than the Russian gas that needs to be replaced, stated an April 28 article in Climate Change News. Germany is also pushing through legislation to restart coal-fired power plants and plans to conserve energy as temporary fixes.

As for the rest of Europe, natural gas inventories are at about 62% of capacity, just below the five-year average, a July 12 article in Natural Gas Intelligence reported. The EU would like each country to have their natural gas storage at 80% of capacity by November 1.

The EU’s goals are to cut imports of natural gas from Russia by two-thirds by year’s end and to phase out Russian gas entirely by 2027. The EU will stop buying Russian coal in August and stop buying Russian oil in six months, a July 6 PBS article explained. The aim is to reduce the $850 million per day in revenue Russia received from European energy sales prior to the Ukraine war.

(4) Russia cuts off customers. While Germany may be in the most dire position, it’s not alone. Russia cut off natural gas sales to Denmark, Poland, and Bulgaria in April after those nations refused to pay in rubles. In May, Russia cut off supplies to Finland, after the country announced its intention to join NATO. And Russian gas supplies to Italy have been halved.

Poland is fortunate to have an LNG terminal that’s running at full capacity. Poland’s natural gas storage facilities, holding 3.2 bcm, were 97% full, a June 30 Reuters article reported. The country plans to expand its storage capacity 25% to 4.0 bcm to better serve the nation’s annual consumption of about 20 bcm, or 2 bcm of gas per month in the winter.

Bulgaria plans to get natural gas from a pipeline that starts in Greece and delivers gas from Azerbaijan. Deliveries are expected to begin on October 1, an AP article reported on July 8.

Natural gas represents 19% of the energy Denmark consumes each year, and the country produced about three-quarters of the natural gas it needed in 2019. At the end of last month, the country’s gas stocks filled about 75% of storage capacity, a June 21 The Local article reported. Only 5% of total energy consumed by Finland is natural gas, a May 21 PBS article explained. The country can also tap the natural gas delivered via the Balticconnector gas pipeline between Finland and Estonia.

The UK gets only 4% of its natural gas from Russia, but the country is being hurt nonetheless because its natural gas imports have grown exponentially more expensive as the competition for natural gas has surged. UK households’ gas and electric bills are expected to increase 65% this winter to more than £3,200 a year and may rise further early into next year, energy consultant Cornwall Insight reported in a July 8 FT article.

(5) Signs of stress. The impact of higher gas prices is being felt in the business community. Utilities that use natural gas to produce electricity are hurting as the price of a primary expense surges. Germany’s utility Uniper has requested a government bailout. And a small British household energy supplier, UK Energy Incubator Hub, has collapsed.

There’s also concern that sharply higher natural gas prices could permanently damage some of Germany’s largest industries—producers of aluminum, glass, and chemicals—which are large consumers of natural gas. According to the country’s plan, industrial users of natural gas would be the first to be forced to cut back consumption in a crisis.

Uncertainty about the future of European natural gas and the potential for a European recession is pressuring the euro, which has fallen 17% since hitting a high in 2021 (Fig. 3). It is at parity with the dollar, which last occurred in December 2002. Ironically, the lower the euro falls against the US dollar, the more expensive natural gas becomes for European buyers, because it’s typically sold in dollars.

The pall cast by the natural gas market and the risk of recession have hurt many European stock markets too. Here’s a performance derby for the ytd through Tuesday’s close for many of the European stock markets (in local currencies): Hungary (-34.0%), Ireland (-29.6), Poland (-28.3), Netherlands (-27.8), Germany (-24.0), Sweden (-22.1), Italy (-20.8), France (-15.0), Switzerland (-14.9), Finland (-14.3), and Greece (-12.1).

China: Developments To Watch. Europe is not the only region facing difficulties. China continues to watch its real estate market deflate and its Covid cases inflate, while worries about its banking system grow. No wonder the recent rally in Chinese shares came to an abrupt halt (Fig. 4). Here’s some news that caught our eye:

(1) Housing troubles spread. We’ve been tracking Chinese property developers that have filed for bankruptcy protection after borrowing too much. Now their customers are showing signs of distress too. Buyers of 35 projects across 22 Chinese cities have stopped paying their mortgages as of July 12 due to project delays and a drop in real estate prices, a July 13 Bloomberg article reported, citing research from Citigroup. Average selling prices of properties in nearby projects were 15% lower than the purchase price over the past three years, the research states.

Mortgage defaults could reach 561 billion yuan ($83 billion), or about 1.4% of outstanding mortgage balances, according to the article. China Construction Bank, Postal Savings Bank of China, and Industrial & Commercial Bank of China may have outsized exposure to mortgage loans.

(2) More banking troubles. Investigators froze accounts in April at five rural banks in Henan province under investigation for fraud. About 1,000 angry customers protested on Sunday, demanding access to their deposits. A video in a July 14 South China Morning Post article shows a surprisingly unruly crowd for the normally subdued country.

The China Bank and Insurance Regulatory Commission subsequently said that individuals with deposits of up to 50,000 yuan ($7,430) will be repaid first, and those with larger deposits will need to wait, a July 12 Bloomberg article reported. Whether this is a one-off situation or a sign of problems lurking in China’s banking system is unclear. The country’s nearly 4,000 small and medium-sized banks control less than 1% of the industry’s total assets, Bloomberg reports, so most banking in China involves large banks.

(3) Covid continues. China remains consumed by its zero-Covid policy. One Covid case prompted the lockdown of 320,000 people in Wugang, a city known for steelmaking, a July 12 NDTV article reported. Nearly 250 million people face some form of restriction, according to Nomura data cited in the article. That’s twice the number of people who were under Covid restrictions the prior week.

Macau’s casinos are shut, and the cities of Xi’an, Lanzhou, and Haikou recently imposed partial lockdowns with nonessential businesses closed due to Covid cases, a July 11 NYT article reported. And with new daily Covid cases in the double digits—too far above zero for the government’s comfort—most of Shanghai’s residents were ordered to get two Covid tests between Tuesday and Thursday. Buying in bulk has resumed.

Disruptive Technology: Battery Recycling. Last Thursday’s Morning Briefing looked at the dirty business of manufacturing lithium batteries, which are used in electric vehicles (EVs) and many consumer electronics. With the raw materials expensive and difficult to extract from the earth, you’d think recycling lithium batteries would be a must. Yet less than 1% of lithium ion batteries are recycled in the US versus 99% of lead-acid batteries (used in cars and power grids).

However, about two dozen entrepreneurs in North America and Europe are setting up recycling facilities. Recycling may help ease the shortage of metals needed to make the batteries, and it will keep these flammable materials out of landfills. In coming years, these new companies will have plentiful supplies of used batteries to recycle: While only 10 million EVs are on the road today, that’s expected to rise 30-fold by 2030 to 300 million, according to IEA data cited in a June 13 WSJ article.

Here’s a look at some of the US players in lithium ion battery recycling business:

(1) Tesla co-founder sets up shop. JB Straubel, co-founder of Tesla, left the EV manufacturer in 2019 to launch Redwood Materials, a lithium ion battery recycler. With more than 300 employees, it has supply contracts with Ford and Panasonic, which makes batteries for Tesla.

While waiting for used EV battery supply to increase, the company is recycling the lithium ion batteries used in consumer products like lawnmowers, cell phones, and toothbrushes, Straubel told the AP in a January 31 interview. While Redwood Materials isn’t profitable yet because it’s investing in its growth, the process of recycling is profitable, he said.

The metals in batteries—lithium, copper, nickel, cobalt, and manganese—can be reused and do not degrade. So once the US fleet of EVs is built, not much more mining will be necessary if the materials are recycled, Straubel contends.

(2) Another Tesla alum. Ryan Melsert helped develop the batteries and the battery factory Tesla uses. Now he’s building a battery recycler, American Battery Technology. When the company’s factory in Nevada is completed at the end of this year, it should take in 20,000 metric tons of recyclable material annually, about a fifth of which would be raw lithium, an April 19 article in ARS Technica reported. Anywhere you can buy a lead acid battery, you can also recycle one. Melsert suggests that a similar system be established for lithium ion batteries.

(3) Repurposing batteries. Before being recycled, some used EV lithium ion batteries are used to store energy on the electric grid. Electricity generated by wind and solar panels is intermittent. So old EV batteries can store excess solar power by day that can be used if needed at night.

“Drivers can expect upward of 100,000 miles of use before a battery loses 20% or more of its capacity, roughly the point at which performance drops noticeably, experts say. But they remain useful for grid storage until their capacity drops to around 60%, potentially giving them another 10 to 15 years of service,” Hans Eric Melin, founder of Circular Energy Storage Research and Consulting, said in the WSJ article noted above.

There will be challenges. Unlike batteries in a gas-powered car, the format of EV batteries is not uniform across different car models. Batteries’ shapes and technology continue to change rapidly, adding a layer of complexity to recycling. But with the price of raw materials elevated, lithium batteries are too valuable to become landfill.

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Earnings, Inflation & Europe

July 13 (Wednesday)

Earnings I: Recession or Margin Squeeze? Joe and I tend to be optimists. Nevertheless, we marvel at the remarkable optimism of industry analysts about company prospects despite the mounting recession concerns that have fed the valuation-led bear market in stocks so far this year. Indeed, the S&P 500’s forward earnings has been making new highs almost every week this year (through the June 30 week), though the ascent has started to look a bit toppy over the past three weeks (Fig. 1). All but two S&P 500 sectors (Communication Services and Consumer Discretionary) have forward earnings at or near recent record highs.

