A Dozen Reasons To Remain Bullish In 2024

December 18 (Monday)

YRI Bulletin Board. We have launched our new website. We will be finetuning it in the coming weeks. We appreciate your patience during the transition and welcome your suggestions.

We will be recharging our batteries for the new year from December 19 to January 2. We won’t be publishing the Morning Briefing during that period or broadcasting our usual Monday webcasts. We will keep you connected to our ongoing analysis of economic and market-related events as they happen through our QuickTakes.

Dr. Ed’s next live webcast with Q&A will be at 11:00 a.m. on Monday, January 8. Replays of past weekly webcasts are available here.
 
Strategy I: Here We Go Again. The Great Debate that started in early 2022 between the stock market’s bulls and the bears continued in 2023 and is set to continue again in 2024. Both sides are marshalling many of the same debating points they have used since early 2022 and a few new ones.

The basic thesis of the bearish debating team is that it isn’t different this time. The Fed raised the federal funds rate by 525bps from March 2020 through August of this year (Fig. 1). That’s the biggest increase since Fed Chair Paul Volcker tightened monetary policy in late 1979. In addition, this time the Fed has been paring the size of its balance sheet through quantitative tightening. This all comes after the Fed provided ultra-easy monetary policies, including ultra-low interest rates and several rounds of quantitative easing, from 2008 through 2021.

Surely such a massive swing from easy to tight monetary policy must cause a credit crunch and a recession, the thinking goes, and probably a severe one! Monetary policy tightening cycles usually have been followed by recessions (Fig. 2). Indeed, each of the past 10 recessions was preceded by such a cycle. Supporting the recession outlook is the yield curve, which has been inverting since the summer of 2022 (Fig. 3). The yield-curve spread is one of the 10 components of the Index of Leading Economic Indicators (LEI), which has been falling since it hit a record high during December 2021 (Fig. 4). It is down 11.8% since then through October. Granted, the Index of Coincident Economic Indicators rose to a record high in October, but it is bound to fall in 2024, according to the bears. Also, an ominous sign for real GDP growth is that real M2 has been falling on a y/y basis since December 2022 (Fig. 5).

Recognizing that consumer spending currently accounts for 68% of nominal GDP, the bears have been attributing the resilience of consumer spending to “excess saving,” which they had expected to run out by now. So now they say that whatever is left will be spent in the coming months, forcing consumers to retrench next year. Meanwhile, another alarming signal, they say, is that consumer credit rose to a record $5.0 trillion, with revolving credit up to a record $1.3 trillion, during October. They’ve also been warning that the resumption of student loan payments during October would depress consumer spending. However, retail sales were surprisingly strong during November, so that is likely to be dropped as a talking point of the bearish squad.

Before we present our rebuttal to the bears’ arguments, here’s some perspective on our stock market outlook and how it compares to the expectations of other Wall Street strategists.

Strategy II: Bullish Targets. The current issue of Barron’s includes the 2024 S&P 500 targets for six investment strategists including yours truly. Our target is the highest at 5400, based on projected S&P 500 earnings per share of $250 next year. Morgan Stanley’s Mike Wilson has the lowest numbers at 4500 for the index’s price target and $229 for earnings per share. In last year’s survey by Barron’s, we had 4800 as our S&P 500 target for last year with earnings at $225. The low comparable readings were 3930 and $199 for 2023.

Along the way, we trimmed our year-end target to a more reasonable 4600. Then, on June 5, we wrote: “Is all the AI euphoria leading the stock market into another ‘MAMU’—‘Mother of All Meltups’? If so, our 4600 target for the S&P 500 by year-end might prove conservative, not controversial.”

On July 19, we wrote: “The S&P 500 is now almost at 4600. It closed at 4556.27 on Tuesday. Rather than raise our year-end target, we are raising our expectations for what the bull market could deliver through the end of 2024 and beyond. We think that 5400 is achievable by the end of next year. If that happens, then 5800 would be our target for the end of 2025. In other words, we think that the bull market has staying power.”

Last week, we raised our 2025 target for the S&P 500 price index to 6000, as our Roaring 2020s scenario is looking not only possible, but also probable.

Strategy III: A Dozen Good Reasons. Now let’s review our talking points on behalf of the bullish team in the Great Debate. Here’s an even dozen:

(1) Interest rates are back to normal. Perhaps the Fed hasn’t been tightening monetary policy so much as normalizing it. Interest rates are back to the Old Normal. They are back to where they were before the New Abnormal period between the Great Financial Crisis and the Great Virus Crisis, during which the Fed pegged interest rates near zero.

The normalization theory implies that the Fed might not lower interest rates next year as much as widely expected. That’s because the economy wouldn’t require as much easing to reverse the tightening. If the economy remains resilient but inflation continues to fall closer to the Fed’s 2.0% target next year—both of which we’re expecting—then the Fed might lower the federal funds rate twice next year, by 25bps each time, instead of four times or more as widely anticipated.

(2) Consumers have purchasing power. Many consumers may soon run out of their excess saving, as the economy’s naysayers are saying. Some consumers could be weighed down by too much consumer debt, especially student loans. Nevertheless, most of them are likely to continue to consume as long as their job security remains high, which it will be as long as there are plenty of job openings and as long as the unemployed and new entrants to the labor force fill those openings. That describes the current state of the labor market.

Indeed, during November, 40% of small business owners reported that they have job openings (Fig. 6). During October, there were 8.7 million job openings overall in the labor market versus 6.5 million unemployed that month. The labor force has increased 3.3 million during the first 11 months of this year. The household measure of employment is up 2.7 million over the same period.

Pandemic-related excess saving certainly helped to boost consumer spending over the previous three years when unemployment was very high and real wages stagnated. But unemployment is low now (i.e., below 4.0% since February 2022), and real average hourly earnings is rising once again along its 1.4% annualized trendline that started in 1993 (Fig. 7).

Both nominal and real wages & salaries in personal income and unearned personal income (including interest income, dividends, rents, and proprietors’ income) rose to record highs during October (Fig. 8). They probably did so again in November.

(3) Households are wealthy and liquid. The net worth of American households totaled a staggering record-high $151.0 trillion at the end of Q3-2023 (Fig. 9). Their portfolios are diversified in various asset holdings that all are at or near record highs (Fig. 10). There are certainly lots of liquid assets that might be sold to buy stocks and bonds when the Fed decides to lower short-term interest rates. A record $5.9 trillion is in money market mutual funds (MMMF) with a record $2.3 trillion in retail MMMFs (Fig. 11). Commercial bank deposits in M2 totaled $17.3 trillion during the December 12 week (Fig. 12).

There are 86 million households who own their own homes, and 40% of them have no mortgages. Many of these homeowners likely are Baby Boomers. They have mostly followed the advice of Star Trek’s Spock, who often said, “Live long and prosper.” Collectively, the generation held $73.1 trillion of net worth at the end of Q3. Boomers are likely to be among the main beneficiaries of record unearned income streams.

(4) Demand for labor is strong. From personal experience, we know that some of the Baby Boomers are providing some financial support to their young adult children. The Boomers are also eating at restaurants and traveling more often. They are visiting their health care providers more frequently to make sure that they live long enough to spend some of their retirement nest eggs.

Not surprisingly, November’s better-than-expected retail sales was led by food services, which rose to yet another record high (Fig. 13). Employment continues to soar in the leisure & hospitality industry as well as in the health care sector.

(5) Onshoring boom is boosting capital spending. American and foreign manufacturing companies clearly are onshoring to the US. Supply-chain disruptions during the pandemic and growing geopolitical tensions between the US and China have stimulated the onshoring rush. So has a shortage of workers in China.

The onshoring boom and the federal government’s increased spending on public infrastructure are boosting new orders for construction machinery, which is up 30.5% over the past 24 months through October (Fig. 14). Onshoring and infrastructure investment also explain why construction employment rose to yet another record high of 8.0 million during November despite the recession in single-family housing starts.

Construction spending on manufacturing facilities is soaring because of the increase in onshoring partly owing to federal incentives. In current dollars, it is up a whopping 71.6% and 136.8% on one-year and two-year bases (Fig. 15).

(6) Housing is all set for a recovery. The plunge in mortgage interest rates since early November undoubtedly will boost new and existing home sales. That should give a boost to housing-related retail sales on appliances, furniture, and furnishings. The rolling recessions in housing and housing-related retailing should turn into rolling recoveries for both.

(7) Corporate cash flow is at a record high. The economy’s resilience can also be attributed to the awesome ability of US corporations to generate cash flow. It totaled a record $3.4 trillion (saar) during Q3-2023. That’s despite the pressure on companies’ profit margins coming from high labor costs and higher interest rates over the past couple of years. Corporate cash flow is up 4.1% y/y, with tax-reported depreciation up 6.9% and undistributed profits down 3.3%. The latter has been relatively flat since Q3-2009.

(8) Inflation is turning out to be transitory. There can be no debate about the transitory nature of goods inflation since H2-2020. It was back down to 0.0 y/y during November (Fig. 16). It turned out to be mostly attributable to the shocks and aftershocks of the pandemic, which have been dissipating since the end of the pandemic.

Almost all the inflationary pressures on durable goods and many nondurable goods stemmed from the pandemic-related supply-chain disruptions, which can be seen in the Global Supply Chain Pressure Index compiled by the Federal Reserve Bank of New York. The index jumped from 0.1 in October 2020 to peak at 4.3 in December 2021. It has plunged since then, returning to 0.1 in November (Fig. 17). The PPI inflation rate for transportation & warehousing has followed suit (Fig. 18).

Now that the goods inflation shock is behind us, the services inflation shock is showing signs of dissipating. We expect it will do just that in 2024.

(9) The High-Tech Revolution is boosting productivity. Companies are allocating more of their capital spending budgets to technology hardware and software to boost their productivity in response to chronic labor shortages. As a result, production of high-tech equipment and spending on software are at all-time highs.

We believe that a major cycle in productivity growth started at the end of 2015, when it bottomed at 0.5% (based on the 20-quarter average) and rose to 1.8% during Q3-2023 (Fig. 19). We expect productivity growth will peak around 4.0% by the end of the decade.

(10) Leading indicators are mostly misleading. What about all those leading indicators that have been signaling an impending recession since last year? We’ve often explained why they are misleading. For example, inverted yield curves in the past have anticipated that the Fed’s tightening would break something in the financial system, causing a credit crunch and a recession, that’s not always the case. There was a mini-banking crisis in March of this year. But it was contained by the Fed so had few systemic ripple effects.

The LEI has misfired its recession signals because its composition is biased toward predicting the goods sector more than the services sector of the economy. There has been a rolling recession in the goods sector, but it has been more than offset by strength in services, nonresidential private and public construction, and high-tech capital spending.

(11) The rest of the world’s challenges should remain contained. Also booming is industrial production of defense, which is likely to continue rising to new record highs given the geopolitical turmoil around the world. The wars between Russia and Ukraine and between Israel and Gaza should remain contained regionally. China’s economic woes reduce the chances that China will invade Taiwan. Nevertheless, these geopolitical hot spots will boost defense spending among the NATO members.

The bursting of China’s property bubble should continue to weigh on global economic growth and commodity prices. China will remain a major source of global deflationary pressures. Europe is in a shallow recession and should recover next year as the European Central Bank lowers interest rates.
 
(12) The Roaring 2020s will broaden the bull market. At last week’s FOMC meeting, Fed Chair Jerome Powell and his colleagues pivoted toward the soft-landing scenario, which is also known as “immaculate disinflation.” In their Summary of Economic Projections (SEP), they projected three 25bps cuts in the federal funds rate next year, up from September’s two rate cuts. They are starting to recognize that inflation can subside without a recession. We think this is happening because China is having a recession and effectively exporting goods deflation to the US. In addition, technology-driven productivity growth is making a comeback, in our opinion.

The current bull market started on October 12, 2023. It received a big boost when AI-related stocks took off late last year. OpenAI launched ChatGPT on November 30, 2022. We believe that date is when the stock market first started to discount our Roaring 2020s scenario. At first, the bull market was narrowly based, but it since has been broadening to include more sectors and industries. We believe that reflects investors’ realization that the beneficiaries of the Roaring 2020s theme aren’t just the companies that make technology but also those that use it to boost their productivity—i.e., companies generally whatever their industry may be.
 
Strategy IV: How About All That Government Debt? The bears’ latest and most compelling talking point is that federal government deficits are out of control. Federal government spending is growing rapidly, led by outlays on net interest paid. They totaled a record $716.7 billion over the past 12 months through November. That’s an unsettling development, for sure.

However, keep in mind the flip side of high interest rates: They represent a big windfall for households that receive interest income, which has increased significantly. In addition, the spending bills passed by Congress last year will continue to boost construction spending on public infrastructure, which is at a record high, and continue to stimulate onshore construction of manufacturing facilities. Better-than-expected productivity-led growth would certainly help to reduce the mounting burden of the federal debt.
 
Nevertheless, the federal government’s need to finance the huge deficit could cause an oversupply of Treasury bonds relative to demand, which could set off a debt crisis. And that certainly could trip up the Roaring 2020s scenario. However, investors realize that nothing will be done to fix the problem in 2024 because it is an election year. Meanwhile, inflation is falling, the Fed is pivoting toward lowering interest rates, and the economy remains resilient.

Movie. “Archie” (+ +) (link) is a British television drama series about actor Cary Grant. He was born into poverty in Bristol in 1904 as Archibald Leach before becoming a star in Hollywood with the new stage name. He was very successful as an actor, playing lead roles in several hit movies. However, his personal life was a mess, as evidenced by his five marriages and four divorces. He suffered greatly from the emotional pain of his childhood. He recognized that he was trapped in the past but couldn’t escape it. However, near the end of his life, he had a baby girl with his fourth wife, Dyan Cannon; it was then that he finally found peace and great satisfaction in the role of good dad.

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Drugs, China & AI

December 14 (Thursday)

Health Care: Hoping for a 2024 Recovery. The S&P 500 Health Care sector stock price index has been sickly all year, posting negative ytd performance through Tuesday’s close. Tough y/y comparisons to Covid-boosted-earnings in 2022 hurt some drug companies. Others fell off patent cliffs. Pharmacy benefit managers have come under pressure from new competition from the online pharmacy services being offered by Amazon and billionaire entrepreneur Mark Cuban. The makers of weight-loss drugs were among the few pharmaceutical manufacturers to have a banner year.

As the new year begins, analysts are optimistic about the 2024 earnings prospects for companies in the Health Care sector. In fact, the sector’s earnings growth next year is expected to trump that of any other S&P 500 sector—including Technology.

Let’s dive into what hurt Health Care names this year and what stands to help the sector in the year ahead:

(1) A tough 2023. The S&P 500 Health Care sector’s stock price index is one of only four among the 11 S&P 500 sectors to fall this year. Here’s the performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Information Technology (54.0%), Communication Services (47.8), Consumer Discretionary (36.9), S&P 500 (20.9), Industrials (12.0), Financials (6.6), Materials (6.3), Real Estate (2.3), Health Care (-2.1), Consumer Staples (-4.1), Energy (-8.4), and Utilities (-10.6) (Fig. 1).

The stock price indexes of all but one of the industries within the S&P 500 Health Care sector severely lagged the S&P 500 ytd through Tuesday’s close: Health Care Distributors (23.1%), Health Care Facilities (8.6), Health Care Equipment (3.9), Health Care Supplies (2.7), Managed Health Care (0.4), Biotechnology (-2.9), Pharmaceuticals (-3.7), Life Sciences Tools and Services (-9.9), and Health Care Services (-12.9) (Fig. 2).

(2) Strong earnings growth expected in ’24. Ironically, given the 2023 underperformance of Health Care’s stock price index, this is the S&P 500 sector that analysts see bound for the strongest earnings growth in 2024—of 19.5%, representing a sharp about-face from the sector’s projected earnings drop this year of 20.2%.

Note how much faster the S&P 500 Health Care sector’s earnings are forecast to grow in 2024 relative to the other S&P 500 sectors: Health Care (19.5%), Communication Services (15.9), Information Technology (14.7), Consumer Discretionary (11.7), Industrials (11.1), S&P 500 (11.0), Utilities (8.1), Financials (5.9), Consumer Staples (5.2), Energy (3.7), Materials (2.9), and Real Estate (-0.5).

The Health Care sector’s healthier earnings growth next year owes much to the rebound in the Pharmaceuticals industry’s earnings. In 2022, pharma earnings were boosted by the pandemic, particularly for companies that sold vaccines or needed supplies. This year, earnings for those companies fell sharply as memories of the pandemic faded. Next year, more normal earnings growth is expected to return.

The Pharmaceuticals industry had 18.0% earnings growth in 2022, followed by a projected 41.9% decline in earnings this year; it’s expected to grow earnings by 51.1% in 2024. As a result, the Pharmaceuticals industry’s earnings are expected to be the second fastest growing in the S&P 500 next year, behind only Movies & Entertainment. Notably, though, the Pharmaceutical industry’s earnings estimates will likely be trimmed over the next week as analysts factor in the sharply lower 2024 earnings guidance that Pfizer announced yesterday.

Here are the 2024 earnings growth estimates for the S&P 500 Health Care sector and its component industries: Pharmaceuticals (51.5%), Health Care sector (19.6), Health Care Distributors (13.0), Managed Health Care (11.0), Health Care Supplies (10.7), Biotechnology (9.1), Health Care Facilities (8.2), Health Care Equipment (8.1), Health Care Services (5.1), and Life Sciences Tools & Services (1.0).

(3) Thank Merck, Pfizer & Lilly. Three pharma stocks are expected to post standout earnings growth next year: Eli Lilly, Merck, and Pfizer. Lilly’s results should get a boost from Mounjaro, a diabetes drug that’s now being used for weight loss. A recent analysis of health records and other data showed that those taking Mounjaro lost weight faster than those taking Novo Nordisk’s competing Wegovy and Ozempic drugs, a November 27 Reuters article reported. Lilly’s earnings are expected to rise 86.2% next year, and its shares have climbed 59.8% ytd.

Merck’s earnings growth will jump next year because this year’s earnings are depressed. The drugmaker is facing the patent expiration of blockbuster cancer drug Keytruda later this decade. In preparation for the expiration, Merck has been doing deals to boost its drug pipeline, including a recently announced joint venture with Daiichi Sankyo to commercialize three antibody-drug conjugates that fight cancer. While an upfront payment of $5.5 billion related to the Daiichi joint venture depressed Merck’s earnings this year, it will make Merck earnings growth in 2024 look impressive: 455.6%. Merck’s shares are 5.9% lower ytd.

Pfizer is also facing drug patent expirations and tough comparisons to Covid-boosted earnings in 2022. To help fill its drug pipeline, Pfizer recently announced the acquisition of Seagen, another antibody drug conjugate for fighting cancer. In October, Pfizer slashed its 2023 sales guidance for Paxlovid (a drug to treat Covid) to $1 billion from $8 billion, announcing that the US government returned roughly a third of the Paxlovid doses it had bought from the company.

On Wednesday, Pfizer announced its 2024 earnings estimate of $2.05-$2.25 a share, far below analysts’ consensus forecast of $3.18 a share. Results will be lower than expected because revenue from Covid-related products are forecast to come in well below what analysts had penciled in. Pfizer’s earnings are still expected to bungie from the $5.47 a share it earned in 2022 down to $1.73 this year, then up 24.4% to $2.15 in 2024, using the midpoint of the earnings range the company gave. But the rebound was far lower than expected; that sent the shares tumbling roughly 7% yesterday, bringing its ytd decline to almost 50%.

China: Is Xi Fiddling? It’s been more than two years since China’s most indebted property developer, Evergrande, defaulted on more than $300 billion of debt. Over that time, no restructuring plan has been agreed to, leaving creditors and an estimated 1.5 million retail homebuyers in limbo. Evergrande isn’t alone. Oher Chinese property developers have defaulted as well, and debt restructurings—the kind that really flush out the system and allow it to grow again—are mostly nonexistent. A few developers have restructured their dollar-denominated debt, but they’ve yet to reduce the amount of local debt outstanding.

The status quo has left consumers who purchased apartments in the developers’ unfinished properties unsure of what will happen to their investments and likely wary of spending much on other goods. Most developers aren’t moving forward with new projects, so they’re not buying new parcels of land from municipalities. That’s leaving local municipal coffers low on funds and staring up a mountain of debt.

Earlier this week, the Chinese Communist Party (CCP) held its annual economic conference, but it concluded without news of any large, splashy spending program to save the day. Meanwhile, more signs of deflation have appeared in China’s economy, an ominous development given the amount of debt the country needs to repay. We wouldn’t be surprised to see a cartoon of President Xi fiddling, as Nero purportedly did while Rome burned (though fiddles didn’t exist in the time of Nero).

Let’s take a closer look at these recent developments:

(1) Many goals, no instructions. The CCP aims to promote “high-quality development” and focus on scientific and technological innovation, according to a government statement published by Xinhua News Agency. The government aims to “vigorously promote” new industrialization, develop the digital economy, and accelerate the development of artificial intelligence. The party is targeting the development of industries that include biomanufacturing, commercial aerospace, quantum, and life sciences, while strengthening applied and cutting-edge research and encouraging both entrepreneurial and equity investments. The government also aims to stimulate consumption and expand investments that have proven profitable.

The statement did acknowledge the real estate problem China faces: “It is necessary to coordinate and resolve risks in real estate, local debt, small and medium-sized financial institutions, etc., severely crack down on illegal financial activities, and resolutely maintain the bottom line of preventing systemic risks.” But no solutions to the problem were given.

Chinese shares have fallen sharply this year, with the China MSCI index closing at a 13-month low on Monday and down 13.9% ytd through Tuesday’s close. The broader Shanghai Shenzhen CSI 300 closed at a 58-month low on Wednesday and is down 13.0% ytd (Fig. 3).

(2) Daunting deflation. Both consumer and producer prices have fallen y/y several months this year, indicating that deflation may be on the verge of becoming entrenched. China’s consumer price index (CPI) fell 0.5% y/y in November, its third month of declines. CPI was negative by 0.2% in October and 0.3% in July and unchanged in June and September. China’s core CPI fell 0.6% y/y in June and was flat in May and July. It was at 0.4% y/y in November.

Producer prices have also been in negative territory since last October and most recently fell by 3.0% in November (Fig. 4).

The specter of deflation should keep Chinese central bankers up at night. It certainly worried former Fed Chair Ben Bernanke when deflation was a problem in the US; he once said that if deflation became serious enough, it could warrant dropping money from a helicopter to resolve it. While he wasn’t serious, the implication is that central bankers should do whatever is possible to steer economies clear of or out of deflationary environments.

(3) Lots of can kicking. Since the start of 2020, at least 60 Chinese property developers with more than $140 billion of dollar-denominated bonds collectively have defaulted, according to a December 8 FT article. That doesn’t include the hundreds of billions of dollars of domestic debt these property developers owe.

While it seems clear that debt restructurings are needed, investors continue to let the heavily leveraged property developers off the hook—for now. In the handful of restructurings that have been proposed, it’s the dollar-denominated offshore debt that’s being restructured, while the local debt remains outstanding.

Just this week, most investors in Country Garden Holdings’ yuan-denominated bonds agreed not to exercise a put option that would require the bond be repaid now, before it matures next year. And they were rewarded. Country Garden announced on Wednesday that it repaid the bond in full. Meanwhile, the builder already defaulted on a dollar-denominated bond in October, and its sales fell 77% in November, a December 12 Bloomberg article reported.

Chinese property developer Shimao Group has proposed a restructuring plan that would reduce its $14 billion of offshore debt by as much as half. Some of the debt would be exchanged for new nine-year loans, new senior secured debt, and equity-linked instruments. The company’s $25 billion of local debt does not seem to be impacted by the restructuring proposal. The company has been selling assets to reduce its debt, but it still had to roll over about CNY18.9 billion of local debt during H1-2023 when it posted a net loss that rose 23% to CNY12.1 billion, a December 8 Yicai Global article reported.

Developer Sunac won court approval to restructure about $10 billion of offshore debt, in part by issuing creditors new notes and convertible bonds. The company did not say whether or how its Rmb1trillion of debt would be affected, an October 5 FT article reported.

Bucking this trend are Evergrande’s offshore creditors, who have petitioned a Hong Kong court to liquidate the company. However, the judge in the case postponed a hearing until January to give the property developer more time to propose a restructuring plan, a December 4 FT article reported.

Disruptive Technologies: Riding the AI Wave. Artificial intelligence (AI) definitely captured the public’s attention this year. All of a sudden, ChatGPT and other AI programs were available to the ordinary Joe for free, firing the imaginations of everyone from 13-year-olds with homework to do (or not?) to CEOs focused on using the technology to increase productivity.

Long-time tech watcher and former Andreessen Horowitz partner Benedict Evans made AI the subject of his annual presentation on macro and strategic trends in the tech industry. It’s worth a look, as is the video of a presentation he gave a year ago on the subject.

In the video, he suggests thinking about AI as an intern. If you employed 50 or 100 interns, what would you ask them to do to make work easier, faster, and more efficient? As with many interns, AI’s output needs to be checked given its proclivity to hallucinate, but that won’t eliminate the technology’s usefulness and ability to increase productivity.

In his presentation, Evans quotes Bill Gates: “In my lifetime, I’ve seen two demonstrations of technology that struck me as revolutionary … the [graphic user interface] and ChatGPT.” Graphic user interfaces (GUI) are the symbols on computer screens that allow you to do things, like open email or cut and paste copy, with the click of a mouse instead of having to write lines of code. GUIs made computers accessible to the everyman, eliminating the need for users to have a programing degree.

Now the question is: What will ChatGPT empower the ordinary Joe to do that once required specialized skills? Our kids know ChatGPT can turn them into writers, artists, and videographers. Companies seem to be harnessing the technology in their marketing departments and in chatbots to improve communication with customers. We’re sure that smart folks will continuously think of novel uses, giving us plenty to write about in 2024.

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Earnings: Yesterday, Today & Tomorrow

December 13 (Wednesday)

Earnings I: The Past. The Q3 earnings season is over, and the final numbers for S&P 500 companies are in. The results in aggregate were better than analysts had expected, which isn’t surprising when the economy is growing. Worse-than-expected results tend to occur when the economy is falling into a recession. Widespread concerns earlier this year that the economy would fall into a recession—which was not our outlook, as you know—have been largely alleviated.

Today, let’s do some time traveling. We’ll review the recent past—i.e., the Q3 results—then go back to the future by revisiting our forecasts for S&P 500 revenues per share, earnings per share, and the profit margin for 2023, 2024, and 2025. Then let’s conclude with a discussion of the outlook for the S&P 500’s forward earnings per share, forward P/E, and stock price index—including our newly announced S&P 500 target of 6000 for year-end 2025.

Here we go:

(1) Revenues. S&P 500 companies’ collective revenues per share rose to a record high for a second straight quarter in Q3 after dipping in Q1 from Q4-2022’s record, but the y/y gain slowed to an 11-quarter low of 5.0% from 7.1% in Q2 (Fig. 1 and Fig. 2). Inflation continued to boost the growth rate, but less so than in Q2—as the GDP price deflator rose only 1.7% in Q3 compared to 3.5% in Q2—but the inflation-adjusted revenues increase was still a solid gain.

(2) Earnings. S&P 500 earnings per share also rose to a record high in Q3, for the first time since Q2-2022, and its 4.6% y/y increase was its first y/y gain in four quarters (Fig. 3 and Fig. 4).

(3) Profit margin. We can calculate the S&P 500’s profit margin by dividing the index’s earnings by revenues (Fig. 5 and Fig. 6). The margin rose 0.8ppts q/q to a four-quarter high of 12.5%, which is up from 11.5% during Q4-2020. But it was still down from the record high of 13.7% during Q2-2021.

The just-ended earnings recession was very mild, with three back-to-back quarters of modest single-digit percentage declines on a y/y basis. There was no revenues recession. The earnings weakness of recent quarters has been entirely attributable to the decline in the profit margin due to cost-push inflation, and productivity has been weak because of unusually high turnover in the labor market, with record-high quits and job openings earlier in the year. However, the improvement in the profit margin during Q3 suggests those pressures are abating now.

Earnings II: The Present. The S&P 500 companies’ actual Q3 earnings per share turned out to be up 4.6% y/y, which was better than the 0.2% decline expected by industry analysts collectively at the start of the earnings season (Fig. 7).

Currently (as of the December 7 week), industry analysts project that S&P 500 earnings will be up 3.5% y/y during Q4, followed by quarterly gains in 2024 of 7.0% (Q1), 11.2% (Q2), 9.3% (Q3), and 17.8% (Q4) (Fig. 8). At the start of Q4, analysts had been expecting a 9.4% gain in Q4-2023 earnings. Since then, expectations were mostly cut at the drugmakers, auto manufacturers, and commodity-related industries in the S&P 500 Materials sector.

Like the economy, revenues and earnings have been experiencing a soft landing so far, and industry analysts as a group have not been slashing their forecasts. Currently, the analysts’ consensus estimates imply the following y/y revenues and earnings growth rates: for 2023 (2.1%, 0.7%), for 2024 (4.9%,11.2%), and for 2025 (5.4%, 12.4%) (Fig. 9 and Fig. 10).

The S&P 500 profit margin forecasts implied by analysts’ revenues and earnings estimates for 2023, 2024, and 2025 are stabilizing now after dropping at the start of this year. The latest readings for the three years are at 11.8%, 12.5%, and 13.4%. The bottoming of industry analysts’ implied margin estimates suggests they believe that the mini recession in earnings attributable to weakening profit margins is over. They may be right, with margins rising again.

As you know, Joe and I are big fans of weekly S&P 500 forward revenues per share and forward earnings per share as great coincident indicators of the actual quarterly series for S&P 500 revenues per share and earnings per share (Fig. 11 and Fig. 12). (Forward revenues and earnings are the time-weighted average of analysts’ estimates for the current year and the coming year.)

During the November 30 week (the latest data available), forward revenues was just 0.2% below its record high, hit during the November 2 week. But forward earnings has been hitting record highs regularly since the September 14 week—the longest string of successive weekly record highs since the June 16, 2022 week. The forward profit margin edged up during the December 7 week to a 13-month high of 12.7% (Fig. 13).

Earnings III: The Future. Now let’s turn to an update of our outlook for the S&P 500 companies’ collective revenues, earnings, and profit margin.

Since earnings have had a soft landing so far, rather than a hard one, we are expecting a U-shaped, rather than a V-shaped, earnings recovery. If we are surprised, then it’s likely to be because the recovery is more robust than we are projecting. If so, that would be attributable to higher profit margins, boosted by technology-driven productivity gains. Let’s think ahead:
 
(1) Revenues. We are projecting that revenues per share will increase 4.0% this year to $1,823, 4.0% in 2024 to $1,896, and 4.0% in 2025 to $1,970 (Fig. 14).

(2) Earnings. We project earnings per share will be $225 this year, $245 next year, and $270 in 2025 (Fig. 15). That’s been our forecast since summer 2022. (The final tally for 2022 was $218. We had been projecting $220.) We are now forecasting $300 in 2026.

(3) Profit margin. Our projections imply that the profit margin will fall from 12.4% in 2022 to 12.3% in 2023 and rise back to 13.2% in 2024 and 13.7% in 2025 (Fig. 16).
 
(4) Forward earnings. We are projecting that S&P 500 forward earnings per share will be $245 at the end of this year (currently $244), $270 at the end of next year and $300 at the end of 2025 (Fig. 17). Those are what we expect the analysts’ consensus earnings expectations then will be for 2024, 2025, and 2026. (At year-ends, forward earnings match the analysts’ projections for the upcoming year.)
 
(5) Valuation & S&P 500 ranges. Now let’s apply forward P/E ranges of 16.0-20.0 to our forward earnings projections to derive target ranges for the S&P 500 (Fig. 18). The range for 2024 is 4320-5400, and the range for 2025 is 4800-6000 (Fig. 19). Our year-end point estimates are 4600 by the end of this year, 5400 by the end of 2024, and 6000 by year-end 2025.

We acknowledge that our valuation multiple ranges are high historically. However, they reflect our expectations that the MegaCap-8 stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) will continue to account for a significant portion of the market cap of the S&P 500, and that they will continue to be highly prized by investors.

We are also seeing more reasons to believe in our Roaring 2020s scenario—the theory that productivity growth will stage a comeback, driven by widely implemented technological solutions to address the US’s chronic labor shortages, and rising productivity will propel economic growth to surprising heights.

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Global Economy Still In A Funk

December 12 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Global Economy: Secular or Cyclical Weakness? The global economy is growing, but at a slow pace. Much of the weakness is attributable to the recessions in China and Europe. US economic growth is slowing from Q3’s rapid pace. Much of the weakness is structural in China but cyclical in the US and Europe.

In 2024, China’s economic weakness is likely to persist and weigh on the global economy. But Europe should start to recover, as Melissa and I discussed last Wednesday. The US economy should continue to grow slowly, though we are inclined to anticipate upside surprises if productivity growth continues to make a comeback, as it did during Q2 and Q3 of this year. In our scenario, global inflation should continue to moderate. It might even fall to the 2.0% y/y rate targeted by the Fed for the US and the European Central Bank (ECB) for the Eurozone by the end of next year.

Yesterday, Debbie and I discussed the prospects for the economy over here. Today, let’s look at the outlook over there:

(1) Global growth indicators crawling. According to the Netherlands Bureau for Economic Policy Analysis, global industrial production rose 0.5% y/y through September. However, it has been basically flat since early 2022, though at a record high (Fig. 1). That’s when China was still imposing pandemic lockdowns, Europe’s economy was hit by the shocks from Russia’s invasion of Ukraine, and US consumers pivoted from buying goods to purchasing services. The volume of global exports has also been flat since early 2022, but also at a record high.

Since December 2021, industrial production and the volume of exports among advancing economies are down 1.3% and 1.2% (through September of this year, the latest data available) (Fig. 2). Both have been essentially flat. Over this same period, the production and exports of emerging economies are up 4.9% and only 0.1%. The industrial production index for the members of the Organization for Economic Co-operation and Development (OECD) has also been flat since the end of 2021 (Fig. 3).

(The OECD, with 38 member countries, was founded in 1961 to stimulate economic progress and world trade. The OECD includes the following countries: Australia, Austria, Belgium, Canada, Chile, Colombia, Costa Rica, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, South Korea, Latvia, Lithuania, Luxembourg, Mexico, Netherland, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, United Kingdom, and the United States.)

The weakness in both production and exports during 2022 can be attributed largely to global supply-chain disruptions. The New York Fed’s Global Supply Chain Pressure Index soared from 0.11 during October 2020 to 4.33 during December 2021 (Fig. 4). It was back down to 0.11 during October, the first reading above zero since January. Jammed ports and overwhelmed trucking systems depressed global production and exports during 2022. Inbound container traffic soared in US West Coast ports from mid-2020 through mid-2022 to new record highs (Fig. 5). It then dropped sharply during H2-2022 to pandemic lockdown levels. It has started to recover in recent months.

(2) Commodity prices remain weak. Commodity prices, especially those of industrial commodities and crude oil, have been weak, confirming that the global economy is weak. The price of a barrel of Brent crude oil has dropped 20% from September 27 through December 8 (Fig. 6). That’s despite output cuts by Saudi Arabia and Russia since the summer and despite the mounting tensions between the US and Iran because of the Gaza war.

The CRB raw industrials spot price index is down 21% from its most recent peak of 689.0 on April 4, 2022 to 541.4 on December 8, near its lowest level since February 8, 2021. The spot price of copper is included in the CRB index, and it is down 10.5% since January 26 on mounting evidence that China’s property crisis is worsening and weighing on Chinese growth. The price of copper is highly correlated with the China MSCI stock price index, which is down a whopping 56.7% since February 17, 2021 (Fig. 7).

(3) Global inflation moderating. Headline and core inflation rates peaked last October for the 38 member countries of the OECD at 10.7% and 7.8%, respectively (Fig. 8). They were down to 5.6% and 6.5% in October. Energy and food inflation among the OECD, which peaked last year at 40.8% and 16.1%, fell to -4.8% and 7.4% during October (Fig. 9). The headline and core CPI inflation rates for the G-7 countries peaked last summer at 7.8% and 5.5%; they were down to 3.4% and 3.9% in October.

Experience suggests that recessions are necessary to bring down inflation. Yet that’s not necessarily true, as inflation has fallen significantly in the US without a recession. However, inflation is a global phenomenon, especially the recent experience, which was largely triggered by the demand shock that overwhelmed goods markets around the world and their supply chains. That explains why goods inflation has dropped so quickly as soon as the buying binge for goods abated and the supply chains were normalized. Services inflation rates have been stickier, but they also are trending down.

Arguably, the US didn’t need a recession to bring inflation down because the recessions in China and Europe have done that job for it. Let’s turn to those two economies.

(4) China’s challenges. Jackie and I often have discussed the downsides of investing in China. The country prospered from the 1980s through 2013. That was the year that Xi Jinping became the president of China. A few years after assuming office, Xi turned increasingly hostile to the free market entrepreneurial spirit that his predecessors had embraced to stimulate widespread prosperity. The Chinese Communist Party (CCP) took back control of the economy. The problem is that the economy had spun out of control, particularly in the real estate sector.

Provincial governments raised revenues for infrastructure spending by selling land to developers who built ghost cities of empty apartments that were purchased by individuals as investments. The Chinese have a high saving rate and purchased stakes in trusts that are exposed to real estate. They also invested in the stock market. Recently, we’ve noted the significant negative wealth effect that China’s consumers are experiencing. As noted above, the China MSCI stock price index is down 56.7% since February 17, 2021. Apartment prices are falling in an illiquid market for such properties.

Just as China’s property market engine has stalled, so too has its export engine. The CCP’s hostile domestic policies toward entrepreneurs and belligerent foreign policies toward democracies have depressed foreign investments in China and China’s exports. The country is no longer viewed as a dependable business partner nor as a reliable source of goods, especially vital parts.

China’s exports have been flat since December 2021 through November of this year (Fig. 10). That partly reflects slower global economic growth. Imports have also been flat since March 2021. That undoubtedly reflects a weaker domestic Chinese economy.

(5) Europe’s shallow recession. Last week, Melissa and I reviewed the economic outlook for the Eurozone. It’s quite bleak currently, but we expect that more secure sources of energy, lower inflation, and lower interest rates will revive economic growth during H2-2024. The latest data suggest that the region is in a shallow recession currently. Real GDP fell 0.4% (q/q saar) during Q3 (Fig. 11).

The Eurozone’s Economic Sentiment Indicator suggests that GDP might be falling again during Q4. So does the volume of retail sales there, which has been falling since November 2021 (Fig. 12).

Also weighing on the region’s economic growth is the weakness in Germany’s manufacturing sector. Manufacturing orders fell 3.7% m/m and 7.3% y/y during October (Fig. 13). New orders were down in major sectors, including fabricated metal products, electrical equipment, and the key automotive industry. Machinery and equipment manufacturing orders dove 13.5% in October. Manufacturing production fell 0.4% m/m and 3.5% y/y.

As we wrote last week, we are expecting that the ECB will start easing its monetary policy next spring as inflation continues to moderate in the Eurozone. Both the 2-year and 10-year German government note yields dropped sharply in recent days to 2.80% and 2.27%, well below the ECB’s 4.00% deposit rate (Fig. 14).

Global Strategy: Go Home or Go Global? Joe and I continue to recommend overweighting the US in global portfolios. Europe should also be overweighted. We would remain underweighted in the emerging market economies—especially China, even though its stocks look relatively cheap at the current valuation of the China MSCI. On the other hand, India’s MSCI stock price index is at a record high partly because it is a primary beneficiary of China’s woes (Fig. 15). Here are a few related observations:

(1) The Stay-Home versus Go-Global MSCI stock price index ratios in dollars and in local currencies have been trending higher since 2010 (Fig. 16). Both are at or near their record highs during the 2021-22 period.

(2) Contributing to the outperformance of the US MSCI have been the various country indexes’ forward earnings (Fig. 17). The one for the US is up 264.3% since March 9, 2009, to a record high. Meanwhile, the other major market indexes’ forward earnings are up less than 100% over this period and have stalled below their record highs for the past two years. The US tends to have the highest forward profit margin of the major markets around the world (Fig. 18).

(3) The forward P/E of the US MSCI tends to be much higher than those of the other major MSCI markets (Fig. 19). That’s mostly because there are more growth stocks with higher valuation multiples in the former than in the latter. The forward P/E of the All Country World ex-US MSCI tends to track that of the S&P 500 Value index quite closely (Fig. 20). The two have diverged more than usual after the pandemic.

(4) The Emerging Market MSCI (in local currency) is highly correlated with the CRB raw industrials spot price index (in dollars) (Fig. 21). Given the lackluster outlook for global economic activity, industrial commodity prices are likely to remain depressed, suggesting not much upside for the Emerging Markets MSCI.

(5) The EMU MSCI, for the European Monetary Union, has been showing some relative strength in recent days as investors seem to believe that the ECB will be lowering interest rates before the Fed does so in 2024.

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Hard Luck For Hard Landers

December 11 (Monday)

YRI Bulletin Board. We are planning on launching our new website at the end of this week on December 15. You might have noticed that we already have cut over to a new design for our charts. We think they are more user-friendly and sharper looking.

We will be recharging our batteries for the new year from December 19 to January 2. We won’t be publishing the Morning Briefing during that period, nor will there be Monday webcasts. We do intend to stay connected with our QuickTakes.

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

The Fed: Tightening or Merely Normalizing? Based on November’s employment report released on Friday, Debbie and I can safely conclude that there is still no sign of an impending recession. The Godot recession is still a no-show. Our soft-landing (a.k.a. rolling recession) scenario remains intact, as it has since early last year. The diehard hard landers are still expecting a recession, as they have been since the Fed started to tighten in early 2022. But they now expect it in 2024 and mostly think that it will be a shallow recession.

The widely anticipated recession scenario has been based on a very simple and logical premise: The Fed started raising interest rates aggressively last year during May. Short-term and long-term rates have increased by at least 500bps through the summer (Fig. 1). That shocking pivot, following a very long period of ultra-easy monetary policy, must be a terrible shock for the economy, the thinking goes. While the “long and variable lags in monetary policy” have turned out to be longer and more variable this time, a recession will surely occur in 2024, the hard landers figure.

Additionally, the hard landers point out: The yield curve has been inverted since the summer of 2022 (Fig. 2). The Index of Leading Economic Indicators has been falling since it peaked at a record high during December 2021 (Fig. 3). The y/y growth rate of real M2 has been negative since May 2022 (Fig. 4). The real federal funds rate has soared from -8.46% during March 2022 to 2.09% during October (Fig. 5). All of them have been mostly accurate leading indicators of recessions in the past.

Yet contrary to this plausible argument, the economy has remained resilient and avoided a recession so far. Here we are in December 2023, and the unemployment rate remains below 4.0%. Full-time employment is at a record high (Fig. 6). So is payroll employment, which is one of the four components of the Index of Coincident Economic indicators (CEI). It is the first to come out every month and suggests that the CEI rose to yet another new record high in November, confounding the LEI’s followers (Fig. 7).

In recent months, we’ve provided several explanations for why the hard landers and their indicators have been wrong so far. (See, for example, “Captain America,” title of our November 8, 2023 Morning Briefing.) Here’s a new one: Perhaps the Fed hasn’t been tightening monetary policy so much as normalizing it. Interest rates are back to the Old Normal. They are back to where they were before the New Abnormal period between the Great Financial Crisis and the Great Virus Crisis, during which the Fed pegged interest rates near zero.

The normalization theory implies that the Fed might not lower interest rates next year as much as widely expected. That’s because the economy wouldn’t require as much easing to reverse the tightening after the tightening has done its job of bringing down inflation. If the economy remains resilient but inflation continues to fall closer to the Fed’s 2.0% target next year—both of which we’re expecting—then the Fed might lower the federal funds rate twice next year, by 25bps each time, instead of four times or more as widely anticipated. After Friday’s employment report, this was less widely anticipated.

US Labor Market I: Working for a Living. Friday’s employment report was bullish for November’s real personal income, real retail sales, and CEI. Each month when the report is released, Debbie and I calculate our Earned Income Proxy (EIP) for private-sector wages and salaries in personal income. All three of its components registered gains: Payroll employment in the private sector rose 0.1%, average weekly hours increased 0.3%, and average hourly earnings gained 0.4%.

So our EIP rose 0.8% m/m during November (Fig. 8). That undoubtedly well exceeded the month’s inflation rate, boosting the purchasing power of consumers. That should be reflected in a solid increase in the month’s retail sales and CEI.

Here are some other signs of labor market strength in November’s employment report:

(1) The household measure of employment also rose to a record high last month. In fact, it jumped by 747,000 to 162.0 million. Its full-employment component rose 347,000 to a record-high 134.8 million.

(2) The increase in household employment exceeded the 532,000 increase in the labor force. So the number of unemployed workers fell by 215,000 last month to 6.3 million (Fig. 9). The average duration of unemployment fell 10.2% to 19.4 weeks (Fig. 10).

(3) The labor force participation rate rose to 62.8%, matching its highest readings since February 2020 (Fig. 11). Despite the sharp increase in the labor force, the unemployment rate fell to 3.7%. It was down to just 3.4% for adults (Fig. 12).

(4) A closer look at the payroll measure of employment shows that lots of industries reported record payrolls along with the total measure. Particularly strong gains continue to be reported by private education & health services (99,000) and leisure & hospitality (40,000) (Fig. 13). On the other hand, the retail trade payroll count was particularly weak during November (-38,400).

US Labor Market II: Real Pay Gains. In the past, Fed Chair Jerome Powell has indicated that wage inflation would probably have to slow to 3.0% (from 4.0%-5.0% currently) to get to the Fed’s 2.0% target for price inflation. He addressed this issue in a November 30, 2022 speech titled “Inflation and the Labor Market.” Powell observed: “In the labor market, demand for workers far exceeds the supply of available workers, and nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time. Thus, another condition we are looking for is the restoration of balance between supply and demand in the labor market.”

That seems to be happening. Consider the following:

(1) Supply and demand. In his speech at the end of last year, Powell presented a clever chart showing the supply of labor as the labor force, and the demand for labor as the sum of employment plus job openings (with the latter pushed ahead by one month) (Fig. 14). It is showing that the demand for labor is down 700,000 since the start of the year, while the supply has increased by 2.5 million. Demand still exceeds supply by 2.4 million workers, but that’s down from a peak of 6.1 million during April 2022.
 
(2) Wages. Average hourly earnings (AHE) continued to moderate in November. It was down to 4.0% and 4.3% for all private-sector workers and for production and nonsupervisory workers (lower-wage workers), who account for about 80% of payroll employment. The AHE of higher-wage workers has been bouncing around 3.0% y/y since early 2022 (Fig. 15).
 
US Economy: GDP vs GDI. Then again: USA TODAY Economics and Jobs Reporter Paul Davidson observed in a December 1 story that while Q3’s real GDP was revised up to an annual rate of 5.2%, real gross domestic income (GDI) is up just 1.5%. It “has grown feebly over the past year even while GDP has advanced solidly. Over the past four quarters, GDP has increased 3% while GDI has fallen 0.16%.” Davidson concluded that maybe the economy “isn’t so resilient after all.”

In theory, GDP should equal GDI since the former measures the demand for goods and services, while the latter measures the income available for purchasing those very same goods and services. In practice, there is always a statistical discrepancy. During Q3, real GDP was 2.6% higher than real GDI, the highest discrepancy since 1993 (Fig. 16).

The discrepancy is even greater between nonfarm business output (NFBO), which jumped 6.1% (saar) during Q3, and GDI. The former is the series used to measure productivity.

(Business sector output is a chain-type, current-weighted index constructed after excluding from GDP the following outputs: general government, nonprofit institutions, and households [including owner-occupied housing]. Nonfarm business, which excludes farming, accounted for about 76% of GDP in 2022.)

So which is it? Are the economy and productivity as resilient and strong as suggested by NFBO and GDP, or are they both as weak as suggested by GDI? Economists tend to pick data that support their story. The hard landers love the GDI story. We are prone to that bias, but we do our best to be balanced and tell you both sides of the story, as we are doing now. Some economists simply take the average of GDP and GDI. For now, we see plenty of evidence to stick with our views that the economy is resilient and productivity growth is making a comeback. The stock market seems to agree with us.

Movie. “Reptile” (+) (link) stars Benicio Monserrate Rafael del Toro Sánchez in this crime drama, which is almost as long as his name. The plot is interesting but is a bit too slow paced. Then again, Del Toro is always fun to watch. His understated intensity is ever-present in the roles he plays. This movie is about a murder, real estate agents, drugs, and cops. Alicia Silverstone and Justin Timberlake have parts, but they don’t add much to the movie.

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Onshoring, Acquisitions & Octopus

December 07 (Thursday)

Industrials: Onshoring’s Ripple Effects. In phase one of the onshoring wave, many large companies announced plans to take advantage of tax breaks and open new manufacturing facilities in the US. Manufacturers in the solar, semiconductor, and chemical industries have been among the most aggressive in taking advantage of so-called Bidenbucks, the dollars and tax breaks available through the CHIPS and Science Act, the Inflation Reduction Act, and the Infrastructure Investment and Jobs Act.

Now comes phase two. Suppliers are following their large customers and building new manufacturing plants in the US of A as well. The process is well underway in Arizona, where Taiwan Semiconductor Manufacturing is spending $40 billion to build two massive plants, the first of which is expected to open in 2025. In upstate New York, where Micron Technologies has committed to building four plants, the green shoots are visible as well.

The development of these new semiconductor ecosystems as well as manufacturing plants in other industries has contributed to the surge in spending on manufacturing structures. It was up 66.4% y/y during Q3 to a record high; in the first three quarters of 2023, such spending rose 43.3% y/y (Fig. 1). That strength has boosted new orders for construction equipment, which rose 6.7% y/y during October to the fourth highest reading on record (Fig. 2).

All this building has led to more jobs. The number of Americans working in manufacturing has risen to 13.0 million as of October, according to the Labor Department. That’s higher than the prior peak in 2019 and brings manufacturing employment back to a level last seen in 2008 (Fig. 3). Likewise, record numbers of folks are working in heavy and civil engineering construction, 1.1 million in October, and in construction, 8.0 million as of October (Fig. 4 and Fig. 5).

Here’s a look at some of the companies building the semiconductor ecosystems in Arizona and New York:

(1) Arizona’s success story. Taiwan Semiconductor first announced plans to build a $12 billion semiconductor plant in Arizona in 2020. Two years later, it doubled down, expanding that project to two plants costing $40 billion. The project hit some bumps this summer, with squabbles erupting over workers being brought in from Taiwan and the opening pushed back a year to 2025; but otherwise, it’s progressing. Intel is also in the process of building two fabs in Arizona with a $20 billion price tag.

These huge commitments have given suppliers confidence to move to Arizona as well. Since the Taiwan Semi news, 27 semiconductor industry-related companies have announced plans to move to the Phoenix area or have bought or leased property there, a September 10 article on azcentral.com reported. The new businesses have attracted new residents, and builders are building new apartment units to house them.

One semi supplier is Solvay, which announced plans last year to invest in a new facility to produce electronic-grade hydrogen peroxide that cleans silicon wafers, a July 26, 2022 company press release stated. The company, which has other factories in the US, purchased 25 acres of land in Arizona and planned to begin construction this year. Taiwan-based Chang Chun also announced plans in 2022 to produce in Arizona electronic-grade hydrogen peroxide and other solutions for the semiconductor industry. Its first US manufacturing facility is expected to cost $300 million and create 200 jobs.

Yield Engineering Systems develops and manufactures thermal, deposition, and wet process equipment used in semiconductor, life sciences, and display manufacturing. It leased a 123,000-square-foot facility in Arizona in May 2022 to house operations that cater to the semiconductor industry, a May 2022 press release from the local municipality states. The ribbon-cutting was in July 2023.

KPCT Advanced Chemicals, a joint venture between Taiwan-based Kanto Group and Chemtrade Logistics in the US, is building an electronic-grade sulphuric acid manufacturing plant in Arizona over 10 acres. It too will supply the semiconductor industry and is expected to be operational by 2025, a November 2022 press release from the Arizona Commerce Authority states.

Many other industries are building new factories in the state as well. Arizona boasts a $675 million plant being built by Nestle USA to produce creamers. Virgin Galactic is building a manufacturing facility to produce as many as six Delta-class spaceships per year. Proctor & Gamble is building a $500 million manufacturing plant to support its fabric care business by 2025, a January 10 article in Engineering News Record.

(2) Upstate NY bets on semis. Manufacturers like General Electric, Kodak, and Carrier have exited or sharply reduced their operations in the upstate New York area in recent decades, forcing many folks relocate if they want to make a decent living. So it was big news when Micron Technology announced in October 2022 that it would spend $100 billion over the next 20 years to build semiconductor plants in Clay, New York, just north of Syracuse. Construction is expected to begin in 2024 on the first of four plants that should be operational by 2030 and employ 3,000 people directly.

Micron anticipates hiring 9,000 people eventually, when all the fabs are constructed, and 41,000 additional jobs are expected to be created by other businesses supplying the company and its employees with everything from materials to maintenance and restaurants, a July 6 MIT Technology Review article reported.

A handful of other semiconductor businesses have cropped up in upstate New York as well. In November 2022, Edwards Vacuum, a UK-based manufacturer of vacuum and abatement equipment for the semiconductor industry, announced plans to develop a $319 million dry pump manufacturing facility in Genesee County, about two hours west of Clay. That follows the April 2022 opening of Wolfspeed’s $1 billion silicon carbide chip plant north of Utica. The chips initially will be used in electric vehicles (EVs) produced by Lucid and General Motors, a May 2, 2022 article in the Utica Observer-Dispatch reported.

New York State is hopeful that more semi suppliers will brave the New York winters. Governor Kathy Hochul announced $40 million in grants to develop shovel-ready tracks of land on which semiconductor suppliers could build plants. “Employers want to know that the permits are in place, the infrastructure is right, and work can begin almost immediately because time is money," Hochul said according to an August 15 article on WXXI News.

To help meet the region’s future need for qualified labor, Syracuse University plans to expand funding for its College of Engineering and Computer Science by 50% over the next five years or so. Onondaga Community College is also creating two new degree programs.

Time will tell whether New York is as successful as Arizona.

(3) Industrials benefit. All this manufacturing activity has helped boost the S&P 500 Industrial sector’s stock price index by 9.6% ytd through Tuesday’s close. Here’s how Industrials’ ytd performance stacks up against that of the S&P 500 and its other sectors: Information Technology (50.2%), Communication Services (45.3), Consumer Discretionary (34.5), S&P 500 (19.0), Industrials (9.6), Financials (4.7), Materials (4.1), Real Estate (2.5), Health Care (-3.3), Consumer Staples (-4.8), Energy (-6.2), and Utilities (-11.7) (Fig. 6).

The Industrials sector would have performed even more admirably had it not been dragged down by some of the defense contractors, airlines, and air freight & logistics industries. Here’s how some of the best performing industries within Industrials have fared ytd through Tuesday’s close: Industrial Machinery (16.0%), Electrical Components & Equipment (15.9), Industrial Conglomerates (14.1), Construction Machinery & Heavy Trucks (11.5), and Aerospace & Defense (0.4) (Fig. 7).

The S&P 500 Industrials sector is expected to grow revenue by 4.3% this year and 4.8% in 2024, while earnings for the sector are projected to increase 14.2% in 2023 and 11.1% next year (Fig. 8 and Fig. 9). The sector’s forward P/E, at 18.4, is toward the upper end of its range of 11 to 26 over the last decade (Fig. 10).

Financials: A Glimmer of Hope. In recent days and weeks, we’ve noticed that reports of large mergers and acquisitions (M&A) seem to have picked up. Executives at some of the largest banks, while still couching their comments, sounded just a touch more optimistic about the M&A deal environment as well.

“M&A deals are coming a little faster," Bank of America CEO Brian Moynihan told a Goldman Sachs conference, a Reuters article reported on Tuesday. As the interest-rate environment stabilizes, there will be more scope for dealmaking, he added. The bank’s investment banking fees of about $1 billion in the current quarter will be down y/y at percentages in the low single digits but are still expected to outperform the industry average.

Goldman Sachs CFO Denis Coleman said that a lot of clients have appetites for strategic deals but that the high cost of funding has kept private equity firms cautious about undertaking them, Reuters reported.

Here are some of the deals that caught our attention in a wide array of industries:

(1) Health care. Cigna is in merger talks with Humana to create a $140 billion giant that combines a huge pharmacy benefit management operation with the second largest Medicare Advantage business. Roche agreed earlier this month to buy Carmot Therapeutics, an obesity drug developer, for $2.7 billion. Meanwhile, AbbVie is paying $10.1 billion in cash to buy ImmuoGen, which has an antibody drug that fights ovarian cancer.

(2) Oil patch. Occidental Petroleum is reportedly in talks to buy shale company CrownRock. Meanwhile, ExxonMobil has offered to acquire Pioneer Natural Resources for $59.5 billion in stock, but the deal could face a bumpy road if the Federal Trade Commission’s recent request for additional information is any indication.

(3) Airlines. Alaska Air Group has offered $1.9 billion to acquire Hawaiian Airlines. The offer was made even as the Justice Department sued to block JetBlue Airways’ $3.8 billion offer to buy Spirit Airlines. The parties are awaiting a judge’s decision.

(4) Odds ’n ends. Steel manufacturer Cleveland-Cliffs is in negotiations to buy US Steel, while Neiman Marcus has turned down Saks Fifth Avenue’s $3 billion acquisition offer after months of negotiations. Talks between the two retailers reportedly continue.

Disruptive Technologies: Introducing Octopus. Windmills always seem to be painted white, so pictures of several purple and hot pink windmills towering outside of the Dubai venue of the big international climate change conference COP28 demanded further attention. They were installed by Octopus Energy, a privately held British company that’s trying to turn the electric industry on its head. It’s attempting to manage the intermittency of solar and wind energy by deploying storage solutions, incentivizing consumers to use electricity when renewable energy is at peak production, and rolling out smart software to manage it all.

The company has its tentacles in many different areas. Here’s a quick look at some of them:

(1) Green production. Octopus owns wind and solar projects in 15 countries, including the UK, France, Finland, Sweeden, and Australia. On Monday, it announced an agreement to develop up to five wind turbines and solar panels with batteries in Sierra Leone in partnership with actor Idris Elba and Siaka Steven’s development company, Sherbro Alliance Partners.

(2) Electricity provider. Octopus sells electricity to consumers and to businesses. It installs heat pumps, EV chargers, smart meters, and other hardware in residential homes. Consumers get the opportunity to invest in that local green energy generation; and if they live near a wind turbine, consumers can receive a 20% discount on electricity used when the wind is blowing most actively. The same goes for solar. The model incentivizes consumers to use electricity when it’s the most available and cheapest for Octopus to provide it.

The company is working with British property developers, telling them how many solar panels to put on a home and what sizes of battery, heat pump, and water heater are necessary to install. The company provides homeowners with a license to consume the solar energy provided and guarantees that they won’t receive an electric bill for 10 years.

(3) EV lessor. Another program Octopus offers gets EVs into consumers’ driveways. Companies can lease EVs from Octopus to offer as employee perks; employees can buy the EVs they’re using over time with a portion of their gross salary. As part of the deal, they receive a free home charger, insurance, car maintenance, and free home charging on the first 4,000 miles driven. The payroll deductions allow employees to save on National Insurance (the UK’s social security system) and income tax, the company’s website explains.

(4) Software manages it all. Perhaps Octopus’ most valuable arm is Kraken Technologies. It offers a software operating system that utilities use to manage and optimize energy production and consumption. Its software also manages customer information, billing, meter data management and offers AI-powered communication and automation.

Intelligent Octopus is a Kraken-powered retail offering that helps British customers max out their renewable electricity use when power is abundant and cheap. “Speaking on a panel at COP28, [Octopus Energy’s founder and CEO Greg Jackson] said that the previous day more than half a million Octopus customers were paid to use less electricity at peak times, which was ‘the equivalent of turning off the entire energy consumption of two cities,’” according to a December 4 article in the Australian Financial Review. As a result, Octopus doesn’t have to buy expensive coal-generated electricity during peak periods. It creates a “virtual power plant” that’s growing 24% m/m in the UK.

The company is selling the Kraken software internationally. On Tuesday, Octopus announced a trial with Abu Dhabi National Energy Company; and last June, the company struck its first US deal with Tenaska Power Services.

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Over There & Over Here

December 06 (Wednesday)

Europe I: Winter Advisory Lifted. Melissa and I foresee brighter days on the horizon for Europe. Our expectation of a resurgence in economic growth as early as spring 2024—contingent on inflation receding and the European Central Bank (ECB) halting its monetary policy tightening—may be starting to materialize.

Earlier, we had advised caution, suggesting that it might be wise to weather the chilly season in European markets, as we were concerned about potential challenges to the region’s energy resilience. However, our optimism has increased along with the gas in the region’s storage facilities.

Our primary concern now shifts to how well the European economy will adapt as fiscal support diminishes, which we’ll continue to monitor. Energy subsidies played a crucial role during the early stages of the Russian-Ukraine conflict, and pandemic-related supports prevented a severe recession. However, the energy shortages and fiscal supports also sparked inflation. The ECB’s tight monetary policy since has cooled inflation but also has slowed economic growth. We anticipate a reversal of the ECB’s tightening measures in the spring, providing the necessary momentum for an economic upswing.

For forward-thinking investors, now seems to be an opportune time to reenter the European equities market. Despite a surge in Europe’s MSCI Index by 8.5% in euro terms during H1-2023, investor enthusiasm waned during the summer, with a slip of 8.5% from the peak on April 21 to a recent low on October 27 (Fig. 1). Yet there has been a 7.4% rebound since then through Monday’s close.

Despite the upturn, the MSCI price index remains reasonably valued. The forward P/E has hovered around 12 since early this year. This is notably lower than in 2021 when the multiple was near 16 before European equities dropped, reflecting uncertainties during Russia’s invasion of Ukraine and concerns about energy stability. We anticipate further valuation increases as Europe’s energy situation stabilizes and interest rates begin to fall.

Europe II: ECB Tames Inflation. In Europe, both growth and inflation are in retreat—an outcome of the ECB’s ten consecutive interest-rate hikes since July 2022, culminating in a pause at a 4.0% main deposit rate in its October 26 meeting. If the current inflation trend persists, Melissa and I think the ECB could initiate rate cuts as early as spring, setting the stage for later-year growth. While we are not banking on that yet, we are willing to bet that the most recent season of ECB hikes is over. Key points:

(1) Growth stalls. The Eurozone’s real GDP growth contracted by 0.1% q/q Q3, influenced by headwinds from high inflation, elevated interest rates, and a less supportive fiscal environment (Fig. 2). This raises the likelihood of a technical recession if the weakness extends into Q4. Germany recorded a notable 0.1% quarterly decline, while France, Spain, and Italy narrowly escaped contraction.

(2) Inflation eases. The Eurozone’s inflation continued its descent in November, marking the seventh consecutive month moving toward the ECB’s 2.0% y/y target from levels above 10.0% a year ago (Fig. 3). Headline consumer price inflation dropped to 2.4% y/y from October’s 2.9%, with nearly all items declining except for processed foods. Core inflation—excluding food, energy, alcohol, and tobacco—eased faster than expected, dipping to 3.6% y/y from 4.2%, driven by a significant drop in services prices.

(3) ECB assesses. Last week, ECB President Christine Lagarde argued that victory over high inflation could not yet be declared, as inflation could stage a comeback owing partly to rapid nominal wage growth. Indeed, despite economic contraction, unemployment remains at a record low (Fig. 4).

However, inflation appears to be falling more rapidly than anticipated by the ECB. Yesterday, Isabel Schnabel, ECB board member and formerly hawkish, informed Reuters that further interest-rate hikes are off the table due to a “remarkable” fall in inflation. However, she cautioned that surprises could occur in either direction and said that forecasting a cut several months out might be premature.

Europe III: Competing Developments. Europe has encountered contrasting economic developments, marked by resilience in addressing the recent gas crisis contrasted with fiscal challenges. Here’s more:

(1) Full capacity. Europe has managed to overcome the feared gas shortages that had been expected to spill over from the Russian-Ukrainian war. In fact, inventories peaked at 99.6% full on November 6, reported Reuters. This exceeds the 89.0% average of the previous decade by over 10ppts, positioning the region well for winter. Even under extreme conditions, projections suggest that inventories will remain substantial—at a minimum of 35% full—which is testament to the effectiveness of Europe’s strategic gas management.

However, this success is tempered by the challenge of coping with higher gas prices over the medium term. Europe faces a shift from relatively inexpensive Russian pipeline gas to costlier liquefied natural gas from diverse sources, including Asia.

(2) Fiscal quandary. On the fiscal front, the European Union (EU) is grappling with divergent views on new fiscal rules, with a consensus unlikely in 2023 and negotiations extending into 2024, reported Reuters. Germany, traditionally fiscally prudent, faces its own crisis due to recent legal rulings threatening €60 billion ($66 billion) in climate spending, as recently discussed in The Economist. This jeopardizes domestic demand, the energy transition, and geopolitical goals.

Germany’s insistence on stringent fiscal guidelines for all EU members further complicates the situation, as other countries seek a more flexible approach. The EU’s Stability and Growth Pact, suspended since 2020, is set to be reinstated in 2024, reflecting the post-pandemic reality of higher public debt and the imperative for increased climate-related investments.

The pact imposes limits on budget deficits (3% of GDP) and debt (60% of GDP), with potential disciplinary action for noncompliance. Many European governments currently exceed those thresholds.

Strategy: The Growth Versus Value Gap. The S&P 500 has rallied sharply since its bottom on October 27, leaving behind the summer swoon on fears of a “higher for longer” interest-rate policy. The index’s surge since October 27 began as those interest-rate fears waned, with the initial phase led by Growth stocks, primarily the MegaCap-8 (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla). That rally has broadened out since November 13 following the release of October’s CPI. Higher-for-longer fears have given way to rising expectations of an economic soft landing, and various jobs-related data releases have even stoked hopes of interest-rate cutting in 2024.

The S&P 500 Value and Equal Weight indexes are benefitting from those changes in perception. So are more of the S&P 500’s sectors. The increasing breadth is welcome news for investors who were left behind when the MegaCap-8 dominated the S&P 500’s performance for much of 2023 following last year’s bottom on October 12 (Fig. 5).

(1) Value now leads Growth following CPI’s release. Since November 13, the S&P 500 Value index has risen 5.4%, more than double Growth’s 2.1% gain. Value’s strong performance has vaulted the index into the top spot for performance during the rally since October 27: Value’s gain has improved to 12.5% from a 9.8% rise for the now-lagging Growth index. In fact, the S&P 500 Value index closed at a record high on Friday
(Fig. 6)!

In contrast, the S&P 500 stands (as of Monday’s close) 4.7% below its January 3, 2022 record high of 4796.56. The Growth index has fared worse by this measurement: It remains mired in a 14.9% correction from its record high on December 27, 2021.

(2) Equal Weight index surging now. Since November 13, the S&P 500 Equal Weight index has jumped 6.9%, nearly double the 3.6% rise for the S&P 500’s market-weighted index (Fig. 7). Comparing the two indexes’ gains since October 27, Equal Weight still beats the market-weighted index but not by nearly as much: Its 12.3% rise compares with the latter’s 11.0% rise (Fig. 8).

(3) Sector breadth is improving too. Prior to the release of the October CPI on November 14, 10 of the S&P 500’s 11 sectors were up from the index’s October 27 low through November 13. However, just four sectors were ahead of the index then: Communication Services, Consumer Discretionary, Financials, and Information Technology. Three of these sectors, all but Financials, are home to the MegaCap-8 group of stocks.

The release of the October CPI upset that order. While the number of sectors rallying since October 27 has dropped to nine as of Monday’s close, five are now ahead of the S&P 500. Some of LargeCap’s traditional Value sectors—e.g., Financials, Real Estate, and Industrials—have surged since then, while Growth-oriented Communication Services and Information Technology have faltered.

Here's how the S&P 500’s 11 sectors have performed since November 13: Real Estate (12.0), Financials (6.7), Materials (6.3), Industrials (6.0), Utilities (5.8), Consumer Discretionary (4.9), Health Care (3.9), S&P 500 (3.6), Consumer Staples (2.3), Information Technology (1.9), Energy (-0.2), and Communication Services (-0.2).

That strong performance since November 13 has increased the number of sectors outperforming the S&P 500 since October 27 to five. Here’s their performance ranking since October 27: Real Estate (18.0), Financials (14.6), Consumer Discretionary (13.9), Information Technology (13.4), Industrials (12.6), S&P 500 (11.0), Materials (9.5), Communication Services (8.5), Health Care (7.1), Utilities (7.0), Consumer Staples (6.3), and Energy (-1.1) (Fig. 9).

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A Remarkably Resilient Economy

December 05 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
US Economy I: Construction Is Booming. The US economy has been remarkably resilient in the face of the Fed’s aggressive tightening of monetary policy since early last year. One of the sectors that accounts for that resilience is the construction industry. In the past, rising interest rates always depressed construction, which exacerbated the resulting recessions (Fig. 1 and Fig. 2). This time, the weakness in residential construction has been offset by relatively strong private nonresidential and public construction (Fig. 3 and Fig. 4). Here’s more:

(1) Private residential construction. While single-family housing construction has been weak, that weakness has partially been offset by record spending on multi-family construction and near-record spending on home improvements, which are almost as large as spending on single-family construction (Fig. 5 and Fig. 6).

(2) Private nonresidential construction. Many of the components of nonresidential construction spending are at or near their record highs, including education, highway & street, amusement & recreation, commercial, and office (Fig. 7 and Fig. 8). The strength of the last two categories is surprising. They might weaken with a lag (maybe in 2024) in response to the tightening of credit conditions during 2022 and 2023. But for now, they are a source of economic strength.

Off the charts is construction spending on manufacturing facilities because of the increase in onshoring owing to federal incentives (Fig. 9). In current dollars, it is up a whopping 71.6% and 136.8% on one-year and two-year bases.

(3) Public construction. Most of the major categories of public construction spending are also at or near their record highs (Fig. 10). Here are their y/y growth rates through October: power (55.9%), sewage & waste disposal (27.2), office (18.1), education (16.5), water supply (15.3), highway & street (12.7), and transportation (8.6).
 
(4) Construction employment. Payroll employment in the construction industry occasionally has been a leading economic indicator and often has been a coincident indicator of the business cycle. So it tends to fall during recessions. There’s no sign of a recession in construction employment currently. It has been rising to fresh record highs since May 2022 (Fig. 11). Employment is strong across all the major building trades, including residential, nonresidential, and heavy & civil engineering (Fig. 12).
 
(5) Related stock indexes. Since the October 27 low in the S&P 500, the stock price index of its Real Estate sector has recovered nicely. So have the stock price indexes of the various S&P 500 REITs (Fig. 13). Here is their performance derby since then through Friday’s close: Office (26.1%), Telecom Tower (25.1), Industrial (21.5), Single-Family Residential (18.2), Self-Storage (17.9), Hotel & Resort (17.7), Real Estate sector (17.3), Retail (16.5), Broadline (15.1), and Data Center (15.1).

US Economy II: Surveys Suggest Goods Recession Is Bottoming. The rolling recession in the goods producing sector of the economy shows signs of bottoming and should transition into a rolling recovery next year. For now, the latest data suggest that the sector may be bottoming:

(1) M-PMI composite. November’s national composite M-PMI remained below 50.0 for the 13th month in a row (Fig. 14). However, it bottomed at 46.0 in June and has remained slightly above that low through November. The regional M-PMI bottomed in May at -16.5 and rose to -4.7 in November.

(2) M-PMI orders. A V-shaped recovery is more discernible in the national and regional orders sub-components of the M-PMI surveys  (Fig. 15). Both bottomed in May. They’ve recovered since then and should be back in growth territory early next year, in our opinion.

(3) Supply-chain index. The rolling recession in the goods producing sector has been the pause that refreshes. It has taken the kinks out of global supply chains. The New York Fed’s Global Supply Chain Pressure Index, which starts with 1998 data, fell from a record high of 4.3 at the end of 2021 to a record low of -1.7 during October (Fig. 16). That’s helped significantly to lower goods inflation over the period.

US Economy III: Record Corporate Cash Flow. The economy’s resilience can also be attributed to the awesome ability of US corporations to generate cash flow. It totaled a record $3.4 trillion (saar) during Q3-2023 (Fig. 17). That’s despite the pressure on companies’ profit margins coming from high labor costs and higher interest rates over the past couple of years. Here are a few related stats:

(1) Corporate cash flow is up 4.1% y/y, with tax-reported depreciation up 6.9% and undistributed profits down 3.3%. The latter has been relatively flat since Q3-2009.

(2) After-tax corporate profits from current production was down 1.7% during Q3, with dividends down 0.9% and undistributed profits down 3.3% (Fig. 18).

(3) The dividend payout ratio using after-tax profits from current production was 67.9% during Q3 (Fig. 19).

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Ho! Ho! Ho!

December 04 (Monday)

YRI Bulletin Board. We will be recharging our batteries for the new year from December 19 to January 2. We won’t be publishing the Morning Briefing during that period, nor will there be Monday webcasts. We do intend to stay connected with our QuickTakes.

We are also planning on launching our new website before the end of this year. You might have noticed that we already have cut over to a new design for our charts. We think they are more user-friendly and sharper looking.

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy: It’s Starting To Look a Lot Like a Santa Claus Rally. Our Wednesday, November 1 QuickTakes was titled “Halloween Is Over. Is Santa Here Already?” Joe and I wrote: “It’s possible that the S&P 500 bottomed today.” In fact, it bottomed a few days earlier on Friday, October 27. On November 5, we wrote: “We are seeing reindeer, so Santa may not be far behind. We may be back on track to hit 4600 by the end of this year.”

The S&P 500 closed at 4594.63 on Friday, up 11.6% since then and only 4.2% below its record high on January 3, 2022 (Fig. 1). Joe observes that the S&P 500 Value stock market index rose to a new record high on Friday (Fig. 2)! Breadth improved dramatically on Friday, as the S&P 500 equal-weighted index rose 1.5% while the market-cap weighted index rose 0.6% (Fig. 3 and Fig. 4).

The rally in stocks has been fueled by the rally in the fixed-income markets. The 2-year Treasury note yield peaked at 5.19% on October 18 and fell to 4.56% on Friday. Over this same period, the 10-year yield fell from 4.91% to 4.22% (Fig. 5).

What changed since October 27? The price of crude oil has been falling since September 27, reducing anxiety about inflation and decreasing the price of gasoline, which has increased consumers’ purchasing power. The broad measures of inflation have continued to moderate. Economic indicators have been weaker than expected, as evidenced by the fall in the Citibank Economic Surprise Index in recent weeks, increasing the odds of a soft-landing following the blowout 5.2% jump in Q3’s real GDP (Fig. 6).

Nevertheless, labor market indicators have remained strong, with plenty of job openings amidst a chronic labor shortage. That keeps consumers spending but companies paying up for workers or making do with fewer of them (and seeking technological solutions to doing so). Industry analysts are expecting that S&P 500 earnings will increase 11.3% in 2024 and 12.0% in 2025 (Fig. 7). S&P 500 forward earnings per share—i.e., the time-weighted average of analysts’ consensus estimates for the current and following years—has been rising to new record highs since the September 14 week.

Also different since October 27: Market participants have gained more confidence that the Fed is done raising interest rates, so much so that their focus now is on when and by how much the Fed might cut rates next year. The 12-month federal funds rate futures fell sharply on Friday to 4.21% (Fig. 8). Also: China’s economic woes are reducing the prices of US imports from China and reducing the likelihood that China will invade Taiwan for a while. The Gaza war hasn’t turned into a major regional war so far.

US Economy I: A Third Year of Living (Not So) Dangerously. So why is Jamie Dimon still so pessimistic? The economy got strong marks from JP Morgan’s CEO in a January 10, 2022 CNBC interview: “The consumer balance sheet has never been in better shape,” said the banking industry giant. Stock prices, home prices, and wages are up. Debt balances are down, savings are up, and job openings are plentiful. Business confidence is high, and balance sheets are solid. The market may be volatile, he noted, but the underlying economy is strong, and if we’re lucky the Fed will engineer a soft landing.

Then on June 1, 2023, CNBC’s Hugh Son reported that Dimon had these words of warning for analysts and investors attending a financial conference in New York: “You know, I said there’s storm clouds, but I’m going to change it … it’s a hurricane.” Son wrote that Dimon went on to say that “[w]hile conditions seem ‘fine’ at the moment, nobody knows if the hurricane is ‘a minor one or Superstorm Sandy,’ … ‘You’d better brace yourself. … JPMorgan is bracing ourselves, and we’re going to be very conservative with our balance sheet.’”

On October 2 of this year, Dimon told Bloomberg TV it’s possible that the central bank will continue hiking rates by another 1.5 percentage points, to 7%. Dimon stressed that this may be the most dangerous time the world has seen in decades and that the wars between Ukraine and Russia and between Israel and Gaza could have far-reaching impacts on energy and food supply, trade, and geopolitical relationships. They could even, he said, lead to “nuclear blackmail.”

Now Dimon seems to be ignoring all the reasons to be optimistic. Last Wednesday, he said, “A lot of things out there are dangerous and inflationary. Be prepared.” He said so at the 2023 New York Times DealBook Summit in New York. “Interest rates may go up and that might lead to recession,” he added.

US Economy II: Consumer Spending at Record High. Since last year, Dimon has been saying that consumer spending was boosted by excess saving accumulated during the pandemic. He has been saying that they soon will run out of that purchasing power and be forced to retrench, causing a consumer-led recession.

At the DealBook Summit, Dimon said that stimulus money handed out during Covid shutdowns and quantitative easing by the Federal Reserve had injected “drugs directly into our system” and caused an economic “sugar high.” But that’s fading, in his opinion.

October’s stats on consumer incomes, saving, spending, and saving were released last Thursday. In our opinion, they show a consumer who continues to enjoy increases in real income and to spend it. Consider the following:

(1) Consumer spending in real GDP. The Atlanta Fed's GDPNow tracking model shows that real consumer spending growth has fallen from Q3's 3.6% to 2.7% saar during Q4. That’s still a solid growth rate.

(2) Sources of income. In real personal income, wages and salaries as well as unearned income (interest, dividends, rent, and proprietors’ income) rose to record highs in October (Fig. 9). During the second half of last year, real average hourly earnings resumed its upward trend that started during the mid-1990s (Fig. 10). Payroll employment rose to yet another record high in October (Fig. 11).

(3) Personal saving and net worth. The personal saving rate remained relatively low at 3.8% during October (Fig. 12). That’s down from a recent peak of 5.3% during May, and 7.7% during February 2020, just before the pandemic. Consumers may still be depleting their excess saving as Dimon contends. Or else, we may see an extended period with a low saving rate because household net worth rose to a record high of $154.3 trillion during Q3, up $37.6 trillion since Q4-2019, just before the pandemic (Fig. 13). The values of the various asset classes held by households are either at or near recent record highs (Fig. 14).

(4) Record spending on. Americans continue to spend lots of money on services. Either at or near recent record highs are outlays on health care ($3.1 trillion saar), food services ($1.2 trillion), air transportation and hotels & motels ($0.4 trillion), and fun-related services ($0.4 trillion) (Fig. 15, Fig. 16, Fig. 17, and Fig. 18). Job openings and hirings remain elevated in these booming service-providing industries.

On the other hand, housing-related purchases on furniture & furnishings and household appliances have weakened since early last year (Fig. 19).

US Economy III: Inflation Recedes. Stocks rallied last Thursday on the news that October's PCED inflation rate continued to moderate. The headline and core rates fell to 3.0% and 3.5% y/y (Fig. 20). Most importantly, the inflation rate of PCED services excluding energy and housing is falling. It has been stuck around 5.0% in 2022 and earlier this year. But it was down to 3.9% y/y in October (Fig. 21). Even rent inflation, its stickiest component, is moderating (Fig. 22).

Fed Chair Jerome Powell and his colleagues have said that they are concerned about the stickiness of this “super-core” measure of inflation. Now they should be less concerned, as it seems to be coming unstuck.

Movie. “The Holdovers” (+) (link) is about a curmudgeonly instructor of ancient history at a New England all-boys prep school. Much to his chagrin, he is picked by the school’s headmaster to watch over a few of the students who have nowhere to go during the Christmas break. The teacher, played to perfection by Paul Giamatti, and one of the students get to know and understand one another and themselves better. The message is that some people aren’t as bad as they seem once you are forced to spend some time with them.

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MegaCap-8, AI & Gates On Climate Change

November 30 (Thursday)

Technology I: MegaCap-8 Closing in on Record. Don’t look now, but the MegaCap-8’s capitalization is within spitting distance of a new record high. The group of eight stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) collectively is up 78.7% from its 18-month low on January 5 through Tuesday’s close. That leaves its capitalization only 1.7% below its previous record set in December 2021, Joe calculates (Fig. 1). And in terms of the percentage of the S&P 500’s total capitalization the MegaCap-8 represents, it has never been higher, at 27.9% (Fig. 2).

Some of the individual stocks’ ytd price gains are even more remarkable than the group’s aggregate advance. Here are how the members of the MegaCap-8 have performed ytd through Tuesday’s close: Nvidia (227.2%), Meta (181.7), Tesla (100.3), Amazon (75.0), Neflix (62.4), Microsoft (59.6), Alphabet (56.2), and Apple (46.5).

The MegaCap-8’s forecasted long-term earnings growth rate (LTEG) has also risen this year, to 41.0%, up from 13.5% at the start of 2023 (Fig. 3). The LTEG estimate owes most of its surge to Nvidia’s booming AI chip sales. Nvidia’s LTEG estimate is 112.8%, up from 21.3% earlier this year and 6.7% before the pandemic.

Despite the surge in stock prices, the growing optimism about future earnings growth has meant the group’s forward P/E has increased only modestly this year. It stands at 27.9, well above the low of 21.1 at the start of this year but well below the high of 38.5 in August 2020 (Fig. 4).

Here are the forward P/Es for the members of the MegaCap-8: Tesla (64.9), Amazon (42.3), Microsoft (32.0), Netflix (30.9), Apple (28.6), Nvidia (25.0), Alphabet (20.7), and Meta (19.8) (Fig. 5). (FYI: “Forward P/Es” are the multiple based on forward earnings, or the time-weighted average of analysts’ consensus operating earnings-per-share estimates for this year and next.)

Technology II: Checking in with Google. The executive drama at ChatGPT has captured headlines in recent weeks, keeping the spotlight off other artificial intelligence (AI) providers. But that doesn’t mean that Alphabet—a.k.a. Google—isn’t making progress with its AI offerings. Here’s a look at some of the new ways the company is using AI and some of the steps it’s taking ahead of the 2024 elections.

(1) Google’s AI learns new tricks. Google’s interest in AI dates back at least to 2014 when it acquired DeepMind Technologies reportedly for around $600 million. The company’s most recent investment is in Anthropic, which was founded by former ChatGPT employees. After investing $500 million in the startup earlier this year, Google invested another $500 million into the firm and may add another $1.5 billion over time, a WSJ article reported on October 27.

Alphabet is expanding the use of AI throughout its offerings. It’s using AI to make it easier for users to search their email inboxes, a June 2 CNBC article reported. Users will see “top results” above the “all results” section. Top results will be picked by Google’s AI to display the most relevant emails. The company also plans to use AI to automate advertising and ad-supported customer services, a May 17 CNBC article reported.

Google’s DeepMind researchers believe they have found a more efficient and automated method of designing computer chips using AI. They’ve also announced an AI vision-language-action model that can help train robots to do things like throw out the trash. And their protein-structure-prediction AI can hunt for the genetic mutations in a person’s proteins that are likely to cause health problems, a September 21 Scientific American article reported.

Most recently, DeepMind AI has made strides in materials science. It has discovered 2.2 million new crystal structures that may be used in areas that range from renewable energy to advanced computation. Researchers will winnow the structures down to 381,000 of the most promising for further testing, a November 29 FT article reported. The news illustrates how much faster AI was able to make successful discoveries.

(2) Google preps for the elections. AI will face a large test next year during the campaigns for the presidential and congressional elections. The technology’s ability to create and distribute false ads will face off against Internet providers’ abilities to detect and identify or eliminate those ads. Google announced that election ads running on its platforms created with or altered by AI will have to carry a clear disclosure.

“Election ads that have been digitally created or altered must include a disclosure such as, ‘This audio was computer-generated,’ or ‘This image does not depict real events,’” a September 7 CNBC article reported. Minor changes do not require disclosure. The article did not state how Google will know if the ad is AI created if it is not voluntarily disclosed.

Google’s former CEO Eric Schmidt is concerned. “The 2024 elections are going to be a mess because social media is not protecting us from false generated AI,” he told CNBC on June 26. “They’re working on it, but they haven’t solved it yet.” Free speech should be allowed on social media for humans, not computers, he noted. And social media companies should mark all their content accordingly, as either human or computer generated.

Disruptive Technologies: Bill Gates on Climate Change. COP28, the world’s annual climate conference, kicks off today, with politicians, scientists, and executives gathering in the United Arab Emirates (UAE). Despite the surge in renewable energy projects, the world is on track to miss the Paris Agreement’s goals of reducing greenhouse gases by roughly 50% by 2030 to limit global warming to 1.5 degrees Celsius.

While Rome burns, expect COP28 attendees to squabble over whether the world should phase out all fossil fuels and whether it should aim for zero emission of carbon dioxide (CO2). Arguments also are expected to revolve around how much funding rich countries should give poor countries to reduce their CO2 emissions.

There’s also controversy surrounding the meeting’s President-Designate Sultan al-Jaber, who also happens to be the head of the Abu Dhabi National Oil Company and chair of the state-owned renewable energy company, Masdar. Papers reportedly indicate that UAE officials planned to pitch the country’s oil and gas business to foreign government officials attending the event, a November 27 BBC article reported.

While President Joe Biden plans to skip the meeting, tech mogul Bill Gates will attend with many of the companies that the Bill & Melinda Gates Foundation has helped to fund and develop. His investment vehicle, Breakthrough Energy, has invested about $2 billion in 100 companies focused on reducing CO2 emissions, and it’s raising another $1 billion of funding.

As you’d expect, Gates approaches climate change like a tech businessman. He assumes that most consumers will not pay more to buy products that are environmentally friendly. Nor does he believe that consumers will buy less or travel less in order to reduce emissions.

As a result, he aims to develop technologies that allow consumers and companies to continue to operate as they do today, while reducing or eliminating their CO2 emissions at no additional cost. When consumers can buy an electric vehicle for less than a gas vehicle, you’ll see mass adoption. “[W]e really do have to acknowledge that this is a world of finite resources. And the one thing that’s magic in this world is … innovation,” he said in a wide ranging interview with the FT on November 3.

Breakthrough Energy recently published State of the Transition 2023, which touches on industry trends in many areas of green energy. In his forward, Gates highlights three that he believes could accelerate efforts to reduce greenhouse gasses: harnessing hydrogen, preparing the grid for surging electricity demand, and carbon sequestration. Here’s a brief look at each area:

(1) Harnessing hydrogen. Lots of work is being done to determine how hydrogen can be used in many areas of the fuel ecosystem. For example, it would be ideal if extra wind or solar power could be used to make hydrogen, which then could be stored in fuel cell batteries until the electricity is needed. Unfortunately, the process is costly.

Breakthrough Energy has invested in a number of companies that are developing alternatives for storing electricity. Malta takes electricity from the grid and uses a heat pump to convert it to thermal energy. The heat is stored in molten salt, and the cold is stored in a chilled liquid antifreeze coolant. The process can be reversed when the grid needs electricity. Form Energy, a company we’ve mentioned in past Morning Briefings, approaches the problem by storing electricity for up to 100 hours in an iron-air battery that converts iron into rust and then reverses the process. Antora stores electricity as heat in solid carbon blocks.

Because of its energy intensity, hydrogen might also be the cost-effective alternative fuel for trucks, ships, and planes. However, scientists need to determine how it can safely be transported and stored and then to develop a distribution system. Engineers are also creating electrofuels, or e-fuels, by pulling carbon out of the air with direct capture technology and combining it with hydrogen. The process, however, is far more expensive than traditional fuel production processes.

(2) Fortifying the grid. In a zero-carbon world, people in 2050 may use triple the amount of electricity used today, the report states. Gas- and coal-fired electric plants that power our homes, offices, and factories will be replaced by green electric power production. Additional capacity will also be needed to charge electric vehicles. Storing and transmitting intermittent solar- and wind-generated electricity “will require big, modernized, and interconnected electric grids. Right now those don’t exist.”

The report contends that if the grid isn’t updated, 80% of the green investments being made by the Inflation Reduction Act will go unrealized. The grid’s transmission capacity needs to be increased by 60% by 2030 and by 200%-300% by 2050. A grid update needs to include the addition of more high-voltage lines that can carry electricity long distances to connect regions and communities. Digital systems will need to be added to make the grid smart, adaptable, and efficient. Fortunately, the technology exists. Unfortunately, no one wants high transmission lines in their backyards, so permitting hurdles may stand in the way of modernization.

(3) Seizing the carbon. Gates and Breakthrough seem skeptical about capturing carbon from the air and pumping it underground because doing so requires energy and is very expensive. Unless the cost is reduced dramatically, companies won’t pay up for that unless new taxes compel them to do so.

Until the price of carbon capture falls, it’s more effective not to emit CO2 in the first place. Even then, carbon capture will have a roll. It will be needed to reduce the CO2 that has been emitted for a century and remains trapped in the atmosphere. It may also be used in industrial activities that can’t go green economically. In that case, governments theoretically would tax any CO2 emissions at a rate high enough to push the companies to pay for the carbon capture needed.

Breakthrough is invested in Heirloom, which uses carbon mineralization to take carbon out of the air at a lower cost. The company places ground-up limestone on trays, and the limestone passively pulls CO2 out of the air. Fully CO2-saturated limestone is put inside an electric kiln to separate the CO2 and pump it underground. The process uses “significantly” less heat and power than direct air carbon capture technologies.

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Breaking Good

November 29 (Wednesday)

Strategy I: From Fear to Less Fear. Investors were very fearful near the end of last year. They mostly feared that inflation would be persistent, forcing the Fed to raise interest rates still higher until a credit crunch and recession occurred. Wouldn’t you know it? These fears were most intense when the stock market bottomed on October 12, 2022.

One metric we use to assess investor fear is the Investor Intelligence Bull/Bear Ratio. It bottomed last year at 0.57 during the October 17 week (Fig. 1). This past summer, it rebounded to 3.06 during the July 10 week, just in time for a 10% correction in the S&P 500 that occurred from July 31 through October 27. During the November 21 week, it was at 2.36, which is a relatively neutral reading. The comparable AAII Bull/Bear Ratio followed the same script (Fig. 2).

Another interesting sentiment index is the stock-prices-lower-in-12-months series included in the monthly consumer confidence survey conducted by The Conference Board. From a contrarian perspective, it is a bit more bullish, with 36.1% of respondents expecting stock prices to be lower in 12 months according to the latest November survey (Fig. 3).

The current consensus outlook is less fearful than it was a year ago. The widespread view is that the Fed is done raising interest rates because inflation is heading in the right direction (i.e., down toward 2.0%) and that this could continue to happen without a credit crunch and recession. The drop in gasoline prices since September has been a welcome development that will help to moderate inflation and avert a recession (Fig. 4).

Geopolitical fears have also abated somewhat. Last Wednesday, China’s President Jinping Xi delivered a very dovish speech in San Francisco, as we discussed yesterday. China’s economy is a mess, reducing the risk that Xi and his comrades will invade Taiwan anytime soon. Israel and Hamas would like to destroy one another but were able to negotiate a truce for a few days to exchange Israeli hostages for Palestinian prisoners. So far, Hezbollah hasn’t joined the war.

The big debate now seems to be when and by how much the Fed will lower interest rates. The federal funds rate peaked just before eight of the past 10 recessions (Fig. 5). It plunged during all of them. The optimists (including yours truly) aren’t expecting a recession through the end of 2024, so we expect that any rate cutting by the Fed next year will be limited, maybe to two to four cuts of 25bps each. The diehard hard-landers expect that a recession in 2024 will force the Fed to cut the federal funds rate significantly. Russia’s war against Ukraine hasn’t been as threatening to the global economic outlook as it was last year.

With the benefit of hindsight, 2023 has been a year of nothing to fear but fear itself. In 2024, we may have to worry that there isn’t enough fear to temper investor optimism.

As noted above, the consumer confidence survey for November was released on Tuesday morning. The Consumer Confidence Index (CCI) was up slightly at 102.0 (Fig. 6). The percentage of respondents reporting “jobs plentiful” remained relatively high at 39.3% (Fig. 7). The “jobs hard to get” response rose to 15.4% in November from a recent February 2023 low of 10.5%, suggesting that the unemployment rate may continue to edge up as in recent months (Fig. 8).

Strategy II: Earnings Heading Our Way. Also breaking good since the end of 2022 has been the outlook for S&P 500 operating earnings per share. There was lots of pessimism over the past year, with a few influential Wall Street strategists predicting that this year’s result could break bad, i.e., below $200. We stuck with our projections of $225 for this year and $250 for 2024, which seemed farfetched (if not delusional) late last year. But then again, we were in the soft-landing camp, not the hard-landing one.

Let’s compare our forecasts to the latest consensus of industry analysts:

(1) 2023 & 2024 quarterly consensus. There was another earnings hook during Q3’s earnings reporting season. S&P 500 earnings per share turned out to be 4.1% better than expected at the start of the season (Fig. 9). However, Q4’s estimate was cut by more in response to cautious guidance by company managements as well as to the impact of the United Auto Workers’ strike. The quarterly consensus estimates for 2024 have been mixed recently (Fig. 10).

(2) 2023 & 2024 annual consensus estimates. The annual consensus estimates for 2023 and 2024 have been relatively stable so far this year. They were $220.85 and $245.98 during the November 23 week (Fig. 11). Both are about $4.00 below our forecasts (Fig. 12). Joe and I are sticking with our projections for now.
 
Strategy III: Estimate Revisions Activity Turns Negative. Last week, LSEG released its November snapshot of industry analysts’ consensus estimate revisions activity over the past month. While the company provides raw data for all its polled measures, we focus primarily on the revenues and earnings forecasts. We use these data to create our Net Revenues Revisions Index (NRRI) and Net Earnings Revisions Index (NERI), captured in our S&P 500 NRRI & NERI chart book.

There, the analysts’ estimate revisions activity is indexed by the number of upward revisions in forward earnings less the number of downward ones, expressed as a percentage of total forward earnings estimates. A zero reading indicates that an equal number of estimates were raised as were lowered over the past three months. We capture this activity over the past three months because that timespan encompasses an entire quarterly reporting cycle. Since analysts tend to revise their estimates to different degrees at different points in the three-month cycle, the three-month data are less volatile—and misleading—than a weekly or monthly series would be.

November’s NRRI and NERI readings come at the end of the quarterly reporting cycle, when analysts typically adjust their financial models to take into account management’s future guidance along with the just-released results. The indexes show that more analysts now are cutting than raising their revenues and earnings forecasts. That’s an about-face from earlier in 2023 when the majority were raising their revenues forecasts following the Q4-2022 season and their earnings forecasts after Q2-2023.

While that may seem to be bad news, the current readings reflect a return to normal revision activity following the extended period of abnormally high positive revisions resulting from the recovery from the pandemic shutdowns.

Furthermore, NRRI and NERI measure the net percentage of estimates raised or lowered without regard for how much those estimates were changed. While the greater cutting than raising indicates that analysts are a bit less bullish than they had been before the Q3 earnings season, that’s not to say they aren’t bullish: Their consensus y/y growth rate forecasts for revenues and earnings remain solidly positive for all of the quarters through the end of 2024.

Joe highlights what’s most notable about the November crop of revisions data below:

(1) S&P 500 NERI turns negative again. The S&P 500’s NERI index was negative in November for the first time in seven months as it weakened to a seven-month low of -5.3% from 0.6% in October (Fig. 13). November’s release is up from a 30-month low of -15.6% in December 2022 and is below the average reading of -2.2% seen since March 1985, when the data first were calculated. Looking at recent trends since the pandemic, NERI had been positive for 23 straight months from August 2020 to June 2022, and was then negative for the next 10 months through April 2023 as analysts posited that the Fed’s aggressive monetary policy would hurt earnings.

(2) Nearly all sectors now have negative NERI. There was just one S&P 500 sector with positive NERI in November, Energy (Fig. 14). That’s down from five sectors with a positive reading in October and September and down from a 13-month high of seven sectors during July. November marked the lowest count of sectors with positive NERI since April, when all 11 sectors were negative.

Looking at November versus October NERI data, all 11 sectors’ NERI weakened. The last time that all 11 sectors’ NERIs weakened on a m/m basis was in October 2022. This compares with eight sectors posting a NERI that declined m/m in October 2023.

(Such broad-based deterioration is a far cry from all 11 sectors’ NERIs improving m/m in May; but that month was unusual, as analysts then were scrambling to raise forecasts after Q1 earnings reports revealed broad-based strength. In fact, May’s revisions activity marked the broadest earnings improvement among the sectors in two and a half years, since September 2020.)

To highlight the good news about the S&P 500 sectors’ November NERI readings, nearly all remained above their lowest levels earlier in 2023. Only the Consumer Staples sector bucked that trend, with its NERI at a 13-month low.

Here’s how NERI ranked for the 11 sectors in November: Energy (11.4%, two-month low), Information Technology (-1.0, seven-month low), Communication Services (-2.6, seven-month low), Consumer Discretionary (-5.0, eight-month low), Financials (-5.1, four-month low), S&P 500 (-5.3, seven-month low), Utilities (-5.6, seven-month low), Industrials (-5.6, 10-month low), Consumer Staples (-10.1, 13-month low), Real Estate (-10.7, seven-month low), Materials (-11.2, three-month low), and Health Care (-12.5, 10-month low).