But on closer inspection, it seems that a few analysts now might have gotten the recession memo from the companies they follow:

(1) Consensus earnings estimates for 2022 & 2023. Here are the ytd percent changes in analysts’ consensus estimates for the 2022 and 2023 earnings of the S&P 500 and its 11 sectors through the June 30 week: Energy (79.4%, 65.2%), Real Estate (15.1, 5.2), Materials (14.4, 10.3), S&P 500 (2.9, 1.9), Information Technology (2.7, 2.0), Health Care (0.6, -1.7),Utilities (-0.4, 0.5), Financials (-1.3, 0.3), Industrials (-1.4, 0.8), Consumer Staples (-1.6, -2.2), Communication Services (-7.5, -6.8), and Consumer Discretionary (-15.7, -7.9). (See Tables 7E and 8E in our Performance Derby: S&P 500 Sectors & Industries Forward Earnings & Revenues.) Six of the sector estimates for this year and four of them for next year show downward revisions (ytd).

(2) Forward revenues boosted by inflation. Remarkably, the forward revenues of the 11 sectors all have been rising since the start of this year, with all but three of them at record highs (Fig. 2). Obviously, any hint of a possible recession in forward revenues has been more than offset by the positive impact of rapidly rising price inflation on revenues.

(3) Profit margins. We have to conclude from the available data that the analysts who have been cutting their earnings outlook aren’t doing so because they’ve received recession memos from the companies they follow but rather memos on profit margin squeezes being experienced (Fig. 3).

Here is are the ytd percentage changes in the forward profit margins of the S&P 500 and its 11 sectors through the June 30 week and the latest readings of those margins: Energy (up 27.7%, 11.7%), Real Estate (11.0, 18.1), Information Technology (0.9, 25.2), Materials (0.2, 13.3), Financials (-0.3, 18.7), S&P 500 (-0.4, 13.3), Industrials (-0.6, 10.3), Consumer Staples (-3.0, 7.4), Health Care (-3.9, 10.9), Communication Services (-4.5, 16.0), Utilities (-5.9, 13.8), and Consumer Discretionary (-7.9, 7.5). (See Table 3 and Table 1 in Performance Derby: S&P 500 Sectors & Industries Forward Profit Margins.) Forward profit margins have been revised down for six of the 11 sectors of the S&P 500.

US Inflation: Persisting for Now. June’s CPI report is coming out this morning. Bloomberg is showing consensus estimates of up 1.1% (8.8% y/y) for the headline and 0.6% (5.8% y/y) for the core inflation rates. There’s no peak represented by these numbers given that the headline and core CPI inflation rates on a y/y basis were 8.6% and 6.0% in May. The same can be said of other recently released measures of inflation, though a few do support our view that inflation should moderate during H2-2022.

We are forecasting that the headline PCED measure of inflation, which ranged between 6% and 7% y/y during H1-2022, will ease to 4%-5% during H2-2022 and to 3%-4% during 2023 (Fig. 4). We don’t expect that getting there will require a hard landing for the economy. Rather, our base-case economic outlook (with a 55% subjective probability) is a short and shallow recession (Fig. 5). Let’s review the latest inflation readings:

(1) Inflationary expectations. The New York Federal Reserve Bank has been conducting a monthly survey of consumers’ inflationary expectations since mid-2013 (Fig. 6). June’s one-year-ahead expectations rose to a record 6.8%, while three-year ahead expectations edged down to 3.6%. Fed officials are likely to conclude that they must proceed with their tightening of monetary policy since longer-term inflationary expectations are being held down by expectations that the Fed will do just that until actual inflation subsides.

(2) Wage inflation. A recent survey from Insight Global found that 78% of US workers would be worried about job security if the US enters another recession. The staffing company surveyed over 1,000 workers in mostly white-collar professions. The survey found that 54% of workers said they would take a pay cut if it meant not getting laid off. All the talk about a possible recession may be starting to moderate wage inflation. June’s average hourly earnings (AHE) measure of inflation was up 5.1% y/y, but the three-month annualized rate was 4.2% (Fig. 7).

Here are the major industries where the AHE year-over-year rates are above their annualized three-month percent changes (suggesting that inflationary pressures are easing): education & health services (6.1%, 5.8%), utilities (6.1, 4.6), professional & business services (5.8, 3.2), transportation & warehousing (5.3, 0.7), wholesale trade (4.5, 4.1), retail trade (4.4, 1.1), durable goods manufacturing (4.3, 3.1), nondurable goods manufacturing (3.8, 3.4), and financial activities (2.4, 0.7).

Here are the major industries where the year-over-year rates are below their three-month annualized rates (suggesting that inflationary pressures are persisting): leisure & hospitality (9.1%, 10.2%), construction (5.6, 6.3), information services (4.4, 8.8), and other services (2.9, 3.6), with the natural resources’ (3.7, 3.8) rates virtually even.

(3) Small business owners survey. The National Federation of Independent Business conducts a monthly survey of small business owners. They are a very unhappy lot indeed. On balance, a net -61% of them expect that the economic outlook over the next six months is better rather than worse than now (Fig. 8). This measure has been falling to record lows since March. That’s mostly because 34% of them said that inflation is their number-one problem (Fig. 9).

They are also complaining about a shortage of workers, as 50% of them have job openings and 60% reported that there are few or no qualified applicants for their open positions (Fig. 10). As a result, 28% of small business owners are planning to raise worker compensation in the next three months (Fig. 11). Meanwhile, a whopping 69% are raising their average selling prices, while 44% are planning to do so (Fig. 12).

(4) Freight rates. About a year ago, the cost to ship containers from China to the US had jumped from $2,000 pre-pandemic to $20,000. According to one report, Flexport, a tech-enabled freight forwarder, has seen rates drop from highs of around $20,000 per container to $10,000.

(5) Used car prices. The Manheim index of wholesale used car prices fell to 9.7% y/y during June. That’s down from a recent high of 46.6% during December and the lowest since mid-2020 (Fig. 13). The used-car component of the CPI has been a major contributor to measures of consumer price inflation over the past year.

(6) Food and energy commodity prices. Finally, the S&P GSCI energy and agricultural commodity price indexes are down 15.4% and 23.0% from their most recent peaks on June 9 and May 17 through July 11 (Fig. 14). This augurs well for a moderation of the energy and food inflation components of July’s CPI. The overall S&P GSCI index is down 15.3% from its recent peak on March 8 through July 11 (Fig. 15). These developments suggest that inflation may be peaking and help to explain why the S&P 500 bottomed on June 16.

Europe Credit I: Positives for Highly Indebted Sovereigns. After the European Central Bank’s (ECB) June 9 policy meeting, a huge sell-off in the European high-yield bond and other credit markets occurred as investors reacted negatively to the ECB’s super-hawkish tone.

The 10-year German bund yield hit a recent high of 1.76% following the release of the ECB’s June 9 Monetary Policy Statement (Fig. 16). “Given the dramatic bund move, the all-in cost for borrowers is not just wider spreads, but much higher base rates,” said a high-yield fund manager quoted in an S&P Global article.

To address the sudden rise in high-yield bonds and spreads, the ECB announced on June 15 that it would accelerate the completion of a new anti-fragmentation instrument to direct funds toward heavily indebted European countries, even as it tightens monetary policy overall to combat inflation. Bond market reactions suggest cautious optimism that the new policy tool will help to stave off a recurrent European debt crisis.

The next day, Christian Lindner, Germany’s finance minister, also attempted to quell market jitters when he told CNBC: “Yes, of course we are witnessing some rising spreads amongst the member states, but there is no need for any concern.” And on June 27, Germany’s financial stability committee said that the effects of Russia’s war on Ukraine are manageable.

So far, the European Commission (EC) has said nothing officially about a possible Eurozone recession. But speaking to CNBC, EU Economics Commissioner Paolo Gentiloni admitted that “We are navigating troubled waters” but said a recession isn’t inevitable. He added that the situation “means that we will have to concentrate our fiscal policies, in reforms, in investments, in a prudent policy, especially for countries with a high level of debt.”

Europe’s financial situation indeed is fragmented by country. Greece and Italy had the two highest debt-to-GDP ratios at year-end 2021—of 193% and 151%, respectively, versus 69% for the more austere Germany and 96% for the Eurozone overall. But Melissa and I found a surprising number of positives in the recent credit profiles of Europe’s two most heavily indebted countries:

(1) Fitch’s positive outlook on Greece. On July 8, Fitch affirmed Greece’s sovereign debt rating of “BB” with a “Positive Outlook.” Fitch’s ratings release noted: “The Positive Outlook reflects a sustained expected decline in public sector indebtedness, in the context of still low average borrowing costs, despite the sharp rise in government bond yields this year. Greek banks have made substantial progress on asset quality improvement, sharply reducing the level of [non-performing loans] in the banking sector.”

The government’s debt-to-GDP ratio is projected to fall further to about 172% by 2024 from about 193%, “driven by improving primary balances and favorable growth-interest costs dynamics.” While the debt ratio in 2024 is still forecast to be among the highest of Fitch-rated sovereigns, mitigating factors support debt sustainability: substantial liquidity, low debt-servicing costs, and manageable amortization schedules.

The 10-year government bond yield for Greece rose sharply from 1.3% at the end of 2021 to average around 4.0% in June 2022 (Fig. 17). However, at around 20 years, the average maturity of Greek debt is among the longest of any sovereign, and the debt is mostly fixed rate, limiting the impact of market interest-rate rises.

Despite the improving credit outlook, however, Greece’s macroeconomic outlook has worsened because of the war. That’s especially because Greece is vulnerable to further energy price shocks, as it relies on Russia for around 40% of overall gas imports.

(2) Italian déjà vu with differences. “Whatever it takes [to rescue the euro],” was former ECB President Mario Draghi’s famous pledge at the height of the 2012 sovereign debt crisis. That reassurance and his follow-up actions—“mop[ping] up a fifth of Italian bonds,” in Reuters’ words—calmed investor fears, causing Italy’s 10-year bond yield to drop.

The ECB’s June 15 reassurances about a new tool to help troubled states worked like Draghi’s magic words: On June 14, Italy's 10-year government bond spiked above 4.0%, the highest since 2013, on renewed concerns about Italy’s ability to sustain its debt under macroeconomic pressure (Fig. 18). The ECB’s announcement the next day brought Italian benchmark yields back toward 3.0%.

We think the rise above the 4.0% threshold was concerning; but notably, back in 2011 Italian 10-year yields rose above 7.0%. Italian banks remain heavily exposed to domestic sovereign debt but not as much so as in the past. For Italy’s top five banks, the ratio of domestic bond holdings to core capital is 148%, according to JPMorgan’s data cited by Reuters, but that’s a lot less than the 261% hit in 2017.

Italy’s bank restructuring that began during the 2012 sovereign debt crisis has progressed but remains incomplete. The top two lenders are sound, noted former ECB executive Ignazio Angeloni at a conference in June, but the mid-sized banks are not yet fully stabilized. Problem loans “could rise again as businesses face higher lending costs, record prices for energy and raw materials as well as disrupted supply chains and the phasing out of COVID support measures,” the Reuters article noted.

Europe Credit II: High Stakes, Low Defaults in High-Yield. In the aftermath of the recent bond scare, investors have been shying away from higher-yielding European debt assets in general. “European high-yield bond issuance is set for the lowest first-half total since the global financial crisis, as volatile interest rates and fears over rising inflation forced investors to assess the impact of a global recession on the asset class,” wrote S&P Global in a June 22 article. Here’s more:

(1) Investors orderly fleeing high yields. The selling of riskier bonds isn’t frantic but orderly. Starting in February, a 10-week closure of the primary market was triggered by the Ukraine war, which escalated fears over inflation and rising interest rates. As a result, the European high-yield asset class faced outflows of 15.6% of assets under management through June 20, according to Spread Research data cited in the S&P Global piece. European high-yield issuance of €15.3 billion in H1-2022 was the lowest since H1-2009, when markets were reacting to the Global Financial Crisis, according to Leveraged Commentary & Data noted S&P Global’s article.

(2) High-yields ascend to double digits. Meanwhile, yields in Europe’s secondary credit markets rose, according to July 20 data from Spread Research. At the lowest end of the ratings spectrum, the CCC yield was quoted at 11.7%. “The current generous pricing in some deals currently in the high yield market is fine if we assume the default rate will remain below the historical average of 4% over the next two years,” Sergio Grasso, director at iason, wrote in a June 28 report. However, “if the current and future restrictive monetary policies will tilt the economies into recession,” then even the current risk on pricing is still “not enough.”

(3) Defaults expected to remain low. The good news is that while European high-yield bond and leveraged loan default rates will increase in 2023 (to 2.5% from 1.5% and to 3.0% from 2.5%, respectively), they’re still expected to remain below 4.0% and below long-term historical levels, according to a June 15 Fitch Ratings report. Fitch does not expect a “severe near-term recession that would lead to wholesale downgrades of credits, unlike the pandemic impact.”

(4) Pain beyond high yield. Even so, the anticipation of higher interest rates ahead is causing pain in not only the high-yield market but also the investment-grade debt market. An index of investment-grade European debt has suffered a record 12.9% loss over the past 12 months, observed Bloomberg on June 24. According to the Bloomberg index, the average yield on euro corporate bonds has risen 2.9 percentage points this year to 3.4%. That compares to a rise of 1.62 points in 2008, the next highest. “We could see earnings impacted because of this rather unexpected rise in the cost of debt,” said ING credit strategist Timothy Rahill.

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Thumbs Up or Down For Q2 Earnings?

July 12 (Tuesday)

Strategy I: Clash of the Titans. As the Roman emperors once said: “Let the games begin!” The latest earnings reporting season is about to begin. The games in the Roman Colosseum usually were brutal. The question today is whether investors are about to face a brutal earnings season if the actual results turn out to be much worse than industry analysts have been predicting. Investors have been fearing such an outcome since the S&P 500 peaked on January 3 of this year and the Nasdaq peaked on November 19, 2021.

The earnings outlook has been thumbs down as far as investors are concerned, as evidenced by the freefalls in the forward P/E multiples of the S&P 500, S&P 400, and S&P 600 indexes since the start of this year (Fig. 1). Yet industry analysts have kept up the good fight, raising their annual revenues and earnings estimates for 2021 and 2022 since the start of this year.

As a result, the forward revenues and forward earnings of the S&P 500/400/600 indexes have been rising to record highs all year (Fig. 2 and Fig. 3). The forward profit margins (i.e., forward earnings divided by forward revenues) hovered at record highs during H1-2022 (Fig. 4). (FYI: “Forward” earnings and revenues are the time-weighted average of analysts’ estimates for the current and next years.)

Let’s have a closer look:

(1) Earnings vs valuation. Here are the percent changes in the forward P/Es and forward earnings of the S&P stock indexes on a y/y basis through July 7: S&P 500 (-24.4%, 18.0%), S&P 400 (-34.2, 30.3), and S&P 600 (-34.5, 28.4) (Fig. 5). These comparisons confirm what we’ve been saying for the past few months: Investors and industry analysts are from different planets, with the former from Mars and the latter from Venus.

(2) Revenues. Here are the current consensus expected growth rates for revenues per share this year and next year: S&P 500 (11.5%, 4.6%), S&P 400 (13.3, 3.8), and S&P 600 (13.4, 3.6). These estimates undoubtedly are boosted by analysts’ expectations that inflation will remain elevated this year and moderate next year. Most importantly, analysts collectively clearly aren’t expecting a recession either this year or next year, while investors have been fretting about the recession scenario all year.

(3) Earnings. Here are the current consensus expected growth rates for operating earnings per share this year and next year: S&P 500 (9.9%, 9.3%), S&P 400 (14.3, 6.3), and S&P 600 (10.8, 11.4). Notwithstanding these upbeat forecasts, during the past couple of weeks, analysts’ consensus earnings projections for this year and next year have started to look a wee bit toppy. Joe observes that for a second straight week through the July 7 week, none of these three indexes had forward earnings at a record high. That hasn’t happened since January 2021.

(4) Margins. The forward profit margins of the S&P 500/400/600 at the end of June were 13.3%, 8.9%, and 7.0%. All three have been fluctuating at record highs since the start of this year. Collectively, industry analysts are implying that profit margins have been holding up remarkably well under the circumstances.

Strategy II: A Guide to the Games. On their Q2 earnings calls, most company managements are likely to report that they are concerned about a recession but aren’t seeing it in their businesses so far. We think they’ll say that inflation is boosting their revenues and that the Fed’s tighter monetary policies in response to inflation aren’t depressing their unit sales so far. That would certainly explain why analysts have been raising their estimates for revenues.

Analysts also have been raising their earnings estimates along with their revenues estimates, implying that overall profit margins are holding firm and not getting squeezed by rapidly rising labor and materials costs or by labor and parts shortages. So it will be interesting to see whether that’s actually been the case during Q2. Other key points that corporate managements undoubtedly will be discussing are the impacts on revenues, earnings, and margins of labor shortages, supply-chain problems, inventory issues, the strong dollar, China’s zero Covid policy, and the Ukraine war.

Joe and I expect company managements to say that while labor shortages are weighing on their companies’ expansion plans, productivity gains are providing some relief. Furthermore, they are likely to report that supply-chain challenges are easing, though that may reflect weakening demand in some cases. Unintended inventories may be piling up, especially among retailers, requiring price cuts to clear them.

The managements of US multinationals undoubtedly will confirm that the strong dollar is weighing on their revenues and earnings from overseas. Geopolitical concerns are challenging the globalization of business. China’s pandemic-related lockdowns are depressing sales in that important market for many companies. We expect to hear increasing concerns that Europe is likely to fall into a severe recession as a result of the region’s energy crisis caused by the Ukraine war.

Now let’s consider the outlook for the S&P 500’s major sectors as the Q2 earnings reporting games are about to begin:

(1) S&P 500 sectors. Joe reports the following consensus expected y/y growth rates for the revenues and earnings of the S&P 500 and its 11 sectors as of the July 8 week (i.e., the start of the earnings reporting season): S&P 500 (10.6%, 5.7%), Communication Services (3.9, -14.4), Consumer Discretionary (10.9, -5.5), Consumer Staples (5.6, -1.7), Energy (59.2, 239.1), Financials (-4.0, -20.8), Health Care (7.0, 1.6), Industrials (12.9, 30.8), Information Technology (7.8, 2.5), Materials (15.7, 17.4), Real Estate (15.4, 4.2), and Utilities (0.7, -12.2). (See our Earnings Season Monitor tables.)

(2) Consumer Discretionary. As we observed yesterday, solid payroll and wage gains are bolstering nominal personal income. However, consumers’ purchasing power continues to be eroded by inflation. That’s depressed spending on consumer discretionary goods as households are forced to spend more on essentials such as food, fuel, and rent. In addition, consumers’ pent-up demand for discretionary goods has been satiated by the post-lockdown buying binge of 2020 and 2021, and now they are pivoting toward spending more on services.

Retailers report their results near the tail end of earnings seasons. Many of them have seen their inventories rising relative to sales as consumers have reduced their spending on discretionary goods. Here is the inventory-to-sales ratios of various retailers during April and a year ago: all retailers (1.18, 1.09), motor vehicle & parts dealers (1.28, 1.22), furniture, home furnishings, electronic & appliance stores (1.62, 1.27), building materials, garden equipment & supplies (1.87, 1.58), and general merchandise stores (1.58, 1.19) (Fig. 6).

The retailers have been forced to discount their excess inventories to clear them. Industry analysts have slashed their earnings expectations for the industry. As a result, the forward profit margin of S&P 500 General Merchandise Stores has dropped by more than a percentage point in recent weeks to 5.2% at the end of June (Fig. 7).