(3) S&P 500 NRRI index for revenues is negative again and at 11-month low. The NRRI index dropped for the S&P 500 to an 11-month low of -7.5% in November from -0.1% in October and is down from a 12-month high of 5.0% in July (Fig. 15). November’s negative reading is the second straight one after eight positive monthly readings through September. It comes on the heels of six straight negative readings from August 2022 to January 2023. The S&P 500’s NRRI now is below the average -0.2% reading since the index was first compiled in March 2004.

(4) NRRI index now negative for 10 sectors. NRRI’s m/m performance was about the same as that of the NERI index by all measures but one: Energy’s NRRI improved m/m versus none with improving NERI (Fig. 16).

Looking at the 11 sectors’ NRRI levels, slightly more than half remained above their 2023 lows. Among those that sank below their 2023 lows, Consumer Staples’ November NRRI reading was at a 43-month low, followed by Financials (41-month low), Real Estate (36-month low), and Utilities (30-month low).

Here’s how the sectors’ NRRIs ranked in November: Energy (14.1%, 13-month high), Utilities (-0.6, 30-month low), Industrials (-2.3, 10-month low), Real Estate (-4.6, 36-month low), Financials (-5.0, 41-month low), Health Care (-7.1, 10-month low), S&P 500 (-7.5, 11-month low), Information Technology (-8.3, 10-month low), Consumer Discretionary (-9.3, 11-month low), Communication Services (-12.4, seven-month low), Consumer Staples (-19.1, 42-month low), and Materials (-20.2, three-month low).

(5) Less Energy in S&P 500’s NRRI and NERI. Since the Energy sector can be especially volatile in terms of revisions activity, hiding trends in the broad S&P 500 index, we also like to look at the data with Energy’s data sliced out. Without the Energy sector, the S&P 500’s November NRRI reading falls to an 11-month low of -8.3% from -0.4% in October and its November NERI is negative for a second month, dropping to a six-month low of -6.3% from -0.1% in October.

As we discussed in the October 25 Morning Briefing, there are several possible reasons for the recent weakness in the revisions data. The impact of higher interest rates is now starting to be reflected in estimate revisions. Also, waning inflation may be lowering revenues as well as impacting companies’ pricing power and ultimately their earnings.

October’s NRRI and NERI readings were very close to the zero mark that indicates equal numbers of estimates rising and falling, and the index’s m/m comparisons were down only slightly; they weren’t collapsing. That suggested to us then that analysts collectively were generally satisfied with their forecasts. That takeaway had all the earmarks of a nice, gentle soft-landing, as we wrote on October 25. Now with a second month of higher net estimate cuts than increases, has our opinion changed? No. While November’s large drop could be seen as worrisome, it’s not cause for alarm, since earnings and revenue growth rates are expected to remain positive through the end of 2024.

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Xi’s New Open-Door Policy

November 28 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

China I: Gee, Why Does Xi Want To Play Nice? China’s economy is in a property-led and fertility-led depression. That’s bad news for China’s people and for the Chinese Communist Party (CCP) but benefits countries that import Chinese goods at depressed prices. China’s bad news is good news for the US in particular, helping to moderate goods inflation. It would be in China’s interest to attract more foreign direct investment to shore up its economy. To achieve that, the Chinese government may have to become less confrontational in matters of foreign affairs, especially vis-vis Taiwan.

That backdrop might explain why Chinese President Xi Jinping delivered a very dovish speech in San Francisco on Wednesday, November 15 at the “Welcome Dinner by Friendly Organizations in the United States” that was framed to curry favor with America and not very subtly. He started by expressing his “sincere thanks to the National Committee on U.S.-China Relations, the U.S.-China Business Council, the Asia Society, the Council on Foreign Relations, the U.S. Chamber of Commerce and other friendly organizations for hosting this event. I also want to express my warm greetings to all American friends who have long committed to growing China-U.S. relations and my best wishes to the friendly American people.”

The tone of the speech remained warm and fuzzy to the end. Xi nostalgically recalled how General Claire Lee Chennault led a group of American volunteers, known as the “Flying Tigers,” to the battlefield in China against Japan during World War II. He mentioned the word “door” twice:

(1) “I am convinced that once opened, the door of China-U.S. relations cannot be shut again. Once started, the cause of China-U.S. friendship cannot be derailed halfway. The tree of our peoples’ friendship has grown tall and strong; and it can surely withstand the assault of any wind or storm.”

(2) “The door of China-U.S. relations was opened by our peoples. For 22 years, there were estrangement and antagonism between our two countries. But the trend of the times brought us together, converging interests enabled us to rise above differences, and the people’s longing broke the ice between the two countries.”

His comments harken back to the “Open Door Policy” statement of principles initiated by the United States in 1899 and 1900 for the protection of equal privileges among countries trading with China and in support of Chinese territorial and administrative integrity.

Xi declared: “China is ready to be a partner and friend of the United States. The fundamental principles that we follow in handling China-U.S. relations are mutual respect, peaceful coexistence and win-win cooperation.”

That’s all fine. However, what about China’s island-building in the South China Sea, threats to invade Taiwan, systematic repression of ethnic minorities in Xinjiang and Tibet, and unfair business and trade practices? They weren’t mentioned. Nor was the Law on Foreign Relations of the People’s Republic of China and the Anti-Espionage Law of the People’s Republic of China, both of which went into effect in July. The former increases the risk of prosecution for complying with sanctions against China imposed by other countries—like the US—if China believes the sanctions are counter to international law. The latter grants broad powers to the state to demand information from businesses operating in China and expands the definition of activities the government considers espionage.

With rising tensions between China and most other developed nations, it’s no wonder that foreign direct investment in China has come to a screeching halt. According to a November 17 article by VOA’s Rob Garver, in Q3-2023, direct investment liabilities in China’s balance of payments—a figure that tracks the movement of money connected to foreign companies—was a negative $11.8 billion. It was the first time since data collection began in 1998 that the figure was not in positive territory.

Obviously, Xi would like American capitalists to invest in China. As discussed in the next section, China’s economy is in deep trouble. The good news is that might deter Xi and his CCP comrades from invading Taiwan anytime soon. Prices are falling in China’s depressed economy, which is helping to bring inflation down in the US and other countries that still import lots of Chinese goods. This partly explains why inflation is moderating in the US without a recession (what we call “immaculate disinflation”).

Xi even resorted to panda diplomacy during his November 15 speech. He said, “Pandas have long been envoys of friendship between the Chinese and American peoples. We are ready to continue our cooperation with the United States on panda conservation.” If relations improve between China and the US, he might send back a few pandas that were recently returned to China.

China II: Big Negative Wealth Effect. The collapse of China’s property market continues. According to a November 15 Bloomberg post, new-home prices (excluding state-subsidized housing) in 70 cities declined 0.4% m/m in October and 0.3% m/m in September, National Bureau of Statistics figures showed. October’s decrease was the steepest since February 2015. The Bloomberg data show that new and second-hand home prices are down 3.4% and 9.3% at the end of October from their August 31, 2021 peaks.

The problems for the property market—which along with related industries accounts for about 20% of China’s economy—began in 2020 when authorities laid out “three red lines.” Those rules set leverage benchmarks that builders had to meet if they wanted to borrow more money. China’s property crisis has engulfed almost all the largest developers. They have been struggling to repay debts and complete projects since a credit crunch emerged three years ago.

Such policies were intended to help curb years of excessive debt-fueled expansion by builders and property speculation by homebuyers. But they wound up tipping a record number of developers into default as refinancing costs surged.

The Shenzhen Real Estate stock price index peaked during 2020 on July 6. It is down 52.5% since then through Friday (Fig. 1). The China MSCI is down 54.5% since February 17, 2021 (Fig. 2).

Now there are signs of cracks in China’s shadow banking system. On Monday, several employees of Zhongzhi Enterprise were arrested. The privately held conglomerate operates several businesses that sold investment products to many wealthy individuals and companies in China; it has struggled for months to make promised payments to investors.

With home prices and stock prices falling, China’s consumers are experiencing a significant negative wealth effect on their spending. That is a particularly painful experience for China’s older population.
 
China III: Rapidly Aging Population. The Chinese economy is also weighed down by its rapidly aging population. Chinese consumers are likely to spend less and save more to offset the erosion of their wealth as their holdings in real estate and stocks depreciate. Here are a few updates on China’s demographic profile:

(1) In 2022, there were 956,000 births in China, the lowest on record (Fig. 3). That’s down 50% from 10 years ago.

(2) The fertility rate (births per woman) has been below 2.00 since 1991. It was down to only 1.16 in 2021 (Fig. 4). The Chinese aren’t having enough babies to replace themselves.

(3) As a result, the population is shrinking (Fig. 5 and Fig. 6). It peaked during 2021 at 1.41 billion. It declined by 850,000 during 2022, the first decline since 1961.
 
US Consumers: Mortgage-Free & Shopping. Since early 2022, the diehard hard-landers have been predicting that consumers will retrench once they run out of the excess saving that they accumulated during the pandemic. We’ve countered that there are lots of people with substantial net worth saved for retirement. Now many of them are retiring.

There has never been a generation with as much in their retirement nest eggs as the Baby Boomers. Indeed, this cohort holds about half the $154.3 trillion in US household net worth (Fig. 7).

The Baby Boomers and other households have lots of their net worth in their houses. During Q2-2023, household residential real estate totaled $44.5 trillion, matching the Q2-2022 record high (Fig. 8). Household mortgages totaled $12.8 trillion, resulting in a near-record $31.6 trillion in owners’ equity.

Since the Great Financial Crisis, the value of homes has increased faster than mortgage debt. As a result, on average, homeowners own 71.1% of their homes, up from 45.9% in Q1-2012.

Now here is the punch line: According to a November 17 Bloomberg post,” The share of US homes that are mortgage-free jumped 5 percentage points from 2012 to 2022, to a record just shy of 40%, or 35 million households. More than half of these owners have reached retirement age. Freedom from mortgage debt gives them the option to age in place—or uproot to sunnier climes.”

They also have the freedom to spend more of their earned and unearned income (such as interest and dividends) since they are free from having to pay a monthly mortgage fee. And of course, many of the 50 million homeowners with mortgages refinanced them at record-low rates during the pandemic. So their monthly payments are low.

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Update: Another Roaring Twenties May Still Be Ahead

November 27 (Monday)

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

Productivity I: The Doubters. Is the stock market starting to discount our Roaring 2020s scenario? We think so, though we are biased, as that scenario has been our longer-term outlook since August 11, 2020, when we first outlined it in our Morning Briefing titled “Another Roaring Twenties May Still Be Ahead.” In our opinion, our upbeat scenario seems more credible now than it did in 2020 when the pandemic was disrupting all our lives.

Nevertheless, we continue to receive pushback from lots of doubters:

(1) Disrupting productivity. The doubters claim that the data have yet to convincingly confirm our underlying thesis that technological innovation is already boosting productivity growth and real incomes much as it did during the Roaring 1920s. They note that disruptive technologies often take a while to boost productivity. At first, such technologies perversely may disrupt productivity growth as they’re just starting to proliferate. In other words, the transition from old to new technologies may not be a smooth one. The doubters rightly observe that the previous productivity growth boom, during the second half of the 1990s, was also attributable to a technology revolution, yet productivity growth fizzled out during the 2000s through the mid-2010s.

(2) Hard-to-solve labor shortage problem. Our basic premise is that technology solves economic problems, particularly shortages. The latest (19th) edition of Economics (2010) by Paul Samuelson and William Nordhaus teaches students that economics “is the study of how societies use scarce resources to produce valuable goods and services and distribute them among different individuals.” This definition hasn’t changed since the first edition of this classic textbook was published in 1948.

In my Predicting the Markets (2018), I countered: “I’ve learned that economics isn’t a zero-sum game, as implied by the definition. Economics is about using technology to increase everyone’s standard of living. Technological innovations are driven by the profits that can be earned by solving the problems posed by scarce resources. Free markets provide the profit incentives to motivate innovators to solve this problem. As they do so, consumer prices tend to fall, driven by their innovations. The market distributes the resulting benefits to all consumers. From my perspective, economics is about creating and spreading abundance, not about distributing scarcity. In other words, don’t worry, be happy!”

Our basic assumption is that technology is solving the biggest economic problem we are facing, i.e., a chronic global shortage of labor, by boosting productivity. The doubters doubt that it is doing so or will. The shortage of skilled workers is particularly acute. Currently available technologies aren’t up to the challenge of replacing workers or augmenting the skills of available workers. Besides, there are lots of hyped up claims about what new technologies such as artificial intelligence (AI) can do. So say the doubters.

Meanwhile, the labor shortage may be about to be solved by the tsunami of illegal immigrants. However, they are mostly unskilled and straining the resources of state and local governments. While immigration was a source of economic growth in the past (including during the 1920s), this time it might be more disruptive than stimulative.

(3) The coming debt crisis. The doubters tend to believe that a much bigger economic problem than the shortage of labor is the looming debt crisis attributable to ballooning federal deficits. They have a good point. US fiscal policy is on a recklessly unsustainable path. However, that’s mostly a political problem, which can be solved easily enough if there is enough political will to do so. Unfortunately, it’s hard to find any such willingness currently.

Part of the solution to mounting deficits is better-than-expected economic growth with lower-than-expected inflation. A productivity growth boom can accomplish that remarkable feat. In the not-too-distant future, AI, automation, and robotics will produce more and more of the goods and services currently produced by workers. That may very well generate enough profits to pay for a basic universal income scheme and provide enough tax revenues to put fiscal policy on a more sustainable path.

(4) Messy climate change transition. Another major challenge for productivity is the bumpy transition from fossil fuels to renewable sources of energy. The federal government is implementing subsidies and penalties to force the reallocation of capital investments from the former to the latter. Governments have a poor record of allocating resources, especially compared to free markets.

For example, Detroit has responded to the government’s pressure by spending lots of capital on EVs only to find that consumers aren’t widely embracing this new technology. Government subsidies have stimulated most of the sales of these relatively expensive alternatives to gasoline-powered vehicles (GVs). Perversely, there are enough EVs on the road today to reduce the demand for gasoline, which lowers the price of gasoline and makes EVs an even less compelling alternative to GVs!

Productivity II: Is Tech Ready for Primetime? Jackie and I have been writing about disruptive technologies for some time, usually in our Thursday Morning Briefing commentaries. (See our archive of Disruptive Technologies Briefings.) The awesome range of futuristic “BRAIN” technological innovations includes biotechnology, robotics and automation, artificial intelligence, and nanotechnology. There are also significant innovations underway in 3-D manufacturing, EVs, battery storage, blockchain, and quantum computing.

Consider the following stats on technology capital spending in the US: High-tech spending on IT equipment, software, and R&D rose to a record $1.84 trillion (saar) during Q3-2023 (Fig. 1). It has hovered around a record 50% of total capital spending in nominal GDP since the pandemic, up from about 25% during 1980 (Fig. 2). During Q3-2023, R&D accounted for 20.2% of capital spending in nominal GDP, while software represented 17.2% and information processing equipment 12.1% (Fig. 3 and Fig. 4).

I first started to write about the High-Tech Revolution in 1993. In 1995, I wrote a Topical Study titled “The High-Tech Revolution in the US of @.” I argued that technology capital spending was another reason to believe that the productivity growth trend was likely to rise, which implied that inflation could continue to fall even as the unemployment rate fell below levels that many traditional macroeconomists believed might revive inflation. During the second half of the 1990s, productivity growth did increase significantly. However, much of that was attributable to the boom in the output of computers and communications equipment (Fig. 5). Of course, spending on software also boomed.

The first wave of the High-Tech Revolution boosted the productivity of the tech sector, which experienced booming demand for hardware and software. However, it had a limited impact on the productivity of other businesses. That’s because the gains applied mostly to companies that could replace lots of secretaries on IBM Selectric typewriters with Microsoft Word and lots of bookkeepers with Microsoft Excel spreadsheets. On the other hand, companies using the new technologies needed large IT departments to install and maintain their new PCs and software programs.

In Predicting the Markets, I observed: “In the past, technology disrupted animal and manual labor. It sped up activities that were too slow when done by horses, such as pulling a plow or a stagecoach. It automated activities that required lots of workers. Assembly lines required fewer workers and increased their productivity. It allowed for a greater division of labor, but the focus was on brawn. Today’s ‘Great Disruption,’ as I like to call it, is increasingly about technology doing what the brain can do, but faster and with greater focus.” That’s what the BRAIN technologies do.

As a result, the second wave of the Great Disruption is much more widespread because the associated new technologies available are more powerful, cheaper, more user friendly, and require fewer IT personnel to install and maintain than those of the first wave. For example, thanks to cloud computing, software updates happen automatically without the need to physically install them on each user’s computer.

The bottom line is that today’s technologies can be used by every sort of business to boost productivity. In this sense, every company is now a technology company no matter whether they supply the technologies or just use them.

Productivity III: The Growth Cycle. In our opinion, the latest productivity growth boom cycle started well before the pandemic, at the end of 2015. During Q4 of that year, the 20-quarter annual average growth rate of productivity was only 0.6%, the slowest pace since the end of 1982 (Fig. 6). It almost tripled, rising to 1.6%, through Q4-2019, just before the pandemic. The pandemic at first boosted productivity growth (when layoffs soared), but then depressed it (when quits soared).

During Q3-2023, this measure of productivity growth was back up to 1.8%. We think it is heading to 3.5%-4.5% by the end of the decade. That might seem far-fetched (maybe even delusional), but our heady targets are consistent with the comparable peak growth rates of the past three productivity boom cycles. And this one has more going for it, in our opinion, as noted above.

The doubters point out that productivity is volatile and prone to significant revisions. They are right about the q/q and even the y/y comparisons, which is why we focus on the 20-quarter annual average growth rate in this variable (Fig. 7).

Of course, productivity can be revised either up or down. During the late 1990s, it was revised higher, confirming our optimistic view back then. During Q2-2023, it was revised up a tad from 3.5% to 3.6% (saar). During Q3-2023, the initial estimate showed increases of 4.7% q/q (saar) and 2.2% y/y. In other words, the latest two quarters are consistent with the Roaring 2020s scenario.

Productivity IV: Driving Prosperity. Often in the past, we’ve shown in the past that the data on productivity and real hourly compensation compiled by the Bureau of Labor Statistics (BLS), both measured at a 20-quarter average annual rate, track one another closely (Fig. 8). That’s because the former drives the latter, as every student of microeconomics knows: Real wages are determined by productivity, i.e., W/P = Z. That’s both in theory and in practice, based on our analysis of the data.

Often forgotten is that the price deflator should be the one that reflects the prices received by business employers rather than the one that measures prices paid by consumers. Accordingly, we use the nonfarm business deflator to inflation-adjust hourly compensation; we have long disagreed with BLS’s practice of reporting real hourly compensation using the CPI. That measure shows a widening gap between productivity and real hourly compensation starting in the early 1970s (Fig. 9). The gap has been widening at a slower pace using the personal consumption expenditures deflator and even less so using the nonfarm business deflator.

By the way, while real hourly compensation growth did stagnate from the early 1970s through the mid-1990s, especially when deflated by the CPI; it mostly has been rising since then to record highs. The claim made by progressives that real wages of workers have stagnated for decades simply is not supported by the data.

In any event, if our Roaring 2020s productivity growth boom unfolds as we predict, then real hourly compensation’s growth will also experience a growth boom. The latter is among the best measures of consumers’ purchasing power, i.e., the standard of living. A chronic labor shortage that is offset by productivity gains means that real incomes will be driven more by real wages than by labor force growth. That’s bullish for real GDP growth.

It also means that wages will rise faster than prices without triggering a wage-price spiral. The Phillips Curve model is wrong because it fails to recognize the importance of productivity. Consumer prices can disinflate and even deflate in a tight labor market if the labor shortages cause business to boost productivity rather than prices. That’s what is happening now. There doesn’t have to be an inverse relationship between inflation and unemployment. That’s because there is a stronger negative relationship between the unemployment-rate cycle and the productivity-growth cycle (Fig. 10). A tight labor market can boost productivity, which allows nominal and real wages to increase while keeping a lid on price inflation.

There is also a strong positive correlation between unit labor costs (ULC), which is the ratio of hourly compensation to productivity, and the CPI headline inflation rate on a y/y basis (Fig. 11). That makes sense since P = W/Z = ULC is the simple variation on the equation above. ULC inflation was down to 1.9% y/y during Q3, suggesting that the CPI inflation could fall from 3.2% closer to 2.0%—i.e., the Fed’s inflation target—sooner than widely expected.

The bottom line: Productivity drives prosperity and should do so during the Roaring 2020s.
 
Consumers: They Should Be Less Miserable. So why is the Consumer Sentiment Index so depressed (Fig. 12)? It fell to 61.3 in November, well below its average of 82.9 since January 1978. In the past, it was inversely correlated with the Misery Index, which is simply the sum of the unemployment rate and the CPI inflation rate on a y/y basis. The latter was down to a relatively low reading of 7.1% in October, well below its average of 9.5%.

Consumers may be suffering from money illusion. They realize that inflation is moderating, but consumer prices remain much higher than before the pandemic. What they aren’t realizing is that their wages have also risen, though not as quickly as prices until this year. Since the start of this year, their wages on the whole have been rising faster than prices. Real wages seem to be back on their uptrend that started in 1995 (Fig. 13).

Perhaps the drop in consumers’ outlays on gasoline since the summer will cheer them up. The average household’s spending on gasoline was about $1,000 less at an annual rate during September than during June partly; that’s because they drove less and partly because the price of gasoline has been falling and continued to do so in October and November (Fig. 14).
 
Strategy: Roaring 2020s Is Buoying Stocks Already. We think our Roaring 2020s scenario explains the stock market rally since October of last year. In our November 3, 2022 Morning Briefing, Jackie and I wrote that “AI is gaining momentum” and that “it will lead to a new surge in corporate productivity.

We observed: “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 was trading at $227 per share when we wrote about AI back then. It closed at $377 on Friday. The AI-related stocks, especially the MegaCap-8—i.e., Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Netflix, NVIDIA, and Tesla—have been leading the bull market ever since.

By the way, the S&P 500’s forward P/E is inversely correlated with the Misery Index (Fig. 15). The plunge in the latter from 12.7 in June 2022 to 7.1 during October helps to explain why the forward P/E rebounded from 15.3 on October 12, 2022 to 19.0 on Friday. So the stock market also has been rising on the realization that inflation can come down without requiring a significant increase of the unemployment rate.

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Oil, Stocks & 3-D Hand Printing

November 21 (Tuesday)

Energy: Thankful for the Low Price of Gas. Many of us will be hitting the road—or the sky—this week to celebrate the Thanksgiving holiday with friends and family. We’ll be joining the 49.1 million Americans planning to travel by car to their Thanksgiving celebrations this year and another 4.7 million planning to travel by plane, according to AAA estimates.

If those estimates are on target, travel by car will still be 1.6% lower than just before the pandemic during Thanksgiving 2019, while air travel will be 2.5% higher. Those traveling by car will benefit from the decline in the price of gasoline to a recent $3.47 per gallon, down from a 2023 high of $4.00 and a 2022 peak of $5.11 (Fig. 1).

Gasoline prices have fallen in step with the price of Brent crude oil futures, which at $80.61 per barrel have fallen from a high of $96.55 this year and $127.98 in 2022 (Fig. 2). Supplies never got as tight as expected earlier this year, in part because the Chinese economy never recovered as strongly as was once expected. Now the market is waiting to see if OPEC+ will announce additional production cuts at its meeting on Sunday, November 26.

Until then, let’s take a look at some of the variables impacting the oil market:

(1) US production at record levels. The US fracking miracle continues. US production of crude oil hit record levels in October, extending into November, with 13.2 mbd produced, surpassing the 12.9 mbd produced at the pre-pandemic peak in 2019. The amazing thing about the surge of production is that it has occurred using far fewer drilling rigs: 500 as of the November 17 week, compared to 877 in January 2019 (Fig. 3).

With production booming, US crude oil & petroleum product imports are flat and exports have grown to 10.9 mbd, up from 10.1 mbd at the 2019 peak (Fig. 4). In addition, the level of US crude oil and petroleum product inventories is running higher than it has in the past two years by 34.8 mbd (Fig. 5).

Putting a floor under the price of oil is the Biden administration’s desire to refill the Strategic Petroleum Reserve. The administration aims to buy six million barrels of crude oil for delivery in December and January at prices of $79 per barrel or less, an increase from the $70 a barrel the agency previously was willing to pay, according to an October 19 Reuters article quoting the US Department of Energy.

(2) China demand underwhelms. The Chinese economic rebound from the pandemic hasn’t been nearly as strong as expected. Economic growth continues to be limited by excess leverage and a real estate crisis that has left millions of unfinished apartments weighing on the market.

The country’s demand for oil hasn’t met bullish expectations. The International Energy Agency expected China’s demand for oil would rise by 1.8mbd this year, but in the first 10 months of 2023 demand has only risen by 1.2mbd to 11.4mbd, a November 20 Reuters article reported. The latest bearish sign comes from Chinese refiners, which began building inventory by more than half a million barrels a day in October. The inventory build was a reversal from September’s inventory drawdown.

(3) Small surpluses forecast. The amount of excess global supply of oil isn’t very far above demand, according to the EIA data. Between now and the end of next year, global oil supply is expected to exceed demand by a total of 0.57mbd on world consumption that exceeds 101mbd.

Here’s the EIA’s forecast for the change in global oil stocks: Q3-2023 (-0.9mbd drawdown), Q4-2023 (0.20mbd build), Q1-2024 (-0.13mbd drawdown), Q2-2024 (0.16mbd build), Q3-2024 (0.16mbd build), and Q4-2024 (0.27mbd build).

(4) All eyes on OPEC+. Hopes that OPEC will cut production at its meeting later this month helped the price of Brent crude oil futures bounce off the low of $77.42 last Thursday to $82.35 on Monday. OPEC+ has already pledged to cut oil production by 3.66mbd, and Saudi Arabia and Russia have a voluntary agreement to cut an additional 1.5mbd of production.

A frequently cited Reuters article quoted a mixture of opinions about what will happen at the meeting from anonymous OPEC+ sources. “One OPEC+ source, who declined to be named, said the existing curbs might be not enough and the group will likely analyse if more could be implemented when it meets. Two other OPEC+ sources said deeper cuts could be discussed … [T]wo other OPEC+ sources said it was too early to say whether further cuts will be discussed, while another said he did not think it was likely with the caveat to ‘wait and see,’” the November 17 Reuters article reported.

(5) Global uncertainties. The price of crude is surprisingly subdued given all the geopolitical uncertainties that potentially threaten the market.

The US and EU are still trying to determine how to enforce the price cap placed on Russian oil after Russia invaded Ukraine. The US Treasury Department took a step in that direction by imposing sanctions on three Emirati shipping companies for transporting Russian oil sold at prices above the $60-per-barrel limit. Meanwhile, Russia has lifted its restrictions on the export of gasoline because it has excess supplies. The ban was initially put in place on September 21 to reduce high domestic prices and shortages.

The US government is considering tightening Iranian sanctions in response to Iran’s support of Hamas in its war with Israel. The US may target Iran’s oil industry with the goal of removing about 1mbd of Iranian oil exports. The Israel/Hamas war may also impact the outcome of the OPEC+ meeting. “An additional OPEC+ cut of up to 1mbd could be on the table, one informed person said, describing the cartel as ‘galvanized’ by the conflict,” a November 17 FT article reported.

Strategy: Thankful for the Rebound. The S&P 500 has bounced almost 10% from its October 27 low through Friday’s close, giving us something to be thankful for as the market approaches its highest levels of 2023. While technology-related names continue to outperform, interest-rate sensitive areas are also showing signs of life, reflecting growing hopes that the Federal Reserve is finished raising interest rates.

Here’s the performance derby for the S&P 500 and its 11 sectors, from the October 27 low through Friday’s close: Information Technology (13.8%), Consumer Discretionary (11.9), Communication Services (11.4), Financials (11.2), Real Estate (11.0), S&P 500 (9.6), Industrials (9.2), Materials (7.0), Utilities (5.5), Consumer Staples (4.1), Health Care (4.1), and Energy (-0.8) (Fig. 6).

Some of the themes that stand out from the performances of various S&P 500 industries’ price indexes during the bounce and so far this year include:

(1) Bets on lower rates pay off. Two interest-rate sensitive sectors have been jolted to life since the market hit its October lows: Financials and Real Estate. Some of the S&P 500 Financials industries with the best performance since October 27 include: Regional Banks (17.2%), Asset Management & Custody Banks (15.7), Diversified Banks (15.1), and Investment Banking & Brokerage (14.6). In the Real Estate sector, outperformance came from Real Estate Services (17.6%), Single-Family Residential REITs (16.4), Telecom Tower REITs (15.1), Hotel & Resort REITs (14.1) Self Storage REITs (13.5), and Industrial REITs (13.1).

The improved interest-rate outlook undoubtedly helped the S&P 500 Homebuilding industry rise 22.7% since October 27, making it the top performing industry in the S&P 500 over that time period. The Home Building Products industry also performed well, rising 15.7%.

Conversely, the recent subdued readings on inflation hurt the S&P 500 Gold industry’s stock price index, which has fallen 6.7% from the October low, making it the worst performing industry in the bunch. Other weak performances were turned in by oil-related industries, including Oil & Gas Equipment & Services (-4.5%), Oil & Gas Exploration & Production (-2.3), and Integrated Oil & Gas (-0.4).

(2) 2023 on verge of being a great year. The gains over the past month have lifted the ytd performances of several sectors to truly impressive heights—north of 30%—as the year draws to a close. Here’s where the S&P 500 and its sectors stand on a ytd basis with just a few more weeks left to go in the year: Information Technology (49.5%), Communication Services (48.9), Consumer Discretionary (31.7), S&P 500 (17.6), Industrials (7.2), Materials (3.1), Financials (2.0), Real Estate (-3.2), Energy (-4.3), Health Care (-5.9), Consumer Staples (-6.0), and Utilities (-12.2) (Fig. 7).

There is a huge chasm between the ytd winners and the losers. The industry indexes with the best ytd performances through Friday’s close are: Semiconductors (92.8%), Interactive Media & Services (79.5), Broadline Retail (68.5), Automobile Manufacturers (67.3), and Application Software (52.2). Each of those industries is very tech-related, including Automobile Manufacturers, which is dominated by Tesla, and Broadline Retail, which includes Amazon.

Meanwhile, the worst performing industries ytd are Personal Care Products (-49.8), Drug Retail (-43.2), Independent Power Producers & Energy Traders (-40.9), Regional Banks (-35.4), and Leisure Products (-26.0). Fortunately, the tech-related industries—with member companies that include Amazon, Alphabet, Meta, Nvidia, and Tesla—have a much larger market cap and impact on the S&P 500 than the underperforming industries, which hold the much smaller stocks of Estee Lauder and Hasbro (Fig. 8).

Disruptive Technologies: 3D Printing Gives Flexible Robotics a Hand. A new method of 3-D printing can create flexible products, including for use in robotics. Human-like robotic hands and artificial organs can be built using this new method, according to researchers at ETH Zurich, a Swiss university; MIT; and Inkbit, a startup company spun out of MIT.

Traditional 3-D inkjet printing uses a material that dries quickly and is then scraped to eliminate any imperfections before the next layer of material is deposited. The end product is stiff, and that’s not useful when it comes to developing something like a robotic hand.

Inkbit developed the new 3-D printing method, called “vision-controlled jetting” (VCJ) technology. Instead of scraping away imperfections, the printer includes “an AI-enabled 3D computer vision scanning system” that visually checks the item being produced for imperfections. When it notices an imperfection, the machine calculates how the next layer of material needs to be deposited to correct the imperfection. “This means that instead of smoothing out uneven layers, the new technology simply takes the unevenness into account when printing the next layer,” a November 15 article on ETH Zurich’s website.

The new printer doesn’t need to use fast-drying materials when building an object because there’s no scraping involved. VCJ can use slow-drying polymers that are more flexible, which dramatically increases the types of objects that can be 3-D printed. The new method also allows hard and soft elements to be printed in an object simultaneously. Researchers used the new printing method to create a 3-D printed robotic hand, with bones, ligaments, and tendons each made of different materials. The slow-drying materials used in the hand allow it to curl when grabbing an object and then uncurl, returning to its original shape. Here’s a video explaining and demonstrating the technology.

The ability to print using different materials has made the assembly process less “hands on”: No human needs to assemble the various pieces of the artificial hand. More details about the hand and other products built using VCJ—including a walking robot and a pump mimicking a heart—appear in a November 15 study in Nature.

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Thanksgiving

November 20 (Monday)

YRI Weekly Webcast Will Be Back Next Week. Join Dr. Ed’s live webcast with Q&A next Monday, November 27, at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Giving Thanks. My team and I wish you a very happy Thanksgiving Day with your family and friends. It’s a great holiday for sure. We eat and drink and go into food shock. Turkey contains tryptophan, which promotes “good sleep and a good mood,” according to Healthline.com. “Tryptophan is one of several essential amino acids, which are considered the building blocks of proteins in animals and plants. Specifically, tryptophan is involved in the production of serotonin (a hormone that helps regulate mood) and melatonin (a hormone that helps regulate your sleep cycle).” Healthline cites research published in Neuroscience and Biobehavioral Reviews and a study published in the journal Nutrients.

The day after Thanksgiving, we recharge by going shopping on Black Friday. Shopping releases dopamine in our brains, which makes us feel good. Studies have shown that it is actually the anticipation of buying things that gives us the high. Many people get a bigger charge from ordering online than from going to stores. (See the Psychology Today article “Shopping, Dopamine, and Anticipation: What monkeys have to teach us about shopping.”)

We will be recharging by publishing the Morning Briefing on Monday and Tuesday and taking the rest of the week off. Dr. Ed’s webcast will be back on Monday, November 27.

We would like to thank you for your interest in our research service and look forward to working with you in 2024. We suggest avoiding controversial subjects at the dinner table on Thursday. Instead, talk about Yardeni Research and our spot-on forecasts in 2023 with your families and friends. Tell them how they can sign up for a four-week trial. Thank you.

We also would like to thank our Founding Fathers for founding this great country. There’s no better place for entrepreneurial capitalists to flourish in a free-market economic system with checks and balances on the political system. As they flourish, they increase the standard of living of most Americans by providing better goods and services at lower prices. Various measures of national prosperity confirm this conclusion. Real GDP is at a record high (Fig. 1). Real consumption per household is at a record high (Fig. 2). Measures of real wages are at record highs (Fig. 3). Household net worth is at a record high. Thank goodness.

Share our upbeat view of the American economy with your family and friends by giving them Dr. Ed’s In Praise of Profits for Hannukah, Christmas, or Kwanzaa. They will thank you for it.

Strategy: SMidCaps Are Showing Signs of Life, Finally. The S&P 500 peaked at 4888.96 on July 31. In the three months that followed, many S&P indexes experienced double-digit percentage declines. This includes the indexes grouped by stocks’ market-capitalization size and those defined by investment style (Growth or Value). On October 27, they and their associated equal-weighted S&P indexes all bottomed.

Initially, the rally off that bottom was powered largely by the S&P 500 LargeCap index; that continued through the close of trading last Monday, November 13. The next morning, October’s CPI was released showing continued moderation of inflation and buoying the odds that the Fed is done tightening monetary policy. Since then, investors have poured into the SmallCap and MidCap indexes (a.k.a. the “SMidCaps”), with a preference for Value over Growth:

(1) SMidCaps outperformed LargeCap following CPI release. The S&P SmallCap 600 has risen 5.2% since last Monday, ahead of the 4.1% and 2.3% gains for the S&P MidCap 400 and S&P LargeCap 500 (Fig. 4). On an equal-weighted basis, SmallCap’s 5.4% advance beat those of MidCap (4.6%) and LargeCap (3.4%). The MegaCap-8 index (composed of Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla)—which led the initial rally from October 27 until November 13—since has trailed the three market-capitalization indexes with a gain of only 2.1%.

(2) Investors favoring Value over Growth? The SMidCap’s Value and Growth style indexes also outperformed those of LargeCap, with Growth getting the nod ahead of Value across all three market-capitalization styles. SmallCap Value rose 5.6%, ahead of SmallCap Growth’s 4.6% rise. Within the MidCap index, Value’s 5.1% rise beat Growth’s 3.3% gain. LargeCap Growth gained 1.8% but lagged the 3.0% rise for its Value counterpart (Fig. 5).

(3) Rising tide lifting all boats now. We’re not too concerned about the recent relative weakness in the performance for the S&P LargeCap 500 and its Growth index. That’s because a typical market rally begins with the strongest leaders—i.e., the MegaCap-8—and later broadens to include companies in other investment-style spectrums.

With investors cheering the rapid decline in the inflation rate and slightly weaker employment readings, they’re now surmising that the Fed’s next step will be to lower interest rates in 2024. The hope is that lower interest rates will help keep the economy out of a recession. That’s bullish for all stocks.

Whether the recent market leadership shifts mark an end to Growth’s domination over Value remains to be seen, so it’s more important now than ever to watch how the two styles perform in terms of earnings expectations and reported results over the next several years. We will be doing so.

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Retailers, Semis & Quantum Computing

November 16 (Thursday)

Consumer Discretionary: Still Shopping. The US consumer continued to spend at a healthy clip last month, helped by plentiful jobs, a drop in the price of gasoline, and moderating inflation. While high interest rates may restrain spending on expensive goods requiring financing, October’s sales levels represent a solid launch to the holiday shopping season.

US retail sales fell by 0.1% in October, the first decline in seven months. However, the picture is brighter viewed against the backdrop of surprisingly strong spending in September, when sales increased 0.9% (Fig. 1). Core retail sales—which excludes the sales of automobiles, gasoline, building materials, and food services—rose 0.2% in October following an upwardly revised 0.7% increase in September (Fig. 2).

The latest data show consumers continued to spend at clips higher than a year ago in restaurants (up 8.6% y/y), online (9.3), in pharmacies (8.4), and at warehouse clubs (2.7). Conversely, sales continued to fall in home-related areas like furniture and home furnishing stores (-11.8) and building materials and garden equipment (-5.6) (Fig. 3, Fig. 4, and Fig. 5). (Percent changes for restaurants, furniture & home furnishing, and building materials & garden equipment are through October; online, warehouse clubs, and pharmacies are through September.)

In recent days, Home Depot and Target reported declining revenue but results that beat analysts’ expectations, while TJX—the strongest of the three retailers—reported a strong increase in quarterly results and signaled optimism about the holiday selling season. Here’s a look at what their managements had to say on their recent earnings reporting conference calls:

(1) TJX’s outperformance continues. TJX reported strong results for its fiscal Q3 (ended October 28). Marshall’s and TJ Maxx stores in the US collectively posted a 7% jump in same-store sales and US HomeGoods stores a 9% increase, with all the gains resulting from higher customer traffic, not price increases. TJX’s total sales rose 9.0% y/y to $13.3 billion, and adjusted earnings per share rose 20% y/y, both better than expected. Margins improved from the year-earlier quarter’s, and inventories were flat y/y

TJX management said the current quarter is off to a “strong start” but gave fiscal Q4 (ending January 31) earnings guidance of $1.07-$1.10 a share, shy of analysts’ $1.13 a share consensus estimate. TXJ raised its fiscal 2024 guidance for the third time this year, a November 15 CNBC article reported, to earnings per share of $3.71-$3.74, up from the previous $3.66-$3.72 range. Analysts already had been expecting EPS in the new range, with a consensus of $3.73, CNBC relayed.

TJX shares, which were up 16.2% ytd through Tuesday’s close, fell by a bit more than 2% on Wednesday after the earnings report.

(2) Home Depot & Target EPS: gloomy but better than expected. Shares of Home Depot and Target both rallied after they reported earnings that beat analysts’ consensus estimates but signaled that both retailers face headwinds.

Home Depot reported earnings per share of $3.81 for the quarter ended October 28, better than analysts’ consensus estimate of $3.76 but lower than the $4.24 a share reported a year ago. Likewise, revenue of $37.7 billion was a touch higher than the $37.6 billion expected but still down from the $38.9 billion last year. Same-store sales declined 3.1% y/y, better than the 3.6% expected but still down sharply, a November 14 CNBC article reported.

High interest rates and rising inflation have put a dent in home sales and renovations, hurting the home improvement retailer’s results. Perhaps new competitors, like Floor & Décor and UK-based Wren Kitchens, have weighed on sales as well? Home Depot shares have risen roughly 7% since reporting results on Tuesday, but remain in negative territory ytd, down 2.4%.

Target’s earnings improved dramatically from the year-earlier level, thanks to easy comparisons. In the year-ago quarter, the company held large sales to move bloated inventories. The retailer’s earnings for Q3 (ended October 28) came in at $2.10 a share, better than analysts’ expectations for $1.48 a share and up sharply from $1.54 earned in the year-ago quarter.

However, in a sign that all isn’t well, Target’s total Q3 revenue was $25.4 billion, a bit better than the $25.3 billion analysts expected but below the $26.5 billion in revenue reported in the year-ago period. Q3 same-store sales fell 4.9% y/y, and digital sales fell 6% y/y. The current quarter’s results aren’t expected to be much better, with Q4 same-store sales expected to drop in the mid-single-digits. Investors opted to look on the bright side of the earnings report and sent Target’s shares higher by almost 18% on Tuesday; but even after those gains, shares remain 12.5% lower ytd.

Technology: Semis Making New Highs. The S&P 500 Semiconductors stock price index hit an all-time high on Tuesday, bringing its ytd gain to a shocking 90.9% through Tuesday’s close (Fig. 6). But the ytd performances of the industry’s members vary widely, from Texas Instruments’ 9.3% decline to Nvidia’s gain of 239.8%, driven by the company’s industry-leading position in chips for artificial intelligence (AI).

Here’s a quick look at what’s been fueling investor optimism:

(1) Industry recovery underway. Investors began the year fretting about an industry downturn but are ending 2023 optimistic that industry sales are recovering. Global semiconductor sales rose 1.9% m/m in September, marking the seventh month in a row of m/m sales increases, the Semiconductor Industry Association reported on November 1. On a y/y basis, September’s sales declined by 4.5% (Fig. 7). (Data reflect a three-month moving average.) Geographically, m/m sales rose in all regions except for Japan: Asia Pacific/All Other (3.4%), Europe (3.0), Americas (2.4), China (0.5), and Japan (-0.2).

(2) Earnings on the upswing. As sales have improved, analysts’ expectations for the industry’s financial results have grown increasingly optimistic (Fig. 8). Consensus expectations for revenues and profits reflect declines this year, of 1.8% and 6.3%, but resumed growth in 2024, of 16.9% and 32.2% (Fig. 9 and Fig. 10). The industry’s forward P/E of 24.9 remains elevated but should fall as earnings recover (Fig. 11).

(3) Some positive news to boot. Investors were heartened last week by the earnings report of Taiwan Semiconductor Manufacturing. The contract manufacturer reported that October sales climbed 15.7% y/y and 34.8% m/m. It was the company’s first month of y/y growth since February, a November 14 Barron’s article reported.

Investors were also glad to see that Nvidia has developed three chips for AI that it should be able to sell into the Chinese market. The US government has restricted the sale of some of Nvidia’s most sophisticated chips into Chinese markets to prevent China’s AI development. The performance of Nvidia’s new chips “has been moderated compared with those that Nvidia had previously sold in China … Nonetheless, the new graphics processing units were expected to remain competitive in the Chinese market,” a November 9 FT article reported.

Disruptive Technologies: Quantum Computing Developments. While AI has become the tech world’s darling, the progress in quantum computing continues. Quantum computers are growing more powerful, and scientists have begun musing about what amazing things quantum computing and AI can produce together. Meanwhile, there have been some disconcerting claims that quantum computing power has managed to crack the security algorithm that keeps our data safe.

Here’s a look at some of the recent headlines:

(1) The power of quantum & AI. The combination of quantum computers with AI software should allow us to tackle problems that aren’t solvable using today’s systems. “It involves the development of algorithms that take advantage of quantum properties to solve AI-related tasks,” explains an October 9 essay at Medium.com. Quantum computers can handle “large datasets and [perform] complex optimizations. This allows AI systems to learn and adapt more quickly, making them more proficient in tasks like image recognition and natural language processing.”

AI often is used to solve optimization problems, like route planning and resource allocation. And those are problems that are efficiently handled by quantum computers, as well. As one recent headline quipped: “If you think AI is terrifying, wait until it has a quantum computer brain.”

Moderna and IBM are already combining the two powerful technologies. They announced earlier this year that they’ll work together using quantum computing and AI to design mRNA medicines. “We are aiming for breakthrough advances with quantum computing, so we are investing now in building a quantum-ready workforce, to be fully prepared to harness the power of this technology,” said Moderna CEO Stéphane Bancel.

(2) Never too many quibits. Quantum computers use quibits to store and process information. Simply put, the more quibits the better. Quantum computers have made quibit-maximizing strides in recent years. Just last month, startup company Atom Computing claimed to have developed a quantum computer with 1,180 quibits, far surpassing IBM’s Osprey machine’s 433 quibits, according to an October 24 article in New Scientist.

Atom’s computer uses neutral atoms trapped by lasers in a two-dimensional grid instead of the super conducting wires cooled to extremely low temperatures used by companies like IBM and Google. Atom’s system lets it add many more quibits. Atom CEO Rob Hays said the company aims to multiply by 10 the number of quibits in its machine every couple of years. Its system also can run error-free for longer than others. Atom aims to have the computer available for customers to use via the cloud by next year.

IBM is working on Condor, a quantum computer with 1,121 quibits. It’s also partnering with the University of Tokyo and the University of Chicago to develop a “quantum-centric” supercomputer powered by 100,000 quibits. The 10-year, $100 million program is expected to include the Argonne National Laboratory and Fermilab National Accelerator Laboratory, according to a May 21 press release.

Separately, Google and PsiQuantum are looking to build 1 million quibit computers. With that many quibits, the computer could still be extraordinarily powerful even if some quibits are out of service because of errors. To build machines with this many quibits, the systems will need to become far more energy efficient, a May 25 article in MIT Technology Review reported.

(3) Cracking the code. A quantum computing developer claims that he’s broken RSA, the security code that keeps some of our most important information safe. Ed Gerck, who works for his own firm, claimed on LinkedIn that he used a cell phone and a commercial Linux desktop computer to break the code at a cost of less than $1,000, a November 1 article in Bankinfo Security reported.

Many are skeptical. Gerck develops cryptography, which he says can be used to replace RSA, a November 3 Tom’s Hardware article reported. “This would be handy if his RSA-2048 cracking claims are correct. Naturally, that also raises the question of whether this ‘crack’ is merely a publicity stunt for his product.”

It’s expected that in the future those with quantum computers more powerful than today’s will be able to break RSA code. In anticipation of that day, a more robust security system, called “CNSA 2.0,” is being rolled out throughout the government starting in 2025 and continuing through 2030. Cloud computing giants already have started transitioning to the more robust security protocol. They may need to move faster given how fast quantum computing power is advancing.

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Transitory After All

November 15 (Wednesday)

Inflation: Back to 2.0%. You read that right: Inflation is back to 2.0%. That’s based on October’s CPI less food, energy, and shelter on a y/y basis (Fig. 1). Excluding only shelter, the CPI inflation rate was even lower at just 1.5%. You might be thinking: “Why are economists always taking out what doesn’t support their story? After all, the headline and core CPI inflation rates were 3.2% and 4.0% in October” (Fig. 2).

Good point, but there is good reason for taking out shelter at least. Here it is as explained by Fed Chair Jerome Powell in his Jackson Hole speech on August 25:

Because leases turn over slowly, it takes time for a decline in market rent growth to work its way into the overall inflation measure. The market rent slowdown has only recently begun to show through to that measure. The slowing growth in rents for new leases over roughly the past year can be thought of as “in the pipeline” and will affect measured housing services inflation over the coming year. Going forward, if market rent growth settles near pre-pandemic levels, housing services inflation should decline toward its pre-pandemic level as well.

Sure enough, CPI rent inflation is coming down but more slowly than the headline and core CPI inflation rates since last summer. The CPI rent of shelter index peaked at 8.3% y/y this March (Fig. 3). It was down to 6.8% in October, which is still a high reading. However, the Zillow current rent index was down to 3.2% y/y in October. It reflects new leases (Fig. 4). As Powell observed, it should be a leading indicator for the CPI shelter inflation rate.

Now consider the following related observations about the latest CPI report:

(1) Nonhousing services CPI. In his Jackson Hole speech, Powell reiterated his concern about the stickiness of inflation in the nonhousing services sector:

The final category, nonhousing services, accounts for over half of the core PCE index and includes a broad range of services, such as health care, food services, transportation, and accommodations. Twelve-month inflation in this sector has moved sideways since liftoff. Inflation measured over the past three and six months has declined, however, which is encouraging. Part of the reason for the modest decline of nonhousing services inflation so far is that many of these services were less affected by global supply chain bottlenecks and are generally thought to be less interest sensitive than other sectors such as housing or durable goods. Production of these services is also relatively labor intensive, and the labor market remains tight. Given the size of this sector, some further progress here will be essential to restoring price stability. Over time, restrictive monetary policy will help bring aggregate supply and demand back into better balance, reducing inflationary pressures in this key sector.

This “supercore” component of the PCED inflation rate has been stuck around 5.0% since October 2021 (Fig. 5). It was down to 4.3% in September. So it may finally be turning less sticky. In any event, the Fed’s job isn’t to finetune the components of the CPI, as Melissa and I have observed recently; what matters is that the overall inflation rate is heading downward, which it is.

By the way, the CPI’s version of supercore inflation (i.e., CPI services less rent of shelter) fell to 3.0% during October, down from last year’s peak of 8.2%. That should be a good harbinger of further declines in the PCED supercore inflation rate.

(2) Durable goods CPI. Inflation has turned out to be transitory for the goods components of the CPI (Fig. 6). This index edged up just 0.4% y/y through October, the lowest reading since December. The CPI for durable goods fell 2.1%. It is deflating again, which is what it has tended to do since the second half of the 1990s until the end of the pandemic lockdown.

(3) Nondurable goods CPI. The nondurable goods CPI inflation rate was well over 10% last summer. Now it is back down to just 1.7%. The most volatile components of this index, of course, are food and energy (Fig. 7). Food inflation peaked last year at 11.4% during August and was back down to 3.3% in October. Energy inflation peaked at 41.6% last year during June and was -4.5% in October. Food and energy prices were boosted by the initial supply shocks caused by Russia’s invasion of Ukraine in late February of last year. Now, weak global economic growth is moderating food and energy inflation.

(4) Transitory after all. There can be no debate about the transitory nature of goods inflation since H2-2020. It turned out to be mostly attributable to the shocks and aftershocks of the pandemic, which have been dissipating since the end of the pandemic.

Almost all the inflationary pressures on durable goods and many nondurable goods stemmed from the pandemic-related supply-chain disruptions, which can be seen in the Global Supply Chain Pressure Index compiled by the Federal Reserve Bank of New York (Fig. 8). The index jumped from 0.1 during October 2020 to peak at 4.3 during December 2021. It has plunged since then to -1.7, the lowest reading in the series, which started in September 1997.

As Debbie and I have often observed, the end of the pandemic lockdown during March and April 2020 led to a goods buying binge. We all had cabin fever and saved some money for a couple of months, then Washington provided three rounds of pandemic relief checks to millions of Americans. To relieve our cabin fever, we all went shopping. The buying binge overwhelmed supply chains, which were also disrupted by labor shortages. Consumers then pivoted away from goods toward purchasing services as they became more available starting around March 2021 (Fig. 9).

That’s all behind us now, as is the goods inflation shock. Now the services inflation shock is showing signs of dissipating.

Fiscal Policy: In Yellen We Trust. When Janet Yellen was Fed chair from October 2010 through February 2014, I often fondly (and respectfully) referred to her as the “Fairy Godmother of the Bull Market.” I noticed that almost every time she spoke publicly about the outlook for monetary policy and the economy, the stock market moved higher.

She hasn’t been as bullish for the stock market since January 2021, when she became the secretary of the US Treasury in the Biden administration. Under her watch so far, the federal budget deficit rose to the pre-pandemic record high of $1.7 trillion over the 12 months through October (Fig. 10). The same can be said about the $2.3 trillion increase over this same period in marketable US Treasury securities, which are up to a staggering $5.0 trillion since Yellen joined the Biden administration.

The deficit outlook has been exacerbated by the record $26 trillion in marketable debt held by the public that the Treasury must refund at higher interest rates than when Yellen took charge at the Treasury. Over the past 12 months through October, the Treasury’s net interest outlays rose to a record $692.2 billion (Fig. 11).

Under Yellen’s watch so far, the debt that the Treasury department issues has been downgraded by Fitch Ratings in August and Moody’s this past Friday. Yet on Monday, Yellen said she disagrees with Moody’s decision and countered that the Biden administration is “completely committed to a credible and sustainable fiscal path.”

On October 26 at an event in Bloomberg’s Washington office, Yellen dismissed the notion that bond yields were rising just because the Treasury’s financing needs have swelled. She stated: “I don’t think much of that is connected.” She blamed higher interest rates on the strong economy: “The economy is continuing to show tremendous robustness, and that suggests that interest rates are likely to stay higher for longer,” she said.

Nevertheless, the Treasury helped to spark a significant bond rally on November 1 by announcing that the next round of auctions would have more bills and fewer notes and bonds. In other words, Yellen in effect admitted that supply does matter.
 
US Economy: Still Lots of Jobs But Few Qualified Applicants. Our main takeaway from October’s small business owners survey conducted by the National Federation of Independent Business is that there are still plenty of job openings. Indeed, 43% of respondents said they have unfilled positions. This series is highly correlated with the JOLTS job openings series, which Fed Chair Powell often mentions in his remarks about the labor market (Fig. 12).

Fewer small business owners are expecting to hire. The percentage saying so fell from a record 32% during August 2021 to 17% in October 2023 (Fig. 13). That’s partly because the percentage who say that there are no qualified applicants rose from 51% at the end of 2022 to 55% in October.

Strategy: Q4’s Weaker Growth Outlook Narrowly Based. Last week, we discussed the strong Q3 results reported so far by the S&P 500 companies and noted that industry analysts’ estimates for Q4-2023 have been falling at the fastest rate since the end of 2022. Today, we’re taking another look at the S&P 500’s Q4 expectations and uncovering where the hits to earnings are taking place.

Here are our main takeaways:

(1) Brief pause ahead for record-high S&P 500 quarterly EPS. The S&P 500’s blended EPS for Q3-2023 has come in at a record-high $58.20, exceeding its prior record of $57.62 during Q2-2022. Looking ahead, the consensus forecast for S&P 500 earnings in Q4-2023 has dropped 4.7% to $55.36 in the six weeks since the start of the quarter. The consensus is expecting below-record-high quarterly EPS of $56.85 in Q1-2024, before rising to new record highs of $60.31 and $63.73 in Q3- and Q4-2024.

According to LSEG, the S&P 500’s expected Q4-2023 growth rate is now down to 5.8% y/y from 11.0% at the start of the quarter. That growth forecast represents a deceleration from the blended 6.3% y/y rate recorded so far for Q3-2023. On its face, the weaker Q4 growth rate appears to be a new worry for investors and provides ammo for those expecting a recession shortly. We disagree.

(2) A transitory “auto-immune deficiency” in Q4. A deeper dig into where expectations primarily have been falling leads us to believe that Q4’s earnings deterioration is transitory too. More than half of the decline in expectations is attributable to just six big companies in two industries: three automakers and three drug companies.

Q4 earnings expectations for Ford and General Motors have deflated due to the impact of the recently ended United Auto Workers strike. Non-unionized Tesla is seeing the effects of reduced prices for its line of electric vehicles as well as high startup production costs for its unprofitable Cybertruck.

The total expected Q4 earnings for these three automakers has fallen 33% since the start of the quarter to a still profitable $4.1 billion. While large, their collective decline in Q4 earnings expectations accounts for just 9% of the overall S&P 500’s $24 billion drop.

The three drug companies (Merck, Moderna, and Pfizer) have accounted for the bulk of the drop in the S&P 500’s total Q4 earnings expectations. Their income statements are experiencing withdrawal symptoms, as demand has evaporated quickly for Covid vaccines and other drugs. All three companies are expected to report a loss in Q4. Altogether, their $11.1 billion drop in expected earnings since the quarter started accounts for 80% of meltdown in the S&P 500 Health Care sector’s anticipated Q4 earnings and 46% of the drop in the overall S&P 500’s.

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Relevant Matters

November 14 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: Record Earnings. As of Friday’s close, the S&P 500 was 7.9% below its record high of 4796.56 on January 3, 2022. However, the composite’s earnings per share is back at its previous record high.

Joe reports that the Q3-2023 earnings reporting season for the S&P 500 firms is over 91% complete. The quarter’s blend of the actual and the remaining expected earnings results rose to $58.20 per share during the November 9 week, above its record high of $57.95 during Q2-2022 (Fig. 1 and Fig. 2).

Here are a few more relevant observations on the recent performance of earnings and the outlook for them:

(1) The latest earnings recession lasted just three quarters, from Q2-2022 through Q1-2023. S&P 500 earnings per share  fell 7.9% over that time. That compares to declines of 33.3%, 77.0%, and 28.4% during the earnings recessions of the Great Virus Crisis, the Great Financial Crisis, and the Tech Wreck from Q2-2000 through Q4-2001.

(2) The bad news is that industry analysts have been cutting their Q4-2023 earnings estimates since the start of the current reporting season for Q3 in response to cautious forward guidance provided by managements. During the week of November 9, analysts’ consensus Q4 earnings-per-share estimate for the S&P 500 companies was down to $55.39 from $58.14 the week of September 28.

(3) The analysts have also been lowering their Q1, Q2, and Q4 estimates for 2024 (Fig. 3). So the Q1 estimate is now $56.85, i.e., a bit below the record high. However, the final three quarters of 2024 are all still in record-high territory at $60.31, $63.73, and $64.48.

(4) The 2023 and 2024 analysts’ consensus estimates for S&P 500 earnings per share are now $220.62 and $245.31. We are still using $225.00 and $250.00.

In our opinion, the stock market discounts the time-weighted average of consensus expected earnings per share during the current year and coming year. This weekly measure, a.k.a. “forward earnings,” rose to a record $241.99 per share during the November 9 week, as it is converging toward the 2024 consensus estimate (Fig. 4).

(5) S&P 500 forward earnings per share tends to be a very good 52-week leading indicator of actual earnings per share (Fig. 5). The same can be said about the relationship between the weekly S&P 500 forward revenues series and the actual quarterly results (Fig. 6). Forward revenues rose to yet another record high during the November 2 week.

The S&P 500 forward profit margin bottomed during the week of April 7 at 12.4% (Fig. 7). It edged up to 12.5% during the November 2 week.

Strategy II: The Valuation Question. There tends to be an inverse relationship between the 10-year US Treasury bond yield and the forward P/E of the S&P 500 (Fig. 8). That’s a well-known relationship. However, it doesn’t always work as expected. The simple theory is that the higher interest rates are, the better alternative to stocks fixed-income securities become.

That inverse relationship might also be attributable to the fact that rising interest rates often lead to recessions, which have always been bad for stock valuations and earnings. If inflation is high and interest rates aren’t high enough to bring it down, stocks might beat bonds because earnings tend to rise in that environment, while the purchasing power of interest payments is eroded by inflation.

In recent years, the MegaCap-8 stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) have been dominating the performance of the S&P 500, including its valuation multiple. They currently account for 27.5% of the market capitalization of the S&P 500 index and 51.4% of its Growth sub-index.

The collective forward P/E of the MegaCap-8 is currently 27.6. The S&P 500’s forward P/E is 17.6 and 15.4 with and without the MegaCap-8. (FYI: Forward P/Es are simply the P/E calculated with forward earnings.)

In theory, the forward P/E of the MegaCap-8 stocks should be inversely correlated with the bond yield because the valuations of these and other Growth stocks tend to be even more sensitive to higher interest rates than those of the Value stocks. However, the MegaCap-8 stocks may be less vulnerable to high interest rates because these eight companies are less dependent on debt than most and have substantial cash flow.

In other words, the relationship between valuation multiples in the stock market and interest rates is a complicated one.

Inflation: Expectations & Oil Prices. The outlook for the economy and the financial markets in 2024 will depend largely on the path of inflation. In our projected scenario, the core PCED inflation rate falls to 2.0%-3.0% next year. It was 3.4% y/y through September.

That’s a reasonable forecast, in our opinion. It is consistent with the FOMC’s September Summary of Economic Projections (SEP) showing the core PCED inflation rate at 2.6% at the end of 2024, 2.3% at the end of 2025, and 2.0% at the end of 2026. According to the SEP, that would be consistent with the federal funds rate remaining at the current level through early 2024 with perhaps two 25bps cuts in the federal funds rate later next year.

Now consider the following relevant developments on the inflation front:

(1) CPI. The next big event on the inflation front is Tuesday’s October CPI report. The Cleveland Fed’s Inflation Nowcasting shows that the CPI headline and core inflation rates rose 0.1% and 0.3% m/m, respectively, during October. That puts the two up 3.3% and 4.2% on a y/y basis. These numbers confirm that inflation remains on a moderating trend.

(2) Expectations. Fed officials often have said that they also want to make sure that inflation is “well anchored.” In other words, they want to see that inflationary expectations are low. So it was a bit unsettling that Friday’s release of the consumer sentiment survey for the first half of November showed the one-year expected inflation rate jumped from 3.2% in September to 4.2% in October and 4.4% in early November (Fig. 9). The survey’s five-years-ahead inflationary expectations rose from 2.8% to 3.2% over this same interval (Fig. 10).

On the other hand, on Monday, we learned that the comparable readings for October’s consumer survey conducted by the Federal Reserve Bank of New York were 3.6% over the coming year and 2.7% over the next five years.

(3) Oil. The increase in the November consumer survey’s inflationary expectations seems odd given that its year-ahead response tends to be highly influenced by the price of gasoline, which has been falling since early October. The recent weakness in gasoline prices reflects record-high crude oil field production in the US (Fig. 11).

Furthermore, Debbie and I seasonally adjusted the four-week moving average of gasoline consumed in the US (Fig. 12). It peaked this year at 9.7 million barrels per day (mbd) through May 1 and plunged to 8.4 mbd at the end of October.

Since the pandemic, consumer demand for gasoline has been more price elastic. That’s because more people are working from home. With less need to commute to work, more driving is discretionary now. So when gas prices go up, people have the option of consuming less gas by driving less around their neighborhoods.

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Stock Investors Back In The Saddle Again

November 13 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy I: False Alarm. The S&P 500 bottomed last year on October 12 at 3577.03 (Fig. 1). At that point, it was down 25.4% from the January 3, 2022 record high of 4796.56. Those endpoints marked a relatively classic, but short, bear market—short because it was attributable to the most widely anticipated recession that didn’t happen since the end of WWII (when a depression was widely expected but didn’t happen). Excessive bearishness along with mounting evidence showing that a recession might not be coming after all helped lift the index off its bottom.

The S&P 500 does correlate with the business cycle; that’s why it’s one of the 10 components of the Index of Leading Economic Indicators (LEI) (Fig. 2). The S&P 500 peaked either just prior to or contemporaneously with the previous eight peaks in the business cycle. It bottomed just before seven of the troughs during the past eight business cycles. This time, the latest bear market in the S&P 500 has sounded a false alarm, so far.

Of course, the S&P 500 will still be viewed as a remarkably prescient leading indicator of the business cycle if a recession happens in 2024, as some pessimistic prognosticators never stopped expecting. They’ll say that the S&P 500 was a bit early but right after all (as they were).

However, since bottoming last year on October 12, the S&P 500 rose 28.3% through July 31 of this year. That’s a classic bull market. It also (like the bear market before it) would be relatively short—if it were over. We think it’s not: Indeed, we are still expecting the S&P 500 to rise just above its July 31 peak to 4600 by year-end and proceed to 5400 by the end of 2024. The index’s 10.3% drop to 4117.37 from July 31 through October 27 was a classic correction within a bull market, we believe. Since October 27, the S&P 500 is up 7.2% through Friday’s close of 4415.24.

So the bull market since October 12, 2022 is still going on, in our view, with the S&P 500 up 23.4% since then through Friday’s close.

Last year’s bear market was attributable to widespread fears that soaring inflation would force the Fed to raise interest rates to levels that would cause a credit crunch and a recession. Sure enough, the Fed raised the federal funds rate by 300bps from March through October of last year, and by another 225bps through July of this year (Fig. 3). Yet the S&P 500 bottomed on October 12 because the widely anticipated recession was a no-show. The stock market rally since then suggests that the S&P 500 is back on track as a leading indicator if indeed there’s no recession through 2024, which happens to be our outlook.

The strength of the economy, in the face of the dramatic increase in the federal funds and other interest rates since early last year, has surprised even optimistic prognosticators, including Debbie and me. The past 10 recessions were all preceded by significant increases in the federal funds rate (Fig. 4). Last week, in Wednesday’s Morning Briefing, we reviewed our five explanations for the resilience of the economy.

Strategy II: Santa Rally Started Before Halloween. The stock market seems to be following the classic pattern of a bullish year that started with a very positive January Barometer. The S&P 500 was up 6.2% this year during that month. It is also the third year of the presidential cycle, which tends to be the best of the four years of a presidential term. Even the seasonal script is back in play after the last two weeks’ epic rally. September and October tend to be tough months for the stock market, setting the stage for Santa Claus rallies during the final two months of the year.

This year, the Santa Claus rally might have started just before Halloween. Fears that the bond yield might continue to surge above 5.00% evaporated during the first week of this month in response to weaker-than-expected employment indicators and a broadening consensus that the Fed is done raising the federal funds rate. The 10-year US Treasury bond yield plunged 41bps from last month's peak of 4.98% on October 19 to 4.57% on Friday, November 3 (Fig. 5).

The stock market rose sharply on Friday, November 10 even though the 10-year Treasury bond yield ticked back up to 4.61%. Stock investors have learned that the economy can live with a 4.50%-5.00% long-term bond yield. If the yield stabilizes in this range, as we expect, then stock prices can move to new record highs through next year, if there’s no recession. Stable bond yields would help to stabilize valuation multiples. The forward P/E of the S&P 500 was 18.2 on Friday (Fig. 6).

The yield-curve spread, which is also a component of the LEI, is now -43bps (Fig. 7). That’s indicative of recession territory, but less so than on June 30, when the spread was -106bps. The yield-curve spread has a good record of calling recessions when it turns negative. This time has been different so far, so stock investors seem to be less concerned about that than they were during H2-2022.

By the way, also helping to boost stock prices on Friday was the uptick in the price of a barrel of Brent crude oil (Fig. 8). Investors have become increasingly concerned that the $15.12 drop since September 27 might reflect a rapidly weakening global economy.

We are expecting that both the bond yield and the oil price will stabilize around current levels. If so, then the Santa Claus rally may proceed through year-end as we project. During the latest stock market correction, the Bond Vigilantes saddled up and were riding high. Now stock investors may be back in the saddle again.

Strategy III: Recession Scare Ahead? So what could possibly go wrong? If Santa is early this year, might Halloween be late? Investors could still get spooked by weaker-than-expected economic indicators and higher-than-expected inflation. Of course, the geopolitical situation remains perilous. Domestic political partisanship remains unsettling. Mounting government debt could push bond yields higher to equilibrate supply with demand. The odds of a recession before the end of next year aren’t insignificant, at 35%, in our opinion.

For now, let’s focus on October’s business and inflation indicators that are coming out this week:

(1) Federal budget (Monday). Every month, the Bond Vigilantes will be incited to riot again by the Monthly Treasury Statement (MTS), showing US government receipts and outlays. In addition to the widening gap between receipts and outlays, they’ll be focusing on the fastest growing outlays category, namely net interest paid by the federal government. Over the past 12 months, it totaled a record $659.2 billion (Fig. 9). It has doubled since May 2021.

Marketable Treasury securities held by the public totaled $26 trillion during October (Fig. 10). So the Treasury paid an average interest rate of 2.50%, according to the latest data. The current 2-year Treasury yield is close to 5.00%.

(2) CPI (Tuesday). October’s headline CPI is expected to be around zero or even slightly negative on a m/m basis because of the drop in gasoline prices during the month (Fig. 11). The Cleveland Fed’s Inflation Nowcasting shows that the CPI headline and core inflation rates rose 0.07% and 0.34% m/m, respectively, during October. That puts the two up 3.3% and 4.2% on a y/y basis.

(3) Retail sales (Wednesday). October’s retail sales excluding gasoline might have been on the weak side. That’s because our Earned Income Proxy for private-sector wages and salaries in personal income was flat during the month (Fig. 12). Retail sales were strong in September, rising 0.7% m/m even though consumer revolving credit rose just $3.1 billion during the month (Fig. 13).

(4) Industrial production (Thursday). October’s employment report showed that aggregate weekly hours in manufacturing fell 0.3% m/m. That decline undoubtedly reflected the United Auto Workers strike (Fig. 14).

Movie. “NYAD” (+) (link) is a Netflix biopic about 64-year-old marathon swimmer Diana Nyad, who became the first person ever to swim from Cuba to Florida without the aid of a shark cage. After several tries during her career, she finally succeeds in 2013, completing the 110-mile swim in 53 hours. The only problem is that her feat wasn’t independently verified. So her controversial achievement was not ratified by the World Open Water Swimming Association or the Guinness World Book of Records. The movie stars Annette Bening as the eponymous American swimmer, while Jodie Foster plays her coach.

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Global Growth Fears Hit Industrials & Materials

November 9 (Thursday)

Industrials: Halloween Arrives Late. China’s declining exports and the drop in the price of oil futures spooked many commodity markets on Tuesday. The news amplified fears that the global economy is slowing under the weight of an overleveraged Chinese economy, higher interest rates, and a stronger US dollar. Truth be told, these fears have been festering and nicking away at commodities prices since many of them peaked earlier this year; they’ve been sliding ever since.

The price of Brent crude futures is $81.61 a barrel, down 11.7% from its recent high on October 19 and down 6.6% over just the past week (Fig. 1). The CRB Industrials metals spot price index has declined 12.0% from its 2023 high (Fig. 2). Within that index, copper futures have been weak for most of this year, declining 14.0% from its January 26, 2023 high (Fig. 3).

Meanwhile, most S&P 500 sectors were amazingly resilient to the global growth scare on Tuesday. Here’s the performance derby for the S&P 500 for Tuesday’s markets: Consumer Discretionary (1.2%), Information Technology (1.1), Communication Services (0.6), S&P 500 (0.3), Consumer Staples (0.2), Health Care (0.0), Financials (-0.1), Industrials (-0.3), Utilities (-0.7), Real Estate (-0.9), Materials (-1.9), and Energy (-2.2) (Table 1).

The S&P 500 Industrials and Materials sectors’ poor performances on Tuesday furthered the downward trajectory they’ve been on since peaking on August 1 and July 31. Industrials have fallen 11.3%, and Materials have dropped 9.3% since the sectors peaked (Fig. 4).

Here’s a closer look at what’s been ailing the Industrials sector’s stocks:

(1) Some winners, some losers. This should be a great time for companies in the Industrials sector, with new factories sprouting up around the US and internationally as companies look to diversify their operations outside of China and meet the huge demand for defense equipment. But instead, the sector’s price index performance is being weighed down by operational issues at Boeing and weakness in the transportation-related industries.

Here are some of the Industrials industries with positive ytd performances through Tuesday’s close: Electrical Components & Equipment (9.8%), Industrial Machinery (8.4), Industrial Conglomerates (6.7), and Construction Machinery & Heavy Trucks (3.3).

Conversely, these industries have been weighing down the Industrials sector’s ytd performance: Air Freight & Logistics (-3.4%), Rail Transportation (-4.2), Aerospace & Defense (-5.5), and Passenger Airlines (-11.5).

(2) Emerson disappoints. Companies catering to the automation of factories should be prospering given all the new factories being built for offshoring, nearshoring, and friend shoring. But the recent quarterly results of Emerson Electric and Rockwell Automation underwhelmed. Emerson shares fell 7.4% on Tuesday to $84.94 due to its fiscal Q4 (ended September 30) earnings report. The shares are down 15.2% from their 2023 high on September 11.

Emerson has been undergoing a transformation, selling slower growing businesses and buying faster growing ones. Adjusted fiscal Q4 earnings per share grew 20.6% to $1.29, but that was below analysts’ consensus estimate of $1.31 and failed to offset investors’ disappointment about recent quarters’ declining orders in the Discrete Automation and Test & Measurement units.

Emerson’s fiscal Q4 sales were up in each of its divisions except Discrete Automation, where they fell 7% y/y due to softer-than-expected demand and weakness in Europe and China, reported CFO Mike Baughman. Management expects the segment’s sales to recover to flat-to-low-single-digit y/y comparisons by H2-2024.

(3) Rockwell disappoints too. Rockwell Automation’s share price has fallen by one-fourth since its peak on July 18. The company attributed its lower-than-expected earnings forecast for fiscal 2024 (ending September 30) to distributors’ inventory destocking and, to a lesser extent, to a slowdown in its business in China. More optimistically, the company confirmed that US stimulus spending to encourage building factories domestically will keep Rockwell’s US business growing for many years.

The company posted strong fiscal Q4 (ended September 30) organic sales growth of 17.7% y/y and adjusted EPS growth of 20% y/y. However, management’s guidance for fiscal 2024 adjusted EPS was less than analysts were expecting: $12.00-$13.50 with a midpoint of $12.75, compared to the consensus estimate of $12.94 for next year and adjusted earnings of $12.12 in full-year fiscal 2023. The consensus estimate for next fiscal year has declined from $13.31 three months ago.

Rockwell noted that its distributors’ excess inventory led to a decline in orders in fiscal Q4 and that inventory right-sizing may continue through fiscal Q1 (ending December 31).

The company’s fiscal 2024 EPS will also be weighed down by $0.25 dilution from last month’s acquisition of Clearpath Robotics, which makes autonomous mobile robots. But over the long run, the acquisition should be a homerun because the market for industrial mobile robots in factory floor applications is expected to grow more than 30% for each of the next five years.

Finally, next year’s results will be weighed down by weakness in the company’s China business, which represents about 6% of its worldwide sales. “While we saw strong sales growth in China in fiscal year ’23, we continue to see high order deferrals and cancellations in China,” said CEO Blake Moret on the company’s earnings conference call. As a result of China’s weakness, orders from Asia are expected to fall y/y in 2024; order growth is expected to be the highest in the Americas. Projects funded by US government stimulus spending are still in the “early innings,” with decisions on what automation equipment to purchase not yet made.

Emerson and Rockwell are members of the S&P 500 Electrical Components & Equipment industry, which was up by 23.9% at its September 1 peak this year but now is up only 9.8% ytd (Fig. 5). The industry is coming off strong results in 2021 and 2022, when earnings grew 26.2% and 14.8%, respectively. The industry’s earnings growth is expected to be tepid this year, at 6.3%, before strengthening to 12.4% in 2024 (Fig. 6). The industry has benefitted from a record forward profit margin of 16.4%, up from around 13% in 2019, and positive net earnings revisions (Fig. 7). The industry’s forward P/E ratio has fallen to a more reasonable 19.5, down from 26.3 in July 2021 (Fig. 8).
 
Materials: Steel Enjoys a Cushion. Investing in steel has not been for the faint of heart. The commodity’s price rose 64.0% from the start of this year through April 12; it then fell 42% through October 3 and since has risen 30% to $890 per metric ton. On a ytd basis, steel has risen 20%, far outperforming the 4% decline in the copper price (Fig. 9).

The share prices of the two companies in the S&P 500 Steel industry, Nucor and Steel Dynamics, are up 14.9% and 12.9% ytd through Tuesday’s close. Both stocks have fallen since March, when both were up by more than 35% (Fig. 10).

These stocks’ appreciation this year is out of step with analysts’ expectations that their earnings will fall sharply. The S&P 500 Steel industry’s aggregate earnings rose 610.6% in 2021 and 28.1% in 2022. This year, they’re expected to fall 36.9%, followed by a 33.8% decline in 2024 (Fig. 11).

Nucor CFO Steve Laxton acknowledged that the steel market had softened in the company’s Q3 earnings conference call on October 24: “We attribute this to uncertainty arising from the United Auto Workers Strike, higher interest rates, credit tightening, elevated geopolitical risk and concern about another potential US government shutdown.” As a result, the company expects Q4 results to decline y/y for the second quarter.

The company’s utilization rate fell to 77% in Q3, down from 84% in Q2, and Q3 EPS of $4.57 fell from $5.81 in Q2 and $6.50 in Q3-2022. Earnings in Q4 are expected to decline from Q3 levels, primarily due to lower prices. Nucor shares are up 14.9% ytd through Tuesday’s close, but they have deflated from gains north of 30% in August.

Let’s take a look at what might be keeping steel stocks in positive territory this year:

(1) Tariffs help. The industry continues to benefit from tariffs that former President Trump placed on imports of steel, arguing that it was important to the US’s national security to have a strong steel industry. At the end of last month, the US Supreme Court declined to hear an American steel importer’s case arguing that tariffs on certain steel products should be invalidated, an October 30 Reuters article reported. The Biden administration urged the Supreme Court not to take up the appeal.

(2) Auto production set to rev up after UAW strike. On October 30, General Motors and the United Auto Workers (UAW) agreed to a tentative deal to end the workers’ six-week strike. Their deal followed deals between Ford Motor and Stellantis and the workers. Workers began walking off the job at specific factories on September 15, and by the strike’s end, one third of United Auto Workers’ 150,000 members were striking, an October 30 Reuters article reported.

With workers back on the job, car manufacturing by the Big Three automakers is no longer imperiled, so US demand for steel should remain strong. US auto sales came in at 15.7mu (saar) in October, down a smidge from their recent high of 16.2mu but well off the lows of 12.7mu in 2022 (Fig. 12). US auto inventories remain near historical lows, with the inventory-to-sales ratio of 1.1 months well below the 2.5 norm (Fig. 13).

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Captain America

November 8 (Wednesday)

US Economy: Superhero. Like Captain America, the American economy seems to have an indestructible shield. The Fed has raised the federal funds rate aggressively by 525bps since March 2022 with the aim of tightening financial conditions to slow the economy and to raise the unemployment rate with the ultimate aim of bringing down price and wage inflation (Fig. 1).

Yet real GDP jumped 4.9% (saar) and rose 2.9% y/y during Q3 (Fig. 2 and Fig. 3). Real nonfarm business output, which is used to calculate productivity, soared 5.9% (saar) during Q3 and rose 3.1% y/y! The unemployment rate has remained below 4.0% since February 2022. Yet both consumer price and wage inflation rates have dropped from their 2022 peaks of 9.1% and 5.9% to 3.7% in September and 4.4% in October (Fig. 4 and Fig. 5).

Debbie and I have been discussing the main reasons for the economy’s resilience and disinflationary tendencies since early last year. Here is a brief review and update:

(1) Resilient consumers. Consumer spending has continued to grow despite the tightening of credit conditions (Fig. 6). As a result, employment has continued to grow, boosting the purchasing power of consumers. Payroll employment rose to a record high of 156.9 million during October, up 1.9% y/y (Fig. 7). Many of the industries with the largest payrolls are continuing to expand their employment rolls into record-high territory, including construction (8.0 million), educational services (4.0 million), financial activities (9.2 million), health care & social assistance (21.7 million), leisure & hospitality (17.0 million), and professional & business services (23.0 million).

Some of the industries that are expanding their payrolls are doing so because of strong demand for their services by Baby Boomers, most of whom now are seniors. These include financial activities, health care & social services, and leisure & hospitality. Retired Boomers have over $75 trillion in net worth and will be spending much of it as they grow older. Many of their adult children likely anticipate inheriting some of their parents’ net worth, prompting them to save less and spend more of their incomes.

Also keep in mind that unearned personal income (from interest, dividends, rent, and proprietors’ income) rose to an all-time record high of $6.5 trillion (saar) during September (Fig. 8).
 
(2) Onshoring & technology-led capital spending. Onshoring is boosting capital spending, as evidenced by the 14.1% y/y jump in real capital spending on new manufacturing structures during Q3 (Fig. 9). Companies are allocating more of their capital spending budgets to technology hardware and software to boost their productivity in response to chronic labor shortages. As a result, production of high-tech equipment and spending on software are at all-time highs (Fig. 10). Also booming is industrial production of defense, which is likely to continue rising to new record highs given the geopolitical turmoil around the world. (Fig. 11).
 
(3) Fiscal stimulus. Federal government spending is growing rapidly, led by outlays on net interest paid. They totaled a record $659.2 billion over the past 12 months through September. That’s an unsettling development, for sure. However, keep in mind that high interest rates represent a big windfall for households that receive interest income, which has increased significantly. Meanwhile, the spending bills passed by Congress last year will continue to boost construction spending on public infrastructure, which is at a record high (Fig. 12).
 
(4) Refinanced balance sheets. In his November 1 press conference, Fed Chair Jerome Powell acknowledged that the Fed “may have underestimated the balance sheet strength of households and small businesses.” That’s partly because many of them refinanced their debts at record-low interest rates over the past few years. So the rise in interest rates since early last year hasn’t boosted their interest payments on their debts enough to weigh on their overall spending.
 
(5) Domestic migration. Since the pandemic, there has been significant migration from northern states to southern ones that have warmer weather, lower taxes, and more job openings. That’s created a big demand for housing, especially rental apartments. It’s also meant that the states with increasing populations must spend more on infrastructure to accommodate their new residents and workers.
 
Global Economy: Unheroic. The NYMEX price of a barrel of crude oil peaked this year at $93.68 on September 27. Notwithstanding the war that started between Israel and Hamas on October 7, the price is down $16.27 from that peak to $77.42. That’s even though Saudi Arabia and Russia reduced their exports during the summer and maintained their cuts through year-end.

One reason for this development is that US crude oil field production is back at record highs (Fig. 13).

Another reason is that the global economy remains weak. For example, China’s October merchandise trade data showed that while imports rose 5.8% y/y, exports fell 4.5% over the same period. In fact, both have been relatively flat since early 2022 (Fig. 14). Japan’s industrial production fell in September (-3.7% y/y) and also has been flat since early 2022 (Fig. 15).

Strategy: Analysts Trimming Estimates Despite Strong Q3. As of mid-day Tuesday, the S&P 500’s Q3-2023 reporting season is more than 85% complete. Like all earnings seasons, there has been good news and bad news. While the just-reported Q3’s results have been mostly good—with strong earnings and revenues surprise data indicating a lot of better-than-expected results—analysts and investors are always looking ahead at the forecasts for the future.

Managements have been tempering their future expectations for their companies, so analysts have been following suit, trimming their estimates for future periods at faster-than-typical rates. But we’re not alarmed. The rate of decline suggests a soft landing for the economy, as we’ve been expecting. A few sectors continue to do very well, most are holding up just fine, and only a few are experiencing challenges, as Joe shows below (note that the data below represent the collective results of just those 85% of S&P 500 companies that have reported Q3 earnings so far, as of mid-day Tuesday):

(1) Q3 revenue and earnings surprise and growth. Comparing Q3’s aggregate revenue and earnings surprises to Q2’s at the same point in the reporting season shows fewer companies exceeding analysts’ estimates but greater y/y growth rates. Specifically, the revenue beat has weakened to 0.7% from Q2’s 1.9%, and the earnings surprise has eased to 7.0% from Q2’s 7.9%. However, the y/y growth rates of both revenues and earnings have improved. Revenues are up 1.4% y/y compared to 0.9% at the same point in the Q2 season, and earnings are up 2.4% y/y compared to a 7.7% decline in Q2.

(2) Q4 forecasts are being trimmed at a faster rate. The S&P 500’s consensus Q4 EPS estimate has fallen 3.6% in the five weeks since the start of Q4-2023. That’s more than the declines during the first three quarters of 2023 over the analogous five-week timeframe (-0.5% in Q3, -0.7% in Q2, and -3.5% in Q1).

However, the decline in the Q4-2023 estimate is still less than the 4.1% and 4.4% declines that occurred in Q3-2022 and Q4-2022, when the MegaCap-8 stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) contributed heavily to the results. Looking back at the 55 quarters since Q1-2010, Q4-2023’s estimate decline of 3.6% to date has been eclipsed during just eight of the 55 quarters (Q4-2011, Q3-2012, Q1-2015, Q1-2016, Q1-2019, Q2-2020, Q3-2022, and Q4-2022).

(3) Single-digit y/y earnings growth now expected in Q4-2023. According to I/B/E/S data from the London Stock Exchange Group, the S&P 500’s proforma y/y earnings growth forecast for Q4-2023 has dropped to 7.0% as of November 3 from a projected 11.0% on October 1. Among the S&P 500’s 11 sectors, only Communication Services and Tech improved since the start of the quarter, while Health Care has posted the biggest drop.

Here’s how the S&P 500 sectors’ Q4-2023 growth rates have fared: Communication Services (50.0% as of November 3, 49.5% as of October 1), Consumer Discretionary (21.5, 28.5), Consumer Staples (1.8, 5.2), Energy (-20.0, -20.6), Financials (11.3, 11.7), Health Care (-14.9, 2.4), Industrials (0.3, 6.3), Information Technology (15.6, 14.7), Materials (-16.5, -7.6), Real Estate (11.7, 14.3), and Utilities (54.5, 55.4).

(4) Waiting for Q4 before adjusting 2024’s expectations. Looking ahead to 2024, analysts have taken only a light pencil to their forecasts so far. They’ll press down harder during the Q4-2023 reporting season, when the managements of the companies they follow provide more detail about their expectations for 2024.

For now, the consensus S&P 500 earnings-per-share forecast of $245.75 for 2024 is down 0.7% over the past five weeks. The quarterly forecasts have changed as follows: Q1 down 1.3%, Q2 down 1.0%, Q3 up 0.8%, and Q4 down 0.9% (Fig. 16). Analysts still expect solid earnings growth of 11.5% in 2024, with their quarterly projections at 7.1% y/y (Q1), 11.0% y/y (Q2), 9.9% y/y (Q3), and 16.0% y/y (Q4) (Fig. 17).

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What’s Next? Pickleball!

November 7 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: What’s Next? The answer to this question is: pickleball. The bulls and the bears in the bond market are likely to keep the 10-year Treasury bond yield in play between 4.50% and 5.00% through the end of this year. The bulls and the bears in the stock market are likely to keep the S&P 500 in play between 4117 and 4589 over the rest of the year, i.e., in a range between the October 27 low and the July 31 high. We are expecting the bulls will prevail by the end of this year, with the bond yield at 4.50% and the stock index at 4600. Consider the following:

(1) Bonds. A year ago, in early November, we called the top in the 10-year Treasury bond yield at 4.25% on October 24, 2022. That remained the top for about a year, until September 13 of this year when the yield rose once again to 4.25% and kept rising, peaking at 4.98% on October 19 (Fig. 1). At the end of last week, it was back down to 4.57%.

Now we reckon that the yield might be rangebound through next year between 4.00% and 5.00%. That would be in line with the yield range that occurred from 2002 through 2007, i.e., the years before the New Abnormal period from the Great Financial Crisis to the Great Virus Crisis, when the Fed repressed interest rates.

Why such a wide projection range? Because we think the forces influencing the bond market will keep the yield fluctuating to-and-fro within that range.

On the one hand, we are reasonably confident that inflation will continue to moderate through next year. Yesterday, we observed that nonfarm unit labor cost (ULC) inflation is a major determinant of the CPI inflation rate. That’s especially the case for the CPI excluding food, energy and shelter, which rose 2.0% y/y in September (Fig. 2). The ULC inflation rate was down to 1.9% during Q3. Moderating inflation, a bullish force, will tend to pull the yield closer to the lower 4.00% end of our target range.

On the other hand, fiscal policy (like our border with Mexico) is out of control. The federal deficit is at a record high excluding the pandemic period. Federal debt is at a record high. The fastest growing component of federal outlays is interest expense (Fig. 3). This bearish factor will tend to push the yield closer to the higher 5.00% end of our target range.

So the tug-of-war between the bond bulls (who are focusing on falling inflation) and the bond bears (who are focusing on the mounting debt) will continue for the foreseeable future, keeping the bond yield in a range of 4.00% to 5.00%, in our opinion.

(2) Stocks. At the end of last year, the widespread consensus was that 2023 would start with a mild recession during H1 and a modest recovery in H2. The Street consensus was that H1 would be bearish for stocks and H2 would be bullish for them. We were bullish with our S&P 500 price index forecast of 4600 by the end of 2023 and our S&P 500 earnings-per-share estimate of $225 for the year.

The S&P 500 peaked just shy of 4600 on July 31. We declared victory and concluded that a correction down to the 200-day moving average (dma) of the S&P 500 was likely next, followed by a year-end rally back to 4600. When the index fell below its 200-dma on October 20, our confidence in that forecast got a little wobbly. It’s less so now that the index jumped to its 50-dma last week (Fig. 4).

Joe and I are sticking with our estimate of $225 for S&P 500 earnings per share for this year (Fig. 5). As of the November 1 week, the consensus of industry analysts was $216. We are also still projecting $250 and $270 for 2024 and 2025.

S&P 500 forward earnings per share rose to a record high of $241.85 during the November 2 week (Fig. 6). If it hits $250 by the end of this year, our year-end target for the S&P 500 price index of 4600 would imply a forward P/E of 18.4.

If forward earnings reaches $270 by the end of next year, the forward P/E implied by our S&P 500 target of 5400 at year-end 2024 would be 20.0.

US Economy: What’s Next? The big surprise in 2024 won’t be a recession. That’s because if a recession does happen, it won’t be a surprise since it has been the most widely anticipated recession in history. The really big surprise would be better-than-expected economic growth that would be led by productivity. In this scenario, the Fed might actually get inflation down to 2.0%, while real economic growth might be 3.0% or more rather than 2.0% or less.

Our earnings forecasts above reflect our confidence in this Roaring 2020s scenario finally coming to life. While Debbie and I have been having some fun with the no-show Godot recession, we must admit that the productivity growth boom likewise has been a no-show. But as we observed last week in our November 2 QuickTakes, Q3’s productivity report suggests that our Godot scenario may be starting to play out. Consider the following:

(1) Productivity. Nonfarm business productivity rose 2.2% y/y during Q3 (Fig. 7). Productivity growth pops typically occur at the tail end of recessions and early recovery periods. The latest pop is consistent with our view that the economy has been in a recession since early 2022, with the proviso that it has been a rolling recession rather than an economy-wide one.

Why might the latest productivity pop be the start of a productivity growth boom? Companies are facing chronic labor shortages, especially of skilled and qualified workers. So they must do whatever they can to boost the productivity of their workers. The working-age population (16 years or older) rose just 1.1% y/y over the 12 months through October (Fig. 8). The labor force is up 1.7% over this same period on the same basis. But it’s constrained by the growth rate of the working-age population.

(2) Real hourly compensation. The main driver of inflation-adjusted hourly compensation is productivity (Fig. 9). Many economists have been alarmed by the widening gap between the two since 1973, with the former increasingly lagging the latter. That’s most noticeable when the CPI is used to deflate hourly compensation. But the CPI has an upward bias. The so-called compensation-productivity gap mostly disappears when the nonfarm business price deflator is used instead of the CPI.

The productivity growth boom we expect for the remainder of the decade should boost real compensation growth commensurately.

(3) Inflation. As noted above, ULC inflation was down to only 1.9% y/y during Q3 as hourly compensation growth of 4.2% was offset by productivity growth of 2.2% (Fig. 10, Fig. 11, and Fig. 12).

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Throwing Caution To The Wind

November 6 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
An Epic Week I: Back on the Right Track. Halloween wasn’t spooky after all. Instead, the S&P 500 bottomed at 4117.37 on Friday, October 27. It found support at the uptrend line connecting the closing lows of March 23, 2020 and October 12, 2022 (Fig. 1). It rose every day last week, gaining 5.8% through Friday. At its recent low on October 27, it was 2.9% below its 200-day moving average (dma). Now it is 2.6% above this average. It was down 10.3% from its 4588.96 high of the year on July 31. Joe and I think that the correction is over and that we may be back on track to achieve our year-end target of 4600.

The Nasdaq rebounded 6.6% last week to 5.0% above its 200-dma and also moved back above its 50-dma (Fig. 2). The plunge in the bond yield boosted the valuation multiples of technology stocks as well as the more traditional interest-rate sensitive ones. Here is last week’s performance derby for the S&P 500 and its 11 sectors: Real Estate (8.5%), Financials (7.4), Consumer Discretionary (7.2), Information Technology (6.8), Communication Services (6.5), S&P 500 (5.9), Industrials (5.3), Utilities (5.2), Materials (5.1), Health Care (3.5), Consumer Staples (3.2), and Energy (2.3).

Joe observes that many S&P 500 sectors had their best weekly gain in at least 51 weeks. The S&P 400 MidCaps and S&P 600 SmallCaps beat the S&P 500 last week with gains of 6.5% and 7.4%, led by Financials, Real Estate, and Utilities. For example, the regional banks rose 13.1%, 10.4%, and 11.5% in the S&P 500, S&P 400, and S&P 600 indexes respectively.

The stock market seems to be following the classic seasonal year-end script of weakness in September and October setting the stage for a Santa Claus rally. We concluded our November 1 QuickTakes with: “Santa may be early this year.”

An Epic Week II: Nothing To Fear for Now? From August through October, investors were spooked by the jump in the 10-year US Treasury bond yield from 3.96% on July 31 to 5.00% a week ago. Over that period, investors became increasingly concerned about the rapidly deteriorating outlook for the US budget deficit. Fed officials also spooked them by hammering them with their “higher-for-longer” mantra that interest rates would be kept restrictive for the foreseeable future.

However, last week, the bond yield fell from 4.93% on Tuesday, October 31 (Halloween) to end the week at 4.57% (Fig. 3). It was an epic rally in the bond market fueled by modestly bullish economic news that seems to have triggered a massive short-covering rally by the bears and a buying panic by the bulls.

Our friend Michael Brush, who is a columnist for MarketWatch, believes that the selling pressure in the bond market ended on October 31 because that was the deadline for money managers to finish tax-loss selling. The day before, on Monday, October 30, Pershing Square’s Bill Ackman revealed that he covered his bet against long-term Treasurys, believing that investors may increasingly buy bonds as a safe haven because of growing geopolitical risks. “There is too much risk in the world to remain short bonds at current long-term rates,” Ackman said in a post on X.

On Wednesday morning, the bond and stock rallies were fueled by a weak ADP private payroll employment report and the Treasury’s decision to do its next round of financing with more in bills and less in bonds. That afternoon, investors listened carefully to Fed Chair Jerome Powell’s press conference following the latest FOMC meeting and concluded that the Fed may be done raising interest rates. A better-than-expected Q3 productivity report on Thursday showed that unit labor costs, the main driver of inflation, fell to just 1.9% y/y during Q3 (Fig. 4). Friday’s weaker-than-expected employment report for October sent the yield back down to almost 4.50%.

In addition to getting spooked by the bond market in recent months, equity investors have been fearing that the war between Hamas and Israel would quickly turn into a regional war masterminded by the Mad Mullahs of Tehran. We have been, too. However, Hezbollah hasn’t opened a significant second front north of Israel, so far. Indeed, on Friday, Sayyed Hassan Nasrallah, the leader of the Lebanese militant group, in his first public comments since the start of the Gaza war, stopped short of announcing an all-out escalation of his group’s battles with Israel despite warning that all options were “on the table.”

Hezbollah has been exchanging fire with Israeli forces across the Lebanese-Israeli frontier since its Palestinian ally Hamas went to war with Israel on October 7. It marks the worst fighting at the frontier since a 2006 war but has mostly been contained to the border area. This suggests that Iran doesn’t want an all-out regional war that might force the US to come to the defense of Israel at this time.

US Economy: Immaculate Disinflation Update. The diehard hard-landers are still expecting a recession, but now it is in 2024 because 2023 is almost over with no sign of a hard landing. They started to predict a recession in 2022 when the Fed began to raise interest rates aggressively. When the yield curve inverted during the summer of 2022, they took that as a sure sign that a recession is imminent (Fig. 5).

Now that the yield curve is disinverting, the hard-landers claim that’s what it does just before a recession occurs. In the past, that’s been true: It would disinvert when the Fed lowered short-term rates faster than long-term rates fell in response to financial crises that quickly turned into credit crunches that caused the recessions. This time, the yield curve has been disinverting since the summer of this year for an entirely different reason, one that hardly suggests an imminent recession: It has disinverted because the bond yield rose faster than the federal funds rate and the two-year Treasury note yield, partly as a result of stronger-than-expected economic growth (Fig. 6)!

We are still soft-landers, assigning subjective odds of 35% to a recession before the end of 2024. As we’ve been expecting, inflation has been moderating without the Fed’s having to trigger a recession to bring it down. Last week’s employment and inflation data support our immaculate disinflation (i.e., without a recession) scenario. Consider the following:

(1) Employers still hiring. Job openings remained elevated during September, and the job-openings series in the Consumer Confidence Index survey remained high as well during its last reading, in October (Fig. 7). So why did payroll employment with and without government employment rise by only 150,000 and 99,000 during October? The supply of labor, as measured by the labor force, declined 201,000 during October, and the labor force participation rate edged down to 62.7% during the month (Fig. 8). That’s still below the pre-pandemic reading of 63.3% during February 2020. Employers still have plenty of job openings, but a shortage of qualified workers remains a problem.

(2) Wage inflation moderating. Notwithstanding the ongoing imbalance with the demand for workers exceeding the supply, wage inflation continues to moderate. It’s doing so because quits are falling as more workers stay put rather than move to a better-paying job for various reasons.

Average hourly earnings inflation edged down to 4.1% y/y during October for all workers. It fell to 4.4% for production and nonsupervisory workers (Fig. 9). During Q3, the Employment Cost Index for wages and salaries was down to 4.5%. These three measures of wage inflation are down from their 2022 peaks of 5.9%, 7.0%, and 5.7%. Also during Q3, hourly compensation rose 3.9% q/q (saar) and 4.2% y/y (Fig. 10).