(3) Energy. May’s value of petroleum shipped by US refineries rose $45.8 billion since its April 2020 bottom, to its highest level since August 2014 (Fig. 8). This series is highly correlated with the forward earnings of the S&P 500 Energy sector. Despite the recent weakness in crude oil prices, industry analysts continue to raise their 2021 and 2022 revenues and earnings estimates for the sector. That’s partly because crack spreads remained very high during June. (See our S&P 500 Industry Briefing: Energy.)

(4) Financials. The big banks will report their earnings this week. JPMorgan Chase and Morgan Stanley go first on Thursday, followed by Citigroup and Wells Fargo on Friday. On June 1, JPMorgan Chase CEO Jamie Dimon said he is preparing the biggest US bank for an economic hurricane on the horizon. Presumably, he is tightening up lending standards and boosting loan loss reserves.

If the big banks increase these reserves, that will weigh on their earnings. However, Jackie and I monitor the weekly data compiled by the Fed on US commercial banks’ allowances for losses, and they’ve continued to decline during Q2 as they did during Q1 (Fig. 9). In addition, demand for commercial and industrial loans has increased every week but one since mid-February, and the banks have obviously been accommodating it (Fig. 10).

(5) Industrials. The S&P 500 Industrials sector includes lots of multinational corporations that are likely to report that a strong dollar has eroded their overseas profits. They may also report that the Ukraine war has wiped out their business in Russia, while China’s lockdowns have slowed their sales in that country. Both the S&P 500 Agricultural & Farm Machinery and Construction & Engineering industries undoubtedly were hit by these developments during Q2.

Nevertheless, new orders for construction, farm, and mining machinery have been rising during the first five months of this year. New orders for industrial, metalworking, and materials handling equipment have remained near their record highs at the beginning of the year (Fig. 11).

Transportation corporations are also included in the S&P 500 Industrials sector. Trucking continues to enjoy a booming business. The industry’s forward earnings rose to another record high at the end of June as its forward profit margin recently rose to a record high of 11.2%. The trucking companies clearly are passing soaring labor and fuel costs on to their customers. (See our S&P 500 Industry Briefing:Trucking.)

(6) Information Technology. The Q2 earnings of the S&P 500 Information Technology sector will also be negatively impacted by the strong dollar. The slowdown in China’s economic growth rate is another negative. Yet data through May showed worldwide semiconductor sales soared to another record high in May (Fig. 12). In the US, industrial production of high-tech equipment remained on the solid uptrend that started after the 2020 lockdown recession through May of this year (Fig. 13).

Strategy III: No Recession in Forward Revenues. S&P 500 forward revenues per share is up 14.5% y/y in current dollars (through the June 30 week) and 5.9% on an inflation-adjusted basis (through May using the CPI) (Fig. 14 and Fig. 15). Both are at record highs. The same can be said for forward earnings. It is up 18.0% y/y in current dollars (through the July 7 week) and 10.8% on an inflation-adjusted basis (through May) (Fig. 16 and Fig. 17). They’re both at record highs too.

So there’s no recession yet evident in either forward revenues or forward earnings. Their growth rates are likely to fall closer to zero but avoid falling into the negative territory consistent with past “official” recessions. That’s if our base-case economic outlook plays out with an “unofficial” mild recession scenario, as we discussed yesterday. That would be consistent with similar mid-cycle slowdowns like the ones during the mid-1980s and mid-2010s.

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Reassessing the ‘Banana’ Scenario

July 11 (Monday)

YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.

US Economy: Leading vs Coincident Indicators. Last week, Debbie and I wrote about the divergence in recent months between the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI). The LEI peaked at a record high during February (Fig. 1). It is down 0.9% since then through May.

As we discussed in the July 6 Morning Briefing, we already know that four of the LEI’s 10 components weighed on it during June—namely, the S&P 500, the M-PMI new orders subindex, a measure of consumer expectations, and initial unemployment claims. The LEI increasingly has been signaling a recession, though not necessarily an imminent one since it peaked by 12 months, on average, before the onset of the past eight recessions.

On the other hand, there is no recession in the CEI, which rose to a record high during May. It includes four components: payroll employment, real personal income less transfer payments, real manufacturing & trade sales, and industrial production. June’s employment report was released on Friday. It provided a mixed picture for the first two CEI components:

(1) Payroll employment. Friday’s report showed a larger-than-expected increase of 372,000 in payroll employment (Fig. 2). The more volatile household measure of employment fell 315,000. However, it is the payroll measure that is included in the CEI, and it is only 0.5% below its record high during February 2020. There’s certainly no recession evident in this coincident indicator.

(2) Personal income. Friday’s employment report also showed moderating wage inflation, as the average hourly earnings (AHE) measure of wages rose 0.3% m/m during June. The bad news is that the consumer price inflation rate (based on the headline PCED) over the past 12 months through May was 6.3%, exceeding the 5.1% increase in the AHE over the same period. So workers’ purchasing power has stagnated over this period (Fig. 3). Odds are that inflation significantly eroded the purchasing power of wages again during June.

This doesn’t augur well for June’s real personal income excluding transfer payments, which is one of the four components of the CEI (Fig. 4). This measure of total consumer purchasing power has been eroded by consumer price inflation too; it is up 8.3% y/y in nominal terms, but only 1.8% in real terms, through May.

Debbie and I calculate our Earned Income Proxy (EIP) for private wages and salaries in personal income when the monthly employment report is released (Fig. 5). It is simply AHE multiplied by aggregate hours worked, which reflects payroll employment and the average length of the workweek. The average workweek (which is one of the components of the LEI, by the way) was flat during June, while aggregate hours worked during the month rose to a record 4.48 billion.

Our EIP rose 0.6% m/m during June (Fig. 6). However, it undoubtedly was eroded by higher consumer price inflation. Over the past 12 months through May, the nominal and real versions of the EIP are up 9.4% and 2.9%.

(3) Subjective probabilities. So according to the LEI, the economy is heading toward a recession. According to the CEI, everything is just swell. Following the release of the jobs report on Friday, the Atlanta Fed’s GDPNow tracking model showed that real GDP fell 1.2% (saar) during Q2, an upward revision from down 1.9%. Real consumer spending growth was revised up from 1.3% to 1.9%, while real gross private domestic investment increased from -14.9% to -13.7%. So real GDP is on track to fall for the second quarter in a row, having decreased 1.6% during Q1.

Last week, we raised our odds of a short and shallow recession from 45% to 55%, with real GDP falling by 2.0% during H2-2022. So a mild recession is our base-case scenario currently. The second-most-likely alternative scenario, with a 25% subjective probability, is a soft landing, with real GDP growing between 0.0% and 2.0% during H2-2022. That puts the odds that real GDP will grow between -2.0% and 2.0% for the foreseeable future at 80%. For now, we assign 10% odds to a hard landing and 10% to a boom.

(4) The “banana” scenario. “Between 1973 and 1975 we had the deepest banana that we had in 35 years, and yet inflation dipped only very briefly,” the economist Alfred Kahn, who headed the Carter administration’s task force to fight inflation, once said. He substituted “banana” for the word “recession.” The reason, he amiably explained, was that references to recessions seemed to make people nervous and irritable. Of course, one of the people made most irritable was his boss, President Jimmy Carter.

In the February 15 Morning Briefing, we wrote: “Debbie and I have been thinking more about the banana scenario. For now, we are singing the 1923 hit song with the ambivalent message ‘Yes! We Have No Bananas.’” We observed that the following factors suggested a low risk of a recession: the LEI and CEI were rising, consumers were in relatively good shape, corporations were also ship-shape, the risk of a credit crunch was low, and the air was coming out of various speculative bubbles in an orderly fashion.

Back then, we identified the main risk as follows: “If the prices of bananas continue to soar along with other food prices and most items in the CPI, then the Fed will have no choice but to implement Volcker’s solution, ushering in the Volcker 2.0 scenario.”

Last Thursday, two Fed officials opined that it should be full-steam ahead for another 75bps hike in the federal funds rate at the end of this month followed by one of 50bps-75bps in September. June’s employment report certainly wouldn’t have changed their minds. Let’s see if June’s CPI report released on Wednesday will take any steam out of the Fed’s current tightening monetary course, or add even more steam.

The 2-year US Treasury note yield is a good year-ahead leading indicator of the federal funds rate, which is currently at 1.63% (Fig. 7). After soaring from 0.73% at the start of the year to a recent high of 3.45% during June 14, it has been back down bouncing around 3.00% since then.

For now, Fed officials remain on course to tighten monetary policy through September, even at the risk of an economic squished banana. Needless to say, the word “banana” did not appear in the FOMC’s June minutes. Neither did the word “recession,” not even once. Instead, the minutes noted: “Most participants assessed that the risks to the outlook for economic growth were skewed to the downside. Downside risks included the possibility that a further tightening in financial conditions would have a larger negative effect on economic activity than anticipated as well as the possibilities that the Russian invasion of Ukraine and the COVID-related lockdowns in China would have larger-than-expected effects on economic growth.”

Strategy I: The S&P 500 as a Leading Indicator. The stock market has predicted nine of the past five recessions. That’s a joke told by master Keynesian of decades ago Paul Samuelson. As noted above, the S&P 500 is one of the 10 components of the monthly LEI. It tends to peak ahead of recessions but has provided a few false alarms as well. However, since 1945, every bear market in the S&P 500 with the exception of the one during 1987 has been associated with a recession (Fig. 8 and Fig. 9).

The question is whether the current bear market might not be a precursor of a recession after all? The answer is that it might not if the recession turns out to be short and shallow as we currently expect. It’s conceivable that such a recession might not make the grade as an official recession as determined by the Dating Committee of the National Bureau of Economic Research. It’s conceivable that the current experience will make the history books as a growth recession or a mid-cycle slowdown, but not an “official” recession.

Since 1945, bear markets in the S&P 500 started, on average, five months before recessions started. The range of the lead time has been 12 months before to one month after the 12 recessions since 1945 (Fig. 10).