(3) Productivity growth rebounding. The great news last week was that Q3’s nonfarm business productivity jumped 4.7% q/q (saar) and 2.2% y/y during Q3. We think that the economy started a productivity growth boom in early 2016 that was interrupted by the pandemic. Now it is likely to be accelerated by the aftereffects of the pandemic, particularly the labor shortage. We expect to see the current productivity growth boom peak by the end of the decade around 4.0%. That would allow real hourly compensation to grow as much. It would also support greater-than-expected economic growth while keeping a tight lid on inflation—the best of both worlds!

(4) YRI Earned Income Proxy flattening. The hard-landers point out that payroll employment excluding government payrolls rose just 99,000 during October. In addition, August and September payrolls were revised down by 101,000 together. Strike activity has had some negative impact on these numbers since August.

Nevertheless, the YRI Earned Income Proxy (EIP) for wages and salaries in private industry was flat during October. That suggests that the month’s retail sales might have been weak, especially on an inflation-adjusted basis. However, as we observed last week, consumers have other significant sources of personal income (i.e., interest, dividend, rental, and proprietors’ income), all of which are at record highs.
 
Bonds: The Treasury’s Bearish List & the Bond Vigilantes. Last week’s bond market rally confirmed our view that there would be sufficient buyers at a 10-year Treasury yield of 5.00% to boost demand enough to meet supply.

We’ve previously observed that the economy had no trouble living with a bond yield of 4.50% to 5.00% from 2003-07. That period was the Old Normal for bonds. It was followed by the New Abnormal period from the Great Financial Crisis through the Great Virus Crisis, when the major central bankers suppressed market forces, keeping interest rates close to zero and buying lots of bonds, all because they were panicked about deflation.

Above, Melissa and I listed some of the reasons that explain last week’s bond rally. We should add kudos to Barron’s for the October 30 cover story titled “Time To Buy Bonds.” The next day, on October 31, the Treasury Borrowing Advisory Committee (TBAC) submitted its regular report to Treasury Secretary Janet Yellen. It listed all the reasons why yields soared from August through October. That list did not include tax-loss selling pressure. It did mention that the federal deficit is troubling the bond market: “There is a view among market participants that the growing imbalance between supply of and demand for US Treasury debt may also have contributed to the sell-off.”

The Bond Vigilantes weren’t mentioned in the TBAC report. We attributed the selloff in the bond market partly to their adverse reaction to the recklessness of fiscal policy. Does last week’s rally suggest that they are no longer concerned? Of course not. Like Arnold Schwarzenegger’s character “The Terminator” (in the 1984 movie of the same name), they’ll be back if necessary to impose law and order In Washington.

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Burritos, Stocks & Hydrogen

November 2 (Thursday)

Consumer Discretionary: Hamburgers, Burritos & Ice Cream. Prices on everything from hamburgers to burritos and ice cream are still rising, pushed up by companies passing on their own rising costs to customers. While price increases have been moderating since last year, they will likely continue to rise, particularly at restaurant chains with locations in California. The Golden State has passed a new law that will increase the minimum wage to $20.00 an hour for workers at restaurant chains starting in April. California’s fast-food workers currently earn an average of $16.60 an hour, and the state’s minimum wage is $15.50 an hour.

Prices for food services and accommodations rose 6.0% y/y in September as measured by the PCED. That’s higher than the 4.3% y/y rise in the non-housing services component of the PCED in September, but the increase in food services and accommodations prices has been decelerating since it peaked at 8.8% y/y in May 2022 (Fig. 1 and Fig. 2).

Chipotle, McDonald’s, and Unilever recently reported Q3 earnings. Here’s some of what their managements had to say on the demand and pricing front:

(1) Customers still eating out. For the most part, Chipotle and McDonald’s customers didn’t blink when facing pricier hamburgers and burritos. Chipotle’s Q3 sales rose by more than 11% y/y to $2.5 billion, including a 5% jump in same-store sales and a 4% increase in transaction growth. Adjusted earnings per share soared 19% y/y.

The company boosted prices by 3% in October, marking the fourth time it has hiked prices since June 2021, an October 30 CNBC article reported. Last year’s price increases were “mostly offset” by food cost inflation, including for beef and queso, said CFO Jack Hartung in the company’s earnings conference call. With that in mind, the company anticipates mid- to high-single-digit same-store sales growth in Q4.

McDonald’s Q3 revenue rose 14% y/y to $6.7 billion, with same-store sales increasing by 8.8% and US same-store sales increasing 8.1%. McDonald’s raised prices in the US by about 10% for all of 2023. Adjusted earnings per share rose 16% y/y.

(2) Different observations on low-income consumers. Chipotle’s Hartung noted that sales are doing well across all consumer income levels. He specifically noted that sales to lower-income consumers are “holding up really well. They’re really hanging in there at about the same level as our medium- and high-income levels.” The strong performance indicates that the company’s food remains affordable despite recent price increases.

McDonald’s US traffic fell y/y during Q3, which was attributed to tough comparisons to last year and reduced visits from customers who make less than $45,000 a year. Conversely, McDonald’s officials said it gained market share with middle- and high-income customers, who may be trading down to McDonald’s from more expensive dining options.

(3) California: The land of rising wages. California is raising the minimum wage earned by restaurant workers to $20.00 an hour in April. Chipotle’s average wage in the state is about $17.00 an hour, and about 15% of its restaurants are in the Golden State. To pay for the required wage increase, Chipotle will raise prices by percentages in the mid- to high single digits, Hartung estimated on the conference call.

In addition to higher prices, the company can improve its profitability via more use of drive-throughs and technology. Meals sold via the Chipotlane have better margins than those sold in the restaurants. Chipotle is also experimenting with advanced automation, including an “Autocado,” which cuts, cores, and scoops avocados, and Hyphen, a robotic assembly line that makes burrito bowls and salads.

McDonald's also expects to increase prices to offset some of the wage pressures it will face due to the new California law. It too will be looking for ways to increase productivity, said CEO Chris Kempczinski on the company’s recent conference call. In general, McDonald’s hopes it will weather the change better than its competitors and increase its market share as a result.

(4) A look at restaurants. Chipotle and McDonald’s both are members of the S&P 500 Restaurants stock price index, which after a strong run for most of 2022, has fallen 12.8% from its peak on May 2 (Fig. 3). Analysts are still optimistic that revenues will grow 9.8% this year and 8.7% in 2024 (Fig. 4). Earnings are also expected to grow sharply, by 16.3% and 11.1% this year and next (Fig. 5). The industry’s forward P/E, which spiked up to 23.2 during the Covid pandemic, has been falling in the ensuing years to a recent 17.6 (Fig. 6).

(5) Problematic price increases. Unilever brought in new CEO Hein Schumacher earlier this year to help turn around the struggling European consumer products company. Schumacher laid out his turnaround plans during the company’s Q3 earnings conference call, during which the company announced that sales grew 5.2% last quarter, with product prices climbing 5.8% and volume declining 0.6%.

One problem area in the company’s product portfolio was the Nutrition business, home to Hellmann’s and Knorr products. The business line’s sales rose 5.6%, reflecting a 9.8% increase in prices partly offset by a 3.8% sales volume decline. The company increased prices in response to “continued material cost inflation,” CFO Graeme Pitkethy said on the earnings conference call .

Meanwhile, ice cream sales dropped 2.8%, as a price increase of 8.2% was more than offset by a volume decline of 10.1%. Unilever owns Ben & Jerry’s, among other ice cream brands. The price increases did not offset all of the cost inflation the company faced, and higher prices pushed cost conscious consumers to trade down to value and private-label brands.

Schumacher’s restructuring plans include focusing on the company’s top 30 brands, emphasizing innovation, spending more on marketing, and pruning brands that underperform. He believes inflation will normalize “back to the levels that we had before we entered the inflation spike,” which should limit the price increases the company will need to take going forward.

The clock is ticking: Activist investor Nelson Peltz joined the company’s board of directors in July. Unilever’s shares have fallen 6.0% ytd through Tuesday’s close, compared to the S&P 500’s 9.2% gain over the same period.
 
Strategy: A Look at the Damage. The S&P 500 is up 9.2% ytd through Tuesday’s close, but that strong performance disguises much of the turbulence the market has experienced since its July 31 peak, at which point the index was up 19.5% for the year.

Here’s a look at how the performance data of S&P 500 sectors and industries have changed since the end of July and a bit about what investors were thinking to produce those shifts:

(1) Sector switches. Interest rates had been rising since early May, but this summer they shot higher, and stocks flinched. Every single sector in the S&P 500 has fallen since July 31; however, on a relative basis the Energy and Health Care sectors went from laggards in the first seven months of the year to leaders in the August-through-October timeframe.

S&P 500 sectors with stocks that typically are purchased for their dividend payments performed poorly both before and after July 31 this year. The dividend yields on the Real Estate, Utilities, and Consumer Staples sectors have lost their luster compared to today’s elevated Treasury yields.

Here’s the performance derby for the S&P 500 sectors as they’ve performed from July 31 through Tuesday’s close: Energy (-2.5%), Communication Services (-5.6), Health Care (-7.1), Information Technology (-8.3), Financials (-8.5), S&P 500 (-8.6), Consumer Staples (-9.7), Industrials (-10.9), Utilities (-11.1), Materials (-11.3), Consumer Discretionary (-11.4), and Real Estate (-13.3) (Table 1).

Note how different—and meager—those August-through-October performances are compared to the sectors’ performances in the year’s first seven months: Information Technology (45.8%), Communication Services (44.7), Consumer Discretionary (35.5), S&P 500 (19.5), Industrials (12.3), Materials (10.2), Financials (3.1), Real Estate (3.1), Consumer Staples (1.9), Energy (-0.5), Health Care (-1.5), and Utilities (-5.0) (Table 2).

(2) Insurance dominates. Everyone needs insurance, and the industry often performs well in good times and bad. Four of the top 15 best performing industries in the S&P 500 since July 31 hail from the insurance business, including the two best performing industries. They’ve benefitted from the ability to raise prices.

Here are the 15 S&P 500 industries that have performed the best from July 31 through Tuesday’s close: Property & Casualty Insurance (9.9%), Reinsurance (9.7), Technology Distributors (7.1), Oil & Gas Refining & Marketing (5.3), Publishing (4.9), Managed Health Care (4.7), Wireless Telecommunication Services (4.4), Integrated Telecommunication Services (4.3), Health Care Distributors (4.2), Communications Equipment (3.0), Multi-Line Insurance (2.7), Insurance Brokers (2.3), Data Processing & Outsourced Services (1.6), Apparel Retail (1.6), and Internet Services & Infrastructure (1.0).

(3) Picking through the rubble. Among the worst performing S&P 500 industries from July 31 through Tuesday’s close are Passenger Airlines (-34.0%) and Casinos & Gaming (-25.7%), which have fallen as oil prices rose and investors came to believe that the post-pandemic pent-up demand for travel has been satiated.

High interest rates keeping homeowners in homes with low-rate mortgages have taken a bite out of share prices in home-related industries including Household Appliances (-27.5%), Home Furnishings (-24.4), Building Products (-17.1), Home Improvement Retail (-15.9), and Homebuilding (-15.8). High interest rates have also hurt stocks industries that depend on financing to fund purchases, including Automobile Manufacturers (-25.1%). The high cost of financing has even hurt Health Care Supplies (-36.4%), the S&P 500’s worst performing industry of the period, as consumers often finance purchases of dental products like braces.

Rounding out the list of the S&P 500’s 15 worst August-through-October performers among industries are: Personal Care Products (-31.5%), Independent Power Producers and Energy Traders (-31.1), Leisure Products (-30.1), Drug Retail (-29.7), Apparel, Accessories & Luxury Goods (-24.7), Copper (-24.3), Office REITs (-23.9), Automotive Parts & Equipment (-20.5), and Regional Banks (-20.3).

Disruptive Technologies: White Hydrogen. Using naturally produced hydrogen to power our world would be beneficial because when hydrogen combusts, it throws off only water, with no carbon dioxide pollution. One of the knocks against the gas is that it often exists in nature in combination with other elements. Separating out the hydrogen requires energy that’s often provided by fossil fuels—like coal or natural gas—that do throw off greenhouse gases when they combust.

The pure hydrogen found in nature is called “white” hydrogen, while hydrogen produced by burning fossil fuels is called “blue” or “gray” hydrogen, and hydrogen produced by using solar or wind power is called “green” hydrogen.

Until recently, it wasn’t thought that white hydrogen occurred in nature in volume. But a recent discovery has scientists questioning that assumption and wildcatters digging wells. Read on for details:

(1) Explosive discovery. Researchers from France’s National Centre of Scientific Research discovered a large reservoir of hydrogen in northern France that could contain between 6 million and 250 million metric tons of the gas, an October 29 article in CNN reported. The researchers went looking for hydrogen deposits because they had heard about a water well in Mali that was spewing hydrogen. The hydrogen in the well was harnessed in 2011 to power a village and continues to do so today.

Scientists believe large deposits of hydrogen are formed when water molecules break down as a result of reacting with iron-rich rocks or coming into contact with radiation. White hydrogen deposits have also been found in the US, Eastern Europe, Russia, Australia, and Oman.

Geoffrey Ellis, a geochemist with the US Geological Survey, “estimates globally there could be tens of billions of tons of white hydrogen. … [I]f just 1% can be found and produced, it would provide 500 million tons of hydrogen for 200 years...” Only 100 million tons a year of hydrogen is currently being produced, and production isn’t expected to hit 500 million until 2050.

(2) A new gold rush. A number of startups are scouring the Earth to find large hydrogen deposits, the CNN article states. Australia-based Gold Hydrogen is drilling in South Australia. Denver-based Koloma hasn’t disclosed where it’s drilling, but it has received funding from Bill Gates’ Breakthrough Energy Ventures and others. And Natural Hydrogen Energy is another hydrogen wildcatter, based in Denver.

Corrigendum. In yesterday’s Morning Briefing, there was an error in the MegaCap-8’s share of the S&P 500. The affected areas are reproduced below with corrected text underlined and italicized:

Strategy: MegaCap-8’s Growing Share of S&P 500. In spite of the stock market’s decline back to correction territory from its July 31 high, the MegaCap-8 group of stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) remains at or near its recent record-high shares of the S&P 500’s market capitalization, forward revenues, and forward earnings (Fig. 6). It’s helpful to remember how high these shares are when considering S&P 500 performance, valuation, and earnings data: A good chunk of that data is attributable to just eight stocks! (FYI: Forward revenues and earnings are the time-weighted average of analysts’ consensus projections for the current and following years; forward profit margins we calculate from forward revenues and earnings.)

Specifically, the MegaCap-8’s collective market-cap share of the S&P 500 was 27.1% during the October 27 week, little changed from its record high 27.4% during the October 6 week. The group’s forward revenue share dropped by just a hair in recent weeks to 10.63% from 10.65% (August 31 week), while its forward earnings rose to a record high 17.54% share.

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Other Central Bankers & The MegaCap-8, Again

November 1 (Wednesday)

Global Central Banks I: BOJ Tweaks Accommodation. Since Bank of Japan (BOJ) Governor Kazuo Ueda assumed office in April, succeeding Governor Haruhiko Kuroda, Japan’s central bank has gradually shifted toward a less accommodative monetary policy stance. Shortly after the change at the helm, the BOJ removed its commitment to maintaining interest rates at current or lower levels; that was on April 28.

Previously, in December 2022, the BOJ enhanced its flexibility by widening the range around its yield target. It did so again in July and once again at the two-day meeting that concluded yesterday.

The BOJ’s October 31 Statement on Monetary Policy explains that the bank is retaining its long-standing super-accommodative monetary policy while making slight modifications to its yield curve control (YCC) bond purchasing plan. The YCC’s objective has been to anchor 10-year Japanese government bond (JGB) yields around the zero mark through appropriate bond purchases. However, the YCC policy is increasingly questionable now that the yield is approaching 1.00%.

In recent months, inflation in Japan has consistently exceeded the BOJ’s 2.0% target. As a result, investors are closely watching the BOJ for signs that they may abandon the YCC policy. This may involve reducing the pace of bond purchases or eliminating the program’s long-term interest rate target altogether. Governor Ueda acknowledged this possibility during a July press conference, stating, “The risk of us being forced to abandon YCC against our will is not zero,” reported CNBC.

The unexpected moves made by the BOJ in December and July surprised investors, whereas yesterday’s subtle adjustment was more widely anticipated. Melissa and I are anticipating a more significant YCC adjustment at the BOJ’s final meeting of the year, on December 18-19.

Let’s dive into where the BOJ currently stands:

(1) Policy tweaks. The BOJ made slight adjustments to its ultra-easy monetary policy last month. While maintaining the short-term interest rate target at -0.1%, the bank altered its YCC policy. In the September statement, the BOJ announced that it would permit 10-year JGB yields to fluctuate within a range of around plus or minus 0.5ppt from the target level, offering to purchase 10-year JGBs at 1.0% daily.

However, the latest move by the bank eliminated the plus or minus 0.5ppt range and introduced a flexible “upper bound” of 1.0% for 10-year JGB yields. In the statement’s footnotes, the bank clarified that it would “determine the offer rate for fixed-rate purchase operations each time, taking market rates and other factors into account.” Essentially, the 1% offer on the bank’s 10-year JGBs could rise without a specific limit.

As of Monday’s close, the 10-year JGB yield was just slightly below the central bank’s flexible reference cap (Fig. 1).

(2) Stagnating purchases. Despite the unprecedentedly high bank balance-sheet assets—which have risen from around 450 trillion yen in 2016 at the beginning of YCC to nearly 750 trillion yen today—purchases clearly have stalled since earlier this year (Fig. 2). Additional purchases could be a challenge, as the bank already owns a very large share of the Japanese bond market.

(3) Inflation overshooting. Japan’s consumer price index, excluding fresh food, has exceeded the bank’s 2.0% y/y target rate consistently since summer 2022, coming in at 2.8% this September (Fig. 3). The bank attributes the prolonged cost increases to a rise in import prices and recent crude oil price increases; it anticipates a 3.0% rate at year-end, up from a previous forecast of 2.8%.

(4) BOJ lagging. In stark contrast to the BOJ’s unyielding ultra-easy policy stance, the Fed has been tightening over the past year—most recently keeping rates unchanged after an aggressive series of hikes—while the European Central Bank (ECB) has taken the bold step of raising its main rates to their loftiest levels in over two decades and is now pausing in restrictive territory. It’s likely that the BOJ won’t be as aggressive as those two counterparts, but inevitably will be on a tightening path soon too.
 
Global Central Banks II: PBOC on Easing Street. An October 24 Bloomberg article explored the People’s Bank of China’s (PBOC) attempts to bolster short-term liquidity in China’s financial system. Maintaining bank funding costs below the PBOC’s preferred rate has been challenging owing to scarce liquidity, primarily a result of surging government debt and tax payments.

Consequently, the PBOC has increased its support to uphold low borrowing costs. Over three days last week, the central bank injected a record net amount of 1.96 trillion yuan (equivalent to $268 billion) in short-term cash into the financial system, according to Bloomberg’s calculations. Simultaneously, outstanding one-year policy loans are on track to reach a historical high of 5.7 trillion yuan after a mid-October operation.

Throughout this year, Beijing’s central planners have been working to bolster the fragile economy, with particular focus on the ailing property sector. Their measures have encompassed reductions in benchmark rates, bank reserve requirements, and various liquidity-boosting initiatives, wrote BNN Bloomberg.

In a report delivered to the Standing Committee during the weekend of October 21, Governor Pan Gongsheng of the PBOC vowed to implement more targeted and robust policy measures. Notably, Chinese President Xi Jinping recently visited the PBOC, the first such visit during his decade-long tenure. The purpose of the visit remains undisclosed, but it undoubtedly pertained to coordinating the nation’s fiscal stimulus policies. A few days later, Chinese authorities announced one of the most substantial alterations to the national budget in years, along with a plan to issue 1 trillion yuan (equivalent to $137 billion) in government bonds.

Following a surge in interest rates yesterday, a source close to the central bank indicated that the PBOC is likely to inject additional liquidity into the money market.
 
Global Central Banks III: ECB Hunkers Down. On October 26, the ECB delivered a pivotal decision by ending its long streak of interest-rate increases. The interest rates on the main refinancing operations, marginal lending facility, and deposit facility all were maintained at 4.50%, 4.75%, and 4.00%, respectively. This pause came after an impressive run of 10 consecutive interest-rate hikes, starting in July 2022 and concluding in September 2023, which lifted the deposit facility rate out of negative territory.

Simultaneously, the ECB has actively trimmed the assets on its balance sheet, primarily by reducing its routine asset purchases and reinvestments while still retaining pandemic-related assets. The likelihood of further rate hikes appears remote, and we don’t anticipate any rate reductions until the second half of 2024.

Here are more key insights:

(1) Inflation easing. Despite pausing the rate hikes, the ECB’s Monetary Press Release underscores the persistence of inflation concerns, stating, “Inflation is still expected to stay too high for too long, and domestic price pressures remain strong.” However, it acknowledges that inflation notably receded in September, partly due to robust base effects, and most indicators of underlying inflation continue to soften.

The Eurozone’s headline CPI rate moderated to 2.9% y/y in October, while the core rate fell but remained elevated at 4.2% (Fig. 4).

(2) Rates adequate. The ECB believes that its previous interest-rate increases effectively have dampened demand, contributing to the moderation of inflation, and that current interest-rate levels are “sufficiently restrictive.” It pledges to maintain them “as long as necessary.”

(3) Shrinking balance sheet. The ECB’s total assets have dropped significantly from their peak in late June 2022, driven by the reduction in asset purchases and reinvestments under the Asset Purchase Program (Fig. 5). On the other hand, the bank has committed to reinvesting principal payments from maturing securities purchased under the Pandemic Emergency Purchase Program through at least the end of 2024.

Strategy: MegaCap-8’s Growing Share of S&P 500. In spite of the stock market’s decline back to correction territory from its July 31 high, the MegaCap-8 group of stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) remains near its recent record-high shares of the S&P 500’s market capitalization, forward revenues, and forward earnings (Fig. 6). It’s helpful to remember how high these shares are when considering S&P 500 performance, valuation, and earnings data: A good chunk of that data is attributable to just eight stocks! (FYI: Forward revenues and earnings are the time-weighted average of analysts’ consensus projections for the current and following years; forward profit margins we calculate from forward revenues and earnings.)

Specifically, the MegaCap-8’s collective market-cap share of the S&P 500 was 27.1% during the October 27 week, little changed from its record high 27.4% during the October 6 week. The group’s forward revenue and forward earnings shares likewise have dropped by just a hair in recent weeks: forward revenues to 2.18% from 2.19% (October 6 week) and forward earnings to 17.25% from 17.34% (September 1 week).

With the Q3-2023 earnings season now more than half finished, I asked Joe to give us an update on the MegaCap-8’s surprise metrics to date and discuss just how much they’ve contributed to the S&P 500’s “REMs” (revenues, earnings, and margins). Here’s his report:

(1) MegaCap-8 Q3 surprise review. Six of the MegaCap-8 stocks have reported Q3 results so far (all but Apple and Nvidia). Among the reporters, all but Tesla beat the analysts’ consensus forecast for revenues and earnings. Collectively, these six have beaten the aggregate revenue forecast by 1.3% and the aggregate earnings forecast by 16.2%. They’ve recorded y/y growth in revenues of 12.8% and in earnings of 58.7%. Their aggregate profit margin of 17.8% well exceeded the 15.5% forecast.

Here’s how each of the six MegaCap-8’s fared in Q3. Their revenue and earnings surprises were mostly positive: Alphabet (1.0% revenues surprise, 6.8% earnings surprise), Amazon (1.2, 60.9), Meta (1.7, 20.9), Microsoft (3.7, 12.7), Netflix (0.1, 6.9), and Tesla (-3.1, -8.2). Their y/y revenue and earnings growth rates were mostly positive too, topped off with a sprinkling of triple-digit percentage earnings growth rates: Alphabet (11.0% y/y revenues growth, 46.2% y/y earnings growth), Amazon (12.6, 452.9), Meta (23.2, 167.7), Microsoft (12.8, 27.2), Netflix (7.8, 20.3), and Tesla (8.8, -37.1)

(2) S&P 500 Q3 results with and without the MegaCap-8. The S&P 500 companies that have reported so far have a revenue surprise of 0.9% and have beaten earnings forecasts by 7.9%. Revenues are up 2.0% y/y and earnings up 6.8% y/y. The S&P 500’s profit margin of 13.2% for companies that have reported so far exceeds the 12.4% forecast and compares favorably to the 12.6% recorded a year earlier in Q3-2022.

The S&P 500 results without the MegaCap-8 reporters to date are mostly weaker. The revenue surprise remains unchanged at 0.9%, but the earnings surprise drops to 6.1% from 7.9%. The y/y growth rates are weaker too, dropping to just 0.3% from 2.0% for revenues and falling to a y/y decline of -1.2% from 6.8% for earnings. The S&P 500 ex-MegaCap-8 profit margin for Q3-2023 drops to 12.5% from 13.2% but still exceeds the forecasted 11.1% and is up from 11.9% a year earlier in Q3-2022.

(3) MegaCap-8’s share of results rose in Q3 and is expected to remain high. On a blended actual/estimate basis, the MegaCap-8’s share of S&P 500 revenues rose to a three-quarter high of 10.7% in Q3-2023 from 10.4% in Q2-2023. The group’s earnings share rose to an 11-quarter high of 19.0% from 17.5%.

Looking ahead to Q4-2023, the group’s shares of the S&P 500’s revenue and earnings are expected to rise to new record highs of 12.2% for revenues and 21.2% for earnings. They’re expected to remain high at least through Q3-2024. Analysts are estimating the MegaCap-8’s revenues share of the S&P 500 to be between 11%-12% with an earnings share of 18%-21%. Revenues are expected to grow at a 12%-13% y/y rate from Q4-2023 to Q4-2024. Earnings growth is expected to decelerate, though, as Nvidia’s y/y growth slows from its torrid triple-digit percentage pace in 2023. Analysts expect the peak y/y earnings growth of 52.8% in Q3-2023 to drop to 43.4% in Q4-2023 before slowing to 10.3% in Q3-2024.

(4) MegaCap-8 on a blended basis. Our earlier analysis primarily focused on the companies that have reported so far. Investors are still waiting on results for the last two MegaCap-8 companies, Apple and Nvidia. Apple’s fiscal Q4 results are due out on Thursday, and Nvidia’s October-quarter results on November 21.

For the group as a whole (using current estimates for Apple and Nvidia), y/y revenue growth picked up to a six-quarter high of 12.1% in Q3-2023 from 10.2% in Q2-2023, and y/y earnings growth is expected to accelerate sharply to a nine-quarter high of 52.8% from 29.4%. The profit margin is expected to rise to a nine-quarter high of 22.2% in Q3-2023 from 20.1%.

However, a third-straight blowout quarter by Nvidia—which has an expected profit margin of 52.0% for Q3-2023—could carry the group over and above its prior record-high profit margin of 23.0%, recorded during Q1-2021. Analysts expect a 24.6% profit margin for Apple.

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Trick Or Treat?

October 31 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Consumers: Beware of the Saving Rate? Halloween arrived early on Wall Street. Investors have had lots to be spooked about since early this year, when the consensus was that the economy would fall into a recession. That hasn’t happened so far, mostly because consumer spending remained surprisingly strong.

The hard-landers have been expecting that consumers would have to start saving more this year once their excess saving windfall (accumulated during the pandemic) was depleted. They’ve reckoned that would happen around now. They could still be right, but it doesn’t look that way from consumers’ recent behavior: Consumers have been reducing their saving rate in recent months, bolstering the upward trend in their inflation-adjusted disposable income.

That behavior is consistent with our view that consumers’ net worth has soared since the pandemic, reducing their need to save. In addition, retiring Baby Boomers are likely spending the “excess saving” they accumulated during their careers in retirement accounts. Let’s have a closer look at the latest relevant data:

(1) Disposable income is on an uptrend. Excluding the three rounds of pandemic relief checks, real disposable personal income (RDPI) mostly fell during 2020 through 2022. This year, it rose 3.0% during the first nine months of the year (Fig. 1). It dipped 0.4% over the last three months, mostly because of a spike in gasoline prices.

Bolstering real RDPI since the end of the lockdowns has been aggregate weekly hours worked, which is payroll employment multiplied by the average length of the workweek in the private sector (Fig. 2). Depressing RDPI has been real average hourly earnings (RAHE), which stagnated during 2020-22 as inflation soared (Fig. 3). This year, it has resumed climbing along its uptrend since 1995, i.e., growth at a 1.2% annual rate on average.

(2) Saving rate remains low. Household net worth rose to a record $154.3 trillion at the end of Q2-2023 (Fig. 4). That’s up $37.6 trillion since the end of 2019, just before the pandemic. It’s been hovering around a record 8.0% of disposable personal income over this period (Fig. 5). Half of households’ net worth (i.e., $77.1 trillion) is owned by the Baby Boomers (Fig. 6).

The Baby Boomers are currently 59-77 years old (Fig. 7). The oldest of them turned 65 years old during 2011 (Fig. 8). Since then, the number of seniors (i.e., aged 65 or older) has increased by 18.3 million, with 4.1 million of those younger seniors remaining in the labor force and 14.2 million having dropped out of the labor force.
 
The pandemic probably convinced more Baby Boomers to retire or to work part-time from home. The ones who are retiring must be saving less and spending more of their retirement net worth. If so, then the personal saving rate may remain below its pre-pandemic level. It was 7.2% during January 2020. It was down to 3.4% in September.
 
Inflation: Beware of the Devil in the Details? Investors have been spooked by inflation since Halloween 2021 as the CPI soared to peak at 9.1% during June 2022. It was down to 3.7% during September of this year. Yet investors are still spooked, fearing that inflation will remain stuck above the Fed’s 2.0% target or will rebound as it did during the 1970s. Consider the following:

(1) We’ve recently observed that the headline and core CPI inflation rates were both 2.0% in September excluding shelter. Of course, the Fed tends to give more weight to the PCED inflation rate. The headline and core inflation rates for this measure of consumer prices were 3.4% and 3.7% during September (Fig. 9).

Excluding rent, the headline and core PCED inflation rates were down to 2.8% and 3.0% in September (Fig. 10). Both are down sharply from their 2022 peaks of 7.4% and 5.9%.

(2) Yes, but what about the “supercore” inflation rate that Fed Chair Powell has been focusing on? It is the PCED inflation rate excluding energy and housing. It edged down to 4.3% in September but has been stuck around 4.5%-5.0% for the past 27 months (Fig. 11). We are optimistic that it too will moderate in coming months given the sharp drop in the core CPI excluding shelter in recent months.

(3) And what about “Swiftflation”? The PCED inflation rate for movies, theaters, concerts, and sporting events jumped to 5.6% just before “Taylor Swift: The Era Tour” concert this past summer (Fig. 12). It jumped again to 10.4% when Taylor Swift started attending football games to see her boyfriend play.

(4) They say that the devil is in the details. That may very well be true about the outlook for inflation. However, inflation is usually defined as a general and relatively broad increase in prices. In any one month, a few of the CPI’s components might account for much of the increase or decrease that month. It’s the underlying trend that matters. That’s what we look to most for either confirmation of our outlook or the need to change it. The latest data confirm for us that our narrative remains on track: Inflation is continuing to moderate.
 
Federal Deficit: Beware of Janet Yellen? Janet Yellen is very mild mannered. When she was running the Fed, we often referred to her as the “Fairy Godmother of the Bull Market” in stocks. She is widely respected. Now as the Secretary of the US Treasury, her most powerful detractors are the Bond Vigilantes. They claim that she was wrong about the inflationary consequences of the Biden administration’s 2022 fiscal spending acts. They are also upset about the huge federal deficits that are widening under her watch. So they’ve pushed the bond yield up to 5.00% in protest and are threatening to push it higher if she doesn’t respond to their concerns.

She responded to their threats on October 26 at an event in Bloomberg’s Washington office. She dismissed the notion that bond yields are rising just because the Treasury’s financing needs have swelled. She stated: “I don’t think much of that is connected.” She blamed higher interest rates on the strong economy: “The economy is continuing to show tremendous robustness and that suggests that interest rates are likely to stay higher for longer,” she said.

She supported her spin by stating that interest rates are going up in advanced countries around the world even those without significant government budget deficits. That’s a weak argument since interest rates around the world tend to follow the lead of US interest rates.

Yellen will provide the trick or treat on Wednesday when the Treasury will detail its next round of financing needs.

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Geopolitics, GDP & Inflation

October 30 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Geopolitics: Getting More Dangerous. The S&P 500 is now down 10.3% since it peaked this year at 4588.96 on July 31 (Fig. 1). The S&P 500 equal-weighted index is down 13.7% since then. The Nasdaq is down 7.9% from its July 19 high (Fig. 2).

This selloff occurred because the 10-year Treasury bond yield spiked from around 4.00% to 5.00% over this short period. It did so because the Treasury announced on July 31 that the government needed to raise $1.0 trillion during Q3. The next day, on August 1, Fitch Ratings downgraded US government debt from AAA to AA+. The economic indicators released since then showed that economic growth was strong, led by better-than-expected consumer spending. In addition, at his September 20 press conference, following the latest FOMC meeting, Fed Chair Jerome Powell reiterated that interest rates are likely to stay higher for longer. Indeed, the FOMC’s Summary of Economic Projections showed that the committee now expects to cut the federal funds rate by 25bps only twice next year rather than four times as was indicated in June’s SEP.

However, the bond yield seems to have found buyers at 5.00% last week and dipped to 4.84% by the end of the week. Thursday’s real GDP report for Q3 showed an increase of 4.9%, about as expected. Yet last week, the S&P 500 fell 2.5% as the Nasdaq experienced a mini tech wreck, falling 2.6%. The earnings reports issued by Google and Facebook did disappoint, but those of Microsoft, IBM, Intel, and Amazon beat expectations.

Joe and I think that the stock market was hit hard by unsettling news out of the Middle East suggesting that the war between Israel and Hamas is spreading. On Thursday, October 19, the USS Carney, a guided missile cruiser operating in the Red Sea, shot down four cruise missiles fired by the Iranian-backed Houthi rebels toward Israel. According to an October 24 WSJ article, a fifth missile was intercepted by Saudi air defense systems, operating to protect Saudi airspace.

The US launched strikes on Iran-linked facilities in Syria on Thursday in retaliation for a series of drone attacks on American military bases in the region, Defense Secretary Lloyd Austin said. From October 17 to Thursday, US and coalition forces were attacked at least 19 separate times in Iraq and Syria by a mix of drones and rockets, according to defense officials. ABC News reported that Austin said, “US military forces conducted self-defense strikes on two facilities in eastern Syria used by Iran’s Islamic Revolutionary Guard Corps (IRGC) and affiliated groups. These precision self-defense strikes are a response to a series of ongoing and mostly unsuccessful attacks against U.S. personnel in Iraq and Syria by Iranian-backed militia groups that began on October 17."

The Biden administration is starting to acknowledge publicly that Iran is the head of the terrorist snake. The administration is sending more forces into the Middle East, including two aircraft carrier groups, additional fighter jets, and missile-defense systems. On Friday, in a speech at the United Nations, Iran’s foreign minister threatened that the US will not escape unaffected if the Hamas-Israel war turns into a broader conflict, firing back after the Biden administration said Iran was ultimately to blame for the recent spate of drone attacks on American forces.

We raised our subjective odds of a recession in the US occurring before the end of 2024 from 25% to 30% on October 10 and again to 35% on October 23 mostly because of the war in the Middle East. Should we do so again now? We’ve decided not to, but we can envision two potential narratives unfolding that could increase the odds of a recession in the US. Here is our thinking:

(1) Recessionary scenario #1: The war in the Middle East spreads, and oil prices soar. In recent years, we’ve viewed geopolitical crises as short-term events that provided buying opportunities in the stock market. But the current crisis has the potential to be a lengthy one and to widen into a regional war. That could spike the price of oil if Iran’s oil exports are reduced by the toughening of US sanctions or if the country’s oil export facilities are attacked. Any spike might not last very long since Saudi Arabia is likely to boost its exports in response. The question then would be whether Iran’s surrogates in Yemen would send drones or missiles to attack Saudi oil production, as they did in 2019 and again in 2022. So there is that potential oil price catalyst to a US recession to consider.

(2) Recessionary scenario #2: Biden’s guns-and-butter fiscal policies enrage the Bond Vigilantes. Perhaps a more plausible reason to raise the odds of a recession is that the high federal budget deficit could be pushed even higher by defense spending, causing bond yields to rise to levels that cause a recession. The US military is facing more challenges than usual—fighting a proxy war against Russia in Ukraine and supporting Israel militarily and fending off Iran-backed terrorists in the Middle East. Meanwhile, the US must provide military deterrence to keep China from invading Taiwan. As a result, defense spending will have to increase at a time that the federal budget deficit is the highest ever excluding the pandemic period.

That could worsen the partisan divide not only between Democrats and Republicans in Congress but also the divides between the extreme wings of both parties from their moderate factions. The Bond Vigilantes might then join the fight by pushing up bond yields to levels that cause a recession.

Meanwhile, the backdrop against which those potentialities could take place includes:

(1) China’s property market disaster is depressing the world economy. The global economic outlook is weighed down by the poor prospects for economic growth in China, as we discussed last week in Tuesday’s Morning Briefing. China’s economic recovery has been weighed down by a slump in its real estate sector, with major property developers China Evergrande Group and Country Garden Holdings Co. saddled with heavy debts. The real estate market accounts for some 30% of China’s GDP. Evergrande filed for bankruptcy in a New York court in August. During the first nine months of 2023, investment in real estate development dropped 9.1% y/y.

China’s slow-motion property market collapse is likely to depress the country’s economy for years.

(2) The US remains the shining city upon a hill. The good news is that the US economy remains resilient, inflation is still on a moderating trend, corporate earnings are growing, the Fed is probably done tightening, and the bond market may be stabilizing. The odds of a recession resulting from the current geopolitical mess are still no greater than 35%, in our opinion, given these positives.

(3) Nothing to fear but fearful developments. Nevertheless, any escalation of the war in the Middle East is bound to unsettle the stock market (and us) by generating more uncertainty about the eventual outcome.

The other problems are well known but still unsettling: Fiscal policy is out of control, the US government is dysfunctional, the Bond Vigilantes are riding high, inflation remains above the Fed’s target, cracks are showing up in the credit system, and geopolitical analysts are wondering whether the US can handle three wars if China attacks Taiwan. Plus, there are China’s property market problems weighing on its economic activity, as discussed above.

So everything is fine with a few notable exceptions.

GDP: No Hard Feelings. Our relatively optimistic economic outlook through the end of 2024 is somewhat less optimistic now that we have lowered its subjective odds to 65% from 75% in early October. While we’ve been in the optimistic camp on the resilience of the economy since early last year, we certainly didn’t expect that real GDP would grow 4.9% during Q3 until the monthly indicators suggested that neither the hard-landers nor the soft-landers had it right.

In his September 20 press conference following the latest FOMC meeting, Fed Chair Jerome Powell said: “[T]he economy has been stronger than many expected given what’s been happening with interest rates. Why is that? … [H]ousehold balance sheets and business balance sheets have been stronger than we had understood, and so spending has held up. … The savings rate for consumers has come down a lot. The question is whether that’s sustainable. [I]t could just mean that the date of [the monetary tightening] effect is later. It could also be that … the neutral rate of interest is higher for various reasons. We don’t know that. It could also just be that policy hasn’t been restrictive enough for long enough.”

Let’s review the recent areas of strength and consider whether they might continue to keep the economy remarkably resilient:

(1) Strong despite rate shock. The Citigroup Economic Surprise Index has remained higher for longer near previous cyclical peaks this year (Fig. 3). This is one of the reasons why the bond yield has risen more than widely expected this year. The question now is whether the US economy can grow with the bond yield at 5.00%, up dramatically from 0.52% during August 2020 (Fig. 4).

On the one hand, the bond yield has normalized to where it was before the Great Financial Crisis from 2002-07, when the economy was expanding. On the other hand, the last time that the yield rose 500bps in such a short time was from 1977 to 1979, which was followed by two recessions in the early 1980s. Then again, both the household and business sectors refinanced quite a bit of their debts at record-low interest rates during the pandemic period.

While real GDP rose 2.9% y/y during Q3, nominal GDP rose 6.3% y/y (Fig. 5). So the bond yield at around 5.00% is still below the growth rate of nominal GDP. During their heydays of the 1980s, the Bond Vigilantes forced yields above nominal GDP growth and raised them three times to slow nominal GDP growth. We are expecting that nominal GDP growth will slow along with inflation with the result that the bond yield remains around 5.00%.

(2) Consumers have several sources of income. Let’s not forget that many households benefit from higher interest rates. Interest income in personal income rose to a record $1.8 trillion during September, up $300 billion from two years ago (Fig. 6). Also at record highs in personal income are proprietors’ income ($1.9 trillion), dividend income ($1.8 trillion), and rental income ($1.0 trillion). These four sources of income totaled a record $6.5 trillion in August and were equivalent to 54% of wages and salaries income.

A large percentage of all that non-wage income was earned by older American households, including many retiring Baby Boomers. As we’ve previously discussed, the Baby Boomers are spending lots of their income on labor-intensive services, which explains why the labor market has been so resilient in the face of tightening credit conditions.

(3) Signs of rolling recovery in consumer goods. During the pandemic, the ratio of real consumer spending on goods to spending on real services soared from March 2020 through March 2021 (Fig. 7). This buying binge for goods fizzled when consumers were able to binge on services, causing the ratio to decline. But the ratio has flattened out in recent months, suggesting that the rolling recession in consumer goods is bottoming and could be turning into a rolling recovery. That’s confirmed by the upturn in both the M-PMI through September and the uptrend since early this year in the four regional business surveys available through October (Fig. 8). However, both remain in contractionary territory.

(4) WFH cushions oil price shocks. By the way, since more consumers are working from home (WFH) now than before the pandemic and fewer commuting, jumps in gasoline prices aren’t as taxing on household budgets as they used to be. Consumers also now have more flexibility to respond quickly to gasoline price increases by driving less in their neighborhoods. That’s what happened when gasoline prices jumped this summer, then dropped when demand weakened recently (Fig. 9). (Consumers may now be the Oil Vigilantes!)
 
Inflation: Still Moderating Enough for the Fed? The FOMC meets on Tuesday and Wednesday. Might they surprise the financial markets and raise the federal funds rate after all? Melissa and I doubt it given the significant rise in the bond yield since the last meeting on September 19-20.

At his post-meeting press conference on Wednesday, Powell is likely to remain as hawkish as he was during his interview on October 19. He undoubtedly will acknowledge that inflation has been moderating, but he will reiterate that it remains too high and that the Fed needs to maintain a restrictive monetary policy stance. Here is a brief overview of the latest inflation data:

(1) Expected inflation. On Friday, the bad news was that the Consumer Sentiment Index survey showed that October’s one-year expected inflation rate jumped to 4.2%, up from 3.2% the month before (Fig. 10). This series tends to be highly influenced by the price of gasoline, which is starting to come down. The comparable survey conducted by the Federal Reserve Bank of New York earlier this month reported that expected inflation over the coming year was 3.7%.

The five-year-ahead expected inflation rate was 3.0% in both surveys. In the Fed’s lexicon, “inflationary expectations remain well anchored.”

(2) PCED inflation. The headline PCED inflation rate remained at 3.4% y/y during September (Fig. 11). The core rate continued to moderate down to 3.7%. Goods inflation has turned out to be transitory after all. It was only 0.9%, with durable goods down 2.3% and nondurable goods inflation up 2.7% (Fig. 12).

The inflation rate for housing and utilities peaked at 8.3% in June and fell to 7.2% in September (Fig. 13). That’s still quite high but is widely expected to continue to fall in coming months, including by Fed officials.

The so-called “super-core” inflation rate remains sticky. This is the PCED core services inflation rate excluding housing-related items (Fig. 14). It did edge down to 4.3% in September. It too is likely to fall in coming months, as suggested by the CPI services less rent of shelter inflation rate.

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Consumer Spending, China & Robots

October 26 (Thursday)

Consumer Discretionary: Pivoting Back to Goods? Remember the spending boom on things that helped us adjust to being trapped at home during the pandemic? Sales of items like home office equipment, outdoor heaters, and bikes surged, then fell sharply as consumers switched to bingeing on services and experiences. Hanging out on the deck wearing a winter coat under a heater was out, and “revenge travel” was in.

But now many people have scratched their travel itch, and buying goods may make a resurgence just in time for the holiday shopping season. The ratio of what consumers spend on goods versus what they spend on services spiked from 0.48 in December 2019, just before the pandemic, to a high of 0.59 in March 2021, one year into it. The ratio fell to 0.53 by November 2022, as consumers increased their spending on services (Fig. 1). The ratio has basically moved sideways since then, suggesting that spending on goods has stopped losing wallet share and may again find favor. (Note: the numerator and denominator of the ratio are adjusted for inflation.)

Let’s take a look at an optimistic holiday spending survey by Deloitte, slowing sales declines at Logitech International and Taiwan Semiconductor, along with some stats on retail sales and transportation:

(1) Could it be a jolly holiday? Many retail analysts are calling for muted spending that sends holiday sales up 3%-4% y/y, which isn’t much after taking inflation into consideration. However, the 2023 Deloitte Holiday Survey caught our eye, as its 4,318 respondents plan to increase spending by 14% y/y on average to $1,652—shelling out 9% more than last year on gifts, 10% more on experiences & entertainment, and a whopping 25% more on “non-gift purchases,” including clothing, home furnishings, and holiday decorations.

Admittedly, the survey was taken from August 30 to September 8, when the 10-year Treasury yield was closer to 4.25% than 5.00% and before war in the Middle East broke out. But if the respondents’ expectations translate into actual spending, 2023 will mark the first year that holiday spending surpasses 2019’s spending of $2,496.

(2) Spending more on mice. The work-from-home trend was one of the biggest to come out of the Covid pandemic. Buying of computer peripherals and gaming equipment from Logitech and others surged before it crashed. But Logitech’s fiscal Q2 (ended September 30) earnings report has us thinking that the bust may be close to running its course.

While Logitech’s sales last quarter fell y/y, they rose q/q for the second quarter in a row and beat Wall Street’s consensus estimate. Here are Logitech’s fiscal Q2 sales over the past four years: fiscal Q2-2024 ($1.06 billion), fiscal Q2-2023 ($1.15 billion) fiscal Q2-2022 ($1.31 billion), and fiscal Q2-2021 ($1.26 billion). Since troughing at $960 million in fiscal Q4-2023 (ended March 31), sales now have been up for two quarters in a row. CFO Chuck Boynton said on the company’s conference call that the y/y rate of decline has improved and is expected to continue doing so in the back half of the year.

The Logitech sales rollercoaster was accompanied by an inventory bubble. Inventory levels have fallen every quarter since peaking in fiscal Q4-2022 at $933 million. The level sank to $533 million in fiscal Q2-2024 but remained north of fiscal Q2-2021’s $395 million.

Logitech shares jumped 12.9% on Tuesday after the company increased its full fiscal year (ending March 31) sales forecast to a range of $4.0 billion to $4.2 billion from the previous $3.8 billion to $4.0 billion. Likewise, management’s adjusted operating income projection for fiscal 2024 was raised to $525 million to $575 million, up from $400 million to $500 million, provided during the fiscal Q1 (ended June 30) earnings report.

(3) More optimism from TSMC. Taiwan Semiconductor Manufacturing Co. (TSMC) recently reported that Q3 sales declined 10.8% y/y, dragged down by the industry’s buildup of chip inventories as sales of cell phones and computers slowed after the pandemic ended. But the company’s revenue forecast for Q4, while still down roughly 4% y/y, is above analysts’ estimates.

“The chipmaker says it has begun to see signs of stabilization in demand for smartphones and personal computers—although C.C. Wei, TSMC’s CEO, says it’s too early to call it a sharp rebound,” an October 19 WSJ article reported. The use of artificial intelligence (AI) is also expected to boost demand for chips.

The company’s shares have risen 23.0% ytd through Tuesday’s close compared with the S&P 500’s 10.6% ytd advance.

(4) Running its course. Sometimes, time does heal all wounds. In this case, the more time that goes by, the more likely it is that consumers will return to buying goods. Real retail sales & food services, which surged 14.5% from December 2019 through April 2021, flatlined over the ensuing three years (Fig. 2).

The flattening of growth in real retail sales has had a huge impact on companies shipping goods. The number of shipping containers entering the West Coast ports fell 24.4% from its peak in August 2021 through last month (Fig. 3). Notably, for the first time since the imports’ downturn began, the number of containers increased ever so slightly, by 115,000 TEUs (twenty-foot equivalent unit) compared to the August level.

The shipping downturn is also apparent in producer prices for truck transportation of freight, which rose 24.9% y/y in May 2022 and has fallen for most of 2023. Most recently, prices fell by 10.4% in September, but that was a very slight improvement over the level in July, when prices fell 12.8% (Fig. 4).

China: More Baby Steps. Faced with below-target economic growth, China took its latest small step to improve the country’s lot by announcing funding for new infrastructure projects. The move isn’t expected to extricate the country from the weight of excessive debt owed by local municipalities or property developers. Nor will it divert attention from the country’s harassment of its private sector. Arresting executives does little to encourage investment. Unless China restructures its debt or starts dropping money out of helicopters, the country’s economy may continue to limp along.

Here’s a look at some of the initiatives that have made headlines recently:

(1) New projects lined up. Earlier this week, China announced a plan to raise 1 trillion yuan ($137 billion) in sovereign debt to fund infrastructure projects in the wake of severe flooding and other natural disasters, an October 24 WSJ article reported. The country also raised its budget deficit target, the first time it has done so outside of a regular legislative session in more than a decade.

There is already criticism that the government’s actions still fall short. “The 1 trillion yuan of sovereign bonds make up less than 1% of China’s gross domestic product. By comparison, the stimulus China launched in the 2008 global financial crisis accounted for more than 12% of its GDP at the time,” the WSJ article stated. Some are calling for the country to give funds directly to citizens to boost consumer spending.

(2) Knocking on the central bank’s door. On Tuesday, China’s President Xi Jinping visited the People’s Bank of China for the first time since he became president a decade ago, an October 24 Bloomberg article reported. He was accompanied by Vice Premier He Lifeng and other government officials, who also visited the Administration of Foreign Exchange. Vice Premier He also stopped by the nation’s sovereign wealth fund, China Investment Corp. (CIC).

What was discussed at the meetings is unknown. The visits came one day after Central Huijin Investment Limited, a unit of the sovereign wealth fund CIC, bought an “undisclosed amount of exchange-traded funds and vowed to keep increasing its holdings in the latest attempt to boost the country’s slumping stock market. Earlier this month, Huijin bought shares in China’s largest state banks,” Bloomberg reported.

(3) Real estate woes continue. The clock is ticking as Evergrande revises its proposed restructuring plan. It will have to move quickly because the company has an October 30 court hearing in Hong Kong regarding a petition to wind up the firm, which could include liquidating its assets, an October 20 Bloomberg article reported. Evergrande has about $327 billion of liabilities, and its founder Hui Ka Yan is “under police control,” as he’s suspected of committing crimes.

Meanwhile, Country Garden Holdings appears headed toward its own restructuring after officially defaulting on a $15.4 million dollar-denominated bond. The price of its dollar-denominated bonds has fallen about 75% this year to only 5 cents on the dollar, an October 25 Bloomberg article reported.

Country Garden is even larger than Evergrande. “The company was the country’s largest builder by contracted sales for several years before plunging to seventh so far in 2023,” the Bloomberg article reported. The company’s sales in September fell 81% y/y, as buyers feared the company wouldn’t be able to complete the construction of its buildings.

(4) China behaving badly. “60 Minutes” had an eye opening segment last weekend about China featuring the US FBI Director Christopher Wray and the intelligence directors of Canada, United Kingdom, Australia, and New Zealand. Together known as “The Five Eyes,” these officials were speaking together for the first time ever to alert executives and officials that “the technology secrets that are about to change the world, in artificial intelligence, biology and computing are falling into the wrong hands—stolen—in a global espionage campaign by China.”

Wray said: “We have seen efforts by the Chinese government, directly or indirectly, trying to steal intellectual property, trade secrets, personal data—all across the country. We’re talking everything from Fortune 100 companies, all to smaller startups. We’re talking about agriculture, biotech, health care, robotics, aviation, academic research. We probably have somewhere in the order of 2,000 active investigations that are just related to the Chinese government’s effort to steal information.”

Australia’s Director-General of Security Mike Burgess said the spying goes well beyond the norm. “This scale of theft is unprecedented in human history. And that’s why we’re calling it out.”

China has been acting with impunity in many areas. In the private sector, it was reported last weekend that Chinese tax authorities were probing Foxconn’s operations in China just as the company’s founder Terry Gou was running for president of Taiwan. Militarily, China has been patrolling the South China Sea as if it owns the neighborhood. A Chinese ship collided with two Filipino boats off contested shoal on Sunday. And of course, recent meetings and trade between Xi and Russian President Vladimir Putin leave no mystery as to whose side Xi is on.

Disruptive Technologies: Humanoid Robots Join the Workforce. Amazon announced last week plans to test Digit, a humanoid robot by Agility Robotics. The internet retailer is famous for the massive amount of technology it uses to pick and move products in its warehouses. But the testing of Digit grabbed headlines because the robot moves on two “legs” and looks a lot like a human wrapped in tinfoil.

Perhaps the most famous designer of these human wannabes is Elon Musk, who is building Optimus. The robot uses neural networks and AI to learn by watching millions of examples of what humans have done and applies what it learns to situations it encounters, we noted in the September 28 Morning Briefing.

But Digit and Optimus aren’t alone. Scientists at startups are also working on EVE, Figure, and Phoenix. Here’s a look:

(1) Introducing Digit. Agility’s Digit can pick up and transport the bins used to bring products from shelves to human packers in warehouses like Amazon’s. It can also return empty bins to areas where they can be refilled. Up next, Digit will learn to unload trailers, and somewhere down the road, it will learn to make home deliveries, a company website explains. Digit runs for 16 hours, longer than most of its humanoid competitors.

A new factory the company is building in Oregon will be able to produce more than 10,000 humanoid robots a year. Digit will be working in the factory, which the company calls “The RoboFab,” a company press release stated last month. Spun out of Oregon State University’s Dynamic Robotics Laboratory in 2015, Agility was one of five companies that received a grant from Amazon’s $1 billion Industrial Innovation fund last April.

(2) Meet EVE. Norway-based 1X Technologies has created EVE, a humanoid robot that rolls around on wheels, wears a white and black cloth “uniform,” and has a face with two large cartoonish eyes that makes it seem friendlier than its fellow humanoids. EVE has an AI “brain” that allows it to observe tasks and then repeat them. It’s been designed for use in factories and warehouses and to patrol buildings for safety or to assist humans, according to the company’s website.

A human can receive feeds of what EVE “sees” and take over control of the robot from a distance. 1X is working with the security firm Everon, which was facing problems with turnover and high costs for human guards. Everon now uses EVE for itself as well as its clients and has invested in 1X. Coming next: NEO, an android that has human-like “legs” and “hands.”

(3) Hello, Figure. Figure, made by a company of the same name, looks like a robot: metallic, legs, hands, and a screen with no friendly googly eyes on its face. Its management’s goal is to build general-purpose humanoid robots that will help alleviate labor shortages, take over unsafe jobs, and boost productivity. Figure CEO Brett Adcock lays out the future in the company’s Master Plan:

“As automation continues to integrate with human life at scale, we can predict that the labor-based economy as we know it will transform. Robots that can think, learn, reason, and interact with their environments will eventually be capable of performing tasks better than humans. … [T]he cost of labor will decrease until it becomes equivalent to the price of renting a robot, facilitating a long-term, holistic reduction in costs. Over time, humans could leave the loop altogether as robots become capable of building other robots—driving prices down even more. This will change our productivity in exciting ways. Manual labor could become optional and higher production could bring an abundance of affordable goods and services, creating the potential for more wealth for everyone.”

The company plans to address areas with labor shortages first—e.g., manufacturing, shipping and logistics, warehousing, and retail—and promises not to use humanoids in military operations.

(4) Phoenix gets a star. Phoenix, a humanoid robot created by Sanctuary AI, was voted one of the best inventions of 2023 by Time magazine. The Canadian company also uses AI to make its robots smarter and able to tackle a wide range of tasks. A YouTube video shows Phoenix doing 60 different tasks, including cutting a cucumber, putting a lid on a paper cup, scanning bar codes, picking fruit, and decorating a Christmas tree.

Prior to co-founding Sanctuary, CEO Gordie Rose founded D-Wave, a quantum computing company, and was CEO of Kindred, a robotics company, founded by Sanctuary co-founder and CTO Suzanne Gildert. Kindred was acquired by Ocado in 2020.

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Earnings Here & There

October 25 (Wednesday)

Global Economy I: October PMIs Weak. In yesterday’s Morning Briefing, we concluded that the latest batch of global economic indicators shows that the global economy is still growing but limping rather than running forward. Today’s batch of flash purchasing managers indexes (PMIs) compiled by S&P Global for October confirms that assessment (Fig. 1).

In the US, the M-PMI (for manufacturing industries) is 50.0 and the NM-PMI (nonmanufacturing) is 50.9. Those are lackluster readings. The latest M-PMI reading is in line with similar readings since the start of this year, while the latest NM-PMI reading is lower than those during the summer months.

The Eurozone’s flash M-PMI fell to 43.0 during October from a 2023 high of 48.8 during January. The region’s manufacturing sector remains depressed. The NM-PMI for the Eurozone was above 50.0 this year from January through July. It’s been down since then and fell to 47.8 this month.

Japan’s M-PMI has been mostly below 50.0 since November 2022 (Fig. 2). That weakness probably reflects slowing exports to China’s economy, which was depressed by lockdowns late last year and a lackluster recovery this year. During September, China’s M-PMI and NM-PMI were 50.2 and 51.7 (Fig. 3).
 
Global Economy II: MSCI Forward Metrics Weak. Joe and I monitor the forward metrics of the various global MSCI stock market indexes to keep track of the global economy—“forward” meaning the time-weighted average of analysts’ consensus expectations for earnings, revenues, and by extrapolation profit margins for the current year and following one.

Here is what we are seeing for the All Country World (ACW) MSCI, with and without the US, all in local currency:

(1) Revenues. The forward revenues of the ACW MSCI rose to a new record high during the October 20 week (Fig. 4). It has been doing so since September 23, 2022. Of course, that’s partly because the global economy has been growing over this period and partly because higher inflation around the world has also been boosting revenues.

Interestingly, forward revenues growth has been essentially flat over the past year for the Developed World ex-US MSCI (Fig. 5). The same can be said about the forward revenues of the Emerging Markets MSCI. In other words, all the upward momentum in the forward revenues of the ACW MSCI has been attributable to the United States!

(2) Earnings. The forward earnings of the ACW MSCI declined during most of last year (Fig. 6). It has been recovering since the start of the year, hitting new record highs in recent weeks. The same can be said about the forward earnings of the US MSCI (Fig. 7). The same metric for the Developed World ex-US has been flat at a record high for the past year, while the one for Emerging Markets fell last year and stopped doing so this year.

(3) Profit margins. The forward profit margin of the ACW MSCI fell from a record high of 11.0% during the week of May 12, 2022 to 10.3% during the week of March 30 (Fig. 8). It rose to 10.6% during the October 19 week. The same story can be told about the US MSCI forward profit margin, which was 12.4% during the October 19 week (Fig. 9). The Developed World ex-US forward profit margin hasn’t recovered from last year’s dip, remaining stalled around 10.0%. The Emerging Markets MSCI forward profit margin peaked at 8.2% during 2021, fell to a low of 6.8% at the start of this year, and managed to recover to just 7.1% recently.

(4) Bottom line. The global economy is growing, albeit at a slow pace. It is doing so notwithstanding the tightening of monetary policies around the world since early last year and despite the geopolitical tensions and conflicts that are challenging globalization.

Earnings I: Still Moving Forward. Here in the US, S&P 500 forward revenues are also up to a record high through the week of October 19 (Fig. 10). This suggests that S&P 500 revenues per share rose to a new record high during Q3. The same can be said about S&P forward earnings and Q3’s earnings per share. Here’s more on forward earnings:

(1) Quarterly consensus estimates. The Q3 earnings season has started. So far, there has been no upward “earnings hook” for the quarter through the October 19 week (Fig. 11). We are still expecting one. However, industry analysts did lower their Q4 estimate this week. At the same time, they slightly raised their Q1-Q3 estimates for 2024 (Fig. 12).

(2) Annual consensus estimates. S&P 500 forward earnings per share rose to a new record high of $241.69 during the October 19 week (Fig. 13). The consensus annual earnings-per-share estimates for 2023, 2024, and 2025 were lowered a touch to $219.74, $246.91, and $276.80. We are still forecasting $225, $250, and $270 (Fig. 14).

Earnings II: Revisions Activity Weakening as Analysts Await Q3 Results. Early this week, Refinitiv released its October snapshot of the monthly consensus earnings estimate revision activity over the past month. While the company provides raw data for all its polled measures, we focus primarily on the revenues and earnings forecasts, captured in our Stock Market Indicators: Net Revenue & Earnings Revisions By Sectors report. There, the analysts’ estimate revisions activity is indexed by the number of upward revisions in forward earnings less the number of downward ones, expressed as a percentage of total forward earnings estimates. We look at this activity over the past three months because that timespan encompasses an entire quarterly reporting cycle. Since analysts’ tendency to revise their estimates differs at different points in the cycle, three-month data are less volatile—and misleading—than a weekly or monthly series would be.

October’s reading comes at the beginning of the Q3 earnings reporting cycle, when analysts’ revisions lighten as they wait and see how much their companies beat their quarterly forecasts before revising their annual estimates. They’ve mostly been raising their revenues forecasts during 2023 following the Q4-2022 season and the earnings forecasts after Q2-2023. While the y/y quarterly revenue growth rates have remained positive this year and earnings growth is expected to turn positive in Q3, analysts now appear to be less bullish about earnings and a tad bearish on revenues, based on their latest NERI (net earnings revisions index) and NRRI (net revenues revisions index) readings.

Joe highlights what’s most notable about the October crop of revisions data below:

(1) S&P 500 NERI still on positive footing, but barely. The S&P 500’s NERI index, which measures the revisions activity for earnings forecasts, was positive for a fifth month but weakened to a five-month low of 0.6%. A zero reading indicates that an equal number of estimates were raised as were lowered over the past three months. October’s release is up from a 30-month low of -15.6% in December and is well above the average reading of -2.2% seen since March 1985 when the data were first calculated.

(2) Less than half of sectors now have positive NERI. Five S&P 500 sectors had positive NERI in October, unchanged from the September count and down from a 13-month high of seven sectors during July. Three sectors improved m/m, the fewest since last December.

That’s a far cry from all 11 improving m/m, as happened in May; but that month was unusual, as analysts then were scrambling to raise forecasts after Q1 earnings reports revealed broad-based strength. In fact, Q1 marked the broadest earnings improvement among the sectors in two and a half years, since Q3-2020.

To highlight standouts among sectors in October’s NERI readings, Energy’s NERI was at a 13-month high, turning positive for the first time in 11 months, and Financials’ was at a 16-month high. However, Financials’ negative NERI streak has now stretched to 16 months, the longest of all sectors’ and just ahead of Materials’ 15-month negative streak.

Here’s how NERI ranked for the 11 sectors in October: Energy (12.3%, 13-month high), Consumer Discretionary (5.2), Information Technology (4.3), Communication Services (4.0), S&P 500 (0.6, five-month low), Industrials (0.1, six-month low), Health Care (-2.4), Financials (-2.5, 16-month high), Utilities (-3.5, five-month low), Consumer Staples (-4.4, 10-month low), Real Estate (-5.8, six-month low), and Materials (-6.0).

(3) S&P 500 NRRI index for revenues is negative now. The NRRI index, which measures the analysts’ revisions activity in their revenue forecasts, dropped for the S&P 500 to -0.1% in October from 1.2% in September and is down from a 12-month high of 5.0% in July. October’s negative reading is its first in nine months and is barely above the average -0.2% reading since it was first compiled in March 2004.

(4) NRRI index still positive for seven sectors. NRRI’s m/m performance was generally weaker than that of the NERI index by all measures but one: Seven sectors had positive NRRI readings versus five with positive NERI.

Looking at m/m NRRI improvement, only two sectors cleared that bar: Energy and Materials. Consumer Staples’ and Utilities’ NRRIs dropped to their lowest readings in 40 months and 20 months, respectively. Energy’s was at an 11-month high.

Here’s how the sectors’ NRRIs ranked in October: Health Care (6.3%, nine-month low), Industrials (5.2, nine-month low), Energy (3.8, 11-month high), Utilities (1.4, 20-month low), Real Estate (1.3, 6-month low), Consumer Discretionary (1.2, nine-month low), Financials (0.6), S&P 500 (-0.1, nine-month low), Information Technology (-1.8, six-month low), Communication Services (-7.6), Consumer Staples (-9.5, 40-month low), and Materials (-14.6).

(5) Energy’s positive revisions boosting S&P 500’s NRRI and NERI again. Without the Energy sector, the S&P 500’s October NRRI reading for revenues falls to -0.4% from 1.2% in September (Fig. 15). Looking at the NERI reading for earnings, the S&P 500 without Energy was negative in October for the first time in six months, dropping to -0.1% from 2.2% in September (Fig. 16).

Materials and Energy—the only sectors to show m/m improvement in NRRI during October—were also the only ones to hit another mark we monitor: showing m/m improvement in NERI.

There are several possible reasons for the recent weakness in the remaining sectors’ revisions data. The impact of higher interest rates may now be starting to be reflected in estimate revisions. Also, waning inflation may be lowering revenues as well as impacting companies’ pricing power and ultimately their earnings.

A zero reading for NRRI and NERI indicates equal numbers of estimates rising and falling. The fact that October’s readings are so close to that mark—and only edging down m/m rather than collapsing—suggests that analysts collectively are generally satisfied with their forecasts for now. That takeaway has all the earmarks of a nice, gentle soft-landing.

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Global Economy Turning Up?

October 24 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Global Economy I: Green Shoots Vs Shooting Wars. The global economy continues to face some serious challenges. Central banks around the world have tightened their monetary policies dramatically since early last year in response to soaring inflation. Inflation has moderated around the world, but it remains high, especially relative to the 2.0% y/y inflation targets of the major central banks. As a result, they remain committed to either raising interest rates further or keeping their restrictive level of interest rates higher for longer. Consequently, bond yields have been rising around the world.

The wars in Ukraine and now the Middle East have unsettled the geopolitical order. So far, the hostilities have been contained geographically. However, they could easily broaden. The allies of Ukraine in the West continue to provide enormous financial support and lots of military aid to that country. The conflict between Ukraine and Russia has turned into a proxy war between Russia and the West. Similarly, the war in the Middle East is a proxy war between Israel and Iran. It conceivably could turn into a direct confrontation between the two adversaries and cause the United States to join the fray on Israel’s side.

China’s economy remains challenged by the bursting of the country’s property bubble. China’s demographic profile is aging rapidly, which is depressing consumer spending and putting pressure on the government to spend more on social benefits. Europe’s economy also is aging rapidly; additionally, Europe continues to struggle with the region’s transition from fossil fuels to renewable energy sources. That transition was complicated by the sanctions placed on imports of Russian oil and gas when Russia attacked Ukraine. Germany’s automakers have been scrambling to compete with foreign manufacturers of electric vehicles.

Soaring interest rates, weak commodity prices, and the strong dollar all have been weighing on many emerging market economies. Many of them are under pressure to choose sides in the global schism between Western democracies and the autocratic axis of China, Iran, North Korea, and Russia.

It’s a messy world order for sure and is getting messier by the day. Yet there have been some green shoots in the global economy recently. Real GDP in the US probably grew by around 5.0% (saar) during Q3, led by surprisingly resilient and robust consumer spending. China’s real GDP rose 4.9% y/y during Q3. That was better than expected, though it was slower than Q2’s pace of 6.3%.

Global Economy II: The Big Picture. Two weeks ago, in its latest World Economic Outlook, the International Monetary Fund (IMF) left its forecast for global real GDP growth in 2023 unchanged at 3.0% but shaved its 2024 forecast to 2.9% from the 3.0% expected in July. World output grew 3.5% in 2022.

In commentary about the decision, IMF Chief Economist Pierre-Olivier Gourinchas said that the global economy has continued to recover from the effects of Covid-19, Russia’s invasion of Ukraine, and last year’s energy crisis, but that diverging growth trends suggest “mediocre” medium-term prospects. The forecasts point generally to a soft landing, he said, but the IMF remains concerned about risks related to China’s property crisis, volatile commodity prices, geopolitical fragmentation, and a resurgence in inflation. Gourinchas told Reuters that it was too early to know how the war in the Middle East would affect the global economy: “Depending how the situation might unfold, there are many very different scenarios that we have not even yet started to explore, so we can’t make any assessment at this point yet.” But he did say that IMF research has shown that a 10% increase in oil prices would dampen global output by about 0.2% in the following year and boost global inflation by about 0.4%.

Debbie and I track several indicators of global economic activity. On balance, they show that global economic growth remains relatively slow. Let’s review them:

(1) Global production & exports. Global industrial production rose just 0.5% y/y through July. Over the same period, the volume of global exports fell 2.5% (Fig. 1 and Fig. 2). Both have been relatively flat since the start of 2022. That reflects the weakness in China’s economy and the pivoting of US consumers from bingeing on goods to services instead. In a sense, there has been a rolling recession in the global production and distribution of goods.

(2) Commodity prices. We calculate a crude Global Growth Barometer (GGB). It is the average of the nearby price of a barrel of Brent crude oil and the CRB raw industrials index (multiplied by 2 and divided by 10) (Fig. 3 and Fig. 4).

Our GGB fell sharply from the summer of 2022 through the summer of 2023. It then rebounded a bit through September but has stalled since then. The price of oil tends to have more geopolitical noise than does the CRB index, which has been falling since it peaked last year on April 4.

The CRB index is highly correlated with the price of copper (which is one of the components of the index) and the Emerging Markets MSCI stock price index (in dollars) (Fig. 5 and Fig. 6). They’ve all been weak recently, notwithstanding better-than-expected growth rates in the real GDPs of China and the United States. That’s because the recession in China’s property sector has depressed global demand for commodities. The rolling recession in the US goods sector has been doing the same.

(3) Global PMIs. The global composite PMI and its components covering advanced and emerging economies all peaked earlier this year (Fig. 7). The composite did so during May at 54.4 and fell to 50.5 in September. Emerging economies have slightly outperformed advanced ones.

In the manufacturing sector, the composite and its advanced economies component have been under 50.0 since last September, while the emerging economies have been mostly above 50.0 since the start of this year.

In the non-manufacturing sector, the PMIs are down from earlier this year and just north of 50.0.

Global Economy III: The Downside of US Economic Strength. As we mentioned above and discussed previously, consumers went on a post-lockdowns spending spree on goods and then pivoted around mid-2021 to do the same on services. US retailers reordered to restock their depleted inventories, which jammed the ports and trucking industry. By the time that the goods were delivered in late 2021, retailers were stuck with them and had to discount their prices to reduce their bloated inventories.

That explains the flattening of global industrial production, the volume of global exports, and global M-PMIs. Apparently, spending on services by US consumers doesn’t have as much of a multiplier effect on the global economy as does their spending on goods. Of course, my wife and I did boost the economies of Croatia and the Scandinavian countries when we vacationed for a week in June and in September. So did lots of the other tourists who swarmed all over Europe this past summer.

Global Economy IV: China’s Bubble Trouble. China’s real GDP expanded 2.9% y/y through Q4-2022—marking one of its slowest growth rates in several decades (Fig. 8). That missed the government’s initial goal of around 5.5%. The Chinese economy was depressed by the country’s stringent zero-Covid policy that restricted people’s movements and disrupted supply chains. Growth picked up during the first three quarters of this year following the two-month Covid-19 lockdown at the end of last year.

China’s economic recovery has been weighed down by a slump in its real estate sector, with major property developers China Evergrande Group and Country Garden Holdings Co. saddled with heavy debts. The real estate market accounts for some 30% of China’s GDP. Evergrande filed for bankruptcy in a New York court in August. During the first nine months of 2023, investment in real estate development dropped 9.1% y/y. Industrial production grew 4.0%, while retail sales of consumer goods rose 6.8% and fixed-asset investment increased 3.1%.

August marked the second time this year that China’s central bank cut its benchmark lending rate to shore up the economy. Unlike most other central banks, the People’s Bank of China is much more concerned about deflation than inflation. Over the past 12 months through September, the country’s CPI was unchanged, while its PPI was down 2.5% (Fig. 9).

Global Economy V: Europe’s Challenges. Real GDP rose just 0.5% y/y through Q2 in the Eurozone (Fig. 10). The outlook remains lackluster, since the region’s Economic Sentiment Indicator—which tends to be highly correlated with real GDP growth—fell in September to 93.3, the lowest reading since November 2020.

The Eurozone’s headline and core CPI inflation rates remained elevated at 4.3% and 4.5% through September (Fig. 11). The European Central Bank (ECB) has responded to inflation by raising the ECB’s official deposit rate from -0.50% during the first half of 2022 to 4.00% currently.

Eurozone private-sector loans peaked at a record €13.1 trillion during September 2022, falling by €84 billion through August of this year (Fig. 12). The volume of retail sales (excluding automobiles and motorcycles) fell 1.3% y/y during August to the lowest since April 2021 (Fig. 13).

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‘Dangerous Times’

October 23 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Geopolitics: Middle East’s Existential Crisis. Jamie Dimon is probably right. On October 13, the CEO of JPMorgan Chase sounded the alarm on the global effects of wars in the Middle East and Ukraine. “This may be the most dangerous time the world has seen in decades,” he said in a statement accompanying the bank’s quarterly earnings. He warned of “far-reaching impacts on energy and food markets, global trade and geopolitical relationships.”

The war in the Middle East between Israel and Hamas might have escalated into a regional war on Thursday. That’s when a US warship heading south in the Suez Canal over a period of nine hours intercepted and destroyed four cruise missiles and 15 drones heading toward Israel from Yemen. The missiles were fired by Iranian-backed Houthi forces in Yemen and were launched “potentially towards targets in Israel,” according to the Pentagon’s press secretary. In response, the US fired sea-launched cruise missiles at Houthi radar facilities in Yemen, according to a CNN report.

This development contributed to the selloff in the S&P 500 on Friday. So did the increase in the 10-year Treasury bond yield to 4.997% Thursday evening. But the yield was back down to 4.928% at Friday’s close. The decline in the yield undoubtedly reflected profit taking by short-sellers and a mini-flight to safety in reaction to the latest unsettling developments in the Middle East.

On October 7, when the war started, I wrote: “Geopolitical crises in the Middle East have usually caused oil prices to rise and stock prices to fall. More often than not, they’ve also tended to be buying opportunities in the stock market. Much will depend on whether the crisis turns out to be another short-term flare-up or something much bigger like a war between Israel and Iran.”

On October 10, Debbie and I raised our subjective odds of a broad-based US recession from 25% to 30% because of the war: “This one isn’t likely to lead to a quick ceasefire between Israel and Hamas, as occurred in the past, because it is in fact a war between Israel and Iran. For Israel, it is existential. This time, Israel’s goal is to wipe out Hamas, which is Iran’s surrogate in Gaza. The war is also existential for Iran’s mullahs, who need it to distract their domestic population from discontent over their authoritarian regime by moving forward on their machinations to wipe out Israel.” And, of course, the war is now existential for Hamas since Israel has vowed to destroy the terrorist organization.

Under the circumstances, the odds of an escalation of the hostilities are increasing, while those of a ceasefire anytime soon are falling. As a result, we’re raising our odds of a recession again, to 35%. A regional war has become more likely now that the US has gotten directly involved by shooting down missiles launched by Iran’s surrogates in the region and destroying their military assets on the ground.

There could still be a year-end stock market rally, but there is likely to be more downside over the next few weeks while the regional combatants and also the US Navy are targeting each other. The S&P 500 index fell back to its 200-day moving average on Friday and looks set to breach it if the news out of the Middle East continues to worsen, as we now expect, even if the bond yield declines on the same news.

The question is whether this war will escalate to the point where American and Israeli policymakers conclude that now is the time to destroy Iran’s nuclear facilities. We are sure the question will be raised. We don’t know what the answer will be or even whether such an escalation is militarily feasible.

We are keeping an eye on Taiwan too, as is China. A month ago, a record number of Chinese fighter planes—103 of them—flew around Taiwan in just one day. On Wednesday, Taiwan reported that 10 Chinese military aircraft and four navy ships buzzed close to the island nation. China’s government might view this as an opportune time to invade Taiwan now that the US is stretched militarily by supporting both Ukraine and Israel.

As Jamie Dimon said, “This may be the most dangerous time the world has seen in decades.” There isn’t likely to be much upside for the stock market until the geopolitical risks turn less dangerous, particularly in the Middle East. We certainly aren’t sure how long that will take, but we think these risks will linger for a few weeks at least.
 
As noted above, geopolitical crises have often turned out to be buying opportunities. At first, the stock market didn’t respond adversely to the war in the Middle East. It may be starting to do so now. If so, then this too should result in buying opportunities, particularly in Energy, Financials, and Information Technology. Of course, defense stocks should also benefit from these dangerous times.
 
Strategy: Market Call. Our cautiousness on the outlook for the S&P 500 over the near term is in sync with the views of our friend Joe Feshbach. Here are his latest thoughts on the stock market from a trading perspective:

“I remain cautious on the stock market, as the internal dynamics—especially as measured by breadth statistics—remain awful. I have been highlighting the Nasdaq in particular, where the cumulative A/D line has been constantly making new lows. Also on the surprisingly disappointing side is how the put/call ratio has responded to this decline. One would have thought that with horrible breadth accompanied by terrible news, put buying would skyrocket. It has not. Yes, the numbers have picked up, but we are nowhere near levels that would indicate fear and a possible low. I’m very curious to see how the ratio will react if the S&P 500 breaks its prior intra-day low of 4216 this week.” Thanks Joe!
 
Bonds: Supply & Demand Update. In his interview Thursday with Bloomberg’s David Westin at the Economic Club of New York, Fed Chair Jerome Powell was asked about the bearish impact of the increasing supply of government debt on the bond market given that the Fed is no longer buying Treasury securities and that foreigners reportedly are reducing their purchases as well. Powell responded that buying by foreigners has “actually been pretty robust” this year.

That statement provides an opportunity for Melissa and me to update our analysis of supply and demand in the Treasury market. Consider the following:

(1) Bears versus bulls. In our August 14 Morning Briefing, titled “Disinversion,” we wrote: “[T]he supply of and the demand for bonds isn’t usually as important to the determination of the bond yield as are actual and expected inflation and the expectations of how the Fed will respond to them.” The 10-year Treasury bond yield was 4.19% at the time, but we were increasingly concerned that it was going higher because of the imbalance between supply and demand.

Favoring the bears in the bond market, we observed, “is the rapidly widening federal deficit and evidence that demand may not match the supply of Treasury securities unless their yields continue to rise. Favoring the bulls, in our opinion, is that since last summer inflation has been on a moderating trend that should persist through 2025 without any further increases in the federal funds rate.”

Inflation remains on a moderating trend. However, the bond yield is now around 5.00%, as supply concerns have mounted along with the federal debt. Supply became a major issue when the Treasury announced significant increases in its auctions on July 31. From July through September, the Treasury needed to borrow $1.01 trillion, $274 billion more than was announced in May. The day after that announcement, on August 1, Fitch Ratings downgraded the government’s credit rating from AAA to AA+. That underscored the significance of the government’s profligate borrowing and accentuated investors’ supply concerns.

(2) Is 5% high enough? The question now is whether the 10-year Treasury bond yield, at 4.93% on Friday, is high enough to attract sufficient bond buyers to equilibrate the market’s supply and demand. We think so. The 10-year yield is back to the highest reading since June 2007 (Fig. 1). We’ve previously characterized the bond yield range of 4.50%-5.00% as a return to the old normal range before the Great Financial Crisis from 2003 through 2007. The big difference between now and then is the size of the federal deficits, which is partly attributable to the rapid rise in the net interest outlays of the federal government.

(3) Bond Vigilantes more powerful than ever. The risk in the bond market is that the difference in the supply factor could push yields higher than 5.00%. That’s another way of saying that the risk is that the Bond Vigilantes will take over control of the market, pushing yields so high that they cause a credit crunch and a recession. That may be the only way to force Washington to lower the unsustainable long-term path of the federal deficit. After all, Washington has provided the Bond Vigilantes with more power than ever by increasing the government’s debt so rapidly in recent years (Fig. 2). Total public debt outstanding excluding intragovernmental holdings has quadrupled since Q4-2008 to $26.3 trillion during September.

It shouldn’t be forgotten that elevated bond yields can have the same monetary tightening effect on the economy as elevated federal funds rates, if not a greater tightening effect.

(4) The bond crop never fails. During fiscal year 2023 (ending September), the federal deficit totaled $1.7 trillion. That well exceeds the pre-pandemic record high of $1.1 trillion over the 12 months through February 2020 (Fig. 3). Outlays totaled $6.1 trillion, while receipts totaled $4.4 trillion (Fig. 4).

Exacerbating the federal deficit has been rapidly increasing outlays on net interest (Fig. 5). Over the past 12 months through September, it totaled $659 billion, doubling since May 2021. The average interest rate on the government’s debt is currently about 2.50%. The 2-year Treasury yield is over 5.00% currently. So this outlay will continue to be the fastest growing one in coming months.

(5) Fed and banks are net sellers. On the demand side, the Fed stopped purchasing Treasury securities during June 2022 and has let its holdings decline as they mature. During this period of quantitative tightening (QT), these holdings peaked at a record $5.77 trillion at the start of June 2022 and were down to $4.96 trillion at the start of October this year (Fig. 6). That’s an average decline of $51 billion per month over that 16-month period. If QT continues to reduce the Fed’s holdings of Treasuries at roughly this pace, other buyers will have to refinance the $600 billion decline, over 12 months, in the Fed’s holdings.

Interestingly, the Fed’s holdings of Treasury bonds maturing in over 10 years actually increased slightly over this period by $80 billion (Fig. 7).

The holdings of US Treasury and agency securities held by all US commercial banks peaked at a record $4.71 trillion during the week of March 1, 2022 and fell $610 billion to $4.10 trillion during the October 11 week (Fig. 8). That period coincides with the Fed’s QT. That’s because QT has been reducing bank’s deposits, forcing them to raise funds by letting their securities mature (Fig. 9).

(6) Foreigners are still buying. Fed Chair Powell is right about foreigners. They are still active buyers of US bonds. According to Treasury International Capital (TIC) data, over the 12 months through August, their net purchases of US bonds was $582 billion, including $596 billion purchased by private foreigners and $14.0 billion sold by official foreign accounts (Fig. 10). Over the past three months through August, foreign investors purchased $75.0 billion in US Treasury notes and bonds, with private foreigners purchasing $79.3 billion and private official accounts selling $4.3 billion.
 
(7) Domestic individual and institutional investors are the known unknowns. Over the past 12 months, bond mutual funds and ETFs have had net inflows of $194.1 billion. Unfortunately, investors piled into these funds at a record pace, which peaked at $1.0 trillion during 2021 on a 12-month sum basis, when interest rates were at or near record lows. Clearly, individual and institutional investors have amassed huge realized and unrealized losses in the bond market.

The question is whether bond yields upwards of 5.00% now will bring investors back into the bond market. We think so. On the other hand, it might take a while since they can earn as much in money market mutual funds, which are up $1.1 trillion y/y through mid-October and more than $2.0 trillion since just before the start of the pandemic (Fig. 11).
 
Consumers: The Spending-Employment Spiral. Why is consumer spending so strong, as evidenced by September’s 0.7% m/m increase in retail sales and the upward revisions in August (from 0.6% to 0.8%) and July (0.5% to 0.6%) (Fig. 12)? The answer is that payroll employment is so strong, with a gain of 336,000 during September, following upward revisions in August and July of 119,000 in total as well. Employment gains averaged 266,000 per month over the past three months through September.

Why is employment so strong? Because consumer spending is so strong. This may sound like circular reasoning, but it’s not. As we’ve explained before, retiring Baby Boomers are eating at restaurants more often, traveling more frequently, and seeing health care providers routinely. These are all labor-intensive services that need more workers to satisfy the demand from their customers, especially the Baby Boomers. So for example, consider the following:

(1) Food services retail sales rose to a record $1.1 trillion (saar) during September, exceeding meals at home by 11.3% (Fig. 13). Employment in food services & drinking places has fully recovered from the pandemic, but they still have more than a million job openings including in accommodations services (Fig. 14).

(2) Personal consumption expenditures on health care services rose to a record high of $3.0 trillion (saar) during August (Fig. 15). Payroll employment in health care and social services rose to a record 21.6 million (Fig. 16). During August, there were 1.8 million job openings in these two industries.

Movie. “Past Lives” (+) (link) is a movie with a romantic story but a realistic one. That’s because love doesn’t always conquer all. There are lots of extenuating circumstances in any relationship. This movie follows the relationship of childhood sweethearts in South Korea. They are separated when one of them moves to Canada and then to the US. Nevertheless, they still have feelings for one another when they are young adults. Will they or won’t they reconnect and surmount new obstacles? In other words, this is a realistic romantic suspense movie. That might be a new genre.

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Bank Earnings, CO2 & The Oceans

October 19 (Thursday)

Financials: So Far, Not Bad. Bank earnings started rolling in over the past week with a wave of relief that so far some of the worst fears have not come to pass. Many earnings reports beat Wall Street analysts’ consensus estimates. Real estate write-offs were lower than expected. Deposits are declining, but slowly enough that the banks can adjust. And the economic outlook at many banks has improved as the consumer has kept on spending.

Some of the biggest complaints in quarterly conference calls came from JPMorgan Chase executives concerned about proposed changes to reserve requirements that could force the bank to raise billions in capital. Investors, on the other hand, didn’t have much to complain about, as the three biggest banks beat Wall Street analysts’ consensus estimates. Here are the actual and forecasted Q3 earnings for Bank of America ($0.90, $0.83), JPMorgan Chase ($4.33, $3.95), and PNC Financial Services Group ($3.60, $3.10).

Let’s take a look at some of the themes in the earnings conference calls held by the managements of Bank of America (BAC), JPMorgan (JPM), and PNC over the past week:

(1) Real estate losses underwhelm. FDIC-insured institutions have been increasing their provision for loan and lease losses relatively sharply in the past nine quarters (Fig. 1). The provision increases have paid off. After all the handwringing, the real estate portfolios of the three banks performed as expected. The losses on loans that went bad were already reflected in reserves. The modest increases in loan loss provisions that did occur were generally attributed to increases in credit card loans outstanding and a return to more normal default rate expectations in those portfolios.

Consumer credit card debt outstanding dipped briefly during the pandemic but began rising again in 2021 (Fig. 2). After initially spiking, credit card delinquency rates fell sharply through mid-2022. Delinquency rates since have risen to more normal levels and remain relatively low historically (Fig. 3).

JPM saw a “trickle” of office real estate charge-offs, but they were already factored into the bank’s allowance for losses. The bank’s Q3 provision for credit losses was $1.4 billion, down slightly y/y and down sharply from $2.9 billion in Q2. The bank’s $1.5 billion of net charge-offs were primarily in credit cards, and the $301 million in net reserve build in credit cards due to loan growth was offset by a reserve release of $250 million in home lending, driven by the increase in home prices. The net reserve build related to commercial real estate was only $37 million and reflected updated pricing variables.

BAC’s commercial loan net charge-offs in Q3 declined from the Q2 level, driven by a reduction in office loan write-downs. Office loans represent 2% of the bank’s total loans, and they are “adequately reserved against the current conditions,” said CFO Alastair Borthwick. In total, the bank’s net charge-offs of $931 million increased by $62 million from Q2 due to credit card losses. Its credit card loss rate of 2.72% last quarter was up slightly from 2.60% in Q2 but still below the pre-pandemic rate of 3.03% in Q4-2019. BAC’s provision for credit losses was $1.2 billion, including a $303 million reserve build that reflects the bank’s expectation that the unemployment rate will rise above 5% in 2024.

PNC’s nonperforming real estate loans jumped 11% q/q to $210 million, but the increase wasn’t more than expected by the bank’s reserves. In the commercial real estate portfolio, total criticized loans remained flat q/q at 23%. Some loans within that category became non-performing loans. “Ultimately, we expect future losses on this portfolio, and we believe we have reserved against those potential losses accordingly. As of September 30, our reserves on the office portfolio were 8.5% of total office loans,” said PNC CFO Rob Reilly.

The bank’s provisions for credit losses actually declined to $129 million in Q3, down from $146 million in Q2 and $241 million in Q3-2022. PNC’s net loan charge-offs of $121 million fell from $194 million in Q2 due to lower commercial real estate net loan charge-offs. The amount was up a smidge from $119 million in Q3-2022.

(2) Deposits shrink, but slowly. Total deposits at commercial banks spiked during the pandemic and since have gradually been falling back to more normal levels (Fig. 4).

At PNC, average deposits decreased by $3.2 billion, or 1%, to $422.5 billion due to a decline in consumer deposits that was somewhat offset by a growth in commercial deposits. Non-interest-bearing deposits were 26% of deposits, down from 27% in Q2 and expected to stabilize in the mid-20% range. The cost of interest-paying deposits has risen to 2.26% in Q3, up from 1.96% in the prior quarter.

“We’re going to have repricings of fixed-rate assets fighting reprices of our liabilities. At some point, that’s going to cross, and banks are going to grow NII at high percentages. I just can’t tell you when that is yet,” said PNC CEO Bill Demchak.

At JPM, average deposits of $2.4 trillion declined 4% y/y and 1% q/q. Total deposits at BAC rose slightly q/q, from $1.875 trillion on June 30 to $1.886 trillion on September 29. Just as importantly, the bank didn’t have to raise rates very high to keep deposits: The rate paid on all deposits was 1.55%, up only 0.31 from last quarter thanks to many low- and no-interest paying consumer checking accounts.

(3) Economic growth slows. JPMorgan’s economists raised their economic growth forecast in Q3 to modest real GDP growth of around 1% for the next few quarters up from the 0.5% decline in GDP in Q4-2023 and Q1-2024 they previously had expected.

Bank of America economists predict a soft landing with a mid-2024 trough. The slower growth is reflected in consumers’ spending, which has slowed to about 4% increase y/y in Q3 and in October, down from 10% y/y spending growth earlier this year and in 2022. The current pace of spending returns consumer activity to the pre-pandemic levels of 2016-19.

The folks at PNC expect a mild recession starting in the first half of 2024, with real GDP contracting by less than 1%. They expect the federal funds rate to remain unchanged at 5.25%-5.50% through mid-2024, when they expect the Fed to start cutting rates. However, CEO Demchak said, “Personally I think the Fed is higher for longer even higher for longer than the market expects.”

(4) Proposed regulations irk JPM. Regulations proposed in July by the Fed, Office of the Comptroller of the Currency, and the FDIC would increase the capital the banks need to hold against their risk-weighted assets. The proposed rules —known as “Basel III Endgame”—would standardize the way firms approach their credit, market, and operational risk exposures, and they’d apply to firms with at least $100 billion in total assets as well as to smaller firms with significant trading activities. If approved, they’d go into effect in 2025.

Of the three banks, JPM appears likely to face the biggest capital shortfalls under the proposed rules. The bank estimates that its risk-weighted assets will increase by 30%, or $500 billion, which increases the firm’s required capital by about 25%, or $50 billion. The bank also would have to increase its capital by $30 billion to meet new requirements regarding capital reserved for operational risk.

The proposed rules require a fourfold increase in the risk-weighted assets held against tax-advantaged investments in the solar and wind industries. It also ups the capital that needs to be held against mortgages and housing loans. If these requirements go through, banks presumably would adjust the pricing on those loans, making them more expensive for borrowers, which would seem counter to the Biden administration’s goals. JPM CFO Jeremy Barnum said that the rule changes might cause the bank to exit certain business lines, like the renewable energy tax credit investment business.

“The current proposal exacerbates existing features to discourage beneficial scale and diversification. If it goes through as written, there will likely be significant impacts on pricing and availability of credit for business and consumers. In addition, the ongoing and persistent increase in the regulatory cost of market-making for banks suggests that the regulators want dramatic changes to the current operation of the US capital markets,” said JPM’s Barnum. Needless to say, JPM will continue to “engage and forcefully advocate during the comment period and beyond.”

While Bank of America’s CEO Brian Moynihan also expressed hope that the proposed rules will be changed, he noted that they’d have limited impact on the bank. The firm’s risk-weighted assets would increase about 20% to $1.95 trillion. BAC would be required to keep $195 billion in capital against those assets, or 10% of the total. The bank has $194 billion of capital currently, and it should be able to raise the minimal shortfall from the capital generated by the bank’s operations.

Executives at PNC continued to pause the bank’s share repurchase activity while the regulatory changes are under consideration. PNC falls short of the required risk-weighted assets-to-long-term debt ratio requirement and would need to raise $9 billion of debt to be in compliance. It expects to raise those funds under the bank’s current funding plans. If other banks decide to sell assets to meet the proposed requirement, PNC would be interested in taking a look.

Disruptive Technologies: Absorbing CO2 from the Oceans. Looking to reverse climate change, scientists are experimenting with various ways to pull carbon dioxide (CO2) out of the atmosphere. Some have turned to the oceans for a solution. The oceans absorb about 30% of the CO2 produced each year. If CO2 can be wrung out of their waters, the oceans would be able to absorb more CO2 from the atmosphere.

Taking CO2 out of the ocean is arguably more efficient than taking it out of the air, requiring less energy and expense for the same amount of gas removed. That’s because the CO2 in the ocean is 150 times more concentrated than the CO2 in the air and doesn’t need to be captured; the ocean has already done so.

Here are a few different approaches that scientists at UCLA, Caltech, MIT, and the University of Pittsburgh are using to help the Earth:

(1) Turning CO2 into seashells. Marine organisms form seashells from calcium and carbonate ions created after CO2 from the atmosphere dissolves in the oceans. So Dante Simonetti, an assistant professor of chemical and biomolecular engineering at the UCLA Samueli School of Engineering, started testing new ways that would speed up the process of turning CO2 into minerals. He helped develop a machine that electrically charges seawater, triggering a reaction that turns the CO2, calcium, and magnesium in the water into limestone and magnesium—essentially a shell-like dust—in addition to hydrogen, which can be sold as a green fuel. The remaining water can be pumped back into the ocean, where it once again absorbs CO2, or the water can be used on the land, a June 3, 2021 Fast Company article reported.

The technology was spun out of UCLA into a startup called Equatic (formerly known as “SeaChange”). Equatic has entered into agreements with Boeing and Fintech company Stripe to remove CO2 from the ocean. The Boeing deal, struck earlier this year, includes a pre-purchase option agreement for “62,000 metric tons of CO2 removal and 2,100 metric tons of ‘carbon-negative’ hydrogen that Boeing sees as feedstock for cleaner jet fuel,” according to a May 31 Axios article.

Equatic has been moving its operations beyond the lab. It’s in the process of building two plants, in Los Angeles and Singapore. It will take 1,800 of the devices to capture 10 billion metric tons of CO2 each year—less than a third of the 37 billion tons of CO2 emitted each year.

(2) Capturing bubbly. Captura is another startup that also electrolyzes a small amount of seawater to “rearrange the molecules into an acid and a base. When the acid is added back into [a larger amount] of the seawater, it reacts with the carbon to release CO2,” a May 4 article on The Verge reported. Captura either stores the CO2 or sells it as a product. The CO2-depleted water is released back into the ocean, where it can absorb CO2 again. The captured CO2 could be sold to companies that produce concrete or carbon fiber. Or Captura could build its plants on retired offshore oil and gas platforms and pump the captured CO2 underground into the deserted oil and gas wells.

The company, which was founded by Caltech researchers, is setting up a pilot project in the Port of Los Angeles. Critics worry that the company’s filters won’t be fine enough to ensure that small ocean creatures, like plankton, aren’t trapped. And if the CO2 is pumped underground, skeptics fear it will leak and emerge above ground over time.

(3) MIT & UPitt on the job, too. At MIT, researchers likewise are electrolyzing the water to separate the CO2; a second step removes the acidity and collects the CO2. The university believes its approach is less expensive than other researchers’ proposed solutions, and the process could be performed by merchant ships as they are sailing, so that their CO2 collections offset their CO2 emissions, a February 27 article in the Scientific American reported. Additionally, other ships could be deployed as “scrubbers of the oceans.”

At the University of Pittsburgh’s Swanson School of Engineering, researchers have developed two systems to capture carbon dioxide. One uses microencapsulated solvents made of sodium carbonate, and the other uses hollow fiber membrane contactors containing sodium hydroxide. As water flows over the systems, CO2 is captured. When the sodium capsules are placed in steam at a temperature of 100-120 degrees Celsius, the CO2 can be removed and stored so that the sodium capsules can be reused, as Inside Climate News reported on September 2.

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Rolling Recovery

October 18 (Wednesday)

Revenues I: Rolling Recovery for Goods Providers. September’s retail sales and industrial production were up by 0.7% m/m and 0.3% m/m. Those were stronger-than-expected increases. Debbie and I weren’t surprised because we’ve been seeing signs recently that the rolling recession for goods producers and distributors, which started in early 2021, is turning into a rolling recovery.

Consumers went on a goods buying binge following the pandemic lockdowns (Fig. 1). They pivoted to binging on services around March 2021. That’s when social distancing restrictions increasingly were lifted in the services sector. When this happened, consumers decided that they had purchased enough “stuff” and it was time to pay for more “stimulus,” i.e., the experiences associated with services. Inflation-adjusted consumer spending on goods has been flat y/y, albeit at a record high, since March 2021 through August 2023. The latest retail sales report suggests that spending on goods may be starting to recover from its growth recession.

This development is the latest setback for the hard-landers. There may be fewer of them, but the diehards are convinced that consumers soon will run out of the excess saving they accumulated during the pandemic, forcing them to retrench. We’ve been countering that it’s more likely consumers have been holding onto quite a bit of those excess saving for precautionary purposes. That explains why the saving rate subsequently fell; they felt they had saved enough for a rainy day. That allowed them to spend more of their disposable income, which has been rising since the start of this year, on goods and services (Fig. 2 and Fig. 3).

Let’s review the latest relevant data:

(1) M-PMI and manufacturing output bottoming. The M-PMI rose to 49.0 in September from a recent low of 46.0 during June (Fig. 4). It’s still below 50.0. However, the sub-indexes for production (52.5) and employment (51.2) rose above 50.0 in September.

US industrial production rose 0.3% m/m in September (Fig. 5). The gain was above expectations of a 0.1% gain, according to a WSJ survey. Manufacturing rose 0.4% in September, with motor vehicle production up 0.3% despite the ongoing strike against three automakers (Fig. 6). Among the strongest gainers were computer & peripheral equipment (1.3%) and communications equipment (1.1%) (Fig. 7). Housing-related production was surprisingly strong, with solid gains in appliances, furniture, and carpeting (4.9%) and construction supplies (1.0%).

(2) September rebound for retailers. Retail & food services sales rose 0.7% m/m during September (Fig. 8). It also rose 0.7% excluding food services. During the month, the CPI for goods rose 0.1%. So real retail sales (excluding food services) rose 0.6% (Fig. 9). The gains were relatively widespread.
 
Revenues II: Manufacturing & Trade Activity Heading Higher. The Census Department releases data on manufacturing and trade sales (M&TS of goods) at the same time as it releases retail sales but for a month earlier. In other words, retail sales for September came out along with M&TS for August. Nevertheless, we follow the monthly M&TS series because it closely tracks S&P 500 aggregate revenues, even though the latter includes revenues from the sales of both goods and services (Fig. 10 and Fig. 11).

M&TS rose 1.3% m/m and 0.2% y/y during August. S&P 500 aggregate revenues rose 6.1% y/y through Q2. Here are some more insights from the latest M&TS data:

(1) Growth recession. Both nominal and real M&TS have been flat for the past year (Fig. 12). The weakness has been widespread among manufacturing shipments, wholesale sales, and retail sales (Fig. 13 and Fig. 14).

In current dollars, M&TS inventories has been flat at a record high since mid-2022 through August, consistent with the rolling recession in goods (Fig. 15). In real terms, these inventories flattened out around this February’s record high through July.

(2) Deflating prices. The price deflator for M&TS peaked at a record high during June 2022 (Fig. 16). It is down 4.9% since then through July 2023. On a y/y basis, deflation in the goods sector is widespread: M&TS (-3.4%), manufacturing (-4.1), wholesale (-5.6), and retail (-0.3).
 
Revenues III: Looking Forward. The latest earnings recession has been relatively short and shallow (Fig. 17). Earnings fell 7.9% from a record peak during Q2-2022 through the recent trough during Q1-2023. S&P 500 operating earnings per share edged up during Q2 and might have risen to a new record high during Q3! S&P 500 revenues per share probably did the same.

Confirming our predictions are S&P 500 forward revenues and forward earnings, which rose to new record highs during the week of October 5 and October 12, respectively. (FYI: Forward revenues and earnings are the time-weighted average of analysts’ consensus projections for the current year and following one. The forward profit margin is calculated from forward revenues and earnings.)

The latest earnings recession was mostly attributable to a drop in the S&P 500’s profit margin from Q2-2021’s peak of 13.4% to 11.5% during Q4-2022. It rose to 11.8% during Q2. The weekly forward profits series that Joe and I track suggests that the quarterly profit margin continued to rise during Q3.

Strategy I: Market’s Recent Swoon Creates Haves and Have-Nots. The rapid rise in bond yields during August and September caught investors off-guard, and their anxiety led to losses in the stock and bond markets. Since then, investors and corporations have re-assessed their “higher for longer” interest-rate expectations and have begun grudgingly to accept the return to more normal levels of interest rates after more than a decade of extraordinarily low ones.

Let’s review how much the various investment-style indexes have dropped from the S&P 500’s high for the year so far, on July 31, and how much they’ve risen from their recent bottoms:

(1) LargeCaps favored over SMidCaps during pullback and recovery. The S&P 500 fell 7.8% from 4588.96 on July 31 to a four-month low of 4229.45 on October 3 (Fig. 18). It narrowly avoided a correction within its rally from its 25.4% bear market low of 3577.03 on October 12, 2022. The S&P MidCap 400 and S&P SmallCap 600 performed worse than their LargeCap counterpart. MidCap’s 11.0% decline through October 3 put that index back into a correction, while SmallCap’s 13.2% drop through its October 13 low caused it to fall back into a bear market.

LargeCap has risen 3.4% from its October low through Monday’s close, better than the respective 2.2% and 1.8% gains for MidCap and SmallCap.

(2) Growth mostly beats Value down and up. The S&P 500’s decline since July 31 was led by a 9.4% drop in the S&P 500 Value index, while S&P 500 Growth fell just 6.5%. The declines from the MidCap and SmallCap indexes’ July 31 peak to their October troughs likewise were less for Growth than Value: MidCap Growth (-9.5%), MidCap Value (-12.7), SmallCap Growth (-11.4), and SmallCap Value (-15.1).

Growth mostly has led Value across these indexes since their troughs, which seems counter-intuitive when interest rates are rising. Here’s how they’ve performed since their October lows: LargeCap Growth & Value (3.8% vs. 2.9%), MidCap Growth & Value (2.5, 1.9), and SmallCap Growth & Value (1.6, 2.0).

(3) Recent gains spreading? While the S&P 500 fell below its 50-day moving average (dma) during its pullback, it has remained above its 200-dma, and the recent buying is spreading. The index rose for a second straight week during the October 13 week after falling in seven of the prior nine weeks. While the index gained just 0.4% for the week, eight of its 11 sectors rose and five outperformed the composite index.

That compares to just three S&P 500 sectors rising during the October 6 week: Communication Services, Consumer Discretionary, and Tech. Those were also the only three sectors to beat the S&P 500 that week. The fact that each houses at least two MegaCap-8 companies certainly helped. (FYI: The MegaCap-8 stocks are: Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla.)

Whether or not last week’s gain represents a broadening of the recovery or simply portfolio re-positioning ahead of the Q3 earnings season remains to be seen.

Strategy II: Positive Signs from Early Reporting Financials. The Q3-2023 earnings season is beginning to ramp up with releases from some of the major companies in the S&P 500 Financials sector. In particular, members of the Asset Managers and Banks industry are off to a great start. Among the reporters so far are Bank of New York Mellon, recent S&P 500 index addition BlackRock, Bank of America, Citigroup, JPMorgan Chase, PNC Financial, and Wells Fargo.

They’ve all reported consensus earnings beats across the board, with Financials’ aggregate earnings-per-share beat and y/y earnings growth coming in at 13.3% and 12.6%, respectively. There were mostly positive surprises and positive y/y growth on the top lines as well. Only BlackRock and PNC missed their consensus revenues forecast, albeit slightly, and only PNC’s revenues were down from a year earlier. Overall, the Q3 results are impressive considering the industry’s challenges this year, including interest-rate angst, regional bank failures, and reduced share buyback activity.

With these and other early reporters’ Q3 results tallied, the S&P 500 earnings season is now nearly 8% complete. Actual earnings for the S&P 500 companies that have reported Q3 so far are ahead of consensus forecasts by 9.9%, but their revenues have exceeded expectations by only 0.9%. That compares to 9.7% and 1.3% at the same point during the Q2-2023 earnings season.

In aggregate, earnings for Q3’s early reporters are up 8.3% y/y, and their revenues have risen 6.5%. During Q2, the comparable figures were 13.4% for y/y earnings growth and 7.7% for revenue growth.

The Q3 data so far suggest a repeat of Q2’s earnings performance—i.e., neither too hot nor too cold—which should help support the nascent recovery in stock prices.

Strategy III: MegaCap-8’s Forward Profit Margin at Notable Highs Now. The MegaCap-8 had a relatively forgettable year during 2022 as its revenues and earnings took a steep dive along with its profit margin. Now the group has come full circle and is giving a much-needed boost to the S&P 500’s profitability, as Joe shows below.

The S&P 500’s latest forward profit margin reading (during the October 6 week) was at a 10-month high of 12.7%. It’s up 0.4pt from a two-year low of 12.3% during the March 31 week (Fig. 19). That margin performance owes much to the contribution of the MegaCap-8.

When we exclude the MegaCap-8, the latest reading for the S&P 500’s forward profit margin drops 1.0pt to 11.7% from 12.7%. That’s the MegaCap-8’s biggest contribution ever (since December 2012) to the broad index’s profit margin. Without the MegaCap-8, the S&P 500’s forward profit margin would be up just 0.1ppt from its two-year low of 11.6% during the June 30 week.

The MegaCap-8’s forward profit margin was back up to 20.8% last week (ended October 13) from a post-pandemic low of 18.1% during the March 31 week. That 20.8% reading is the highest in two years and only 0.1pt below the group’s post-pandemic high of 20.9% two years ago (during the September 10, 2021 week).

The MegaCap-8 is clearly in a rolling profits recovery.

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It’s Different This Time

October 17 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
History I: Then & Now. Mark Twain said, “History doesn’t repeat itself, but it often rhymes.” In other words, details change, circumstances change, settings change, names change, but similar events will essentially recycle. That’s because human nature doesn’t change. Several years after Twain’s comment on history, Yogi Berra observed, “It’s like déjà vu all over again.”

Debbie and I were recently asked by one of our accounts in Manhattan to compare the current economic and financial environment to those of the late 1970s, the early 2000s, and the mid-2000s. The first period was associated with the Great Inflation. The second period included the Tech Wreck and the 9/11 terrorist attacks. The third period was marked by the bursting of the housing bubble.

We were tasked with the job of assessing the similarities and the differences between what happened back then and what is happening now. We were asked to focus on GDP, inflation, money and credit, speculative bubbles, and geopolitics. We’ve previously compared what happened then and now. Indeed, in 2018, I wrote a book on the subject titled “Predicting the Markets: A Professional Autobiography.” In effect, it is a history of the first 40 years of my career on Wall Street, which started in 1979. Over that period, history often rhymed, though not always.

The four historical cycles under review, including the current one, all started with easy credit conditions that fueled economic booms and inflated consumer prices and/or assets prices. Price inflation and/or speculative asset bubbles forced the Fed to tighten credit conditions. The result during the first three cycles were financial crises that morphed into economy-wide credit crunches and recessions. Price inflation moderated and the speculative bubbles burst, which exacerbated the economic downturn.

So far, this time has been different, but it still rhymes with recent history. Easy money boosted economic growth following the pandemic lockdown. Fiscal policy also was very stimulative, much more so than in the past. Price inflation soared, as it did during the 1970s. Wage inflation did so too. Assorted speculative mini-bubbles in the stock market burst, causing a relatively short bear market. But the biggest bubble turned out to be the one in the bond market, which has suffered the worst bear market of all times over the past three years as the Fed slammed on the monetary brakes to break the back of inflation.

This time, there was a financial crisis that caused a couple of banks in California to collapse. But the Fed contained the problem by quickly providing an emergency liquidity facility for the banks. Credit conditions certainly have tightened, but there hasn’t been an economy-wide credit crunch like the ones during the previous three periods. So far, the most widely anticipated recession of all times has been a no-show, even though the tightening of monetary policy is reminiscent of that of the late 1970s, when the Fed, under then-chairman Paul Volcker, likewise slammed on the brakes.

History II: GDP. There were four recessions during the Great Inflation from 1965 through 1982 (Fig. 1 and Fig. 2). The second and the fourth were among the longest and deepest ones since the end World War II. Leading the way down were the quarterly housing and auto components of real GDP (Fig. 3 and Fig. 4). They fell along with the monthly series on housing starts and auto sales (Fig. 5 and Fig. 6).

The recession at the start of the 2000s was largely attributable to the bursting of the tech bubble. There was a big boom in spending on communications equipment prior to that recession. The industrial production index for communication equipment plunged 40.7% from January 2001 through October 2002 (Fig. 7). During the recession of the Great Financial Crisis (GFC), computer & peripheral equipment output dropped 41.9% from May 2008 through March 2011.

The biggest contributor to the recession of the GFC was the bursting of the real estate bubble and all the credit derivatives that had inflated the bubble. The resulting credit crunch was significant.

History III: Inflation. The most intense and prolonged bout of inflation occurred during the Great Inflation period (Fig. 8). The Great Inflation of the 1970s actually started during the second half of the 1960s. It was triggered by President Lyndon Johnson’s decision to deficit-finance the Vietnam War rather than to increase taxes to fund the war. The same can be said about his Great Society initiative. A result of this guns-and-butter approach to fiscal policy was higher inflation.

President Richard Nixon continued that approach during the early 1970s and exacerbated inflation by closing the gold window on August 15, 1971, which caused the dollar to depreciate significantly. The weaker dollar boosted commodity prices and caused OPEC to drive oil prices higher during the 1970s. A wage-price-rent spiral ensued during the Great Inflation.

Then-Fed Chair Paul Volcker allowed interest rates to soar in late 1979 and the early 1980s to halt the Great Inflation by triggering a credit crunch and a recession. Inflation did decline and remained low during the Great Moderation from the mid-1980s until the start of the GFC. From the GFC through the GVC (Great Virus Crisis), central bankers obsessed about deflation and provided ultra-easy monetary policy, hoping to boost inflation to their 2.0% inflation targets.

This time, several rounds of fiscal stimulus programs combined with ultra-accommodative monetary policies caused a demand shock that overwhelmed supplies, unleashing the current bout of inflation. The programs presumably were aimed at offsetting the negative impact of the pandemic on workers. The Fed has raised the federal funds rate by 500bps since March 2022 from 0.00%-0.25% to 5.00%-5.25%. It has been the most aggressive tightening of monetary policy since Volcker headed the Fed.

What’s different this time is that the US dollar is strong. The Fed has been more aggressive in tightening monetary policy in response to inflation than the other major central banks. Also, the US economy is performing much better than the other major economies, which likewise supports the dollar. In addition, the current inflationary spike is turning out to be relatively transitory, as we discussed in yesterday’s Morning Briefing.
 
History IV: Money & Credit. The most intense credit crunch occurred during the GFC. Home mortgage borrowing collapsed from a record high of $1.26 trillion over the four quarters through Q2-2006 to a record low of -$136 billion through Q4-2010 (Fig. 9). Commercial mortgage borrowing peaked at a record $289 billion over the four quarters through Q4-2006 and plunged to -$143 billion during Q3-2010 (Fig. 10).
 
The credit crunch triggered by Volcker hit consumer spending on durable goods and housing the most. During the Tech Wreck of the early 2000s, the credit market for telecommunication loans and bonds was hit the hardest. Several significant failures ensued, including WorldCom (2002). It was brought down by an accounting scandal. So too was Enron in 2021.

This time, credit conditions have tightened in response to the Fed’s aggressive tightening of monetary policy. However, there remains plenty of liquidity in the financial system. In any event, the economy has proven to be remarkably resilient.
 
History V: Bubbles. During the 1970s, the biggest bubble was inflated in the global energy industry as oil prices soared. When it burst in the first half of the 1980s, the US energy sector fell into a rolling recession. The overall economy continued to grow because the Fed lowered interest rates. Commercial real estate turned out to be a bubble in the oil patch back then.

The tech bubble burst in the early 2000s. It had less to do with the Fed than with the cash burn rate of unprofitable dotcom startups. Many were able to raise money for a while during the late 1990s. They used the funds to buy lots of IT hardware and software. In addition, such spending was boosted by a scramble to avert a Y2K calamity by upgrading. At the turn of the millennium, Y2K spending dried up, and most dotcoms failed to attract more funding for their questionable business plans.

The housing bubble during the GFC was an accident waiting to happen. A series of blowups in the credit derivatives market led to a credit crunch that spread well beyond the US housing market after Lehman Brothers failed in September 2008.

This time, as noted above, the biggest bubble to burst has been the bond market’s, as the yield on the 10-year US Treasury bond soared from a record low of 0.52% on August 4, 2020 to 4.80% recently (Fig. 11). Yet so far, there has been no significant adverse effect on the overall economy and labor market. That’s partly because bond investors aren’t forced to take losses if they can hold their bonds to maturity. In addition, as we’ve previously observed, there is still lots of liquidity in the financial system. Many corporations refinanced their debts at record-low interest rates. Corporate cash flow is at a record high (Fig. 12). Household net worth is also at a record high (Fig. 13).

History VI: Geopolitics. Fifty years ago, on October 6, 1973, Israel was hit by a surprise attack by Arab armies from Egypt, Jordan, and Syria. That was the Yom Kippur War. A week ago, on Saturday, October 7, Israel was hit by a surprise attack by Hamas terrorists.

In recent years, previous geopolitical crises in the Middle East have tended to be short-lived. Selloffs in the US stock market turned out to be buying opportunities. So far, the stock market hasn’t reacted adversely to the latest crisis. That’s partly because the price of oil hasn’t spiked on this development. The widespread assumption is that this crisis will also be short-lived and won’t turn into a regional war with Iran joining forces with Hamas and Hezbollah.
 
History VII: Now & Then. There are many similarities and many differences between now and our very brief review of the 1970s and the 2000s. Books have been written about the financial and economic history of the past 40+ years, including my own book.

In our opinion as prognosticators, the most important difference between now and then is that we are expecting a productivity growth boom over the rest of this decade. Conversely, productivity growth collapsed during the previous three periods we spotlighted above (Fig. 14).

The biggest risk to our optimistic outlook is that the Bond Vigilantes respond to Washington’s fiscal excesses and follies by pushing the bond yield up to levels that cause a credit crunch and a recession. We reckon that would put the 10-year Treasury bond yield well north of 5.00%.

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All About Inflation

October 16 (Monday)

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

Inflation I: Selectively Slicing & Dicing the CPI. Most economists, including Debbie and me, believe that if the data don’t support our forecasts, then there must be something wrong with the data and that they will be revised to show we were right after all. Most economists, including yours truly, also often dismiss components of headline indicators that don’t support our story and look to the remaining “core” indicators for conformity to our outlook and therefore confirmation of it.

This slicing-and-dicing approach to the major economic indicators is usually what happens when the monthly employment report is released. If the seasonally adjusted data don’t support one’s narrative, the thinking goes, perhaps the data on a not seasonally adjusted basis will. Or perhaps the revisions to the prior months’ data will point in the “right” direction and therefore be what to highlight. If the payroll measure of employment isn’t as friendly as the household measure, focus on the household one.

Another major economic indicator that is invariably sliced and diced by the brotherhood and sisterhood of economists is the CPI. September’s number was released along with all its components last week on Thursday. Some economists (such as us) claimed that it confirmed that inflation is still moderating and is turning out to be relatively transitory. Others looked at the report and concluded that inflation is stalling at a pace well above the Fed’s 2.0% inflation target. A few economists found evidence that inflation may be accelerating again, so it remains a persistent problem.
 
So who is right? We all are right all the time because there’s plenty of data to support all of our stories. Nonconforming data are dismissed as preliminary estimates that undoubtedly will be revised or simply are flawed. Future revisions no doubt will show that we are on the right track after all; if not, different data do so. We may not all be Keynesians or monetarists, but we are all prescient based on the data we choose to support our outlook!

Now let’s slice and dice the latest CPI and see what’s left:

(1) Ignore the headline. Pay no attention to the headline inflation rate. That was one of the messages in the speech delivered by Fed Chair Jerome Powell at Jackson Hole on August 25. From the get-go, he said that “food and energy prices are influenced by global factors that remain volatile and can provide a misleading signal of where inflation is headed.” So he focused his analysis on the core inflation rate, i.e., the headline rate less energy and food. Of course, this has been the Fed’s approach for many years.

The Fed’s preferred measure of inflation has been the core PCED, which closely tracks the core CPI (Fig. 1). The latter tends to exceed the former. For today, we will focus on the CPI through September since the PCED’s September reading won’t be out until near the end of the month.

The headline CPI inflation rate was 3.7% y/y through September (Fig. 2). The core rate for the CPI was higher at 4.1%. Both are down from their 2022 peaks of 9.1% and 6.6%, respectively. But both remain well above the Fed’s 2.0% target.

(2) Taking out shelter. Before we go any further, here’s our punch line: The headline and core CPI inflation rates excluding shelter were both 2.0% y/y during September (Fig. 3). So to the question of when we’re going to get to the Fed’s inflation target, the answer is that we’re there now excluding shelter, at least based on the CPI measure!

Rent of shelter accounts for a whopping 34.7% and 43.6% of the headline and core CPI measures. Its inflation rate jumped from a low of 1.5% during February 2021 to a peak of 8.2% during March 2023 (Fig. 4). It was down in September but only to 7.2%.

In his speech, Powell observed: “Because leases turn over slowly, it takes time for a decline in market rent growth to work its way into the overall inflation measure. The market rent slowdown has only recently begun to show through to that measure. The slowing growth in rents for new leases over roughly the past year can be thought of as ‘in the pipeline’ and will affect measured housing services inflation over the coming year.”

Also, Powell acknowledged in his speech that “market rent” inflation (i.e., for new leases) has declined “steadily” this year. The Zillow rent index was down to 3.2% y/y during September. Using that reading rather than the CPI’s rent of shelter reading of 7.2%, Debbie found that the headline CPI is up just 2.3% versus 3.7% for the actual headline CPI!

Based on our analysis so far, the latest bout of inflation is turning out to be transitory rather than persistent after all, in our opinion. The Fed might achieve its 2.0% target for the core PCED inflation rate well ahead of schedule, i.e., in 2024 rather than 2025.
 
(3) Goods inflation is good. In his speech, Powell implied that core goods inflation undoubtedly has turned out to be transitory after all. He said: “Core goods inflation has fallen sharply, particularly for durable goods, as both tighter monetary policy and the slow unwinding of supply and demand dislocations are bringing it down.”

We’ve previously explained that consumers’ post-lockdown buying binge was focused on goods because services were still hampered by social distancing restrictions. That caused goods inflation to spike from around zero in the summer of 2020 to 14.0% in 2022 (Fig. 5). During September, goods inflation was down to 1.4%, with durable goods down 2.2% and nondurable goods up 3.2%. Core goods were unchanged in September from a year ago (Fig. 6).
 
(4) Supercore inflation is persistent. In his speech, Powell said: To understand the factors that will likely drive further progress [on lowering inflation], it is useful to separately examine the three broad components of core PCE inflation—inflation for goods, for housing services, and for all other services, sometimes referred to as nonhousing services.” That last category has also come to be known as the “supercore” inflation rate. It has been sticky, having been stuck around 4.5%-5.0% since October 2021 (Fig. 7). However, the CPI services less housing inflation rate was down to 2.8% in September from last year’s peak of 8.2%.
 
(5) Health insurance is wild. It is widely recognized that the CPI’s health insurance component is very volatile and based on a very questionable measurement technique (Fig. 8). Far more sensible is the PCED’s measure of health insurance, which recently has been relatively stable and in the low single digits on a y/y basis, while the CPI measure has been bouncing around between positive and negative double-digit y/y percent changes. The latter was down 37.3% y/y during September and is now expected to swing back into positive territory for the next few months.

We all know this and will adjust for this distortion. In any event, it has a tiny weight of 0.545% of the CPI.
 
(6) Auto prices could accelerate. Contributing to the volatility and transitory nature of inflation since the pandemic have been new and used car prices. Supply-chain disruptions disrupted the supply of new cars in 2020 through the first half of 2022, sending new car prices soaring. As these problems abated, the inflation rate of new car prices plummeted (Fig. 9).

Used car prices soared even more than new cars prices during the pandemic, and the former plunged more than the latter afterwards (Fig. 10). Now the concern is that the UAW strike will cause a shortage of new auto inventories that once again will boost new and used auto prices.

(7) Bottom line. They say that the devil is in the details. That may very well be true about the outlook for inflation. However, inflation is usually defined as a general and relatively broad increase in prices. In any one month, a few of the CPI’s components might account for much of the increase or decrease that month. It’s the underlying trend that matters. That’s what we look to most for either confirmation of our outlook or the need to change it. The latest data confirm for us that our narrative remains on track: Inflation is continuing to moderate.

Inflation II: Slicing & Dicing Other Indicators. Last week, other inflation indicators were also released, including the PPI, the wage growth tracker (WGT), consumers’ inflation expectations, and import & export prices. Let’s slice and dice them as well:

(1) PPI. September’s PPI for final demand was up 0.5% m/m, which was a bit hotter than expected. Yet it was up only 2.2% y/y. More importantly, in our opinion, is that the core PPI for final demand of personal consumption rose 2.7% (Fig. 11). It tends to be a leading indicator for the core CPI and the core PCED, which were 4.1% in September and 3.9% in August. The PPI measure of prices received by consumer-related companies does not include rent and suggests that the other two measures should continue to fall if rent inflation falls as we expect.

(2) WGT. The WGT fell to 5.2% y/y in September, the lowest since January 2022 (Fig. 12). That’s still a high reading. However, it tends to exceed the wage inflation rate measured using average hourly earnings for production and nonsupervisory workers, which was down to 4.3% in September. Fed Chair Powell previously has said that he would like to see wage inflation closer to 3.0%. It is still heading in the right direction.

Interestingly, the WGT measure of wage inflation for job switchers has declined more rapidly than for job stayers since they both peaked last year (Fig. 13). This may explain why the quits rate has dropped since early last year.

(3) Expectations. The Federal Reserve Bank of New York released its survey of consumer expectations last week for September. It showed upticks in the one-year- and three-years-ahead inflation expectations to 3.7% and 3.0% (Fig. 14). Those are still relatively low readings. They edged up mostly because gasoline prices rose last month.

(4) Import prices. The US continues to import deflation from overseas. Import prices fell 1.7% and 1.2% y/y with and without petroleum through September (Fig. 15). Contributing to the weakness in US import prices are deflationary forces that are depressing China’s PPI (-2.5% y/y in September) and CPI (unchanged y/y) (Fig. 16). These forces include the bursting of China’s property bubble and the rapidly aging population.

Movie. “Somewhere in Queens” (+) (link) was written and directed by Ray Romano about an Italian family living in Queens. Ray stars as Leo Russo, the father. He works for his father’s construction company. It’s a family business, and Leo’s large extended family is in everybody else’s business. They regularly get together at the local catering hall for family events. Leo is obsessed with helping his son overcome his social awkwardness by pushing him to succeed on his high school basketball team, which he does. Leo pushes a bit too hard to get his son a college basketball scholarship and causes a family crisis as a result. It’s a warm-hearted film about the importance of famiglia in our lives.

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Banks, Biotech & Digital Money

October 12 (Thursday)

Financials: Could They Surprise? The S&P 500 Financials sector has had a terrible year, especially considering that the US economy managed to avert recession. Worries about commercial real estate loans, underwater Treasury bonds, and fleeing deposits have cast a pall over the sector’s stocks.

Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Communication Services (45.4%), Information Technology (38.5), Consumer Discretionary (27.0), S&P 500 (13.5), Industrials (4.8), Materials (1.5), Energy (1.1), Financials (-2.8), Health Care (-3.6), Real Estate (-7.9), Consumer Staples (-8.5), and Utilities (-17.0) (Fig. 1).

The S&P 500 Financials sector’s -2.8% ytd return actually masks how awful the year has been for banks and brokers because insurance-related industries have had strong ytd performances: Reinsurance (16.3%), Insurance Brokers (12.4), and Financial Exchanges & Data (12.3). On the other side of the coin, the Financials industries with miserable ytd performances include: Regional Banks (-38.4%), Investment Banking & Brokerage (-17.4), Asset Management & Custody Banks (-8.8), and Diversified Banks (-4.7) (Fig. 2).

With Q3 earnings reports kicking off on Friday, we decided to look for what might go right for these beleaguered monetary giants. Here are a few of the optimistic nuggets that might offset some of the gloom:

(1) Capital markets thawing. Firms involved with capital markets activity may have benefitted from the reopening of the IPO market and stabilization in the fixed-income markets. This week, deal flow included an IPO from comfy shoemaker Birkenstock and ExxonMobil’s announcement that it has struck a deal to acquire Pioneer Natural Resources for $59.5 billion.

Improvement in the capital markets was evident in Jefferies Financial Group’s Q3 results reported on September 27. Revenue in its Q3 debt and equity underwriting businesses jumped 16.2% y/y, and its equities and fixed-income capital markets business jumped 14.0% y/y. The only area still lagging was the firm’s investment banking advisory business, due to a decline in global M&A volume. Revenue in this area dropped 30.4% y/y but rose 31.9% q/q.

(2) Loan losses could rise slowly. Most consumers are gainfully employed, with the unemployment rate remaining remarkably low at 3.8%. Those with a job should be able to make credit card and home mortgage payments, though banks have been slowly increasing their reserves. In Q2, even the impenetrable JPMorgan more than doubled its provision for credit losses in consumer lending to $1.9 billion due to a jump in provisions in the credit card area. As long as provisions can rise slowly, banks should be able to absorb them. Even after increasing provisions, JPMorgan earned $14.5 billion in Q2.

More concerning is the health of commercial real estate loans, particularly those involving office buildings given that many employees have been unwilling to return to the office more than three days a week. Tales of half-empty buildings in downtown areas have filled the headlines. And some small, less diversified banks may indeed have problems.

But PNC Financial Services Group’s Q2 earnings report indicated that larger banks may be able to manage their way through whatever office real estate bankruptcies lie ahead. PNC’s office real estate loans total $8.7 billion; that’s 24% of its $35.9 billion commercial real estate loan portfolio but only 5.0% of the bank’s $177.6 billion commercial and industrial loan portfolio and a mere 2.7% of its total loans.

Nonperforming office loans totaled 3.3% of the office loan portfolio, but that number is sure to increase, as 22.5% of the portfolio is criticized—i.e., the loans are still performing but exhibit some weakness in safety or soundness, perhaps due to high leverage or deteriorating collateral values. The bank’s filing says it has established reserves that reflect expected losses in the office loan portfolio.

Loan losses and provisions for loan losses across the banking industry are rising, with the best part of the credit cycle in the rear-view mirror. FDIC-insured institutions increased their provisions for loan and lease losses by $21.5 billion in Q2, compared to a much smaller increase of $11.1 billion in Q2-2022 and decrease of $10.8 billion in Q2-2021 (Fig. 3).

(3) Problematic Treasuries. Banks that have been caught holding long-dated Treasuries and mortgage-backed securities in their held-to-maturity accounts, such as Bank of America, may underearn their peers for a few quarters. But those securities, if held to maturity, will be paid back in full and replaced with higher-earning investments. These are not the CDOs of 2008 that ended up being worth pennies on the dollar. And if we’ve seen the peak in interest rates for this cycle, worries about the banks’ paper losses on these securities may have peaked as well.

(4) Pessimism so bad it’s good. Perhaps most importantly, Wall Street’s analysts are a relatively pessimistic bunch when it comes to banking-related financials. For the banks in the S&P 500 Regional Banks industry, they’re forecasting a collective 7.9% drop in earnings this year and a 6.2% decline in 2024 (Fig. 4). The S&P Diversified Banks industry is expected to post solid earnings growth of 16.0% this year, but that disappears next year when earnings are forecast to drop 4.9% (Fig. 5). Only the S&P Investment Banking & Brokerage industry is expected to see earnings growth of 30.3% next year after a projected earnings decline of 11.9% this year (Fig. 6).

Forward P/Es for the Regional Banks and the Diversified Banks industries are both under 10, at 7.6 and 8.5, respectively (Fig. 7 and Fig. 8). Only the Investment Banking & Brokerage industry’s forward P/E has risen modestly from its June 23, 2022 low of 9.5 to a recent 10.8 (Fig. 9).

Health Care: M&A Biotech Boost. It hasn’t been a great year for biotechnology stocks. The S&P 500 Biotechnology stock price index has fallen 3.8% ytd through Tuesday’s close, and the iShares Biotechnology ETF, known by its ticker IBB, has declined 6.3% ytd (Fig. 10). That leaves these biotech stock indexes lagging the S&P 500 Health Care sector’s ytd return of -3.6% and the S&P 500’s 13.5% gain so far this year.

Biotech shares, many of which don’t generate profits, have come under pressure from the jump in interest rates this year. But continued momentum in the M&A market may underpin stock prices. So far in 2023, there have been 28 biotech acquisitions valued at more than $500 million. That compares to the 43 deals of 2022, 35 in 2021, 28 in 2020, 29 in 2019, and 24 in 2018, according to data from BiopharmaDive in an October 8 article. Here’s a quick look at what’s driving the industry:

(1) Lots of dry powder. Global pharmaceutical companies have $700 billion in cash and leverage available to make acquisitions and bolster their research pipelines as patents expire, according to calculations by Goldman Sachs. “There’s tremendous interest in M&A driven by the fact that pharmaceutical companies are facing big cliffs toward the end of the decade with roughly $200 billion in revenue that will erode as a result of patent expirations that will allow for competition from generic drugs,” said Goldman healthcare analyst Asad Haider in July.

(2) Bristol makes its move. M&A deals are almost always good news for biotech targets. This week, Bristol-Myers Squibb announced it will acquire Mirati Therapeutics for up to $5.8 billion to gain access to Mirati’s oncology drugs that target genetic drivers of specific cancers. Mirati’s portfolio includes its lung cancer drug, Krazati, which was approved in December. The company’s shareholders will receive $58 a share in cash and one non-tradeable contingent value right for each Mirati share. Mirati shares jumped to $56.60 as of Tuesday’s close, up from a 2023 low of $28.06 in August and high of $54.26 in February.

This deal follows Bristol’s acquisition of Turning Point Therapeutics for $4.1 billion last year, and it helps to boost Bristol’s drug portfolio now that two of its largest drugs, Revlimid and Eliquis, face generic competition.

(3) Modest earnings expectations. Analysts are looking for companies in the S&P 500 Biotechnology index collectively to produce revenue that inches up by 1.6% in 2024 after decreasing by 8.2% this year (Fig. 11). Earnings for index members are forecast to fall 22.4% this year and improve by 3.4% in 2024 (Fig. 12).
 
Disruptive Technologies: China Pushes Digital Yuan. For years, the Federal Reserve and other federal agencies have been studying the viability of a digital dollar. Their job has gotten harder now that many mainstream Republicans, Silicon Valley libertarians, and anti-establishment leftists have opposed a digital US currency. Some opponents prefer bitcoin and/or oppose the control and information that a digital dollar would give the government.

While we study and bicker over the possibility of a digital dollar, the Chinese government has already rolled out its digital currency, the e-CNY, with mixed success. The digital yuan was available in 26 cities, and 5.6 million merchants have registered to use it as of last year. There have been 120 million wallets opened to hold e-CNY, and 950 million transactions valued at 1.8 trillion yuan ($249.9 billion) have occurred as of July, according to an October 10 article in the South China Morning Post (SCMP).

Those figures, while large, have much room left to grow if the digital currency is broadly adopted by China’s massive population. The government appears to be finding ways to encourage (dare we say “push”?) its citizens and others to use the digital currency. Here’s a look at some of them:
 
(1) Tourists using e-CNY. Starting last month, foreigners in China are allowed to sign up for an e-CNY wallet using their international phone number and their Visa or Mastercard. The wallet can be used to make purchases at stores that display the e-yuan acceptance sign and on online platforms, like Meituan and Ctrip.

The e-CNY wallets are also linked to the Faster Payments System of the Hong Kong Monetary Authority. Tourists from Hong Kong can open an e-wallet, use e-CNY for purchases, and pay lower transaction costs. This feature was introduced in advance of the Asian Games, held recently and used by attending athletes, an October 9 article on Bitcoin.com reported.

In September at the China-Asean expo, a large trade show held in Nanning, many banks set up e-CNY experience zones at their booths, the SCMP article reported.

(2) E-CNY for bus fare. Some Chinese provincial and city governments have begun to pay their employees in e-CNY, including Jiangsu province and the city of Changshu.

Meanwhile, the city of Suqian plans to adopt digital yuan wallets for government budget units. In the city of Jinan, citizens will use digital wallets to pay for bus rides. And the e-CNY can be used for subway tickets in the city of Ningbo.

(3) WeChat and Alipay onboard. One reason why the adoption of the e-CNY has been slow is because most Chinese citizens already use digital wallets from WeChat and Alipay for their transactions. “The payment market structure formed by cash, bank cards, and third-party payment platforms are currently satisfying the needs for daily consumption in China,” a former director-general of research at the People’s Bank of China (PBOC) said at a conference, according to a December 31 article on Bitcoin.com.

With this in mind, the PBOC has worked to improve the compatibility and the integration of the e-CNY with the WeChat and Alipay wallets, a July 5 Bitcoin.com article reported. WeChat announced in March that the e-CNY would be integrated into its system, and Alipay did the same in December.

(4) Bridging countries. The PBOC joined the central banks of the United Arab Emirates, Thailand, and Hong Kong and the BIS Innovation Hub Hong Kong Center in 2021 to develop the mBridge. It uses digital currencies and blockchain to facilitate cross-border payments.

The organization’s stated goal is to allow cross-border payments to be immediate, cheap, and universally accessible with secure settlement. In September, Tencent became one of the first organizations chosen to participate in the project’s pilot. And presumably from China’s government’s perspective, if the program happens to help the yuan replace the dollar, all the better.

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Bonds & Stocks

October 11 (Wednesday)

Bonds: Explanations for the Recent Rout. Why did the 10-year Treasury bond yield soar from 3.97% on July 31 to 4.81% on October 3 (Fig. 1)? There are several explanations, and the answer is probably “all of the below.” Consider the following:

(1) Too much supply of Treasuries. We’ve been arguing that the deluge of Treasury supply has been the main driver of this rout in the bond market. The rapidly widening federal deficit forced the Treasury to announce during the summer a significant increase in the securities that would have to be sold over the rest of the year. During August and September, the amount of US Treasury debt held by the public rose $335 billion and $286 billion, respectively (Fig. 2). The bond yield rose quickly to a level that should stimulate enough demand to clear the increased supply of Treasuries over the rest of this year through next year.

(2) Higher for longer short-term interest rates. Another thesis that also makes sense is that the rout was exacerbated by Fed Chair Jerome Powell when he reiterated at his September 20 press conference that the FOMC intended to remain restrictive through next year by maintaining the federal funds rate higher for longer. Specifically, he said: “We’re prepared to raise rates further if appropriate, and we intend to hold policy at a restrictive level until we’re confident that inflation is moving down sustainably toward our objective. In determining the extent of additional policy firming that may be appropriate to return inflation to 2 percent over time, 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.”

The big shock that same day was the release of the FOMC’s latest quarterly Summary of Economic Projections (SEP). Instead of four rate cuts totaling 100bps next year (as was projected in June’s SEP), the latest SEP showed two cuts totaling 50bps.

(3) Stronger-than-expected economic growth. Meanwhile, the yield-curve spread between the 10-year and 2-year Treasury notes has narrowed significantly from a recent low of -108bps to -30bps on Friday (Fig. 3). The disinverting yield curve might suggest that a recession is less likely now. After all, Q3’s economic indicators have been mostly stronger than expected, as evidenced by the Citigroup Economic Surprise Index (CESI) (Fig. 4). Since the summer, it has been hovering around 60.0, which is a relatively high reading. The 13-week change in the bond yield tends to track the CESI closely (Fig. 5).

In the past, inverted yield curves disinverted during recessions when the Fed cut interest rates to revive economic growth. Short-term rates fell faster than long-term rates. This time, the 10-year Treasury bond yield is rising faster than the 2-year yield. If that continues, the chances of something breaking in the credit markets will increase. If something breaks, it could precipitate a credit crunch and a recession after all!

(4) Demand for Treasuries has decreased. Exacerbating the bond rout has been the weakening demand for Treasuries. The Fed started its quantitative tightening (QT) program on June 1, 2022. Since then, through the October 4 week, the Fed’s holdings of Treasuries has declined by $841 billion (Fig. 6). In effect, QT has widened the consolidated federal deficit of “T-Fed” by that amount over that period. The Fed is on pace to continue to reduce its holdings of Treasuries by $60 billion per month.

The Fed’s QT program has put downward pressure on the demand deposits of the commercial banking system. So the banks stopped increasing their holdings of US Treasury and agency securities when QT started. Instead, they’ve been letting them mature and using the funds to offset the weakness in their deposits (Fig. 7 and Fig. 8). The banks’ holdings of Treasuries and agencies is down $554 billion from the week of June 1, 2022 through the September 27 week. (There’s no data for just Treasuries held by the banks.)

While the Fed and the banks have been letting their Treasury and agency securities mature without rolling the proceeds into more securities, foreign private investors added $755 billion to their portfolios of US Treasuries over the 12 months through July (Fig. 9). That’s the latest available data from the US Treasury International Capital System (TICS). There’s no evidence in the TICS that foreign central banks and other official institutions have been major sellers of US Treasuries, on balance, as widely feared. From 2015 to 2020, they were mostly selling, but they haven’t done much buying or selling since then.

(5) Why are foreign bond yields also soaring? By the way, the supply-demand imbalance theory has been disputed by economists who observe that yields have also soared overseas, where fiscal profligacy isn’t as much of a concern as in the United States (Fig. 10 and Fig. 11). That’s true, but the bond market is a global one, and yields overseas tend to follow the path of comparable US yields.

(6) The bottom line. The question is whether the backup in the bond yield is enough to attract enough demand from domestic and foreign individual and institutional investors to boost demand for the increased supply of demand. We think so. So we expect that the bond yield can stabilize between 4.50% and 5.00% through the end of this year into next year.

That’s mostly because we expect that inflation will continue to moderate. We also think that the Fed is done raising the federal funds rate (FFR), especially after two Fed officials acknowledged on Monday that the recent surge in the bond yield might have mitigated the need for any additional FFR hikes given that the bond market has done all the heavy lifting in the fixed-income market recently.

(7) Stress tests ahead. The next auctions of the 10-year and 30-year Treasury bonds will be on Wednesday and Thursday. September’s PPI and CPI will be released on Wednesday and Thursday. We will be looking at the bid-cover and foreign participation stats for both auctions for indications that yields are high enough to stabilize the bond market.

Stocks: MegaCap-8 a Bigger Share of the S&P 500 Despite Valuation Decline. The MegaCap-8 group of stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) currently accounts for a record-high 27.4% of the S&P 500’s capitalization and has led the index higher in a big way so far in 2023 (Fig. 12). The stocks’ performances this year in part reflect much improved revenues and earnings growth prospects for most of the eight companies.

However, the MegaCap-8’s valuation has pulled back since July amid stock investors’ angst over the bond market after Fitch Ratings downgraded US federal debt on August 1. The eight stocks’ collective market cap has shrunk accordingly. However, their share of the composite index’s market cap has increased, as they weren’t the only stocks to take valuation hits after Fitch’s downgrade (Fig. 13).

Currently, the group’s collective valuation is higher than when the year began, but it is substantially lower than it was during 2020-21, when the MegaCap-8’s forward P/E flirted with 39 (Fig. 14). We don’t expect a return to those heady valuations anytime soon. However, the Mega-Cap-8’s valuation has held up slightly better than the collective valuation of the S&P 500 companies in recent months. Supporting the MegaCap-8’s valuation have been earnings—mostly strong Q2 results and even stronger y/y growth results expected for Q3.

I asked Joe to update us on the MegaCap-8. Here’s his report:

(1) Market capitalization. The combined market cap for the MegaCap-8 stocks tumbled 41.5% in 2022 before rebounding 66.8% ytd to an 18-month high of $11.8 trillion through July 18. Since then, it fell 9.1% in a near-correction to $10.7 trillion on September 26 before rising 4.9% through Friday’s close. That leaves the group up 58.9% ytd compared to a 12.2% gain for the S&P 500 (Fig. 15).

Following their deep bear market decline of 45.0% through January 5, the MegaCap-8 stocks have now improved to 9.0% below their peak back on December 27, 2021. If their collective earnings expectations continue to improve faster than the rest of the market’s, as we expect, the group’s combined market cap may be on the road to new highs despite lower valuations.

(2) Market-capitalization share at a record high, again. As a percentage of the S&P 500’s market cap, the group was at new record-high of 27.4% during the October 6 week. Its market-cap share had soared from 19.4% at the start of the year to a then-record-high 27.3% during the July 14 week, before dropping to a low of 26.0% during the August 18 week.

(3) Valuations slipping amid higher rates. The MegaCap-8’s forward P/E rose above 30.0 in mid-June for the first time in 15 months but has since dropped below that mark, as investor activity has not maintained the group’s valuation despite strong Q2 earnings and upwardly revised forecasts for the future. After the forward P/E bottomed at 21.1 during the January 6 week, it soared 46% to its 2023 high of 31.2 as of the July 14 week. The forward P/E is now down 13% since then to 27.0 as of the October 6 week, which remains below the record high of 38.5 during the August 28, 2020 week.

Looking at the individual MegaCap-8 stocks, forward P/Es rose for all of them from January 6 through mid-July, before correcting along with the rest of the S&P 500’s collective valuation amid bond market’s turmoil. Illogically though, the growthier MegaCap-8 has dropped just 3.3% since the market’s July 31 high, less than the 5.5% decline for the S&P 500 through Monday’s close. While five of the MegaCap-8 stocks now—as of Friday’s close—are valued above their January 6 bottoms, all have declined since the end of July, as Joe shows below.

Here’s how much valuation has changed for each of the MegaCap-8 stocks since the S&P 500’s July 31 high through Friday’s close: Nvidia (down 38% to 29.8 from 48.4), Amazon (down 30% to 42.8 from 60.9), Netflix (down 16% to 25.8 from 30.6), Apple (down 11% to 26.7 from 30.2), Meta (down 11% to 19.5 from 21.9), Microsoft (down 6% to 28.4 from 30.3), Tesla (down 3% to 61.5 from 63.7), and Alphabet (down 2% to 21.1 from 21.6) (Fig. 16).

The sharp valuation declines for Nvidia and Amazon come despite sharply increased forward revenues and earnings guidance relative to their MegaCap-8 cohorts, but that likely reflects investors taking some of their ytd gains off the table. Nvidia’s stock had tumbled 16.9% through September 21 from its August 31 record high, but has since risen 10.4% through Monday’s close to a ytd gain of 209.8%. (FYI: Forward revenues and earnings are the time-weighted averages of industry analysts’ estimates for the current year and following one.)

While Nvidia’s forward earnings are at a record high now, Amazon’s remains challenged. Its forward EPS, though up 82% ytd, remains 9% below its record high in July 2021, and Amazon’s stock price reflects that. It tumbled 55.7% from its November 18, 2021 record high to its bottom on December 28, 2022, and remains in a deep 30.6% bear market through Monday’s close.

(4) Reviewing the MegaCap-8’s y/y forward revenues and earnings performance. Seven of the MegaCap-8 companies have enjoyed both rising forward revenues and rising forward earnings so far in 2023 (Fig. 17 and Fig. 18).The only laggards are Apple’s forward revenues and Tesla’s forward earnings. As a group, the MegaCap-8’s forward revenues has jumped 7.3% y/y, and its forward earnings has soared 17.2%—trouncing the S&P 500’s forward revenues rise of 4.3% ytd and forward earnings gain of only 4.7% ytd.

Here’s how each of the MegaCap-8 companies’ forward revenues and earnings forecasts has performed y/y: Alphabet (forward revenues up 5.1%, forward earnings up 12.7%), Amazon (6.6, 55.1), Apple (-1.3, 2.2), Meta (14.8, 51.3), Microsoft (6.6, 7.7), Netflix (11.1, 38.5), Nvidia (150.4, 263.5), and Tesla (2.6, -24.5). Nvidia’s surge in such a short period on expectations for AI chip sales is stunning, and certainly ranks among the all-time top performers (i.e., since consensus forecasts were first calculated over 40 years ago).

(5) Forward profit margins improving broadly. The S&P 500’s forward profit margin—which we calculate from forward earnings and revenues—dropped when this year began, from 12.6% at the beginning of January to 12.3% during the March 30 week, but since has recovered all of that decline, clocking in at 12.6% during the September 28 week. The MegaCap-8’s collective margin has surged from 18.0% at the year’s start to 20.8% at September’s end, with 1.5ppts of that gain coming since the Q2 earnings season started. Among the MegaCap-8s, all but Tesla have seen their forward profit margins rise ytd: Alphabet (up from 23.0% to 25.8%), Amazon (3.0 to 4.9), Apple (25.2 to 26.6), Meta (21.1 to 29.8), Microsoft (34.6 to 35.0), Netflix (14.1 to 17.8), Nvidia (36.7 to 51.3), and Tesla (15.9 to 12.4) (Fig. 19).

It can be disconcerting for investors when valuations disconnect sharply from a company’s earnings prospects. But opportunistic entry points are available for investors who take their cues from the profit margins implied by analysts’ revenue and earnings expectations, considered in the context of past levels.

Finally, we would add that, while higher bond yields tend to weigh on the valuations of Growth stocks more than on those of Value stocks, investors may be buying the MegaCap-8 because their exposure to rising bond yields tends to be less than that of many companies, having relatively less debt exposure.

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Reassessing Recession Risk

October 10 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Worry List I: New Worries & Unchanged Hopes. We are raising our odds of a recession before year-end 2024, though that’s still not our base-case outlook. Our subjective probability of a recession is now 30%, up from 25%. We raised it from 15% to 25% on September 18.

The September increase reflected our new concern about a US debt crisis attributable to the widespread recognition that US federal government deficits are too d@mn wide. Today’s increase reflects a new concern: the start of the latest war in the Middle East on Saturday. This one isn’t likely to lead to a quick ceasefire between Israel and Hamas, as occurred in the past, because it is in fact a war between Israel and Iran. For Israel, it is existential. This time, Israel’s goal is to wipe out Hamas, which is Iran’s surrogate in Gaza. The war is also existential for Iran’s mullahs, who need it to distract the population from discontent over their authoritarian regime by moving forward on their machinations to wipe out Israel.

Our base case remains a rolling recession with rolling recoveries, now with a 70% subjective probability. The economy-wide recession scenario has been based on the widely held view that the Fed’s aggressive rate hiking combined with quantitative tightening since early last year would trigger a credit crunch and a recession. Lending credence to that forecast have been the inversion of the yield curve and falling leading indicators. However, the Godot recession has been a no-show so far because the economy has proven remarkably resilient in the face of rolling recessions that have rolled through the single-family housing and retailing industries. There was a banking crisis in March, but the Fed contained it quickly.

Meanwhile, the labor market remains strong, as evidenced by the latest payroll employment and job openings reports (Fig. 1). Consumer spending has held up very well thanks to record-high employment (Fig. 2). The Atlanta Fed’s GDPNow tracking model is currently forecasting that real GDP rose 4.9% (saar) during Q3, led by a 3.7% increase in consumer spending.

While the Index of Leading Economic Indicators is down 10.5% since it peaked on December 2021 through August of this year, the Index of Coincident Economic Indicators (CEI) rose to new record highs during that period (Fig. 3). Payroll employment is one of the four components of the CEI (Fig. 4). It is the first one of them that is reported at the beginning of every month and tends to predict the other three. We’ve said it before: It’s hard to have a consumer-led recession when payroll employment is rising to record highs month after month.

Nevertheless, let’s discuss the latest risks to this happy outlook to explain why we’ve ratcheted up our odds of a recession.

Worry List II: Debt Crisis. The potential for a debt crisis became apparent after Fitch Ratings downgraded US Treasury debt from AAA to AA+ on August 1. Fitch’s reasons for doing so were well known; however, the downgrade suddenly brought the deficit issue to the fore.

I’ve often said that I will care about the deficit issue when the financial markets care about the issue. They clearly care now. So does the financial press, which has been running lots of stories about the unmanageable size of the deficit now and in the future. And most importantly, the Bond Vigilantes seem to have saddled up and formed a posse of rough riders aiming to bring law and order back to fiscal policy. Consider the following:

(1) Bond yield soaring too much. The 10-year Treasury bond yield was 3.97% on July 31. Following the Fitch downgrade, it soared to 4.78% on Friday (Fig. 5). The 30-year Treasury yield rose from 4.02% to 4.95% during this same period. Both are back to their Old Normal levels, i.e., where they were from 2003 to 2007, which preceded the “New Abnormal” period from 2008 to early 2022, i.e., from the Great Financial Crisis through the Great Virus Crisis.

We still expect that the 10-year Treasury bond yield will settle around the Old Normal range of 4.50%-5.00%. That will happen only if inflation continues to moderate, as we’ve been predicting. Inflation is turning out to be relatively transitory after all, in our opinion. As we’ve noted previously, the headline and core CPI inflation rates excluding shelter rose just 1.9% and 2.2% y/y through August (Fig. 6). We know that rent inflation is heading lower in coming months (Fig. 7).

(2) Yield curve disinverting the wrong way. Meanwhile, the yield-curve spread between the 10-year and 2-year Treasury notes has narrowed significantly from a recent low of -108bps to -30bps on Friday (Fig. 8). Does a disinverting yield curve signal that a recession is now less likely?

In the past, yield-curve inversions disinverted during recessions when the Fed cut interest rates to revive economic growth. Short-term rates fell faster than long-term rates. This time, the 10-year Treasury bond yield is rising faster than the 2-year yield. If that continues, the chances of something breaking in the credit markets will increase. If something breaks, it could precipitate a credit crunch and a recession.

(3) Dalio’s debt crisis. Our baseline scenario requires that the bond yield is now high enough to equilibrate the supply and demand for Treasury securities without causing a recession. The “immaculate disinflation” (i.e., without a recession) that we expect should facilitate such an equilibrium. We will be watching the Treasury’s bond auctions in coming months, along with everyone else, to see whether the bond yield is stabilizing or needs to go higher to clear the Treasury market’s supply.

If the auctions are sloppy, yields will continue to rise above 5.00%. That would increase the odds of Ray Dalio’s debt crisis scenario in which the yield rises to levels that crowd out demand for the private sector’s debt, triggering a financial crisis, credit crunch, and a recession (see our October 4 Morning Briefing).

Worry List III: Geopolitical Crisis. The debt crisis scenario is a relatively new worry for the markets and for us. We all started to worry about it this summer, as noted above, especially after the 10-year Treasury bond yield jumped above last year’s high of 4.25% on August 16.

The new worry is that the war that broke out on Saturday between Hamas, Iran’s proxy in Gaza, and Israel will widen and be prolonged. That would be the case if Hezbollah, Iran’s proxy in Lebanon, enters the war.

It’s unlikely that the result will be a direct confrontation between Iran and Israel, but that scenario isn’t out of the question. More likely is that the Biden administration will tighten sanctions on Iran’s oil exports, which plunged 1.6 million barrels per day during the Trump administration and rose 0.6 mbd during the first three years of the Biden administration (Fig. 9).

The tightening of sanctions on Iran oil could cause oil prices to spike above $100 a barrel, which could trigger a worldwide recession. More likely is that Saudi Arabia would increase its production and exports to keep the price of oil below $100 a barrel. Producers just recently learned that the 23% increase in the price of a barrel of crude oil during Q3-2023 immediately depressed oil demand, especially gasoline usage in the US (Fig. 10).
 
Worry List IV: US Credit Risks. Of course, we continue to monitor the weekly commercial bank data compiled by the Fed for signs of a bank-led credit crunch. The latest data show slowing growth in loans but not a sudden credit contraction:

(1) Here are the y/y growth rates of the major bank loan categories through the September 27 week and their recent peaks either last year or earlier this year: commercial & industrial (C&I) loans (0.4%, 15.0%), residential real estate (5.2, 10.2), commercial real estate (6.8, 13.5), and consumer loans (5.2, 12.8) (Fig. 11).

The most notable slowdown is in C&I loans. Last week, we attributed this development to a lack of demand to finance inventories as a result of the rolling recession in the goods sector. So the weakness reflects a weakening of credit demand rather than a tightening of credit supply.

(2) We are on high alert for a credit problem in commercial real estate. Here, too, we are seeing a slowdown; but we are certain it is heading for a credit crunch as long as bond yields remain high or go higher (Fig. 12). Interestingly, commercial real estate loans secured by multi-family properties are up 14.4% y/y through August, but that’s down from a red-hot peak of 27.7% during December 2022.

(3) We are also monitoring provisions for loan losses at the large and small banks (Fig. 13). They have been rising for both, but not in an alarming fashion.

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Consumers: Hotter For Longer

October 9 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Consumers I: The Quick Employment Theory. On Friday, after September’s employment report was released, CNBC’s ace anchor Becky Quick suggested that the unexpected surge in payrolls might indicate that more people are going back to work because they are running out of the excess saving they accumulated during the pandemic. That’s a refreshingly optimistic insight.
 
The widely held pessimistic view has been that once consumers run out of their excess saving, they will have to retrench. The resumption of student loan payments will cause consumers to cut back, according to this glum view. And of course, tighter lending conditions will force consumers to buy less on credit, as evidenced by rising consumer credit delinquencies. In other words, a consumer-led recession is coming and probably sooner rather than later. JP Morgan Chase Chairman and CEO Jamie Dimon has been an especially vocal proponent of this scenario since May 2022.
 
Debbie and I have been among the optimists on the outlook for consumer spending. We’ve observed that it’s hard to have a consumer-led recession when employment is rising and real wages are trending higher. We’ve countered the excess saving story with our own story about the massive retirement saving accumulated by the Baby Boomers.

We are members of this cohort. While we are still working, many of our friends are retiring and starting to spend their nest eggs. They are spending less on goods and more on services like restaurants, airlines, hotels, and health care providers. All of these are labor-intensive service-providing industries that have been scrambling to add workers to accommodate the booming demand for their services, especially from Baby Boomers.
 
That’s how we’ve explained the resilience of the consumer. If the trend in real disposable incomes remains upward, consumer-led growth should continue to fuel gains in GDP.

What should the Fed do, considering the resilience of payroll employment? Nothing! Wage inflation continued to moderate during September despite the strength in employment and the low unemployment rate. Meanwhile, the 10-year bond yield has jumped by 43bps since the FOMC met on September 19-20. The bond market has tightened for the Fed. Any more tightening by the Fed risks causing a credit crunch and a recession, which clearly isn’t necessary to bring inflation down. That’s because inflation is turning out to be a transitory pandemic-related phenomenon after all, as we have been suggesting.

By the way, Sunday’s WSJ features an article titled “The U.S. Economy’s Secret Weapon: Seniors With Money to Spend.” It is subtitled: “Americans 65 and older account for record share of spending and are less susceptible to interest rates.” Debbie, Melissa, and I have been making the same points since the summer. See for example, our June 26 Morning Briefing titled “Baby Boomers Retiring On $75 Trillion In Net Worth.”

US Consumers II: Born To Shop. We’ve often observed that Americans go shopping when they feel good. When they feel bad, they go shopping too because it releases dopamine in their brains, which makes them feel better. They always feel bad during recessions, but not as many have the income to shop away their troubles, especially if they have lost their jobs. In the current situation, consumers feel relatively bad, but the labor market is running hot. So they have jobs and can go shopping to make themselves feel better, if not great.

From this perspective, let’s review that latest batch of relevant consumer indicators:

(1) Confidence. Debbie and I track the Consumer Optimism Index, which we construct by averaging the Consumer Sentiment Index and the Consumer Confidence Index (COI) (Fig. 1). The overall index was 85.6 in September. That’s up from last year’s low of 73.4 during July. But it is still around the low readings that preceded past recessions. Similar observations apply to the current conditions and expectations components of the COI.

Consumers should be less miserable than they were last year because the Misery Index is down from a peak of 12.7 during June 2022 to 7.5 in August (Fig. 2). The index is the sum of the unemployment rate and the headline CPI inflation rate on a y/y basis (Fig. 3).

(2) Earned income proxy. Our Earned Income Proxy for private industry wages and salaries in personal income rose 0.4% m/m to another record high in September (Fig. 4). Aggregate hours worked and average hourly earnings each edged up 0.2% (Fig. 5).

The increase in aggregate hours worked was attributable to the 0.2% increase in payroll employment, while the average workweek was unchanged (Fig. 6). Payroll employment was revised higher in both July and August by a total of 119,000 (Fig. 7). Over the past three months, payroll employment is up 799,000, or 266,300 per month on average.

(3) Real income & spending. Inflation-adjusted consumer spending tends to grow at a relatively steady pace during economic expansions (Fig. 8). It naturally follows the upward trend of real disposable personal income (DPI), which is somewhat more volatile. During H2-2021 and H1-2022, the two diverged as real DPI fell while real consumer spending rose. The former was depressed by rapidly rising prices, while the latter was boosted by the spending of the saving accumulated during the pandemic.

Since mid-2022, real DPI has been trending higher, while consumption has continued to grow. The strength of the labor market should continue to support consumer spending.
 
US Consumer III: Disinflating Wages. Average hourly earnings (AHE) for all private industry workers fell to 4.2% y/y in September, down from last year’s peak of 5.9% and the lowest since June 2021 (Fig. 9). The three-month change was down to 3.3% (saar) through September, the lowest since March 2021. Fed Chair Jerome Powell frequently has said that wage inflation closer to 3.0% would be consistent with price inflation falling to the Fed’s target of 2.0%.

Here is the performance derby of major industries’ AHE in September on a y/y change basis compared with their peak rates in 2021, 2022, or 2023: natural resources (5.6, 7.1), construction (5.1, 5.9), leisure & hospitality (4.7, 14.0), utilities (4.6, 6.6), transportation & warehousing (4.4, 7.0), professional & business services (4.3, 7.1), retail trade (4.2, 6.7), education & health service (3.2, 7.3), and information services (0.9, 7.7) (Fig. 10).

The biggest declines in inflation from industries’ most recent peaks have occurred in leisure & hospitality (-9.3ppts), information services (-6.8), and education & health services (-4.1), professional & business services (-2.8), and transportation & warehousing (-2.6).
 
US Consumers IV: Lots of Jobs. The Godot recession is still MIA. Payroll employment is one of the four components of the Index of Coincident Economic Indicators. It rose to a record high in September. There’s no sign of a recession in the payrolls of the major industries. The following rose to record highs in September: wholesale trade, hospitals, ambulatory health care services, social assistance, construction, financial activities, and food services & drinking places, and educational services.

Movie. “The Sixth Commandment” (+ +) (link) is a British docudrama series based on the murders of Peter Farquhar and Ann Moore-Martin by Ben Field. Field was a fiend who preyed on two lonely elderly people by pretending to be in love with them. His motive was to get them to rewrite their wills to his benefit. He pretended to be a religious and caring young poet but was actually a cold-blooded embodiment of Hannah Arandt’s concept of the “banality of evil.”

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Copper, Travel & AI

October 5 (Thursday)

Materials: Mixed Signals. Fears of inflation and growing supply have sent Treasury bond yields up to levels not seen in more than 15 years. The price of copper, however, is not signaling any concerns about inflation or overheated economic growth. The price of the industrial metal was down 0.6% on Tuesday; it fell 0.8% during Q3 and 4.7% ytd through Tuesday’s close (Fig. 1). At a recent $3.62, the price of copper is below its 2022 high of $4.93 in March but well off its 2020 low of $2.12.

Copper prices typically move in lockstep with global economic activity. The copper market’s recent torpor likely reflects the depressed Chinese real estate market, a European economy that is teetering on recession, and rising interest rates that should slow US economic growth. The strong dollar isn’t helping (Fig. 2). And investors seem unmoved by offsetting factors that are bullish for copper demand over the long term, such as booming production of electric vehicles (EVs) and meager new copper production hitting the market.

Let’s take a closer look at what’s keeping copper prices so subdued:

(1) Inventories piling up. Last month, copper inventories in London Metal Exchange (LME) registered warehouses were at their highest levels since May 2022, an October 2 article at Oilprice.com reported. Copper stocks held there have more than doubled in the past two months. The article also noted that the LME copper futures curve was in extreme contango, with copper’s three-month futures price trading above the cash price.

(2) China’s property market weighs. Near term, there’s concern about Chinese economic growth. Some of China’s largest real estate developers continue to struggle to make debt payments, and many have thrown in the towel and filed for bankruptcy protection. The sector’s woes mean less property will be purchased for development from municipalities, which pinches their budgets. Meanwhile, lower home prices are hurting consumers and worries about bad property loans cloud the future of Chinese banks.

China’s real GDP rose 6.3% y/y in Q2, but it fell 1.7% (saar) q/q (Fig. 3). And the MSCI China share price index is down 10.5% ytd (Fig. 4).

(3) Bright future. Analysts remain optimistic about the future of copper prices because there’s little in the way of new capacity being built in the industry and demand should rise with the growing number of EVs being built along with other areas of electrification.

The world’s going to need two times as much copper over the next 30 years as it needed over the last 30 years, BHP CEO Mike Henry told CNBC on September 27. Meanwhile, the commodity is getting harder to find, what’s found is of lower quality, and old and new mines face tough environmental, social, and governance (ESG) requirements.

Bringing a new mine online takes time, effort, and money. “For the 127 new mines opened globally between 2002 and 2023, it took an average of 15.7 years after discovery to get to commercial production, although actual figures ranged from six to 32 years,” an October 3 WSJ article reported, citing S&P Global Market Intelligence data. Given the long road, some companies are opting to reopen closed mines, which can be slightly faster.

Running mines once they are opened is expensive too. In the 12 months through June, BHP’s output costs rose roughly 9%, and they are now higher than they were before the pandemic, a September 28 WSJ article reported. Beyond just operational costs, miners are paying fatter royalties to foreign governments and paying for offsets to their carbon emissions. Given the increases in the industry’s project costs and rising wages, Morgan Stanley analysts raised their real long-run price forecasts for copper, lithium, and other mined commodities, the WSJ article noted.

(4) The S&P 500 Copper stock price index only has one member, Freeport-McMoRan, which mines gold and molybdenum in addition to copper. Industry analysts have been modestly optimistic about the industry’s revenue, with forecasts of 1.9% growth this year and 6.2% growth in 2024 (Fig. 5). While earnings are expected to fall 31.0% this year, they’re expected to rebound and grow 26.4% in 2024 (Fig. 6).

So far, the industry’s stock price index isn’t betting on that earnings rebound. It’s down 4.4% ytd and down 18.6% from its July 31 summer high (Fig. 7). Perhaps that’s because net earnings revisions have been decidedly negative for six months; they came in at -16.3% in September (Fig. 8). At 18.1, the industry’s forward P/E is in between its typical lows when earnings are strong and its typical highs when earnings are low (Fig. 9).
 
Consumer Discretionary: Has the Travel Itch Been Scratched? This summer, travel-related stocks were on a tear, as it seemed that everyone was jetting off somewhere. Personal spending on air transportation was at an all-time high in August, and spending at hotels and motels was near record levels (Fig. 10). We wondered how long the investor enthusiasm could continue given three looming risks: higher oil prices, higher wage-related expenses, and excessive bullishness. A little less than three months later, travel-related industries’ stocks have fallen sharply.

The S&P 500 Casinos & Gaming industry stock price index has fallen 24.5% from its July 31 high. The S&P 500 Passenger Airlines industry’s index has nosedived 30.3% since its July 11 high. And the stock price index for the S&P 500 Hotels, Resorts & Cruise Lines industry has dropped 8.4% since July 31, a touch more than the S%P 500’s 7.8% drop over the same period (Fig. 11 and Fig. 12).

Here’s a look at the forces that have weighed on these travel-related stock price indexes since we last discussed them, in our July 13 Morning Briefing:

(1) Fuel prices take a toll. Production cuts by OPEC+ have sent the price of Brent crude oil futures up 27% from their low this year, and that’s causing turbulence for transportation companies of all stripes (Fig. 13).

Cruise line operator Carnival lowered its Q2 guidance because higher fuel prices and the stronger dollar are sinking results. The company warned last week that it expects a Q4 loss of between 10 cents to 18 cents a share even though occupancy rates have finally rebounded to 2019 levels, a September 29 Barron’s article reported. Analysts responded by lowering their estimates for the quarter to a loss of 13 cents a share, down from the loss of eight cents a share they expected three months ago.

(2) Wages flying higher. Many of the travel companies’ employees are members of unions that have demanded higher wages, successfully. Most recently, United Airlines’ pilots approved a new contract that includes pay raises of as much as 40% over the course of four years. That follows Delta Air Lines pilots’ new contract struck in March, which gives them 34% pay raises over four years. And American Airlines pilots’ contract grants wage increases of 46% over four years.

Higher labor costs and fuel expense led American Airlines to slash its Q3 adjusted earnings forecast last month to 20-30 cents a share from 85-95 cents previously, a September 13 Barron’s article reported.
 
(3) Falling prices for the holidays. Very early data about holiday travel indicates that “revenge travel” may have run its course. While it’s still early for holiday air bookings, most prices for holiday air travel and car rentals are down y/y even though both Christmas and New Year’s fall on weekends. For Thanksgiving travel, airfares are 14% lower and car rentals 17% lower than last year, an October 2 USA Today article reported. For Christmas, domestic flights are 12% cheaper than in 2022, but fares to many international locations are higher by mid-single-digit percentages.

Even Disney has resorted to lowering prices after seeing a slowdown in park attendance. Tickets for Disneyland can be purchased for as low as $50 each if used between January 8 and March 10, CNBC reported yesterday. And at Disney World, children’s tickets and dining plans will be half-off for those who purchase a four-day, four-night package at Disney resorts for use from March 3 through June 30.

Looking ahead, two groups of travelers could bolster travel stocks’ fortunes if they take to the skies in sufficient numbers: If business travelers return to their road warrior ways or if Chinese tourists decide to visit the US of A, travel stocks could improve. Otherwise, the stocks will be facing tough y/y comparisons over the next year.

(4) A look at earnings. The rate of earnings growth expected for some travel-related industries has been dropping in recent weeks and months, as analysts have been trimming their earnings estimates for the industries’ constituent companies.

The S&P 500 Passenger Airlines industry’s expected 2023 earnings growth has fallen to 150.7% from the high triple-digit percentages projected in March 2022. Looking into next year, the industry’s projected earnings growth has descended to 13.0% from an estimate of 38.0% about a year ago (Fig. 14).

The S&P 500 Casinos & Gaming industry’s earnings for 2024 have been revised downward sharply. In January 2023, earnings for 2024 were expected to grow by 177.4%, but now those earnings are expected only to inch up by 4.9% (Fig. 15).

The earnings growth expected for the S&P 500 Hotels, Resorts & Cruise Lines industry has held up the best. Earnings are projected to soar in 2023 from a very small profit in 2022; for 2024, projected earnings growth has held relatively steady at 27.7% (Fig. 16).

Disruptive Technologies: Developers Embrace AI. OpenAI and Bard have captured the headlines about artificial intelligence (AI), but there’s also a slew of small developers, working in small startups, that are harnessing AI engines to provide various services to customers. OpenAI and Bard can write copy and answer questions, but these small developers have created programs with consumer-friendly interfaces that perform various specific tasks faster and better than ever before.

Let’s have a look at some of their most popular offerings:

(1) Everyone’s a writer. Companies like Surfer and Jasper are using AI to write everything from blog posts to SEO-optimized articles. This video explains how users can pick the keywords they’d like to appear in an article and the article’s tone of voice, and SurferAI will generate an outline. The user then approves or amends the outline before SurferAI writes the article. SurferAI will score the article on how well it’s optimized for Google searches, and it will show similar articles composed by competitors.

SurferAI uses Open AI’s technology along with its own “proprietary optimization algorithms.” Soon it hopes to provide users with links to the source information used to write the copy. Other AI writers of SEO-optimized copy include Frase, GrowthBar, Copysmith, Article Forge, Writesonic, Content at Scale, and KoalaWriter.

There are many “AI-powered” programs to help with marketing tasks, including Phrasee, Optimove, Instatext, Grammarly, Acrolinx, Smartwriter.ai, Zapier, and Hemingway App, according an April 8 article at AnalyticsInsight.net. Phrasee specializes in increasing the “brand language used by businesses in their copy to achieve its goals.” Optimove gathers data from a company’s many information platforms and presents it in one dashboard so that a business can better analyze it. Grammarly checks copy for grammar and spelling errors, and Instatext does the same in addition to improving the readability of sentences.

The question is whether these independent apps can survive as Microsoft and Google integrate their AI programs into Word and Docs.

(2) Smarter teaching apps. Dulingo is an app that for many years taught users a new language a little bit every day. The company came out with a new and improved app that harnesses GPT-4. Its new Explain My Answer function allows users to learn why they didn’t get an answer right. And its Roleplay function “lets you chat with an AI bot in your chosen language in guided simulations, complete with tips to help you on your learning journey,” an article at lifehacker.com reported.

Meanwhile, Socratic uses Google’s AI to help with high school and college level homework. Coursework covered includes algebra, geometry, trigonometry, calculus, biology, chemistry, physics, earth and environmental studies, US and world history, and literature.

(3) AI lends an ear. Woebot Health dates back to 2017 and aims to help users reduce symptoms of stress, depression, and anxiety. “AI allows Woebot to create that empathetic environment with great specificity to both patient and situation. As a rules-based conversational agent, Woebot does not generate its own sentences, but rather selects an appropriate evidence-based response crafted by the company’s team of writers and clinicians,” noted a September 11 article by Kai Patel, CEO of BrightInsight, a digital health platform for biopharma and medical device companies.

The responses sound relatively human-like. “Say, for example, that a patient has had a difficult argument with a family member. Rather than delivering a formulaic output—‘That sounds like a relationship problem’—Woebot responds with true empathy: ‘Family situations can be hard—especially at this time of year.’” The response builds a relationship with patients, letting them know they’ve been heard. That motivates patients to use the actual therapeutic tool, which leads them through exercises based on cognitive behavioral therapy, such as encouraging them to reframe negative thoughts.

(4) Helping the blind. Be My Eyes uses GPT-4 to help blind and low-vision people with daily challenges. Its Virtual Volunteer tool lets users snap a picture of their problem, and the AI can identify what’s occurring and try to help. It can take a picture of your refrigerator and tell the user what ingredients are available and how they could be used for dinner. If the bot can’t help, a sighted volunteer is called to help via a video chat.

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The Debt Crisis Scenario

October 4 (Wednesday)

Debt Crisis I: A Plausible Scenario? “We’re going to have a debt crisis in this country,” Ray Dalio, the founder of hedge fund Bridgewater Associates, warned in an interview with CNBC’s Sara Eisen that aired last Thursday. The two were speaking at a fireside chat at the Managed Funds Association. “How fast it transpires, I think, is going to be a function of that supply-demand issue, so I’m watching that very closely.”

Melissa and I referenced Dalio’s debt crisis scenario yesterday. It’s a simple plot that makes sense. We’ve been covering the story but haven’t concluded that it must end as badly as Dalio expects. Consider the following:

(1) Fiscal policy is out of control, as evidenced by the rapidly widening federal government budget deficit. Over the past 12 months through August, the deficit totaled $2.0 trillion, up from a recent low of $1.0 trillion through July 2022 (Fig. 1). It’s simple arithmetic: The trend in outlays is steeper than the trend in revenues (Fig. 2).

In the past, the federal budget deficit was counter-cyclical. As a percent of nominal GDP, it widened when the economy fell into recessions and narrowed during expansions (Fig. 3). As a percent of nominal GDP, outlays rose during recessions and fell during expansions (Fig. 4). Receipts tended to do the opposite of outlays.

So it is disturbing to see that outlays are rising while receipts are falling during the current economic expansion.

(2) It is widely assumed that the recent widening of the federal deficit is mainly attributable to the spending programs enacted by the Biden administration during 2022. In fact, the recent widening is mainly attributable to inflation, which has boosted federal government outlays on Social Security and net interest (Fig. 5).

Net interest totaled $634 billion over the past 12 months through August (Fig. 6). It has doubled since April 2021. It is the fastest growing of the federal government outlays categories (Fig. 7). We calculate that the federal government is currently paying about 2.50% on its outstanding debt held by the public (Fig. 8). The 2-year Treasury note is currently above 5.00%.

The biggest contributor to the bulging deficit in recent months has been a decline in individual income tax revenues during the current fiscal year after they were boosted last year when investors sold lots of their stocks that had capital gains during the 2022 bear market. They paid lots of capital gains taxes.

(3) Outlays will get boosted even more in coming years by all the spending Congress approved last year. In addition, the net interest expense of the federal government will continue to soar, as it has been doing ever since the Fed started raising interest rates aggressively in 2022.

(4) The Treasury supply issue came to the fore during the past summer, when the Treasury securities outstanding held by the public jumped by a whopping $1.4 trillion from June through August (Fig. 9). Fitch Ratings downgraded the federal debt from AAA to AA+ on August 1 on concerns about the mounting federal debt and the lack of political will in Washington to do anything to rein in the deficit. That announcement really marked the start of the Treasury bond market’s concern about too much supply relative to demand. The 10-year bond yield was 4.05% on August 1. Now it is almost 4.80%.

(5) So the bond market is adjusting yields upward to clear the market, i.e., to boost demand to meet the increased supply. The risk is that the market yield will crowd out the credit demands of the private sector. That would amount to a credit crunch, which would cause a recession.

In the debt crisis scenario, a recession attributable to excessive fiscal deficits would require the federal government to reduce spending and increase taxes, which would exacerbate the credit crunch and the recession. In a worst-case scenario, it could unleash a deflationary debt default spiral. In this scenario, the Fed might be forced to lower interest rates and to terminate its quantitative tightening.

Debt Crisis II: It Doesn’t Have To End Badly. Okay, now let’s come up for some air from these lower depths. So far, the Treasury bond yield has essentially normalized to the yield levels of 4.00% to 5.00% that prevailed from 2003 to 2007, before the “New Abnormal” (Fig. 10). That was the period from the Great Financial Crisis through the Great Virus Crisis, when the major central banks worried about deflation and obsessed about raising the inflation rate up to their 2.0% targets. During that period, interest rates were abnormally low and quantitative ease proliferated.

So far, the economy has proven remarkably resilient in the face of the three-year jump in the bond yield from a record low of 0.52% on August 4, 2020 to almost 4.80% currently. This raises the possibility that the economy can live with the bond yield back to its old normal level.

Then again, the velocity of the rate backup has been head-spinning, as it took only three years to fully reverse the decline in the bond yield during the 12 years of the New Abnormal. Depressing lagged effects on the economy are likely still to emerge. However, they might continue to play out as a rolling recession rather than an economy-wide recession. The rolling recession is currently rolling into the commercial real estate market.

What would it take to stop the Treasury bond yield from climbing well above 5.00% other than a deflationary debt debacle? Possibly the “immaculate disinflation” we expect. That is, we think inflation can continue to fall without an economy-wide recession. We also expect to see a slowdown from Q3’s consumer-led boomlet, with real GDP rising to between 4.0% and 5.0%. We think that Q4 real GDP growth will be back down to 2.0%. In this scenario, demand for Treasuries should absorb the supply with the yield south of 5.00%.

Be warned: If we see the yield soaring over 5.00%, we (along with everyone else) will have to conclude that Dalio’s debt crisis might have started.

Earnings I: Eyes Back on the Earnings Ball. There are plenty of questions about the outlooks for the economy and stock market floating around nowadays and few solid answers. One thing’s for sure: The stock market follows earnings and profitability over the longer term, both of which have been improving so far this year (Fig. 11).

In Monday’s QuickTakes titled The Wild Bunch, we wrote: “[W]e believe that the Q3 earnings season during October and early November will be much better than widely expected. After all, Q3’s real GDP is turning out to be well above consensus forecasts. Looking ahead to Q4, analysts are predicting that S&P 500 operating earnings per share (EPS) will be at a record high during the final quarter of this year. That’s barring a long auto strike, a government shutdown, and surprising credit losses at the banks.”

However, Joe’s analysis of the consensus EPS estimate data for S&P 500 companies in the context of historical trends suggests a very real possibility that record-high operating earnings could come sooner, i.e., during Q3. Here’s what he says:

(1) The case for record-high quarterly S&P 500 EPS as soon as Q3. As of the September 27 week, analysts polled by I/B/E/S are estimating that Q3 earnings will be $55.92. That represents only a 3.7% upside earnings surprise hook, which is historically low so could well turn out to be greater. Also, the latest Q3 consensus is below the record-high actual EPS of $57.62 recorded by I/B/E/S for Q2-2022. A surprise surpassing that prior record high appears easily attainable given the historical surprise patterns of the past (Fig. 12).

By the way, we have been forecasting that the S&P 500 would report record-high EPS of $58.00 for the quarter since last November, when we first initiated our forecast.

(2) More sectors could see record-high quarterly earnings in Q3 than in Q2. Let’s take a look at what analysts are expecting for the 11 S&P 500 sectors’ Q3 earnings as of September 29 to see which look bound for hitting record highs in quarterly earnings (using data from Q1-2009 to Q2-2023).

During Q2-2023, quarterly earnings hit record highs for two sectors, Consumer Discretionary and Industrials. That was an improvement from Q1-2023, when no sectors hit that mark; but it fell well short of the seven sectors several years earlier, in Q2-2021 (Fig. 13).

The current Q3-2023 consensus estimate for Utilities, if realized, would be a record high. While the estimates for Communication Services, Consumer Discretionary, and Consumer Staples are still 3%-4% below their past record actuals, even a modest earnings hook would propel them to new highs too in Q3-2023. So we think four sectors’ Q3 EPS will be at record highs. For Communication Services, Q3 would mark its first record high in quarterly EPS since Q4-2021.

Looking further ahead to Q4, the consensus currently expects record-high quarterly earnings for the S&P 500 and two sectors: Communication Services and Information Technology.

Despite the recent improvement in its earnings estimates, Energy still has a long way to go before surpassing its record level in Q2-2022. However, Energy’s recovery is now having a negative impact on the profit forecasts for the Airlines industry and the sector where it’s housed, Industrials.

While the remaining seven sectors currently don’t have record quarterly earnings forecast for Q4-2023, a continuation of this year’s upward estimate revision trend in response to the Q3-2023 earnings releases could propel many of them higher, possibly into the record-high realm (Fig. 14 and Fig. 15).

(3) Revisiting the S&P 500 sectors Q3 earnings growth outlook. S&P 500 companies’ collective earnings growth is expected to be positive y/y in Q3-2023 following declines in the prior three quarters. These are the S&P 500 sectors’ expected earnings growth rates for Q3-2023, on a proforma basis, versus their final earnings growth rates for Q2-2023: Communication Services (34.0% in Q3-2023 versus 15.7% in Q2-2023), Consumer Discretionary (23.0, 57.0), Utilities (12.4, 0.6), Financials (11.9, 9.3), Industrials (8.6, 15.7), S&P 500 ex-Energy (6.7, 3.6), Information Technology (5.9, 5.0), S&P 500 (1.6, -2.8), Consumer Staples (1.3, 8.5), Real Estate (-7.1, -2.1), Health Care (-9.7, -26.7), Materials (-20.5, -26.4), and Energy (-35.0, -47.5).

Earnings II: Revisiting S&P 500 Growth Prospects Ex Energy & MegaCap-8. In the September 27 Morning Briefing, we presented the Q2 actual results for S&P 500 companies’ collective revenues and earnings growth along with the Q3 outlook. We included the outlooks on an ex-Energy-sector basis as well as an ex-MegaCap-8 basis (i.e., excluding the stocks of Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla). We’ve been asked by accounts to update the S&P 500’s growth rates excluding both groups. Here’s what Joe found:

(1) Revenues growth. During Q2, the S&P 500 revenues growth rate was 1.2% y/y with both groups included; that improves to 4.6% without them. Energy’s revenues tumbled 28.9% y/y in Q2, while the MegaCap-8’s revenues rose 10.2%.

Looking ahead to Q3, S&P 500 revenues are expected to rise 0.8% with both groups included, which improves to 2.8% without them. Analysts expect Energy’s revenues to fall 22.5% y/y in Q3 and the Megacap-8’s revenue growth to accelerate to 11.1% y/y.

(2) Earnings growth. S&P 500 earnings fell 2.8% y/y in Q2 with both groups but rose 4.6% without them. Energy’s earnings tumbled 47.5% y/y in Q2, while the MegaCap-8’s earnings rose 29.7%.

A 1.6% gain is expected for the S&P 500 in Q3, but that improves to 2.8% without both groups. Analysts think Energy’s earnings will fall 35.0% y/y in Q3, but they expect the MegaCap-8’s earnings to soar 39.1% y/y.

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The Bond Vigilantes Are On The March

October 3 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

The Wild Bunch I: Unrelenting Climb. The latest batch of economic indicators was weaker than expected. On Friday, we learned that real personal consumption expenditures rose just 0.1% during August. The core PCED edged up by only 0.1% during the month. September’s Consumer Sentiment Index fell 1.4 points to 68.1. As a result, the Citigroup Economic Surprise Index (CESI) fell to 45.1% from a recent high of 81.9% on July 27 (Fig. 1).

The 10-year Treasury bond yield should have declined on the news since its 13-week change tends to track the CESI closely (Fig. 2). Instead, the yield has continued to march higher, up to 4.70% on Monday morning. Most of the bond indicators that worked in the past haven’t been working for a while. For example, the bond yield was highly correlated with the ratio of the prices of copper to gold from 2005 through 2019 (Fig. 3). They’ve diverged significantly since then, with the ratio currently showing that the bond yield should be closer to 2.00% than to 5.00%.

The same can be said about the usually tight correlation between the bond yield and the M-PMI—i.e., they’ve decoupled (Fig. 4). The bond yield didn’t flinch to the downside when September’s M-PMI was reported Monday morning showing that the index remained below 50.0 for the eleventh consecutive month. Even the decrease in the M-PMI’s prices-paid index from 48.4 in August to 43.8 didn’t move the bond yield lower. The index suggests that the CPI goods inflation rate remained moderate last month (Fig. 5).

The Wild Bunch II: Disinverting. In the past, inverted yield curves provided strong buy signals for bonds. The 10-year US Treasury yield usually peaked at about the same time as the 2-year Treasury yield rose to match or exceed it (Fig. 6). That’s because bond investors started to anticipate that further hikes in the federal funds rate by the Fed were increasingly likely to cause a financial crisis, a credit crunch, and a recession. In the past, those expectations typically were met, forcing the Fed to lower interest rates as the economy tanked and inflation plunged.

The federal budget deficit widened during past recessions. But the increased supply of Treasuries was no problem, since private-sector credit demands dropped during those periods. So in the past, the balance between supply and demand in the Treasury market was not a significant issue for bond investors. Instead, they focused mostly on actual and expected inflation and the Fed’s actual and expected response to rising, falling, or stable inflation.

The yield curve has been disinverting since the 10- vs 2-year yield spread bottomed around -100bps in June. It was back up to -43bps on Monday. Perversely, now that the Fed seems to be on the verge of terminating its rate hiking, bond investors might have concluded that short-term rates aren’t high enough to cause a financial crisis, credit crunch, and a recession. There was a regional banking crisis in March, but the Fed provided a liquidity lending facility that contained the crisis quickly.

While the Fed’s restrictive stance of keeping the federal funds rate around the current level for longer might help to bring inflation down, the problem in the Treasury bond market is too much supply because of profligate fiscal policy. The supply problem has been exacerbated by the Fed’s quantitative tightening (QT) since last June. The Fed’s QT has depressed bank deposits (as have high interest rates on money market securities). So the banks have also stopped buying Treasury and agency securities and haven’t replaced their maturing securities. Consider the following:

(1) Since the start of QT in 2022, the Fed’s portfolio of Treasuries and agencies is down by $1,015 billion through the September 20 week (Fig. 7).

(2) The comparable portfolio held by commercial banks since the start of QT is down $544 billion through the September 20 week.

(3) We’ve previously observed that since the start of QT in 2022, the Fed’s Treasury bond holdings actually has increased, by $75 billion through the September 27 week. The Fed isn’t selling its Treasury bonds, as widely feared (Fig. 8).

The Wild Bunch III: High Yields. While the 10-year Treasury bond yield has increased by 81bps since the end of last year from 3.88% to 4.69% on Monday, the yield on US high-yield corporate bonds has been remarkably flat and stable around 9.00% (Fig. 9). So the yield spread between the latter and the former has narrowed, suggesting that credit conditions remain relatively easy, at least for high-yield corporates (Fig. 10).

While the Wild Bunch—a.k.a. the Bond Vigilantes—has wreaked havoc in the Treasury bond market, they’ve left the high-yield market alone. Could it be that some of them view the government’s securities as riskier than high-yield corporates? The result of their rampage in the Treasury market suggests as much.

Melissa and I are watching for signs that the credit market unrest unleashed by the Bond Vigilantes is spreading to the high-yield market.

The Wild Bunch IV: Uncharted. “We’re going to have a debt crisis in this country,” Ray Dalio, the founder of hedge fund Bridgewater Associates, warned in an interview with CNBC’s Sara Eisen that aired last Thursday. The two were speaking at a fireside chat at the Managed Funds Association. “How fast it transpires, I think, is going to be a function of that supply-demand issue, so I’m watching that very closely.”

Based on our analysis above, he may be right. The Wild Bunch has caused the Treasury bond market to fully reverse the drop in the 10-year bond’s yield from the Great Financial Crisis through the Great Virus Crisis in the past three years (Fig. 11).

We aren’t ready to join Dalio’s camp, yet. We still expect that inflation will continue to moderate, making bonds look even more attractive to investors. We suspect that Fed officials may soon be alarmed by the unyielding climb in yields. If they aren’t already, they should be. If a debt crisis becomes more apparent, the Fed probably would suspend its QT program to calm the situation.

Meanwhile, the current message of the Bond Vigilantes to fiscal policymakers in Washington is: “Take meaningful actions to reduce the federal deficit now and in the future or we will push the bond yield up to whatever level it takes to get you to do so!”

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Some Good News & Not So

October 2 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Good News I: Signs of Improving Productivity. There was lots of economic and financial news last week that mostly supports our optimistic economic outlook through the end of 2024. Debbie and I are still currently assigning subjective odds of 75% to a soft-landing scenario with immaculate disinflation (i.e., disinflation without a recession) and 25% to a hard-landing one.

We are also optimistic about the outlook for productivity growth over the rest of the decade. We still expect the decade will deserve to be called the “Roaring 2020s,” though we’ve acknowledged that it could also turn out to be a repeat of the Great Inflation of the 1970s. Our current subjective odds on the former versus the latter are 75% and 25%. Like the Fed, we will continue to assess the data to guide our odds-making.

Let’s start with the productivity story. As we’ve previously noted, there is a very good correlation between productivity and real hourly compensation growth, both on a 20-quarter percent change basis at an annual rate (Fig. 1). The standard of living as measured by consumers’ purchasing power is driven by productivity.

The boom-and-bust cycle in real hourly compensation growth is nearly identical to that of productivity growth. Their peaks and troughs tend to coincide in both timing and magnitude. There have been three productivity growth booms since the 1950s. There was a major bust in productivity growth from the mid-1960s through the early 1980s that coincided with the Great Inflation period (Fig. 2).

In our opinion, the latest productivity boom started during Q4-2015, when productivity growth troughed at 0.4% at an annual rate and rose to 1.4% during Q4-2019, just before the pandemic. The pandemic initially boosted productivity during the lockdowns then depressed it when quits soared. But now productivity is normalizing. It was back to 1.6% during Q2-2023.

Last week, the personal consumption expenditures deflator was up 0.4% m/m in August, above the 0.2% increase in average hourly earnings (of production & nonsupervisory workers) during the month. This measure of real wages stagnated last year but is up 0.9% since the start of this year through August (Fig. 3). It is back growing on its 1.2% upward trendline, which started in 1995. This can happen on a sustainable basis only if productivity is growing. What about August? The core PCED was up only 0.1%, just below the increase in the wage measure.

Another encouraging sign for our upbeat productivity story is that the S&P 500 profit margin seems to have bottomed during the first half of this year around 11.5%, not much below its record high of 13.7% during Q2-2021 (Fig. 4). Furthermore, the weekly series for the forward profit margin of the S&P 500 has been rebounding for the past 21 weeks through the September 21 week.
 
Good News II: Onshoring & Infrastructure Boom. Last week’s real GDP report caused one of the series that we’ve been following very closely recently to soar off our chart’s scale. It was fixed investment in manufacturing facilities (Fig. 5). It’s up 64.5% y/y through Q2-2023 and 74.9% since Q4-2019, just before the pandemic. That’s on an inflation-adjusted basis!

American and foreign manufacturing companies clearly are onshoring to the US. Supply-chain disruptions during the pandemic and growing geopolitical tensions between the US and China have stimulated the onshoring rush. So has a shortage of workers in China.

The onshoring boom and the federal government’s increased spending on public infrastructure are boosting new orders for construction machinery, which is up 8.4% y/y through July (Fig. 6). Onshoring and infrastructure investment also explain why construction employment rose to yet another record high of 8.0 million during August despite the recession in single-family housing starts (Fig. 7). Employment in heavy & civil engineering construction has been rising to record highs in recent months as well, at 1.1 million in August (Fig. 8).

There was one piece of bad news in the building trade two weeks ago. Multi-family housing starts plunged 26.3% m/m during August (Fig. 9). As we noted previously, that might have been a fluke or it might reflect that soaring commercial mortgage rates and disinflating rents are starting to depress the construction of rental housing, which may be facing a glut in some areas. That would be good news for our optimistic outlook for inflation. Meanwhile, the rolling recession in single-family housing starts may be bottoming (Fig. 10).

Good News III: Inventories Manageable. Thursday’s real GDP report showed that inventory investment remained close to zero during the first half of this year (Fig. 11).

That followed five quarters of significant unintended inventory accumulation, particularly by wholesale and retail distributors (excluding auto dealers’ inventories). That pileup occurred when inventories were depleted by consumers’ buying binge for goods during the pandemic years of 2020 and 2021. Retailers scrambled to order more merchandise, which jammed the ports and overloaded the trucking industry. By the time all the goods finally were delivered to distributors in 2022, consumers had pivoted away from binging on goods to purchasing a lot more services.

Now inventories seem to be more in line with demand. In current dollars, they’ve been flat since mid-2022, consistent with flat retail sales in current dollars (Fig. 12). So an inventory-led recession is less likely now.
 
Mixed News I: Corporate Cash Flow at a Record High. Thursday’s GDP report showed that after-tax profits as reported to the IRS fell 7.8% y/y during Q2-2023, but we think that might mark the bottom (Fig. 13). After-tax profits from current production fell 4.1% y/y over the same period. We refer to this series as “cash-flow profits” because it is adjusted for the historical cost basis used in profits tax accounting for inventory withdrawals and depreciation to the current cost measures used in GDP.

After-tax cash flow profits plus tax-reported depreciation edged up to $3.2 trillion (saar) during Q2-2023 (Fig. 14). This measure of corporate cash flow matched its record-high three quarters ago. This abundance of corporate cash flow following a very mild profits recession suggests that corporations have ample homegrown liquidity to avoid the adverse consequences of tightening credit conditions.
 
Mixed News II: Inflation Mostly Moderating. The bad news is that August’s PCED rose 0.4% m/m and 3.5% y/y. Excluding food and energy, it was up just 0.1% m/m but 3.9% y/y. We are especially encouraged to see that the headline and core PCED, both excluding rent, rose only 2.8% and 3.2% y/y through August (Fig. 15). We know that the rent inflation component of the PCED is heading lower based on indexes of current rents. On the other hand, the non-housing services component of the PCED has been stuck at a pace of around 4.5% y/y since late 2021 (Fig. 16). We expect that it will moderate along with wage inflation in the coming months.

Meanwhile, in July, there was deflation in the price deflators of goods sold by manufacturers (-4.1% y/y), wholesalers (-5.6%), and retailers (-0.3%) (Fig. 17). Such deflation is consistent with what occurred during past recessions. However, so far this time, the recession has been a rolling recession among goods producers and distributors rather than an economy-wide recession.
 
Mixed News III: Consumers Cooling. Consumers continued to spend more on services than on goods during August. The 0.1% increase in real personal consumption expenditures in August reflected an increase of 0.2% in spending on services and a decrease of 0.2% in spending on goods (Fig. 18). Within services, the leading contributors to the increase were transportation services (led by air transportation) and health care (led by hospitals and nursing homes). Within goods, the largest contributor to the decrease was motor vehicles and parts (led by new motor vehicles). We like these numbers because in our outlook consumer spending slows; it doesn’t fall.
 
Mixed News IV: Banks Lending Cautiously. Bank loans has stopped growing. The series is essentially unchanged over the past 18 weeks through the September 20 week. Over this same period, commercial & industrial (C&I) loans is down $99 billion. This sounds like bad news, but the other loans are up $74 billion collectively. In addition, the weakness in C&I loans reflects reduced demand because inventories have been holding steady, as noted above (Fig. 19).
 
Bad News I: Bond Vigilantes Are P.O.’d About Deficits. The September 30 WSJ features an article by Spencer Jakab titled “America’s Debt Problem Is Too Big for the Bond Vigilantes.” It discusses a festering problem that has come to the fore since Fitch Ratings downgraded US Treasuries on August 1. Simply put: The federal budget deficits are too d@mn wide!

In our August 8 Morning Briefing, we wrote: “The Bond Vigilantes may be turning more vigilant following the Fitch downgrade. They are happiest when the economy is weak and inflation is subdued. They are not so happy right now. ...

“Over the years, we’ve frequently been asked why we aren’t more concerned about the widening US federal government budget deficit. We’ve consistently responded that we will be concerned about it when the financial markets are concerned about it.

“We believe that supply and demand for bonds isn’t usually as important to the determination of the bond yield as are actual and expected inflation and the expectations of how the Fed will respond to them. So given that we expect inflation to continue to moderate, we currently predict that the bond yield won’t rise above 4.25%. If we are wrong about that, and the bond market has trouble financing the government’s huge deficits at current market interest rates, then the Bond Vigilantes will go wild. If that happens, head for the hills for the rest of the summer and maybe September too.”

We’ve been wrong about 4.25% because the Bond Vigilantes are mad as h€ll about profligate fiscal policy. They have no quarrel with the Fed’s tough monetary stance. But seeing the federal deficit widen so rapidly this year with no relief in sight has provoked the Wild Bunch.