Strategy II: The Da Vinci Code. Joe and I remain hopeful that the Da Vinci Code (DVC) will be right again in calling a major market bottom. The S&P 500 fell to 666 on an intra-day basis on March 6, 2009. That devilish number marked the bottom in the previous bear market. On June 16 of this year, the S&P 500 closed at 3666, down 23.6% from its record high on January 3. That marked the bottom to date in the current bear market. The index is up 6.3% since then and down 18.7% since its January 3 peak (Fig. 11).

Of course, we are fundamentalists, not DVC symbolists. The S&P GSCI commodities index is down 14.8% from its recent peak on June 8 through Friday’s close. Over this same period, its energy and agricultural commodities subindexes are each down 15.6%. The price of copper is down 19.8% over this period.

The drop in commodity prices triggered a significant decline in the 10-year US Treasury bond yield from this year’s peak of 3.48% on June 14 to 3.09% on Friday.

All these developments signal that inflation might be peaking and therefore that the Fed’s monetary policy tightening cycle might be over sooner rather than later. If so, then the forward P/E of the S&P 500 might have bottomed on June 16 at 15.3. On the other hand, all these developments might also be signaling a recession, which would be bad news for S&P 500 earnings and could very well push the forward P/E below its June 16 low. Given that a mild recession (which might not even make the history books) is our base-case scenario, we think the Da Vinci Code has a shot of having called the bottom.

Strategy III: Are Earnings Real? The recession question for investors is now focusing on the Q2-2022 earnings reporting season, which starts this week. The relative weakness of the economy will be judged by its impact on earnings during Q2 and by the guidance provided by corporate managements during their upcoming earnings calls. The results will help investors decide whether industry analysts have been too optimistic, if not totally delusional, about earnings. Here is our guidance for the earnings reporting season ahead:

(1) Quarterly earnings. Industry analysts lowered their Q2 estimates for S&P 500 earnings slightly during April when Q1 earnings were being reported, but not by much and haven’t changed their estimates since then (Fig. 12). During the June 30 week, they estimated that earnings rose 4.9% y/y through Q2 (Fig. 13). History suggests that analysts tend to be too pessimistic just before earnings seasons begin, as the actual results turn out to be better. We will be monitoring their estimates for Q3 and Q4 to see how Q2’s results and guidance affect their outlook.

(2) Annual earnings. Industry analysts remain totally oblivious to all the chatter about a recession, as evidenced by the record highs in both S&P 500 forward revenues and earnings during the June 30 week (Fig. 14). The forward profit margin remains at its record-high reading of about 13.3% since the end of last year.

(3) Adjusting for inflation. One of our accounts recently asked us if the strength in forward revenues and earnings might be attributable mostly or solely to inflation. Data available through May show that real forward earnings has been rising every month to new records since May 2021 (Fig. 15). Real S&P 500 forward earnings was up 10.8% y/y through May, while nominal forward earnings was up 18.4% y/y through the June 30 week (Fig. 16).

During recessions, the growth rates of both nominal and real forward earnings tend to be negative on a y/y basis. We aren’t there yet, and we might not get there.

Movie. “Staircase” (+ +) (link) is an HBO Max TV mini-series inspired by the truly bizarre story of Michael Peterson, a crime novelist. He was found guilty of killing his wife Kathleen. During the trial, his defense lawyer claimed that she died falling down the back staircase at their home. The prosecution argued that her head injuries showed that she was hit several times by her husband after she might have threatened to leave him because she might have discovered that he was cheating on her. The jury sided with the prosecutors partly because Michael had had numerous affairs and a history of lying about his past. The relationships between Michael, Kathleen, and their five children both before and after her death is an interesting aspect of this crime story, which has lots of twists and turns. Colin Firth admirably plays Michael playing everyone around him. Toni Collette plays his very unhappy wife.

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China, Earnings & Batteries

July 07 (Thursday)

China: Real Estate Woes Continue. Just over a year ago, it was widely expected that President Xi Jinping would secure an unprecedented third term when the Chinese Communist Party meets this fall. That was before a number of headwinds hurt the once-unstoppable Chinese economy, casting doubt on Xi’s prospects. Xi’s zero-tolerance Covid policy placed major cities under quarantine for months at a time when Covid cases were detected. Some of the country’s largest real estate developers have filed for bankruptcy protection, unable to make interest payments on their billions in outstanding debt. And now the global economy is slowing, jeopardizing China’s exports.

The Chinese government hasn’t sat on its hands. It provided fiscal stimulus with the latest round of government-funded infrastructure projects, announced last week, and monetary stimulus by lowering reserve requirements for banks. Also, China’s central bankers have kept its prime lending rate steady instead of raising it to fight inflation, as many other major central banks have done (Fig. 1 and Fig. 2). Moreover, President Xi has softened his disastrous anti-business policies, giving investors hope that a more business-friendly environment has arrived—at least until the CCP meets.

These business-friendly moves are reflected in the stock market’s recent performance. After falling 54.5% from its peak on February 17, 2021 through its trough on March 15, China’s MSCI stock market index has rebounded sharply this year, rising 27.0% from its lows (Fig. 3). And on July 4, the Caixin services purchasing managers’ index jumped to 54.5 in June, up from 41.4 in May.

But we remain concerned about three matters over which even Xi has little control: The potential for new Covid cases and related quarantines, China’s high real estate debt, and a recession in the US and Europe hurting Chinese exports. The continuation of Xi’s zero-tolerance Covid policy seems unsustainable, and restructuring billions of dollars of debt across many companies could take longer than Xi would like.

Here’s a look at some of the recent developments:

(1) Deflating real estate bubble. China’s housing sales have fallen y/y for 11 months in a row, yet the unwinding of China’s real estate market continues. The most recent casualty is Chinese developer Shimao, which defaulted on $1 billion of dollar-denominated bonds when it missed a payment on Sunday. The country’s 14^th largest builder (as measured by contracted sales) has about $5.5 billion of offshore bonds outstanding, a July 3 Bloomberg article reported.

In May, China’s third-largest property developer, Sunac China Holdings, defaulted on a $750 million bond. Sunac’s aggregated sales in March and April fell 65% from a year ago due to Covid outbreaks in various cities, and its refinancing and asset disposal plans did not materialize after a series of rating downgrades earlier this year, a May 12 Reuters article reported.

The largest real estate developer to default is China Evergrande Group, which filed for bankruptcy in December. Roughly $300 billion of the company’s debt will need to be restructured.

All told, nineteen Chinese real estate developers have defaulted on billions of dollars of debt, and their woes are weighing on Chinese economic growth. Real estate and related sectors account for 28% of China’s GDP, according to Moody’s Investors Service.

Consider just the sale of land by municipalities to land developers. Last year, property developers and others paid 8.7 trillion yuan to local governments for land purchases. Revenue from land sales represented 42% of the total revenue generated by local governments excluding funding from the central government. Local governments’ land sale revenue grew tremendously over the past decade. In 2011, it was only 3.3 trillion yuan, or 36.7% of their revenue, according to a May 21 South China Morning Post (SCMP) article. And for some cities, land sales brought in more revenue than taxes.

This year, land sales—and the revenue they bring to local governments—are down sharply. Land sales in yuan terms fell by 14%-91% in 17 of the 19 cities surveyed in a May 21 SCMP article compared to a year ago. Here are a few cities mentioned with the change in their land sales over the same period: Tianjin (91%), Wuhan (89), Guangzhou (-63), Beijing (-56), and Shanghai (-48).

The Chinese government has taken some actions to help the real estate sector. The five-year loan prime rate was cut by 15bps to 4.45% on May 20, which was more than expected and the greatest reduction in that rate by since 2019, a May 20 Reuters article reported. It was the second rate cut this year. Additionally, the government has given buyers subsidies and required smaller down payments. Relaxation of Covid restrictions also has helped.

These moves appear to hit their mark: New home prices in 100 cities stopped falling in May and June, according to data from the China Index Academy, an independent real estate research firm quoted in a July 1 Reuters article. Of the 100 cities surveyed, 47 experienced price growth m/m, up from 40 cities in May.

But it’s hard to get a true read on prices, as more than 22 cities have set limits on price cuts since the second half of last year. Prices are further distorted by developers who are offering additional perks or accepting food in lieu of cash to pay for apartments. One developer accepted watermelons to reduce the price on the apartment by $14,935, a June 29 Reuters article stated. It noted that “Among 100 major real estate firms, most achieved less than 30% of their sales targets as of the end of May.” China’s April property sales fell 47% y/y and 43% m/m.

(2) Covid still percolating. Just as occurred in the US, China’s economy undoubtedly will receive a boost now that the Covid-related lockdowns have been lifted in Shanghai and Beijing. But there certainly are no guarantees that lockdowns won’t occur again in those cities or elsewhere, as Xi’s zero-tolerance policy continues.

Mainland China reported 418 new Covid cases on July 4 and 460 cases the prior day, according to a July 5 Reuters article. Beijing and Shanghai each reported three new cases on July 4, and there have been reports of cases in smaller cities around China.

Wuxi, a manufacturing city near Shanghai, closed many shops and supermarkets and suspended in-restaurant dining after 42 asymptomatic cases were discovered Saturday, a July 3 New York Post (NYP) article reported. Residents were asked to work from home and not leave the city unless absolutely necessary.

Si, a city of 760,000, is locked down after 288 cases were found Saturday, the NYP relayed. And flights from Yiwu to Beijing were canceled indefinitely after the smaller city reported three new Covid cases over the past week.

Two port workers in Wuhan came down with Covid, a June 30 Bloomberg article reported. And there were more than 570 Covid cases in Macau, where more than 7,000 people are in mandatory quarantine, a June 30 Reuters article reported. People have been asked to stay at home as much as possible, and bars, hair salons, outdoor parks, and other venues are closed. Casinos, though largely empty, are open. In Hong Kong, cases jumped to more than 2,000 a day in June.