We are still counting on falling inflation to stabilize the bond yield. In the August 22 Morning Briefing, we wrote that the bond yield has normalized, returning to where it had been during 2003-07, before the period of abnormally low interest rates from the Great Financial Crisis through the Great Virus Crisis. We concluded that “the 10-year nominal bond yield should be around 4.50%.”

In the past, the Bond Vigilantes didn’t care much about federal budget deficits because it was normal to see them widen during recessions when inflation was moderating and the Fed was easing. Now that the Bond Vigilantes do care about deficits, we care about deficits too. Indeed, the biggest risk to our optimistic outlook for the economy is that the Bond Vigilantes are about to send a very loud message to Washington: “Cut the deficits or we will raise bond yields until they cause a credit crunch and a recession.”

Bad News II: Round Up the Usual Suspects. There are lots of bricks in today’s wall of worry. Fed Chair Jerome Powell in his press conference on September 20 noted: “So there is a long list, and you hit some of them. But, you know, it’s the strike, it’s government shutdown, resumption of student loan payments, higher long-term rates, oil price shock.”

We are placing our bets on relatively happy outcomes over the next few weeks: The strike and the shutdown (in 45 days, maybe) are short. Employment and real wage gains support consumer spending, though at a slower pace than during Q3-2023. Bond yields and oil prices stabilize. Most importantly, core inflation continues to moderate. Wish us luck!

Movie. “A Good Person” (+ +) (link) is about dysfunctional people dealing with the adversities that life can deliver. There’s a terrible car accident, alcohol and drug addiction, and abusive fathers. So the movie is depressing, though it might be uplifting to be reminded that things aren’t all that bad in our own lives compared to the miserable fate that others suffer. The movie is slow and a bit long, but the acting performances of Florence Pugh and Morgan Freeman are superb and worthy of Oscars.

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Semis, Earnings & Musk’s Robot

September 28 (Thursday)

Technology: Everyone’s Making Semis. Large tech companies have been jumping into the semiconductor industry. Amazon, Google, Tesla, and others have developed semiconductors for use in their own operations instead of buying all of their semiconductors from Nvidia, Intel and the like. Custom-made chips tailored to their company’s specific requirements can perform better and are cheaper to make than buying other companies’ chips in the market.

In the case of AI server chips, companies undoubtedly are looking to save money by developing an alternative to Nvidia’s chips, which in the case of its A100 GPUs can sell for $20,000 to $25,000 each on eBay. The costs can add up quickly. OpenAI, for example, will need more than 30,000 of Nvidia’s A100 GPUs for the commercialization of ChatGPT, an April 18 article at TheVerge.com reported.

Here’s a look at the progress some tech companies are making in designing their own chips:

(1) Amazon chips in. Earlier this week, Amazon said it will invest up to $4 billion in Anthropic, an artificial intelligence (AI) firm with an AI chatbot called “Claude 2.” Anthropic will use Amazon Web Services (AWS) as its primary cloud provider, and it will use AWS-designed semiconductors when training the AI models on vast amounts of data.

Anthropic will use AWS Trainium and Inferentia chips to build, train, and deploy future foundation models. The two companies will also collaborate on the development of future Trinium and Inferentia technology. The two chips are considered a less expensive, more accessible alternative to Nvidia chips used for the same purposes.

Amazon jumpstarted its efforts in chip development in 2015 when it purchased Annapurna Labs, an Israeli startup. Since then, it has produced Graviton and Nitro, chips used in its servers. Now Amazon has an AI package to offer clients. In addition to Anthropic, Amazon can offer clients its Trainium and Inferentia chips; Titan, a large language model; and Bedrock, a service to help developers enhance software using generative AI. Some believe that having its own AI chips—which Microsoft does not have—will become a differentiator for Amazon, an excellent August 21 CNBC article on Amazon’s efforts reported.

(2) Google has AI chips too. Google has custom developed Tensor Processing Units, chips designed to accelerate machine learning tasks like image recognition, natural language processing, and predictive analysis. Only customers of Google Cloud access the chips.
 
Google has also developed Tensor chips for its Pixel phones in conjunction with Samsung. Google reportedly is working to design its first fully custom chipset, the Tensor G5, by 2025 without the aid of Samsung, a July 7 Tom’s Guide article reported. TSMC would handle the production of the chip.

(3) Tesla has Dojo. Tesla has built the Dojo chip to train AI networks in data centers. The chips are designed and built for “maximum performance, throughput and bandwidth at every granularity,” the company’s website states. The chips are used in the company’s Dojo supercomputer, first revealed in 2021, and used to train Tesla’s self-driving AI models. It can quickly analyze the company’s extensive video from its fleet of vehicles, a September 25 article on DriveTeslaCanada.ca reported. The system could also be used in robotics and other autonomous systems. Tesla uses Taiwan Semiconductor Manufacturing Co. to manufacture the Dojo chips and reportedly has doubled its order this year, the article stated.

(4) Meta & Microsoft in the mix. Microsoft is working on developing the Althena AI chip, which could replace Nvidia chips. The project, which began in 2019, reportedly will result in chips that will be made available to Microsoft and Open AI employees as soon as next year.
 
Meta is also working on a chip for its AI services. The Meta Training and Inference Accelerator—or MTIA chip—in combination with GPUs purportedly delivers better performance, decreased latency, and greater efficiency, a May 18 article at TheVerge.com reported. It’s not expected to come out until 2025.

(5) Semi industry performance data. The S&P 500 Semiconductors stock price index has risen 66.2% ytd through Tuesday’s close, though it’s down 11.5% from its record high on August 1 (Fig. 1). Nvidia has had a huge impact on the industry this year. Its shares have risen 188.9% ytd through Tuesday’s close. If the company were removed from the S&P 500 Semiconductors stock price index, the index would be up only 23.2% ytd.

Semiconductor stocks have rallied in advance of the rebound anticipated in revenues and earnings growth next year. The industry is expected to see its revenue growth flip from a decline of 2.1% this year to an increase of 17.4% in 2024 (Fig. 2). Likewise, earnings are expected to decline 7.5% this year but surge 37.0% in 2024 (Fig. 3). If Nvidia’s earnings were eliminated from the Semiconductors industry, the industry’s forward revenues growth rate would drop to 7.9% from 15.6% and its forward earnings growth drops to 20.6% from 35.5%.

The Semiconductors industry’s forward P/E peaked at 29.5 in mid-July, and it currently stands at 22.7 (Fig. 4). But as earnings rebound next year, the cyclical industry’s forward P/E should fall. If Nvidia’s forward P/E of 28.3 were eliminated from the calculation, the industry’s forward P/E would be only 19.0.

Strategy: Looking at 2024. You’d never know it by this week’s stock market performance, but analysts actually are quite optimistic about the S&P 500 companies’ earnings prospects in 2024. They’re collectively forecasting an 11.7% earnings increase next year, following flattish growth this year of a projected 1.1% and last year’s actual 7.1% increase.

Notably, earnings growth is expected for all 11 of the S&P 500’s sectors next year. Here’s the performance derby for Wall Street analysts’ consensus 2024 earnings forecasts for the S&P 500 and its 11 sectors: Communication Services (18.2%), Technology (15.3), Consumer Discretionary (15.1), Health Care (13.1), Industrials (13.1), S&P 500 (11.7), Utilities (8.6), Financials (8.5), Consumer Staples (7.4), Materials (6.1), Real Estate (3.6), and Energy (2.1) (Table 1).

Several of the industries expected to enjoy the strongest earnings growth in 2024 nonetheless have stock price indexes that have fallen ytd through Tuesday’s close. Here those industries are, ranked by their 2024 earnings growth forecasts: Property & Casualty Insurance (46.6% 2024 earnings growth forecast, -2% ytd return), Gold (38.3, -16.5), Investment Banking & Brokerage (30.8, -14.9), Aerospace & Defense (29.6, -12.2), Housewares & Specialties (26.8, -27.5), Copper (26.4, -3.8), Broadcasting (25.6, -9.9), Pharmaceuticals (23.6, -2.5), Home Furnishings (22.7, -17.0), and Reinsurance (22.5, -0.7).

Three industries from the Financials sector are expected to have an impressive earnings turnaround in 2024: Property & Casualty Insurance, Investment Banking & Brokerage, and Reinsurance. Some observers have been optimistic that recent IPOs from ARM and Instacart would signal the beginning of a new IPO cycle. The market selloff might squash this nascent optimism. Insurance industry analysts may be hopeful that the companies will be able to raise the premiums they charge in the wake of recent disasters. Stock investors don’t seem quite so sure.

The strong earnings expected for both the Copper and Gold industries stands in sharp contrast to the poor performance of their stock price indexes. As for the underlying commodities, the price of copper is down 4.7% ytd through Tuesday’s close, and the price of gold is up 4.6% ytd. The Gold industry contains the shares of Newmont Mining, which have been under pressure since the company offered to purchase Australian gold and copper miner Newcrest Mining for $17.5 billion.

Disruptive Technologies: Musk’s Neural Networks. While Elon Musk is best known for manufacturing electric cars and space rockets, he’s also juggling some smaller projects that are equally as interesting. They include developing human-like robots and mind-reading devices, both of which involve neural networks and both of which have made progress recently. Let’s take a look:

(1) Optimus grows up. Last weekend, Tesla released an impressive video on X (a.k.a. Twitter) of Optimus, its human-like robot. It showed Optimus using “vision” to pick up and sort small blocks. The robot has human-like fingers and moves smoothly, more like a human than a herky-jerky robot. When a human moved around the blocks, Optimus was able to react to the changes and continue sorting. When one of the blocks fell on its side, Optimus knew to set the block upright.

Optimus has a neural network, which is also used in AI and in Tesla’s autonomous cars. “A neural network is a method in artificial intelligence that teaches computers to process data in a way that is inspired by the human brain. It is a type of machine learning process, called deep learning, that uses interconnected nodes or neurons in a layered structure that resembles the human brain. It creates an adaptive system that computers use to learn from their mistakes and improve continuously. Thus, artificial neural networks attempt to solve complicated problems, like summarizing documents or recognizing faces, with greater accuracy,” explains the AWS website.

Tesla switched to using neural networks over the last year. Previously, Tesla’s Autopilot system was trained using a rules-based approach. The car’s camera would identify a red light, and its software program would create rules instructing it to stop at red lights.

Neural networks learn by watching “millions of examples of what humans have done … It’s like the way humans learn to speak and drive … [W]e might be given a set of rules to follow, but mainly we pick up the skills by observing how others do them,” explained Dhaval Shroff, a member of Tesla’s autopilot team in an excerpt from Water Isaacson’s Elon Musk biography. The Autopilot system is shown millions of videos of humans reacting properly to driving situations, which have been recorded by Tesla vehicles. By learning this way, the system reacts to unusual situations and breaks the rules when necessary, just as humans do when driving. The driving system based on neural networks is awaiting approval from regulators.

While no time has been given for Optimus’ release, it’s easy to imagine the robot working in Tesla factories; if the company slashed its labor costs as a result and passed the savings onto customers by lowering the price of a Tesla, it could gain a competitive advantage. Never one for humility, Musk said earlier this year that the “Optimus stuff is extremely underrated,” and demand could be as high as 10-20 billion units, a September 24 Electrek article reported. “He went as far as ‘confidently predicting’ that Optimus will account for ‘a majority of Tesla’s long-term value.’”

(2) Harnessing brain waves. Neural networks are something Musk is familiar with from another of his companies, Neuralink. It has developed a device that’s implanted in a monkey’s head and can transmit the monkey’s thoughts to a lever, allowing the monkey to play the “Pong” video game without ever touching a controller.

The brain’s neurons send information to different parts of the body. Neurons connect to each other in a neural network and communicate using chemical signals called neurotransmitters. “The reaction between different neurons will create an electric field, and these reactions can be recorded by placing neurotransmitters nearby. The electrodes will then translate these signals into an algorithm a computer can interpret,” explained November 2020 article published in Medium.

Neuralink received FDA approval in May to test its device on humans in a six-year trial that will evaluate whether the system can help those with paralysis control devices by using their thoughts. The PRIME (Precise Robotically Implanted Brain-Computer Interface) study is looking for people with quadriplegia due to vertical spinal cord injury or ALS who are over the age of 22 and have a consistent caregiver, a September 19 article at TheVerge.com reported. The brain device, a surgical robot that implants the device, and the user app each will be evaluated. Neuralink and Musk have come under criticism for Neuralink’s treatment of monkeys during the development of the product.

Some have speculated that the system could be used to treat conditions such as obesity, autism, depression, hearing loss, and schizophrenia. There are also reports that the device could be used to download a new language or stream music into your head. The company does face competition. Precision Neuroscience, formed by a Neuralink co-founder, has developed a thin piece of tape that sits on the brain’s surface, and Blackrock Neurotech implanted its first brain-computer interface back in 2004, noted a September 21 BBC article.

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Consumers, Earnings & MegaCap-8

September 27 (Wednesday)

Weekly Webcast. If you missed Tuesday’s live webcast, you can view a replay here.
 
US Consumers I: What’s Been Driving Them? The main reason that the US economy has dodged a recession so far is that payroll employment remains strong. It’s hard to have a recession when employment is rising to record highs month after month (Fig. 1). Employment gains have bolstered consumer spending. So too has inflation-adjusted average hourly earnings, which has been rising since the start of the year (Fig. 2).

As a result, consumers’ real disposable personal income has been on an upward trend since the start of the year (Fig. 3). During July, it was up 3.8% y/y and 3.5% above its January 2020 reading, just before the pandemic. However, it is still below its pre-pandemic trendline.

So with consumers’ real disposable income growing at a slower pace than it was before the pandemic, how is it that real personal consumption expenditures was at a record high in July? In fact, it hit a then-record high in early 2021 and has resumed its pre-pandemic upward trend since then.

The answer, of course, is that consumers’ high rates of saving during the pandemic supported their record-high spending pace afterwards. Inflation-adjusted personal saving soared along with real disposable income during the pandemic as Americans saved more of their earnings and much of the three rounds of pandemic relief checks (Fig. 4). That allowed them to save less and spend more as the pandemic abated, even as inflation eroded their disposable income from mid-2021 through mid-2022.

Since then, the pace of consumers’ real saving has stopped falling but remains low compared to their pre-pandemic real saving. But their rising real disposable income has provided consumers with the purchasing power to drive real consumer spending to record highs along the same upward trend as before the pandemic.

US Consumers II: Why Is Employment So Strong? The resilience of the labor market has been one of the main reasons why the widely expected recession has been a no-show since early last year. It was widely expected that the Fed’s aggressive tightening of monetary policy would reduce consumer demand and depress employment, which would further weigh on consumer spending. In his press conference last Wednesday, Powell frequently stated that the labor market is coming into balance, but he still described it as “very hot.” Why hasn’t it cooled off, and will it do so? Consider the following:

(1) Many industries at record highs. Payroll employment was at a record high in August because many of its components were at or near record highs in August, including the following: construction, heavy & civil engineering construction, transportation & warehousing, wholesale trade, food services & drinking places, professional & business services, financial activities, educational services, hospitals, ambulatory health care services, and social assistance.

(2) No recession in construction industry. Record highs in construction employment don’t happen during recessions (Fig. 5). Single-family housing starts have been in a recession since early last year (Fig. 6). However, multi-family starts remained strong until they plunged in August. The result has been that construction employment in the residential building sector rose to a record high in August (Fig. 7).

Construction employment in the nonresidential building industry also rose to a record high in August, boosted by more spending by manufacturers on onshoring and by the government on infrastructure (Fig. 8).

(3) Online shopping is booming. Retail sales, excluding food services and online retail sales, has been relatively flat since May 2022 (Fig. 9). On the other hand, online shopping, which soared to record highs during the pandemic, has continued to do so (Fig. 10). Such sales on a per-household basis and at an annual rate have doubled from about $5,000 just before the pandemic to almost $10,000 currently (Fig. 11).

Over this same period, employment in warehousing and storage (i.e., mostly fulfillment centers for online retailers) has increased by more than 500,000, while employment in retail trade has been flat (Fig. 12).

(4) Baby Boomers dining out and visiting healthcare providers. Americans are going to restaurants in record numbers since the end of the pandemic. That’s resulted in a big increase in employment in food services & drinking places (Fig. 13).

Many of the Baby Boomers no longer have their children at home, and more of them are retiring with ample nest eggs. That explains the strength in restaurant sales and employment. The aging of the Baby Boomers also explains why employment in healthcare is booming, as older people tend to visit healthcare providers more often than younger ones (Fig. 14).

(5) The bottom line. Some of the post-pandemic strength in payroll employment is attributable to the abatement of the pandemic itself. Some is also related to more structural developments, including onshoring of manufacturing and the aging of the Baby Boomers. The labor market is showing some signs of cooling, but it is likely to remain a source of jobs and economic strength. In our opinion, that doesn’t mean that the Fed must continue to raise interest rates to subdue inflation. They are high and restrictive enough to do the job. Besides, the inflation shocks attributable to the pandemic are also abating.
 
Earnings I: With & Without MegaCap-8. During 2022, the collective revenues and earnings growth rates of the MegaCap-8 stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) sagged considerably after surging for pandemic-related reasons during 2021. Quarterly revenues growth last year remained positive on a y/y basis but dropped to single-digit percentage rates. Earnings fared much worse, falling y/y for four straight quarters through Q1-2023. However, Q2 was a notable turning point for the MegaCap-8’s earnings and revenues growth. And both are expected to improve further in Q3, as Joe shows below:

(1) Q2 revenue and earnings results. During Q2-2023, the MegaCap-8’s collective y/y revenues growth reaccelerated to double-digit percentages, and its earnings growth turned positive for the first time in five quarters. The MegaCap-8’s revenues rose 10.2% y/y in Q2-2023 following a 4.6% rise in Q1-2023, and the group’s earnings jumped 29.7% y/y after declining 3.1% in Q1. In stark contrast, the S&P 500’s revenues growth slowed to 1.2% y/y during Q2-2023 from 4.6% in Q1, while its y/y earnings decline slowed to -0.4% on a proforma basis from -4.9% in Q1.

When we exclude the MegaCap-8 from the S&P 500, Q2-2023’s y/y growth metrics were substantially weaker for revenues and earnings. S&P 500 revenues growth without the MegaCap-8 fell to an anemic 0.2% y/y in Q2-2023 from 1.2%, and the y/y earnings decline worsened to -5.1% from -0.4%.

(2) Q3’s outlook for revenue and earnings growth. Looking ahead to Q3-2023, analysts collectively expect the S&P 500 companies’ aggregate y/y revenues growth rate to slow to a 0.8% crawl from 1.2% in Q2, and for earnings to drop 1.6% y/y following a 0.4% decrease in Q2. But they hold shining expectations for the MegaCap-8’s Q3 revenues growth, which they see accelerating to 11.1% y/y from 10.2% in Q2, and for the group’s earnings growth, projecting a jump to 39.1% from 29.7%. The former would be the strongest revenues growth the MegaCap-8 has experienced since Q1-2022, and the latter would be its best earnings growth since Q3-2021!

Looking at the Q3 revenues and earnings growth predicted for the S&P 500 minus the boosts provided by the MegaCap-8 is a sorry sight. Without these eight stocks, revenues would be expected to decline 0.4% y/y in Q3, compared to a 0.2% gain in Q2, and the earnings decline projected in Q3 would deepen from Q2’s decline, to -7.6% from -1.6%. If those forecasts come to pass, it would be the first revenue decline for the S&P 500 ex-MegaCap-8 since Q4-2020 and the third straight quarterly decline in earnings.

Earnings II: With & Without Energy. During 2023, the S&P 500 Energy sector’s revenues and earnings growth has tumbled deep into negative territory following the cyclically high double- and triple-digit percentage increases of 2022. Energy’s revenues growth turned negative in Q1-2023 and worsened in Q2, while the sector’s earnings growth turned negative on a y/y basis in Q2. However, analysts expect Q3 to be less bad for the Energy sector, and the S&P 500’s ex-Energy earnings results are expected to improve considerably, as Joe shows below:

(1) Q2 revenue and earnings results. During Q2-2023, Energy’s percentage y/y revenue decline worsened to -28.9% from 5.2% in Q1, and the sector’s earnings tumbled 47.7% y/y after rising 21.0% in Q1. This dragged down the S&P 500’s revenues growth to 1.2% y/y during Q2-2023 from 4.6% in Q1, while its y/y earnings decline slowed to -0.4% on a proforma basis from -4.9% in Q1.

When we exclude the Energy sector from the S&P 500, Q2-2023’s y/y growth metrics for revenues become substantially stronger and earnings growth actually turns positive. S&P 500 revenues growth without Energy jumps to 4.4% y/y in Q2-2023 from 1.2% with Energy, and the y/y earnings decline of 0.4% turns into a gain of 3.6%.

(2) Q3’s outlook for revenue and earnings growth without Energy. As mentioned above, the S&P 500’s y/y revenues growth rate is expected to slow to 0.8% in Q3 from 1.2% in Q2, and its earnings aren’t expected to grow at all y/y but to decline 1.6% versus a 0.4% decline in Q2. Analysts think that the worst is past for the Energy sector and that Q2 marked the worst of the y/y comparisons. They still expect revenues and earnings to fall on a y/y basis in Q3, but less so, as oil prices are recovering now, and consensus forecast declines have given way to upward revisions in recent weeks.

Analysts are calling for Energy’s revenues decline to lessen to 22.5% y/y in Q3 from -28.9% in Q2, and for the sector’s earnings growth to jump to 39.1% from 29.7%. The S&P 500’s revenue and earnings growth predictions are markedly better without the Energy sector: Revenues are expected to rise 3.4% y/y in Q3 compared to a 4.4% gain in Q2, and the earnings increase picks up to 6.7% without Energy from 3.6% in Q2. If those forecasts come to pass, the S&P 500 ex-Energy’s revenues growth rate will be positive yet again, and earnings growth would be positive for a second straight quarter after being negative for four quarters through Q1-2023.

On a brighter note, earnings seasons typically deliver an upside surprise for revenues and earnings. Just how much of a surprise, and whether the S&P 500’s earnings growth will be positive on a y/y basis instead of falling, the coming weeks will tell. This year’s quarters so far have pleasantly surprised, and we think Q3 will too.

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Is Powell’s Path Forward Widening Or Narrowing?

September 26 (Tuesday)

YRI Weekly Webcast. This week, join Dr. Ed’s live webcast with Q&A on Tuesday, September 26, at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Credit I: Is Federal Funds Rate a Leading Indicator? Let’s say that the Fed is done raising the federal funds rate (FFR) for now. So far, so good: There hasn’t been a recession during this round of tightening. However, proponents of a hard-landing economic outlook observe that the FFR peaked before the last four recessions, implying that the peak might be a leading indicator of recession (Fig. 1).

It clearly was not a leading indicator of recessions during the 1970s and 1980s; it was a coincident indicator of the four recessions back then.

The soft-landers, including Debbie and me, observe that past peaks in the federal funds rate coincided with financial crises that were attributable to the tightening of monetary policy (Fig. 2). So the FFR actually was a coincident indicator of financial crises. The crises caused the Fed either to ease monetary policy or at least to pause its tightening until the financial crises morphed into widespread credit crunches that caused recessions.

This time so far, there has been a financial crisis that occurred in March, but the Fed contained it quickly. It didn’t precipitate a credit crunch, so there hasn’t been a recession.

Where are we now? The Fed has raised the FFR very aggressively, by 525bps, since March 2022. There have been 13 FOMC meetings since then. The Fed paused its rate hiking only twice so far, and that was at last week’s meeting and back in June (Fig. 3). Fed officials have said that there might be more rate hikes ahead if economic growth doesn’t slow and if inflation doesn’t continue to fall toward the Fed’s 2.0% target.

Even if both conditions occur, Fed officials have indicated that they will be in no rush to lower interest rates. Indeed, at last week’s FOMC meeting, the committee’s median forecast for the FFR in 2024 was changed from four rate cuts to two of them, totaling 50bps rather than 100bps.

If the Fed is done raising the FFR but keeps it at the current level for a prolonged period through 2024, that still would be a restrictive stance for monetary policy. In our opinion, that would be preferable to more rate hikes, which would increase the chance of something breaking in the financial market.

During his presser last week, Powell was asked by one of the reporters: “Would you call the soft landing now a baseline expectation?” Powell responded saying: “No, no. I would not do that. … I’ve always thought that the soft landing was a plausible outcome, that there was a path, really, to a soft landing. … I’ve said that since we lifted off. It’s also possible that the path is narrowed, and it’s widened apparently. Ultimately, this may be decided by factors that are outside our control at the end of the day. But I do think it’s possible.”

So a soft landing isn’t Powell’s baseline scenario; but it is still possible, and the path to it might have widened. The reporter was right to ask whether a soft landing is the Fed’s baseline since the FOMC’s Summary of Economic Projections (SEP) released last week maps out a soft-landing scenario:

(1) The latest SEP shows headline PCED inflation continuing to moderate from 3.3% this year to 2.5% next year, 2.2% in 2025, and 2.0% in 2026. That’s nearly identical to the path projected in June’s SEP.

(2) The committee boosted this year’s estimated real GDP growth rate from 1.0% to 2.1% and next year’s from 1.1% to 1.5%. As a result, the trajectory of the unemployment rate was lowered to 3.8% this year from 4.1% and to 4.1% next year from 4.5%.

(3) Last Thursday, we wrote: “It all adds up to a soft-landing scenario. Skeptics undoubtedly will claim that the Fed is always wrong, so a hard landing is an even more likely outcome. We are siding with the Fed. We think they’ve done a very good job so far. They’ve been guiding the markets to expect higher-for-longer interest rates since last year. Now they are guiding markets to expect that the Fed will hold the federal funds rate for longer. That’s a better way to keep monetary policy restrictive without raising the federal funds rate further (or much further). This approach reduces the chances of a financial crisis and credit crunch, in our opinion.”

(4) Powell mentioned and was asked about “external factors” that might possibly determine whether the economy experiences a soft or hard landing. He responded to the question as follows: “So there is a long list, and you hit some of them. But, you know, it’s the strike, it’s government shutdown, resumption of student loan payments, higher long-term rates, oil price shock. You know, there are a lot of things that you can look at. And, you know, so what we try to do is assess all of them and handicap all of them. And ultimately, though, there’s so much uncertainty around these things.”

He concluded his answer by noting that the economy has “significant momentum ... but we do have this collection of risks.”

Credit II: Cracks in Commercial Real Estate. Powell did not discuss the biggest risk of them all, namely that restrictive monetary policy could still trigger a financial crisis even if the Fed stops raising interest rates but maintains the FFR at the current level. It is widely recognized that there are long and variable lags between the tightening of monetary policy and its impact on the financial system and the economy.

Currently, our main concern is that the rolling recession is rolling into the commercial real estate (CRE) market, which tends to be highly leveraged. So CRE debt had been (during the S&L crisis of the late 1980s and early 1990s) and once again could be the epicenter of a financial crisis that could morph into a credit crunch and cause an economy-wide recession. Accordingly, Melissa and I are watching it closely. Consider the following:

(1) Most of the focus in the financial press has been on old office buildings in urban areas. They were hard hit by the pandemic when many workers worked from home. Many of those workers continued to work from home after the pandemic or went to their offices on a part-time basis, which reduced the amount of space that companies needed for their offices. Now many of those office buildings have lots of vacancies and face more as leases expire. Building owners must lower rents to keep or attract tenants. And now, many of the loans taken out to purchase the buildings will have to be refinanced at much higher interest rates. There are already delinquencies in the space and more to come.

(2) Of course, the issue of refinancing debt at much higher interest rates isn’t a problem just for old office buildings but for all commercial real estate with debts that are coming due. That makes it a problem for their lenders. During the September 13 week, commercial banks held $2.9 trillion in CRE loans (Fig. 4). Large banks had $0.9 trillion, while small banks had $2.0 trillion. So the smaller banks are especially vulnerable to loan losses.

Commercial banks had $484 billion in construction and land development loans during the September 13 week. Large and small banks had $133 billion and $337 billion of them, respectively (Fig. 5).

CRE loans secured by nonfarm nonresidential properties totaled $1.8 trillion during the September 13 week. The large banks and small banks held $0.5 trillion and $1.2 trillion (Fig. 6).

(3) Also vulnerable to refinancing risk are CRE loans secured by multi-family residential properties. They totaled $580 billion during the September 13 week, with $232 billion at the large banks and $328 billion at the small ones (Fig. 7). We noticed that multi-family housing starts dropped 26.3% m/m during August (Fig. 8). Here is what happened regionally last month: Northeast (+4.9), Midwest (+3.9), South (-34.6), and West (-32.6) (Fig. 9).

August’s weakness in multi-family starts might have been a fluke or it might be signaling that this CRE sector has overbuilt (especially down South and out West), as evidenced by rapidly declining rent inflation on new leases, while financing rates have soared (Fig. 10). In other words, the math may no longer work for the multi-family sector of the CRE market.

Credit III: Fed’s Assessment of CRE Risk. The path to a soft landing has “widened apparently,” according to Fed Chair Jerome Powell, as we noted above. We aren’t quite so sure, which is why we raised our subjective odds of a hard landing from 15% to 25% in the September 18 issue of our Morning Briefing. In other words, we think the path may be narrowing. Our main concern is profligate fiscal policy. It is causing mounting federal deficits that could keep bond yields at levels that stress out many borrowers who must refinance their debts at much higher interest rates. This is certainly a problem in the CRE market.

The Fed’s May 2023 Financial Stability Report included a review of the CRE credit market. After we read it, we concluded that troubles in that market shouldn’t cause an economy-wide credit crunch and a recession. We still think so, but we are on alert. The report observed:

“The shift toward telework in many industries has dramatically reduced demand for office space, which could lead to a correction in the values of office buildings and downtown retail properties that largely depend on office workers. Moreover, the rise in interest rates over the past year increases the risk that CRE mortgage borrowers will not be able to refinance their loans when the loans reach the end of their term. With CRE valuations remaining elevated (see Section 1, Asset Valuations), the magnitude of a correction in property values could be sizable and therefore could lead to credit losses by holders of CRE debt.”

For more of our analysis of the Fed’s report, see the July 24 issue of our Morning Briefing titled “Rolling Recession Rolling Over Commercial Real Estate.”

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Money & Credit: Debatable Points

September 25 (Monday)

YRI Weekly Webcast. This week, join Dr. Ed’s live webcast with Q&A on Tuesday, September 26, at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Money I: The Velocity Myth. Among the debating points proffered by the proponents of the hard-landing economic outlook since last year is that the M2 monetary aggregate has been falling since it peaked at a record high of $21.7 trillion in July 2022 (Fig. 1). It is down $801 billion since then through July of this year. They’ve observed that on a yearly percent change basis, it turned negative for the first time ever in December 2022; the data series is available since 1959 (Fig. 2). In July, it was down 3.7%.

On an inflation-adjusted basis, using the CPI as the deflator, real M2 peaked in December 2021 and fell 11.5% through July (Fig. 3). On a yearly percent change basis, it turned negative in April 2022 and was down 6.7% in July (Fig. 4).

The flaw in this hard-landing argument is the assumption that M2 and GDP are correlated. We point out that nominal and real GDP were up 6.1% y/y and 2.5%, respectively, during Q2-2023 (Fig. 5 and Fig. 6). This suggests that any correlation between M2 and GDP is debatable. Consider the following:

(1) Velocity is a fudge factor. It is widely believed that the growth rate of nominal (real) GDP is determined by the growth rate of nominal (real M2) multiplied by the velocity of money. That’s a myth because velocity is a meaningless residual variable that is calculated as the ratio of nominal GDP divided by M2 (Fig. 7).

There is no predictable relationship between M2 and GDP, in either nominal or real terms—because V is unpredictable. V was relatively stable and predictable from the 1960s through the late 1980s. Then it rose through the mid-1990s and mostly fell since then through the pandemic. It has been rising over the past seven quarters through Q2.

The quantity theory of money posits that M2 x V = GDP, in current dollars. From our perspective, this isn’t a theory at all; it is a meaningless tautology!

(2) Before M2 fell, it soared. The recent decline in M2 seems much less alarming when we recall that it soared during the pandemic because it was boosted by three rounds of pandemic relief checks dropped by the US Treasury into the deposit accounts of millions of Americans. In addition, many Americans saved more in the liquid assets included in M2 because they couldn’t spend much of their incomes during the pandemic lockdowns; they continued to save more for a while after that point for precautionary reasons. Indeed, the 12-month change in M2 has tracked the 12-month sum of personal saving very closely since the start of the pandemic (Fig. 8).

M2 soared by $6.3 trillion from January 2020 (just before the pandemic) to its record high on July 2022. It then fell $801 billion, as noted above. Our opinion is that it is simply falling back to its pre-pandemic upward trendline. In July, we reckon it was still about $3 trillion above that trendline. Meanwhile, M2 has been flat since May. The weekly commercial bank deposits series, which closely tracks M2, has been relatively flat for the past 24 weeks through the September 13 week (Fig. 9).
 
Money II: The Excess Saving Myth. The hard-landers have also been claiming that the reason that they have been wrong since early last year is that consumers have been holding the economy aloft by spending their excess saving accrued during the pandemic, which will soon be depleted. So a consumer-led recession is imminent, they figure.

They observe that personal saving soared during the pandemic years well above the pre-pandemic pace. It then fell below that pace. They claim that the excess saving with which consumers were left after the pandemic now mostly has been spent, as saving has fallen below the pre-pandemic pace since mid-2021. Presumably, consumers’ spending on goods and services will take a dive, probably soon when the excess saving is gone and the pace of saving returns to its pre-pandemic trend.

The hard-lander’s narrative seems to make sense, but it might be nonsense. There are good reasons to believe that consumer spending is not about to retrench. Consider the following:

(1) The sum of total deposits at all commercial banks plus money market mutual funds (MMMFs) jumped $2.8 trillion during the lockdowns from the last week of February 2020 through the last week of April 2020 (Fig. 10). This series has continued to climb to a record $22.9 trillion through the September 13 week. It is well above its pre-pandemic uptrend. Of course, consumers aren’t the only holders of these assets, but the sum of deposits plus MMMFs suggests that there is still plenty of excess saving that hasn’t been spent by consumers and may remain in liquid assets, especially now that the yields on deposits and money market securities are so high!

(2) The net worth of the household sector rose to a record $154.3 trillion at the end of Q2-2023 (Fig. 11). It is up a whopping $37.6 trillion since Q4-2019, just before the pandemic. There’s no pressing need for consumers to save more than they’ve been saving recently, in our opinion. There tends to be an inverse relationship between the personal saving rate and household net worth as a percentage of disposable personal income (DPI) (Fig. 12).

(3) Prior to the pandemic, the main driver of real personal consumption expenditures was real DPI (Fig. 13). During the pandemic years (2020 and early 2021), pandemic relief checks boosted real DPI, while consumption didn’t recover back to its pre-pandemic trend until mid-2021. Real DPI fell during most of 2021 and early 2022, but real consumer spending resumed its pre-pandemic upward trend because households saved less. Meanwhile, real DPI has been rising again since early 2022.

So in reality, consumers saved less of their real DPI to bolster their spending on goods and services when real DPI was falling. They could afford to do so because they enjoyed a huge windfall from the “helicopter money” dropped by the government in their accounts, much of which still seems to be sitting in liquid assets. They also enjoyed gains again in their stock portfolios since October of last year, while their home values remained elevated despite rising mortgage rates. So now there is no pressing need for consumers to boost their saving rate back to where it was just before the pandemic (i.e., at 9.1% during January 2020 from 3.5% during July 2023).

(4) The bottom line is that a significant portion of the pandemic relief checks might remain in consumers’ net worth. They saved rather than spent quite a bit of their so-called excess saving. Then when their DPI fell, they saved less of it, so their spending actually rose. Now growing DPI is supporting consumption without any compelling reason for consumers to save more of it.

Credit I: No-Show Credit Crunch Despite Inverted Yield Curve. The inverted yield curve has also been a favorite debating point of the hard-landers. The yield-curve spread between the 10-year US Treasury bond yield and the federal funds rate is one of the 10 components of the Index of Leading Economic Indicators (LEI) (Fig. 14). It has contributed to the decline in the LEI, which peaked at a record high in December 2021 and has been falling since then through July. The yield curve has been inverted since December 2022.

Yet so far, the inverted yield curve hasn’t correctly predicted a credit crunch, which is what caused previous recessions. So far, the credit crunch has been a no-show, just like the Godot recession. The inverted yield curve did correctly predict a financial crisis, which occurred in the banking system during March. But the Fed whacked that mole by quickly providing an emergency lending facility for the banking system.

So while the hard-landers still argue that Godot soon will make a belated entrance on stage, the Index of Coincident Economic Indicators (CEI) suggests not: It rose 0.2% m/m in August to yet another record high (Fig. 15). It tracks the y/y growth rate of real GDP closely. The former was up 1.4% y/y in July, while real GDP was up 2.5% y/y through Q2 (Fig. 16).

Meanwhile, the yield curve has been disinverting. From a daily perspective, the yield-curve spread between the 10-year and 2-year Treasuries narrowed to -66bps on Friday from a low of -108bps on July 3 (Fig. 17). That’s because the economic outlook currently appears to be “stronger for longer,” which is why Fed officials have been promoting a higher-for-longer outlook for the federal funds rate.

By the way, Melissa and I literally “wrote the book” on the yield curve in 2019; it’s titled The Yield Curve: What Is It Really Predicting? You can download a pdf of it at the provided link.

Credit II: Banks Lending As Usual. Notwithstanding the above, Melissa and I are on full alert watching for a credit crunch in the weekly balance-sheet data on the commercial banking system provided by the Fed. So far, so good. Keep in mind that commercial and industrial (C&I) loans at the banks is a component of the Index of Lagging Economic Indicators. In any event, here are our observations on the latest data, through September 13:

(1) All loans and leases rose 4.4% y/y through the September 13 week, down from a recent peak of 12.2% during the October 26, 2022 week (Fig. 18). The slowdown is widespread among the four major loan categories, and especially noticeable for C&I loans, which are up just 0.1% y/y (Fig. 19). Might this weakness signal a credit crunch? More likely is that it is coinciding with the business inventory cycle, especially for retailers that had to discount unsold merchandise late last year to clear it out of their stores (Fig. 20).

(2) Interestingly, commercial real estate loans were still up 7.3% y/y during the September 13 week to a record high of $2.9 trillion (Fig. 21). Nevertheless, we still believe that the commercial real estate (CRE) market is getting hit with a rolling recession. It is likely to be quite severe and spread beyond old urban office buildings as CRE borrowers are forced to refinance their properties at much higher interest rates. A glut of new multi-family residential housing is depressing rents and could cause distress in this sector of the CRE market. We note that multi-family housing starts dropped sharply in August.

(3) The only bit of bank loan data that, taken alone, could be construed as a sign of a credit crunch so far is that auto loans are down 2.2% y/y (Fig. 22). But credit card and other revolving plans are up by a much greater 10.8% y/y.

Movie. “Golda” (+ + +) (link) is a docudrama about Golda Meir, when she led Israel as prime minister during the Yom Kippur War in 1973. Helen Mirren does an incredibly good job in the lead role. The movie depicts Israel’s existential crisis attributable to the war and Golda’s adroit management of the near calamity. Israel succeeded in winning the war, which started with a surprise attack by a coalition of Arab states led by Egypt and Syria. Golda agreed to a ceasefire with Egyptian President Anwar Sadat. She lived to see the signing of the Camp David Accords in 1978. It was the first formal peace agreement between Israel and its Arab neighbors.

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The Fed, The Deficit & Earnings

September 21 (Thursday)

The Fed: Holding for Longer. The FOMC’s latest Summary of Economic Projections (SEP) shows that the median forecast for the federal funds rate (FFR) for 2023 is 5.6%, unchanged from June’s SEP. The 2024 forecast was raised to 5.1% from 4.6%. As we expected, the FOMC’s message is that the FFR might be lowered next year by 50bps rather than 100bps.

The latest SEP shows headline PCED inflation continuing to moderate from 3.3% this year to 2.5% next year, 2.2% in 2025, and 2.0% in 2026. That’s nearly identical to the path projected in June’s SEP.

So why did the committee raise the FFR trajectory to holding-for-longer? The economy has been stronger than expected. The committee boosted this year’s estimated real GDP growth rate from 1.0% to 2.1% and next year’s from 1.1% to 1.5%. As a result, the trajectory of the unemployment rate was lowered to 3.8% this year from 4.1% and to 4.1% next year from 4.5%.

It all adds up to a soft-landing scenario. Skeptics undoubtedly will claim that the Fed is always wrong, so a hard landing is an even more likely outcome. We are siding with the Fed. We think they’ve done a very good job so far. They’ve been guiding the markets to expect higher-for-longer interest rates since last year. Now they are guiding markets to expect that the Fed will hold the federal funds rate for longer. That’s a better way to keep monetary policy restrictive without raising the federal funds rate further (or much further). This approach reduces the chances of a financial crisis and credit crunch, in our opinion.

Bond and stock prices were hit hard yesterday. We did warn you that September isn’t over. Now that the FOMC’s blackout period has ended, we can expect more hawkish squawking from Fed officials. The only good news yesterday was that the price of oil also was knocked down.
 
US Budget Deficit: More To Come. It is widely assumed that the recent widening of the federal deficit is mainly attributable to the spending programs enacted by the Biden administration during 2022. In fact, the recent widening is mainly attributable to inflation, which has boosted federal government outlays on Social Security and net interest. The biggest contributor to the bulging deficit has been a decline in individual income tax revenues during the current fiscal year after they were boosted last year when investors sold lots of their stocks that had capital gains during the 2022 bear market. They paid lots of capital gains taxes.

So outlays will get boosted even more in coming years by all the spending Congress approved last year. To monitor this development, Debbie and I are tracking total outlays excluding spending on the major entitlement programs, defense, and net interest: Here is what the data show so far:

(1) Federal government outlays totaled $6.4 trillion over the past 12 months through August. Also on a 12-month basis, the sum of outlays on Social Security, Medicare, health, income security, defense, and net interest was $5.3 trillion (Fig. 1 and Fig. 2).

The difference between total outlays and the sum of the nondiscretionary spending categories listed above (including defense) is mostly attributable to discretionary spending on goods and services (Fig. 3). This series has been too noisy since the pandemic to be useful for our purposes.

(2) On a quarterly basis, we can track federal government spending on goods and service in nominal GDP to assess when Biden’s spending spree will hit the economy (Fig. 4). This series did rise 6.0% y/y during Q2 with more to come. By the way, federal government outlays on income redistribution account for 74.6% of total federal outlays during Q2 (Fig. 5).
 
Earnings: A Sweeter Outlook for Q3 Earnings Growth. Joe has been tracking the quarterly earnings forecast for S&P 500 companies collectively each week since the series started in Q1-1994. Each reporting season brings a typical playbook: Industry analysts cut their estimates gradually until reality sets in during the final month of the quarter, when some companies warn of weaker results. The combination of falling forecasts for companies that have underperformed earlier expectations, steady forecasts for those holding good news close to their vests, and insufficient estimate increases so close to reporting time to balance out the lowered expectations invariably creates an “earnings hook” pattern in the charted estimate/actual data as reported earnings exceed the latest estimates—i.e., a positive earnings surprise. In other words, the final month of quarters usually sets the stage for better-than-expected earnings reports.

That’s what usually happens, but the upcoming Q3-2023 earnings season has marked a departure in the data trend: Analysts have raised their estimates on a net basis over the course of the quarter so far.

Let’s recap briefly what brought us to this point: The strong earnings recovery following the Great Virus Crisis (GVC) had analysts scrambling to raise their forecasts for six straight quarters from Q2-2020 through Q3-2021, and not even coming close to catching up to the actual earnings results. The S&P 500 recorded unusually high double-digit percentage earnings beats for the first time since the aftermath of the Great Financial Crisis (GFC) during 2009-10.

The tide turned after Q1-2022, and y/y earnings growth has been slightly negative for three straight quarters through Q2-2023. The latest earnings downturn has been largely a mild profits recession, as revenue growth has remained positive throughout. But signs of a turnaround have emerged recently, as analysts’ earnings estimates have increased over the course of the quarter, not decreased as usual, and they now expect a return to positive y/y earnings growth in Q3-2023.

Below, Joe separates the good news in what the data tells us from the bad news:

(1) Q3 marks departure from quarters of estimate cutting. After falling slightly during H1-2022, the pace of estimate declines for the S&P 500 throughout the quarter accelerated in Q3-2022, when the estimate dropped 6.6%. Declines remained elevated during Q4-2022 and Q1-2023, abated for Q2-2023, and now have turned into a gain for Q3-2023. Specifically, the Q4-2022 estimate was down 5.9% during the runup to its earnings season, followed by a similar 6.2% in Q1-2023, then just 2.5% in Q2-2023. With two weeks left before the end of Q3-2023, the S&P 500’s Q3 estimate has risen 0.3% so far.

Q3-2023’s estimate gain is the first in seven quarters and the largest since Q3-2021. If the gain holds until the end of September, it would only be the 21st time that has occurred in the 118 quarters dating back to Q2-1994.

(2) Most S&P 500 sectors have rising Q3 estimates now. Analysts had been too bullish and overestimated the length of the post-GVC boom in earnings, resulting in very broad quarterly earnings declines at the sector level during their runup to the earnings seasons through Q1-2023. At the peak of optimism in Q2-2021, nine of the 11 sectors had their quarterly estimate rise during the quarter. By Q1-2022, that count was down to five sectors (Energy, Financials, Real Estate, Tech, and Utilities) before dwindling to just one sector during Q3-2022 (Energy), Q4-2022 (Utilities), and Q1-2023 (Utilities). During Q2-2023, the count recovered to four sectors and it has further improved to six sectors as of the September 14 week (Fig. 6).

Among the six sectors with gains, Consumer Discretionary’s Q3-2023 earnings estimate has risen 5.7% since the end of Q2-2023, ahead of Communication Services (4.7%), Information Technology (4.0), Energy (2.1), Real Estate (1.3), and Financials (1.1). Analysts who read the recession memo earlier this year since have tossed it into the recycle bin, reversing course to play catch-up, especially in the Energy, Financials, and Real Estate sectors.

Among the weakest sectors, here's how much their collective Q3-2023 estimate has changed over the course of the quarter: Materials (-12.0%), Utilities (-4.2), Industrials (-4.1), Consumer Staples (-3.4), and Health Care (-2.1).

(3) Seven sectors to show y/y growth in Q3-2023. Seven sectors are expected to record positive y/y percentage earnings growth in Q3-2023, unchanged from Q2-2023’s count, but five of the seven are expected to record double-digit percentage gains. That’s up from three sectors with double-digit gains in Q2-2023. With 34.5% expected y/y growth for Q3-2023, Communication Services is well ahead of Consumer Discretionary (22.2%), Financials (15.3), Utilities (13.1), Industrials (10.3), Information Technology (5.6), and Consumer Staples (1.4).

Along with the large number of sectors with double-digit positive percentage y/y growth, analysts now expect the S&P 500’s earnings growth rate to be positive on a frozen actual basis for the first time in four quarters. They expect 0.1% y/y growth in Q3-2023, up from -5.4% y/y in Q2-2023, -3.1% in Q1-2023, and -1.5% in Q4-2022. On a pro forma basis, they expect earnings to rise 1.9% in Q3-2023. That compares to a 2.9% decline in Q2-2023, a 0.1% gain in Q1-2023, and a 3.2% decline in Q4-2022. When the dust finally clears on the Q3 earnings reports, we think y/y growth will settle around 3.5%.

(4) Energy remains a drag on overall S&P 500 earnings. Looking at the data without the Energy sector is telling as well. On an ex-Energy-sector basis, S&P 500 earnings are expected to rise 7.3% in Q3 for its second straight gain and its biggest since Q4-2021. That compares to a 3.6% rise in Q2, a 1.6% decline in Q1-2023, and the 7.4% drop in Q4-2022. The typical earnings surprise hook again in Q3 could easily result in double-digit percentage y/y growth for the S&P 500 ex-Energy on a pro forma basis. Here's the four sectors expected to report a y/y earnings decline in Q3: Energy (-37.0%), Materials (-20.2), Health Care (-9.6), and Real Estate (-6.8).

(5) Y/Y growth streaks: winners and losers. In Q3-2023, the S&P 500 is expected to break its three-quarter string of y/y earnings declines on a frozen actual basis. The Industrials sector remains on a strong positive earnings growth path, with Q3-2023 on track for its 10th straight quarter of growth. Consumer Staples and Financials are expected to rise for a third straight quarter, followed by two quarters of growth for Communication Services and Information Technology. Materials is expected to mark its fifth straight y/y decline in quarterly earnings, followed by Health Care at four quarters (Fig. 7).

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What’s Up With Earnings?

September 20 (Wednesday)

Earnings I: The Revenues Story. Joe reports that S&P has released Q2 revenues data for the S&P 500. S&P also compiles comparable earnings series. While for our purposes, Joe and I prefer to monitor the operating earnings-per-share data compiled by I/B/E/S, let’s review the S&P data, starting with revenues then proceeding to earnings:

(1) S&P 500 revenues per share & inflation. There has been no recession in S&P 500 revenues per share since the first half of 2020, when the pandemic lockdowns caused a 14.6% drop in this series from Q4-2019 through Q2-2020 (Fig. 1). Back then, it bottomed at $315.61 per share. Since then, it is up 46.4% through Q2-2023 to a record $462.16 per share.

S&P 500 revenues per share was up 7.1% y/y through Q2-2023 (Fig. 2). Of course, business sales have been boosted by rapidly rising inflation since late 2021. Inflation-adjusted S&P 500 revenues (using the GDP deflator) is up 25.9% since it bottomed in Q2-2020 and up 3.4% y/y through Q2-2023 (Fig. 3).

While S&P 500 revenues per share rose 7.1% y/y, aggregate revenues rose 6.1% y/y (Fig. 4). Joe derives the latter by multiplying S&P 500 revenues per share by the S&P 500 divisor for each quarter.

(2) S&P 500 aggregate revenues & business sales of goods. In current dollars, the trend and the cycles in S&P 500 aggregate revenues closely track those of nominal GDP (Fig. 5). Interestingly, they track business sales of goods (a.k.a. manufacturing shipments plus wholesale and retail sales) much better, even though S&P 500 revenues includes the sales of both goods and services (Fig. 6). That’s because the business cycle is usually more pronounced for producers and distributors of goods than providers of services.

The y/y growth rate in business sales of goods closely tracks the y/y growth rate of S&P 500 revenues (Fig. 7). The former is a monthly series. So it is usually a good leading indicator of the quarterly revenues series. It hasn’t been so good since the second half of last year. That’s because the rolling recession in the goods sector has been more than offset by strength in services. The monthly series was down 1.2% y/y through July, while S&P 500 aggregate revenues was up 6.1% during Q2.

Not surprisingly, the y/y growth rate in aggregate revenues closely tracks the y/y growth rate in nominal GDP of goods (Fig. 8). The former has been tracking better with the latter than with business sales of goods recently.

In the past, there wasn’t much of a correlation between the growth rates of aggregate revenues and nominal GDP of services, which was much less volatile than the growth rate of nominal GDP of goods (Fig. 9). Of course, since the pandemic, the services sector has been much more volatile than usual and more closely correlated with aggregate revenues.

(3) S&P 500 revenues per share and forward revenues. A much better coincident indicator of quarterly S&P 500 revenues per share is weekly S&P 500 forward revenues per share (Fig. 10). The series is monthly from January 2004 through December 2005, then weekly. It doesn’t catch every zig and zag in the quarterly series, but it certainly gets the trends and cycles right. It rose to a record high during the September 7 week.

Forward revenues per share is a time-weighted average of industry analysts’ estimates for the current and the coming years’ S&P 500 revenues (Fig. 11). As of the September 7 week, industry analysts expect that S&P 500 revenues per share will increase 2.2% this year, 4.8% next year, and 5.3% in 2025 (Fig. 12).
 
Earnings II: The Earnings Story. As noted above, in our work we tend to focus on S&P 500 operating earnings per share as reported by I/B/E/S rather than S&P. The big difference between the S&P and I/B/E/S measures of operating earnings per share is that the former determines which one-time items to exclude (or include) from reported earnings, while the latter is based on majority rule. In other words, it is based on the industry analysts’ consensus on operating earnings, which tends to be the same as the operating numbers reported by the companies in their quarterly filings.

That allows us to calculate the weekly series on S&P 500 forward operating earnings using the analysts’ consensus earnings estimates for the current and the coming years. Now let’s have a look at the latest earnings data:

(1) Earnings per share. S&P 500 operating earnings per share edged up 2.7% q/q during Q2, suggesting that earnings bottomed during Q1 (Fig. 13). On a y/y basis, it was still down 5.4% during Q2 (Fig. 14). But these comparisons should start to turn positive over the final two quarters of this year.

(2) Forward earnings per share. S&P 500 forward earnings rose to a record high during the September 14 week (Fig. 15). It closely tracks the actual quarterly operating earnings data as reported by I/B/E/S. The weekly forward series tends to lead the quarterly actual one by about a year (Fig. 16). So it is a great predictor of the outlook for earnings during economic expansions. However, it consistently fails to anticipate recessions. If you agree with us that a recession isn’t very likely over the next 52 weeks, then the prospect for earnings is bright over this period ahead.

(3) Annual consensus earnings estimates and growth rates. During the week of September 14, industry analysts estimated that earnings per share will be $221.37 this year, $247.94 next year, and $278.28 in 2025 (Fig. 17). They are expecting earnings per share to grow 1.1% this year, 11.6% next year, and 12.5% in 2025 (Fig. 18).
 
Earnings III: The Profit Margin Story. The weakness in earnings in recent quarters has been attributable to the decline in the S&P 500 profit margin per share since revenues have been trending upward to new record highs (Fig. 19 and Fig. 20).

The quarterly profit margin peaked at a record high of 13.7% during Q2-2021. It peaked last year at 13.4% during Q2. It then fell to 11.5% during Q4-2022. It edged up to 11.8% during Q2.

The forward profit margin peaked at a record 13.4% during the June 9 week last year. It bottomed at 12.3% during the March 30 week this year and edged up to 12.7% during the September 7 week.
 
Earnings IV: Their Forecasts & Ours. Joe and I promised to revisit our earnings outlook following the release of Q2’s results. We thought we might have to lower our projections, which have been among the most optimistic on Wall Street. We’ve decided to stay with them for now. Consider the following:
 
(1) Revenues. Joe and I are predicting that S&P 500 revenues per share will increase 4.0% this year, 4.0% next year, and 3.9% in 2025 (Fig. 21). We obviously are not expecting an economy-wide recession this year, though we did increase our subjective odds of one before the end of next year to 25% from 15% on Monday. Industry analysts have been raising their S&P 500 revenues-per-share estimates in recent weeks, and they almost match our projections.

(2) Earnings. The same can be said about their estimates for S&P 500 earnings-per-share and ours (Fig. 22). We are sticking with $225 this year (up 3.2% y/y), $250 next year (up 11.1% y/y), and $270 in 2025 (up 8.0% y/y).

(3) Profit margin. Industry analysts also recently have been raising their profit margin forecasts (implied by their earnings and revenues forecasts), which now are up to our forecasts (Fig. 23). We are projecting 12.3% this year, 13.2% next year, and 13.7% in 2025. Our optimism is substantially based on our view that productivity growth is likely to rebound over the rest of the decade.

(4) Forward earnings. Again, we are happy to report that S&P 500 forward earnings per share has risen to a record high of $240.28 during the September 14 week; it’s getting closer to our year-end estimate of $250 (Fig. 24). Our year-end forward earnings estimates for 2024 and 2025 are $279 and $290.

(5) S&P 500 valuation. Joe and I expect the S&P 500 forward P/E to range between 16.0 and 20.0 through the end of 2025 (Fig. 25). The historically high upper end of the range assumes that the MegaCap-8 stocks will continue to account for about 25% of the S&P 500’s market capitalization, and that they will continue to sport high valuation multiples.
 
(6) S&P 500 price targets. Applying these valuation ranges to our forward earnings projections yields the following S&P 500 stock price index ranges: 2023 (4000-5000), 2024 (4320-5400), and 2025 (4640-5800) (Fig. 26).

For those of you who prefer point estimates, here are our year-end forecasts for the S&P 500: 2023 (4600), 2024 (5400), 2025 (5800).

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China: Party Tricks

September 19 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
China I: Bad Policies. The Chinese Communist Party (CCP) has an implicit deal with the citizens of China. The CCP will deliver widespread economic prosperity with lots of jobs and rising real incomes. The citizens will accept less freedom under the authoritarian rule of the CCP. Their deal with the devil has worked so far. Never in the history of the world has the standard of living of so many people improved in such a short time as it did in China from the 1980s through the mid-2010s.

Ironically, much of China’s prosperity during that period occurred when the CCP turned less authoritarian. The party allowed capitalism to flourish for a while, and so did the Chinese economy. However, in recent years, under President Xi Jinping—who has served as the undisputed supreme leader since 2012—the CCP has turned increasingly authoritarian and hostile to capitalism.

That transition has been occurring just as the Chinese economy has started to sputter. That’s happening for several reasons:

(1) Geopolitical tensions & trade. The CCP under President Xi has turned increasingly bellicose in matters of international relations. The government has been building islands in the South China Sea to claim territorial sovereignty over more of the surrounding waters. The Chinese government has ignored the protestations of neighboring nations and others that dispute the practice as an illegal threat to international commerce.

The disruptions that occurred to global supply chains during the pandemic triggered a move toward onshoring that has weighed on China’s exports to the rest of the world. Rising political tensions between China and the West over Taiwan and China’s unfair business practices have convinced many foreign businesses that China isn’t a reliable trading partner.

China’s exports in yuan terms have been essentially flat since early last year (Fig. 1). China’s imports have been flat since late 2020, reflecting the weakness of domestic consumption and the lack of stimulus from exports. The weakness in exports has been most pronounced for those going to advanced economies (Fig. 2). Some of that weakness was offset by stronger exports to emerging economies.

(2) Anti-business policies. Since 2021, Xi has been promoting a vision for the country he calls “common prosperity.” It’s a progressive framework that emphasizes reducing inequality, balanced regional development, and a healthy “spiritual and moral culture.” Since then, the CCP imposed a rash of new regulations and fines on private capital and technology companies.

On July 1 of this year, the Chinese government substantially broadened its law on espionage. The changes “have raised legitimate concerns about conducting certain routine business activities, which now risk being considered espionage,” Craig Allen, president of the US-China Business Council, recently blogged. “Confidence in China’s market will suffer further if the law is applied frequently and without a clear, narrow and direct link to activities universally recognized as espionage.”

(3) Demographic issues. The CCP’s disastrous one-child policy, imposed from 1979 to 2015, has resulted in a rapidly aging demographic profile that is now weighing on economic growth. We’ve often described China as the world’s largest nursing home. China’s population is aging faster than those of nearly all other countries in modern history.

A March 22 article in Nikkei Asia reported: “By 2035, an estimated 400 million people in China will be age 60 and over, representing 30% of the population, according to the government’s own projections. And the ratio of old to young is expected to rapidly grow more unbalanced after deaths outnumbered births last year, for the first time since 1961.” China’s population declined in 2022, plummeting by 850,000 to 1.412 billion (Fig. 3). China’s fertility rate slipped to below 1.1 in 2022. A rate of 2.1 is required to sustain a population.

The rapidly aging population is weighing on inflation-adjusted retail sales in China. The 12-month average of the yearly percent change in real retail sales exceeded 10% from March 2005 through December 2014 (Fig. 4). It fell to 5.1% during December 2019, just before the pandemic. It’s been fluctuating around zero since then. Older people with a grown child don’t spend much money. Neither do married young adults, who must care for their older parents and maybe one child.

(4) Property bubble. For many years, one of the major drivers of Chinese economic growth was the property boom. The provincial governments sold land to developers, who built brand-new cities full of brand-new apartments, which were purchased as investments by Chinese households and often left vacant. The local governments used the revenues to build public infrastructure. That resulted in lots of economic growth and probably the biggest property bubble in history. The air is coming out of the bubble as the Chinese government scrambles to keep it from bursting. Developers are no longer buying more land, so the local governments are seeing their revenues dry up.

(5) Youth unemployment. In August, the Chinese government, rather than report an expected seventh consecutive monthly increase in youth unemployment, opted to suspend release of the information. The unemployment rate among 16- to 24-year-olds in urban areas hit 21.3%, a record high, in June and has risen every month this year through June. An August 15 article in The New York Times reported: “On top of the damage inflicted on the job market during the pandemic, the government cracked down on the country’s technology, real estate and education industries, where educated young Chinese had flocked for jobs. The regulatory actions caused hundreds of thousands of layoffs and left companies and investors more cautious about expanding their businesses. When businesses are wary, hiring typically suffers.”

China II: Same Old Tricks. Under pressure to get the economy growing faster, the Chinese government and related institutions have taken many small steps to encourage borrowing and lending and to bolster private industry:

(1) The government announced on September 4 plans to set up an agency to coordinate policies across various government bodies to help develop the private economy. This is quite a reversal from the Chinese government’s stance toward private companies and financial markets in 2021, when it blocked the IPO of Ant Group. Additional moves that China made recently to facilitate financial market activity include halving the stamp duty, a tax charged on shares traded; restricting share sales by major shareholders under certain circumstances; and lowering margin requirements.

(2) To boost the property sector, the People’s Bank of China (PBOC) and other agencies lowered the down payment for first-time home buyers to 20% and for second-time purchasers to 30%. Chinese state-owned banks are expected to help borrowers by lowering interest rates on existing mortgages or replacing them with new mortgages. Chinese banks cut deposit rates to encourage savers to become spenders, and the one-year loan prime rate was lowered by 10 basis points to 3.45% last month.

The PBOC’s ability to cut rates is somewhat limited if it aims to keep the yuan from falling below its current decade-low level. The yuan traded at 7.3 to the dollar yesterday, down from its recent peak of 6.7 and its lowest level since early November 2022 (Fig. 5). It rebounded on Friday following a slew of better-than-expected economic indicators, as discussed below.

(3) Regulators also have lent a hand by cutting reserve ratios. At large depository institutions, the reserve ratio has fallen to 10.50% from 12.00% two years ago (Fig. 6). The latest cut of 25bps occurred on Thursday.

By cutting reserve requirements, the PBOC aims to stimulate more bank lending. That doesn’t mean that banks haven’t been lending. On the contrary, over the past 12 months through August, bank loans are up 22.6 yuan, or $3.2 trillion (Fig. 7). Indeed, China’s economic growth since the end of the Great Financial Crisis has been fueled by lots of debt, especially bank loans. They’ve more than quintupled over the past 13 years, from $6.1 trillion at the start of 2010 to a record $32.4 trillion through August (Fig. 8). Over this same period, US bank loans only about doubled, from $6.4 trillion to $12.2 trillion through July.
 
China III: Green Sprouts vs the Red Metal. The latest batch of Chinese economic indicators, for August, suggests that the government’s stimulative policy initiatives may be providing a lift to the economy. While these green shoots are sprouting, Professor Copper, the red metal with a PhD in economics, isn’t convinced that the outlook for China’s economy is improving much if at all. The nearby futures price of copper has been trading just below $4.00 per pound since early this year (Fig. 9).

The government’s stimulus program announcements haven’t caused China’s MSCI stock price index in yuan to rally. Investors may be skeptical (as we are) that the CCP’s old tricks for boosting the Chinese economy will work. Perhaps Friday’s batch of economic indicators will rally stocks in the coming days and weeks.

Let’s review the latest batch of economic indicators:

(1) Industrial output rose 4.5% y/y in August, accelerating from the 3.7% pace in July (Fig. 10). The growth marked the quickest pace since April. It suggests that Q3’s real GDP will be up around 5.0% y/y.

(2) Retail sales also increased faster in August, at a pace of 4.6%, aided by the summer travel season; it was the quickest growth since May. That compared with a 2.5% increase in July. Inflation-adjusted retail sales rose 4.5% y/y (Fig. 11).

(3) Separate commodities data showed China’s primary aluminum output hit a record-monthly high in August, while oil refinery throughput also rose to a record.

On the other hand:

(4) Fixed-asset investment expanded at a lackluster pace of 3.2% during the first eight months of 2023 from the same period a year earlier, versus 3.4% in the first seven months.

(5) For August, property investment extended its fall, down 19.1% y/y from a 17.8% slump the previous month, according to Reuters calculations.

(6) Government revenue from state land sales fell for the 20th consecutive month in August, finance ministry data showed on Friday, weighing on the already debt-laden local governments’ finances.

(7) US and European firms are shifting investment away from China to other developing markets, a report from Rhodium Group showed, with India receiving most of this redirected foreign capital, followed by Mexico, Vietnam, and Malaysia. The September 13 Reuters reported: “These companies are turning their backs on the world’s second-largest economy even as its share of global growth continues to increase, highlighting how concerns over China’s business environment, economic recovery and politics weigh heavy on the minds of foreign investors.”

The value of announced US and European greenfield investment capital flowing into India shot up by $65 billion, or 400%, from 2021 to 2022, the report said, while investment into China dropped to less than $20 billion last year, from a peak of $120 billion in 2018.

(8) China’s CPI edged up by 0.1% y/y in August, reversing course slightly from a fall of 0.3% y/y in July (Fig. 12). Meanwhile, the drop in China’s PPI narrowed from -4.4% in July to -3.0% in August. The PPI has fallen for 11 months in a row, reflecting the weakness in China’s economy.

By the way, the China and US CPI inflation rates are highly correlated (Fig. 13). The same can be said about the two countries’ PPIs (Fig. 14). Some of America’s inflation is made in China, which has tended to have a disinflationary impact on the US.

China IV: Depressed Forward Metrics. Did China peak in 2014? The forward revenues of the China MSCI has been on a downward trend since 2014 after it soared dramatically during the previous 10 years (Fig. 15). The forward earnings of the China MSCI soared after the country entered the World Trade Organization in late 2001 (Fig. 16). This series has flattened since late 2011. The China MSCI stock price index rallied along with earnings from 2003 through 2007 (Fig. 17). It has been essentially flat, though volatile, since then.

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Inflation: Twin Peaks Again?

September 18 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy I: Raising Odds of a Recession a Tad. On July 31, Debbie and I lowered our odds of a recession. We wrote: “Our script has played out as expected so far. The soft-landing scenario looks increasingly like a no-landing one. As a result, we are raising the odds of a no-landing scenario from 75% to 85% and lowering the odds of a hard-landing scenario from 25% to 15% through the end of next year.” On August 21, in response to the backup in bond yields, we wrote: “We currently are still assigning 85% odds to a no-landing scenario through the end of next year and 15% to a hard-landing one. However, we are leaning toward lowering the former and raising the latter.” Today, in response to several new developments, we are raising the odds of a recession before the end of next year from 15% to 25%.

We remain in the rolling-recession-and-recoveries camp for now. However, the 30% increase in a barrel of Brent crude oil since June 27 is a concern (Fig. 1). It has resulted in an 8.2% increase in the retail price of gasoline since late June to $3.94 during the September 11 week (Fig. 2). If the price of oil breaches $100 per barrel and the price of gasoline rises solidly above $4.00 a gallon and both remain above those levels for a while, they could trigger a renewed wage-price spiral and higher inflationary expectations.

That scenario would be reminiscent of the 1970s, when the first wave of inflation was followed by a second wave and both triggered recessions (Fig. 3). That is not the scenario we consider most likely, but it is the risk to our happier outlook. It’s partly because of this risk that we’ve raised our subjective odds of this alternative scenario to 25%.

US Economy II: Dueling Decades. Now consider the following comparison of the 1970s and the 2020s (so far):

(1) The dollar. The Great Inflation of the 1970s actually started during the second half of the 1960s. It was triggered by President Lyndon Johnson’s decision to deficit-finance the Vietnam War rather than to increase taxes to fund the war. The same can be said about his Great Society initiative. A result of this guns-and-butter approach to fiscal policy was higher inflation.

President Richard Nixon continued that approach during the early 1970s and exacerbated inflation by closing the gold window on August 15, 1971, which caused the dollar to depreciate significantly. The weaker dollar boosted commodity prices and caused OPEC to drive oil prices higher during the 1970s.

This time, several rounds of fiscal stimulus programs combined with ultra-accommodative monetary policies caused a demand shock that overwhelmed supplies, unleashing the current bout of inflation. The programs presumably were aimed at offsetting the negative impact of the pandemic on workers. More accurately, they were another example of Washington’s politicians “never letting a good crisis to go to waste” (in the words of Rahm Emanuel, spoken when he was chief-of-staff in the Obama administration).

What’s different this time is that the US dollar is strong. The Fed has been more aggressive in tightening monetary policy in response to inflation than the other major central banks. Also, the US economy is performing much better than the other major economies, which likewise supports the dollar.

(2) Oil & food prices. We have no doubt that the Great Inflation of the 1970s was caused by the two spikes in the price of oil during 1973/74 and again in 1979, both triggered by wars in the Middle East (Fig. 4). The price of a barrel of West Texas Intermediate crude oil jumped 213% and 166% during these two episodes. Both caused recessions.

This time, the price of a barrel of Brent crude oil jumped 46% during H1-2022, triggered by Russia’s invasion of Ukraine. But there was no recession. The rise in the price of oil so far this year isn’t likely to cause a recession either unless it is the start of a major spike resulting from another geopolitical crisis, particularly in the Middle East. That possibility cannot be ruled out given the hostilities between Israel and Iran.

The twin peaks in the headline CPI inflation rate during the Great Inflation of the 1970s were 12.3% and 14.8% (Fig. 5). Last year, it peaked at 9.1%. The twin peaks in the core CPI inflation rate during the 1970s were 11.9% and 13.6%. Last year, it was 6.6%.

The twin peaks in the CPI energy component during the 1970s were 33.7% and 47.1%. Last year’s peak was 41.6%. The twin peaks in the CPI food component were 20.3% and 13.1% during the 1970s, while the peak was 11.4% last year.

(3) Other prices. This time, supply-chain disruptions triggered a much greater spike in the inflation rate for durable goods (Fig. 6). The CPI durable goods inflation rate peaked at 14.3% and 11.3% in the 1970s. This time, it peaked at 18.7% last year and plunged much faster than during the 1970s. It was back down to -2.0% y/y through August, in the range of the mildly deflationary readings prior to the pandemic. This component of inflation has turned out to be quite transitory this time, while it was more persistent during the 1970s.

The jury is out on the CPI for nondurable goods, including food and energy. It peaked at 16.2% last year, comparable to the levels hit during the twin peaks of the 1970s. It too fully reversed last year’s spike. But oil prices have been rising again in recent weeks.

During the 1970s, services inflation was especially persistent, with three consecutively higher peaks at 8.5% (in 1970), 11.7% (in 1975), and 18.1% (in 1980). This time, so far, the CPI services inflation rate peaked at 7.6% last year and declined to 5.4% in August. Exacerbating the services inflation problem during the 1970s was a wage-rent inflation spiral (Fig. 7 and Fig. 8). This time, both wage and rent inflation rates peaked last year (at 7.0% and 8.9%, respectively, and are down to 4.5% and 8.1%). The rent component of the CPI is on track to moderate significantly, reflecting the trend in current rental leases.

(4) Wages & union contracts. Will wage inflation moderate along with rent inflation this time? Currently, union members make up a much smaller percentage of the labor force. The available data show membership is down to 6.0% of private-sector wage and salary employment from 16.8% in 1983 (Fig. 9). Nevertheless, today’s unions have been energized by stagnating real wages. They’ve achieved sizeable compensation gains in recent negotiations.

(5) Productivity & technology. The big difference we are forecasting between now and then is that productivity growth, which collapsed during the 1970s, will be improving significantly over the rest of the decade (Fig. 10). The average annualized five-year growth rate of productivity peaked at a record high of 4.5% during Q1-1966, then proceeded to plunge to a record low of 0.1% during Q3-1982. This time, productivity growth bottomed at 0.4% during Q4-2015. It rose to 1.4% during Q4-2019 just before the pandemic. It soared during the lockdowns and fell when quits rose sharply during the pandemic. Now it is settling down, with a 1.6% increase during Q2-2023.

But we expect that our measure of productivity growth will resume its pre-pandemic ascent to 4.0% by the end of the decade. That may seem farfetched, but that would be consistent with the peaks in the previous three productivity growth cycle booms. This time, we expect to see the plethora of technological innovations boosting productivity in many more companies in many more industries than ever before. In this sense, all companies are now technology companies.

The collapse in productivity growth combined with rapidly rising compensation caused unit labor costs inflation (ULC) to soar during the 1970s (Fig. 11 and Fig. 12). There actually were three peaks in this inflation rate, which closely tracks the headline CPI inflation rate. This time, ULC inflation peaked last year at 7.0% y/y during Q2 and fell to 2.5% during Q2-2023. The headline CPI inflation rate peaked at 9.1% last summer and fell to 3.7% during August.

(6) Bottom line. We’ve raised our subjective odds of a recession from 15% to 25%. The recent rise in the price of oil is somewhat reminiscent of what happened during the Great Inflation of the 1970s. So is the push by labor unions for higher wages to offset the rapid rise in the cost of living. Nevertheless, we don’t expect a replay of the 1970s. In our most likely scenario, productivity growth resumes its upward trend that started at the end of 2015, which was interrupted during the pandemic, and overall compensation inflation continues to moderate. So we don’t expect to see a second peak for inflation that would force the Fed to cause a recession to bring inflation down.

It isn’t just the recent upturn in oil prices that’s caused us to raise the recession warning flag a bit higher. We are also concerned about the widening federal budget deficit, with the government’s net interest outlays soaring. Bond yields might have to rise higher to attract buyers for the mounting supply of Treasuries, especially if there is an inflation scare along the way. More immediate concerns are the United Auto Workers’ strike and the likelihood of a government shutdown at the end of the month.

There’s never a dull moment in our business. Actually, there is occasionally: When the S&P 500 rose at the end of July to our year-end target of 4600, we predicted that the remainder of this year might be a dull one for stock prices, with the index still at 4600 by the end of the year. So far, so dull.

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Transports Flying Into Headwinds

September 14 (Thursday)

Industrials: Transports in the Slow Lane. The S&P 500 Transportation stock price index was gaining altitude ytd through the end of July; then its performance stalled. Demand for transportation services softened as US imports and exports fell, dragged down by consumers’ preference to spend more on services and less on goods in the wake of the Covid pandemic. The behavioral change has resulted in a US inventory correction that’s been exacerbated by the economic slowdowns in China and other economies. Making matters worse for the transporters of goods, costs have increased as fuel prices and employee wages have risen.

The S&P 500 Transportation index has fallen 10.7% from the end of July through Tuesday’s close, lagging far behind the S&P 500’s 2.8% decline over the same period. As a result, the S&P 500 Transportation index’s ytd gain, which stood at 15.8% on July 31, has shriveled to 3.5% as of Tuesday’s close.

Here’s the performance derby for the industries in the S&P 500 Transportation index from July 31 through Tuesday’s close: Passenger Airlines (-13.5%), Air Freight & Logistics (-12.9), Rail Transportation (-9.4), and Cargo Ground Transportation (-3.0). Each of the industries fell more than the S&P 500’s 2.8% decline over the same period.

Here’s the performance derby for the industries in the S&P 500 Transportation index from August 1 through Tuesday’s close: Passenger Airlines (-13.5%), Air Freight & Logistics (-12.9), Railroad Transportation (-9.4), and Cargo Ground Transportation (-3.0).

We’ll be watching for signs that the inventory correction has run its course. Perhaps by next spring, consumers will store their suitcases away and start spending more of their incomes on goods once again. Meanwhile, let’s look at the business pressures that have put the brakes on transportation stocks:

(1) Airlines lose altitude. With consumers traveling at home and abroad, the S&P 500 Passenger Airlines industry stock price index took off as the year started and gained 37.4% at its peak on July 11 of this year. The industry’s stock price index has since lost altitude, though it remains up 9.2% ytd (Fig. 1).

Like other transport industries, airlines are facing higher expenses. American Airlines and Spirit Airlines warned on Wednesday that higher fuel costs and wages will eat into Q3 profits. American cut its Q3 earnings estimate to 20-30 cents a share, down from its previous forecast of 95 cents a share.

Brent crude oil futures have risen from a low this year of $71.84 per barrel to a recent high of $92.06 (Fig. 2). Wages in the industry are also climbing due to a shortage of pilots and the renewed confidence of unions. “In January, JetBlue agreed to a two-year contract extension that provided a compensation increase of 21.5% over 18 months. In March, Delta agreed on a pilot contract that increases wages 34% by 2026. In July, United Airlines pilots agreed to a pilot contract that would increase pay up to 40% over four years. And [in August], American agreed to a similar 40% pay boost over its new four-year contract,” an August 25 Seattle Times article reported. Most recently, Alaska Airlines pilots received an 11.2% pay increase on September 1 because their contract stipulates the airline’s wages must keep pace with wages at rival airlines.

The airline industry has also struggled to buy enough planes to meet travelers’ desire for post-pandemic revenge travel. The industry’s capacity constraints increased this week for some airlines when RTX announced it would have to ground 600-700 Airbus jets to conduct quality inspections of Pratt & Whitney Geared Turbofan engines due to a manufacturing flaw, a September 12 Reuters article explained.

The RTX news follows Boeing’s ongoing difficulties ramping up output of new planes. The manufacturer’s deliveries dropped to 35 planes in August from 43 planes in July and 60 in June, as it has been fixing a manufacturing defect on the 737 Max. Despite the setback, Boeing’s deliveries this year are still an improvement over 2022’s deliveries, which were hampered by supply-chain and production difficulties.

Analysts expect the S&P 500 Passenger Airlines industry’s earnings growth to slow to 10.4% in 2024, down from the 165.3% surge expected in 2023 when the industry was rebounding from pandemic-related losses (Fig. 3). Notably, analysts have been trimming their 2024 earnings estimates for the industry, which had indicated growth as high as 43.8% in October 2022. The cyclical industry’s forward P/E has fallen to a record low of 5.9 as its earnings have recovered (Fig. 4).

(2) Trucking along. The S&P 500 Cargo Ground Transportation stock price index has been a top performer this year, climbing 32.7% ytd through Tuesday’s close (Fig. 5). The index has been boosted by Old Dominion Freight Line’s stock, which has risen 48.7% ytd, as investors hope it will benefit from the bankruptcy of its less-than-truckload competitor Yellow. Old Dominion has bid $1.5 billion for Yellow’s North American real estate holdings.

Shares of the index’s other constituent, J.B. Hunt Transport Services, haven’t fared as well, rising 4.3% ytd through Tuesday’s close. Hunt isn’t a large player in the less-than-truckload market, so it isn’t expected to benefit as much from Yellow’s bankruptcy. Hunt and others are facing a market where trucking demand has fallen as consumers slowed their goods purchasing, forcing retailers to shrink bloated inventories.

Business inventories stopped seeing sharp increases at the end of 2022 and were up just 2.2% y/y in June, the weakest since February 2022 (Fig. 6). Likewise, trade through the West Coast ports has slowed, hurt by US inventory destocking and softness in global economic growth. Outbound plus inbound West Coast port container traffic fell 19.0% y/y in July, and it declined 22.5% from its peak in June 2021 based on 12-month data (Fig. 7). Likewise, the real dollar value of exports and imports has been flattish since it peaked in March 2022 (Fig. 8).

The ATA Truck Tonnage index has fallen 3.4% from its recent peak in September 2022 and declined 0.7% y/y in July (Fig. 9). Softer demand for trucking services is reflected in the recent sharp 9.5% drop in purchases of new medium and heavy trucks since May and the 12.4% y/y decline in prices for trucking services (Fig. 10 and Fig. 11). The recent loss of truck transportation jobs may have been amplified by the Yellow bankruptcy (Fig. 12).

(3) Rails at a crossing. The S&P 500 Rail Transportation industry stock price index is the only industry in the transport area that’s in negative territory ytd, falling 3.0% through Tuesday’s close (Fig. 13). The rail index has been dragged down by a 19.4% ytd decline in Norfolk Southern’s share price, while CSX and Union Pacific shares have logged flattish performances over the same period (-1.3% and 3.3%, respectively).

Norfolk Southern has been cleaning up hazardous materials spilled in an Ohio train derailment, which the company estimates could cost $803 million. Costs could rise further if additional legal costs, fines, or penalties arise.

Fundamentally, the rail industry has faced the same headwinds that the truckers face: inventory destocking and less trade have meant less stuff to move. Intermodal railcar loadings have fallen 4.2% ytd and 14.5% since the late January 2021 peak, based on the 26-week average (Fig. 14). The good news: Loadings ticked up ever so slightly in August, boosted by a jump in shipments of chemicals and petroleum products, nonmetalic minerals, metals and products, and waste and scrap (Fig. 15).

Analysts are forecasting a 3.0% decline in rail revenues this year followed by a 3.3% increase in 2024 (Fig. 16). Earnings are expected to follow a similar pattern, falling 6.3% in 2023 and rising 9.6% in 2024 (Fig. 17). The S&P 500 Rail Transportation industry’s profit margins have been under pressure, falling from a peak of 30.4% in December 2021 to a three-year low of 26.9% (Fig. 18). But investors may be looking ahead to better times, as the industry’s forward P/E has risen to 16.8 from a low of 15.2 earlier this year (Fig. 19).

(4) Less freight and logistics. Inventory destocking and less trade also mean there’s less freight to ship and logistics to manage. The S&P 500 Air Freight & Logistics stock price index has gained only 3.7% ytd through Tuesday’s close (Fig. 20). The stocks in the index have had very different ytd returns: FedEx (45.2%), Expeditors International of Washington (12.1), C.H. Robinson Worldwide (-5.0), and UPS (-9.9).

FedEx shares have benefitted from a company-wide restructuring pushed by activist investor D.E. Shaw. The company’s ground and express delivery units were combined among other cost-saving moves. Conversely, its competitor UPS has struggled with union negotiations this summer that resulted in higher pay for employees and sent shares tumbling. The industry’s earnings are expected to fall 18.3% this year after declining by 5.2% last year. But analysts are optimistic that earnings will jump 14.6% in 2024 (Fig. 21).

Disruptive Technologies: The Race for Stronger Batteries. We’ve long believed that the winner in the race for electric vehicle (EV) dominance would begin and end with who has the best battery at the best price. So far, Tesla has passed that test, with cars that can drive for 300-400 miles on a charge. But scientists are developing new batteries that will add hundreds of miles to a car’s driving range on a single charge. Here’s a look at who’s making progress:

(1) 900 miles from Toyota. Toyota believes it can build a solid-state battery that delivers 900 miles of range. That’s quite a claim from a company that until now has sold hybrid cars but shunned fully electric models. Getting there will be a winding road. In 2026, the company plans to produce a lithium nickel cobalt manganese battery that offers 504 miles of range, improving that to 660 miles of range by 2028. Research on the 900-mile battery is ongoing with no delivery date disclosed, a June 13 Electrek article reported.

(2) 600 miles from WeLion. Chinese battery manufacturer WeLion New Energy Technology (WeLion) has built a “semi-solid-state” battery that gives the Nio ES6 SUV, which is currently for sale, 578-miles of range on one charge, an August 7 PC Magazine article reported. Were it used in a lighter, more aerodynamic passenger car, the battery could provide 621 miles of range.

WeLion, which is building four plants in China, reportedly plans an IPO by 2025 to help fund its expansion. “Founder Li Hong said he was targeting a 20 times increase in annual revenue to CNY10bn (US$1.4bn) by 2025 and noted that, in the latest private funding round, the company was valued at CNY16bn” ($1.2 billion), an August 8 article in JustAuto reported. WeLion’s battery reportedly has a solid electrolyte, an anode made of a silicon graphite composite, and a cathode with ultra-high nickel content, a July 4 Electrive article noted.

(3) Don’t count out Tesla. Tesla has simplified its battery manufacturing process and developed the 4680 battery, which allows the company to promise a $25,000 car that offers a range of 250-300 miles. Most low-cost EVs have a range closer to 100-200 miles. It’s believed that the 4680 batteries will use new single-crystal cathodes that battery supplier LG Chem is developing. The new cathodes are expected to increase battery lifespan by more than 30% and increase the capacity of the battery by 10% compared to current batteries, a June 30 article by InsideEVs reported.

(4) Batteries taking flight. NASA is working on a solid-state battery for use in planes. Solid-state batteries are preferred because they don’t catch fire, as some liquid electrolyte batteries can when exposed to heat. “A prototype sulphur selenium battery developed by the project produces 500 watt-hours of energy per kilogram of battery. That is double the energy density of a standard lithium-ion battery,” an August 17 Euronews.green article reported. The battery also weighs less and can release energy more quickly than a standard battery.

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AI For All

September 13 (Wednesday)

Information Technology I: Everyone’s Adopting AI. News headlines are filled almost daily with the latest ways companies are deploying artificial intelligence (AI). Just this week, we learned that Tesla is creating its own GPU chips to power a supercomputer that will train the AI to be used in its fully autonomous vehicles. It’s quickly become clear that all companies will adopt AI in some form or another, just as all use the Internet today.

AI has shown its ability to create, analyze large amounts of data, and supply answers and education distilled from vast troves of information far faster than any human could hope to in their wildest dreams. The sheer operating speed at which AI can perform these three sets of tasks holds great potential to make companies of all kinds far more efficient than ever before.

Here’s just sampling of the many ways companies have found to leverage AI’s three key skill sets:

(1) AI creates art. One of the things that makes AI fascinating, albeit creepy at times, is its ability to replicate human creativity. When fed the right information, AI can create movies, develop video games, and edit films, as we discussed in the March 9 Morning Briefing.

AI is even being used to make music. Warner Brothers signed Noonoouri, a 19-year-old avatar in the metaverse who has modeled for Dior, appeared in Elle and Vogue, and signed with top modeling agency IMG Models Worldwide, a September 8 New York Post article reported. Most recently Noonoouri released an AI-generated song, “Dominoes,” and a music video. An AI program used the voices of two human musicians, Leonardo Martinelli and Rafa Caivano, who receive royalties from the song.

AI’s threat to human jobs is one of the reasons why Hollywood actors are on strike. They’re asking for tighter regulation of AI’s use in creative projects, among other things. Actors don’t want their likenesses used to train AI programs nor do they want be replaced by AI, a July 19 CBS article stated. They don’t want the studios to be able to scan a background actor, pay them for one day’s work, and then use the scan in future projects. The studios say they would only have the right to use the digital copy of the background actor in the picture for which the scan was taken; to use the digital copy again, they’d need the actor’s consent.

Marketing campaigns are tapping AI to create text, video, and images for emails, blog posts, social media, chatbots, websites, and SEO content, a September 6 Forbes article stated. Marketers use ChatGPT for human-like text, Copy.ai for natural language processing, Jasper.ai for copywriting, Peppertype.ai for articles, Lensa for image editing, and DALL-E and MidJourney for image generation.

One example: A marketing video created for the Forbes author’s Restaurant Furniture Plus business by Synthesia’s AI technology. “It was produced in a couple of minutes from a simple copy and paste of our About Us copy on our website without any human involvement or professional actors involved,” he stated. The impressive video can be accessed in the article and is worth checking out.

(2) AI analyzes data. For years, companies have digitized their operations and collected reams of data. Now they’re hoping AI will help them analyze that data and make operations more efficient. Logistics companies, pharmaceutical companies, and even bakers are adopting the technology.

In the logistics arena, Pando has developed a platform that takes “the fire hose of data that [companies] manage and [applies] AI to sync it all together in various ways. The AI can essentially tell companies how to run their logistics differently to boost efficiency and revenue while cutting costs,” a September 8 WSJ article reported. Reliable Robotics is developing autonomous cargo planes that fly with little or no pilot involvement, and Cheetah is developing demand forecasting and inventory prediction systems for restaurants.

The pharmaceutical industry is using AI to accelerate drug development. At LabGenius, a “machine learning algorithm designs antibodies to target specific diseases, and then automated robotic systems build and grow them in the lab, run tests, and feed the data back into the algorithm, all with limited human supervision,” an August 9 Wired article explained. Meanwhile, Bayer has partnered with Google Cloud’s Tensor Processing Units to conduct large quantum chemistry calculations and identify new insights. It will also use Google Cloud’s Vertex AI and Med-PaLM2 in clinical trials to improve analysis of the data, a September 4 Forbes article reported.

The construction industry is sending information from cameras and sensors to AI programs to coordinate when new crews and materials should arrive or to determine when a window’s placement doesn’t match the project’s blueprint, an August 15 NYT article reported. The Internal Revenue Service is using AI to help it pinpoint which of the nation’s largest, most complex partnerships should be examined, a NYT article on September 8 reported.

Even bakers are using AI. Bimbo Bakeries USA makes Sara Lee cakes, Entenmann’s donuts, and Thomas’ English muffins in 59 bakeries around the US. It improved its demand forecasting by using an AI model developed by Antuit.ai. The model uses data provided by planners and route operators around the country, as well as more unusual inputs like information about the weather, local events, store inventory, and point-of-sale data, a September 8 article in AutomationWorld reported. Now that’s sweet!

(3) AI teaches. Perhaps the best-known use of AI is as the provider of information, whether via search engine or chatbot. Again, the ability to quickly scan through more information than any human could ever read makes these AI wizards extraordinarily smart, when they aren’t hallucinating and providing inaccurate information.

JLL developed JLL GPT, a chatbot trained on commercial real estate data that JLL has been collecting for years that now can be used by JLL clients, an August 1 company press release stated.

Morgan Stanley and OpenAI developed a virtual assistant that will listen to conversations between financial advisors and their clients and can quickly serve up research or forms discussed or requested, a September 7 Reuters article reported. In the future, the virtual assistant should be able to create a meeting summary, draft an email with suggestions on next steps, or schedule a follow-up appointment.

Meanwhile, the Connecticut Department of Education and Varsity Tutors, an online tutoring company, are developing one AI program that will connect students to the right online tutor and another that will design lesson plans. Similar programs are being used in schools in Indiana, Ohio, Texas, Florida, and California, a September 6 article in the CT Mirror reported.

Information Technology II: AI Titans Go to Washington. Washington’s legislators are clamoring to be seen as knowledgeable about AI, as they talk about creating legislation that protects the public but doesn’t stifle innovation. There are no fewer than four hearings just this week on the subject, and we’d expect many, many more to follow in the months and years to come.

“We see AI as the perfect Washington topic: It is infinitely broad in scope and can fuel endless think tank panel discussions and Congressional hearings without resulting in any new law,” wrote Robert Kaminski of Capital Alpha Partners. “The momentum to ‘regulate AI’ looks to us like the same momentum to ‘regulate Big Tech’ we saw starting in 2017-18, and we carry the same skepticism that any legislation will pass.”

Perhaps that’s why tech CEOs have acquiesced to testify on multiple occasions. By doing so, they look cooperative yet risk little, as restrictive legislation is unlikely to pass.

The most high-profile hearing occurs today: Senate Majority Leader Chuck Schumer (D-NY) is holding the first in a series of meetings entitled “AI Insight Forum,” at which industry executives will examine how to regulate AI and prevent human extinction at the theoretical hands of AI. Tech titans in attendance are expected to include the CEOs of OpenAI, Google, IBM, Meta, Nvidia, and Tesla as well as Microsoft co-founder Bill Gates, a September 11 NBC News article reported. There will also be representatives from labor and human rights groups, the CEO of the Motion Picture Association, and the American Federation of Teachers.

Unfortunately, the AI Insight Forum is occurring behind closed doors, without any reason given for excluding the public and the press. Only a post-forum summary and information leaks, if any, will shed light on meeting proceedings.

Another AI-focused hearing titled “How are Federal Agencies Harnessing Artificial Intelligence?” is also being held on Wednesday by the House Oversight subcommittee, led by Representative Nancy Aace (R-SC), with Biden administration tech officials in attendance.
 
Two AI hearings were held on Tuesday, one focused on how AI companies can boost transparency and the public’s trust (“The Need for Transparency in Artificial Intelligence,” held by the Senate Commerce and Science subcommittee) and the other on AI oversight and regulation (“Oversight of AI: Legislating on Artificial Intelligence,” held by the Senate Judiciary’s subcommittee on technology and privacy).

Information Technology III: A Look at Valuations. Almost every stock of every business even remotely related to AI has performed well so far this year—even if they’ve sold off from their summer peaks. In fact, the S&P 500 Information Technology sector as a whole rose 47.7% to a July 18 peak only to tumble 9.0% through mid-August before resuming its climb. The sector is up 41.3% ytd through Monday’s close, outperforming all other S&P 500 sectors except one.

Here’s the performance derby for the S&P 500 sectors ytd through Monday’s close: Communication Services (45.0%), Information Technology (41.3), Consumer Discretionary (36.0), S&P 500 (16.9), Industrials (7.1), Materials (5.3), Energy (2.9), Financials (0.2), Real Estate (-1.3), Consumer Staples (-2.5), Health Care (-2.5), and Utilities (-10.8) (Fig. 1).

Driving the S&P 500 Information Technology sector’s ytd outperformance are a handful of industries: Semiconductors (77.7%), Application Software (49.1), and Systems Software (42.1) with Technology Hardware, Storage & Peripherals (37.3), Semiconductor Equipment (25.6), and Communications Equipment (20.8) not far behind (Fig. 2).

Let’s take a look at the three best performing tech industries so far this year, all of which have gotten a helping hand from the market’s AI ebullience:

(1) Semiconductors. You can’t talk about semiconductors and AI without talking about Nvidia. The company’s stock has risen 209.1% ytd and is less than 10% from its August high. Companies are clamoring to get their hands on Nvidia’s AI chips, which the company believes will replace many of the CPU chips in the marketplace. A data center with more than 900-1000 CPU servers can be replaced by just 2 GPU servers, allowing Nvidia customers to save on the cost of server infrastructure, data centers, and energy, said CFO Colette Kress according to a transcript of Citi’s 2023 Technology Conference on September 7.

Nvidia makes up 57% of the S&P 500 Semiconductor industry’s market capitalization. Were it taken out of the industry, the industry’s ytd performance would sink to 34.2% from 77.7%, according to Joe’s calculations.

Including Nvidia, analysts expect the collective revenue of companies in the S&P 500 Semiconductor industry to fall 2.1% this year and jump 17.1% in 2024, as the industry’s inventory correction appears to have run its course (Fig. 3). Earnings are forecast to fall 7.5% this year and to rebound a hearty 36.4% next year (Fig. 4). The industry’s Net Earnings Revisions Index turned positive in August after 13 months of negative monthly readings (Fig. 5). And the industry’s forward P/E of 25.9 stands near its recent peak, reflecting investors’ restored confidence in the industry’s earnings prospects (Fig. 6). (FYI: Forward P/Es are based on forward earnings, which is the time-weighted average of analysts’ operating earnings-per-share estimates for this year and next.)

(2) Application Software. The S&P 500 Application Software industry has risen almost 50% this year yet still stands 17.2% from its highest level of 2021 (Fig. 7). Many members of the industry, which includes Salesforce and Adobe, are adding AI to their software offerings, which is expected to catalyze revenue growth to a projected 11.3% this year and 11.0% in 2024 and earnings growth to 24.2% this year and 14.5% next (Fig. 8 and Fig. 9). The industry’s forward profit margin (which we calculate from forward revenue and earnings) is at a record-high 28.8%, and net earnings revisions have been definitively positive in recent months (Fig. 10 and Fig. 11). The industry’s forward P/E multiple is 30.6, well below where it has been over the past 10 years and roughly twice its expected LTEG forecast (LTEG is the 5-year forward consensus expected earnings growth) (Fig. 12).

(3) Systems Software. The S&P 500 Systems Software industry stock price index is sitting near a new high, having finally rallied past its 2021 peak level (Fig. 13). Forward revenue and earnings per share are expected to continue hit new record levels (Fig. 14 and Fig. 15). Earnings growth is forecast to slow from its torrid paces of 2020 and 2021 but still reach a respectable 8.1% this year and 12.5% in 2024. The Systems Software industry’s forward P/E is 29.1, on par with the Application Software industry’s forward P/E (Fig. 16).

For more information consider reading the Disruptive Technology sections in the following 2023 Morning Briefings: AI Develops Drugs (July 13), The AI Job Interview (April 6), AI Everything (March 23), AI on the Big Screen (March 9), AI Copies Your Voice (March 2), The AI Race Is On (February 9), and Thinking About ChatGPT (January 19).

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Europe Agonistes

September 12 (Tuesday)

Weekly Webcast. If you missed this week’s webcast, you can view a replay here.

Europe I: Winter Advisory. Brighter days may be on the horizon for Europe. A resurgence of economic growth could begin as soon as spring 2024, provided that inflation recedes as Melissa and I anticipate and that the European Central Bank (ECB) halts its monetary policy tightening in response. However, for now, the upcoming winter could challenge Europe’s energy resilience, especially if is very cold. It might be prudent to wait out the chilly season in European markets.

Investors in European stocks seemed more optimistic than European consumers and producers during the first half of this year. Europe’s MSCI Index surged 8.5% in euro terms during H1-2023 (Fig. 1). However, this surge reflected a valuation catch-up after Europe was spared the gas shortage widely expected last winter. Investors’ enthusiasm cooled during the summer, with Europe’s MSCI Index slipping 3.6% in euro terms from its recent peak on April 21 through Friday’s close.

Analysts’ consensus estimate for the Europe MSCI’s 2023 earnings growth rate has slipped into negative territory recently, at -1.8% (Fig. 2). While the estimate for 2024 earnings growth has remained positive so far this year, it has plateaued around 6.5%. In August, the Net Earnings Revisions Index of the Europe MSCI turned negative again following three positive readings (Fig. 3).

Factors like inflation, energy resilience, Germany’s economic performance, China’s influence on Europe, and potential banking sector risks will continue to shape the region’s economic forecast—and therefore the potential risks and opportunities in European stock markets as well.

Europe II: Inflation Challenge. Given the persistence of high inflation in the Eurozone, the European Central Bank (ECB) remains committed to tight monetary policy. But the ECB may be up against formidable forces that lie beyond its sphere of influence, notably the prospect of surging energy prices in the event of a harsh winter. Elevated interest rates that curtail lending at a time of resurgent energy inflation could well plunge the European economy into a recession.

Let’s have a closer look at this dicey situation:

(1) Moderating headline CPI. The headline CPI inflation rate declined again in July, from a peak of 10.6% in October 2022, primarily due to significantly lower energy prices. However, inflation remains on the high side, showing a 5.3% increase compared to the previous year (Fig. 4).

(2) Stubborn core CPI. Eurozone core inflation—excluding energy, food, alcohol, and tobacco prices—proved stubborn in June, rebounding slightly to 5.5% and holding at that rate in July after a slight dip in May to 5.4% (Fig. 5).

(3) Determined ECB. While the headline CPI inflation rate may have reached its peak in the Eurozone, along with energy prices in recent months, the ECB remains unwavering in its efforts to curb inflation. However, the path ahead is long as the ECB strives to achieve its 2.0% target. Currently, the ECB’s main refinancing rate stands at 4.25%, surpassing levels seen since the period preceding the 2009 financial crisis. Notably, the central bank has raised rates nine times after maintaining them at zero from early 2016 through mid-2022 (Fig. 6).

(4) Sluggish lending. The ECB’s tightening has curtailed Eurozone bank lending. Total outstanding loans at the Eurozone’s monetary financial institutions dipped by €30.6 billion over the past three months through July (Fig. 7).

(5) Lagarde on guard. Admitting to a miscalculation, ECB President Christine Lagarde conceded in a September 4 speech, “We underestimated both the dynamics of inflation and its persistence.” This admission implies that the ECB sees a need to make up for lost tightening and suggests that the timing may be less than ideal. Lagarde went on to say, “We are entering a world of major transitions in labor markets, energy markets, and geopolitics, all of which can lead to larger and more frequent relative price shocks.”

(6) Toss-up meeting. However, some economists argue that a pause in the rate hikes at this week’s monetary policy meeting would be prudent (as expressed in this analysis and this perspective). They point to the turning tide in inflation, and they recall Lagarde’s July statements suggesting that the additional tightening phase was over. It’s worth noting that these July remarks came several months before Lagarde’s recent comments.

In our opinion, the ECB won’t stop tightening to avert a hard landing as long as inflation remains too high. Even if this week’s meeting results in a pause, we doubt that would mark the end of this round of tightening. After all, the ECB’s paramount objective, to bring inflation in line with its target, has yet to be realized.

Europe III: Energy Security. Europe’s long-term price stability and energy security remain uncertain, as discussed in a September 7 CNN article. Europe continues to count on Russia for a portion of its energy supplies and will likely become increasingly reliant on China as a partner in it shift toward renewable energy.

Moreover, Europe remains especially exposed to the volatility of global liquified natural gas (LNG) markets; LNG makes up much of Europe’s energy reserves and imports currently. As a result, Europe is highly vulnerable to price fluctuations in the LNG market. Supplies are tight, and there is a potential for disruptions like the recent spike in European gas prices as a result of Australian LNG supplier strikes.

LNG is commonly traded on exchanges, with contracts based on volumes and no explicit reference to its origin. LNG’s inherent flexibility and tradability mean that Russia still has a role to play as a source. In fact, Russia supplied 13.2% of the European Union’s LNG supply in 2023, according to Eurostat.

The good news is that LNG terminals coming online from the US and Quatar should help to rebalance the market, noted Reuters. Also, EU gas demand is expected to move lower as renewable energy sources increasingly come onto the energy scene.

In its pursuit of enhanced energy independence, Europe is banking on a green energy transformation, embodied by the ambitious “Green Deal.” This initiative necessitates substantial investments in renewable energy sources. However, sluggish progress toward meeting the Green Deal’s emission targets may compel Europe to depend more on China. China has secured vital resources—including lithium for batteries and steel for wind turbines—and established manufacturing capabilities for green technologies, according to the CNN article.

China could leverage its energy influence in Europe to advance its geopolitical objectives, such as Chinese President Xi’s aspirations regarding the reunification of China and Taiwan. Furthermore, it’s worth noting that renewables themselves are not impervious to challenges, even without China’s involvement. As reported in a recent Bloomberg article, a few weeks of cloudy and rainy weather can significantly affect power output from both wind turbines and solar panels.

Europe IV: German Gloom. Germany, the powerhouse of Europe’s economy, appears to be on the brink of further contraction as its manufacturing sector continues to weaken. German manufacturers, heavily reliant on energy, have borne the brunt of surging energy costs in the wake of Russia’s invasion of Europe. Additionally, Germany faces persistent structural challenges, including an international trade environment that has depressed demand for German goods and a shortage of skilled labor, which has driven up production costs.

Let’s delve into key indicators highlighting the weaknesses within the Eurozone in general and Germany in particular:

(1) Eurozone. GDP grew a meager 0.5% (seasonally adjusted annual rate) during Q2-2023 following several quarters of sluggish growth (Fig. 8). On Monday, as we were writing this piece, the European Union lowered its GDP growth forecast for this year to 0.8% from its 1.1% forecast in the spring, the commission said. For next year, the growth expectation was lowered to 1.3% from 1.6%.

IFO, the economic institute, projected on September 7 that Germany’s GDP would contract by 0.4% in 2023. It’s worth noting that manufacturing contributed to approximately 20% of German GDP in 2021, the WSJ recently observed.

(2) Eurozone sentiment eroding. The Eurozone’s economic sentiment indicator (ESI) has remained below 100 since July 2022, deteriorating further as the war in Ukraine intensified and concerns grew over a harsh winter. It continued to decline through August this year, reflecting ongoing worries related to rising interest rates (Fig. 9). Consumer sentiment in the Eurozone has been consistently weak; that’s reflected in the volume and value of retail sales, which have slightly picked up in recent months but remain depressed through July (Fig. 10).

(3) Industrial performance weaking. German industrial production declined during July compared to the previous month, and it’s down 4.0% since February 2022, the month of Russia’s Ukraine invasion (Fig. 11).

Germany’s energy-intensive manufacturing sector also saw production dip during July as manufacturers adjusted to decreased demand and rising costs. Manufacturing orders dropped more on a m/m basis in July than in any other month since April 2020 as the backlog of orders from the pandemic era diminished (Fig. 12).

On a y/y percentage change basis, Eurozone industrial production has bounced around zero since late 2022 (Fig. 13).

(4) Business confidence declining. Germany’s IFO business confidence index, encompassing both manufacturing and service sectors, reached a recent low in October 2022 before briefly rebounding through April of this year. Since then, the index has steadily declined through August (Fig. 14). Both the current situation and expectations indexes have dropped recently, reflecting uncertainty and reduced confidence among German businesses (Fig. 15).

(5) PMIs disappointing. The latest Eurozone PMI data indicate continued weakening of economic activity across the region, providing further confirmation of our pessimistic outlook for the European economy (Fig. 16). While the pace of manufacturing activity decelerated somewhat in August compared to previous months, the pace of activity in the service sector slowed sharply.

Germany’s manufacturing PMI remained in contractionary territory during August, and now Germany’s non-manufacturing PMI has joined it there, plummeting below 50 during August (Fig. 17). The data adds to Germany’s economic woes and dashes hopes of stability in the Eurozone region’s services sector.

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‘Talk To An Economist’

September 11 (Monday)

YRI Weekly Webcast. Dr. Ed is on vacation and has prerecorded his Monday webcast, which is available here along with replays of his past weekly webcasts. He will see you next week live on Monday at 11:00 a.m. for his next weekly webcast.

US Federal Deficit I: The Two-Trillion-Pound Gorilla. The September 5 issue of The New York Post reported:

“White House Press Secretary Karine Jean-Pierre on Tuesday called President Biden ‘fiscally responsible’—but couldn’t explain away the latest dismal deficit figures, saying dismissively, ‘Talk to an economist.’

“The Biden rep brushed off statistics indicating the federal deficit is on track to double this year, blaming the tenuous situation on ‘volatile’ factors—but then refusing to be more specific. ‘Deficits from year to year can be volatile, and so that’s kind of how we have tracked that, but the reality is the president has a real plan, as we have laid out multiple times, to reduce the deficit,’ Jean-Pierre claimed at her regular briefing in response to a question from a Time reporter.

“The scribe followed up, ‘What is the reason it’s going up, though? Why is the deficit increasing?’ Jean-Pierre responded, ‘I just said, it can be year to year—it can be very volatile.’ When challenged again for a reason, Jean-Pierre repeated, ‘I just laid out, it can be very volatile. … That’s the way it is, from year to year, it can be variable.’ A reporter from The Post interjected, ‘Why?’ She shot back, ‘Talk to an economist, and they’ll tell you specifically.’”
 
The nonpartisan Committee for a Responsible Federal Budget recently projected that the federal deficit for fiscal 2023, which ends September 30, will hit $2 trillion. That’s the highest ever excluding during the Covid-19 pandemic, despite Biden’s claim that his administration has implemented measures to slash the deficit.

If Jean-Pierre were to talk about the deficit with Debbie and me, we would make the following points:

(1) Deficit cycle. The federal deficit always widens during economic recessions as tax receipts fall and outlays increase owing to automatic federal income support programs and spending (and/or tax cuts) aimed at boosting the economy. As a result, the ratio of the deficit to nominal GDP is inversely correlated with the unemployment rate and the growth rate of real GDP (Fig. 1 and Fig. 2). So it is extremely unusual to see the ratio rising—as it is now—at times like now, when the economy is growing and the unemployment rate is near record lows, around 3.5% recently.

(2) Ballooning deficit. The federal deficit, on a 12-month sum basis, narrowed from a record $4.1 trillion through March 2021 to a recent low of $1.0 trillion through July 2022 (Fig. 3). Since then, it has ballooned to $2.3 trillion through July.

(3) Revenues. The recent widening of the federal deficit is partly attributable to a significant drop in federal individual income tax receipts so far this year (Fig. 4). Meanwhile, payroll tax receipts rose to a record high of $1.6 trillion over the 12 months through July, reflecting record employment. Corporate tax receipts totaled $430.7 billion, near their recent record high. But individual income tax receipts fell from a record high of $2.7 trillion over the 12 months through last April to $2.2 trillion over the 12 months through this July.

Last year’s individual income tax revenues were boosted by capital gains tax revenues, as individual investors bailed out of their stocks during the 2022 bear market. So this year’s decline reflects a more normal pace of income tax receipts. Unfortunately, without such one-time windfalls boosting revenues, the underlying trend in the federal deficit is to widen.

(4) Outlays. While revenues are falling (on a 12-month sum basis), outlays are rising at a more rapid pace led by net interest income, Social Security, and Medicare (Fig. 5 and Fig. 6). The former (on a 12-month sum basis) is up $628 billion y/y, while the sum of the latter two is up $2,151 billion.

US Federal Deficit II: Bond Drivers. How much higher might record federal deficits drive up the 10-year Treasury bond yield? In the past, we’ve often observed that supply and demand for bonds aren’t usually as important to the determination of the bond yield as are actual and expected inflation and the expectations of how the Fed will respond to them. So given that we expect inflation to continue to moderate toward 2%-3% by late next year, we currently predict that the bond yield should range between 4.25% and 4.50%.

That’s not so high in a historical context, as we’ve previously shown; it simply represents a return to the “old normal” yields of 2003-07, i.e., before interest rates were slashed to the “new abnormal” levels from the Great Financial Crisis through the Great Virus Crisis. From 2003-07, the 10-year TIPS yield averaged about 2.00%, and the expected inflation spread between the 10-year nominal Treasury and comparable TIPS yield ranged around 2.25%-2.50% (Fig. 7 and Fig. 8). They add up to a normal nominal bond yield of 4.25%-4.50%.

On August 1, Fitch Ratings downgraded US government debt from AAA to AA+ for all the reasons that have been concerning the investors for years. None of this is news. However, the Fitch downgrade serves as a reminder to financial markets broadly that fiscal policy continues to get more and more abnormally profligate.

As noted above, in the past, federal deficits tended to narrow during economic expansions and to widen during recessions. Now the federal deficit is widening even though the economy is expanding. This raises the possibility that the bond market might have trouble financing the government’s huge deficits at current market interest rates.

Let’s assess the outlook for the bond market based on a supply-and-demand analysis:

(1) The Fed and banks are sellers. The US Treasury will be selling lots of notes and bonds over the rest of this year and next year, while the Fed's quantitative tightening (QT) program will continue to reduce the Fed's holdings of Treasuries by about $60 billion per month (Fig. 9). Additionally, commercial banks are allowing their portfolios of securities to mature and using the proceeds to offset net deposit outflows (Fig. 10).

(2) Other investors are buyers. The Treasury, therefore, must increasingly rely on US households, US institutional investors, and foreign investors to purchase the rapidly increasing supply of US debt. They will undoubtedly do so. The only question is whether interest rates are high enough already to attract these buyers or whether rates would have to go higher to do so.

We have monthly data on net inflows into all bond mutual funds and ETFs in the US. On a 12-month-sum basis, they show net outflows from September 2022 through April 2023 (Fig. 11). Through July, there have been net inflows of $189 billion. That’s not much. Weekly data on money market mutual funds (MMMF) show significant net inflows of $1,060 billion over the past year through the September 6 week, with $599 billion in retail and $461 billion in institutional MMMF (Fig. 12 and Fig. 13).

Monthly data compiled by the US Treasury on net capital inflows show private foreign purchases of US Treasury notes and bonds at a record $989.5 billion over the 12-month period through October 2022 (Fig. 14). This pace slowed to $761.3 billion through June. That is still a very large number.

(3) Fed still buying Treasury bonds. By the way, the Fed has been trying to moderate the impact of its QT program on the bond market by continuing to purchase Treasury bonds with maturities of 10 years or longer (Fig. 15). The Fed’s holdings of these securities rose $74 billion since the start of QT through the September 6 week. The Fed’s total holdings of Treasuries fell $857 billion over this period.

(4) Bottom line. So: How much higher might record federal deficits drive up the 10-year Treasury bond yield? We are sticking with our back-to-the-old-normal bond yield forecast of 4.25%-4.50%. The yield has been trading in that range since early August. Staying in that range when the federal deficit is abnormally large requires that inflation continues to moderate as we expect.

We acknowledge that there could be temporary setbacks in the disinflationary trend since last summer. Those could send the yield temporarily above our range, but we would view them as temporary buying opportunities in the bond market.

Of course, we could be wrong about inflation. In a rebounding inflation scenario, the federal deficit obviously would exacerbate the rise in the bond yield. That would be a very ugly scenario for stock and bond investors as well as for the economy. That’s not our outlook. But that scenario is the risk to our outlook.

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Oil, China & The Ocean

September 7 (Thursday)

Energy: Saudis Play With Prices. Saudi Arabia and Russia continue to flex their muscle in the oil market, holding back production and pushing up prices. Saudi Arabia announced on Tuesday that it will extend its 1 million barrels per day (mbd) supply cut through the end of this year. On the same day, Russia announced that it will do the same with 300,000mbd. This is in addition to the 1.66mbd of production cuts through year-end that OPEC+ had agreed to earlier. The price of Brent crude futures responded to Tuesday’s news by rising to $90.04 a barrel that day, up from its recent low of $72.26 on June 27 (Fig. 1).

Before Tuesday’s announcement, Saudi Arabia and Russia had said their cuts were to extend through September. The US Energy Information Administration’s (EIA) August outlook anticipated that the global oil market would move from a surplus position during H1-2023 to a deficit during H2-2023. After the announcement, that deficit undoubtedly will grow, though it is tempered somewhat by unexpectedly strong US production.

The EIA no doubt will be revising its quarterly production and consumption forecasts through 2024 to reflect Tuesday’s news, but as of August 3 they stood as follows: Q1-2023 (101.00 mbd production, 100.16 mbd consumption), Q2-2023 (101.31, 100.97), Q3-2023 (101.03, 101.67), Q4-2023 (101.83, 101.95), Q1-2024 (102.33, 102.29), Q2-2024 (102.83, 102.36), Q3-2024 (103.38, 103.29), and Q4-2024 (103.47, 103.24).

The future course of oil prices is always a function of demand and supply. Determinants on the demand side include the rates of economic growth in China and the United States. But from a supply perspective, oil prices will be heavily determined by the production decisions of Saudi Arabia as well as US production levels. Let’s take a deeper look at the dynamics underpinning both:

(1) Saudis need prices high. Saudi Arabia’s budget deficit jumped by 80% to $1.4 billion in Q2-2023 due to spending on social benefits and capital expenditures. Non-oil revenues rose, but oil-related revenues inched up 0.6% q/q and fell 28% y/y, according to an August 4 article at OilPrice.com. In May, the International Monetary Fund said that the country needed oil prices at $80.90 a barrel to balance its budget this year. While that level seemed unlikely to analysts at the time, today it looks far more feasible.

Rising prices might also mean that Saudi Arabia could reverse recent production cuts and generate more revenue from exports, giving its economy a needed boost. The country’s GDP slowed to 1.1% in Q2 from 3.8% in Q1 and 11.2% in Q2-2022, a July 31 CNBC article reported.

High oil prices also would boost the share price of the stock offering that Saudi Arabia’s Aramco is considering. The company may sell as much as $50 billion of shares before year-end, which would make it the largest offering ever sold in the capital markets, according to a September 1 WSJ article. The higher the price of oil, the more likely the stock offering will occur. The country’s Crown Prince Mohammed bin Salman has been monetizing Saudi Arabia’s oil-related assets and investing the proceeds in industries outside of the oil patch. Oil priced at $80 a barrel or higher would also help fund the kingdom’s efforts to diversify its economy.

(2) US production on the rise. US oil production has risen to near-record levels, but that’s still not high enough to entirely offset the 1.3mbd production cuts by Saudi Arabia and Russia. The US produced 12.8mbd of crude oil in the week ending August 25; that’s only 0.3mbd shy of the record production level of 13.1mbd in February and March 2020.

The recent jump in US production comes even as the number of rigs used for drilling has fallen to 512 from a recent peak of 627 (Fig. 2). US shale producers have been lengthening the horizontal laterals they drill, and they’ve been using new techniques to get more oil out of old wells. ExxonMobil believes that shale producers can double crude output from existing wells by using new fracking technologies.

Exxon “is trying to frack more precisely along the well so that more oil-soaked rock gets drained. It’s also looking for ways to keep the fracked cracks open longer so as to boost the flow of oil,” a June 4 OilPrice.com article reported. In addition, oil companies are returning to old, fracked wells and using a high-pressured blast to get more oil out of them.

The EIA increased its forecast for US oil production by 360,000 barrels per day this year and by 240,000 in 2025, according to its August 23 report.

(3) Energy stocks on a roll. Although energy stocks fell during most of this year, they’ve gushed higher in recent months, helped by the surge in the price of crude oil. Since the end of May, the S&P 500 Energy sector has outperformed all other S&P 500 sectors.

Here’s the performance derby for the S&P 500 sectors from May 31 through Tuesday’s close: Energy (18.6%), Consumer Discretionary (12.5), Industrials (10.4), Materials (9.7), Communication Services (8.5), Information Technology (8.4), Financials (8.2), S&P 500 (7.6), Health Care (3.5), Real Estate (1.7), Consumer Staples (-0.8), and Utilities (-5.1).

Energy stocks may have started to price in a more optimistic future than industry analysts have anticipated. Industry analysts are expecting the S&P 500 Energy sector’s revenue to fall 17.4% this year and remain flat in 2024, while calling for the sector’s earnings to fall 27.4% this year and rise 1.7% next year (Fig. 3 and Fig. 4). Higher-than-expected crude oil prices could push analysts to revise those estimates up sharply. Thank Saudi Arabia.

China: Waiting for the Restructuring. In recent weeks, China and its property developers have taken steps to keep the Chinese residential real estate market and the broader economy afloat. China has made investing in real estate more attractive, and Country Garden Holdings, one of China’s largest property developers, has made an interest payment and extended the maturities on three of its bonds.

While this may allow the Chinese economy to continue limping along, it won’t reduce the excessive leverage that’s weighing down the real estate sector and local governments. We’ve long thought that the government ultimately will have to sponsor a debt restructuring program if it hopes to put China’s leverage problems in the rearview mirror anytime soon.

The most recent data about China’s economy arrived Tuesday: The Caixin/S&P Global services purchasing managers’ index fell to 51.8 in August from 54.1 in July. While the August reading marked a slight expansion, it was the lowest reading since December, when Covid-19 kept consumers in their homes (Fig. 5). Official figures out of China weren’t much better, with August’s nonmanufacturing PMI reported at 51.0 and manufacturing PMI at 49.7 (Fig. 6).

Here's a look at the steps the Chinese government and Country Garden have taken to keep the train moving down the tracks, albeit very, very slowly:
 
(1) Default averted—for now. Country Garden Holdings dodged default earlier this week by making a $22.5 million interest payment on US dollar-denominated debt; it also extended the maturities on $1.5 billion of local currency-denominated debt. The developer still has about $162 million of offshore bond interest payments due this year and nearly $15 billion of debt due within the next year in the form of bonds, notes, bank debt, and other borrowings—dwarfing the developer’s $13.9 billion of cash and equivalents, a September 5 NYT article reported. Country Garden has warned that default is a risk if its financial performance continues to deteriorate. During a tough H1-2023, it posted a record $7.1 billion loss, a September 4 Reuters article reported.

The company has total liabilities of almost $190 billion, which is smaller than China Evergrande Group’s more than $300 billion of debt. But don’t underestimate the impact that a Country Garden default would have on the Chinese economy. The company had more than 3,100 projects in development across every Chinese province at the end of 2022, with nearly 947 million square feet already presold, a September 2 South China Morning Post article reported. That far exceeds Evergrande’s 1,200 projects in June 2021, before its distress became apparent. If Country Garden defaults and can’t deliver units that have already been paid for, more than one million households could be affected.

(2) Government lends a hand. Under pressure to get the economy growing faster, the Chinese government and related institutions have taken many small steps to encourage borrowing and lending and to bolster private industry.

The government announced on Monday plans to set up an agency to “coordinate policies across different government bodies and help development of the private economy,” a September 4 WSJ article reported. This is quite a reversal from the Chinese government’s stance toward private companies and financial markets in 2021, when it blocked the IPO of Ant Group. Additional moves that China made recently to facilitate financial market activity include halving the stamp duty, a tax charged on shares traded; restricting share sales by major shareholders under certain circumstances; and lowering margin requirements.

In an effort to boost the property sector, the People’s Bank of China (PBOC) and other agencies lowered the down payment for first-time home buyers to 20% and for second-time purchasers to 30%. Chinese state-owned banks are expected to help borrowers by lowering interest rates on existing mortgages or replacing them with new mortgages. Chinese banks cut deposit rates to encourage savers to become spenders, and the one-year loan prime rate was lowered by 10 basis points to 3.45% last month. Regulators also have lent a hand by cutting reserve ratios. At large depository institutions, the reserve ratio has fallen to 10.75 from 12.00 two years ago (Fig. 7).

The PBOC’s ability to cut rates is somewhat limited if it aims to keep the yuan from falling below its current decade-low level. The yuan trades at 7.3 to the dollar, down from its recent peak of 6.7 and its lowest level since early November 2022 (Fig. 8).

(3) China’s stocks are down, but are they cheap? The MSCI China share price index is down 4.1% ytd, and the Shanghai-Shenzhen 300 has lost 1.5% ytd (Fig. 9 and Fig. 10). After recent government actions to boost the economy and the markets, China’s MSCI stock price index has outperformed most other international markets during the opening days of September, rising 1.4%. That beat the 0.2% decline in the US MSCI index over the same period.

The collective revenues of the companies in China MSCI stock price index are expected to rise 5.8% this year and 7.5% in 2024 (Fig. 11). Their earnings are forecast to increase 18.1% in 2023 and 14.9% in 2024 (Fig. 12). Net earnings revision have been decidedly negative over the past 24 months (Fig. 13).

The China MSCI’s forward P/E has fallen from a peak of 18.3 in February 2021 to a recent 10.0 (Fig. 14). The index’s valuations have fallen into the single digits during times of extreme stress in the past, and unless the Chinese government proactively works to reduce the leverage in its economy, more distressed valuations may be coming.

Disruptive Technologies: Oceans Getting Cleaned. The Ocean Cleanup, a group focused on ridding our rivers and oceans of trash, has made solid progress since we wrote about them in the November 17, 2022 Morning Briefing. At the end of August, the organization deployed System 03, its largest ocean cleanup system, into the Great Pacific Garbage Patch (GPGP). It’s goal: To make removing trash from the ocean faster and more cost effective.

Here’s a look at what the organization has accomplished and what’s left to do:

(1) Getting bigger. Over the past two years, System 002 cleaned more than 3,000 square miles of ocean and removed 623,439 pounds of plastic from the GPGP. On its last trip, it brought back more than 55 tons of trash back to shore, but there’s plenty left to do because the GPGP contains around 100,000 tons of plastic. That job will fall to System 03.

As in the past, System 03 uses two boats that each hold one end of a net that’s open at the bottom. As the boats move slowly through the ocean, trash is captured by the nets and pushed back into a large sack called the “retention zone.” When the sack is full, it’s pulled onto one of the boats and emptied.

System 03 has a 7,000-foot-long net that’s three times longer than System 002’s net. Hanging down from the net is a screen that reaches much deeper to catch plastic flowing underneath the surface. At peak efficiency, System 03 can clean an area the size of a football field every five seconds, according to the company’s website. The ability to clean up more of the ocean faster and using fewer resources lowers the cost per kilogram of plastic removal from the ocean. The Ocean Cleanup believes it will need a fleet of ships using 12 System 03s to successfully cleanup the GPGP and move onto other problem areas in the world’s oceans.

System 03 added a Marine Animal Safety Hatch (MASH) to provide an escape route for animals caught in the retention zone. The MASH is monitored on the ship by humans and underwater by cameras and artificial intelligence (AI).

(2) Kia steps up. Kia announced in April 2022 that it would enter a seven-year partnership with The Ocean Cleanup. Kia provides funding and in-kind contributions to support the environmental organization and agreed to use its recycled plastic. Kia will use “a portion” of the recycled plastic made from the last haul of System 002 in its electric vehicles, a September 4 Plastics Today article reported.

(3) What’s next. Looking forward, The Ocean Cleanup is evaluating how best to sort its hauls of trash. As the hauls increase in size, sorting by hand will not be scalable and may need to occur on shore instead of on the ship. Larger hauls will also require new systems on the ships to compact and store the trash. The Ocean Cleanup would like to move recycling operations to North America and find new ways to process items that aren’t currently recyclable.

Additionally, the organization remains proactive, with systems cleaning up rivers to prevent trash from ending up in the oceans.

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From Strong To Soft Patch?

September 6 (Wednesday)

Weekly Webcast. If you missed yesterday’s live webcast, you can view a replay here.
 
US Economy I: Another Soft Landing Ahead. Our economic forecast has put us in the soft-landing camp since early last year. That worked out well so far. However, Q3 is turning out to be a very strong patch in the soft-landing scenario. We doubt it is sustainable.

The question is: What comes next? Will the strong patch be followed by a resumption of our rolling recession paradigm, which has been driving our soft-landing scenario? Or will it be followed by the recession that was so widely expected last year and early this year? A recession is still expected by many economic forecasters even now, but not as widely as at the start of this year.

Of course, from a contrarian perspective, the biggest surprise of all would be that the current strong patch is the start of better-than-expected economic growth for the rest of this year and into next year. Debbie and I like to be contrarians when it makes sense. But stronger-for-longer economic growth seems to be at odds with the Fed’s current higher-for-longer stance on interest rates. On the other hand, fiscal policy remains very stimulative. Capital spending might strengthen as business managers do what they can to boost productivity to offset the shortage of workers, especially skilled ones.

Then again, the rolling recession is rolling into the commercial real estate sector, hitting office buildings hard and boosting nonperforming loans at the banks. The rolling recovery in housing starts is likely to be aborted by the recent jump in mortgage interest rates. The consumer has been remarkably resilient. However, consumers’ excess savings could be depleted by the end of this year. Student loan payments are resuming. Delinquency rates on consumer loans are moving higher. Nevertheless, we don’t expect these developments to result in a hard landing.

Let’s review the latest data relevant to assessing which way the economy is heading:

(1) GDP. The Atlanta Fed’s GDPNow tracking model shows real GDP rising 5.6% (saar) during Q3 as of September 1. That follows increases of 2.0% and 2.1% during the first two quarters of this year (Fig. 1). Leading the way is a 7.2% increase in residential investment following declines of 4.0% and 3.6% during Q1 and Q2. Also strong is personal consumption expenditures with a gain of 4.2% compared to 1.7% during Q2. In capital spending, equipment is up 2.7%, while nonresidential structures is up just 0.2%.

(2) Coincident indicators. There may be a bust coming according to the Index of Leading Economic Indicators, which peaked during December 2021. But there is still no hint of a recession in the Index of Coincident Economic Indicators (CEI), which rose 0.4% m/m to yet another record high in July (Fig. 2). On the other hand, there’s no boom in the CEI, which on a y/y basis tracks real GDP very closely. The former rose 1.7% in July, while the latter rose 2.5% during Q2.

The CEI probably rose again during August. Payroll employment, which is one of the four components of the CEI, rose 0.1% last month to a new record high. Real personal income less government transfer payments, another CEI component, most likely rose too since aggregate hours worked increased 0.4% to a new record high last month (Fig. 3). Wages as measured by average hourly earnings rose 0.2% last month, which might have been a downtick on an inflation-adjusted basis.

Another CEI component, real business sales, might have been weighed down by some weakness in August retail sales after July was boosted by Amazon’s Prime Day. Auto loans suggest that autos sales may be weakening. Finally, the aggregate number of hours worked in manufacturing rose 0.2% during August, suggesting that manufacturing output remained relatively flat last month (Fig. 4).

None of the above confirms the strength in Q3’s real GDP or suggests that it is sustainable. Nor do they hint at an impending recession.

(3) Housing. Housing starts rebounded during the spring and early summer (Fig. 5). Single-family starts led the way. Meanwhile, multi-family starts remained high, but multi-family building permits have been falling since March, when the banking crisis first hit (Fig. 6). In addition to tightening credit conditions, rapidly falling rent inflation may also be weighing on multi-family starts (Fig. 7).

Real residential investment could very well increase during Q3, but it’s easier to imagine another leg down ahead rather than further gains (Fig. 8). Mortgage applications for new home purchases declined during August to the lowest since April 1995 (Fig. 9). That does not augur well for new and existing home sales.

(4) Capital spending. The Business Roundtable CEO Outlook Index stabilized during the first half of this year around 75.0, down from a record high of 123.5 during Q4-2021 (Fig. 10). Not surprisingly, it is highly correlated with the growth rate of capital spending in real GDP on a y/y basis. JP Morgan Chase CEO Jamie Dimon is a member of the Roundtable and might have depressed the other members with his warnings last year of a coming recession.

Real capital spending rose at a solid pace of 4.2% y/y during Q2, but could now start to slow. Nondefense capital goods orders have stalled this year through July at a record high (Fig. 11). However, on an inflation-adjusted basis, this series has been falling since early 2022. Industrial production of business equipment has also been relatively weak since the end of last year (Fig. 12). The regional business surveys conducted by five of the 12 Federal Reserve district banks have been showing relatively weak capital spending readings in recent months (Fig. 13).

(5) Construction. One area of strength in capital spending has been nonresidential construction, led by a building boom in factories (Fig. 14). Onshoring and federal government incentives have boosted these outlays. In addition, the federal government is spending lots of money on infrastructure, lifting public construction spending to a new high in June (Fig. 15).

(6) Bottom line. All of the above suggest that Q3’s strong patch isn’t likely to be sustainable. However, we still need to spend some time with the elephant in the room: The economic outlook will be mostly determined by consumers. Let’s turn to a review of what we know about them in the next section.

US Economy II: Born To Shop. Debbie and I have often observed that Americans are born to shop. We’ve also observed that they spend when they are happy and sometimes spend even more when they are depressed. That’s because shopping releases dopamine in the brain and makes us feel better.

Consumer confidence has been depressed by high inflation over the past couple of years; yet consumers continued to shop, no doubt frustrating the hard-landers with their dire forecasts. Nevertheless, the hard-landers are confident that a consumer-led recession is coming soon once consumers’ excess saving is depleted. Let’s review the outlook for consumers since they are likely to make or break the pessimists’ outlook:

(1) Excess saving. It is certainly true that personal saving rose significantly during the pandemic years of 2020 and 2021 (Fig. 16). It totaled $5.2 trillion over the course of those two years compared to $2.6 trillion over the prior two years. It was down to $658 billion in 2022 and has remained low so far in 2023.

The resulting drop in the personal saving rate since mid-2021 has meant that consumers spent more of their disposable income on goods and services (Fig. 17). If now they were to reverse that behavior abruptly, returning to saving at the pre-pandemic rate, that undoubtedly would cause a consumer-led recession.

However, if they were to increase their rate of saving gradually rather than abruptly or if they were to delay increasing their low saving rate for a while, a recession wouldn’t be a foregone conclusion. Those might be more likely scenarios because consumers shouldn’t be in a rush to replenish their savings, as they didn’t actually deplete their savings to spend more over the past two years. Rather, they accumulated less net worth (by saving less) because they had accumulated so much during the pandemic period!

In short, there’s no compelling reason for consumers to suddenly slam on their spending brakes. That’s especially true if both payroll employment and real wages continue to rise to record highs. In our scenario, real consumer spending should grow along with real disposable income, driven by rising employment and real wages. That’s assuming that consumers aren’t in a rush to save more of their disposable income than they’re now saving.

Collectively, US households’ net worth totaled a near-record $140.6 trillion during Q1, up a whopping $36.4 trillion since Q1-2020, just before the pandemic (Fig. 18). Are consumers really under pressure to suddenly save more? We don’t think so.

(2) Student loan payments. The Chamber of Commerce updated its fact sheet on Student Loan Debt on July 6. Student loan payments were put on hold during March 2020. They are set to resume on October 1. According to the US Department of Education, 43.6 million Americans have federal student loan debt, amounting to more than $1.64 trillion. The average amount of federal student loan debt is $37,717.

The resumption of student loan payments undoubtedly will weigh on consumer spending. That’s one reason why we expect that the recent strong patch in economic growth isn’t sustainable. However, we don’t expect that the resumption of student loan payments will result in a consumer-led recession.

(3) Delinquencies. Tightening credit conditions are starting to stress some low-and middle-income consumers. This year, credit card delinquencies have hit 3.8%, while 3.6% of car loan holders have defaulted on their car loans, according to credit agency Equifax. Both figures are the highest in more than 10 years.

There are 70 million more credit card accounts open now than before the pandemic in 2019, and credit card debt surpassed $1 trillion for the first time ever this year, according to the New York Federal Reserve. Also, retailers—including Macy’s, Kohl’s, and Nordstrom—have called out rising delinquency rates among their customers with private-label store cards.

(4) Mortgage payments. Last but not least: Let’s not forget that many of the approximately 50 million households with mortgages have refinanced them at record-low interest rates between 3%-4% in 2020 and 2021. They obviously have more cash to spend than they would have had they not refinanced. On the other hand, they aren’t likely to move to another home anytime soon, a situation that should continue to exert drag on housing-related consumer spending.

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Powell’s Ideal Economy

September 5 (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.

Ideal Economy I: Rebalancing Labor Market. In his Jackson Hole speech on August 25, Fed Chair Jerome Powell sounded quite hawkish. He implied that he would turn less hawkish if price inflation continued to fall toward the Fed’s 2.0% target. In the past, he has indicated that wage inflation would probably have to slow to 3.0% (from 4%-5% currently) to get there, which would require that the supply of labor increase at a faster pace than the demand for labor. He also would like to see hot consumer spending cool off. Powell has said on numerous occasions that he believes monetary policy is on course to achieve this ideal outcome without a recession.

Powell’s naysayers say that he is naïve. History shows that only a recession can subdue price and wage inflation; it does so by depressing consumer spending. Debbie and I have been pointing to examples in the past when midcycle slowdowns (a.k.a. soft landings or growth recessions) subdued inflation without recessions. The clearest examples occurred during the mid-1980s and mid-2010s (Fig. 1 and Fig. 2). We think this is happening again now.

Thursday’s personal income report for July confirmed that price inflation remains on a downward path. Consumer spending was hot during the month, but we expect it to cool. Friday’s employment report for August showed that labor supply may be starting to outpace labor demand. Tuesday’s JOLTS report for July confirmed this development, as did the Consumer Confidence Index survey.

Let’s have a closer look, starting with the labor market:

(1) Labor supply. The unemployment rate jumped from 3.5% in July to 3.8% in August as the labor force swelled by 736,000, outpacing the 222,000 increase in the household measure of employment (Fig. 3 and Fig. 4). Notably, the household measure counts the number of people with jobs rather than the number of jobs, unlike payroll employment, which counts the number of jobs. The labor force participation rate rose from 62.6% in July to 62.8% in August, led by a jump in the labor force participation rate of women (Fig. 5).

(2) Labor demand. Payroll employment rose 187,000 during August, the third consecutive reading below 200,000 (averaging 150,000 over the period) (Fig. 6). It averaged gains of 287,000 during the first five months of this year. The average workweek in private industry edged up from 34.3 hours in July to 34.4 hours in August (Fig. 7). It’s down from a recent high of 35.0 hours during January 2021 and back to the more normal readings before the pandemic.

(By the way, July’s employment gain would have been over 200,000 but for the loss of 30,000 jobs in the trucking industry resulting from the bankruptcy of Yellow and the Writers Guild of America and Screen Actors Guild strike involving 16,000 workers. On the other hand, June and July payrolls were revised down by 110,000.)

Also heading back down toward more normal pre-pandemic readings is the JOLTS job openings series (Fig. 8). It is down from a record 12.0 million during March 2022 to 8.8 million in August. That’s still a very high reading, but it is falling. Also falling is the “jobs plentiful” series included in the Consumer Confidence Index survey from a peak of 56.7% saying so last March to 40.3% this August, which is below the pre-pandemic readings during 2019 (Fig. 9). However, the “jobs hard to get” series remained low at 14.1% in August.

(3) Wages. Average hourly earnings of all workers in private industry rose just 0.2% m/m during August. However, it was still up 4.3% y/y (Fig. 10). That’s still well above Powell’s ideal of 3.0%, but it is heading in the right direction given that it peaked at 5.9% during March 2022.

Ideal Economy II: Slowing Consumer Spending. Forecasters who’ve long been expecting a hard landing of the economy made a big mistake in betting against American consumers. But the hard-landers are not accepting that consumer spending isn’t going to retrench; instead, they’re doubling down by predicting that it will happen soon, because consumers are running out of pandemic-related excess savings now and have too much consumer debt. In addition, payments on student loans are about to resume.

Powell doesn’t want consumers to retrench. He just wants them to cool their jets. We think they will do just that. Inflation-adjusted consumer spending jumped 0.6% m/m during July (Fig. 11). But that was boosted by Amazon’s Prime Day (and maybe by Taylor Swift’s concerts). In current dollars, retail sales of non-store retailers jumped 1.9% during July.

Let’s have a closer look at the consumer-related data:

(1) Earned Income Proxy. Our Earned Income Proxy (EIP) for private wages and salaries in personal income rose 0.6% m/m during August, as aggregate hours worked rose 0.4% and average hourly earnings increased 0.2% (Fig. 12). That augers well for August’s personal income and retail sales reports.

(2) Disposable personal income and consumption. Inflation-adjusted disposable income fell 0.2% m/m during July, while real consumer spending on goods and services rose 0.6% m/m (Fig. 13).

(3) Personal saving. The personal saving rate fell to 3.5% during July, remaining near its post-pandemic lows and well below 9.3%, which was its reading in February 2020 just before the pandemic (Fig. 14). It is widely expected that the saving rate will start moving higher later this year or early next year once consumers deplete the excess savings they accumulated during the pandemic.

We don’t agree. We believe that as the Baby Boomers continue to retire, they are no longer saving. Instead, they are spending their retirement nest eggs. The oldest Baby Boomers turned 65 during 2011 and 75 during 2021. The youngest of this cohort will turn 65 in 2029 and 75 in 2039 (Fig. 15).

The Baby Boomers’ net worth at the end of Q1-2023 was $74.8 trillion (Fig. 16). That’s a huge pile of “excess saving.”

Ideal Economy III: Moderating Price Inflation. Both the headline and core PCED inflation rates rose 0.2% m/m in July. Powell anticipated in his August 25 Jackson Hole speech that these rates would be moderate in July, as they were in June. However, he said that two consecutive months of such moderation aren’t enough. He wants to see inflation drop closer to the Fed’s 2.0% target on a y/y basis. The headline and core PCED inflation rates were 3.3% and 4.2% on a y/y basis during July (Fig. 17). He focuses on the core rate, which, by the way, rose at an annualized rate of just 2.9% over the past three months.

Headline goods inflation was -0.5% y/y in July. Housing services inflation (for rent, etc.) peaked at the start of this year and is slowly heading lower. Non-housing services inflation has been stuck around 5.0% for the past two years and remains one of Powell’s major concerns about inflation (Fig. 18).

Excluding rent, the headline and core PCED inflation rates were only 2.6% and 3.6% in July on a y/y basis (Fig. 19).

We are still predicting that the core PCED inflation rate will fall close to 3.5% by the end of this year and 2.5% by the end of next year (Fig. 20).

Movie. “The Crowded Room” (+) (link), an Apple TV+ series, is a slow-paced psychological thriller. So it isn’t very thrilling and is only mildly entertaining. Tom Holland plays the lead role of a young man dealing with some major childhood trauma. His psychologist is played by Amanda Seyfried. Previously, he starred in a couple of Spiderman flicks, and she played scamstress Elizabeth Holmes in “The Dropout.” This series failed to provide either actor with a good script to show off their talents.

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Hooray! The Job Market Is Rebalancing

August 31 (Thursday)

US Strategy: Forward Earnings Remains on Recovery Road. The stock market rallied from Friday through Wednesday despite Fed Chair Jerome Powell’s hawkish speech at Jackson Hole on Friday. The rally received a bullish jolt from July’s JOLTS report on Tuesday morning showing both fewer job openings and fewer quits than expected during the month.

These are bullish developments, as we discuss further below, because they suggest that the labor market is “rebalancing,” with demand for labor easing. Powell has stressed the importance of these two variables for the setting of monetary policy. Both are heading in the right direction, i.e., the one that increases the likelihood that the Fed is done raising interest rates.

Also heading in the right direction are analysts’ consensus expectations for the operating earnings of the S&P 500. During Q2, the actual result fell 5.3% y/y, led by a 48.0% y/y drop in the Energy sector. Excluding Energy, S&P 500 earnings rose 3.4%. Meanwhile, industry analysts have been raising their earnings estimates for 2023, 2024, and 2025 in recent weeks (Fig. 1). They’ve also been raising their estimates for the final two quarters of 2023 as well as all four quarters of 2024 (Fig. 2 and Fig. 3).

There’s no recession apparent in the analysts’ consensus earnings forecasts. Let’s review the latest data:

(1) Quarterly. Here are the actual and current expected y/y quarterly growth rates for 2023 (-3.1%, -5.3%, -0.1%, and 9.1%). Here are the expectations for 2024’s quarters (8.8%, 12.0%, 12.7%, and 12.8%).

(2) Annually. The analysts are currently expecting that earnings on a “frozen actual” basis will rise 11.8% y/y next year to $247.09 from $221.01 this year, which would be up 1.3% from 2022 (Fig. 4). They expect 2025 earnings to increase 12.6% to $278.10.

(3) Forward. During the August 24 week, S&P 500 forward revenues rose to yet another record high (Fig. 5). S&P 500 forward earnings is still below its record high of $239.93 during the week of June 23, 2022. However, it bottomed this year during the February 9 week and is up 5.4% since then to $238.06 during the August 24 week. (FYI: Forward revenues and earnings are the time-weighted average of analysts’ consensus expectations for the current year and following year. The forward profit margin is calculated by us from forward revenues and earnings.)

These two series suggest that the latest earnings recession was wholly attributable to the decline in the profit margin. Indeed, the forward profit margin fell from a record high of 13.4% during the week of June 9, 2022 to a recent low of 12.3% during this year’s March 30 week. It rose to a seven-month high of 12.6% during the latest week of August 24.

(4) Earnings breadth. Joe calculates a series showing the percentage of S&P 500 companies with positive three-month percent changes in forward earnings (Fig. 6). It was up to 73.3% at the end of August from a recent low of 44.4% during the December 30 week of 2022.

(5) Bottom line. Joe and I believe that the earnings recession ended in Q2. Revenues growth is likely to slow along with inflation in our forecast. However, that should be more than offset by the ongoing rebound in the profit margin.

We are still estimating that S&P 500 earnings per share will be $225 this year, $250 next year, and $270 in 2025 (Fig. 7). We haven’t changed these estimates since last November. They’ve been higher than the consensus of investment strategists mostly because we’ve been in the soft-landing rather than the hard-landing camp since last year.

Heads up: Once we have all the final numbers for Q2, we may shave our 2023 earnings estimate, but we will stick with our 2024 and 2025 numbers. Can you believe that we are already starting to think about 2025? That’s because the market is probably starting to do so, and industry analysts already have earnings estimates that far out. How time flies!

US Economy I: Job Openings & Quits Falling. Job openings fell by 338,000 to 8.8 million during July, the lowest since March 2021 (Fig. 8). This series is highly correlated with the “jobs plentiful” series included in the monthly survey of consumer confidence. The latter fell from 43.7% saying so in July to 40.3% in August, the lowest since April 2021.

In discussing the “rebalancing” of the labor market in his Jackson Hole speech, Powell said: “Demand for labor has moderated as well. Job openings remain high but are trending lower.” He views this as a favorable development. We do too, and so do the stock and bond markets.

In Powell’s previous recent remarks on the labor market, he noted that the quits rate (which is reported along with job openings in the JOLTS report) is highly correlated with measures of wage inflation. He has been rooting for the quits rate to decline to reduce wage inflation. That seems to be happening. The quits rate for private industry fell from 2.7% during June to 2.5% during July, the lowest since November 2020. It tends to lead wage inflation by about six months (Fig. 9).

Workers tend to have a higher propensity to change jobs when there are more opportunities to get a pay increase by doing so. That certainly was the case last year. It’s increasingly less so this year.

US Economy II: Rolling Recovery For Goods? Yesterday, Jackie reviewed the rolling recession that hit retailers especially hard during Q2 of this year; we reckon it actually started in late 2021 when consumers pivoted from buying lots of goods to purchasing lots of services. The good news is that the goods sector may soon experience a rolling recovery.

That’s based on our reading of August’s regional business surveys conducted by five of the 12 Federal Reserve district banks. The average of their general business indexes rose from a recent low of -16.5 during May to -6.2 during August (Fig. 10). This series is highly correlated with the national M-PMI, which was 46.4 during July. The August result will be released on Friday. We expect a reading up closer to 50.0.

Global Credit: Loan Growth Falling in US & Eurozone. Monetary policy works with a long and variable lag. The major central banks started tightening their monetary policies early last year in response to surging inflation. In the US, the yield curve inverted last summer, suggesting that the odds of a financial crisis triggering a credit crunch and a recession were increasing.

Sure enough, a banking crisis occurred during March of this year. However, it didn’t morph into a credit crunch because the Fed responded quickly with an emergency lending facility for the banks. At the same time, Credit Suisse imploded in Europe. However, Europe’s banking crisis also was contained; it didn’t turn into a credit crunch.

Nevertheless, the yield curve remains inverted in the US. The growth rates of bank loans in the US and in Europe are falling. The US economy remains resilient, while the European economy is less so. Both will be weighed down by tightening credit conditions. Let’s review the latest relevant data:

(1) US bank loans. The growth rate of loans and leases at all commercial banks in the US fell to 4.8% y/y during the August 16 week (Fig. 11). That’s down from a recent peak of 12.5% during the December 7, 2022 week. That’s a slowdown, but it isn’t a credit crunch.

Here are the latest y/y growth rates of the banks’ major loan categories: commercial & industrial (0.8%), commercial real estate (7.8%), mortgages (5.8%), and consumer credit (5.8%) (Fig. 12).

Also available on a weekly basis is consumer credit card balances at the banks, which is up 11.4% y/y (Fig. 13). Auto loans is down 2.2% y/y, signaling that credit conditions and demand are deteriorating in this segment of the banks’ loan portfolios.

(2) Eurozone MFI loans. Outstanding loans held by the Eurozone’s monetary financial institutions (MFIs) fell by €58 billion through July after having peaked at a record €13.1 trillion during last September (Fig. 14).

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Consumers Spending Selectively

August 30 (Wednesday)

Consumer Discretionary I: Retailing’s Rolling Recession. In recent weeks, many retailers have reported y/y declines in Q2 revenue, including Foot Locker, Home Depot, Lowe’s, Macy’s, Nordstrom, and Target. There were some exceptions, including Walmart and TJX; but in general, the rolling recession that we have tracked as it has rolled through various industries also has hit hard-goods retailers.

The tough retailing environment hasn’t held back the S&P 500 Consumer Discretionary sector, however. It handily beat the ytd performance of the S&P 500 and eight other sectors (through Monday’s close): Communication Services (40.0%), Information Technology (39.0), Consumer Discretionary (29.6), S&P 500 (15.5), Industrials (9.0), Materials (4.5), Energy (-0.2), Financials (-0.4), Real Estate (-0.9), Health Care (-1.9), Consumer Staples (-2.0), and Utilities (-10.3) (Fig. 1).

While consumers haven’t been shopping ’til they drop lately, they have been out and about, paying up for services and big-ticket items like cars and homes. Among the Consumer Discretionary sector’s top performing component industries so far this year are Hotels, Resorts & Cruise Lines (up 44.6% ytd), Casinos & Gaming (19.6%), and Restaurants (7.4%). Even more impressive, the Automobile Manufacturers industry is up 73.3% ytd thanks to shares of Tesla, which have raced ahead by 93.9% ytd. More modest ytd gains have been logged by other auto-related industries: Automotive Parts & Equipment (9.3%) and Automotive Retail (3.4%). The Homebuilding industry is another star performer in the sector, up 34.8% ytd, as the lack of home inventory has offset the impact of rising mortgage interest rates—so far.

Meanwhile, the Consumer Discretionary sector’s retail-related industries have had a miserable year, with most of them posting negative returns ytd: Housewares & Specialties (-20.3%), Apparel, Accessories & Luxury Goods (-15.8), Footwear (-14.9), Other Specialty Retail (-8.7), Computer & Electronics Retail (-7.7), Home Furnishings (-4.0), Household Appliances (-3.5), Home Improvement Retail (5.6), and Apparel Retail (10.4) (Table 1).

Apparel Retail, with star constituent TJX, is an exception, as US consumers love a bargain in good times and bad. Amazon’s shares also have bucked the downtrend; they rose 58.5% ytd, as revenue from the company’s cloud services and advertising business lines grew faster than expected last quarter. Amazon’s shares are in the Broadline Retail industry, which was created earlier this year and therefore doesn’t have a y/y comparison. If Amazon and Tesla stocks were eliminated from the S&P 500 Consumer Discretionary sector, the sector’s ytd return would be 5.5% instead of 29.6%, Joe calculates.

But outside of a few bright spots, most retailers are struggling regardless of whether they’re selling candles, high fashion, or sneakers. Growing sales is tough this year, and growing profits is even tougher. Let’s take a look at what’s ailing some of the retailers in the S&P 500 Consumer Discretionary sector:

(1) Tough times in the kitchen. Newell Rubbermaid, the sole constituent of the Housewares & Specialties industry, makes Rubbermaid kitchen products, Sharpie pens, Coleman gear, Yankee Candles, Paper Mate pens, and Elmer’s glue, among other things. It posted a 13.0% y/y decline in Q2 sales to $2.2 billion and adjusted Q2 earnings per share of 24 cents compared to 56 cents in the year-ago quarter. The company has a new CEO and is in the process of restructuring by reducing its number of brands, prioritizing the top countries in which it sells, and streamlining its manufacturing and distribution processes.

Analysts are hoping that next year brings better results. They’re forecasting a 1.4% increase in sales and 26.8% earnings growth in 2024, a fast improvement from the 12.2% and 45.9% declines expected this year (Fig. 2 and Fig. 3). Other home-related industries with stock price indexes that have fallen ytd include Household Appliances (-3.5%) and Home Furnishings (-4.0%).

(2) Fashion and footwear flounder. Consumers seem to be thinking twice before splurging, whether it be on high-end duds or kicks to lounge around in. The S&P 500 Apparel, Accessories & Luxury Goods industry includes retailers Ralph Lauren (up 7.7% ytd), Tapestry (-12.8%), and VF Corp. (-30.3%). Ralph Lauren’s international exposure helped boost its overall fiscal Q1 (ended July 1) performance, as weakness in North America was offset by strength in Europe and Asia.

The shares of Tapestry, which owns Coach and Kate Spade, fell sharply earlier this month following news that it plans to buy Capri Holdings, owner of Versace, Jimmy Choo, and Michael Kors, for $8.5 billion. Mid-tier or aspirational luxury brands have had a tough time attracting squeezed consumers and an even tougher time competing against European luxury conglomerates that dominate the high end of the industry, an August 25 WSJ article reported. Meanwhile, VF Corp. has struggled as its Vans shoes have lost their cool and the company recently hired a new CEO who lacks a background in apparel and footwear retail.

The S&P 500 Footwear industry’s sole member is Nike. It reported a 5% sales increase in fiscal Q4 (ended May 31) but a 28% drop in net income to $1.0 billion, citing higher operating and freight expenses, a higher tax rate, and product markdowns. Facing new competition from On, Hoka, and others, Nike—like many retailers—has needed to trim excess inventory. Nike has also been hurt by disappointing results at Footlocker, a major retailer of Nike products. Footlocker recently reported a 9.9% sales decline in its fiscal Q2 (ended July 29), and management has lowered its outlook guidance and suspended the stock’s dividend.

(3) Pressure on lotion & makeup. The S&P 500 Other Specialty Retail industry includes Bath & Body Works (-15.0% ytd), Ulta (-12.4%), and Tractor Supply (-2.7%). Bath & Body Works expects sales to decline 1.5%-3.5% in 2023. Investors looked past Ulta’s 10.1% revenue growth in the quarter ended July 29 and focused instead on the 110bps decline in gross margin to 39.3%, which was blamed on inventory shrink (goods stolen from stores) and higher supply-chain costs. The shrink problem has become a recurring theme for retailers as varied as Ulta, Macy’s, and Dick’s Sporting Goods.

(4) No new computers needed. During the Covid pandemic, consumers working from home and students learning from home scrambled to buy larger and faster computers. That surge of buying pulled forward sales and hurt the industry in the ensuing years. Yesterday, Best Buy reported big y/y declines in its fiscal Q2 (ended July) sales and earnings: Sales dropped by 7.2% to $9.6 billion and adjusted earnings per share fell 20.8% to $1.22. Best Buy shares rallied 3.9% on Tuesday nonetheless because those results beat analysts’ consensus expectations and management said that demand is likely to improve in 2024.

“[W]e continue to expect that this year will be the low point in tech demand after two years of sales declines. Next year the consumer electronics industry should see stabilization and possibly growth driven by the natural upgrade and replacement cycles and the normalization of tech innovation,” said CEO Corie Barry in a company press release. Best Buy is the sole member of the S&P 500 Computer and Electronics Retail industry. After two years of earnings declines, analysts are hopeful the industry will post earnings growth north of 10% in 2024.

(5) Consumers love a bargain. The one retail-related industry that has fared well this year is the S&P 500 Apparel Retail industry; its stock price index has risen 10.4% ytd. The industry includes Ross Stores (up 3.3% ytd) and TJX (13.4%). The off-price retailers always seem to have a following, as consumers love hunting for a bargain. TJX also benefits from having the HomeGoods and HomeSense stores, which likely have gained shoppers who had frequented the now defunct Bed Bath and Beyond stores. TJX sales rose 7.7% to $12.8 billion in its fiscal Q2 (ended July 29), and its net income jumped 22.1% to $989 million.

Consumer Discretionary II: Not Shopping Doesn’t Mean Not Spending. Even as interest rates have risen this year, consumers have continued to spend on travel, dining, and new homes. Most are employed, have received a raise or two in recent years, and still have low debt service costs relative to their incomes. Student loan payments are set to resume in October, and gasoline prices have been creeping up, which could crimp consumer spending. But generally speaking, consumers remain in solid shape.

Here's some of the recent data on the consumer’s financial state:

(1) Gainfully employed. Tuesday brought news from the JOLTS report that the labor market continued to cool off modestly this summer. Job openings declined by 338,000 in July m/m to 8.8 million seasonally adjusted, and the quits rate declined to 2.3% in July from 2.4% in June. Fewer quits suggests that employees may be growing slightly more concerned about the employment picture. That said, both statistics indicate that the labor market remains strong: Job openings is far above its 2019 average of 7.2 million, and the quits rate is back down at its 2019 average (Fig. 4).

The next reading on the job market comes on Friday with the release of the August employment report. In July, with the unemployment rate at 3.5%, almost everyone who wanted a job had a job (Fig. 5). The adult unemployment rate was even lower, at 3.2%, and the rate for people with a bachelor’s degree was only 2.0%. Even those with no high-school degree had an unemployment rate of only 5.2% (Fig. 6).

Those who have a job have also benefitted from rising wages. Average hourly earnings in private industry was $33.74 in July, up 4.4% y/y and up 10.1% over the past two years (Fig. 7). No doubt, some of the wage increases have been eaten away by inflation. Personal income rose 5.3% y/y in June, while real personal income rose only 2.3%. Likewise, the YRI Earned Income Proxy (aggregate weekly hours times average hourly earnings of total private industries times 52) rose 6.3% in June but only 3.3% adjusted for inflation (Fig. 8). (The Proxy’s nominal reading fell to 5.7% y/y in July; a real rate for July is not yet available.)

(2) Watching rising debt. Consumers have been borrowing more freely this year. Consumer credit outstanding is at a record high of $5.0 trillion as of June (Fig. 9). Revolving credit card debt has jumped 11.2% y/y to $1.3 trillion as of June, and nonrevolving debt—which includes auto and student loans—has jumped 4.0% y/y to $3.7 trillion as of June.

Some solace comes from the household debt service ratio, which at 9.6 as of Q1 remains low by historical standards (Fig. 10). However, it should continue to climb along with interest rates, which are up sharply since Q1; the 10-year Treasury bond yield is 4.20%, up from 3.48% at the end of Q1. And while personal savings has fallen to $742 billion as of June, well below its March 2021 peak of $3.5 trillion, it remains solidly above the 12-month change in consumer credit outstanding, which is $271 billion (Fig. 11).

This may explain why the percentage of credit card loans that are delinquent by 90 days or more remains relatively low at 8.0% as of Q2. That’s above its 2022 low of 7.6% but below the average of 9.2% from 2002 through 2008 (Fig. 12).

Last week, however, Macy’s warned that it has seen a spike in the number of customers delinquent on their credit card payments. The company had expected delinquencies to climb after the post-Covid lull, but the “speed at which the increase occurred for us and the broader credit card industry … was faster than planned,” COO Adrian Mitchell said in an earnings conference call, an August 23 CNN article reported. The problem “accelerated” in June and July.

(3) Student loans & gasoline. Retailers and investors are concerned that the resumption of student loan payments in October will prompt consumers to pull back on spending. Interest starts accruing on more than $1 trillion of student loans on Friday for the first time since it was paused beginning three years ago due to the onset of the Covid pandemic. The impact may be muted over the next 12 months when interest on student loans will accrue but loans won’t be marked as delinquent or reported to credit rating agencies if payments are missed, an August 28 WSJ article reported.

The resumption of student loan payments may disproportionately affect younger consumers. Here’s a breakdown of the percent of student loan holders by age group and the average amount they still owe, courtesy of Quill Intelligence data cited in an August 29 report from The Daily Shot: under 30 years old (23%, $23,857), 30-39 years old (32%, $42,748), 40-49 (22%, $44,864), 50-59 (15%, $44,020), 60 and older (8%, $35,897).

The weekly trip to the gas station may also begin weighing on consumers’ wallets. The price of a gallon of gasoline has jumped to $3.93 as of August 28. That’s up from a recent bottom of $3.20 during the final week of 2022 (Fig. 13).

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Wishing Upon An R-Star

August 29 (Tuesday)

R-Star: Twinkle, Twinkle. In his Jackson Hole speech on Friday, Fed Chair Jerome Powell waxed poetic for an instant, saying: “[W]e are navigating by the stars under cloudy skies.”

Fed officials regularly suggest—even when their decision making happens under clear skies—that they are guided by their perception of “r-star.” The problem is that r-star is a theoretical construct and cannot be measured. Even if it could be measured, what if it isn’t constant like the North Star? In this case, even if an econometric model could measure r-star at a particular point in time, its value might move higher or lower unpredictably.

Melissa and I are reminded of the Heisenberg Uncertainty Principle in physics. It states that we cannot know both the position and speed of a particle, such as an electron, with perfect accuracy; the more we nail down the particle’s position, the less we know about its speed and vice versa. If we know where it is, we don’t know how fast it is going. If we know how fast it is going, we don’t know where it is.

What is r-star exactly? Even its various definitions sound fuzzy. Here are a couple of them:

(1) The New York Times interviewed John C. Williams, president of the Federal Reserve Bank of New York, on August 7. Williams said: “I think of monetary policy primarily in terms of real interest rates, and we set nominal rates.” The interviewer explained: “Real interest rates subtract out inflation, while nominal rates include it. Estimates of the so-called ‘neutral’ rate setting that neither heats nor cools the economy are usually expressed in inflation-adjusted, real terms.” The neutral rate is another name for r-star.

(2) A much more convoluted definition can be found in the boilerplate introduction to the FOMC’s quarterly Summary of Economic Projections (SEP). The SEP shows the median forecasts of the committee for real GDP growth, the unemployment rate, the PCED inflation rate, the core PCED inflation rate, and the federal funds rate. The latest SEP shows these projections for 2023, 2024, 2025, and the “longer run.”

The SEP explains: “The longer-run projections represent each participant’s assessment of the value to which each variable would be expected to converge, over time, under appropriate monetary policy and in the absence of further shocks to the economy. ‘Appropriate monetary policy’ is defined as the future path of policy that each participant deems most likely to foster outcomes for economic activity and inflation that best satisfy his or her individual interpretation of the statutory mandate to promote maximum employment and price stability.”

Buried in that Fedspeak is the notion that the projected path of the federal funds rate should be the ideal one that over the next three years (or so) takes us to the Promised Land of low unemployment and low inflation, consistent with the Fed’s congressional dual mandate. So r-star should be the value of the federal funds rate that over the long run “fosters” the ideal outcomes for economic growth and inflation.

According to June’s SEP, the federal funds rate’s path should be 5.6%, 4.6%, and 3.4% for 2023, 2024, and 2025 and settle at 2.5% over the longer run. That path should deliver longer-run real GDP growth of 1.8% and inflation of 2.0%. So is 2.5% r-star? No because the 2.5% is a nominal rate, unadjusted for inflation. Okay, then if long-run inflation is 2.0%, r-star would be 0.5%. But wait: Does it make any sense to adjust the federal funds rate, which is an overnight rate, by longer-run inflation, a y/y rate?

This is more astrology than astronomy.

(3) Yesterday, in our analysis of Fed Chair Jerome Powell’s Jackson Hole Speech, we wrote: “Powell said that the Fed is monitoring real interest rates and that they are ‘now positive and well above mainstream estimates of the neutral policy rate,’ which is widely referred to as r-star. However, he strongly suggested that r-star is a useless concept for policymakers. We agree. That’s because it can’t be measured: ‘But we cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty about the precise level of monetary policy restraint.’”

(4) In the interview cited above, John Williams explained why he believes that real interest rates matter: “Assuming inflation continues to come down … next year, as many forecast, including the [FOMC members’] economic projections, if we don’t cut interest rates at some point next year then real interest rates will go up, and up, and up. And that won’t be consistent with our goals. So … from my perspective, to keep maintaining a restrictive stance may very well involve cutting the federal funds rate next year or [the] year after; but really, it’s about how are we affecting real interest rates—not nominal rates.”

That’s the scenario outlined in June’s SEP. It is the one we are rooting for, of course.

Strategy: MegaCap-8 No Longer Providing as Much Oomph. The MegaCap-8 group of stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla)—currently accounting for about a fourth of the S&P 500’s capitalization—has led the index higher in a big way so far in 2023. The stocks’ improved performances this year in part reflects much improved revenues and earnings growth prospects for most of the eight companies.

Recently, however, the MegaCap-8’s valuation has pulled back and the group’s collective market cap has shrunk some following the companies’ Q2 earnings releases. Even though the companies’ Q2 results were mostly strong and even though these eight stocks still account for a large part of the S&P 500’s market capitalization, their earnings strength hasn’t lifted the S&P 500’s performance the way it had been doing for most of this year. Stock investors’ angst over the bond market seems to be the gating factor.

Currently, the group’s collective valuation isn’t as cheap as it was when the year began but is a good deal cheaper than during 2020-21, when the MegaCap-8’s forward P/E flirted with 39 (Fig. 1).

I asked Joe to update us on the MegaCap-8. Here’s his report:

(1) Market capitalization. The combined market cap for the MegaCap-8 stocks tumbled 41.5% in 2022 before rebounding 66.8% ytd to an 18-month high of $11.8 trillion through July 18. Since then, it has corrected in garden-variety fashion, dropping 6.4% to $11.0 trillion; that leaves it up 56.2% ytd through Friday’s close (Fig. 2).

As a percentage of the S&P 500’s market cap, the group soared from 19.4% at the start of the year to a record-high 27.3% during the July 14 week, before dropping to 26.0% during the August 18 week (Fig. 3).

(2) Valuation slipping after rising sharply. The MegaCap-8’s forward P/E rose above 30.0 in mid-June for the first time in 15 months but has since dropped below that mark, as investor activity has not maintained the group’s valuation despite strong Q2 earnings. After the forward P/E bottomed at 21.1 during the January 6 week, it soared 46% to its 2023 high of 31.2 as of the July 14 week. The forward P/E is now down 12% since then to 27.4, which remains below the record high of 38.5 during the August 28, 2020 week.

Looking at the individual MegaCap-8 stocks, forward P/Es rose for all of them from January 6 through mid-July. With the stock market in decline since the end of July amid higher interest rates, just five of the MegaCap-8 stocks now—as of Friday’s close—are valued above their January 6 bottoms, as Joe shows below.

Here’s how much valuation has changed for each of the MegaCap-8 stocks since the S&P 500’s January 6 bottom through Friday’s close: Alphabet (up 23% to 20.5 from 16.6), Amazon (down 4% to 47.0 from 48.8), Apple (up 34% to 27.2 from 20.3), Meta (up 14% to 18.2 from 16.0), Microsoft (up 34% to 28.7 from 21.4), Netflix (down 1% to 29.2 from 29.4), Nvidia (down 4% to 33.2 from 34.5), and Tesla (up 152% to 55.5 from 22.0).

Counterintuitively, Nvidia’s sharp valuation decline followed the company’s stunningly good Q2 earnings release and sharply increased forward guidance, while Tesla’s eye-popping valuation gain occurred despite the company’s declining forward earnings. It can be disconcerting for investors when valuations temporarily disconnect from a company’s earnings prospects, but it can also provide an opportunistic entry point for investors.

(3) Forward revenues and earnings. Seven of the MegaCap-8 companies have enjoyed both rising forward revenues and rising forward earnings so far in 2023. The only laggards are Apple’s forward revenues and Tesla’s forward earnings. As a group, the MegaCap-8’s forward revenues has jumped 8.3% ytd, and its forward earnings has soared 23.4%—trouncing the S&P 500’s forward revenues rise of 4.0% ytd and forward earnings gain of only 3.4% ytd. (FYI: Forward revenues and earnings are the time-weighted averages of industry analysts’ estimates for the current year and following one.)

Here’s how each of the MegaCap-8 companies’ forward revenues and earnings forecasts have performed ytd: Alphabet (forward revenues up 6.8%, forward earnings up 11.9%), Amazon (9.4, 72.6), Apple (-1.3, 3.5), Meta (18.5, 97.3), Microsoft (6.3, 8.4), Netflix (8.3, 35.7), Nvidia (131.7, 228.8), and Tesla (4.0, -19.3). Nvidia’s surge in such a short period on expectations for AI chip sales is stunning, and certainly ranks among the all-time top performers (i.e., since consensus forecasts were first calculated over 40 years ago).

(4) Forward profit margin. The S&P 500’s forward profit margin has dropped this year, but barely, to 12.5% during the August 20 week from 12.6% at the start of the year (Fig. 4). The MegaCap-8’s collective margin has surged from 18.0% to 20.6%, with 1.3ppts of that gain coming since the Q2 earnings season started. Among the MegaCap-8s, all but Tesla have seen their forward profit margin rise ytd: Alphabet (up from 23.0% to 25.4%), Amazon (3.0 to 4.7), Apple (25.2 to 26.4), Meta (21.1 to 29.4), Microsoft (34.6 to 34.9), Netflix (14.1 to 17.5), Nvidia (36.7 to 51.5), and Tesla (15.9 to 12.7) (Fig. 5).

(5) Q2 revenue and earnings results. During 2022, the MegaCap-8’s revenues and earnings growth sagged. Quarterly revenues growth remained positive on a y/y basis but dropped to single-digit percentage rates. Earnings fared much worse, falling y/y for four straight quarters through Q1-2023.

During Q2-2023, y/y growth improved markedly for revenues and turned positive again for earnings. The MegaCap-8’s revenues rose 10.2% y/y in Q2-2023 following a 4.6% rise in Q1-2023, and the group’s earnings jumped 29.9% y/y after declining 3.5% in Q1. In stark contrast, the S&P 500’s revenues were up 1.2% y/y during Q2-2023, while its earnings dropped 5.4% y/y.

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The Chairman’s Speech

August 28 (Monday)

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

Fed I: ‘Navigating by the Stars Under Cloudy Skies.’ Everyone who has heard or read Fed Chair Jerome Powell’s speech at Jackson Hole on Friday probably agrees: It was hawkish on the whole. He did acknowledge that inflation has moderated since last summer and that it continued to do so over the past two months. However, he did not directly confirm or even suggest what Melissa and I were hoping to hear: that if inflation continues to moderate, the Fed will probably lower the federal funds rate sometime next year. That would have been totally consistent with the FOMC’s June Summary of Economic Projections (SEP). That’s also still our outlook.

Instead, Powell concluded by saying: “At upcoming meetings, we will assess our progress based on the totality of the data and the evolving outlook and risks. Based on this assessment, we will proceed carefully as we decide whether to tighten further or, instead, to hold the policy rate constant and await further data.” There was no mention of what it would take for the Fed to lower interest rates. Again, the latest SEP shows that the FOMC is expecting to lower the federal funds rate in 2024 and 2025 as inflation falls toward the committee’s 2.0% target.

Powell’s speech was all about inflation. Indeed, it was titled “Inflation: Progress and the Path Ahead.” He started the speech by stating: “It is the Fed’s job to bring inflation down to our 2 percent goal, and we will do so.” He clearly sought to dispel any notion that the Fed might raise its inflation target. Near the end of his speech, he said: “Two percent is and will remain our inflation target.”

Powell acknowledged that the federal funds rate is currently restrictive. However, Fed officials aren’t sure if it is restrictive enough to bring inflation down over time to 2.0%. He strongly reiterated that if inflation stalls or heads back up again, the Fed won’t hesitate to raise interest rates further.

Powell said that the Fed is monitoring real interest rates and that they are “now positive and well above mainstream estimates of the neutral policy rate,” which is widely referred to as r-star (or r*). However, he strongly suggested that r-star is a useless concept for policymakers. We agree. That’s because it can’t be measured: “But we cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty about the precise level of monetary policy restraint.”

For an instant, Powell waxed poetic: “[W]e are navigating by the stars under cloudy skies.” These would make good lyrics for the Fed’s official anthem.

Complicating the Fed’s assessment of the restrictiveness of its monetary policy are the long and variable lags of monetary policy: “Since the symposium a year ago, the Committee has raised the policy rate by 300 basis points, including 100 basis points over the past seven months. And we have substantially reduced the size of our securities holdings. The wide range of estimates of these lags suggests that there may be significant further drag in the pipeline.”

Powell didn’t mention any of the specific factors—one of which was monetary policy—that caused inflation to soar in 2021 and 2022. He blamed “unprecedented pandemic-related demand and supply distortions.” He explained that the tightening of monetary policy aimed to “slow the growth of aggregate demand, allowing supply time to catch up.” He predicted that “the process still has a long way to go, even with the more favorable recent [inflation] readings.”

The speech ended with a pledge: “We will keep at it until the job is done.”

Fed II: Powell’s Inflation Dashboard. Of course, Fed policy remains data dependent. In fact, Powell mentioned “data” nine times in his speech (including the footnotes). Let’s review the various data series he flagged:

(1) Inflation (core PCED). Powell focused on the core PCED measure of inflation, which excludes food and energy, because these volatile components “can provide a misleading signal of where inflation is headed.”

Core PCED inflation peaked at 5.4% y/y in February 2022. It declined gradually to 4.1% in June, and only 3.3% at an annual rate over the past three months through June (Fig. 1 and Fig. 2). The Fed staff estimates that it edged back up to 4.3% in July based on the month’s CPI.

Nevertheless, Powell said that “lower monthly readings for core inflation in June and July were welcome, but two months of good data are only the beginning of what it will take to build confidence that inflation is moving down sustainably toward our goal.” In any event, he noted, the latest core 12-month inflation rate is still too high relative to the Fed’s target of 2.0%.

(2) Inflation (core PCED goods). As in Powell’s November 30, 2022 speech “Inflation and the Labor Market,” he separately examined the three broad components of core PCED inflation—inflation for goods, for housing services, and for non-housing services (Fig. 3).

Powell started with a brief analysis of core goods inflation (Fig. 4). Here are last year’s peaks and June’s readings for the inflation rates of core PCED goods (7.6%, 1.7%), core PCED nondurable goods (6.3%, 4.2%), and durable goods (10.6%, -0.4%).

Powell’s assessment of the progress made in lowering core goods inflation was cautious: “Core goods prices fell the past two months, but on a 12-month basis, core goods inflation remains well above its pre-pandemic level. Sustained progress is needed, and restrictive monetary policy is called for to achieve that progress.”

(3) Inflation (core PCED housing and non-housing services). Powell then explained why he is relatively optimistic about the rent component of the PCED, which accounts for 15.0% of the headline PCED, 16.9% of the core PCED, and 22.5% of PCED services.

He noted that current inflation rates of market rents on new leases, as measured by Zillow and CoreLogic, have dropped sharply since last summer from peaks of 13%-16% y/y to around 2%-4% currently (Fig. 5). These declines are only now starting to lower the PCED measure of rent inflation: “Because leases turn over slowly, it takes time for a decline in market rent growth to work its way into the overall inflation measure.”

Powell’s big hangup is with the non-housing services components of the PCED measure of inflation, which “accounts for over half of the core PCE index and includes a broad range of services, such as health care, food services, transportation, and accommodations.” It has moved sideways around 4.5% from July 2021 through this June (Fig. 6).

A look at the seven major components of PCED services shows that transportation inflation has dropped sharply from 16.7% during October 2022 to 3.6% in June (Fig. 7). The stickiest component other than housing & utilities (7.0%) has been food services & accommodation, currently at 6.5%. Recreation services, currently 4.7%, has been stuck around 5.0% since early last year. Not participating at all in the inflation spike has been health care (2.2%).

(4) Economic growth (GDP). Melissa and I take issue with the following statement Powell made in his speech: “Getting inflation sustainably back down to 2 percent is expected to require a period of below-trend economic growth as well as some softening in labor market conditions.”

In our opinion, the labor market is tight because of a chronic shortage of labor attributable to demographic factors. That won’t change with an economic slowdown. But what’s happening in response, we believe, is that company managements increasingly are using technology-based innovations to boost productivity. That should boost economic growth and dampen inflationary pressures. It should also lift real wages and increase corporate profitability. The relationship between real GDP growth and inflation as measured by the GDP price deflator is a weak one at best and unpredictable (Fig. 8).

(5) Economic growth (consumer spending). Nevertheless, Powell and his colleagues still believe in the questionable Phillips Curve paradigm that posits an inverse relationship between the inflation rate and the unemployment rate and a direct one between inflation and economic growth. They believe that tight monetary policy should slow the growth of demand, especially consumer demand, which should boost the unemployment rate, cooling price and wage inflation.

And demand is still too strong, Powell said: “But we are attentive to signs that the economy may not be cooling as expected. So far this year, GDP … growth has come in above expectations and above its longer-run trend, and recent readings on consumer spending have been especially robust.”

In our opinion, however, the Phillips Curve is flawed: The relationship between the growth rate of real consumer spending and inflation as measured by the PCED is also a weak one at best and unpredictable (Fig. 9).

(6) Economic growth (housing). Powell noted that even housing is showing signs of “picking back up.” His hawkish conclusion was: “Additional evidence of persistently above-trend growth could put further progress on inflation at risk and could warrant further tightening of monetary policy.”

However, the recent renewed jumps in mortgage interest rates and mortgage applications to purchase homes strongly suggest that housing’s recent recovery is already crumbling (Fig. 10).

(7) Labor supply (participation rate). Powell closely monitors the relationship between labor supply and labor demand. He noted that the supply side has improved, “driven by stronger participation among workers aged 25 to 54 and by an increase in immigration back toward pre-pandemic levels. Indeed, the labor force participation rate of women in their prime working years reached an all-time high in June.”

The labor force participation rate of the civilian noninstitutional working-age population bottomed at 60.1% during April 2020 and rose to 62.6% in July (Fig. 11). The labor force participation rate of 25- to 54-year-olds rose to 83.4% during July, exceeding its pre-pandemic high of 83.1% during January 2020 (Fig. 12).

(8) Labor demand (job openings & payroll growth). Powell also closely watches the JOLTS measure of job openings. The three measures of job openings that we track (including the JOLTS series) all have been declining this year but remain historically high (Fig. 13). Powell observed: “Demand for labor has moderated as well. Job openings remain high but are trending lower.”

(9) Labor demand (aggregate hours worked & average workweek). Powell also mentioned that payroll employment growth has slowed significantly, aggregate hours worked has been flat over the past six months, and the average workweek has declined to the lower end of its pre-pandemic range, “reflecting a gradual normalization in labor market conditions” (Fig. 14, Fig. 15, and Fig. 16).

Nevertheless, Powell warned: “We expect this labor market rebalancing to continue. Evidence that the tightness in the labor market is no longer easing could also call for a monetary policy response.”

(10) Labor market (unemployment & wages). Powell acknowledged that “rebalancing” of supply and demand in the labor market “has eased wage pressures.” Measures of wage inflation—including average hourly earnings, wages in the employment cost index, and the wage growth tracker—have all moderated since last summer (Fig. 17). However, they all must “slow to a rate that is consistent with 2 percent inflation.” So they need to decline from 4%-6% currently to closer to 3%, according to Powell’s previous discussions of this issue.

(11) Real interest rates. As noted above, Powell is watching real interest rates, which have turned positive this year (Fig. 18). He’s just not sure whether they are restrictive enough currently. The 10-year TIPS yield rose to 1.92% on Friday, not far from last Monday’s 2.00%, which was the highest reading since July 6, 2009.

(12) Financial conditions. Powell is monitoring various measures of financial conditions and believes that restrictive monetary policy has tightened them: “Beyond changes in interest rates, bank lending standards have tightened, and loan growth has slowed sharply. Such a tightening of broad financial conditions typically contributes to a slowing in the growth of economic activity, and there is evidence of that in this cycle as well. For example, growth in industrial production has slowed, and the amount spent on residential investment has declined in each of the past five quarters.”

Commercial bank loans are up 4.8% y/y, the slowest pace since February 23, 2022 (Fig. 19). Industrial production was down 0.2% y/y through July (Fig. 20).

Movie. “Painkiller” (+) (link) is another miniseries about how the Sackler family made a fortune selling OxyContin produced by their company, Purdue Pharmaceuticals. They were essentially drug dealers assisted by the do-nothing US Food and Drug Administration. This series was produced by Netflix and isn’t as good as Hulu’s “Dopesick,” which was released in 2021. The latest series is like a fast-paced caricature of the earlier one and stars Matthew Broderick in the lead role of Dr. Richard Sackler. His performance pales in comparison to Michael Stuhlbarg’s portrayal of Sackler in the original. In any case, both series clearly depict the deadly OxyContin crisis that killed so many people and shattered so many families. Even more deadly today is the fentanyl crisis. The government may be assisting this one too, by failing to keep this narcotic from pouring across the Rio Grande.

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FTC, Tech & Fusion

August 24 (Thursday)

Technology: FTC Keeps Trying. Tech industry giants Amazon, Meta, and Microsoft have been in the Federal Trade Commission’s (FTC) crosshairs. Under Chair Lina Khan’s leadership, the FTC has brought cases against each of them with mixed results. This year, the FTC failed to block both Microsoft’s acquisition of video game designer Activision Blizard and Meta’s acquisition of small VR content maker Within, drawing criticism by Republican legislators that Khan has reached beyond the FTC’s authority.

Undeterred, Khan, whose term goes through 2024, is expected to forge ahead with new cases against Amazon and Meta. She’s also rolling out new M&A guidelines and has started to consider how artificial intelligence (AI) will challenge the competitive landscape.

Here's where Khan may lead the FTC next:

(1) Amazon’s a potential target. Amazon representatives were slated to have a “last-rights” meeting with FTC commissioners earlier this month, a move that often precedes either a lawsuit or a settlement. While the FTC has not disclosed details, the commission has examined “Amazon practices, including whether it favors its own products over competitors’ on its platforms and how it treats outside sellers on Amazon.com, ” an August 7 WSJ article reported.

Over the past year, Amazon has eliminated 27 of its 30 clothing private-label brands and dropped its private-label furniture brands, an August 10 WSJ article reported. The company routinely eliminates products that don’t resonate with customers, management says, and works to boost profits by cutting unprofitable businesses. But there’s speculation that the company’s cuts were made to head off any FTC action.

Amazon is already facing an FTC lawsuit filed in June that contends that the company enrolled customers in Prime without their consent and made it difficult to cancel the service. Amazon has said the allegations are “false on the facts and the law.”

The case may be tough to prove given that millions of consumers have shown that they like the value that Prime offers. About 72% of all US households have a paid Prime membership. JPMorgan analysts estimated last year that the $139 annual subscription would cost $1,100 a year if each of its benefits were sold separately, a June 21 WSJ article reported.

(2) Meta targeted, too. The FTC has moved to impose a “blanket prohibition” on the collection of young people’s personal data by Meta. If the agency succeeds, Meta would be prohibited from profiting from data it collects from users under the age of 18 on its Facebook, Instagram, and Horizon Worlds platforms.

Regulators claim Meta “misled parents about their ability to control whom their children communicated with on its Messenger Kids app and misrepresented the access it gave some app developers to users’ private data,” a May 3 NYT article reported. The FTC would like to expand the $5 billion consent order Meta agreed to in 2020 that said the company failed to meet its commitments to overhaul its privacy practices. Meta has asked a federal court to block the FTC’s actions, arguing that it has not violated the consent order and that the agency cannot change it.

(3) Is AI next? In a May 3 NYT essay, Chair Khan makes no bones about it: The FTC will ensure that competition is preserved and consumers are protected in the new era of AI. Only a handful of companies have the computing power, cloud services, and vast data needed to develop AI. Regulators should prohibit large companies from excluding or discriminating against smaller companies to further entrench their dominance, she notes. And AI shouldn’t be used by companies to collude to inflate prices or discriminate.

Agencies will have to guard against fraud from AI-created spear-phishing emails, fake websites, and fake consumer reviews. “Scammers … can draft highly targeted spear-phishing emails based on individual users’ social media posts. Alongside tools that create deep fake videos and voice clones, these technologies can be used to facilitate fraud and extortion on a massive scale,” warns Khan.

The FTC will target not just the fraudsters but also the larger “upstream” firms that enable the fraud, she adds. And finally, laws prohibiting discrimination and the exploitive collection of personal data will be enforced if AI programs use error-filled information to lock people out of jobs, housing, or key services.

(4) Tougher new guidelines proposed. The FTC and the Department of Justice published a draft update of their Merger Guidelines, which describes how the agencies will review mergers’ and acquisitions’ compliance with antitrust laws. The proposed guidelines would make it easier to prove industry concentration: A “market consisting of 10 companies each with a 10% market share is ‘concentrated,’ where previously it would have been considered ‘unconcentrated’; and a market consisting of five companies each with a 20% market share is ‘highly concentrated,’ where previously it would be only ‘moderately concentrated,’” a July 20 note from the law firm WilmerHale explains.

The rules highlight different instances in which vertical mergers can be anticompetitive. They also discuss the harm caused by deals that eliminate potential competition. For example, when a large company acquires a smaller one in another industry, regulators must consider how capable it is of dominating the newly entered industry. And acquiring companies could be in violation of the rules if their mergers entrench or extend an existing dominant position or if they make a series of acquisitions in the same or related industries.

If adopted, the proposed guidelines would guide the agency’s investigations, but they’d have less of an impact on the courts, which rely on precedent and legislation when ruling. A newly elected Republican president presumably would replace Khan as FTC chair; the new chair would likely revise these guidelines.

Meanwhile, the new proposed guidelines may further slow the already depressed pace of tech M&A deals. Tech deals reached a high of $173 billion in Q1-2022 but dropped to $7.5 billion in Q2-2023, a June 28 InformationWeek article reported.

Disruptive Technologies: Fusion Advances. For a second time, the Lawrence Livermore National Laboratory has proved naysayers wrong by generating more energy from a fusion reaction than used to set off that reaction. That was just the latest baby step that scientists at private and public institutions have taken toward the goal of harnessing fusion to generate energy instead of burning fossil fuels, which produce the undesirable byproduct carbon dioxide. Let’s take a look:

(1) Fusion in the lab. The Lawrence Livermore National Laboratory didn’t disclose the amount of energy its second successful fusion experiment netted; but the first experiment produced 3.15 megajoules of energy after consuming 2.05 megajoules to generate the reaction. The research institute uses an inertial confinement reactor, which shoots 192 lasers at a capsule that contains a deuterium-tritium pellet. The lasers cause the pellet to collapse and a fusion reaction to occur, reported an August 9 article in Popular Mechanics.

Skeptics note that the net energy calculation fails to include the energy needed to start up the lasers and that the split-second reaction requires hours of laser-cool-down time before the next one. So it’s hard to imagine how this method of fusion can generate enough steady electricity for everyday use. But scientists are working on it.

(2) Private companies dreaming too. Many small, private companies are working to make fusion a reality, including General Fusion, Marvel Fusion, Helion Energy, Zap Energy, Avalanche Energy, ExoFusion, and Kyoto Fusioneering.

Earlier this month, General Fusion raised $25 million of new funding to build a new demonstration machine in British Columbia. Over its lifetime, it has raised $330 million, including funds from Jeff Bezos. General Fusion hopes to generate net energy by 2025 and commercialize the technology in the early 2030s, an August 9 GeekWire article reported.

(3) Helion strikes a deal. Washington-based Helion has contracted to sell Microsoft 50 megawatts of power generated by a Helion fusion plant by 2028, a May 10 Reuters article reported. While exact terms of the deal weren’t revealed, there reportedly are financial penalties if the power isn’t delivered. Helion’s fusion directly produces electricity, which is stored in capacitors. OpenAI CEO Sam Altman invested $375 million in Helion in 2021 and takes an active interest in the company, visiting it once a month.

Separately, Avalanche Energy raised $40 million in venture funding in April, including funds from Peter Thiel’s Founders Fund, an April 27 article in Canary Media reported.

(4) Lots of lasers. Colorado State University and Germany based Marvel Fusion are constructing a $150 million high-power laser and fusion research facility in Colorado. “Targeted for completion in 2026, the project plans to feature at least three laser systems, each with a multi-petawatt peak power and an ultra-fast repetition rate of ten flashes per second,” the university’s August 7 press release stated.

(5) Zap & CFS plugging away. Zap Energy hopes to get fusion-generated electricity onto the grid by 2030. Zap’s fusion occurs in the Fuze-O, which is the size of an office desk and has housed thousands of fusion reactions; hopefully in time it will generate net energy. The Fuze-O plus some heat exchangers and metal turbines theoretically could power up to 30,000 homes.

Commonwealth Fusion Systems, which counts Marc Benioff and Bill Gates as investors, is also developing a compact fusion reactor. Eventually, its tokamak will have a molten salt blanket that absorbs radiated neutrons; the molten salt will be pumped outside of the tokamak to heat water into steam; that steam will power a turbine to make electricity, an August 3 article in IEEE Spectrum explained. The company was spun out of MIT.

For additional information on fusion, check out the Disruptive Technology sections in the Morning Briefings of December 15, 2022, March 31, 2022, December 2, 2021, August 1, 2019.

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Dueling Composite Indicators

August 23 (Wednesday)

US Economy I: Misleading Indicators? While we await Fed Chair Jerome Powell’s Jackson Hole speech on Friday, which is bound to impact the financial markets, let’s review the latest composite economic indexes.

The Conference Board compiles the Index of Leading Economic Indicators (LEI), the Index of Coincident Economic Indicators (CEI), and the Index of Lagging Economic Indicators (LAGEI). July’s indexes were released last week on Thursday. Collectively, they are a mixed bag. The LEI continues to ring the alarm bell about a recession, while the CEI continues to confirm that the economy is growing. The LAGEI is showing signs of peaking, which is what it does near the end of recessions.

So which one is right? Is the economy about to fall into a recession? Is it not about to? Or has it been in a rolling recession, which is almost over? We pick Door #3.

Here’s what we make of this trio’s July readings:

(1) LEI. The LEI peaked at a record high during December 2021 (Fig. 1). It is down 10.2% since then through July. It has declined for the past 16 consecutive months. It has correctly signaled the last eight recessions with an average lead time of 12 months. So a recession is overdue.

Debbie and I have previously shown that the yearly percent change in the LEI is highly correlated with the national M-PMI (Fig. 2). The same can be said for the former and the yearly percent change in real GDP for goods (Fig. 3). There’s almost no correlation between the yearly percent changes in the LEI and real GDP for services (Fig. 4).

We previously have shown that five of the 10 components of the LEI are related to the goods economy, which tends to be more cyclical than the services economy (Fig. 5). Three of the 10 relate to the financial markets. Two of the three track the labor market and consumer expectations. So the LEI over-weights the goods economy, which has been in a recession while the services economy has been booming.

In current dollars, services now account for 60.5% of nominal GDP, up from 39.8% at the start of the data in 1947 (Fig. 6).

(2) CEI. The CEI rose to a record high during July (Fig. 7). Its yearly percent change closely tracks the yearly percent change in real GDP (Fig. 8). Of its four components, two rose to record highs in July (payroll employment and real personal income less transfer payments), while the other two have stalled in recent months at their record highs (real manufacturing & trade sales and industrial production). The yearly percent change in the CEI also tends to be more highly correlated with the growth rate of real GDP goods than real GDP services (Fig. 9 and Fig. 10). Nevertheless, it is still making new highs and not peaking as it always does when a recession is starting.

(3) LAGEI. The LAGEI is the Rodney Dangerfield of the composite cyclical indicators. It gets no respect. It’s rarely mentioned. That’s because it tends to peak at the end of recessions and trough well after they end (Fig. 11). Oddly, it seems to be peaking in recent months, suggesting that the no-show recession is almost over! Perhaps, it is signaling that our rolling recession is over and that a rolling recovery is underway.

It’s also interesting to monitor the seven components of the LAGEI (Fig. 12). Like the Seven Dwarfs, some are sleepy, some are grumpy, while others are happy. We often hear that record consumer installment credit may force consumers to retrench, causing a recession. The ratio of consumer installment credit to personal income is actually a lagging indicator, not a leading or coincident one. So are the six-month percent change in the CPI for services and—perhaps surprisingly to some—inflation-adjusted commercial & industrial loans.

 US Economy II: Inflation Is Really Moderating. So the six-month percent change in the CPI services inflation rate is an official component of the LAGEI. That shouldn’t be a surprise since rent accounts for 53.7% of the CPI services index. We all know by now that the inflation rate of tenant rents on new leases has been dropping much faster than the CPI rent index (Fig. 13).

Also not surprising is that the CPI goods inflation rate tends to lead the CPI services inflation rate (Fig. 14). This time shouldn’t be different. The CPI goods inflation rate peaked at 14.2% y/y during March of last year and plunged to -0.6% during July. The CPI services inflation rate peaked at 7.6% during the first two months of this year and was down to just 5.7% during July of this year.

As we noted recently, the headline and core CPI excluding shelter inflation rates were down to only 1.0% and 2.5% during July (Fig. 15). Debbie calculates that the headline and core PCED excluding rent inflation rates were 2.2% and 3.4% in June (Fig. 16).

Strategy: Q2 Earnings Season Nearing Finish Line. With just a handful of companies left to release Q2 results, Joe reports that S&P and I/B/E/S have compiled Q2’s near-final data for S&P 500 earnings per share. We’re still awaiting S&P’s final figures for revenues and the profit margin, which we’ll analyze after they’re released in the next week or so.

While we track both S&P and I/B/E/S’ numbers for quarterly operating earnings, we generally focus on the I/B/E/S data, especially because we use its measure of forward earnings (i.e., the time-weighted average of analysts’ consensus estimates for the current year and following one). Forward earnings is important to our stock market forecast, because stock investors discount majority-rule industry analysts’ operating earnings forecasts over the coming 12 months.

For now, let’s focus on the bottom-line numbers for Q2:

(1) S&P 500 Q1 earnings. S&P 500 operating EPS was $54.20 during Q2 according to I/B/E/S, a 2.1% q/q improvement from $53.08 during Q1-2023 but still down 5.9% y/y from its record EPS a year earlier during Q2-2022. The y/y earnings growth rate slowed for an eighth straight quarter and was negative for a third straight quarter, after having edged down 3.1% y/y during Q1-2023 (Fig. 17 and Fig. 18). While Q2-2023’s y/y decline was the largest since Q3-2020, we think it marks the worst comps of the cycle and should improve beginning in Q3-2023.

According to S&P, their measure of operating EPS was $54.81 during Q2, up 16.9% y/y and positive for a second straight quarter following four quarters of decline. S&P’s version of operating EPS remains 3.4% below its record high of $56.73 during Q4-2021. Regardless of which measure investors look at, the peak-to-trough declines in operating EPS thus far have been relatively modest compared to those of past downturns. (Keep reading to see why the S&P and I/B/E/S growth rates are so different.)

(2) S&P, I/B/E/S & write-offs. S&P and I/B/E/S each have their own polling services and derive their estimates and actuals on a different basis. 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 makes their estimates higher than S&P’s earnings series. Since Q1-1993, the two series of quarterly operating EPS actuals have diverged by an average of 5.2%.

During Q2, I/B/E/S’ operating EPS actual figure of $54.20 was just 1.1% lower than S&P’s $54.81, which ranks among the smallest divergences between the two actuals in the past 30 years. That divergence has declined each quarter since Q2-2022 when it peaked at a nine-quarter high of 23.6%. We weren’t concerned at the time because the large divergence was due to an unusually large mark-to-market accounting loss that reduced Berkshire Hathaway’s earnings significantly.

(3) S&P 500 sectors’ Q2 growth: The I/B/E/S data show that six of the 11 S&P 500 sectors recorded positive y/y earnings growth in Q2, up from five in Q1-2023. Among the strongest sectors, Consumer Staples rose y/y for a 12th straight quarter, and Industrials was up for a ninth quarter. Rising on a y/y basis for the first time in five quarters were the Communication Services, Information Technology, and Utilities sectors. Among the laggards, Energy declined y/y for the first time in 10 quarters; Health Care fell by a record amount; and Materials was down for a fourth straight quarter (Fig. 19).

Here’s how the S&P 500 sectors’ y/y earnings growth rates stacked up in Q2-2023: Consumer Discretionary (49.5%), Communication Services (17.6), Industrials (13.0), Consumer Staples (6.0), Information Technology (1.8), Utilities (0.5), Financials (-1.8), S&P 500 (-5.9), Real Estate (-9.8), Materials (-23.3), Health Care (-27.1), and Energy (-48.0).

(4) Q3-2023 estimate revisions. We’re very encouraged by the recent estimate revisions trend. With six weeks to go before companies close their Q3 books, analysts’ consensus S&P 500 Q3 earnings forecast is down just 0.2% since the quarter began—the slowest rate of decline since Q4-2021. It’s markedly less than the 2.2% decline of the Q1-2023 estimate at a similar point in that quarter’s reporting season as well as the average 4.0% decline of all quarters since 1994.

Among the 11 S&P 500 sectors, Q3 EPS estimates have risen since the quarter started for four: Communication Services, Consumer Discretionary, Financials, and Information Technology. Energy, Materials, and Utilities have registered the biggest declines, while the remaining sectors are down marginally (Fig. 20). The relatively modest declines in the S&P 500’s EPS estimate suggest that the table is being set for yet another strong earnings surprise in Q3-2023. That’s likely to mean more upward estimate revisions for future period forecasts in a repeat of the pattern that occurred during the Q1- and Q2-2023 earnings seasons.

 (5) Q3 growth forecasts. Analysts currently expect seven of the 11 S&P 500 sectors to record positive y/y growth in Q3-2023. S&P 500 earnings are expected to edge down 0.5% y/y on a frozen-actual basis as the index recovers from its worst y/y comparison so far in this cycle. On a proforma same-company basis, which is provided by Refinitiv’s research department, S&P 500 earnings growth is expected to rise 1.3% y/y for the S&P 500.

Here are the readings of the analysts’ latest proforma y/y Q3-2023 earnings growth rate estimates for the 11 sectors of the S&P 500 versus their preliminary growth rates for Q2-2023 as of the week of August 18: Communication Services (34.6% in Q3-2023 versus 16.0% in Q2-2023), Consumer Discretionary (21.6, 53.6), Financials (15.2, 9.9), Industrials (13.5, 15.7), Utilities (12.1, 0.6), S&P 500 ex-Energy (6.9, 3.0), Consumer Staples (3.5, 8.7), Information Technology (2.5, 2.6), S&P 500 (1.3, -3.4), Real Estate (-6.7, -2.2), Health Care (-10.1, -26.7), Materials (-19.5, -26.4), and Energy (-39.8, -47.7).