As of March, only about half of China’s people aged 80 and over were fully vaccinated, and fewer than 20% had gotten a booster shot, according to Statista data. Until China’s population is better protected, Covid will continue to pose a threat to the country’s economy and its people.

(3) Exports to US/Europe slowing. Chinese exports are a major engine of the country’s economic growth, contributing 20% to 2021 GDP. Exports to the US surged 44.0% from the recent bottom to $827.5 billion (saar) through February, while exports to Europe jumped 44.3% from their recent bottom to $705.5 billion also through February. Since then, exports to both regions have fallen sharply, to $621.7 billion to the US and $580.4 billion to Europe both through May (Fig. 4 and Fig. 5). Post Covid, US consumers have opted to spend more on experiences outside of the home than on stuff for inside the home.

Analysts have been slashing their revenues and earnings estimates to new lows for companies in the China MSCI index. The consensus revenue per share estimate for 2022 has fallen 19.7% since it peaked in November 2020. And the consensus per share estimate for 2022 earnings is down 31.2% over the same time period (Fig. 6).

Earnings: A Look at Revisions. In the first half of 2022, there was a major disconnect between the S&P 500’s performance and analysts’ earnings estimates. The S&P 500 has fallen 19.6% ytd through Tuesday’s close, yet industry analysts forecast S&P 500 companies will log earnings growth of 10.8% this year and 9.1% in 2023.

Analysts have a lot of estimate slashing to do if the stock market is correct. So we decided to kick off the second half of the year by looking at which sectors and industries have had estimate cuts already this year, for perhaps those analysts are ahead of the curve.

First, here’s how much earnings growth analysts currently project for companies in the S&P 500 and its 11 sectors this year and next: Energy (121.4%, -11.7%), Industrials (36.5, 19.5), Materials (20.2, -5.8), Information Technology (13.0, 11.2), Consumer Discretionary (11.0, 32.7), S&P 500 (10.8, 9.1), Health Care (5.9, 0.0), Consumer Staples (3.9, 7.3), Utilities (2.2, 7.9), Communications Services (-4.5, 15.6), Real Estate (-10.3, 3.0), and Financials (-10.6, 13.5) (Table 1).

Earnings estimates for 2022 have been revised upwards so far this year for Energy (79.4%), Real Estate (15.1), Materials (14.4), S&P 500 (2.9), Information Technology (2.7), and Health Care (0.6). There’s no disconnect in the Energy sector’s earnings revision direction and stock market performance, as its stock price index is up 25.5% ytd. But the stock price indexes of the four other sectors with upward revisions have suffered ytd declines, including the Technology sector’s sharp 26.2% ytd drop (Table 2).

Conversely, analysts have trimmed their 2022 earnings estimates for the following sectors so far this year: Utilities (-0.4%), Financials (-1.3), Industrials (-1.4), Consumer Staples (-1.6), Communications Services (-7.5), and Consumer Discretionary (-15.7).

And they’ve cut their 2022 estimates for the following S&P 500 industries by more than 10% since the start of the year: Internet & Direct Marketing Retail (-70.7%), Hotels (-61.2), Broadcasting (-29.1), Airlines (-20.7), Office REITs (-20.5), Health Care Supplies (-20.2), General Merchandise Stores (-19.2), Footwear (-18.2), Interactive Home Entertainment (-15.6), Wireless Telecommunication Services (-14.8), Auto Parts & Equipment (-14.1), Movies & Entertainment (-14.1), Aerospace & Defense (-12.7), and Apparel Retail (-12.1).

Among S&P 500 sectors, some of the more dramatic reductions in forward earnings have occurred during the past 13 weeks: Consumer Discretionary (-5.2%), Health Care (-1.6), and Communications Services (-1.2). Among S&P 500 industries, the handful with the sharpest forward earnings declines are: Internet & Direct Marketing Retail (-37.3%), General Merchandise Stores (-17.5), Broadcasting (-15.0), Health Care Supplies (-13.3), Footwear (-10.8), and Copper (Table 3).

Disruptive Technologies: Dirty EVs. The surge in gasoline prices this year has accelerated interest in plug-in vehicles, both hybrid and solely electric. Almost 700,000 plug-in electric cars were registered globally in May, up 55% y/y, a July 6 InsideEVs article reported. As a result, the global plug-in vehicle’s share of the overall global auto market grew to 12% in May.

Before environmentalists can rejoice over the increasing electrification of automobile transportation, however, they need to address the damage caused by the mining, processing, and disposing of the minerals used in batteries even as demand for those materials increases. By 2030, worldwide demand for lithium is expected to grow to six times the 2020 level of 350,000 tons, a March 28 PBS article reported.

Here’s a quick look at some of the problems the industry will need to quickly address:

(1) Damage from the beginning. The US has 4% of the world’s reserves of lithium, but there’s only one mine in the US, first opened in the 1960s. It produces 5,000 tons of lithium a year, or 2% of the world’s annual supply, the PBS article noted. California has so much of the mineral that Governor Gavin Newsom has called the state the “Saudi Arabia of lithium.” There are various projects being developed in Maine, North Carolina, California, and Nevada. But right now, most of the raw lithium used in the US is mined in Latin America or Australia and processed in China, a May 6, 2021 NYT article stated.

Mining for lithium involves either open-pit mining, which uses ground water, can contaminate the water that remains in the ground, and leaves behind waste. The alternative involves extracting lithium from a mineral-rich brine that’s pumped to the surface. “Opponents, including the Sierra Club have raised concerns that the projects could harm sacred indigenous lands and jeopardize fragile ecosystems and wildlife,” the PBS article stated.
 
Lithium America plans an open pit mine in Nevada that may ultimately be 370 feet deep and produce 66,000 tons a year of battery-grade lithium. The company has said the mine will use 3,224 gallons of water per minute, which could cause the local water table to drop by about 12 feet, the NYTs article reported. Federal documents say the mine may contaminate the groundwater with antimony, arsenic and other metals.

It gets worse. Per the NYT’s: “The lithium will be extracted by mixing clay dug out from the mountainside with as much as 5,800 tons a day of sulfuric acid. This whole process will also create 354 million cubic yards of mining waste that will be loaded with discharge from the sulfuric acid treatment, and may contain modestly radioactive uranium, permit documents disclose.”

(2) How green is your electricity? How much good an electric vehicle does for the environment depends largely on where it’s charged. If the utility providing electricity burns coal to generate electricity, the benefit isn’t nearly as good as it could be if the utility uses renewable sources, like solar, wind or hydro. So the benefit of driving an EV in the US, where 21.9% of electricity is generated using coal and 38.4% is generated using natural gas, is less than it would be if the EV was driven in Iceland, where the electric grid runs almost entirely on hydro, geothermal and solar energy.

(3) Batteries filling landfills. Batteries are built to last for a solid amount of time. Tesla’s CEO Elon Musk Tweeted in 2019 that the Model 3’s battery should last 300,000 to 500,000 miles and that “replacement modules” will cost between $5,000 and $7,000. The Model 3 contains four modules, but Musk says replacing 2 or 3 modules will allow the car to drive for up to 1 million miles, an April 13, 2019 Electrek article reported

Tesla has backed up its promises with various warranties on its Model 3 and Model Y high-voltage batteries. The warrantees range from eight years or 100,000 miles to 10 years and 150,000 miles in California, a July 5 JD Power article reported. The car company guarantees that the two cars will retain 70% of their original battery capacity for the duration of the battery warranty period.

But eventually even Tesla’s batteries run out of juice. The car maker says that none of its scrapped batteries go to landfilling and 100% are recycled. The company doesn’t explain exactly what that means. Is every piece of the battery reused by Tesla or do all of its batteries get sent to a recycler that manages to recycle some percentage of the battery only to throw what remains in a landfill?

Recycling lithium is tricky because it’s tough to separate from other elements in batteries, like nickel, cobalt, and aluminum. The material can also be flammable, and has caused landfill fires that emit toxic gasses, an August 16, 2021 article in Vice reported. Historically it has been cheaper to mine for new lithium than it has been to recycle and reuse it.

Fortunately, there are many companies who are working to perfect lithium battery recycling. Will visit that subject next week.

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A Recession: To Be or Not To Be?

July 06 (Wednesday)

Strategy: Earnings Forecasts & Market Targets. Yesterday, Debbie and I lowered our outlook for real GDP to reflect a short and shallow recession in the US this year and a recovery next year. We are raising the odds of this scenario from 45% to 55%. So we might still skirt an outright recession. Let’s review the implications for the fundamentals of the stock market:

(1) S&P 500 annual & forward earnings. Joe and I revised our S&P 500 operating earnings per share downward by $10 to $215 for this year and by $5 to $235 in yesterday’s Morning Briefing (Fig. 1). (We had the correct numbers in yesterday’s chart but typos in the text; a corrected version is available here.) We also lowered our S&P 500 forward operating earnings per share forecast to $235 per share at the end of this year and $255 per share at the end of next year (Fig. 2). Both are down $20 from our previous estimates. Forward earnings stood at $240 per share during the week of June 30. (Forward earnings is the time-weighted average of industry analysts’ consensus estimates for the current year and the coming year.)

(2) S&P 500 valuation & targets. In our work, the stock market equation (i.e., P = P/E x E) is based on our projections of both forward earnings (determined by analysts) and the forward P/E (determined by investors). When we formulate year-end targets for the S&P 500, we do so by multiplying our projection of analysts’ consensus forward earnings by our subjective assessments of a plausible range for the forward P/E at the end of the year.

For 2022, we are using projected forward earnings per share of $235 by the end of this year and a forward P/E range of 14-17, which yields a year-end S&P 500 target range of 3290-3995 (Fig. 3 and Fig. 4).