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Bond Yields Returning To Normal

August 22 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Bonds I: Bloomberg on the Bond Vigilantes & Me. I am rarely misquoted or taken out of context by my friends in the financial press. However, I recently was compared to the boy who cried “Wolf!” in an August 18 Bloomberg article titled “Yardeni, Economist Who Cried ‘Bond Vigilantes,’ Spots Them Again.”

I would like to set the record straight with the help of three articles about me and the Bond Vigilantes previously posted on Bloomberg and actually referenced in the latest one. The latest article states: “Edward Yardeni, the economist who coined the term ‘bond vigilantes’ during the 1980s and has regularly predicted their return to the investment landscape ever since, said they’re ‘saddling up.’”

I did not regularly predict their return. I did coin the term “Bond Vigilantes” in 1983. I was consistently bullish on bonds from then through 2021. I was among the first disinflationists at the start of the 1980s. I changed my mind about bonds along with everyone else in early 2022 when inflation reared its ugly head. Yet the Bloomberg story implies that I was mostly bearish that whole time since the early 1980s, presumably because I saw Bond Vigilantes around every corner.

For the record, I did see them three times during the 1980s, when yields rose and effectively slowed nominal GDP growth. In the early 1990s, I observed that the Clinton administration maintained fiscal discipline largely because they feared the Bond Vigilantes. Inflation remained subdued during the second half of the 1990s through 2021, and I remained mostly bullish on bonds. I didn’t cry ”Wolf!”

Now let’s go to the Bloomberg stories, referenced in the article, that got it right:

(1) Bond Vigilantes Are ‘Baaaack!’, Says Economist Who Coined Term (September 27, 2022). “In a note titled ‘The Bond Vigilantes: They’re Baaaack!’ Ed Yardeni said the huge amount of monetary and fiscal stimulus released during the pandemic has unleashed forces that haven’t been seen for decades, forcing central banks to respond with the massive policy tightening seen this year. ‘Once the central banks were forced to stop their Great Financial Repression, the bond vigilantes were set loose,’ wrote Yardeni … His comments came as the worst bond selloff in decades is seeing few signs of ending.”

(2) Yardeni Says Bond Vigilantes May Return After Virus Crisis Fades (March 18, 2020). “The market veteran credited with coining the term ‘bond vigilantes’ says there’s a chance they could make a return in the aftermath of the coronavirus, after being largely absent for decades. Government debt in most developed nations has seen a powerful rally the past two months as the deadly epidemic throttled economic growth. But once the outbreak finally subsides, they might start tumbling when investors consider the tremendous amount of stimulus enacted by policy makers, says Ed Yardeni, president and chief investment strategist of Yardeni Research Inc. ‘After we get through this GVC [Great Virus Crisis], we may very well have an inflation scare where the bond vigilantes might very well be able to push bond yields higher,’ Yardeni said in an interview.”

The story also quotes me as saying, “I haven’t seen them [i.e., the Bond Vigilantes] for quite some time.” As noted in the story, I said that the last time I saw them was during the Greek debt crisis in 2010. Furthermore, according to the article: “In the end, they may return ‘because even the central banks will recognize that they need to at least try to do some normalization of monetary policy to head off inflationary consequences of all the stimulus provided,’ he said.”

(3) Bond Vigilantes Lie In Wait for Trump’s Debt-Swelling Tax Plan (April 27, 2017). I was quoted in this article with a title suggesting that it might have represented my view, since I am widely associated with the Wild Bunch. Here was what I said in the story: “Bond vigilantes are now clearly showing no signs of vigilantism.” I explained: “‘The bond vigilantes get much more excited about inflation than they do about the supply of government securities,’ Yardeni said. ‘We are trained that market prices are dictated by supply and demand, so having bigger and bigger deficits should matter. It does matter to bond vigilantes, but much more weight seems to be given to inflation.’” I added that since the 2008 financial crisis, “‘the bond vigilantes have been pretty quiet.’”

Just for the record: “The Bond Vigilantes,” an excerpt from my 2018 book Predicting the Markets, is posted on our website.

Bonds II: What Is Normal? So now what? Where do we go from here? Since 1983, I have been keeping track of the Bond Vigilantes, and not regularly ringing the alarm bell about their return. I viewed them as a disinflationary force that was bullish for bonds. They’ve undoubtedly returned recently, as the 10-year Treasury bond yield—which had dropped from 4.25% on October 24 to 3.30% on April 6—rebounded to 4.34% yesterday on mounting concerns about mounting federal deficits, as Melissa and I discussed in yesterday’s Morning Briefing.

The question we need to answer is whether bond yields can fall if inflation continues to moderate, as we expect, while the federal deficit widens even though the economy is growing? As I observed in the April 27, 2017 Bloomberg article cited above, supply and demand for bonds mattered to the level of bond yields in the past, but not as much as inflation mattered. Now the former may matter at least as much as inflation given the unprecedented profligate fiscal excesses occurring since the pandemic.

Of course, if we are wrong about inflation—either because it stops moderating or it starts moving up again—we all know that bond yields are going higher. But if inflation does moderate, can bonds rally or at least stabilize at current levels despite the large supply of Treasuries while the Fed is tapering its holdings of Treasuries? Now that the Fed and other central banks have been forced to normalize their monetary policies, what should the normal bond yield be under the circumstances?

Consider the following:

(1) The Bond Vigilante Model relates the bond yield to the growth rate in nominal GDP, which reflects inflation as well as the growth rate of real GDP. This model shows that since 1953, the yield has fluctuated around the growth rate of nominal GDP (Fig. 1). However, both the bond yield and nominal GDP growth tend to be volatile. While they usually are in the same ballpark, they rarely coincide. When their trajectories diverge, the model forces us to explain why this is happening.

During Q2, nominal GDP was up 6.3% y/y, which was down from a peak of 17.4% y/y during Q2-2021. It seems to be converging with the 10-year Treasury bond yield, which rose from a record low of 0.52% during August 2020 to 4.34% on Monday. Nominal GDP growth should continue to moderate along with inflation.

The GDP deflator (GDP-D) peaked at 7.6% y/y during Q2-2022 (Fig. 2). It was down to 3.6% during Q2-2023. It has converged with the bond yield. However, in the past, the bond yield almost always has exceeded the GDP-D inflation rate (Fig. 3). But there is no constant or even consistent value for this measure of the real bond yield. Our forecast is that the deflator is heading toward 2.0%-2.5% by 2025. If the real bond yield rises from zero during Q2-2023 to 1.50%-2.50% (where it was just before the pandemic), the nominal yield would be 3.50%-5.00%. Admittedly, that’s a wide range, but it would be a return to normal compared to the period from the GFC through the GVC.

(2) The TIPS Model defines the nominal 10-year Treasury bond yield as equaling the 10-year TIPS yield plus an expected inflation proxy, i.e., the nominal yield minus the comparable TIPS yield (Fig. 4 and Fig. 5).

The recent rebound in the nominal yield has been driven by the rebound in the TIPS yield from a low of 1.06% on April 6 to 2.00% yesterday. The latter seems to be normalizing back around 2.00%, which is where it was during 2003-06, the years just before the Great Financial Crisis (GFC) of 2008 set the stage for the TIPS yield to fluctuate around 1.00% to -1.00% from 2010-22.

The history of the 10-year expected inflation proxy shows that it mostly has hovered around 2.50% since 2003 except for during the recessions associated with the GFC and the GVC, along with the mid-cycle slowdown of 2015-16. During those three periods of economic weakness, the TIPS yield fell below 1.50%.

This model suggests that during normal times, the 10-year nominal bond yield should be around 4.50%.

(3) The Yield Curve Model is based on investors’ expectations of how monetary policy will respond to inflation and impact the business cycle. In the past, inverted yield curves signaled that the 10-year Treasury bond yield was getting close to peaking (Fig. 6 and Fig. 7). That’s because inverted yield curves typically imply that bond investors believe that if the Fed continues to raise short-term interest rates, something in the financial system will break, triggering an economy-wide credit crunch and a recession.

This time, the inverted yield curve correctly anticipated the banking crisis that occurred during March. But there has been no credit crunch because the Fed responded quickly with an emergency lending facility for the banks. So there has been no recession attributable to a credit crunch. The bond yield has been rising since April as investors became increasingly impressed with the resilience of the economy.

As a result, the inverted yield curve is disinverting, with the bond yield rising toward the 2-year Treasury note yield (Fig. 8). We think that the yield curve is normalizing as the economy returns to its Old Normal, leaving behind the New Abnormal that spanned from the GFC through the GVC periods. In the past, the yield curve disinverted, with the 2-year yield falling faster than the 10-year yield, during recessions and early recovery periods.

In our opinion, what we are seeing now is the bond yield returning to its normal pre-GFC range of 4.50%-4.75%.

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No Hard Feelings

August 21 (Monday)

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

US Economy I: The Great Debate Continues. To our pessimistic friends on the dark side of the Great Debate over the economic outlook, we say: “Keep up your thought-provoking work! We are constantly challenged by your insights as we continue to be your sparring partners on the lighter side of the debate.”

Let’s review the honorable opposition’s latest debating points before we focus on the federal budget deficit issue, which does concern us:

(1) Jeremy Grantham. In an August 18 interview on Bloomberg Wealth with David Rubenstein, Jeremy Grantham of GMO doubled down on his grim outlook for the economy. He is betting with near certitude that the Fed will fail to avoid a recession: “They have never called a recession, and particularly not the ones following the great bubbles.” As higher rates continue to depress other corners of the market, particularly real estate, the US economy will see “a recession running perhaps deep into next year and an accompanying decline in stock prices.” Grantham thinks that inflation will “never be as [low as] its average for the last 10 years.” So interest rates will remain higher, which will “push asset prices down.”

(2) David Rosenberg. In an August 17 post on X (a.k.a. Twitter), David Rosenberg of Rosenberg Research predicted that equites are “heading into a new bear phase.” He noted that “rule number eight” by Wall Street veteran Bob Farrell states that bear markets have three stages, namely, sharp down, reflexive rebound, and drawn-out fundamental downtrend. The same day that he posted his tweet, he told BNN Bloomberg in a TV interview: “The recession has been delayed; it’s not derailed.” Rosenberg said that on average recessions start two years after the first Fed rate hike. He warned that a “huge default cycle” is coming. He added, “We’re not getting out of this without a recession.”

(3) Mike Wilson. In an interview posted on August 8 by Fortune, Mike Wilson of Morgan Stanley warned that “excessive” government spending could be fueling a “boom-bust” scenario in the stock market.

(4) Marko Kolanovic. On August 2, Yahoo! Finance reported that Marko Kolanovic of JPMorgan wrote the following in a note to investors: “While the economy’s recent resilience may delay the onset of a recession, we believe that most of the lagged effects of the past year’s monetary tightening have yet to be felt, and ultimately a recession will likely be necessary to return inflation to target.”

(5) Ray Dalio. At a June 7 Bloomberg conference, Ray Dalio of Bridgewater Associates warned that the US is facing a debt crisis and a looming balance-sheet recession. One of his concerns is that there may not be enough buyers for the deluge of securities that the Treasury must issue to finance the rapidly widening deficit. “In my opinion, we are at the beginning of a very classic late, big-cycle debt crisis when you are producing too much debt and have also a shortage of buyers,” Dalio said. He argued that interest rates are likely to stay high for some time, which will weigh down the economy.

(6) Bottom line. At the beginning of the year, the bears warned that a recession was imminent. Instead, real GDP rose 2.0% (saar) during Q1 and 2.4% during Q2. The Atlanta Fed’s GDPNow model is tracking real GDP growth at 5.8% during Q3. The estimate has consistently been rising since July 27, when it was 2.0%.

Now some of the economy’s naysayers are saying that the strength of the economy means that inflation will stay higher for longer, forcing the Fed to continue hiking the federal funds rate until a recession occurs, maybe early next year. Others in the bearish camp are saying that the Fed’s tightening of monetary policy since early last year will cause a recession even if the Fed doesn’t raise rates because the long and variable lags of monetary policy will soon hit the economy hard.

The gloomiest pessimists expect that the mounting federal deficits can be financed only at higher interest rates, which will cause a debt crisis and a recession. The doomsday version of this scenario is that the net interest outlays of the federal government will compound at a pace that is simply unsustainable, with lots of dire consequences.

We are counting on continued moderation in the inflation rate and lower interest rates next year to prevent these dire predictions from playing out. Nevertheless, let’s have a closer look at the federal deficit issue, which is the one that troubles us the most.

US Economy II: Federal Budget Deficit Matters. The hard-landers are highly regarded strategists with some great calls behind them. They’ve been wrong so far about a recession arriving in 2022 and 2023, but they could still be right about one coming before year-end 2024. In particular, Debbie and I share their concerns about the mounting federal budget deficit, which has been exacerbated by mounting federal outlays led by soaring net interest outlays.

In the past, we didn’t care as much about the federal budget deficit because it tended to widen during recessions and narrow during economic expansions relative to nominal GDP (Fig. 1). That’s because during recessions (expansions), outlays rose (fell) relative to GDP, while tax receipts declined (increased) relative to GDP (Fig. 2). This time, the government’s outlays are increasing while its revenues are decreasing relative to rising GDP as the economy expands.

In the past, bond investors were much more focused on inflation and the Fed’s policy response to it rather than on the supply of Treasuries. That’s because inflation tended to moderate during recessions and economic recoveries (as productivity rebounded) (Fig. 3). So a widening deficit didn’t matter much. That’s why in the past, we didn’t care that much about the federal budget deficit—because the bond market didn’t care that much.

The Fitch Ratings downgrade of US federal government debt from AAA to AA+ on August 1 reminded us all that fiscal policy has turned increasingly profligate since the pandemic. As Clinton administration adviser Rahm Emanuel famously said: “You never let a serious crisis go to waste. And what I mean by that it's an opportunity to do things you think you could not do before.” That’s always been Washington’s modus operandi, but never more so than since the pandemic.

Arguably, the first round of pandemic relief checks distributed by the Treasury during the spring of 2020 worked remarkably well to stabilize the economy that year. But the second round in late 2020 and the third round during the spring of 2021 set the stage for a significant surge in inflation. Here is a summary of the three rounds of checks and subsequent fiscal extravaganzas:

Round 1 (March 2020): $401.5 billion sent in 167.6 million payments.

Round 2 (December 2020): $141.5 billion sent in 146.5 million payments.

Round 3 (March 2021): $271.4 billion sent in 161.9 million payments.

American Rescue Plan (March 2021): This act authorized the third round of relief checks, with a total price tag of $1.9 trillion.

Infrastructure Investment and Jobs Act (November 2021): The Biden administration’s second legislative victory came in November. This act provided $1.2 trillion to fund physical infrastructure projects such as roads, bridges, water pipes, and broadband internet.

CHIPS and Science Act (July 2022): This act included more than $50 billion for incentivizing the expansion of the semiconductor manufacturing industry in the US. It also increased funding for the Advanced Manufacturing Investment Tax Credit by nearly $25 billion and provided nearly $5 billion for research and innovation.

Inflation Reduction Act (August 2022): This act included nearly $370 billion for clean energy and climate programs.

The Congressional Budget office (CBO) issued a July 20 report that assessed the long-term budget outlook and included the following grim summary: “If current laws governing taxes and spending generally remained unchanged, the federal budget deficit would nearly double in relation to gross domestic product (GDP) over the next 30 years, driving up federal debt, the Congressional Budget Office projects. In CBO’s extended baseline projections, debt held by the public rises from 98 percent of GDP in 2023 to 181 percent of GDP in 2053—exceeding any previously recorded level and on track to increase further. Those projections are not predictions of budgetary outcomes; rather, they give lawmakers a point of comparison from which to measure the effects of policy options or proposed legislation.”

In other words, the Fitch downgrade was justified by the CBO’s projections.

The Fed: Will Powell Calm the Bond Vigilantes? It’s hard to put lipstick on this pig. Our relatively sanguine outlook since last year has been predicated on inflation coming down this year, which it has. As a result, we concluded that the 10-year Treasury yield probably peaked at 4.25% on October 24 and that the Fed would soon stop raising the federal funds rate.

The bond yield bottomed this year at 3.30% on April 6. But here it is, back to 4.25% on Friday, led higher by the 10-year TIPS yield’s rise to 1.94%, little changed from Thursday’s 1.97%, which was the highest since July 6, 2009 (Fig. 4). The yield rebounded from its low as the hard-landers were forced to concede that the economy was more resilient than they expected. The yield rose above 4.00% following the Fitch downgrade on August 1. The July FOMC minutes released on August 16 showed that the committee might continue to raise the federal funds rate if inflation doesn’t continue to moderate.

Melissa and I expect that Fed Chair Jerome Powell will try to calm the bond market with his speech on Friday at the Fed’s annual Jackson Hole conference. We think he will agree with the views expressed by New York Federal Reserve Bank President John Williams earlier this month—basically that monetary policy is restrictive enough as it is to bring down inflation. Powell will likely acknowledge that inflation has been moderating and say that if it continues to do so, the Fed may have to lower the federal funds rate next year to stop real interest rates from tightening credit conditions further.

If he doesn’t do so (or succeed in doing so), the yield curve will continue to disinvert, with the 10-year yield rising toward the 2-year yield (Fig. 5 and Fig. 6). In that scenario, the rating agencies, anticipating more loan defaults, would subject the banking sector to another round of credit-rating downgrades, especially in the commercial real estate sector.

The odds of a recession occurring before the end of next year would increase in that scenario. That would be unfortunate indeed since inflation is likely to continue to moderate without requiring a recession to do so. We currently are still assigning 85% odds to a no-landing scenario through the end of next year and 15% to a hard-landing one. However, we are leaning toward lowering the former and raising the latter.

Powell’s speech will matter a great deal to what happens next.

Movie. “Breaking” (+ +) (link) is based on the 2017 real-life story of the late Brian Brown-Easley, a decorated Marine Corps veteran who walked into a Wells Fargo bank and claimed to have a bomb in his backpack. He didn’t want to rob the bank. Rather, he wanted the regional office of the Department of Veterans Affairs (VA) to give him his benefits check for $892. The VA used the money to reduce the balance on his outstanding student loan instead. It’s a very sad story, suggesting that we need to do much more to help our veterans after they’ve bravely served our country.

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China, Consumers & Alzheimer’s Breakthroughs

August 17 (Thursday)

China: The Real Estate Morass Deepens. It’s been almost two years since China Evergrande Group, once China’s largest real estate developer, shocked the financial markets by defaulting on $340 billion in debt. Since then, the Chinese real estate market has been in a serious slump.

Developers in China sold 60.3 million square feet of residential property in July—the least in any given month since 2012, an August 15 WSJ article reported. Real estate prices are falling, most recently by 0.2% m/m in July. Investment in real estate fell 8.5% y/y during the first seven months of this year. And over the past few years, more than 70 real estate developers have gone bankrupt, according to KPMG’s count. Two more names may join the illustrious list: Real estate developers Country Garden and Sino-Ocean Group Holding have missed payments on billions of dollars of debt.

Were that not enough, Zhongrong International Trust and its major investor Zhongzhi Enterprise Group stopped making payments on some trust investments they sold to investors. Add July’s dour economic reports to the equation, and it’s clear why the People’s Bank of China (PBOC) cut interest rates on Tuesday. The central bank’s move failed to staunch the slide in Chinese stocks or currency. The country needs a good US-style restructuring of its real estate market, where apartment prices are slashed, debt is restructured, and new equity investors are brought in as grave-dancers.

Until then, we’re left watching the wreckage unfold. Let’s take a look at some of this week’s major events in the Chinese real estate market:

(1) Debt payments missed. Once China’s largest real estate developer by sales, Country Garden sold more than a half a trillion renminbi (RMB) of real estate annually from 2018 to 2021. However, its sales have slid sharply in the past two years. In July, sales declined for the fourth month in a row to just 12.1 billion RMB, down from 30.1 billion RMB in July 2022 and 54.3 billion RMB in July 2021, an August 10 FT article reported. Chinese developers depend on cash deposits collected when an apartment is purchased to fund operations. As sales have slumped, so too have developers’ cash flows.

Last week, Country Garden missed $22.5 million of payments on two international bonds. The company—which expects to report a net loss of 45 billion to 55 billion yuan in 1H-2023—owes almost $200 billion of debt and has 35 billion yuan of bonds maturing through January, reported an August 14 South China Morning Post (SCMP) article. If the company doesn’t make the interest payment within 30 days of the skipped payment, it will be in default.

State-controlled Sino Ocean also recently ran into a wall. It suspended trading of its 6% guaranteed notes due in 2024 after missing a $20.9 million interest payment. China’s 25^th largest real estate developer has conducted a consent solicitation of bond investors, securing an extraordinary resolution to defer its interest payments. But ultimately, default seems probable because the company has $1.6 billion of bond debt due by year-end and only $811 million of cash or equivalents, according to its annual report. Almost 30% of Sino-Ocean’s shares are owned by China’s finance ministry.

(2) Ripple effects hits financial companies. There’s growing concern that Chinese real estate debt defaults increasingly could impact the financial sector, including trust companies that loan to and invest in real estate developments in addition to stocks, bonds, and commodities. Zhongrong International Trust has delayed payment on some of its maturing wealth products, an August 13 SCMP article reported. It had bought stakes in at least 10 real estate projects last year, hoping that unfinished homes would sell and pay off some of the projects’ $230 billion in property-backed debt.

The news comes amid rumors that Zhongzhi Enterprise Group, a major shareholder in Zhongrong, was experiencing its own liquidity crisis. Zhongzhi has about 1 trillion yuan ($138 billion) of assets under management. Zhongzhi owns many different businesses, including Datang Wealth, which also has missed payments on a wealth product, an August 14 FT article reported.

Zhongzhi’s wealth arms have delayed payments to “more than 150,000 clients with outstanding investments totaling 230 billion yuan,” an August 14 Bloomberg article reported.

Concern about trust companies and other Chinese shadow banks’ exposure to the real estate market is growing. The shadow banking industry totals about $3 trillion, and JPMorgan estimates that its rising trust defaults could drag down the country’s y/y GDP growth by 0.3-0.4ppts, an August 14 Reuters article reported. “Chinese authorities [are studying] possible contagion with the banking regulator examining risks at Zhongzhi,” according to the August 14 Bloomberg article.

(3) Government responds a bit. China’s central bank responded to this and other disappointing economic data discussed in yesterday’s Morning Briefing by cutting interest rates. The PBOC lowered the interest rate on one-year loans to banks to 2.50% from 2.65%, while adding $55.2 billion of new loans into the banking system. This isn’t likely to be the last thing the government must do to steady its economic ship.

The MSCI China share price index fell by 0.9% (in local currency) on Tuesday despite the PBOC’s moves. The country’s stock price index is down 4.6% ytd through Tuesday’s close, compared to a 15.9% increase in the US MSCI index (Fig. 1). China’s yuan also has been under pressure, falling to 7.29 relative to the dollar on Tuesday. It’s down 4.7% ytd (Fig. 2).

Consumer Discretionary: An Unusual Year. The S&P 500 Consumer Discretionary sector may be up 31.8% ytd through Tuesday’s close, but that does not translate into a booming traditional retail environment for clothes and home goods. Instead, it’s a reflection of the amazing performance this year of Amazon, Tesla, homebuilders, and the travel industry.

Excluding just Amazon and Tesla drops the Consumer Discretionary sector’s ytd performance to 7.5%. Tesla’s 89.1% gain through Tuesday’s close helped the S&P 500 Automobile Manufacturing industry’s stock price index jump 69.7% ytd (Fig. 3). Likewise, Amazon’s 63.9% ytd gained helped the stock price index of its industry, Broadline Retail, soar 60.3% ytd (Fig. 4). The Consumer Discretionary sector was also boosted by the 45.7% surge in the Homebuilding industry’s stock price index (Fig. 5). Meanwhile, the post-pandemic travel surge has benefitted the stock price indexes of the Hotels, Resorts & Cruise Lines industry, up 49.7% ytd, and the Casinos & Gaming industry, up 21.7% (Fig. 6).

Compare those numbers to the sluggish ytd performances of the S&P 500’s more traditional retail categories’ stock price indexes: General Apparel Retail (4.9%) and Other Specialty Stores (-3.5). The Consumer Staples Merchandise Retail industry—which is in the Consumer Staples sector—includes Walmart, Target, and the dollar stores. Its stock price index has risen 8.9% ytd but still trails the S&P 500’s 15.6% ytd return.

So which accurately reflects the health of the prototypical consumer—the one spending on services by jetting off to Europe or the one keeping his or her wallet shut and spurning the latest fashion trend? It’s hard to tell by the Q2 earnings reports of Target and TJX released yesterday. Same-store sales fell 5.4% y/y for Target but rose 6.0% y/y for TJX.

Let’s take a look at what the retailers reporting last quarter’s earnings had to say:

(1) Missing the target. Target’s results were dented after the retailer found itself at the center of the culture wars for offending some customers with the Pride merchandise it displayed. Target CEO Brian Cornell noted in Wednesday’s earnings conference call that inflation continues to push consumers to purchase more staples and fewer discretionary items, and the preference to spend on services instead of consumables continues. And he added: “[T]he rollback of government efforts to support consumers during the pandemic, including stimulus payments, enhanced childcare tax credits, and the suspension of student loan payments, presents an ongoing headwind…”

That said, the company has reduced its inventory by 17% y/y, ending the need to run unexpected sales and allowing margins to rebound from last year. Nonetheless, management expects Target’s same-store sales will decline for the remainder of the year, and it reduced its fiscal 2024 (ending January) earnings-per-share target to $7.00-$8.00 from $7.75-$8.75.

(2) Maxxinistas still shopping. TJX, which didn’t face a culture backlash, reported stronger-than-expected Q2 same-store sales, driven by an increase in customer transactions across all of its divisions, which include Marshall’s, TJ Maxx, and Home Goods. Consumers purchased less expensive items but made up for it by buying more items. Same-store sales are expected to slow during H2-2023 but remain positive, bringing management’s fiscal 2024 (ending January) same-store sales guidance to an increase of 3%-4%. Management increased its fiscal 2024 earnings-per-share guidance to $3.66-$3.72, up from the $3.49-$3.58 offered a quarter ago.

Disruptive Technologies: Med Tech Takes on Alzheimer’s. Advancements in medical technology are taking aim at Alzheimer’s. About 6.5 million Americans have Alzheimer’s, and scientists are harnessing stem cells, CRISPR, and immunotherapy to slow the disease’s progression and eventually find a cure.

Fortunately, there is a full pipeline of potential Alzheimer’s drugs in various stages of testing, according to a study cited by the Alzheimer’s Association. There are 187 Phase 1, 2, or 3 clinical trials assessing 141 treatments as of January 1, and 55 of the trials are in Phase 3. Just in time for the Baby Boomers’ old age!

Let’s take a look at some of the theories scientists are testing out:

(1) CRISPR to the rescue. Microglia are brain cells that protect the central nervous system from disease. Some believe that damaged microglia create the excessive beta-amyloid plaques associated with Alzheimer’s or inhibit the body’s ability to clear the plaques away. Beta-amyloid is a protein that accumulates in the brains of Alzheimer’s patients and creates a sticky plaque that interferes with neurons and prevents the transmission of information.

Until recently, scientists have been unable to remove damaged microglia cells to replace them with healthy cells. However, an FDA-approved cancer drug, pexidartinib, blocks a protein on microglia cells and kills them. The problem: The cancer drug will kill both the healthy, donated microglia cells as well as the damaged microglia cells.

Neuroscientists at the University of California, Irvine (UCI) and the University of Pennsylvania used CRISPR gene editing to solve the problem, a January 30 UCI press release announced. CRISPR created one amino acid mutation, known as “G795A,” which they introduced into microglia produced either from human stem cells or from a mouse microglial cell line. CRISPR-edited microglia injected into mice were resistant to the cancer drug. Meanwhile, the damaged microglia cells were killed off by the cancer drug. Next, scientists will study how to use the CRISPER-edited microglia to attack the plaques associated with Alzheimer’s.

(2) The power of stem cells. Scientists at the University of California San Diego are also focused on microglia cells. They’ve been evaluating whether stem cells that generate new, healthy microglia could slow the progression of Alzheimer’s.

Scientists transplanted healthy “wild-type hematopoietic stem and progenitor cells into Alzheimer’s mice and found that the transplanted cells did differentiate into microglia-like cells in the brain,” an August 11 article in SciTechDaily reported. They found that memory loss and neurocognitive impairment were “completely prevented” in mice receiving the transplant. The mice that received stem cells showed a “significant reduction” in beta-amyloid plaques and reduced microgliosis and neuroinflammation.

Next, the scientists plan to study how the transplanted cells produced such impressive improvements and whether transplants will work to stop the progression of—or perhaps even cure—Alzheimer’s in humans.

(3) Immunotherapy gets the nod. The Food and Drug Administration (FDA) gave accelerated approval in January to the first Alzheimer’s drug, Leqembi, developed by Eisai. Used in early stages of the disease, Leqembi has been shown to reduce the disease’s progression by 27% after 18 months; however, it is not a cure.

Leqembi is a monoclonal antibody, a protein made in the lab that acts like an antibody. It binds to the plaque and helps to remove it.

Eli Lilly’s donanemab is another monoclonal antibody, which in trials slowed the progression of Alzheimer’s by up to 35%. The earlier in the disease’s progression that it’s given, the greater the impact the drug has. The trial involved 1,743 early-stage patients who were given a monthly infusion of donanemab until all of their brains’ plaques were gone. After 76 weeks of treatment, the drug slowed clinical decline by 35.1%, a July 17 article in Independent reported. Lilly expects an FDA decision by year-end.

Patients must visit a clinic to receive Leqembi or donanemab via an intravenous drip, increasing the cost and difficulty involved with administering the drugs. Eli Lilly’s Remternetug is also an immunotherapy that targets beta-amyloids, but it’s delivered via an injection. Scientists hope that this more easily delivered drug will be more effective and have fewer side effects. Early results from ongoing trials are encouraging. “[A]fter 6 months of treatment 75% of 41 people tested had amyloid cleared from their brains. This is in contrast with donanemab which took 18 months to have 72% of patients cleared of amyloid,” reported a July 19 Alzheimer’s Society blog post.

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Hard Landing In China, No Landing In US

August 16 (Wednesday)

China’s Economy I: Desperately Seeking a New Engine. The Chinese are providing American consumers with cheaper goods. By doing so, the Chinese are increasing the purchasing power of American consumers, who are doing what they do best; they are shopping. It’s a gain for the US economy, which is getting better economic growth with lower inflation. It’s a loss for Chinese consumers, who are facing deflation and higher unemployment and dealing with the consequences of the bursting of their property bubble. China’s rapidly aging demographic profile is only exacerbating these problems.

The woes in the Chinese property market are weighing on consumer spending since many of the Chinese have significant portions of their personal assets in brand new empty apartments. They were worth owning when they appreciated in value, but now they have been losing value. The persistent drag in the property sector is impeding the sale of land by local governments, which is depressing their revenues and their spending on infrastructure as well as making it harder to service their debts.

Additionally, foreign demand for Chinese goods continues to be weak, posing a major impediment to fostering a sustainable economic recovery. Youth unemployment is at a record high. China is attempting a painful transition to a less debt-fueled, less property-centric, and less export-oriented economy. The problem is that it isn’t turning into a consumer-driven economy as government officials had hoped.

The Chinese government desperately has been seeking a new engine for growth without any success so far.

China’s Economy II: Lots of Woes. Jackie and I have been on top of this story for quite a while. In tomorrow’s Morning Briefing, she will provide an update of the mess in the property market. Today, let’s review the latest developments in this ongoing saga:

(1) Consumer spending and the CPI. Retail sales rose 2.5% y/y, down from a 3.1% increase in June, and missed analysts’ forecasts of 4.4% growth (Fig. 1). Real retail sales rose 2.8% as the CPI declined 0.3% y/y in July, falling for the first time in two years and sparking fears of deflation (Fig. 2). The underlying growth rate of real retail sales has plunged from more than 15% during the late 2000s to the low single digits now, reflecting the rapidly aging demographic profile of Chinese consumers (Fig. 3). China continues to be the world’s largest nursing home.

(2) Trade. Last week, the National Bureau of Statistics reported greater-than-expected declines in July exports and imports (Fig. 4). The former was down 9.3% y/y, while the latter was down 6.7% y/y. Imports has been virtually flat since mid-2021.

(3) Industrial production & the PPI. Industrial production rose 3.7% y/y in July, down from 4.4% in June and missing the consensus forecast of 4.6% (Fig. 5). It has been sliding downward along with real GDP growth since 2010. Chinese factories have been challenged by weak demand at home and less demand for exports overseas, as western consumers have been pulling back on spending and foreign producers have been moving their factories to friendlier countries in response to China’s increasingly anti-business regulations and hostile foreign policy.

Foreign direct investment in China in Q2-2023 was just $4.9 billion, according to data from China’s balance of payments, the lowest quarterly total in records starting in 1998.

(4) Unemployment. The urban unemployment rate rose in July, for the first time since February, to 5.3% from 5.2% in June. More troubling is that the urban unemployment rate for people aged 16 to 24 has ratcheted up steadily from month to month this year, hitting a record 21.3% in June—four times the overall jobless figure. Chinese officials announced on Tuesday that they will temporarily stop publishing the youth unemployment rate, claiming they need to refine how it’s calculated.

China’s universities churn out lots of graduates with skills that don’t match the needs of employers. Job opportunities have been reduced in several heavily regulated industries, including education, real estate, and technology.

(5) Property. Country Garden Holdings, one of China’s largest real-estate developers, missed payments on some of its bonds and warned that it expects to post a record loss for the first six months of the year as sales and profit slump. The property bubble is still bursting.

(6) Credit. Data released on Friday showed that Chinese banks lent far less than expected to households and businesses last month, highlighting weak demand for borrowing despite a succession of interest-rate cuts by the People’s Bank of China (PBOC). Chinese bank loans rose by just $5.1 billion during July, down sharply from June’s gain of $453.4 billion and the lowest since October 2006 (Fig. 6).

Household loans, mostly mortgages, fell by 200.7 billion yuan in July, after rising 963.9 billion yuan in June as the debt crisis in the property sector worsened, while corporate loans slid to 237.8 billion yuan last month from 2.28 trillion yuan in June.

(7) Policy. Earlier Tuesday, the Chinese central bank unexpectedly cut its key interest rate for the second time in three months to boost the economy. The August 15 WSJ reported: “The People’s Bank of China said Tuesday that it lowered the interest rate on a key facility that funnels one-year loans to banks to 2.5% from 2.65% previously, at the same time shoveling the equivalent of $55.2 billion of new loans into the banking system. Such a move is usually followed within days by a reduction in bank lending rates to households and businesses.”

US Economy I: China’s Gift to the US. The question is: Will American consumers save China from a bad recession? One of the reasons for China’s woes stems from the behavior of American consumers, after all: They embarked on a goods buying binge when the pandemic lockdowns were lifted in the spring of 2020. But that binge ended unexpectedly around year-end 2021 when US consumers pivoted to purchasing services as social distancing restrictions were lifted. Chinese exporters benefited greatly from the goods buying binge in the US. But they’ve been forced to lower their export prices to maintain their sales to Americans so far this year.

The US import price index fell 4.4% y/y and 1.3% y/y with and without petroleum (Fig. 7). Contributing to the decline was the US import price index from China, which was down 2.3% y/y through July (Fig. 8). China’s homegrown deflation in its PPI, which was down 4.4% y/y, is likely to continue to weigh on the US import price index from China (Fig. 9).

China’s recession and deflation are reducing the risks that the US must fall into a recession to bring down inflation!

US Economy II: Consumers Buying More Goods Again. In the US, the rolling recession that hit the goods market since mid-2021 seems to be morphing into a rolling recovery, as we’ve been predicting. Retail sales jumped 0.7% m/m during July. That same month, the headline CPI for goods fell 0.1% m/m. As a result, the Atlanta Fed’s GDPNow tracking model increased its latest forecast for Q3’s real GDP from 4.1% to 5.0%, led by an increase in real consumer spending from 3.2% to 4.4%.

Not only has there been no hard landing, but also the soft-landing scenario may be history. Until further notice, it’s looking more like a no-landing scenario, consistent with our rolling recovery thesis. However, the housing industry is likely to roll back into its recession given the recent jump in mortgage rates. The National Association of Home Builders (NAHB) Housing Market Index (HMI) fell 6 points from last month to 50, the index's first monthly decline in the past eight months. The commercial real estate market is certainly rolling into a recession, especially now that long-term interest rates have moved higher.

Before we get too excited about July’s retail sales report, let’s keep in mind the following:

(1) Housing-related retail sales remain weak (Fig. 10). Building materials are included in the residential investment component of GDP.

(2) Sales at nonstore retailers jumped 1.9% m/m during July because of Amazon’s Prime Day sale during the month (Fig. 11).

(3) Food services and drinking places reported a 1.4% collective increase in their sales during July (Fig. 12). In the GDP calculation, this industry is included in consumer services rather than consumer goods.

(4) On an inflation-adjusted basis, retail sales remains on its flat trend that started in mid-2021. It is still on a modest downward trend over this period excluding building materials and food services (Fig. 13 and Fig. 14).

Strategy: Tech’s Market-Cap Share. Since the introduction of the PC in the early 1980s, businesses have used and integrated computing technology into their operations to improve productivity and profitability. Back then, the first question of portfolio managers looking at investment candidates was: “What’s the dividend yield?” Now that question is: “Is it a tech company?” Then come questions about how the company leverages technology to business advantage—and looming in the back of minds: “Could this company become another Amazon?”

We strive to provide the data showing how much tech stocks influence the broader stock market’s performance. But now that new tech is being created and used everywhere, tracking how great a part of the stock market technology companies represent is no longer a simple exercise.

Using data since 1985, we have tracked each S&P 500 sector’s market-capitalization share of the S&P 500 index. For much of that time since, their capitalization shares have changed as portfolio managers invested funds based on the fundamental fortunes of the companies within each sector. However, there have been tracking complications along the way. Their capitalization share has also changed as constituents were added and removed from the index. This was especially true for the Information Technology sector, which saw many companies reclassified out of the sector in 2018 and again this year in March.

(1) Impact of past reclassifications on Tech’s market-cap share. Following the market’s close on September 21, 2018, Information Technology’s total market capitalization dropped 20.5% overnight as companies were reclassified to the newly renamed Communication Services and Consumer Discretionary sectors. Among them were several of today’s largest companies, Alphabet and Meta. As a result, Tech saw its market-cap share drop in September 2018 to 20.6% from 25.9%. Earlier this year, on March 17, S&P/MSCI removed the Data Processing & Outsourced Services sub-industry from the Information Technology sector and transferred the bulk of the companies to a new sub-industry in the Financials sector called “Transaction Processing & Payment Services.” The resulting 10.7% decline in Tech’s market capitalization caused the sector’s market-cap share to drop overnight to 25.9% from 29.0%.

(2) Tech’s current share looks peaky. During the August 3 week, Tech’s share of the S&P 500’s market cap was 27.9% (Fig. 15). Despite the GICS reductions in 2018 and 2023, that’s still the highest market-cap share of the S&P 500’s 11 economic sectors. But it isn’t even close to the record-high 34.2% during the June 23, 2000 week. Or is it? Had the reclassifications never happened, Joe’s analysis found, Tech’s market-cap share would be very different.

(3) Undoing reclassifications boosts Tech’s share to new record. Joe redid Information Technology’s current market capitalization to include the companies that were removed from the sector in 2018 and 2023 (Fig. 16). This adjustment of Tech’s market capitalization boosts the sector’s market-cap share to 35.3% as of the August 11 week, well above the 27.1% at which it stands with the reclassification.

Comparing Tech’s total market cap on an apples-to-apples basis with its historical record, that 35.3% share surpasses Tech’s prior record of 34.2% during the June 23, 2000 week. Tech’s adjusted market-cap share peaked during the July 14 week at a record-high 36.6%.

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The 1970s All Over Again?

August 15 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Inflation: Twin Peaks? One of our many thought-provoking accounts sent us the following thought-provoking email message on Sunday: “Is it even possible to have an environment where the Fed is raising rates, fiscal policy is pedal to the metal, employment is totally full, and we get non-inflationary growth? Has it ever happened before? Isn’t it always at best stagflation?”

Here was my short response: “It hasn’t happened before, but it is what we have right now.” The following is my long answer.

Since March 2022, monetary policy has been restrictive, while fiscal policy has been stimulative. As a result, the rapid increase in interest rates since early last year hasn’t caused a recession so far. Indeed, the unemployment rate was 3.5% in July. Yet inflation has been moderating since last summer. The headline CPI peaked at 9.1% y/y last year during June (Fig. 1). The headline CPI with and without shelter were down to 3.2% and 2.0% last month. The core CPI with and without shelter peaked at 6.6% and 7.6% last year, falling to only 4.7% and 2.5% in July (Fig. 2). Meanwhile, the Atlanta Fed’s GDPNow tracking model is currently estimating that real GDP is rising by 4.1% (saar during Q3).

My friend responded that this happy outcome can’t be sustainable and inquired: “What’s next?”

He might be right: This remarkably bright picture could still turn dark, resulting in stagflation. The analogy often proffered is the twin peaks in the inflation rate during the Great Inflation of the 1970s and the resulting stagflation during the decade. I first discussed this analogy in the September 27, 2021 Morning Briefing:

“In recent months, we’ve been discussing two alternative scenarios: The Roaring 2020s (TR-20) and The Great Inflation 2.0 (TGI-2.0). In the first scenario, the relevant paradigm is the decade of the 1920s; in the second, it’s the 1970s. In recent Zoom calls, I’ve been asked by some of our accounts to assign subjective probabilities to these alternative scenarios. I am going with 65% odds for TR-20 versus 35% for TGI-2.0. I may be spending much of the rest of this decade tweaking these probabilities.”

For now, I am sticking with those odds.

Today, reflationists undoubtedly would give higher odds to a rerun of the 1970s—probably well over 50%. After all, the price of oil is rising again. Labor unions are pushing for big pay increases and getting them. Some are even aiming to bring back cost-of-living-adjustment (COLA) clauses in their contracts. The federal deficit is ballooning as the federal government spends on infrastructure, green projects, and incentives to onshore manufacturing, particularly of semiconductors. The government is crowding out other borrowers in the capital markets and competing for workers in the labor market.

The reflationists have a point: It may be only a matter of time before these cost pressures show up as a second wave of inflation. That would force the Fed to keep raising interest rates until something breaks in the financial system, triggering an economy-wide credit crunch and a recession. It could all happen during the first half of the 2020s—like the 1970s on steroids.

But even in that case, I believe that the second half of the 2020s still could follow the 1920s script. In any event, Debbie and I remain disinflationists. We think that inflation peaked last summer and likely will fall to the Fed’s 2.0% target by 2025.

Let’s compare the 1970s to the 2020s so far:

(1) Overview. During the 1970s, two OPEC oil supply shocks triggered an inflationary wage-price spiral (Fig. 3). They also caused a couple of nasty recessions. The US budget deficit swelled as the government pursued a policy of both “guns and butter.” Defense spending rose as the nation competed in the nuclear arms race with the Soviet Union and waged a war in Vietnam. At the same time, spending on social welfare programs increased in response to widespread riots in the inner cities. The US trade deficit ballooned when Japan emerged as a significant threat to many American industries, especially the auto industry. There were growing concerns about “de-industrialization.” Productivity growth collapsed during the decade.

Inflation trended higher despite a couple of severe recessions. That led to a widely held view that inflation had become a structural problem, raising the question of whether recessions could ever bring it down again. The oil shocks of 1973 and 1979 were transmitted to the wages of union workers by automatic COLAs in many of their contracts. As labor and fuel costs soared, companies raised prices. It was a classic wage–price spiral—which economists called “cost-push inflation”—caused by an exogenous inflation shock (Fig. 4).

In addition to a wage-price spiral during the 1970s, there was a rent-wage spiral. The CPI tenant rent inflation rate rose from 4.0% y/y at the beginning of the decade to peak at a record 11.0% during August 1981 (Fig. 5). That put lots of upward pressure on wage inflation (Fig. 6).

(2) Commodities. At the start of the 1970s, commodity prices soared when President Richard Nixon allowed the dollar to depreciate significantly (Fig. 7). Oil is priced in dollars, so OPEC cartel members, to offset the effects on their profits of the dollar’s depreciation, succeeded in raising the price of oil by lowering their output. Both energy and food prices soared during the early 1970s and near the end of the decade, when oil prices jumped again, raising the cost of producing food (Fig. 8).

This time, the dollar remains relatively strong. Commodity prices remain weak. The price of oil has rebounded in recent weeks. However, global economic activity and demand for commodities remain lackluster as both China and Europe grapple with rapidly aging demographic profiles, depressing consumer spending. In addition, China is struggling with the deflationary consequences of the depression in its property market. In the US, the housing market remains in a recession.

(3) Wages & rent. In the US, union membership has dropped significantly since the 1970s. The available data show that 16.8% of private wage and salary employment was unionized in 1983 (Fig. 9). This percentage dropped to a record low of 6.0% during 2022. So we don’t expect that the headline-grabbing news about recent union settlements will be as likely to boost overall wage inflation as it did in the 1970s.

Also, as noted above, there was a wage-rent spiral that spiraled out of control during the 1970s. We don’t see that happening this time. Average hourly earnings for all workers peaked last year at 5.9% y/y during March. It was down to 4.4% this July. According to Zillow, rent inflation for new leases has dropped from last year’s peak of 16.4% during March to 3.5% this July (Fig. 10). That augurs well for the CPI and PCED rent components in coming months since the Zillow rate leads them by about 10 months. It also augurs well for lower wage inflation.

(4) Labor & productivity. The Baby Boomers first entered the labor force during the 1970s, thus boosting its growth rate (Fig. 11). They were well educated but inexperienced. They contributed to the collapse in productivity growth mentioned above, as did rigid and costly work rules imposed on employers by their contracts with unions (Fig. 12). Meanwhile, hourly compensation soared during the 1970s, and so did unit labor costs (ULC) in the nonfarm business sector (Fig. 13).

This time, ULC peaked last year at 7.0% y/y during Q2, well below the double-digit twin peaks of the 1970s. ULC inflation tends to drive the CPI inflation rate. The former fell to 2.4% during Q2, confirming the drop in the CPI inflation rate to 3.2% y/y during July.

This time, the economy is experiencing structural shortages of labor. That could lead to higher wage inflation, we suppose. However, we are expecting a productivity boom over the remainder of the Roaring 2020s, which will keep a lid on price inflation while boosting real wages and profitability.

(5) Inflation expectations. By the end of the 1970s and the start of the 1980s, expected inflation over the next five years was in the high single digits. That’s according to the same survey that is used to compile the Consumer Sentiment Index (CSI). In early August of this year, expected inflation was 2.9% y/y (Fig. 14). Fed officials have been saying that inflationary expectations are “well contained,” and they’ve been right about that. Since mid-2021, when inflation started to take off, this measure of long-term inflationary expectations has remained close to 3.0%, up slightly from around 2.5% before the pandemic during 2018 and 2019.

Yesterday, the Federal Reserve Bank of New York released its monthly survey of one-year-ahead and three-year-ahead expected inflation rates. The former was down to 3.6% from a peak of 6.8% last year during June (Fig. 15). That’s the lowest reading since April 2021. The latter was up 2.9%, confirming the low number in the CSI survey.

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Disinversion

August 14 (Monday)

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

 Yield Curve I: Two Alternative Disinversion Scenarios. Over the years, I’ve frequently been asked why I am not more concerned about the widening US federal government budget deficit and the resulting mountain of mounting federal debt. I’ve consistently responded that I will care about this issue when the financial markets care about it. That time has come because the bond market seems to be concerned.

In the past, I’ve observed that the supply of and the demand for bonds isn’t usually as important to the determination of the bond yield as are actual and expected inflation and the expectations of how the Fed will respond to them. So given that Debbie and I expect inflation to continue to moderate, we currently predict that the bond yield won’t rise above 4.25%. It closed at 4.16% on Friday. If we are wrong about that, however, and the bond market has trouble financing the government’s huge deficit at current market interest rates, then the Bond Vigilantes could go wild. We don’t think that means that the 10-year jumps to 5.00%-5.50%, but it could rise to 4.50%-4.75%.

In the past, bond yields tended to fall when the federal budget deficit widened because it did so during recessions as the government’s revenues decreased. Private credit demands decline during recessions. The Fed lowers short-term interest rates during recessions as inflation moderates, which causes investors to buy bonds.

This time, the budget deficit widened as the government sought to avert a pandemic-related depression by providing lots of fiscal spending, including three rounds of pandemic relief checks during 2020 and 2021. The combination of ultra-easy monetary and fiscal policies amounted to the dropping of trillions of dollars of “helicopter money” on the economy. The result was a surge in inflation during the second half of 2021 through the summer of 2022, when it peaked.

The inflation surge forced the Fed to raise the federal funds rate significantly, from zero at the start of 2022 to 5.25%-5.50% currently (Fig. 1). However, fiscal policy doubled down, with Congress enacting several spending initiatives promoted by the Biden administration in 2021. That’s mainly why the US economy hasn’t fallen into a recession: Tight monetary policy was offset by very stimulative fiscal policy.

The 10-year US Treasury bond yield has been rising along with the federal funds rate and the 2-year Treasury yield since 2022 but at a slower pace than them. As a result, the yield-curve spread between the 10-year and 2-year Treasuries inverted last summer (Fig. 2 and Fig. 3).

That inversion was widely interpreted to be a reliable signal that a recession was coming. The only reason that investors would buy a 10-year bond at a yield below the 2-year note is that they see a good chance that increasingly restrictive monetary policy will break something in the financial system, setting off a broad credit crunch and a recession. Then the Fed would be forced to reverse course.

Sure enough, a banking crisis occurred in March, and on August 7 Moody’s downgraded the credit ratings of several regional banks. However, there has been no credit crunch so far because the Fed responded quickly in March with an emergency liquidity facility for the banks. So far, the most widely anticipated recession of all times remains a no-show.

Bond investors therefore are concluding that, while the Fed might be done raising the federal funds rate, it won’t be lowering that rate anytime soon. With short-term money market rates likely to stay elevated for longer than was expected earlier this year (when a recession was widely anticipated), there’s less of a rush to buy bonds. Meanwhile, fears that a deluge of Treasury securities might push yields higher can be self-fulfilling as investors plow into money market instruments.

In the past, the yield curve disinverted during recessions, when the Fed lowered the federal funds rate faster than bond yields fell. This time, the risk is that with no recession in sight, the yield curve will disinvert as the bond yield rises toward the elevated level of money market rates.

That shouldn’t happen if inflation continues to moderate, raising expectations that the Fed might start to lower interest rates next year. Indeed, in an August 2 NYT interview, Federal Reserve Bank of NY President John Williams suggested that’s a very plausible scenario:

“Assuming inflation continues to come down … next year, as many forecast, including the [FOMC members’] economic projections, if we don’t cut interest rates at some point next year then real interest rates will go up, and up, and up. And that won’t be consistent with our goals. So … from my perspective, to keep maintaining a restrictive stance may very well involve cutting the federal funds rate next year or [the] year after; but really, it’s about how are we affecting real interest rates—not nominal rates.”

That’s the scenario we are rooting for, of course. The alternative is that while we are waiting for the happy one to occur, the mounting federal budget deficit spooks the bond market, causing bond yields to spike higher. In the first scenario, the yield curve disinverts as short-term interest rates fall faster than long-term ones. In the second scenario, bond yields rise to narrow their gap with short-term rates.

Yield Curve II: Supply & Demand vs Inflation. If we didn’t all have skin in the game, the tug of war in the bond market between the bulls and the bears would be very entertaining. The consequences of who wins obviously matter greatly, not only to bond investors but also to stock investors.

Favoring the bears in both markets is the rapidly widening federal deficit and evidence that demand may not match the supply of Treasury securities unless their yields continue to rise. Favoring the bulls, in our opinion, is that since last summer inflation has been on a moderating trend that should persist through 2025 without any further increases in the federal funds rate. The Williams scenario should kick in next year if inflation continues to head toward the Fed’s 2.0% y/y target by 2025.

Now let’s review the latest relevant bearish and bullish data:

(1) Lots of supply. On August 1, Fitch Ratings downgraded US government debt from AAA to AA+ for all the reasons that have been concerning investors for years. None of this is news. However, the Fitch downgrade reminds us all that fiscal policy continues to get more and more profligate and that the supply of US Treasuries could weigh more and more on the bond market.

The US federal deficit and the resulting mounting US debt are growing as percentages of nominal GDP. On a 12-month-sum basis, the former just jumped from $1.0 trillion last July to $2.3 trillion through July, as outlays have been rising while revenues have been falling over the past several months (Fig. 4 and Fig. 5).

The net interest paid by the government has continued to rise rapidly along with interest rates since early last year. This outlay rose to a record $627.5 billion over the 12 months through July (Fig. 6). Just before the pandemic, it was $377.5 billion.

Total federal government debt subject to the debt limit rose to a record $32.5 trillion during July, up 6.5% y/y (Fig. 7). The publicly held debt excluding the Fed’s holdings was $20.6 trillion. The government held $9.8 trillion of its own debt in trust funds and including the Fed’s holdings of $5.7 trillion.

(2) Dwindling demand. The Fed’s QT program will continue to reduce the Fed’s holdings of Treasuries by about $60 billion per month (Fig. 8). Commercial banks in the US have also been reducing their holdings of government securities (including Treasuries and agencies) since early 2022 (Fig. 9).

On a 12-month sum basis, buying of US Treasury notes and bonds by private foreign investors peaked at a record $1.0 trillion last October (Fig. 10). It was down to $787.8 billion through May.

(3) Moderating inflation. The CPI inflation rate remained on a moderating trend during July. The CPI rent component continues to be the stickiest one, but it too is moderating. Excluding shelter, the headline and core CPI inflation rates were just 2.0% y/y and 2.5% y/y in July (Fig. 11).

Also in July, the PPI final demand inflation rate was only 0.8% y/y, with goods down 2.5% and services up 2.5% (Fig. 12). The report showed goods prices outside food and energy were unchanged last month, indicating that the recent goods disinflation was becoming entrenched. On the other hand, the cost of wholesale services jumped 0.5% m/m, the largest increase since last August, after dipping 0.1% in June. The PPI report noted that a huge 7.6% m/m surge in portfolio management fees accounted for 40% of the rise in services. Portfolio management fees had dropped 0.4% in June. Last month's surge was likely due to the strong performance of financial markets as investors bet that the Fed was probably done hiking rates.

Contributing to the moderation in the core CPI and PPI final demand goods inflation measures are falling prices on Chinese imports (Fig. 13). The US doesn’t need to fall into a recession to bring inflation down if China falls into a deflationary recession instead.

(4) The TIPS yield. It wouldn’t take much to see the 10-year Treasury yield trading at 4.50%-4.75%. The 10-year TIPS yield was 1.80% on Friday (Fig. 14). If economic activity remains as strong as it has been lately and the supply of Treasuries weighs on the bond market, this yield could easily rise to 2.00%-2.25%. It was there during 2006 and 2007. The spread between the nominal and TIPS yields on the 10-year Treasury closed at 2.36% on Friday (Fig. 15). If it rises to 2.50%, the nominal yield will range between 4.50% and 4.75%.

(5) Hot & cold economic indicators. The 13-week change in the 10-year Treasury bond yield closely tracks the Citigroup Economic Surprise Index (CESI) (Fig. 16). The CESI rose from zero on May 24 to 73.7 on Friday. Over the past 13 weeks, the yield is up 63bps. The Atlanta Fed’s GDPNow tracking model is currently showing real GDP rising 4.1% (saar) during Q3, confirming that the economy remains hot.

(6) Weak individual tax receipts. The recent widening of the federal deficit is partly attributable to a significant drop in federal individual tax receipts so far this year (Fig. 17). Meanwhile, payroll tax receipts rose to a record high of $1.6 trillion over the 12 months through July. Corporate tax receipts totaled $430.7 billion, near their recent record high. But individual income tax receipts (over the past 12 months) fell from a record high of $2.7 trillion last April to $2.2 trillion through this July.

Our hunch is that last year’s individual income tax revenues were boosted by capital gains tax revenues, as individual investors bailed out of their stocks during the 2022 bear market. So this year’s decline reflects a more normal pace of income tax receipts. Unfortunately, without such one-time windfalls, the underlying trend in the federal deficit is a bearish one for bonds.

(7) Bidenomics, MMT, and the Bond Vigilantes. The current administration is attempting to take credit for any good economic news while blaming the previous one for the bad news. Of course, that’s the modus operandi of all occupants of the White House.

What is unique about the current administration is that it has embraced Modern Monetary Theory (MMT), which claims that fears of widening federal deficits are based on several myths: that the federal government should budget like a household; that deficits will harm the next generation, crowd out private investment, and undermine long-term growth; and that entitlements are propelling us toward a grave fiscal crisis.

While the MMT proponents certainly have converted the Biden administration to their religion, the Bond Vigilantes remain heretics. The Biden administration may need to recall that in 1994, James Carville, a political adviser to President Clinton, famously remarked that if there were such a thing as reincarnation, he would like to be reincarnated as the bond market. By this, he meant that he would like to wield the bond market’s immense power to discipline and rein in errant economic policymakers by driving up interest rates. In other words, don’t incite the Bond Vigilantes!

Movie. “The Man Who Saved the Game” (+ + +) (link) is a warm-hearted movie about Roger Sharpe, the man who saved the pinball machine from decades of prohibition in many states around the country, including New York. It was widely deemed to be a gambling game controlled by the mob. Sharpe successfully convinced the powers-that-be in New York that pinball is a game of skill and provides lots of entertainment. What’s heart-warming about the movie is Roger’s relationship with his girlfriend, Ellen, and her son, who help him along the way. It’s nostalgia time for those of us who were pinball wizards! Don’t forget to listen to “Pinball Wizard” by the Who after you see the movie.

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Semis, Ag & FinTech

August 10 (Thursday)

Technology: Semis on the Rise. Investors have decided that the semiconductor industry’s cycle has bottomed, and things are looking up. The S&P 500 Semiconductor industry’s stock price index has risen an astounding 79.1% ytd through Tuesday’s close (Fig. 1). It’s sitting 4.6% below its August 1 record high and 6.6% above its previous high in November 2021. The Semiconductor Industry Association’s most recent sales data confirm the notion that a turn has arrived, as did commentary from Skyworks Solutions executives during the company’s June-quarter (its fiscal Q3) earnings conference call. I asked Jackie to take a look at what each had to say:

(1) Industry data improves. Global semiconductor sales are still down sharply compared to last year, but they’ve been improving on a sequential-quarter basis, giving investors hope that the cycle’s bottom is behind us. Q2 global semi sales fell 17.3% y/y in June according to an August 4 Semiconductor Industry Association (SIA) press release. The Q2 y/y sales declines were broad based, in all the major regions except Europe: Europe (7.6%), Japan (-3.5), Americas (-17.9), Asia Pacific (-20.4), and China (-24.4).

However, on a q/q basis, global semi sales increased 4.7% in Q2 compared to Q1 sales. June marked the fourth consecutive month that the industry’s revenue has increased m/m (Fig. 2). The m/m sales gains, based on a three-month moving average, also were broad based geographically, with June sales rising over May levels by 4.2% in the Americas, 3.2% in China, 0.9% in Japan, and 0.1% in Europe. The only region in which m/m sales fell in June was Asia Pacific/All Other, -0.5% m/m.

The upward turn in semiconductor sales is confirming the jump in the S&P 500 Semiconductors industry’s forward earnings estimates, which have been climbing since mid-February (Fig. 3). Likewise, the industrial production of semiconductor and other electronic components has risen for the last five months, by 9.3%, after dropping 7.0% from a recent high during February 2022 through this January (Fig. 4).

(2) Skyworks sees blue skies. Skyworks executives’ optimism about the future countered the y/y and q/q sales declines that the company reported last quarter: Revenue of $1.1 billion was down 13.1% y/y and down 7.1% q/q. The inventory correction continues at Android original equipment manufacturers and at Skyworks itself, noted CEO Liam Griffin in the company’s quarterly conference call. The company aims to reduce its inventory to $1.0 billion or slightly below that, down from $1.2 billion last quarter—a process that will take a couple more quarters.

Nonetheless, Griffin expects double-digit sequential-quarter revenue and earnings growth in the current quarter. Specifically, the company expects its fiscal Q4 (ending September) revenue to increase 13% sequentially (using the midpoint of the company’s expected revenue range) and its fiscal Q4 earnings to increase 21% sequentially to $2.10 per share—still far below the year-earlier $3.02 a share. In a display of confidence, Skyworks recently boosted its quarterly dividend 10% to $0.68 a share.

Next quarter’s results should be bolstered by Apple’s expected introduction of a new phone this fall. Longer term, several trends should support the company’s sales. Griffin believes that artificial intelligence (AI) will spark “exponential growth in the amount of data accessed from the network edge to the cloud. In turn this will further drive complexity in wireless infrastructure network, as AI will require higher throughput, more secure connections, lower latency, and improved power management.” Consumers’ switch to electric vehicles, the expansion of the Internet of Things, and the emergence of augmented and virtual reality also should boost demand for the company’s products.

 

(3) Semi stats. Analysts are expecting earnings for the S&P 500 Semiconductor industry to fall 15.3% this year but rebound sharply in 2024, by 32.3% (Fig. 5). The net earnings revisions data that Joe tracks for the industry have yet to turn positive but have been improving. The industry’s forward P/E has jumped to 27.7 as of August 3 from 13.7 on June 20, 2022, as share prices have soared in anticipation of an earnings recovery (Fig. 6). Enthusiasm about AI and its impact on chip demand likewise have boosted some chip makers’ valuations. We wouldn’t be surprised if the industry’s stock price index moved sideways for a while after its recent ascent, allowing the industry’s P/E to decline as earnings improve.

Consumer Staples: Life’s Tough on the Farm. Tyson Foods posted disappointing results for its third fiscal quarter ended June. Revenue was down 3% y/y, and adjusted operating income fell 82% y/y to $179 million. The company faced headwinds in each of its poultry and meat categories—chicken, beef, and pork—for varying reasons:

(1) Where’s the beef? Revenue from beef sales was flat last quarter y/y, but adjusted operating profit in the segment dropped to $79 million from $506 million a year earlier because the price of cattle has risen sharply. The number of US cows being raised for their beef has fallen to the lowest level since at least 1971, when records began, and the futures price for live cattle has risen 30% over the past year and 47% over the past two years (Fig. 7).

Normally, we’d expect ranchers to respond to high cow prices by increasing the number of cows they raise. This time, that may be trickier, as herd size is being affected by changes in weather patterns and herd counts may remain lower for longer. “Ranchers have increasingly sent cows to slaughter as dry weather reduced the amount of pasture available for grazing,” a July 21 Reuters article reported. Tyson doesn’t expect relief anytime soon.

(2) Dropping pork & chicken prices. The pork market has suffered from excess supply and falling demand from consumers at home and in China. In Tyson’s pork division, that has translated into a decline in both volume and average price, leading to an adjusted operating loss of $70 million last quarter compared to an adjusted operating profit of $25 million a year earlier.

Revenue in the chicken segment declined last quarter due to lower prices for processed chicken. Higher feed costs further darkened the picture, boosting expenses and leading to an adjusted operating loss of $63 million compared to the $269 million of profits the segment enjoyed in the same quarter last year. Tyson may get some relief on feed prices, as recent rains have resulted in a bumper corn crop in the US, sending the price of corn down 28% ytd (Fig. 8).

While tough times are expected to continue in the current quarter, Tyson executives noted the company’s improvement on a q/q basis. Tyson reported a loss of four cents a share in its fiscal Q2 (ended March) compared to the 15 cents a share it earned last quarter. Tyson has closed some of its chicken processing plants and increased the automation in remaining plants to improve utilization and profitability. The processors’ shares have fallen 11.6% ytd through Tuesday’s close compared to the S&P 500’s 17.2% gain. Since they peaked in February 2022, Tyson shares have fallen by 41.0%, dramatically underperforming the S&P 500’s 2.5% gain.

(3) Industry data. Tyson is a member of the S&P 500 Packaged Foods & Meats stock price index, which is near an all-time high (Fig. 9). The industry is dominated by food companies including Hershey, Kellogg, and J.M. Smucker. After raising prices and enjoying strong revenue growth in recent years—6.0% in 2021 and 8.4% in 2022—the industry’s top-line growth is forecast to slow to 4.8% this year and 2.7% in 2024 (Fig. 10). Profits have grown more slowly than revenue—4.7% in 2021 and 4.0% in 2022—and they’re expected to decline 6.3% this year and rebound 9.6% in 2024 (Fig. 11). The industry’s forward P/E has risen from a low of 13.9 in 2018 to 18.3, not far from its recent peak of 20.0 on May 11.

Disruptive Technology: Fintech’s Drumbeat Grows Louder. Fintech companies have started to grow up. They might not be large enough to keep JP Morgan Chase CEO Jamie Dimon awake at night—yet. But they’re offering competitive interest rates on a fast-growing pile of deposits, which make them a competitive threat to smaller banks and perhaps even to regional players.

Apple announced earlier this month that its online savings account had accumulated more than $10 billion in deposits in less than four months!

To put that in perspective, if Apple were a bank, its deposit base would be the 141st largest in the US. That’s according to a January 23 blog post listing financial institutions by deposit size as of year-end 2022, courtesy of MX Technologies, a tech company catering to the financial industry. Again, that’s not likely to worry JP Morgan or Bank of America, ranked number one and two on MX’s list with roughly $2.0 trillion of deposits each. But deposit sizes drop pretty quickly as the institutions on the list get smaller: Ranked 10th was TD Bank ($329.7 billion of deposits at year-end), 20th was the now-defunct Silicon Valley Bank ($161.5 billion), and 30th was Discover Bank ($94.9 billion). At the rate Apple has been growing deposits, it won’t take long before it’s among these top 30.

Let’s take a look at what Apple and other players in the dynamic fintech space—Walmart, SoFi, Bread, and Chime—have been up to:

(1) Apple taking a bite. Apple has a way of making things easy. Its Wallet app comes already installed on the iPhone. It started small, asking customers to load information from other credit cards onto the app. Then in 2019, Apple started offering its own credit card, the Apple Card, which is provided by Goldman Sachs. Apple initially had the cash back from credit card purchases loaded onto the Apple Cash Card, which was issued by Green Dot Bank. (Green Dot boasts FDIC insurance and $3.7 billion of deposits.)

Now consumers have another option. They can deposit the cash earned on credit card purchases into an Apple savings account, which is also provided by the FDIC-insured Goldman Sachs Bank, a division of The Goldman Sachs Group. The savings account has no annual fees, no minimum balances, and pays a 4.15% interest rate. Consumers can opt to deposit additional funds into the account from other banks.

The Goldman Sachs Group had $148.3 billion of consumer deposits as of June 30 that came from Apple and Marcus, its retail banking arm. The MX blog ranking includes deposits from other arms of Goldman, which when taken together totaled $352.0 billion at year-end and placed the firm in 9th place. Despite the fast deposit growth, Goldman has indicated that it wants out of retail banking and is in talks to sell the Apple credit card and high-yield savings account business to American Express, according to a June 30 CNBC article. While the division grew its revenue over the past two years, it failed to turn a profit.

(2) Walmart jumps in too. Walmart offers One, a debit card and savings account provided by Coastal Community Bank. The bank is part of Coastal Financial Corporation, which had $3.2 billion of deposits as of June 30. About half of the deposits comes from its online banking services arm, and the other half comes from a traditional brick-and-mortar community bank.

Walmart also offers credit cards through Capital One and the Walmart MoneyCard, another debit card provided by Green Dot. Walmart has sued in an attempt to break its contract with Capital One. The company has said it’s doing so because Capital One has failed to deliver on its customer care responsibilities. But there’s speculation that the retailer would much prefer to issue its own credit cards under the One brand.

(3) Online-only banks in the mix. Bread Financial offers its banking services online, including a high-yield savings account boasting a 5% interest rate. The firm also provides private-label credit cards to more than 50 million individuals on behalf of retailers, like BJs and Wayfair. The company owns Comenity Capital Bank, which has $9.2 billion in deposits, placing it 148th on the MX list of deposits.

SoFi also offers its financial services online, sometimes on its own and sometimes through partnerships with other financial institutions. SoFi Bank, which is FDIC insured, had $12.7 billion of deposits at the end of Q2, 98% of which were insured. That’s up from $7.3 billion at year-end, when the firm ranked 176 on the MX list. Today, its online savings account offers a 4.5% annual yield.

Other financial services SoFi offers include cyber insurance through Blink by Chubb, auto insurance from Gabi, life insurance from Ladder, and homeowners’ and renters’ insurance by Lemonade. Personal, student, and auto loans as well as credit cards and small business loans are provided by the Bank of Missouri.

Chime’s checking and savings accounts are offered through The Bancorp Bank or Stride Bank, both FDIC members. Bancorp Bank had $7.1 billion of deposits at year-end, putting it in 182nd place on the MX list.

For more on fintech’s charge into banking, consider reading earlier Morning Briefings dated May 18, 2023, May 19, 2022, and March 11, 2021.

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Mostly About Consumers

August 09 (Wednesday)

Strategy: Moody’s Darkens the Mood for Financials. Joe and I have been predicting that the second half of this year will be more challenging than the first half. The S&P 500 rose 19.5% from the end of last year through the bull market’s high of 4588.96 on July 31. So our year-end S&P 500 target of 4600 occurred five months ahead of schedule. We’ve left it at 4600, figuring that the market might move sideways or sell off through September before commencing a year-end rally back to 4600.

Now we have a good reason for why the second scenario (down, then up) might happen. On Monday, after the markets’ close, Moody’s cut the credit ratings of several small to mid-sized US banks and said that it may downgrade some of the nation’s biggest lenders, warning that the sector’s credit strength likely will be tested by funding risks and weaker profitability.

That supports our cautious market call, but it pulls the rug out from under our recommendation to overweight the S&P 1500 Financials, for now. However, we’re still expecting lots of M&A activity in the sector to provide a boost to the bank stocks. The downgrade should hasten that scenario. But for now, the downgrade is what it is, i.e., bearish for the Financials over the short term.

The downgrade activated the risk-off trade benefitting the US Treasury bond market, which was downgraded on August 1 by Fitch Ratings from AAA to AA+ for all the reasons that have been concerning the bond market for years. None of this is news. However, the Fitch downgrade reminds us all that fiscal policy continues to get more and more profligate. The US Treasury will be selling lots of notes and bonds during August and over the rest of this year, while the Fed’s quantitative tightening program will continue to reduce the Fed’s holdings of Treasuries by about $60 billion per month.

So ironically, Moody’s downgrade of the banks should make it easier for the US Treasury to fund its deficit with its securities (downgraded by Fitch) without a significant increase in interest rates in the Treasury’s auctions for now. This confirms our prediction that the 10-year Treasury yield’s peak of 4.25% last year on October 24 should not be breached this year. It certainly came close on Friday, when the yield jumped to 4.20% before falling closer to 4.00% by day-end.

We still believe that October 12 marked the start of a new bull market in stocks, which should take the S&P 500 up to 5400 by the end of 2024.
 
Note to our friends at the Fed: Congratulations! You’ve been aiming for over a year to raise the federal funds rate to a sufficiently restrictive level to bring inflation down without causing a recession. Mission accomplished! But please don’t jinx it by saying so. You can say that Moody’s downgrade of the banks and your recent Senior Loan Officer Opinion Survey (SLOOS) confirm that credit conditions are tightening quickly so there’s no reason to risk an overkill by raising the federal funds rate again.
 
US Consumers I: Odd Drop in Revolving Credit. Just when many pessimistic prognosticators claimed that consumers were on a credit card fueled buying binge, revolving credit fell $604.5 million during June (Fig. 1). That was the first decline in more than two years. Over the previous 24 months, the average pace of consumers’ credit card borrowing was $11.8 billion per month. June’s decline in credit card debt is odd given that nominal personal consumption expenditures rose 0.5% m/m during June and retail sales increased 0.2% during the month.

In other words, it’s hard to explain the latest drop. Perhaps it was a one-month aberration. Also funky was that nonrevolving credit, which includes mostly auto and student loans, rose $18.5 billion during June following a weak gain of just $967.4 million during May, which might have been another statistical aberration. Total consumer credit rose $17.8 billion during June, which is more in line with the pace of such borrowing over the past two years or so.

In any event, we often hear concerns that consumers have had to borrow because inflation has boosted the prices of the goods and services that they buy on credit. That makes sense. The hard-landers assert that consumers are overindebted to such an extent that when their excess savings accumulated during the pandemic runs out—likely before year-end—they’ll have to retrench because they will be maxed out on their credit cards.

Of course, this grim outlook assumes that the prospects for personal income and employment also are likely to deteriorate, though that seems to be an assumption rather than a well reasoned analysis. The assertion is that when the unemployment rate is historically low, as it is now, the next big move is always to the upside, especially when the Fed is tightening monetary policy to achieve that very aim, as it is now.

Now consider the following related observations:

(1) Revolving credit rose to a record high of $1.3 trillion during May (Fig. 2). It exceeds the pre-pandemic peak of $1.1 trillion during 2020 by $161.7 billion.

(2) Revolving credit currently equals only 6.3% of nominal disposable personal income and 6.9% of total consumer spending excluding autos and owners’ equivalent rent (Fig. 3 and Fig. 4).

(3) At the end of Q2 (i.e., during June), student loans totaled a near-record $1.8 trillion and auto loans totaled a record $1.5 trillion (Fig. 5).

(4) The Fed also compiles monthly data on consumer-related loans at all commercial banks on a weekly basis. They rose to a record high of $1.89 trillion during the week of June 14 and edged down $7.2 billion through the July 26 week (Fig. 6). Credit card loans rose to a record high of $1.0 trillion at the end of July. The banks’ auto loans peaked last year and declined modestly to $508 billion during the July 26 week.

(5) The banks certainly have raised the interest rates they charge on consumer loans. On all credit cards, the rate rose from 14.60% in 2021 to 20.68% in May. The rate on 60-month new car loans is up from 4.82% in 2021 to 7.81% in May. These rates are clearly meant to encourage users to pay off their balances every month.

(6) The Fed’s Q3 SLOOS showed that the bankers’ willingness to make consumer loans dropped sharply during the past five quarters. This series tends to lead the yearly percent change in consumer loans by four quarters (Fig. 7).

(7) Our bottom line is that when it comes to the key drivers of consumer spending, consumer credit matters but not as much as personal income does. Perhaps once Americans return from their summer vacations in Europe, they’ll see how much damage they did on their credit cards and retrench. More likely, they will keep shopping as long as their purchasing power increases along with employment and real wages.

US Consumers II: Rent. The rent components of the CPI and PCED account for much of the stickiness in the inflation rates for both. However, as we noted last week, rent inflation for new leases has declined sharply in recent months, and that should increasingly be reflected in the two price measures that measure rent on all outstanding leases.

Just for fun, Debbie and I played with the rent numbers to assess their importance to consumers and to the inflation rate:

(1) We calculated personal consumption expenditures (PCE) on tenant rent divided by the total number of households that rent (Fig. 8). It rose to a record annualized $15,032 per renter household during Q2. It is up 8.3% y/y (Fig. 9). This series loosely tracks the CPI primary rent inflation rate.

(2) We can do a similar analysis for owners’ equivalent rent. It rose to a record annualized $24,245 per homeowning household during Q2 (Fig. 10). It also loosely tracks the CPI owners’ equivalent rent, both on a y/y basis (Fig. 11).

(3) Tenant rent and owners’ equivalent rent currently account for 3.6% and 11.4% of personal consumption expenditures as well as the headline PCED (Fig. 12). Tenant and owners’ equivalent rent account for 7.6% and 25.5% of the headline CPI.

(4) The good news is that rent inflation, which is a major component of the PCED services inflation rate (22.5% currently), is likely to head lower at a faster pace in coming months. Rent inflation in the PCED, including both rent of primary residence and owners’ equivalent rent, edged down to 8.0% in June from a recent high of 8.4% in April (Fig. 13). It lags measures of rent on new leases such as the Zillow Index and the ApartmentList Index, which were down to 4.1% in June and -0.7% in July, respectively.
 
US Consumers III: Lots of Singles & Fewer Renters. While we are on the subject of the American consumer, here are a few interesting demographic updates:

(1) Among the US population 16 years and older, the number of singles rose to a record high of 137.4 million in July (Fig. 14). Singles now account for 51.5% of the civilian noninstitutional working age population, up from 38% in 1977 (Fig. 15). Singles who’ve never married made up a record 33.1% of the US population in July, while those who are divorced, separated, or widowed represented 18.4% (Fig. 16).
 
With a third of the adult population representing never-married singles, our hunch is that this group must be having some important consequences for the US economy. Never-married singles might have a higher propensity to spend and a lower propensity to save. They are likely to dine out and travel more than married couples and families. They certainly are more mobile, for both work and pleasure, since most aren’t tied to the schedules of children.

(2) The number of US households rose to a record high of 130.2 million in June, a 27% increase since 2000 (Fig. 17). The number of homeowner-occupied households totaled a record 85.3 million during Q2, while the number of renting households was flat at 44.1 million (Fig. 18).

Since the pandemic, there has been a relatively strong demand for homeownership, which has kept home prices high despite soaring mortgage rates (Fig. 19). The demand for rentals has dwindled so far this year, which must be putting downward pressure on rent inflation.

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Worry List Update

August 08 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Strategy I: Don’t Worry, Be Happy. The hard-landing scenario has had a hard landing. Fewer economists are worrying about an imminent recession. Stock investors are also less concerned about a downturn that could send corporate earnings lower. The S&P 500 rose 28.3% from its bear market bottom on October 12, when it closed at 3577.03, to its bull market high on July 31 of 4588.96 (Fig. 1).

The rebound in the S&P 500 has been led by its forward P/E, which rose from 15.1 on October 12 last year to 19.6 on July 31 (Fig. 2). So it rose 29.8% over this period, while the S&P 500 rose 28.3%, indicating that investors are discounting an improvement in earnings in coming months.

Industry analysts have also turned more optimistic, as evidenced by S&P 500 forward earnings, which recently bottomed during the February 9 week and rose 4.0% through the August 3 week (Fig. 3). S&P 500 forward revenues has continued to rise to record highs, while the forward profit margin has stopped falling in recent months. (FYI: Forward earnings and revenues are the time-weighted average of industry analysts’ forecasts for the current year and following one, the forward P/E is the multiple based on forward earnings, and the forward profit margin is the margin calculated from forward revenues and earnings.)

Stock market sentiment has turned very bullish since the start of the current bull market. Investor’s Intelligence Bull/Bear Ratio was down to 0.57 during the October 11 week (Fig. 4). It rose to 3.07 during the August 1 week. The percentage of bulls rose from 25.0% to 57.1% over this period, while the percentage of bears fell from 44.1% to 18.6%.

The 10-year Treasury bond yield peaked last year at 4.25% on October 24, fell to a 2023 low of 3.30% on April 5, and rose back to just a bit over 4.00% last week (Fig. 5). The 2-year Treasury bond yield fell to this year’s low (so far) of 3.75% on May 4, mostly on fears that the March banking crisis would turn into an economy-wide credit crunch and recession (Fig. 6). Since that low, the 2-year yield jumped to 4.78% on Friday.

Of course, the depleted contingent of hard-landers can still take some comfort from the inverted yield curve. The yield spread between the 10-year and 2-year Treasury notes widened to a low of -100bps on June 30 (Fig. 7). It narrowed to -67bps on Monday. But it was still significantly negative, supporting the opinion of some prognosticators that a recession is still coming, since inverted yield curves have always predicted recessions. We don’t share that view currently.

Strategy II: Worry, But Be Happy Anyway. So now that investors, analysts, and investment strategists are mostly bullish, Debbie, Joe, Melissa, and I are on the alert for what could go wrong. We’ve been updating our worry list over the past couple of weeks. Here is our latest update:

(1) Commercial real estate crisis. According to the latest US National Office Report from CommercialEdge, the national vacancy rate for office buildings was 17.1% as of July 2023, up from 15.3% a year ago. This means that out of the total US office stock of 6.8 billion square feet, about 1.2 billion square feet of office space was vacant.

Some owners of vacant office buildings are demolishing them and building structures that should be easier to lease. For example, owners of a two-building campus in Santa Ana, California are taking the unusual step of tearing down their recently renovated property and converting the eight-acre site into a logistics hub.

“Picklemall” may be the solution for some vacant mall space. A pickleball facility has replaced the former At Home store in Tempe, Arizona. It’s a 104,000-square-foot business that’s now home to more than a dozen pickleball courts.

Nevertheless, many owners of commercial real estate may have no choice but to default on their mortgages, and their bankers will have to sell the properties at distressed prices.

The Fed’s Q3 Senior Loan Officer Opinion Survey (SLOOS) found that 67.8% of lenders continued to tighten lending standards for commercial real estate (CRE) loans (Fig. 8). The net percentage of lenders reporting stronger demand was -53.3% (Fig. 9).

CRE loans at all commercial banks have been flat at a record high just below $3.0 trillion since the March 15 week, the same time as the banking crisis hit (Fig. 10).
 
(2) Renewed wage-price spiral. The economic recovery from the Covid-19 pandemic unleashed a wage-price spiral in the labor market. As the economy reopened, workers pushed for higher wages and better benefits, forcing companies to raise their prices. Many workers achieved wage increases by quitting their jobs for better paying ones. They could do so because the demand for labor has exceeded the supply since May 2021 (Fig. 11). That’s still the case, though wage and price inflation both have moderated.

Meanwhile, unionized workers haven’t been doing as well as nonunionized ones. The Employment Cost Index for the former rose 3.6% y/y through Q2 and for the latter 4.5% y/y (Fig. 12). As a result, labor unions have grown more assertive. And they’ve grown more powerful, as they’ve succeeded in organizing new workers and winning strikes in recent years. The labor unrest is being felt across a wide range of industries, including transportation, healthcare, and retail.

The United Auto Workers union is starting negotiations with the auto industry by demanding a 20% immediate wage increase and an additional 5% during each year of the contract. The autoworkers’ wages at the Big Three currently range from roughly $18-$32 an hour, depending on seniority, according to the union. Starting wages are about $10-per-hour lower than what they would be had they kept up with inflation since 2007, the UAW said.

Unionized workers are a relatively small percentage of the labor force. But their contracts can have an influence on wages in the nonunionized sector.

(3) Consumers retrench. Of course, it’s still possible that when consumers’ excess savings run out later this year, they will reduce their spending. A more important determinant of consumer spending is disposable personal income, which depends on aggregate weekly hours worked. Friday’s employment report showed that the latter rose just 1.3% y/y during July, the slowest pace since March 2021 (Fig. 13). This slowdown is partly offset by the fact that average hourly earnings adjusted for inflation has been rising in recent months.

(4) Federal deficit spiral. The US federal deficits and the resulting mounting US debt are growing as percentages of nominal GDP. On a 12-month-sum basis, the former just jumped from $1.0 trillion last July to $2.3 trillion through this June, as outlays have been soaring while revenues have fallen (Fig. 14 and Fig. 15). The net interest paid by the government has continued to rise rapidly along with interest rates since early last year. This outlay rose to a record $615.8 billion over the 12 months through June (Fig. 16). Just before the pandemic, it was $383.7 billion.

On August 1, Fitch Ratings downgraded US government debt from AAA to AA+ for all the reasons that have been concerning the bond market for years. None of this is news. However, the Fitch downgrade reminds us all that fiscal policy continues to get more and more profligate. The US Treasury will be selling lots of notes and bonds during August and over the rest of this year, while the Fed's QT program will continue to reduce the Fed's holdings of Treasuries by about $60 billion per month (Fig. 17).

(5) Bond Vigilantes rampage. The Bond Vigilantes may be turning more vigilant following the Fitch downgrade. They are happiest when the economy is weak and inflation is subdued. They are not so happy right now.

We are still expecting that the 10-year Treasury yield won’t rise above the October 24 high of 4.25%. But it wouldn’t take much for that to happen, which would set off lots of alarm bells about the yield potentially rising to 5.00%-5.50%. In that scenario, the valuation multiple of both the S&P 500 and Nasdaq would likely take significant hits.

Over the years, we’ve frequently been asked why we aren’t more concerned about the widening US federal government budget deficit. We’ve consistently responded that we will be concerned about it when the financial markets are concerned about it.

We believe that supply and demand for bonds isn’t usually as important to the determination of the bond yield as are actual and expected inflation and the expectations of how the Fed will respond to them. So given that we expect inflation to continue to moderate, we currently predict that the bond yield won’t rise above 4.25%. If we are wrong about that, and the bond market has trouble financing the government’s huge deficits at current market interest rates, then the Bond Vigilantes will go wild. If that happens, head for the hills for the rest of the summer and maybe September too.

(6) Fed goes Volcker. If inflation doesn’t continue to moderate and appears increasingly sticky well above the Fed’s 2.0% target, Fed Chair Jerome Powell and his colleagues may conclude that they have no choice but to “Volckerize” interest rates, i.e., raise them until they vaporize economic growth, as former Fed Chair Paul Volcker did in the late 1970s.
 
(7) Bottom line. The half dozen worries listed above will likely keep us busy over the rest of this year. For now, our economic outlook remains 85% odds of a no-landing or soft-landing scenario and 15% odds of a hard landing; that should remain the case unless one or several of the worries become more worrisome.

We think the S&P 500 should churn below 4600 over the rest of the year, offering opportunities to invest in those companies, industries, and sectors that have been performance laggards over the first half of this year while taking some profits in the leaders—which may face challenges to their lofty valuations from the Bond Vigilantes.

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Guess What?

August 07 (Monday)

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

US Economy I: What a Coincidence! Now that everyone agrees that a recession isn’t imminent, July’s Index of Coincident Economic Indicators (CEI) could be flat or even down slightly. That’s after showing no change in June (Fig. 1).

The CEI’s component indicators—payroll employment, real personal income less transfer payments, real manufacturing and trade sales, and industrial production—are included among the data used to determine recessions in the US. The CEI on a y/y basis tracks the y/y growth rate of real GDP very closely (Fig. 2). For the past two months, industrial production has contributed negatively to the coincident index, offsetting gains from the employment, sales, and income components (Fig. 3). Consider the following:

(1) Employment. Friday’s employment report showed that payroll employment edged up just 0.1% m/m to a new record high during July. However, it also showed that the other three components of the CEI likely fell slightly last month. By the way, Debbie and I have looked at the various components of payroll employment by industry and found that truck transportation and temporary help services are good leading economic indicators (Fig. 4). Truck transportation employment looks toppy, while temporary help services is weakening.

(2) Real personal income. Our Earned Income Proxy (EIP) for private-sector wages and salaries in personal income rose 0.2% m/m during July. While private payroll employment rose 0.1%, the average workweek fell 0.3%. So aggregate weekly hours worked declined 0.2% m/m, though it is still up 1.3% y/y (Fig. 5 and Fig. 6). Our EIP, which multiplies aggregate weekly hours by average hourly earnings, edged up just 0.2% during July (Fig. 7). This suggests that personal income could have declined modestly on an inflation-adjusted basis during July.

(3) Real business sales. Retail sales currently accounts for 33% of nominal manufacturing and distributors sales. On an inflation-adjusted basis, it too might have been weaker last month based on our real EIP (Fig. 8). We know that payroll employment in retail trade was basically flat last month. However, unit auto sales rose 0.6% during July (Fig. 9). Furthermore, payroll employment in wholesale trade rose to a new record high in July. On the other hand, given the weakness in industrial production during May and June, manufacturing shipments were probably down last month.

(4) Industrial production. The employment report obviously provides lots of clues about the CEI components. It does so for the industrial production component too, via the employment report’s series for aggregate weekly hours in manufacturing (Fig. 10). The latter was flat on both m/m and y/y bases during July.

US Economy II: Surprises, Bonds & Ackman. Now that almost everyone in the investment community is optimistic, at least about the near-term economic outlook, the economic surprises could be on the downside for a while. Don’t get us wrong: We are still assigning 85% subjective odds to a no-recession scenario through the end of next year and 15% odds of a downturn. We are still targeting the S&P 500 at 4600 by the end of this year (so there isn’t much upside now, in our opinion) and 5400 by the end of next year (so it’s still a bull market).

However, our contrarian instincts are on high alert because the most widely anticipated recession of all times is no longer widely anticipated. Consider the following:

(1) My friend David Rosenberg of Rosenberg Research, who continues to expect a recession soon and remains bearish on stocks, wrote last week that his COO told him: “[T]he ‘hate mail’ I have received on social media these past few weeks has been ‘off the charts.’ Use that information any way you want—but it is a contrarian indicator.”

(2) Billionaire Bill Ackman, CEO of Pershing Square, recently posted a very bearish tweet on the X social media platform. He wrote that he has placed a bearish bet “in size” on the 30-year Treasury bond yield rising to 5.50%, using options to limit his downside risk. He stated: “There are few macro investments that still offer reasonably probable asymmetric payoffs, and this is one of them.” He views it as a hedge. He focuses on the same bearish supply and demand factors as we have recently. Where we differ is in our outlook for inflation. He thinks it isn’t likely to fall below 3.0% in the long run. So the 30-year yield should be “3% + 0.5% (the real rate) + 2% (term premium).”

We haven’t changed our opinion that the 10-year Treasury bond yield peaked at 4.25% on October 24, 2022. That’s because we think that inflation could fall back down to 2.0% by 2025. This is the Fed’s objective, and we think the Fed’s game plan of keeping the federal funds rate at the currently restrictive level for longer will do the job, as will other disinflationary forces.

(3) So we are rooting for a decline in the Citigroup Economic Surprise Index (CESI) since that would help to stabilize the bond market. The 10-year US Treasury bond yield (on a 13-week change basis) closely tracks the CESI (Fig. 11). Friday’s payroll employment report was weaker than expected and might have set the stage for a batch of weaker economic indicators ahead, as discussed above.

(4) There may not be much upside for the S&P 500 and the Nasdaq through the end of this year since investors will be torn between fretting about the potential for much higher bond yields (Ackman’s scenario) or a recession after all (Rosenberg’s outlook).

US Inflation: Unit Labor Costs Still Moderating. Debbie and I believe that inflation will continue to moderate and might very well reach the Fed’s goal of 2.0% by 2025. Fed officials consistently have said that’s their game plan. None of them have said that they expect to get there this year or even next year. The FOMC’s latest Summary of Economic Projections issued on June 14 showed that the committee’s median forecast of the core PCED inflation rate was 3.9% this year, 2.6% next year, and 2.2% in 2025. This rate was 4.1% in June.

Yet when Friday’s employment report showed that average hourly earnings (AHE) for all workers rose 4.4% in July, the same as in June, that pace was deemed by several commentators to be inconsistent with the Fed’s 2.0% target for the PCED. That’s true, but the target is for 2025, not for this year. Wages growing at 3.0% would be more consistent with 2.0% price inflation, assuming that productivity growth is around 1.0%. That’s a realistic scenario by 2025, in our opinion.

Now let’s have a closer look at the latest batch of labor compensation indicators to assess whether they are moving in the right direction, i.e., downwards:

(1) Average hourly earnings (AHE). AHE for all workers rose 0.4% m/m in July for the third time in four months, following three consecutive months of 0.3% gains. Nevertheless, the trend is still down for this measure of wage inflation on a y/y basis. It peaked at 5.9% last March, falling to 4.4% in July (Fig. 12).

AHE for production and nonsupervisory workers covers about 80% of payroll employment. This set of workers includes all the lower-wage workers, who have been getting bigger pay increases than higher-wage workers. This measure of wage inflation peaked at 7.0% last March and was down to 4.8% during July. During July, all workers were paid $33.74 per hour on average, while higher-wage workers received $54.80 and lower-wage workers received $28.96. While AHE for all workers rose 4.4% y/y, the averages for the higher and lower paid workers rose 3.3% and 4.8% respectively (Fig. 13).

Here are July’s y/y increases in AHE for all workers versus their recent highs: leisure & hospitality (5.6 from 14.0), education & health services (2.9 from 7.3), information (3.8 from 7.7), retail trade (4.0 from 6.7), professional & business (4.6 from 7.1), natural resources (4.8 from 7.1), and transportation & warehousing (4.9 from 7.0). Wage inflation rates for financial activities, utilities, and construction are moving sideways, the latter around recent highs, while rates for manufacturing and wholesale trade have moved higher recently, though the latter looks toppy (Fig. 14).

(2) Employment cost index (ECI). During Q2, wages and salaries in the ECI rose 4.6%, about the same as the 4.4% increase in the AHE for all workers and 4.8% for lower-wage workers (Fig. 15). The overall ECI including wages, salaries, and benefits rose 4.5% during Q2 (Fig. 16).

The recent increase in labor unrest among union workers reflects the fact that their overall ECI rose 3.6% y/y through Q2, below the 4.5% increase in the compensation paid to nonunion workers. The former’s pay gains have been lagging the pay of nonunion workers since mid-2021 (Fig. 17).

(3) Hourly compensation (HC). HC is the most inclusive measure of hourly compensation and the most volatile (Fig. 18 and Fig. 19). It is also the measure used by the Bureau of Labor Statistics to calculate unit labor costs (ULC). On Thursday, we learned that HC rose 3.7% y/y during Q2 while productivity increased 1.3%, so that ULC rose 2.4%, down from last year’s peak of 7.0% during Q2-2022.

The headline CPI and ULC inflation rate, both on a y/y basis, are highly correlated (Fig. 20). Both have plunged from high to low single digits over the past year.

(4) Wage Growth Tracker (WGT). The Atlanta Fed’s WGT (using the three-month smoothed series) tends to be less volatile than the AHE measure. That’s because the latter doesn’t adjust for swings in employment between lower-wage and higher-wage industries, which had a huge impact on AHE during the pandemic when the former lost lots more jobs than the latter. That gave a big boost to AHE in 2020 that was reversed in 2021 (Fig. 21).

The WGT rose 5.6% y/y during June, which is the highest reading of the four wage inflation measures. On a three-month smoothed basis, it shows that wage inflation since the start of the pandemic was boosted by job switchers who quit their jobs for better pay elsewhere (Fig. 22). The good news is that the WGT for job switchers fell from a peak of 8.5% last July to 6.1% this June.

That’s because the quit rate for private industry peaked last year at 3.3% during April and fell to 2.7% during June. It tends to be a very good six-month leading indicator of wage inflation (Fig. 23 and Fig. 24).

Movie. “The Beanie Bubble” (+ + +) (link) is a very colorful and entertaining flick about yet another bubble, the 1990s Beanie Babies craze. So it is another toy story movie similar in some ways to the recently released “Barbie.” Both appeal to the audience’s nostalgia for the toys they played with growing up. But it is also another cautionary tale about speculative excess and corporate hubris. The Ty company that sold the toys created “artificial scarcity” for them by regularly discontinuing certain babies and even producing a few with defects. The company was also among the first to have a website and to use social media to boost sales. Interestingly, eBay owes its early success to Beanie Babies auctions, as collectors flocked to acquire the limited editions, with some going for thousands of dollars. Sales were so big that eBay was required by the SEC to list the babies as a “risk factor” when they went public in 1998. The Beanie bubble burst in 1999.

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Oil, Cat & Flying Cars

August 03 (Thursday)

Energy: Oil Deficits. The price of crude oil has risen in recent months as investors have grown more confident that the US economy will dodge a recession. The Brent crude futures price is up to $84.91 a barrel from its recent low of $72.26 on June 27 (Fig. 1). The past year’s crude oil surpluses—which have kept the world’s fuel prices in check—will become deficits this quarter and continuing through next year if estimates by the US Energy Information Administration (EIA) are on target.
 
Here are the EIA’s quarterly production and consumption forecasts for the global oil market in 2023 and 2024: Q1-2023 (101.04 mbd production, 100.06 mbd consumption), Q2-2023 (101.13, 100.96), Q3-2023 (100.77, 101.75), Q4-2023 (101.45, 101.83), Q1-2024 (101.90, 102.32), Q2-2024 (102.08, 102.38), Q3-2024 (102.95, 103.29), and Q4-2024 (103.34, 103.22).

The EIA’s oil production and consumption estimates no doubt reflect the more-resilient-than-expected US economy, the weaker-than-expected Chinese economy, and OPEC’s disciplined adherence to production cuts. Let’s take a closer look at these dynamics:

(1) The recession that never arrived. The US economy grew 2.4% in Q2, defying naysayers’ dour projections (Fig. 2). All that economic activity boosted oil demand more than expected, which depleted oil inventories at a record-breaking pace last week. US oil inventories fell by 17 million barrels in the week ending July 28, according to EIA data cited in an August 2 Reuters article. It was the largest weekly drop in US crude inventories ever recorded (record taking began in 1982).

Recent market conditions have prompted the Biden administration to pull its offer to buy 6 million barrels of oil as it attempts to refill the Strategic Petroleum Reserve. The administration released 180 million barrels from the reserve last year after the price of oil spiked in reaction to Russia’s invasion of Ukraine (Fig. 3). Only 6.3 million barrels has been replaced, but the administration has said it will buy oil for the reserve when it costs between $67 and $72 a barrel.

Meanwhile, oil demand in China continues to grow even though its economic growth isn’t as strong as expected. Instead of booming after Covid restrictions were lifted, Chinese economic growth has disappointed, burdened by high youth unemployment and real estate companies’ excessive leverage. Chinese GDP grew 6.3% y/y in Q2, faster than Q1’s rate of 4.5% y/y but below the consensus forecast of 7.3% y/y growth.

While China’s economic growth has been slower than expected, its consumption of oil and other liquids is still expected to grow to 16.13mbd in Q2-2023, up from 15.94mbd in Q1-2023 and 15.10mbd in Q2-2022, the EIA forecasts.