For 2023, we are using projected forward earnings per share of $255 by the end of next year and a forward P/E range of 15-18, which yields a year-end S&P 500 target range of 3825-4590.

We conclude that the S&P 500 will recover next year, coming close to its January 3, 2022 record high of 4796.56 but probably not exceeding it until 2024.

(3) S&P 500 revenues & margins. For 2022 and 2023, we are still forecasting that S&P 500 revenues per share will increase 11.6% to $1,750, and 7.1% to $1,875 as inflation continues to boost business sales this year and an economic recovery does the same next year (Fig. 5). As a result, we are projecting that the profit margin of the S&P 500 will fall from 13.4% last year to 12.3% this year and edge up to 12.5% next year (Fig. 6). Industry analysts are currently projecting profit margins of 13.0% this year and 13.5% next year. (See YRI S&P 500 Earnings Forecast.)

US Economy: Falling Leading Indicators. Prior to Tuesday’s Morning Briefing, our subjective probability of a recession was 45% for this year and next year. The latest batch of leading economic indicators suggests that several coincident economic indicators might soon begin to fall. So we now place the odds of a mild recession at 55%, making it our base-case outlook.

Let’s review what we have so far for June’s Index of Leading Economic Indicators (LEI) and May's Index of Coincident Economic Indicators (CEI):

(1) Timing issue. While it is widely believed that the LEI tends to peak three consecutive months prior to recessions, the average lead time between the LEI peak and the CEI peak has been 12 months during the previous eight business cycles, with a range of 2-22 months (Fig. 7). The CEI cycle has coincided with both the official peaks and troughs of the previous eight business cycles, as determined by the Dating Committee of the National Bureau of Economic Research.

The CEI tracks the growth rate of real GDP, both on a y/y basis, very closely (Fig. 8). The former was up 3.0% during May, while the latter was up 3.5% during Q1.

(2) Three strikes. The LEI fell for the third month in a row in May, and that makes four declines in the last five months. We already know that three of the 10 LEI components were down in June, i.e., the S&P 500, the M-PMI new orders subindex, and the average of the CCI and CSI consumer expectations measures (Fig. 9). Also weighing on the LEI during June was an increase in initial unemployment claims. Odds are that nondefense capital goods orders excluding aircraft lowered June’s LEI as well.

(3) Recession or not? So real GDP apparently fell two quarters in a row during H1-2022. The LEI has dropped for three consecutive months through May. The jury is out on whether this will turn out to be an official recession, especially since the CEI rose to a record high in May and since it peaked 12 months, on average, after the LEI peaked during the past eight business cycles, as noted above. For now, we are raising the odds of a recession from 45% to 55%. In any event, industry analysts are likely to be cutting their earnings estimates during H2-2022.

Global Food I: The Price of a Burger. The soaring price of food no doubt was a big conversation topic at last weekend’s Fourth of July barbeques, with a prime example sizzling on the grill. This year’s cookout was 17% more expensive than last year’s, according to a new report from the American Farm Bureau Federation. The price of ground beef rose especially high.

US households are spending $341 more a month to purchase the same goods and services as last year, according to an analysis by Moody’s Analytics, reported CNBC on May 12. And a lot of that increase is for food. In the US, the Consumer Price Index for food rose 10.1% y/y during May (Fig. 10). The increase is the highest seen since the 1980s. Why?

“[T]he broader question is ‘What is not contributing to higher food prices?,’” Jennifer Hatcher of The Food Industry Association said at The Heritage Foundation’s June 28 podcast on inflation across the food supply chain. She attributed rising food prices to energy costs, transportation costs, supply-chain bottlenecks, the labor shortage, and ingredient shortages. According to a June 7 article in Vox, Tyson Foods, America’s largest meat producer, would add two additional items to that list: higher demand for meat and the rise in the price of grain fed to farm animals.

In our view, the problems cited above are mainly attributable to the pandemic and to Russia’s war on Ukraine. How long they will be inflating food prices is the question. Melissa and I think the pandemic’s inflationary impacts could persist for a while. The impacts of the war on food prices in the US and globally are hard to assess; but the longer the war lasts, the worse the consequences for food prices. While most Americans won’t experience a shortage of bread on our shelves, that’s not the case for many developing countries that depend on food supply from the Black Sea region.

Before we delve further into the war’s impacts on global food supply, let’s explore some of the key challenges impacting the supply of, as well as rising demand for, food, leading to higher prices in the US:

(1) Food production & inputs. The US Department of Agriculture (USDA) expects wholesale prices for meat, dairy, and flour to be up at rates in the double digits this year. During the pandemic, many food manufacturing plants, meat processing ones in particular, were forced to close due to Covid outbreaks among workers. To keep those workers safe and prevent future closures, many manufacturers are investing more in automated technologies and remote capabilities for workers.

That investment aside, input costs are up overall for manufacturers. In May, the producer’s price index (PPI) for final demand goods and services rose 10.8% y/y (Fig. 11). Contributing to the rising cost of meat is the rising cost of prepared animal feed—up nearly 13% since last year, according to a Bank of America analysis. Farmers are paying more for agricultural chemicals, especially for fertilizers and pesticides. Fertilizers and chemicals represent 10%-20% of US farmers’ total costs, Bank of America said. The energy-intensive nature of fertilizer production makes it especially costly.

(2) Food demand. Higher meat prices reflect a supply that can barely meet record-setting demand, which remained high even after the pandemic, said Mark Dopp of the North American Meat Institute at the Heritage event. Some of the demand is panic buying, he added. Many consumers continue to buy more than they need, to have supply on hand if stores run out of certain items as during the pandemic. More folks eat more often at home than before the pandemic, which can mean eating more frequently.

(3) Energy, transport, and labor. Rising fuel costs and the state of the transportation industry also are boosting food costs across the supply chain. The transportation of freight index, which measures the cost of shipping goods in the US, jumped 25.8% y/y during May (Fig. 12). There’s a problem when it comes to finding capacity necessary to move product, Tom Madrecki of Consumer Brands Association noted during the Heritage event. Madrecki cited the truck driver shortage as a major contributor to transportation costs; it’s difficult to both find and retain drivers.

Global Food II: The Price of War. Outright food shortages are possible in 2023 if Russia continues to block Ukraine’s crop exports, the head of the United Nations World Food Program warned according to an article covering the WSJ Global Food Forum on June 28. The forum comments suggest—as we did in our April 27 Morning Briefing—that most people in the developed world will not suffer from a shortage of food, but many will suffer from the inflated cost of purchasing it, for the reasons discussed above in addition to the war.

However, developing countries, particularly those most dependent on Ukrainian food imports, face a potential humanitarian hunger calamity. Reduced food exports from Ukraine, one of the world’s largest harvesters of wheat and food oils, are hitting their food supplies at a time when the supplies are already depressed by climate-change challenges. Here’s the latest on the situation:

(1) Russia blockades. Russia has been accused of weaponizing food prices and capitalizing on food shortages. Before Russia’s invasion, nearly all of Ukraine’s grain exports transited through ports on the Black Sea, reported a June 5 WSJ article. But a Russian naval blockade has stopped traffic at those ports, and key export infrastructure has been targeted by Russian attacks. Not many good options are available for shipping Ukrainian harvested grain through the Black Sea.

Russia has been accused of stealing Ukrainian grain and exporting it, but authorities in Turkey are working with the Ukrainian government to prevent stolen grain from leaving ports. Russia continues to export its own grain, and the Food and Agriculture Organization (FAO) expects it to reap a record wheat crop in September. However, Western financial sanctions on Russia could hinder exports. Fewer shipments than usual are booked to depart Russian Black Sea ports after July.

(2) Developing dependencies. Before the war, the Ukraine supplied one-third of global wheat exports; that has been halved, according to USDA, as the June 28 WSJ article reported. Four countries imported over 50% of their wheat supplies from the Ukraine, including Lebanon, Pakistan, Djibouti, and Somalia, according to the FAO, observed the June 5 WSJ.

Most other countries that depend on Ukraine for 10%–50% of their imports are developing ones in Africa, the Middle East, and Southeast Asia. Turkey, Egypt, and Somalia also depend heavily on wheat exports from Russia, typically the world’s largest wheat exporter. But the two countries produce just 7.0% of the world’s wheat, observed the WSJ, so the impact of lower grain exports from Ukraine and Russia shouldn’t be exaggerated.

On a hopeful note, in a recent small but significant victory for Ukraine, Russian soldiers withdrew last Thursday from Snake Island, an outpost in the Black Sea. The retreat could weaken the Kremlin’s Black Sea blockade.

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The Second Half of 2022

July 05 (Tuesday)

YRI Weekly Webcast. Join Dr. Ed’s live Q&A webinar today at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the weekly webinars are available here.

US Economy: A Mild Recession. The economy is falling into a recession. Debbie and I are lowering our forecast for real GDP growth from 1.1% this year to -1.9%, based on the Q4/Q4 percent change (Fig. 1). So it is likely to be a relatively mild and short one but a recession nonetheless. Next year, we expect growth to resume, with a 2.9% increase projected.

The good news is that under this scenario of weaker economic growth, there’s a greater likelihood that inflation will decline during the second half of this year and in 2023, as we’ve been projecting. So we aren’t revising our inflation forecast. We see the headline PCED inflation rate falling from 6.3% y/y during May to 4.0%-5.0% during H2-2022 and to 3.0%-4.0% during 2023 (Fig. 2).

Melissa and I are still anticipating that the FOMC will increase the federal funds rate on July 27 by 75bps and again on September 21 by that amount (or now possibly less). In any event, two more rate hikes should conclude the Fed’s current monetary policy tightening cycle for a while.

This outlook supports our view that the 10-year US Treasury bond yield should stabilize for a while around 3.00%, a view confirmed recently by the ratio of the nearby futures prices of copper to gold (Fig. 3). Actually, the ratio is now more consistent with a bond yield closer to 2.00%. Its weakness in recent days confirms the recession scenario and the recent top in the yield (at 3.49% on June 14), as does the Citibank Economic Surprise Index (Fig. 4). It is down from 17.9% at the start of this year to -75.8% on Friday.

Before Joe and I discuss the implications for the stock market of our revised economic outlook, let’s review the past week’s batch of recessionary data that caused us to lower our estimates for real GDP for the rest of this year:

(1) GDP. Q1’s real GDP was revised down slightly to -1.6% (saar) by the Bureau of Economic Analysis on Wednesday, but it was still up 3.5% y/y (Fig. 5). During mild recessions, this growth rate tends to fall to zero. During severe recessions, it falls well below zero. In our current forecast, the y/y growth rate in real GDP bottoms at -1.9% during Q4 of this year. That’s somewhere in between a soft and hard landing.

Most of Q1’s weakness was attributable to an unusually large widening of the goods and services trade deficit (Fig. 6). Real final sales to domestic purchasers rose 2.0% (saar) during the quarter, led by a 1.8% increase in real consumer spending, with outlays on goods and services down 0.3% and up 3.0%, respectively. Capital spending rose 10.0% (saar) to a record high, led by a 14.1% increase in spending on equipment (with information processing up 24.7%, industrial up 13.0%, but transportation down 7.9%). On the downside was total government spending, which fell 2.9%.

That doesn’t really add up to a very recessionary quarter even though real GDP fell. Q2, however, is moving more in the recessionary direction with weakness in final demand, led by residential investment. Consumer and capital spending are slowing as well.

At the start of last week, the Atlanta Fed’s GDPNow tracking model showed that real GDP was unchanged during Q2; that dropped to -2.1% by the end of the week. Real consumer spending was revised down from 1.7% to 0.8%, and real gross private investment growth was lowered from -13.2% to -15.2%. Leading the decline is still residential investment (-12.0%), followed by nonresidential structures (-6.6%) and capital equipment (-4.5%).

(2) Consumer confidence & spending. Contributing greatly to last week’s downward revision in the GDPNow tracking estimate, as well as to our revised outlook for the economy, were last week’s latest readings on the consumer sector. On Tuesday, June’s Consumer Confidence Index (CCI) confirmed the weakness in the month’s Consumer Sentiment Index (CSI). The former tends to be more sensitive to employment, while the latter tends to be more affected by inflation. Notwithstanding the strength of the labor market, both were very weak last month (Fig. 7).

Inflation is clearly depressing consumers. It has been eroding their purchasing power, essentially offsetting what seem to be solid increases in nominal wages. In other words, the wage-price spiral is making consumers’ heads spin. Inflation-adjusted personal income is actually down 1.0% y/y through May (Fig. 8). That comparison is skewed by the pandemic-related government support provided a year ago. Excluding these benefits shows that inflation-adjusted personal income is up, but by a relatively meager 1.8% y/y through May.

Real personal consumption expenditures (PCE) increased 2.0% y/y through May (Fig. 9). The post-lockdown spending binge on goods during 2020 and 2021 has been followed by a 2.7% y/y decline in real spending on them. That’s been more than offset by a 4.7% increase on real spending on services. May’s data suggest that strength in spending on services may no longer be more than offsetting weakness in spending on goods. Real PCE decreased 0.4%, with goods down 1.6% and services up 0.3%. In addition, March and April real PCE were revised downward from 0.5% to 0.3% and from 0.7% to 0.3%.

Inflation has been skewed toward essentials including groceries, gasoline, and rents. Consumers offset that squeeze by lowering their personal saving rate, which had been boosted in 2020 and 2021 by the government support payments (Fig. 10 and Fig. 11). There might not be much more room for the personal saving rate to fall; it was down from 10.4% a year ago to 5.4% in May, holding near April’s 5.2%, which was the lowest since October 2009.

Keep in mind that the average of the expectations components of the CCI and CSI is one of the 10 components of the Index of Leading Economic Indicators (LEI). This average dropped to 56.9 during June, the lowest since October 2011. That’s a recessionary reading.

(3) Business surveys. Friday’s release of June’s manufacturing purchasing managers index (M-PMI)—and the underlying survey conducted by the Institute for Supply Management (ISM)—was a major contributor to the downward revision in the GDPNow estimate. The M-PMI was down from May’s 56.1 to 53.0, the lowest since June 2020 (Fig. 12).

The ISM report stated: “This figure indicates expansion in the overall economy for the 25th month in a row after a contraction in April and May 2020.” (Anything above 48.7 indicates expansion according to the report.) However, the new orders index dropped sharply from May’s 55.1, to 49.2. The report stated: “This indicates that new order volumes contracted after growing for 24 consecutive months.”

The M-PMI’s new orders subindex is also one of the 10 components of the LEI. It tends to be highly correlated with the y/y growth rate of new orders for nondefense capital goods ex aircraft (Fig. 13). The latter was up 9.8% during May, but that probably reflects a relatively high inflation rate for such orders. In any event, the M-PMI new orders index suggests that the growth of new orders for capital goods slowed significantly during June.

The picture is darker looking at the average of the business surveys conducted by five of the 12 district Federal Reserve Banks. The composite regional business index dropped further below zero in June—to -4.2 from -0.4 in May—which was the first negative reading since May 2020. June’s regional index was the lowest since last May and a more recessionary reading than that of the latest M-PMI (Fig. 14). The average of the regional new orders indexes was -9.7%, also the lowest since May 2020 and consistent with the M-PMI new orders index (Fig. 15).

The regional business surveys can be used to construct averages of their current and future indexes of capital spending (Fig. 16). Both averages peaked last year and have been heading lower since then. But they remained in solidly positive territory during June, at 12.0% for the current average index and 19.4% for the future average index. The regional and national business surveys suggest that supply-chain problems are abating (Fig. 17). That’s probably a result of weakening demand and improving supply-chain logistics.

(4) The Dating Committee. It is widely believed that two consecutive declines in quarterly real GDP is a good rule of thumb for determining recessions. The first two quarters of this year are shaping up that way, even though Q1’s underlying performance actually was reasonably good, as discussed above. Another rule of thumb is that a string of three consecutive declines in the LEI foreshadows an imminent recession. The LEI fell for the third month in a row in May, and that makes four declines in the last five months. We already know that three of the 10 LEI components were down in June, i.e., the S&P 500, the M-PMI new orders subindex, and the average of the CCI and CSI consumer expectations measures.

While we can declare unofficially that a recession may have started in June, we can’t be certain of it. It will be up to the Dating Committee of the National Bureau of Economic Research to make the official determination. They do so after the fact. Therefore, they focus more on the Index of Coincident Economic Indicators (CEI) than the LEI. The CEI rose to a new record high during May, casting doubt on the notion that a recession has begun; however, if the LEI’s signals are on the mark, the latest business cycle might have peaked in June. (The CEI includes payroll employment, real personal income less transfer payments, real manufacturing & trade sales, and industrial production.)

Strategy I: Getting Closer to the Bottom. Given all the above, it’s no wonder that pessimism is in fashion. It’s certainly getting harder to be an optimist these days. The CSI is the lowest it has ever been since the start of the series in 1952. As we recently observed, Investor Intelligence Bull/Bear Ratio fell to 0.60 during the June 21 week, the lowest since the March 10, 2009 week, which was the bottom of the bear market caused by the Great Financial Crisis.

But for stock investing, this pessimism is potentially good news from a contrarian perspective. Investor sentiment should improve at some point once inflation peaks definitively and the Fed ends its monetary tightening cycle. Along the way, the recession will end. When all that happens, the stock market should bottom.

That may happen sooner rather than later based on our reading of the relationship between the yearly percentage change in the S&P 500 and the M-PMI, which are highly correlated (Fig. 18). The former was -8.0% during June, essentially already anticipating that the M-PMI (at 53.0 in June) will fall below 50.0 in July and August.

An even tighter relationship is the one between the yearly percentage change in the S&P 500 and the composite regional general business index (Fig. 19).

The aforementioned business-cycle indicators are signaling that the economy is in a recession or falling rapidly toward one. It is certainly premature to declare that they’ve bottomed or soon will do so. But they are getting closer to doing so, and therefore so is the stock market.

Strategy II: Recession Memo Is on the Way. During the first half of this year, Joe and I have observed that industry analysts didn’t receive the recession memo. Odds are that more of them will be getting it and lowering their 2022 and 2023 earnings estimates in coming months. Consider the following:

(1) Revenues, earnings estimate revisions & the M-PMI. The weakness in June’s M-PMI (along with the even weaker regional data) point to a significant slowdown in S&P 500 revenues and earnings growth on a y/y basis over the rest of this year (Fig. 20 and Fig. 21). The M-PMI is also highly correlated with both our Net Revenues Revisions Index (a.k.a. NRRI) and Net Earnings Revisions Index (NERI) for the S&P 500. Both of the latter already have declined sharply since the start of the year, though they remained positive during June at 5.0% and 1.5% (Fig. 22 and Fig. 23). They are likely to turn slightly negative in coming months.

(2) Annual & forward earnings estimates. Now that we too have received the recession memo, we are lowering our estimates for S&P 500 companies’ earnings in 2022 and 2023. We expect analysts will be doing the same.

We are reducing our S&P 500 operating earnings-per-share forecast for 2022 by $10 to $215 and for 2023 by $5 to $235 (Fig. 24). During the June 23 week, industry analysts were estimating $229 and $251.

We are lowering our forward earnings forecast to $235 per share at the end of this year and $255 per share at the end of next year (Fig. 25). Both are down $20 from our previous estimates. Forward earnings stood at $240 per share during the week of June 30. (FYI: “Forward earnings” is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for the current year and the next one; at year-ends, they align with analysts’ next-year estimates.)

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