(2) OPEC gets religion. OPEC’s Joint Ministerial Monitoring Committee is scheduled to meet today. The organization’s crude production fell by 0.9mbd in July to an average of 27.8mbd, according to a Bloomberg survey cited in an August 1 Oilprice.com article. The production reduction includes Saudi Arabia’s voluntary cut of 1mbd. The country reportedly wants to see the price of crude oil at $90 a barrel or more before starting to unwind its oil production cut.

Production also fell in Nigeria, by 130,000bpd, because Shell suspended loadings of crude due to a potential leak at the export terminal. Libya’s production fell by 50,000bpd due to a protest at a field.

(3) Signs of life. Energy stocks had a tough start to 2023 as the price of oil tumbled. But since oil prices hit a low for the year in early June, the sector and its industries have enjoyed a strong rebound. Here’s the performance derby for the S&P 500 and its 11 sectors from June 1 through Tuesday’s close: Industrials (14.7%), Materials (14.0), Energy (13.7), Consumer Discretionary (13.4), Financials (11.5), S&P 500 (9.5), Information Technology (9.4), Communication Services (9.2), Real Estate (5.9), Health Care (4.5), Consumer Staples (4.4), and Utilities (2.6) (Table 1).

The rebound among a handful of industries in the S&P 500 Energy sector over the same period is even more impressive: Oil & Gas Equipment & Services (34.3%), Oil & Gas Refining & Marketing (24.0), Oil & Gas Exploration & Production (18.5), and Oil & Gas Storage & Transportation (15.8). The S&P 500 Oil and Gas Refining and Marketing industry’s stock price index is near a record high even though analysts are calling for the industry’s earnings to fall by 26.9% this year and 29.4% in 2024 from record levels (Fig. 4).

The S&P 500 Oil & Gas Equipment & Services stock price index is near its highest level since the Covid pandemic descended and sent oil prices tumbling in late 2019 and into 2020. Analysts expect the industry will post strong earnings growth of 43.2% this year and 21.5% next year (Fig. 5). Meanwhile, earnings for the S&P 500 Oil & Gas Exploration & Production industry are forecast to drop sharply this year, by 34.8%, and then grow 20.7% in 2024 (Fig. 6). All three industries have forward P/Es below that of the S&P 500: Oil & Gas Refining & Marketing (8.2), Oil & Gas Exploration & Production (11.2), and Oil & Gas Equipment & Services (15.8).

Industrials: Lessons From the Cat. Caterpillar’s Q2 earnings illustrate the power of three important trends: the demand for more new homes, the demand for more minerals, and the push to bring manufacturing back to the US. Each requires the yellow earth-moving equipment that Caterpillar manufactures.

The company reported Q2 sales that jumped 22% to $17.3 billion and operating income that surged 88% to $3.7 billion, far exceeding analysts’ expectations. The company’s shares jumped 8.9% on Tuesday in response, to $288.68, bringing their ytd gain through Tuesday’s close to 20.5%. Earnings growth is expected to continue next year, but much more slowly. Analysts expect the company, which earned $12.64 a share in 2022, to grow earnings per share by 52.6% this year to $19.29 and 4.6% next year to $20.18.

Caterpillar’s growth in both revenues and earnings was amazingly broad based, bolstering each of its segments: construction industries (19% revenues, 82% operating profits), resource industries (20, 108), and energy & transportation (27, 93). Let’s take a look at what Caterpillar management said drove its success last quarter:

(1) Thank Uncle Sam. Revenue in Caterpillar’s construction industries segment was helped by the strong markets for new homes and new factories in the US. The segment’s North American sales jumped 32%, eclipsing the 20% jump in Europe, Africa & the Middle East, the flat results in Asia, and the 11% decline in Latin America.

In the company’s Q2 earnings conference call, CEO James Umpleby credited strong demand for equipment in the residential construction market and in the non-residential construction market, which continues “to benefit from government-related infrastructure and construction projects.” Those projects are also boosting demand for heavy equipment used in quarries and to mine aggregates. The impact of these infrastructure projects should “last for some time,” as some projects wait for permits to come through before they can even break ground.

(2) Thank EVs. The demand for materials used in batteries, like cobalt and lithium, has sent geologists scouring the Earth to find new sources for the minerals. Benchmark Mineral Intelligence studied how many new mines would be needed to ensure adequate materials for the batteries to be used over the next decade. “The group’s study found that at least 359 new mines and similar facilities could be needed to meet the demand expected for these materials by 2035, though that number could easily rise to 384. This would include 74 mines for lithium, 62 mines for cobalt, 72 mines for nickel, 97 mines for natural graphite and 54 plants for producing synthetic graphite. If manufacturers are able to make better use of recycled materials, the number shrinks slightly—but only to 336 [mines],” according to a September 19, 2022 article in the Robb Report.

Caterpillar’s Umpleby sees demand for EV-related minerals driving growth for Cat equipment: “We continue to believe the energy transition will support increased commodit[ies] demand, expanding our total addressable market and providing further opportunities for profitable growth.”

(3) Energy and turbines help too. Caterpillar is less well known for the products and services it supplies to the oil and gas industry and the gas-powered turbines used by a variety of industries, including data centers; but this segment also had a great Q2, with total sales jumping 27% y/y and operating profit increasing 93% y/y.

(4) Comps get tougher. While revenue is expected to grow, CFO Andrew Bonfield did point out that y/y comparisons during H2-2023 will be tougher because the company started raising prices in Q3-2022 and continued to do so in the ensuing quarters. For example, last quarter sales volume boosted revenue by $1.8 billion in the company’s three equipment operating segments, and price increases boosted revenue by almost as much: $1.4 billion.

Management expects price increases to slow during H2-2023 and the operating margin improvements of the past year to halt as well. That said, the company is sitting on a healthy order backlog of $30.7 billion, up $300 million q/q.

(5) Supply chain still healing. While Caterpillar’s supply chain has improved, Umpleby noted that there are still “challenges.” “We’re still dealing with supply chain constraints around large engines, which impact both E&T and machines. And we also have some issues with things like semiconductors for displays that are impacting other machines as well,” said Umpleby. As a result, the company keeps more inventory on hand than it might otherwise. When the supply chain returns to normal, Caterpillar should be able to reduce its inventory and free up additional cash.

Disruptive Technologies: Still Working on Flying Cars. When we wrote about flying cars in a 2018 Morning Briefing, inventors were excited about a future filled with vehicles that could allow us to bypass traffic jams like George or Jane Jetson. Five years later, and the topic of flying cars still leaves inventors breathless, but their inventions have yet to hit the market. Some projects have crashed, and others have faded away. But entrepreneurs are still plugging away at making the flying car a reality within the next few years.

Let’s take a look at some of these initiatives:

(1) Some throw in the towel. Kittyhawk, backed by Google co-founder Larry Page and Boeing, wound down its attempts to build air taxis last fall. Likewise, Uber had grand plans to test its flying taxi by 2020 and start commercial flights this year, plans that never materialized.

Under pressure to cut costs, Uber sold the division in 2020 to Joby Aviation, which is working to get a flying vehicle approved. Joby is developing an eVTOL, an electric vertical take-off and landing vehicle, which is closer to a helicopter alternative than a flying car. In June, Joby received a Federal Aviation Administration (FAA) Special Airworthiness Certificate, which allows testing of its prototype. By March 2024, the company aims to deliver two of the aircraft to the US Air Force, and it hopes to begin commercial operation in 2025. Joby, which counts Toyota as an investor, plans to operate the vehicles itself and offer customers ridesharing services.

Another company we mentioned in 2018, Opener, has forged ahead on developing its single-seat BlackFly eVTOL. The vehicle, which doesn’t have wheels, is undergoing testing by qualified owners before the company opens sales to the general public. And Archer Aviation announced last week a contract with the US Air Force worth up to $142 million that includes supplying up to six of its Midnight eVTOL air taxi planes once they’re certified, a July 31 article in DroneDJ reported.

(2) Closer to a flying car. Alef Aeronautics has developed a vehicle that looks more like a flying car than a helicopter. The company’s two-seat Model A drives on roads and can take off and land vertically. The electric vehicle can drive for 200 miles—but only at a maximum speed of 25 miles per hour—and fly for 110 miles, a July 5 Electrive article reported.

The Model A has also received a FAA Special Airworthiness Certificate, but it still needs approval from the National Highway Traffic Safety Administration to be tested on public roads. The company has received 2,500 preorders for its $300,000 two-seat model, which it plans to deliver in late 2025, a July 29 Newsweek article reported. The company is also working on a four-person vehicle and hopes that drivers won’t be required to have a pilot’s license to operate the vehicle.

(3) One more flying car. The Asaka A5 looks less like a car than Alef’s model, but it too has wheels that allow the vehicle to drive on a road and park in a standard parking spot. However, when the operator wants to fly, wings unfold and allow the vehicle to take off and land either vertically like a helicopter or horizontally on a runway like a traditional airplane. The A5 is a gas/electric hybrid that can fly for 250 miles at 150 miles per hour or drive at up to 70 miles per hour, a July 30 Freethink article reported.

The A5’s faster speed and longer range comes with a higher price tag: $789,000. Asaka also plans to rent the A5 to pilots in 2026. The Department of Motor Vehicles is allowing the vehicle to drive on public roads, and the FAA gave the company’s prototype a Special Airworthiness Certification.

(4) Lots of competition. Hopeful market entrants include companies based abroad as well. In Germany, Lilium and Volocopter are developing vehicles. In the UK, Vertical Aerospace received a $25 million investment from American Airlines Group last year. Eve Air Mobility was created by Brazil’s Embraer and plans to produce a four-seat eVTOL in Brazil. United Airlines announced plans for a San Francisco commuter service using Eve Air’s planes and has invested $15 million in the company.

China’s battery manufacturer CATL entered a joint venture with government-owned aircraft manufacturer Commercial Aircraft Corp. of China and the Shanghai Jiao Tong University Enterprise Development Group to develop a battery powered aircraft. It’s not an eVTOL but rather a fixed-wing electric aircraft. And in France, AutoFlight and Airport operator Groupe ADP announced plans to fly passengers around Paris during next year’s Summer Olympics.

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Global Smorgasbord

August 02 (Wednesday)

Global Economy: Fizzling. Tourists sightseeing in Europe in recent weeks have had to do so in sweltering heat. On the other hand, the European economy has been not so hot. Also lackluster has been China’s economy. Meanwhile, the US economy continues to surprise on the upside. It all adds up to a global economy that is growing but at a subdued pace. Let’s start with a quick tour of China and Europe before coming back stateside:
 
(1) China’s PMIs weakening. China’s official M-PMI rose slightly to 49.3 last month, remaining below the 50.0 mark that separates expansion from contraction for the fourth month in a row (Fig. 1). The NM-PMI, which measures activity in the services and construction sectors, eased to 51.5 (Fig. 2). A subindex focused on services also declined to 51.5, from June’s 52.8.

New manufacturing export orders continued to decline, with the subindex inching down to 46.3 from 46.4 in the previous month. A manufacturing employment subindex remained in contraction for a fifth straight month. A subindex measuring nonmanufacturing employment edged down to 46.6 from 46.8 in the previous month.

Government officials have promised to implement measures to stimulate consumption. On Friday, the government announced a slew of initiatives to help industries in home goods, food, plastic products, leather, and other industries.

(2) Europe’s ESIs & PMIs falling. The European Union’s economic sentiment index (ESI) fell further below 100.0, to 93.6, in July (Fig. 3). It has been below 100.0 since July 2022. So has the Eurozone’s ESI, which declined to 94.5 in July. Leading the weakness in the Eurozone’s ESI has been its industrial component, while the consumer component has been rebounding since late last year because a milder-than-expected winter and plenty of natural gas calmed concerns about freezing in the dark.

Germany has been leading the downturn in the Eurozone’s ESI for the industrial sector (Fig. 4). The same can be said for the Eurozone’s M-PMI, which was down to 42.7 in July, with Germany’s index down to 38.8 (Fig. 5). The Eurozone’s NM-PMI has also been falling in recent months but remained above 50.0 in July, at 51.1, with France’s measure falling to 47.4 (Fig. 6).

(3) Euro-based CESI is down and out. Confirming the weakness of the Eurozone economy is the euro-based Citigroup Economic Surprise Index. It has been hovering below 100.0 since February 7 and is well below the neutral reading of 0.0 (Fig. 7). It’s showing the lowest readings since early 2020 when the pandemic started.

(4) Our Global Growth Barometer upticks. Meanwhile, our Global Growth Barometer (GGB) has rebounded slightly in recent days, as both the Brent price of oil and the CRB raw industrials spot price index have moved higher (Fig. 8 and Fig. 9). However, the increase in the price of oil may have more to do with less supply than with more demand. On July 31, Reuters reported: “OPEC oil output has fallen in July after Saudi Arabia made an additional voluntary cut as part of the OPEC+ producer group’s latest agreement to support the market and an outage curbed Nigerian supply.”
 
US Economy: Sizzling. While the rest of the world is fizzling, the US economy is sizzling. For the past year and a half, we have been in the soft-landing camp. We’ve promoted the “rolling recession” scenario. Now it’s looking increasingly like a no-landing and rolling recovery scenario for the next year and a half. We turned more optimistic on Monday by assigning 85% subjective odds to this scenario and only 15% to a hard landing one. Previously we had been at 75/25.

Let’s review the latest US economic indicators, which indicate that all is well in the US economy:

(1) CESI is hot. The Citigroup Economic Surprise Index (CESI) for the US rose to 76.1 on July 31 from this year’s low of 24.7 on January 18 (Fig. 10). The spread between the US CESI and Eurozone CESI is 192.1 (Fig. 11).

(2) M-PMI bottoming. The M-PMI has been below 50.0 since November (Fig. 12). We think that it has been reflecting the rolling recession that has depressed goods producers and distributors, as consumers pivoted from buying goods to purchasing services since mid-2021. We think that the recession is bottoming, as evidenced by the bottoming of the M-PMI around 45.0 in recent months. It ticked up to 46.4 during July.
 
(3) Construction is booming. Construction spending rose to a record high in June (Fig. 13). Private residential construction actually rose 3.8% during the two months through June, having posted only three gains since it peaked at a record high last May (Fig. 14). Private nonresidential construction was flat in June following a 0.8% decline in May from April’s record high, reflecting a pause in the vertical ascent in construction of manufacturing facilities. Public construction edged up to a new record high, led by record spending on water supply, sewage, and waste disposal. (See our Construction Spending chart book.)
 
(4) Lots of job openings again. The labor market continues to provide lots of job openings. The number of available positions declined to 9.6 million in June according to the JOLTS report. That is the lowest since April 2021, but it remains elevated. Odds are good that it remained so during July according to the “jobs plentiful” series included in the Conference Board’s consumer confidence survey (Fig. 15).

The decline in openings was led by goods-producing sectors such as manufacturing, while several service industries, including health care and arts and entertainment, registered increases. The ratio of openings to unemployed people was little changed at 1.6 in June. Prior to the pandemic, it was about 1.2.
 
(5) SLOOS is not loose. The Fed’s latest Senior Loan Officer Opinion Survey, or SLOOS, was released on Monday. It showed that banks reported having tighter credit standards and seeing weaker loan demand from both businesses and consumers. Banks expect to tighten their lending standards further over the rest of 2023 as well. So far, there’s no evidence in the Fed’s weekly report on commercial banks’ balance sheet suggesting that an economy-wide credit crunch is underway.
 
(6) GDPNoW is WOW! The earliest read on Q3’s GDP was a whopping 3.5% on July 28, according to the Atlanta Fed’s GDPNow tracking model. The estimate was raised to 3.9% on August 1. It’s too soon to place much faith in these numbers. But they are certainly consistent with our more optimistic no-landing outlook for the economy.

US Strategy I: Earnings Looking Up. The current earnings reporting season for the S&P 500 showed an uptick in the Q2 blended number of actual and estimated results during the July 27 week (Fig. 16). More importantly, the Q3 and Q4 estimates stopped falling during the final week of July. Even more significant is that the S&P 500’s forward earnings continued its recovery, which started earlier this year (Fig. 17). Industry analysts are currently estimating that operating earnings per share will be $245.15 next year, up 12.5% from this year’s $217.83 estimate.
 
US Strategy II: Mostly Positive Revisions. Last week, Refinitiv released its July snapshot of the monthly consensus estimate revisions activity over the past month. While Refinitiv provides raw data for all its polled measures, we focus primarily on the revenues and earnings forecasts, as shown in our Stock Market Indicators: Net Revenue & Earnings Revisions By Sectors report. There, the analysts’ revisions activity is indexed by the number of forward earnings estimates up less number of estimates down, expressed as a percentage of the total number of forward earnings estimates. We look at their activity over the past three months because it encompasses an entire quarterly reporting cycle, which is less volatile (and misleading) than a weekly or monthly series.

July’s reading comes at the beginning of the Q2 earnings reporting cycle, when revisions activity typically pauses as analysts wait to see how actual results for the quarter compare with their forecasts before revising their annual estimates. The pause follows a long period of mostly downward revisions through April, when analysts began to realize that instead of a deep recession, there would be a mid-cycle slowdown with negative y/y quarterly growth comparisons due to very strong results and pricing power a year earlier.

Below, Joe highlights notable points after analyzing the July estimate revisions data:

(1) S&P 500 NERI back on positive footing. The S&P 500’s NERI index measures the net revisions activity for earnings forecasts; a zero reading indicates an equal number of raised and lowered estimates over the past three months. NERI improved for a fourth straight month in July and edged even higher into positive territory. It rose to a 14-month high of 1.3% from 0.6% in June. July’s release is up from a 30-month low of -15.6% in December and is well above the average reading of -2.2% seen since March 1985 (when NERI was first calculated).

(2) More than half of sectors now have positive NERI. Seven of the 11 S&P 500 sectors registered positive NERI in July, up from six in June and zero in March and April. Six sectors improved m/m, down from all 11 improving m/m in May. But May was unusual in this regard: There was a flurry of upward earnings revisions as analysts scrambled to raise forecasts following broad-based Q1 earnings strength—in fact, May saw the broadest earnings improvement among the sectors since July-September 2020. June’s improvement continued in July, when six of the 11 sectors reached their highest NERI readings in at least nine months. Among them, Communication Services turned positive for the first time in 21 months. Energy and Financials both remained on lengthy negative NERI streaks, at 13 and 12 months, respectively.

Here’s how NERI ranked for the 11 S&P 500 sectors in July: Industrials (9.3%), Consumer Discretionary (8.6, 21-month high), Information Technology (4.1, 14-month high), Communication Services (3.5, 21-month high), Real Estate (3.3, 12-month high), Health Care (1.8), Consumer Staples (1.7), S&P 500 (1.3, 13-month high), Utilities (-0.7), Financials (-7.0, 12-month high), Materials (-7.5), and Energy (-17.9).

(3) S&P 500 NRRI index for revenues still positive and stabilizing. The NRRI index, which measures the revisions activity in analysts’ revenue forecasts, ticked down for the S&P 500 to 3.5% in July from 3.7% in June but was positive for a sixth straight month. That’s still above the average reading of -0.2% when NRRI data were first compiled in March 2004.

(4) NRRI index positive for seven sectors now. NRRI’s m/m performance was a tad weaker than the NERI index’s by one measure: Just five sectors had NRRI readings improve m/m, versus six with improving NERI. However, seven sectors registered positive NRRI during the month, with three standouts leading the way: Communication Services, Information Technology, and Real Estate all posted their highest NRRI readings in at least nine months. Notably, Tech’s was positive for the first time in 13 months. Of the 11 sectors, only Energy and Materials have still-depressed NRRI readings.

Here’s how the S&P 500 sectors’ NRRI readings ranked in July: Utilities (12.5%), Real Estate (10.2, 9-month high), Industrials (9.9), Health Care (9.7), Consumer Discretionary (8.9), Consumer Staples (7.3), S&P 500 (3.5), Information Technology (2.0, 14-month high), Financials (-1.1), Communication Services (-7.0, 15-month high), Materials (-13.4), and Energy (-21.4).

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Mostly All About Inflation

August 01 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Inflation I: Symmetry & Shockwaves. Inflation tends to be a symmetrical phenomenon. It tends to come down as quickly or as slowly as it went up when measured on a y/y basis. We can see this consistent pattern in the CPI inflation rate for the US since 1921 (Fig. 1). The inflation symmetry has been particularly pronounced in the goods-producing sector (Fig. 2).

That’s because goods prices tend to respond quickly to changes in supply and demand caused by price changes. Rising (falling) prices of goods, especially of commodities, tend to dampen (boost) demand while stimulating (depressing) supply. Prices in the services-providing sector tend to be stickier because labor costs tend to be more important there than among goods-producing industries, which are less dependent on labor thanks to productivity-enhancing innovations. Nevertheless, the CPI inflation rate in services has also been relatively symmetrical since the start of the monthly data in 1957.

The boom-and-bust business cycle plays a role in the symmetry of inflation; inflation typically accelerates during the later stage of booms and moderates during busts. Monetary policy plays an important role in the inflation cycle as central banks fall behind the inflation curve during economic expansions, thus boosting inflation. They then scramble to get ahead of the inflation curve by aggressively tightening monetary policy, which triggers recessions.

That’s a simple and stylized description of the relationship of the inflation cycle to the business and monetary cycles. Ever since Milton Friedman taught us all during the 1970s that inflation is always and everywhere a monetary phenomenon, experience has taught us that lots of other factors besides monetary policy also influence inflation. In fact, Friedman later clarified that he was referring to episodes of persistent inflation. In the short run, he acknowledged that supply shocks can impact price levels.

Indeed, our central thesis since inflation reared its ugly head in 2021 and 2022 has been that the high rates of inflation were triggered by various supply shocks attributable mostly to the pandemic and to the Russian invasion of Ukraine. In the March 16, 2022 Morning Briefing, we wrote: “Debbie and I raised our inflation forecast as a result of the Ukraine crisis. We now expect that the core PCED inflation rate will peak at 6.0%-7.0% around mid-year and fall to 4.0%-5.0% by the end of the year. Then it might decline to 3%-4% in 2023, maybe.”

More recently, in the July 17 Morning Briefing, we wrote: “The CPI inflation rate for goods has turned out to be transitory, peaking last summer and falling to -1.2% y/y, with the CPI durable and nondurable goods down 0.8% and 1.3% respectively during June. Inflation has been one of the shockwaves unleashed by the pandemic that is abating. Excessively stimulative fiscal and monetary policies during the pandemic resulted in a buying binge for goods that overwhelmed global supply chains, as can be seen in the New York Fed’s Global Supply Chain Pressure Index. This index soared from 0.11 during October 2020 to 4.31 during December 2021. It was down to -1.20 during June.” We added that services inflation, particularly rent inflation, would also turn out to be transitory.

Inflation this time around has been attributable to supply shocks that were exacerbated by demand shocks. In our opinion, the inflationary pandemic-related shockwaves should continue to moderate through next year without an economy-wide recession.

Inflation II: Global Perspective. The latest inflation cycle was certainly attributable to a demand shock that occurred when fiscal and monetary authorities provided excessively stimulative policies during 2020 and 2021. They triggered a goods-buying binge that caused durable goods inflation to soar. Russia’s invasion of Ukraine early last year caused nondurable goods inflation to soar, led by energy and food prices.

The demand shock caused a supply shock. Supply-chain disruptions proliferated around the world, as evidenced by the New York Fed’s Global Supply Chain Pressure Index, mentioned above (Fig. 3). Supply chains are working properly again, and the US and Eurozone increasingly are importing goods deflation from abroad. Consider the following:

(1) The US import price index is down 6.1% y/y through June (Fig. 4). Excluding petroleum imports, the index is down 2.0%. The US import price index from newly industrialized economies in Asia (Hong Kong, Singapore, South Korea, and Taiwan) is down 6.2% y/y, while the comparable China index is down 2.3% (Fig. 5).

(2) China’s CPI was flat over the past year through June, while its PPI for industrial products was down 5.4% y/y (Fig. 6). China’s PPI inflation rate tends to be a coincident indicator of PPI goods inflation in the US and the Eurozone, which were down 2.8% and 1.5% in June (Fig. 7 and Fig. 8).

A global perspective shows that China’s lackluster economic recovery from last year’s pandemic lockdowns, which were lifted in early December, is having a deflationary impact on goods markets around the world. This suggests that the US and the Eurozone can experience disinflation in the goods sector without a recession. This still leaves the question of inflating services prices.

(3) The Eurozone’s headline CPI inflation rate fell to 5.3% in July based on the flash estimate, down from a peak of 10.7% in October 2022 (Fig. 9). However, the core rate edged up to 5.5%, not much below its recent peak of 5.7% in March. The CPI for goods was down to 5.5% from a peak of 15.1% in October 2022 (Fig. 10). The CPI service inflation rate rose to a new high of 5.4% for the current inflation cycle (Fig. 11).

Inflation III: Disinflating Prices. In the United States, both June’s CPI and PCED inflation rates continued to confirm their disinflationary trends since last summer for goods. Services inflation has been stickier but should be less so over the rest of this year. Consider the following:

(1) July’s prices-paid and prices-received indexes for the US regional surveys conducted by five of the Federal Reserve district banks flattened in July but are down sharply from last year’s highs and the lowest since late 2020 (Fig. 12). Odds are good that the national M-PMI prices-paid-index (which is correlated with the comparable regional index) remained below 50.0 in July (Fig. 13).

(2) June’s PCED inflation rate for goods was down to -0.6% y/y from last year’s peak of 10.6% in March and June (Fig. 14). The services price component remained sticky, declining to 4.9% from a recent peak of 5.8% in February.

The good news is that rent inflation, which is a major component of the PCED services inflation rate, is likely to head lower at a faster pace in coming months. Rent inflation in the PCED, including both rent of primary residence and owners’ equivalent rent, edged down to 8.0% in June from a recent high of 8.4% in April (Fig. 15). It lags behind measures of rent on new leases such as the Zillow Index and the ApartmentList Index, which were down to 4.1% in June and -0.7% in July, respectively.

Other components of the PCED inflation rate are showing some stickiness, such as personal care (10.2%) and recreation (4.7%). But transportation services inflation has dropped to 3.6% from 16.3% in January of this year (Fig. 16). Remaining low are communication services (-0.5%), health care (2.2%), and education (2.5%).

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The Godot Recession

July 31 (Monday)

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US Economy I: The Honorable Opposition. There was no sign of a recession in Q2’s real GDP. Yet Vladimir and Estragon are still waiting for Godot to show up. The hapless hard-landers have been frustrated so far, but they aren’t giving up. In their opinion, a recession is still coming. Debbie and I have argued since early last year that the recession has already made its entrance on stage, but as a rolling recession relatively unnoticed rather than a dramatic economy-wide recession. Now that rolling recession is changing into a rolling recovery.

Our script has played out as expected so far. The soft-landing scenario looks increasingly like a no-landing one. As a result, we are raising the odds of a no-landing scenario from 75% to 85% and lowering the odds of a hard-landing scenario from 25% to 15% through the end of next year.

Nevertheless, now that we are even more optimistic about the economic outlook, it’s even more important to remain on the lookout for that troublesome and elusive Godot. Last week, we discussed two items on our worry list—namely, the vulnerabilities in the commercial real estate market and the ongoing push by unions for higher wages, which could cause another wage-price spiral and force the Fed to keep tightening.

To make sure that we are covering all the bases, we are closely following the warnings of a few of the leading bears. Here is what they are currently saying:

(1) The strategists at JP Morgan rightly caution that the tightening of monetary policy in the US can have a long and variable depressing impact on the economy. The worst may still be ahead. They predict that once excess savings accumulated during the pandemic are depleted, consumers will be forced to retrench. They also observe that the global geopolitical situation remains “deeply troubling.” They attribute the stock market rally to a handful of stocks that have been driven up by AI-hype. They conclude that “the level and increase of stock concentration in S&P 500 now is at 60-year highs” which is “indicative of a bubble.” (See “Top JP Morgan Strategist Says the Worst May Still Be Coming,” 24/7 Wall St., July 27, 2023.)

(2) The strategists at Morgan Stanley were correctly bearish last year, but recently acknowledged that they missed calling the bottom last October. Nevertheless, their year-end 2023 target for the S&P 500 is still 3900, and their year-end 2024 target is 4200. The S&P 500 closed at 4582.22 on Friday. They are still bearish. Their concern now is that moderating inflation will weigh on the growth rates of both S&P 500 revenues and earnings. They warn, “With price being the main factor that has held sales growth above zero for many companies this year, it would be a material headwind if that pricing power were to roll over.” (See “‘We Were Wrong’: Morgan Stanley’s Wilson Offers Stocks Mea Culpa,” Bloomberg, July 24, 2023.)

(3) Our thought-provoking friend David Rosenberg at Rosenberg Research remains bearish as well. He recently opined: “There is no chance we’re having a soft landing in the context of the most pernicious tightening by the Fed since the Paul Volcker years.” He previously had warned that once consumers spend their excess savings, they’ll have to cut their spending. He frequently has observed that the drop in the Index of Leading Economic Indicators (LEI)—including the inversion of the yield curve—has an excellent track record of forecasting recessions. He also thinks that the stock market is in a “get-rich-quick” speculative bubble, as evidenced by the jump in valuation multiples. (See “The US stock market has become a ‘get-rich-quick’ scheme that’s ignoring oncoming economic pain, top economist David Rosenberg says,” Yahoo! Finance, July 26, 2023.)

(4) GMO. Jeremy Grantham, the co-founder of GMO Investments, has lowered the likelihood he sees of a market crash from an earlier prediction of 85% to 70% now. He also thinks the jury is still out on the severity of the crash and how much it will impact the economy and profit margins. He attributes the current market bubble to the AI craze, which has created a mini-bubble within a larger bubble. (See “Billionaire Investor Jeremy Grantham Says the AI Craze Is Delaying a Looming and ‘Epic’ Market Crash,” The Motley Fool, July 8, 2023.)

US Economy II: Our Rebuttal. We’ve spent the past year and a half debating the hard-landers. Their debate with the soft-landers and no-landers certainly isn’t over:

(1) Leading indicators. While the hard-landers use the LEI’s weakness as support for their argument, we’ve observed that the LEI on a y/y basis is highly correlated with the M-PMI, confirming that it is biased toward the goods-producing sector, which has been in a rolling recession, at the expense of the services-providing sector, which has been very strong (Fig. 1). Nevertheless, the LEI does have a good track record of calling recessions, and it is still doing so. We will rest easier when we see the LEI turning higher, signaling that the goods recession is over. If instead, consumers do retrench their spending on both goods and services when their excess savings dry up, then the LEI and the hard-landers will finally be right.

(2) Inverted yield curve. We’ve also explained that the inverted yield curve doesn’t cause recessions and doesn’t directly predict them, as commonly believed. Rather, it indicates that monetary policy is restrictive and that if it gets more so, then something will break in the financial system, leading to an economy-wide credit crunch and a recession (Fig. 2). This time has been different so far. The inverted yield curve correctly called the banking crisis that occurred for two days, March 9 and 10. But the Fed averted a credit crunch by providing an emergency bank lending facility on March 12. This time, the inverted yield curve may be anticipating that inflation will continue to moderate toward the Fed’s 2.0% target by 2025 without a recession.

(3) Credit conditions. So far, there are signs that credit conditions have tightened; but there’s no outright credit crunch, as the hard-landers think is coming. We continue to monitor the weekly data compiled by the Fed on the US commercial banking industry. The deposits of commercial banks have been falling since mid-2022 but seem to have been stabilizing in recent weeks (Fig. 3). The banks have offset the weakness in their deposits by reducing their holdings of bonds as they mature and using the proceeds to fund their loan portfolios. Their major loan categories remain on uptrends (Fig. 4).

This morning, the Fed will release its Q3 Senior Loan Officer Opinion Survey (SLOOS). It undoubtedly will show that credit conditions have continued to tighten from Q2 levels (Fig. 5). At his press conference this past Wednesday, Fed Chair Jerome Powell revealed that the next SLOOS “gives a picture of pretty tight credit conditions in the economy.” The good news: That reduces the Fed’s need to raise the federal funds rate again. The bad news: It gives the hard-landers another debating point.

(4) Liquidity. The hard-landers have been obsessed with the 3.6% y/y drop in M2 through June (Fig. 6). However, that’s after peaking at a record 26.9% during February 2021. M2 is roughly $1.0 trillion above its pre-pandemic trendline. The sum of all commercial bank deposits and all money market funds remained in record-high territory at $22.8 trillion during the July 19 week, up a whopping $5.8 trillion since the last week of February 2020, just before the pandemic (Fig. 7). Apparently, there is lots of excess liquidity available to keep the economy growing and to drive stock prices higher, notwithstanding the tightening of monetary policy!
 
(5) Capital spending. The hard-landers mostly have failed to recognize the stimulative impact of onshoring as manufacturing returns to the US homeland. Among the strongest components of real GDP recently has been spending on manufacturing structures. It was up 54.4% y/y during Q2 to a record high (Fig. 8). That strength has boosted new orders for construction equipment, which rose 13.5% y/y during May to the second highest reading on record (Fig. 9).

The hard-landers mostly have dismissed AI as hype. That’s probably a subject for another debate. But the facts are that software and research & development spending in real GDP rose during Q2 by 10.0% y/y and 1.0% y/y to fresh record highs (Fig. 10). The pessimists also have overlooked that new orders for nondefense aircraft are booming along with international tourism (Fig. 11).
 
(6) Government spending. Also missing from the hard-landers’ debating points is any acknowledgement of the fact that tighter monetary policy has been offset by looser fiscal policy. Total government spending rose 2.6% (saar) during Q2 to a record high (Fig. 12). The 12-month US federal budget deficit has ballooned from $962 billion 11 months ago to $2.3 trillion through June (Fig. 13).

Some of the widening of the deficit is attributable to the ramping up of infrastructure spending by federal, state, and local governments. Also boosting the deficit have been record-high federal outlays on net interest, exceeding $600 billion during the 12 months through June (Fig. 14). On the flip side, the high cost of interest also is stimulative when it’s paid out to consumers: The personal interest income of consumers rose to a record $1.8 trillion (saar) during June.

US Economy III: A Guide to Consumers. The biggest debatable issue dividing the hard-landers from the soft-landers and no-landers is the outlook for consumer spending. That makes sense since it accounts for just over two-thirds of nominal GDP. It’s hard to have an economy-wide recession if consumers don’t retrench.

The hard-landers think that consumers will do so once their pandemic-related excess savings are depleted. Just before the pandemic, consumers saved around $1.5 trillion on a 12-month-sum basis (Fig. 15). Over the past 12 months through June of this year, they saved at half this pace. But their excess savings likely will be all gone within the next few months, setting the stage for a consumer-led recession. That’s the key argument put forward by the hard-landers’ ace debating team.

Our narrative posits that consumers have lots of other sources of purchasing power that should continue to support their spending. One of our accounts asked us to discuss the major economic indicators we track to assess the outlook for consumer spending. We wrote two chapters on this subject in our 2018 book Predicting the Markets; we could write an entire book just on this subject. Here is a very brief guide, based on the timeline of when the key consumer-related indicators come out and our current assessments of each:

(1) Initial unemployment claims. Jobless claims data are released by the Bureau of Labor Statistics (BLS) on Thursday mornings at 8:30 am. They are highly correlated with the unemployment rate (Fig. 16). They’ve remained near previous record lows so far this year. They indicate that the labor market remained strong through the July 22 week.

(2) Consumer confidence. The Conference Board’s survey of consumer confidence is released near the end of each month and is also one of the earliest indicators of the month’s labor market conditions. Its “jobs-hard-to-get” series is highly correlated with the unemployment rate too (Fig. 17). The July reading of just 9.7% suggests that the unemployment rate remained low near June’s 3.6%. The survey’s “jobs-plentiful” series is highly correlated with the job openings series in the JOLTS report (Fig. 18). This series’ reading of 46.9% for July suggests that job openings (currently available through May) remained elevated through June and July.

(3) JOLTS. As noted above, the JOLTS report compiled by the BLS is a laggard. The report for June will come out tomorrow. Nevertheless, it includes useful data on hires, quits, and layoffs in addition to job openings. The May report shows that the labor market remained tight back then.

(4) Employment. The BIGGIE employment report is released by the BLS at 8:30 a.m. on the first Friday of each month and reflects the prior month’s labor market conditions. So July’s report will be available at the end of this week. It is the first of the four components of the Index of Coincident Economic Indicators (CEI) available for each month and provides clues to their likely readings.

For example, every month, we use the payroll employment data to calculate our Earned Income Proxy (EIP) for private-sector wages and salaries in personal income, which is a CEI component. Our EIP has been rising to new record highs all year and has been outpacing price inflation for the past three months (Fig. 19). It reflects both total hours worked and hourly wages. On an inflation-adjusted basis, the latter has been rising for the past 12 months along its long-term trendline of 1.2% per year (Fig. 20).

(5) Retail sales. Also included in the CEI is a series for the sales of goods by manufacturers & distributors, which includes retail sales. An advance report of the latter is released by the Census Bureau about a week after the BLS employment report for the previous month. Not surprisingly, it is highly correlated with our EIP and wages & salaries in personal income (Fig. 21). However, consumers spend on both goods and services. Since mid-2021, they’ve pivoted toward spending more on services than on goods. So the weakness in retail sales since then confirmed the rolling recession in the goods-producing sector, while the service-providing sector has been strong, averting an economy-wide consumer-led recession.

(6) Personal income. Near the end of each month, the Bureau of Economic Analysis reports personal income, saving, and consumption for the prior month, as well as the personal consumption expenditures deflator. We already have some insights into the data from the employment and retail sales reports. As noted above, personal saving has been relatively low over the past year as consumers have been spending their excess savings. However, inflation-adjusted personal income has been growing along with employment and real hourly wages.

The key driver of consumption is real disposable personal income (DPI), which represents the purchasing power of consumers’ incomes after they’ve paid their taxes and received their government benefits. DPI received a big boost from pandemic relief checks paid by the government during 2020 and early 2021. It then dropped through mid-2022, but consumer spending continued to rise as excess savings were used to support consumption. DPI has been rising again since mid-2022, suggesting that consumers are now supporting their spending with employment and real wage gains.

The personal income release also includes series for unearned income, including dividends, interest, and rent, as well as proprietors’ income and Social Security benefits. They all were at record highs during June.

(7) Net worth. Finally, Debbie, Melissa, and I continue to monitor the Fed’s quarterly data on the net worth of the household sector. It rose to a record high of $148.8 trillion at the end of Q1. Recently, we’ve also analyzed the available data for the net worth of the major age cohorts, particularly the Baby Boomers, who collectively had a record $74.5 trillion in net worth at the end of Q1. As they retire, we expect they will spend some of their retirement assets, depressing the national personal saving rate. When they pass away, their children will inherit what’s left. So the younger generations might also save less. This is all likely to boost consumption.

Movie. “Barbie” (+) (link) is a warm-hearted nostalgia movie for mothers and their daughters. My 22-year-old daughter saw it with her girlfriends and loved it. She wanted to see it a second time and convinced her mom and dad to join her. Barbie was created by Ruth Handler and launched by Mattel in 1959. The doll has become a cultural icon. Barbie has kept up with the times. She started as a teenage fashion model, but over the years had lots of interesting careers from astronaut to surgeon. After Barbie’s debut on store shelves, little girls no longer were limited to playing with baby dolls and imagining being a mother but now could imagine being as successful as Barbie in whatever career they chose. She was aspirational. The History Channel featured Barbie in an excellent docudrama series titled “The Toys That Built America.”

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Industrials, Tech & Identifying Humans

July 27 (Thursday)

Industrials: Onshoring Bumps. Foreign and domestic manufacturers have pounced on the opportunity to receive trillions of dollars in tax breaks and other incentives offered in the Biden administration’s CHIPS and Science Act, the Inflation Reduction Act, and the Infrastructure Investment and Jobs Act. Add that to supply-chain disruptions and geopolitical tensions, and it’s no wonder that manufacturers have been reconsidering their sourcing options. Reshoring, nearshoring, and “friendshoring” (sourcing from countries that are political allies) have been getting a second look.

In a recent survey of 2,000 US and UK CEOs, 43% said they have been or are currently actively looking at onshoring or nearshoring some or all of their supply chains, according to a July 6 Proxima press release. Plants making everything from solar panels to semiconductors are under development or have come online already. The positive economic impacts of more US manufacturing jobs are showing up in the data and should only intensify.

As might be expected, some problems have cropped up. Companies are grousing about the length of time it takes to receive environmental approvals and local permits, and they’re not happy about the cost of US labor. This week, Taiwan Semiconductor Manufacturing reported that the opening of its Arizona semiconductor chip factory will be pushed back a year to 2025 due to difficulty finding skilled workers in the US and the need to bring in workers from Taiwan. And in March, Stanley Black & Decker shut down the automated Craftsman tool plant built in Texas that was plagued by problems with its machinery among other things.

The Wall Street Journal recently relayed the experience of two manufacturers. Jervois Global tried and failed to launch a cobalt mine in Idaho. Bath & Body Works managed to bring its manufacturing and packaging operations and suppliers to Ohio from their previous locations at home and abroad. Their different outcomes are instructive. Let’s take a look at what these two companies encountered, along with data on how the manufacturing boom is boosting the US economy:

(1) A tale of defeat. Jervois halted progress on its mine because the price of cobalt fell from almost $40 a pound in May 2022 to about $15 more recently. The mine’s breakeven price is about $17.50 a pound, and the company will wait until prices rebound to $25 or more before reopening the mine, a July 22 WSJ article reported. The company spent almost twice what it had expected to spend constructing the Idaho facility and obtaining permits; the required red tape—including environmental reviews and dealing with appeals by rival miners—took almost a decade. A fire in the area presented another challenge.

Even though the mine is closed, its maintenance costs about $1 million a month. Despite the mine’s closure, the Pentagon awarded Jervois $15 million last month to keep drilling in Idaho and to study the potential for a US refinery. The funding, which needs regulatory approval, is expected in August, and the company has also applied for an Energy Department loan.

“A senior official at the Pentagon, which under the Defense Production Act could get priority to buy cobalt in an emergency, said such investments are risks worth taking. With the exception of some deposits in Idaho and Missouri, additional U.S. production would have to come as a byproduct of another metal, the U.S. Geological Survey said in a report earlier this year,” the WSJ article noted.

(2) A tale of success. In 2008, Bath & Body Works wanted to get its products to market more quickly, so it decided to move its production from China, Canada, and Virginia to the outskirts of Columbus, Ohio near the company’s existing distribution center. There, the company and its suppliers now make soaps, bottles, labels, and anything else needed with 5,000 employees during peak season, a July 25 WSJ article reported.

Replicating Bath & Body Work’s success may be tough for companies that produce items like semiconductors or smartphones, which rely on very specialized suppliers located in Asia. Bath & Body Works had to guarantee its suppliers business for a set number of years, and suppliers had to fill their factories with automation to remain competitive. “[P]roduction in the U.S. employs around 10 people and required $12 million in capital investment, versus employing around 50 people with under $2 million in investment for similar production capacity in China,” one supplier told the WSJ. But the company reaped the benefit of production times that shrunk to under a month from five months previously.

(3) Quantifying the boom. The move to bring manufacturing back to US shores may be in the early innings, but the impact is already being felt. Jobs in manufacturing are on the rise. New jobs announced in Q1 related to reshoring and foreign direct investment (FDI) in the US rose to 406,214 on an annualized basis, up 11% from 2022, according to a May 18 press release from the Reshoring Initiative. The figure has jumped dramatically since 2019, when only 100,487 jobs were added due to reshoring or FDI.

Labor Department figures tell a similar tale. The number of people working in manufacturing, 13.0 million as of June, has climbed past the prior peak hit in 2019 to a level last seen in November 2008. Likewise, the number of employees in goods producing jobs—including manufacturing, construction, mining, oil and gas extraction, agriculture, forestry, fishing, and hunting—has climbed to 21.6 million, past 2019 levels and back to levels not seen since May 2008 (Fig. 1).

Companies and suppliers building factories have helped to push up construction machinery orders up 13.5% y/y (Fig. 2). Several categories of machinery orders have posted double-digit gains. Here’s a look: turbines, generators, and other power transmission equipment (20.5% y/y), mining, oil field & gas field machinery (14.8), and material handling equipment (12.8) (Fig. 3).

The influence is also apparent in construction spending. While residential construction spending has slumped over the past year, spending on nonresidential construction has soared 20.5% y/y in May, while spending on public construction was up a more modest 12.3% (Fig. 4).

All this activity has benefited the S&P 500 Industrials sector’s price index. Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Information Technology (45.9%), Communication Services (36.7), Consumer Discretionary (33.5), S&P 500 (19.0), Industrials (11.6), Materials (9.9), Real Estate (4.5), Financials (3.2), Consumer Staples (2.0), Health Care (-0.2), Energy (-1.9), and Utilities (-3.0) (Fig. 5).

Some industries in the Industrials and Materials sectors that are closely tied to industrial activity have also risen sharply ytd through Tuesday’s close: Construction Materials (31.0%), Steel (23.5), Electrical Components & Equipment (18.3), Industrial Conglomerates (17.6), Industrial Machinery (17.0), Industrial Gases (13.7), and Construction Machinery & Heavy Trucks (12.8).

Technology: The AI Shakeup. Artificial intelligence (AI) may dramatically change how we search for news and how we use computer software like Word and Excel. The question is: Will it change which search engines and which software programs we use? The answer may have a material impact on the future of Alphabet and Microsoft.

Both companies are spending billions to infuse AI into their cloud services, office software, and search engines. Google undoubtedly wants to expand its share of the office software market and defend its dominance in search, while Microsoft would like to make Bing a search leader instead of an afterthought and defend its dominance of the office software market.

While the two companies’ shares have risen by a similar amount this year, investors seem to be betting that Microsoft will come out ahead. Microsoft shares climbed 46.4% ytd and Alphabet shares 38.4% ytd through Tuesday’s close. However, Microsoft shares sport a much higher valuation, with a forward P/E of 31.3, while Alphabet shares trade at 20.0 times forward earnings estimates. (FYI: “Forward P/E” is the multiple based on forward earnings, or the time-weighted average of analysts’ consensus operating earnings-per-share estimates for the current year and following one.)

Here's a look at some of the highlights of the companies’ earnings from last quarter and some data on the S&P 500 industries in which the stocks reside:

(1) The search jump ball. Alphabet generated $42.6 billion in advertising revenue from “Google Search & other” in Q2, up 4.8% y/y. Even though the company has diversified into different businesses, Google search remains a cornerstone. Google search advertising revenue is 57.1% of the company’s total Q2 revenue, and the company maintains a dominant share of the search market—83.5% as of March (no wonder “google” has become a verb!). That’s far larger than the 8.2% market share of its largest competitor, Bing, according to Statista data.

Therein lies the opportunity for Microsoft, where search and news advertising increased 3% y/y to $86 million last quarter, a pimple on the company’s $56.2 billion in total revenues. Microsoft has demonstrated AI-infused Bing, which serves up answers with citations showing where the information was sourced. The company will have to offer up a demonstrably better search experience before users shake their googling habit.

(2) Spend big or go home. Spending on AI and on boosting cloud capacity rose much more sharply at Microsoft than it did at Alphabet last quarter. Microsoft’s spending on capital expenditures rose 23.0% y/y last quarter to $10.7 billion “to support cloud demand, including investments in AI infrastructure,” explained CFO Amy Hood on the company’s earnings conference call. Hood said spending will accelerate again next quarter.

Alphabet’s capex was $6.9 billion last quarter, largely unchanged y/y and lower than expected because of construction projects delays. Spending should pick up in H2-2023 and in 2024. “The primary driver is to support the opportunities we see in AI across Alphabet, including investments in GPUs and proprietary TPUs, as well as data center capacity,” said CFO Ruth Porat.
 
(3) Cloud growth slowing. Revenue growth from both companies’ cloud operations continues to grow fast, but it’s decelerating. Microsoft’s Azure cloud revenue increased 26% y/y last quarter, down from 40% growth a year earlier. The company doesn’t report Azure’s revenue in dollars. Likewise, Alphabet’s cloud revenue jumped by 28.0% y/y to $8.0 billion, but that was down from 40%-plus growth a year earlier.

(4) Industry stats. Microsoft and Alphabet reside in two different S&P 500 industries and sectors: Microsoft is housed in the S&P 500 Information Technology sector’s Systems Software industry, while Alphabet is in the S&P 500 Communication Services sector’s Interactive Media & Services industry.

The Systems Software stock price index has risen 46.1% ytd through Tuesday’s close, and it has topped its December 2021 high after tumbling sharply in 2022 before rebounding this year (Fig. 6). Revenues and earnings growth slowed a touch this year but have been amazingly resilient over the years. Earnings grew 20.7% in 2020, 33.9% in 2021, and 13.1% in 2022; they’re expected to climb 6.6% this year and 14.3% in 2024 (Fig. 7). Earnings estimate revisions have been net positive in May, June, and July after declining for much of the prior year (Fig. 8). The industry’s only potential drawback is its forward P/E of 31.5, which is up from 20.8 in 2022 and not far from its 34.3 high in 2021 (Fig. 9).

The S&P 500 Interactive Media & Services industry (which includes industry giant Meta) has seen its price index rise 60.7% ytd, but it remains 18.5% off of its September 2021 high (Fig. 10). The industry posted a 22.0% drop in earnings in 2022, hurt by a slowdown in digital advertising, but analysts are expecting a strong rebound with targets of 22.7% earnings growth this year and a 20.3% increase in 2024 (Fig. 11). Net earnings revisions have been positive since March, after being negative for more than a year prior (Fig. 12). Yet the industry’s forward P/E remains in the doldrums at 21.5, still down sharply from its peak of 32.3 in September 2020 (Fig. 13).

Disruptive Technology: Altman’s Worldcoin Starts Trading. AI has created a problem. It is increasingly difficult for consumers of online content to know whether what they’re reading, listening to, or watching is the handiwork of humans or robots. Sam Altman, one of the creators of ChatGPT, has devised a solution.

Altman founded Tools for Humanity, a company that uses an orb—a five-pound shiny, round device—to snap pictures of humans’ irises. Each picture is translated into a code that reflects the uniqueness of each iris. It will be used to identify humans as humans and solve the problem that AI has created, as we discussed in the June 1 Morning Briefing. Humans who get their eyes scanned receive 25 free Worldcoin tokens, a cryptocurrency that can be stored in the company’s payment app, the World App.

This week marked a milestone for Worldcoin. It started trading on markets where cryptos can legally trade. That means it does not trade on US exchanges. But internationally, the price of Worldcoin surged more than 60% to a high of $3.58 on Monday from its initial price of $1.70 that morning. It since has settled down to $2.32 by late Wednesday. So far, 110.6 million of Worldcoins have been issued and $294.3 million of the coins have traded, according to Coinbase.

Worldcoin plans to sharply increase the pace of iris scans by boosting the number of available orbs to 1,500 in 35 cities around the world this summer and fall. Doing so will increase the number of signups it can handle five-fold, up to 200,000 a week. Although Worldcoins don’t trade in the US, iris scanners are available in New York, Los Angeles, San Francisco, and Miami, the company’s blog states.

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Over There & Over Here

July 26 (Wednesday)

Global Economy I: Getting Softer. Here in the United States, the debate between the hard landers and soft landers continues even though the data suggest that the no-landing scenario might more aptly describe the performance of the economy.

On a global basis, there was much talk about a hard landing last summer, especially in Europe and China. But the Europeans enjoyed a warm winter and found plenty of natural gas to avoid freezing in the dark had it been a severe winter. The Chinese government abruptly ended its draconian policy of pandemic lockdowns at the end of last year. It was widely expected that the Chinese economy would experience a post-lockdown boom. Instead, the recovery has been anemic at best. Meanwhile, the US economy continues to grow, albeit slowly.

The flash S&P global PMIs for July suggest that the global economy continues to avoid a hard landing, while falling into a soft landing. Let’s review the data, starting with our Global Growth Barometer (GGB):

(1) Global Growth Barometer. Debbie and I like to monitor our daily GGB to assess whether global economic activity is growing or slowing (Fig. 1). The GGB is the average of the Brent crude oil nearby futures price and the CRB raw industrials index (multiplied by 2 and divided by 10). Our GGB closely tracks the S&P Goldman Sachs commodity index (Fig. 2). However, we prefer our GGB because it does not include agricultural and lumber prices and because we can track the contributions of the CRB index (which does not include energy, food, or lumber commodities) and the price of oil to our GGB (Fig. 3).

Our GGB peaked near the beginning of last year at 130.7 on March 8. It fell to 99.9 by the end of 2022. On Monday, July 24, it was down slightly to 97.2.

By the way, both our GGB and the S&P Goldman Sachs index are inversely correlated with the trade-weighted dollar (Fig. 4 and Fig. 5). The dollar tends to be strong (weak) when the global economy is relatively weak (strong) compared to the US. The dollar has been lackluster and range-bound since the start of the year, even though the US economy has performed relatively well compared to the rest of the world.

(2) US PMIs. The S&P Global M-PMI for the US edged up in July to 49.0 (Fig. 6). It has been mostly below 50.0 since November 2022, as consumers have pivoted from buying goods to buying services. The NM-PMI edged down to 52.4 in July, remaining above 50.0 since February.

(3) Eurozone PMIs. The Eurozone M-PMI has been below 50.0 since July 2022 (Fig. 7). It was 42.7 in July, the lowest since May 2020. The region’s NM-PMI was 51.1 during July, the weakest since January.

Especially weak has been Germany’s M-PMI at only 38.8 during July (Fig. 8). During the month France had the weakest NM-PMI at 47.4 (Fig. 9).

(4) Japan PMIs. During July, Japan’s M-PMI edged down to 49.4 from 49.8 in June (Fig. 10). It has been mostly below 50.0 since November 2022.

(5) MSCI forward revenues. Forward revenues for the US MSCI has been on a gradual uptrend since mid-2022 following a steep uptrend that started in mid-2020 (Fig. 11 and Fig. 12). It rose to a record high during the July 13 week. Over the past year, the forward revenues for the developed world ex-US and for the emerging markets MSCI indexes have been flat. (FYI: Forward revenues is the time-weighted average of industry analysts’ consensus revenues estimates for the current year and following one.)

Global Economy II: CCP to the Rescue? As we’ve previously observed, China’s economy is having more difficulty than expected emerging from the three years of zero-Covid lockdowns that ended late last year. Real GDP fell 1.7% q/q (saar) during Q2-2023. China’s property market is in decline and so is the construction work it generates—responsible for about a quarter of economic growth—as the air continues to come out of its property bubble. Consumer spending remains lackluster, as households are cautious about making big purchases. A rapidly aging demographic profile is also weighing on consumption.

The unemployment rate for 16- to 24-year-olds hit a record-high 21% last month. Indebted local governments are edging toward defaulting on their debts. A record 11.6 million people left college this summer and are finding fewer jobs than usual. Some of the young unemployed are living with their parents and jokingly describe themselves as “full-time children” again.

The Chinese Communist Party (CCP) has long justified its authoritarian rule by promising a brighter economic future. President Xi Jinping pledged to reduce inequality and deliver “common prosperity.” But the economy is sputtering, and the future is looking less bright.

China’s leaders are clearly worried about social unrest. The CCP is scrambling to boost economic growth. The government is shifting course to improve the business environment following three years of heavy-handed measures to regulate and supervise the economy more tightly. In addition, Beijing is formulating measures to boost consumption, particularly of electric vehicles. The government also has promised to “adjust and optimize policies in a timely manner” for its depressed property sector, and to “activate capital markets and boost investor confidence.”

It's obviously too soon to tell whether the barrage of promises to make things better for the economy will work. We are skeptical. So far, the reactions of the nearby futures price of copper and the China MSCI stock price index have been muted (Fig. 13). Both are sensitive indicators of China’s economic activity. We do expect China’s leadership will tone down its belligerent rhetoric about Taiwan while the country’s leaders are playing nice, for a change, to attract foreign investors.

US Labor Market: Still Booming. The earliest monthly indicator of the US jobs market is the consumer confidence survey conducted monthly by the Conference Board. July’s survey came out on Tuesday. The Consumer Confidence Index rose smartly this month, with solid gains in both its current conditions and expectations components (Fig. 14). Furthermore, consider the following:

(1) The survey’s “jobs plentiful” series edged up to 46.9% (Fig. 15). That’s down from readings of over 50.0% last year, but it remains elevated and suggests that the “job openings” series in the JOLTS report remained very high in June and July.

(2) The survey’s “jobs hard to get” series edged down to a near-record low (since 1967) of 9.7% this month (Fig. 16). This series is highly correlated with the unemployment rate and suggests that it remained near recent lows during July. July’s employment report will be released on August 4. It could be another strong one. The next recession remains a no-show for now.

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Workers Of The World: Strike!

July 25 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

US Labor Market I: Unrest. Labor unrest in the United States has been on the rise in recent years. In 2022, there were 424 work stoppages—including 417 strikes and seven lockouts—up 52% from 279 in 2021.

Several factors have contributed to the rise in labor unrest:

(1) Pandemic’s labor market effects. The economic recovery from the Covid-19 pandemic unleashed several shockwaves that impacted the labor market. As the economy reopened, workers pushed for higher wages and better benefits. Many did so by quitting their jobs for better paying ones. They could do so because the demand for labor exceeded the supply since May 2021. The former can be measured as the sum of the household employment (which counts the number of people with jobs) plus job openings, while the latter is simply the labor force (Fig. 1). During May, excess demand for labor totaled 3.7 million workers.

The unemployment rate was 3.6% during June (Fig. 2). The short-term unemployment rate was only 2.9%, while the long-term rate was just 0.7%. The jobless rate for adults was 3.3%, while it was 11.0% for teenagers, which is a relatively low reading (Fig. 3). Here are June’s unemployment rates by education level: college degree (2.0%), some college (3.1%), high school (3.9%), and less than high school (6.0%) (Fig. 4).

On the demand side of the labor market, job openings exceeded 10.0 million from June 2021 through January of this year, and have been hovering around 10.0 million through May (Fig. 5). There were more than 1.5 job openings per unemployed worker from October 2021 through this May.

(2) Pandemic’s inflation effects. The pandemic triggered a surge in inflation that started during 2021, peaked during the summer of 2022, and has moderated since then. At first, it seemed to cause a wage-price spiral. While wages increased rapidly, so did prices. Inflation-adjusted wages stagnated from mid-2020 through early 2022 (Fig. 6). Many workers were frustrated to see that their pay increases were eroded by rapidly rising prices. That seems to be changing in recent months, as wages have been rising faster than prices. But many workers may not be experiencing that improvement in their purchasing power.

(3) Labor unions’ heightened power. Labor unions have grown more powerful as they’ve become more successful in organizing new workers and winning strikes in recent years. The labor unrest is being felt across a wide range of industries, including transportation, healthcare, and retail. Some of the most notable strikes in recent months have included:

• Thousands of hotel workers in Southern California walked off the job on July 3, 2023, demanding higher pay and better benefits. The strike involved workers at 19 hotels in Los Angeles, Orange, and San Diego counties. The workers are members of the Unite Here union.
• 20,000 nurses at Kaiser Permanente hospitals in California went on strike on July 11, 2023, demanding better staffing levels and safer working conditions. The strike involved nurses at 10 hospitals in the Los Angeles area. The nurses are members of the National Nurses United union.
• 1,400 pilots at Spirit Airlines went on strike on July 1, 2023, demanding better pay and benefits. The strike involved pilots at Spirit Airlines' main hub in Fort Lauderdale, Florida. The pilots are members of the Air Line Pilots Association.
• Thousands of Hollywood writers went on strike on May 10, 2023, demanding better pay and benefits. The strike involved writers for television, film, and streaming services. The writers are members of the Writers Guild of America, West.

(4) More strikes ahead? Important negotiations going on now that could lead to significant strikes include:

• The Teamsters and UPS are currently in contract negotiations, and there is a possibility of a strike if the two sides cannot reach an agreement. The Teamsters represent 340,000 UPS workers.
• The United Auto Workers (UAW) has three separate contracts with General Motors, Ford, and Stellantis that are due to expire on September 14. Ahead of contract negotiations that began on July 13, the head of the UAW declared that its 150,000 members are prepared to strike against the Big Three US automakers if the automakers do not meet their demands.

These are just a few examples of recent labor unrest. Many other strikes are going on across the country, and we likely will see more in the coming months and years.

(5) Flying wages. On Saturday, CNBC reported that American Airlines raised its offer for a new pilot contract by more than $1 billion to match a preliminary deal last week between rival United Airlines and that carrier’s aviators. The CNBC story observed: “Airlines and pilot unions had been negotiating new deals for years. Unions have won more bargaining power in the wake of Covid as the industry grapples with a prolonged pilot shortage just as travel demand recovered. Delta Air Lines pilots approved a new agreement in March for a deal that includes 34% raises over four years.” American’s new offer includes 21% pay bonuses and pay on par with that paid by United and Delta, according to their union, the Allied Pilots Association.

US Labor Market II: Wages & Prices. Now that almost everyone is bullish on the outlook for the economy and the stock market, a renewed wage-price spiral should be added to our worry list. Yesterday, we added the recession that is rolling into the commercial real estate markets, which might have adverse consequences for the widespread availability of credit. Our risque du jour is that the Fed concludes that a renewed wage-price spiral is a significant risk that can be avoided only by causing a recession.

Both price and wage inflation have been moderating so far this year, with the former down more than the latter. As a result, real wages have been rising at a pace consistent with a modest improvement in productivity growth. The risk is that a wave of labor strikes and expensive new contract settlements could cause wage inflation to rebound, forcing companies to raise their prices at a faster clip again. That would trigger a renewed wage-price spiral.

Don’t get us wrong: We are still 75/25 on the odds of a rolling recovery versus an economy-wide recession. But we are spending more time thinking about what could go wrong. We continue to expect that rebounding labor productivity growth will be consistent with wages’ rising faster than prices. We will be monitoring some of the following wage data:

(1) The quarterly Employment Cost Index (ECI) includes series for union and nonunion compensation (Fig. 7). Since H2-2021, the latter has been outpacing the former. During Q1-2023, nonunion compensation rose 5.0% y/y, while union compensation rose 3.6%. Union workers feel like they’ve fallen not just below price inflation, but also below nonunion workers.

(2) The ECI compensation inflation rate is highly correlated with the core CPI inflation rate (Fig. 8). The Fed focuses on the ECI as one of the important indicators of wage inflation that can spiral up and down with price inflation.

(3) The good news is that labor market turnover is falling, as evidenced by the drop in the quit rate from a peak of 3.0% in April of last year to 2.6% this past May. This series tends to lead the ECI wages & salaries inflation rate by nine months (Fig. 9).

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Rolling Recession Rolling Over Commercial Real Estate

July 24 (Monday)

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

Commercial Real Estate I: ‘Category 5 Hurricane.’ Barry Sternlicht was interviewed on Bloomberg Wealth With David Rubenstein on June 28 in New York. The interview with the chairman of Starwood Capital Group will be aired on July 25 at 9 p.m. The highlights were featured in a July 20 Bloomberg story titled “Billionaire Sternlicht Sees ‘Category 5 Hurricane’ Spurred by Fed Rate Hikes.”

Sternlicht has amassed his fortune in real estate by purchasing distressed properties during financial crises. He did so during the savings & loan collapse and again during the Great Financial Crisis. He sees similar opportunities now in the commercial real estate (CRE) market for office buildings. Nevertheless, he said, “It’s sort of a blackout hovering over the entire industry until we get some relief or some understanding of what the Fed’s going to do over the longer term.”

Among the companies exposed to this CRE hurricane is Starwood, which has more than $115 billion in assets under management. On July 9, the firm failed to refinance or pay off the $212.5 million mortgage on Tower Place 100 in Atlanta’s Buckhead district. The firm is negotiating an agreement with its lenders. Blackstone Inc. and Brookfield Asset Management Ltd. also have stopped making payments on a few of their office buildings.

June’s Trepp CMBS Research reported that “the commercial mortgage-backed securities (CMBS) market saw a noticeable uptick in delinquencies,” during May and June, with the overall CMBS delinquency rate (i.e., percent late by 30 or more days) rising to 3.90% last month led by retail (6.48% down from 6.69% a year ago), lodging (5.35% down from 5.94%), and office (4.50% up from 1.68%) (Table 1, below). The Atlanta area’s office-vacancy rate climbed to 22.4% in the second quarter, compared with the US average of 20.6%, according to brokerage Jones Lang LaSalle Inc.

Office vacancies are up sharply since the pandemic forced many office workers to work from home. Now many of them want to continue doing so and are resisting returning to their cubicles. Many employers are fine with that and have adopted hybrid schedules allowing workers to come to the office part of the time and work from home otherwise. Many of the employers haven’t been renewing their leases, opting instead to move to smaller spaces.

In a CNBC interview on November 17, 2022, Sternlicht warned that the Fed’s aggressive tightening of monetary policy would depress the economy more than expected. “It’s not sustainable,” he said. “What they want to do is clearly suicide.” In his latest interview on Bloomberg, he said, “You could see 400 or 500 banks that could fail. And they will have to sell. It also will be a great opportunity.”

Commercial Real Estate II: How Distressing Is It? Debbie, Melissa, and I aren’t distressed about the distress in the CRE market for office buildings. There will be a market for distressed properties. There’s lots of cash ready to be deployed in distressed asset funds. Sellers will take their losses, reducing the rate of returns on their CRE portfolios. Many of the banks already have increased their provisions for loan losses.

In his latest interview, Sternlicht said, “You could see a second RTC.” He was referring to the Resolution Trust Corporation, the government entity charged with liquidating assets of the savings & loan associations that failed in the late 1980s and early 1990s. But what about the hundreds of bank failures that he expects? We think that CRE loan losses and higher regulatory costs will result in a wave of mergers and acquisitions, averting a banking crisis.

After all, hurricanes are local, not national events. In this case, the financial storms are likely to hit the office districts of several urban areas. The loan losses will likely be concentrated among large banks and institutional investors. Suburban office buildings are less likely to be distressed by the work-from-home trend because suburban workers typically live closer to their workplaces than urban workers with long commutes from homes in the suburbs. So small banks may not be all that exposed to loan losses on their suburban office properties.

Commercial Real Estate III: By the Numbers. Now let’s have a closer look at the loan portfolios of the US commercial banks focusing on their exposure to CRE loans. The data are available weekly in the Fed’s H.8 release titled “Assets and Liabilities of Commercial Banks in the United States - H.8.” The release shows outstanding loans for the following categories: commercial & industrial, commercial real estate, residential real estate, and consumer credit. Series are also available for large and small banks:

(1) All loans. Loans held by banks of all three categories—“all,” “large,” and “small”—have flattened out in recent weeks at record highs around $12.1 trillion, $6.7 trillion, and $4.3 trillion, respectively (Fig. 1).

(2) C&I loans. Commercial & industrial loans soared during the first few months of the pandemic as companies scrambled to take down their lines of credit at the banks. The Fed’s emergency liquidity facilities and ultra-easy monetary policies in response to the pandemic stopped the panic borrowing, and C&I loans fell during most of 2020 and 2021 (Fig. 2). During that period, consumers’ buying binge for goods depleted business inventories and reduced the demand for C&I loans. During 2022 through early 2023, unintended inventory accumulation occurred as the buying binge came to an end, boosting the demand for C&I loans.

Now inventories have been pared back, as reflected by the weakness in C&I loans for all three bank categories in recent weeks. Of course, the tightening of lending standards might also be weighing on C&I loans.

(3) CRE loans. During the July 12 week, all banks held $2.9 trillion in CRE loans, with small and large banks holding $1.9 trillion and $0.9 trillion, respectively (Fig. 3). These loans have plateaued in recent weeks at these record levels. In other words, so far, the data suggest that banks on average are not adding to their CRE loan portfolios.

(4) Residential and consumer loans. Banks of all sizes have $2.5 trillion in residential loans. Small banks’ residential loans rose to a record high of $0.9 trillion during the July 12 week, while large banks, with $1.6 trillion in residential loans, appear to have started paring back their holdings (Fig. 4). Loans for multi-family properties remain on uptrends for the three categories of banks, though they are starting to look toppy at the large banks (Fig. 5).

The same pattern can be discerned in consumer loans. Consumer loans at all banks currently total a record $1.9 trillion, with large and small banks holding $1.4 trillion (a slight downtick from the recent record high) and $0.5 trillion (a record high), respectively (Fig. 6).

Data are also available for auto loans at the banks. They are weakening, especially recently and especially at the large banks (Fig. 7).

(5) Provisions for loan losses. The banks have increased their provisions for loan losses as a result of mounting concerns that the Fed’s aggressive tightening of monetary policy might cause a recession. Allowances for loan losses at all the banks have increased $27.0 billion over the past year through the July 12 week to $187.5 billion (Fig. 8). That’s still below the pandemic high of $220.7 billion during the September 23 week of 2020.

FactSet estimates that the 15 banks in the S&P 500 Banks industry increased their provisions for loan losses to $9.9 billion during Q2-2023, up from $4.9 billion a year ago. On Thursday, Key Bank reported a bigger-than-expected 50% fall in quarterly profits as the lender’s provisions for credit losses jumped by 271% to $167 million at the quarter’s end from $45 million in the year-ago quarter.

(We monitor the weekly balance sheet of the commercial banks with our two chart books: Commercial Bank Book and Commercial Bank Loans. They are automatically updated after the data are released on Fridays at 4:15 p.m.)

Commercial Real Estate IV: The Fed’s Assessment. The Fed’s May 2023 Financial Stability Report included a review of the CRE credit market. Our conclusion is that a hurricane in that market shouldn’t cause an economy-wide credit crunch and a recession. The report observes:

“The shift toward telework in many industries has dramatically reduced demand for office space, which could lead to a correction in the values of office buildings and downtown retail properties that largely depend on office workers. Moreover, the rise in interest rates over the past year increases the risk that CRE mortgage borrowers will not be able to refinance their loans when the loans reach the end of their term. With CRE valuations remaining elevated (see Section 1, Asset Valuations), the magnitude of a correction in property values could be sizable and therefore could lead to credit losses by holders of CRE debt.”

The Fed’s report includes the following table. Below are some of the key findings:

(1) At the end of Q4-2022, banks held $2.17 trillion in CRE mortgage assets, or 61% of the total outstanding. The smaller banks held $1.55 trillion, or 43% of these assets. So the latter group of investors is most exposed to potential losses in CRE, though those whose portfolios have more suburban than urban office buildings might be less exposed. Nevertheless, their CRE borrowers may have to refinance their mortgages at prohibitively high rates or renegotiate the terms of their refinancings with their lenders.

(2) The Fed’s data show that small banks are in fact heavily exposed to office and downtown retail CRE loans to the tune of $510 billion during Q4-2022. The data don’t show how much of the exposure to office buildings is in urban centers versus the suburbs.

(3) In his June 14 press conference, Fed Chair Jerome Powell said that the Fed is closely monitoring the CRE sector. He observed: “There’s a substantial amount of commercial real estate in the banking system. A large part of it is in smaller banks.” He expects that there will be losses and he expects that the problem “will be around for some time.” He doesn’t expect that it “will suddenly hit” in a way that causes “systematic risk.” We agree with him.
 
Movie. “Oppenheimer” (+ + +) (link) is an excellent biopic and docudrama about Robert Oppenheimer, who directed the secret Manhattan Project, which developed and built the two atom bombs that were dropped on Japan and ended World War II. The cast is outstanding, starring Cillian Murphy in the title role. Standout performances were also delivered by Robert Downey Jr. as Lewis Strauss and Matt Damon as Lt. Gen. Leslie Groves Jr. Director Christopher Nolan’s achievement is to look beyond the bomb at the man behind it as well as the national and geopolitical implications of the bomb. Also considered are the implications for humanity of creating a weapon of mass destruction that could wipe out creation itself.

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Defense, China & Quantum Computers

July 20 (Thursday)

Industrials: Playing Defense. On Tuesday, Lockheed Martin reported Q2 earnings that beat analysts’ forecasts and an orders backlog that hit a record high. The company also upped its 2023 earnings-per-share forecast. Nonetheless, that day saw the defense contractor’s share price fall by 3.0% compared to the S&P 500’s 0.7% gain. A couple of company-specific problems revealed on the earnings call apparently diverted investors’ attention from the strong growth in defense spending that’s been occurring around the world in response to threats from China and Russia.

European members of NATO and Canada are expected to boost defense spending by 8.3% this year to $356 billion, faster than the 2.0% increase last year and 2.8% jump in 2021, according to a July 7 NATO press release. This year’s defense spending increase by NATO’s European members and Canada is higher than any annual increase over the past decade, including the prior fastest spending increase of 5.9% in 2017.

The jump in spending by NATO’s European members and Canada on defense equipment specifically is even more dramatic: up an estimated 24.9% this year compared to an estimated 8.5% increase in 2022, 11.3% in 2021, and 8.9% in 2020. These spending changes are calculated using 2015 prices and would be larger had they been adjusted for inflation.

So let’s take a look at what may have disappointed Lockheed investors on Tuesday, while also remembering the surge of spending that should bolster the defense industry’s results for years to come:

(1) Disappointing details. Lockheed shares initially rose on Tuesday after the company reported that sales rose 8.1% y/y to $16.7 billion in Q2, compared to the consensus expectation of $15.9 billion, according to a July 18 Investor’s Business Daily article. Management boosted its 2023 earnings-per-share forecast to $27.00-$27.20, up from the $26.60-$26.90 projected in April. And Lockheed’s backlog grew 5.3% from the start of the year to a record $158.1 billion. The company’s various product offerings include aircraft (e.g., the F-35 and the F-16), missiles, rockets, unmanned systems, helicopters, radar systems, undersea systems, space technologies, and transport systems.

The company’s shares fell later in the day as more details about the quarter emerged. Management didn’t increase the “single-digit growth” it sees for 2024 revenues, albeit now measured off a higher 2023 base than previously expected. Lockheed executives attributed their cautious 2024 outlook to the company’s suppliers’ inability to keep up with demand.

“It’s not a question of demand; it’ll be a question of supply. And we need to go through that analysis over the next few months and determine to what extent our growth outlook will change, if anything from this baseline of low single digit,” said CFO Jay Malave on the earnings conference call.

Lockheed also reduced the number of F-35s it plans to deliver this year to 100-120 from 147-153 owing to difficulties getting certification for updated hardware and software, a July 18 Defense One article reported. The updated planes will have 20-25 times more computing power, more memory, and a new panoramic cockpit display. But the new systems have had reliability issues, and the Pentagon stopped accepting jets with the updates in June. By 2025, however, the company anticipates delivering 156 of the planes annually.

Lockheed suffered another blow earlier this year when it lost a contract with the US Army to produce the next generation of aircraft to Textron’s Bell division’s V-280 Valor. Last year, the Army placed what will likely be its last order for Lockheed’s Black Hawk helicopters in a program that will run through 2027.

(2) Dangerous world boosts defense spending. Defense spending domestically and abroad is increasing as countries respond to the potential threats posed by China and Russia. In addition, munitions and supplies used in the Ukraine war need to be replaced.

Domestically, the US House of Representatives has passed the $886 million National Defense Authorization Act. It includes a 5.2% pay raise for military members, initiatives to counter China, an additional $300 million to support Ukraine, and increased spending on aircraft including the F-35, the July 18 Investor’s Business Daily article reported. The spending would mark a 3.3% increase from this year’s $858 billion defense budget. Senate Democrats are expected to reject social items included in the House bill.

Additionally, the US is expected to announce $1.3 billion of military aid for Ukraine within the next few days that includes air defenses, counter-drone systems, exploding drones, and ammunition, a July 18 Reuters article reported.

As we noted above, European nations and Canada have also been boosting their military budgets, as have other countries around the world. Lockheed received a $3 billion order earlier this month from the Israel Ministry of Defense to supply the country with 25 F-35s, which will expand that nation’s fleet of the aircraft to 75. The Biden administration has agreed to let Turkey buy 40 of Lockheed’s F-16s and modernization kits for other aircraft. The Czech Republic has expressed interest in the F-35, and Germany put in an order for 35 of the planes late last year. Lockheed says its F-35 backlog stands at 421 aircraft.

(3) Lessons from Ukraine. Russia’s risky invasion of Ukraine may imply that it will take similar risks in the future. Defense ministers in NATO countries are increasing their defense budgets because of the “elevated risks that they perceive to their own countries for some foreseeable future,” said Lockheed CEO James Taiclet on the earnings conference call.

In addition, Ukraine has used far more munitions than existing wargame models have implied. So in addition to replacing the munitions used by Ukraine, the US and allies’ stockpiles will need to be larger than they’ve been in the past to deter future conflicts by showing potential adversaries that they can defend themselves for a long period of time, said Taiclet.

“We think this is a longer term, essentially, sea change in national defense strategy for the US and for our western allies, including Japan and the Philippines and others,” said Taiclet. “The lessons and the future demand for these kinds of products is going to stay elevated for a very long time, we think.”

As for Lockheed, it has learned that it needs a stronger, more resilient supply chain that can scale quickly if necessary. The company is also looking to expand production internationally.

(4) Industry data. US industrial production of defense and space equipment has been robust, climbing 5.2% y/y in June, while total industrial production fell 0.4% y/y last month (Fig. 1 and Fig. 2). Likewise, shipments of defense goods rose 7.1% y/y in June, while shipments of defense aircraft and parts increased 7.0% y/y (Fig. 3 and Fig. 4).

Despite strong production, the S&P 500 Aerospace & Defense industry’s stock price index has moved sideways for the better part of this year so far (Fig. 5). It’s down 2.1% ytd through Tuesday’s close, underperforming the S&P 500’s 18.6% climb. That’s a reversal from last year, when the industry’s stock price index climbed 15.5%, way outperforming the S&P 500’s 19.4% decline that year.

The S&P 500 Aerospace & Defense industry’s constituent companies collectively have grown both top and bottom lines in recent years. Revenue grew by 3.2% in 2022, and it’s expected to increase by 7.7% this year and 8.2% in 2024 (Fig. 6). The industry’s earnings grew by 1.8% in 2022, and analysts’ consensus estimates target earnings growth of 41.8% in 2023 and 27.4% next year (Fig. 7). The industry’s share price index has a forward P/E of 21.6, near the high end of the range over the past 29 years (Fig. 8). But after hitting some bumps in recent years, Lockheed’s forward earnings multiple of 16.5 is below the industry’s.

China: Debt Is Such a Drag. China’s government needs to put forward a comprehensive debt restructuring plan to end the two-year drip, drip, drip of bad news from real estate development companies having difficulties meeting their debt obligations. JPMorgan estimates that 50 property developers have defaulted on $100 billion of offshore bonds over the past two years, and the bad news continued this week, sending the price of China’s dollar-denominated junk bonds tumbling. They’re now down 10% ytd, according to a July 19 Bloomberg article.

Here’s a look at some of the recent news that has spooked the market:

(1) Latest default hits. Greenland Holding Group defaulted on $432 million of debt Wednesday. The country’s seventh largest property developer missed an amortization payment on a 6.75% dollar-denominated bond due in 2024. Greenland, which is partially owned by local governments, had extended payments on its dollar bonds last year. The default comes even after Shanghai officials told local state-owned enterprises to buy $350 million of new Greenland debt in late 2021, Reuters reported in a March 15, 2022 article.

Greenland “built Sydney’s tallest residential tower and has billions of dollars worth of projects in London, New York, Los Angeles, and Paris. At home, its projects include construction of the tallest building in northwest China and it is heavily involved in building subways, highways and bridges,” Reuters reported.

(2) More negotiations proposed. Sino-Ocean Group Holding, a Beijing-based real estate state developer, proposed extending by one year the repayment of a local note worth $277.3 million that matures on August 2. The firm reportedly has offered to pay only interest and has asked to extend its maturity, a July 19 Reuters article reported. Sino-Ocean Group also has a payment due later this month on an offshore bond.

Separately, Dalian Wanda Group, China’s largest commercial property firm, warned that it was short the funding needed to make a $400 million payment on a dollar-denominated bond due in 2024. The bond fell 15.3 cents on the dollar to 27 cents on Wednesday.

(3) Future problem? Shui On Land reportedly has been trying to identify bondholders, an action often taken prior to payment delays. Its 5.5% note due in 2025 fell 10.3 cents to 57 cents on the dollar. However, the company said its efforts were part of an investor relations exercise to better understand how its bond investor base has changed in order to enhance communication.

(4) That’s not chump change. China Evergrande Group, which defaulted on its debt in 2021, reported that it lost $81 billion in 2021 and 2022 due to writedowns of properties, return of lands, losses on financial assets, and financing costs, a July 18 CNBC article reported. The company’s debt has risen to $340 billion, and the company says it has $350 billion in assets; but it has struggled to turn those assets into cash to pay bondholders. Trading in Evergrande’s shares has been suspended since last year, and the company has warned that its finances “indicate the existence of material uncertainties that may cast significant doubt on the Group’s ability to continue as a going concern,” a July 18 AP article reported.

Disruptive Technologies: Quantum Leaps. The promise of quantum computing—and what humans can accomplish with such vast amounts of computing power—makes scientists giddy. Google, Amazon, Microsoft, and IBM are leading the race to develop these computers and offer access to them in the cloud.

Here are some recent developments in the area:
 
(1) Google boasts supremacy. The king of search claims quantum supremacy. The latest iteration of its Sycamore quantum system has 70 qubits and a quantum processor that’s 241 million times more powerful than the company’s previous offering. Google’s quantum computer “can outperform the most powerful supercomputer in the world, running calculations that would take the massive 1.68 exaflops ‘Frontier’ system at Oak Ridge National Laboratories 47 years to complete,” explained a July 18 article in The Next Platform.

(2) Amazon plays host. Amazon Bracket is a service that lets users build their own quantum algorithms and then test them on quantum computers in Amazon’s cloud. Amazon reports that a number of organizations are tapping into quantum computing in Amazon’s cloud, including the Technology Innovation Institute, a scientific research center that’s a part of Abu Dhabi’s Advanced Technology Research Council; Volkswagen Group; Fidelity Center for Applied Technology; Amgen; multinational power company Enel; Aioli, an insurance agency; and the Institute for Quantum Computing at the University of Waterloo.

(3) More qubits than others? Last fall, IBM reported that it has developed a 433-qubit Osprey processor, more qubits than any other IBM processor and more than triple those of the Eagle processor made public in 2021. IBM Quantum System’s goal is to have a system with 4,000 or more qubits by 2025.

IBM also hosts a number of companies that want to tap into more than 20 quantum computers in the cloud. The company said German conglomerate Bosch, telecom provider Vodafone, and French bank Credit Mutuel Alliance Federale all have joined IBM’s Quantum Network.

(4) New particles discovered. Qubits are prone to error, so Microsoft has been building a better mousetrap. Company scientists are building qubits from quasiparticles, “which are not true particles but collective vibrations that can emerge when particles like electrons act together,” a June 21 article in New Scientist reported. Called “Majorana zero modes,” these antiparticles have a charge and energy that equate to zero and make “unprecedentedly reliable” qubits.

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(Hot) Global Soft Landing

July 19 (Wednesday)

Global Economy: Hot Summer Weighing on Growth. It has been a very hot summer around the world, and summer isn’t over yet. Record-high temperatures in many places around the world are likely to weigh on global economic growth during July and maybe August too. Global economic growth was lackluster going into the hot summer. Consider the following:

(1) Eurozone. The Eurozone is in a mild recession, with real GDP falling during the past two quarters. Economic output in the 20 nations that use the euro currency declined 0.4% (saar) during Q1-2023, after a Q4-2022 contraction of the same magnitude. Consumer spending in the Eurozone fell 1.2% (saar) in the first three months of this year after falling 4.0% in the previous quarter. Imports were also down sharply as demand for goods and services shrank.

The volume of retail sales excluding automobiles and motorcycles in the Eurozone has been falling since early 2022 (Fig. 1). It is down 2.9% y/y. The region’s Economic Sentiment Indicator has fallen below 100 since mid-2022 (Fig. 2). That suggests that real GDP, which was up just 1.0% y/y, could turn negative soon.

(2) China. China’s real GDP rose 6.3% y/y during Q2 but fell 1.8% q/q (saar) (Fig. 3). Inflation-adjusted retail sales rose 3.1% y/y through June (Fig. 4). That was relatively weak considering that many areas of China were depressed by government-mandated pandemic lockdowns last year. Indeed, a year ago during June 2022, real retail sales was basically flat y/y.

The Chinese government has been trying to stimulate domestic consumption without much success. The 24-month annualized growth rate of real retail sales has been in the low single digits since early 2020. Of course, some of that weakness was related to pandemic restrictions. But the growth rate in this series has plunged from the high teens during 2010 and 2011, which we attribute mostly to China’s rapidly aging demographic profile. China has turned into the world’s largest nursing home over the past few years. That’s the legacy of the government’s horrible One-Child Policy from 1979 to 2015.

(3) United States. The US economy is performing better than the other major developed economies. However, American consumers have been pivoting toward spending less on goods and more on services. As a result, inflation-adjusted merchandise imports peaked at a record high during March 2022 and fell 8.3% through May of this year (Fig. 5).That’s after these imports jumped 45.2% from their post-lockdowns low during May 2020 through last year’s peak.

All those imports caused a major backup at the West Coast ports as measured by the 12-month sum of container traffic at those ports during 2021 and 2022 (Fig. 6). But that series was back down to its 2020 low during June of this year.

June’s US retail sales report, released yesterday by the Census Bureau, showed that retail sales rose just 0.2% m/m during June, following May’s 0.5% increase, which was revised up from 0.3%. Excluding gasoline station sales, retail sales rose 0.3% last month. Excluding building materials and food services, it was up 0.4% (Fig. 7).

On an inflation-adjusted basis, retail sales has remained relatively flat since mid-2021 (Fig. 8).

More Americans than ever are traveling and spending more abroad during their vacations (Fig. 9). However, the weakness in their demand for imported merchandise is probably on balance still a drag on the global economy.

(4) Global Growth Barometer. Our Global Growth Barometer (GGB) rose slightly last week, but it remains on a downward trend since mid-2022 (Fig. 10). Our GGB is simply the average of the Brent crude oil nearby futures price and the CRB raw industrials spot price index (multiplied by 2 and divided by 100).

Strategy I: Raising Our S&P 500 Targets. In case you missed it, Joe and I raised our forward P/E and price targets for the S&P 500 in our Sunday, July 16 QuickTakes. (FYI: The “forward” P/E is the multiple based on forward earnings, which is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for the current year and following one.)

In our November 3, 2020 Morning Briefing, we wrote that “we think the S&P 500 bottomed on October 12 and see a few potentially uplifting developments to come.” On January 9, 2023, we predicted: “The S&P 500 will move higher during the first half of the year, rising to 4500 and then stall there until a year-end rally drives it up to a new record high of 4800 in anticipation of higher earnings in 2024.”

Along the way, we trimmed our year-end target to a more reasonable 4600. On June 5, we wrote: “Is all the AI euphoria leading the stock market into another ‘MAMU’—'Mother of All Meltups’? If so, our 4600 target for the S&P 500 by year-end might prove conservative, not controversial.”

The S&P 500 is now almost at 4600. It closed at 4556.27 on Tuesday. Rather than raise our year-end target, we are raising our expectations for what the bull market could deliver through the end of 2024 and beyond. We think that 5400 is achievable by the end of next year. If that happens, then 5800 would be our target for the end of 2025. In other words, we think that the bull market has staying power.

That’s because we give only 25% odds to a recession scenario over the next two and a half years. So we estimate that S&P 500 earnings per share should be $225 this year, $250 next year, and $270 in 2025 (Fig. 11). If forward earnings rises to $270 at the end of next year and $290 at the end of 2025, as we expect, then the S&P 500 would be 5400 at the end of 2024 and 5800 at the end of 2025 assuming a forward P/E of 20.0 for both forecasts (Fig. 12).

That might seem like an awfully high valuation multiple. However, the S&P 500’s forward P/E has rebounded from 15.0 to 19.6 since October 12 thanks to the rebound in the MegaCap-8. These stocks now account for a record-high 27.3% of the market capitalization of the S&P 500, and they are likely to remain the market’s leaders for the foreseeable future.
 
Strategy II: MegaCap-8 Leading the Way. The MegaCap-8 group of stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) has been leading the S&P 500 higher in a big way so far in 2023. While they’re not as cheap as they were at the start of this year, when they were very cheap, they are still less expensive than they were during 2020-21, when their forward P/E flirted with 35 (Fig. 13). Their improved performance this year in part reflects much improved revenues and earnings growth prospects for most of the eight companies.

The MegaCap-8 still accounts for a large part of the S&P 500’s market capitalization, and their soon-to-be-released results for Q2—which come on the heels of aggressive cost-cutting—could continue to set the tone for the S&P 500’s performance. I asked Joe for an update on the MegaCap-8. Here it is:

(1) Market capitalization. The combined market cap for the MegaCap-8 tumbled 41.5% in 2022 but has since rebounded 63.6% ytd to an 18-month high of $11.5 trillion through Friday’s close (Fig. 14). Through Friday’s close, the S&P 500’s market cap is up 17.1% ytd with the MegaCap-8 stocks included but up only 5.5% without them. The MegaCap-8’s market-capitalization share of the S&P 500 has recovered too, soaring from 19.4% at the start of the year to a record-high 27.3% during the July 14 week (Fig. 15).

(2) Valuation. The MegaCap-8’s forward P/E rose above 30.0 in mid-June for the first time in 15 months. Since the January 6 week, the forward P/E has soared 46% to 31.2 as of the July 14 week from 21.1. However, it remains below the record-high of 38.5 during the August 28, 2020 week. Since their January 6 bottom, forward P/Es have risen for all of MegaCap-8 stocks, as Joe shows below.

Here’s how much valuation has changed for each of the MegaCap-8 stocks since the S&P 500’s January 6 bottom: Alphabet (up 28% to 21.3 from 16.6), Amazon (27% to 62.2 from 48.8), Apple (up 45% to 29.4 from 20.3), Meta (up 43% to 22.9 from 16.0), Microsoft (up 45% to 31.1 from 21.4), Netflix (up 14.2% to 33.6 from 29.4), Nvidia (up 40% to 48.4 from 34.5), and Tesla (up 201% to 66.2 from 22.0). Tesla’s eye-popping valuation gain has come at the expense of declining forward earnings, as the company has cut vehicle prices sharply to maintain sales growth.

(3) Forward revenues and earnings. Seven of the MegaCap-8 companies have enjoyed both rising forward revenues and rising forward earnings so far in 2023. The only laggards are Apple’s forward revenues and Tesla’s forward earnings. As a group, the MegaCap-8’s forward revenues has risen 4.4% ytd, and its forward earnings has soared 12.3%—trouncing the S&P 500’s forward revenues rise of 3.1% ytd and forward earnings gain of only 1.9% ytd.

Here’s how each of the MegaCap-8 companies’ forward revenues and earnings forecasts have performed ytd: Alphabet (forward revenues up 3.2%, forward earnings up 11.9%), Amazon (5.3, 22.8), Apple (-1.4, 1.6), Meta (9.9, 66.2), Microsoft (4.0, 5.7), Netflix (6.8, 22.6), Nvidia (70.5, 118.2), and Tesla (2.2, -17.2). Nvidia’s surge in such a short period on expectations for AI chip sales is stunning, and must rank near the all-time top (i.e., since consensus forecasts were first calculated over 40 years ago).

(4) Forward profit margin. Through the July 6 week, the S&P 500’s forward profit margin has dropped to 12.4% from 12.6% at the start of the year (Fig. 16). The MegaCap-8’s collective margin has surged from 18.0% to 19.5%. Among the MegaCap-8’s, all but Tesla have seen their forward profit margin rise ytd: Alphabet (up from 23.0% to 24.2%), Amazon (3.0 to 3.7), Apple (25.2 to 26.0), Meta (21.1 to 27.0), Microsoft (34.6 to 35.2), Netflix (14.1 to 16.2), Nvidia (36.7 to 47.1), and Tesla (15.9 to 12.7) (Fig. 17).

(5) Q2 revenue and earnings outlook. During 2022, the MegaCap-8’s revenues and earnings growth sagged. Quarterly revenues growth remained positive on a y/y basis but dropped to single-digit percentage rates. Earnings fared much worse, falling y/y for four straight quarters through Q1-2023.

But both are expected to turn positive again in Q2-2023. The MegaCap-8’s revenues are forecasted to rise 7.8% y/y in Q2-2023 following a 4.6% rise in Q1-2023, and earnings are expected to gain 16.2% y/y after the prior quarter’s 3.5% decline. In stark comparison, the S&P 500’s revenues are forecasted to decline 0.9% y/y during Q2-2023, while its earnings drop 8.1% y/y.

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Dismissing The Dismal Definition Of Economics

July 18 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
US Economy I: Scarcity vs Abundance. Economics is widely known as the “dismal science.” Economists have tended to be pessimistic ever since Thomas Malthus predicted that population growth would exceed the rate of increase in food supplies, resulting in mass starvation.

Modern-day economists were mostly introduced to the dismal science by reading Paul Samuelson’s famous Economics textbook, which also had a dismal spin. The latest (19th) edition of Economics (2010), by Samuelson and William Nordhaus, teaches students that economics “is the study of how societies use scarce resources to produce valuable goods and services and distribute them among different individuals.” This definition hasn’t changed since the first edition of this classic textbook was published in 1948.

That’s a relatively depressing definition of economics: Resources are scarce, and economists must determine the best way to distribute them. That’s led to lots of infighting within the profession between those who believe that the free market is the best way to divvy up the scarce resources and those who contend that the government should do it.

In my 2018 book Predicting the Markets, I objected to the dismal characterization of economics as follows:

“I’ve learned that economics isn’t a zero-sum game, as implied by the definition. Economics is about using technology to increase everyone’s standard of living. Technological innovations are driven by the profits that can be earned by solving the problems posed by scarce resources. Free markets provide the profit incentives to motivate innovators to solve this problem. As they do so, consumer prices tend to fall, driven by their innovations. The market distributes the resulting benefits to all consumers. From my perspective, economics is about creating and spreading abundance, not about distributing scarcity.”

US Economy II: Today’s Dismal Scientists. Over the past year or so, economists mostly have been very pessimistic about the economic outlook. The vast majority expected a recession as a result of the tightening of Fed policy in the face of mounting inflation. For a while during 2021 when inflation was starting to take off, it was widely perceived that inflation was a transitory problem. But during 2022, the consensus among economists shifted: Inflation was viewed as a more persistent and pernicious problem that could only be stopped with a Fed-engineered recession.

But the economy has defied its detractors, proving to be remarkably resilient. More recently, inflation has proven to be more transitory than persistent, as we wrote in yesterday’s Morning Briefing. As a result, the consensus view among economists is turning less pessimistic.

Indeed, the July 15 WSJ included an article titled “Economists Are Cutting Back Their Recession Expectations.” It is subtitled: “Forecasters still expect GDP to eventually contract, but later, and by less, than previously.” Here’s more:

(1) The article observes: “Easing inflation, a still-strong labor market and economic resilience led business and academic economists polled by The Wall Street Journal to lower the probability of a recession in the next 12 months to 54% from 61% in the prior two surveys.

“While that probability is still high by historical comparison, it represents the largest month-over-month percentage-point drop since August 2020, as the economy was recovering from a short but sharp recession induced by the Covid-19 pandemic. It reflects the fact that the economy has kept growing even as the Federal Reserve has raised interest rates and inflation declined.”

Furthermore, the article explains: “Nearly 60% of economists said their main reason for optimism about the economic outlook is their expectation that inflation will continue to slow.” The survey of 69 economists was conducted July 7-12. That was mostly before June’s lower-than-expected CPI was released on July 12. It rose just 3.0% y/y last month, sharply lower than the peak of 9.1% in June 2022 and the slowest in more than two years.

(2) The Philly Fed’s Survey of Professional Forecasters, which started in 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 they see of a decline in real GDP in the quarter after a survey is taken and the probability of a recession over the next four quarters (Fig. 2).

The Philly Fed’s Q2 survey, dated May 12, showed that the forecasters saw less risk of negative growth during Q2 than previously estimated but higher risk during subsequent quarters. The estimate for Q2 was 38.8%, down from the previous estimate of 42.4%. The Q1-2024 estimate saw the largest revision in the risk of a contraction in real GDP. The forecasters pegged the risk at 39.3%, marking an upward revision from 31.8% in the previous survey three months earlier.

(3) The Conference Board, which compiles the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI), also maintains a US recession probability model. The latest version, dated April 12, 2023, calculated that the recession probability estimate was “near 99 percent pointing to the likelihood of a recession in the US within the next 12 months.” The proprietors of the model observed: “Despite better-than-expected consumer spending recently, the Federal Reserve’s interest rate hikes and tightening monetary policy will lead to a recession in 2023.” This outlook is consistent with the LEI, which peaked at a record high during December 2021 and is down 9.4% since then through May (Fig. 3). On the other hand, the CEI increased 2.3% over this same period to a new record high (Fig. 4).

(4) Even the Fed’s staff economists have been forecasting a recession. The January FOMC minutes noted: “The sluggish growth in real private domestic spending expected this year and the persistently tight financial conditions were seen as tilting the risks to the downside around the baseline projection for real economic activity, and the staff still viewed the possibility of a recession sometime this year as a plausible alternative to the baseline.”

The March FOMC minutes indicated that a mild recession forecast was now the staff’s baseline: “Given their assessment of the potential economic effects of the recent banking-sector developments, the staff’s projection at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years.” That outlook was maintained in the May FOMC minutes and the June FOMC minutes.

US Economy III: Waller’s Scenario. Among the Fed officials who spoke publicly before the Fed’s blackout period started this past Saturday was Fed Governor Christopher Waller. He did so in a speech titled “Big Shocks Travel Fast: Why Policy Lags May Be Shorter Than You Think” on Thursday, July 13 at the Money Marketeers of New York University. That was a day after the release of June’s lower-than-expected CPI report for June. Waller said:

“Yesterday, we received new data on consumer price index (CPI) inflation. After 5 consecutive monthly readings of core inflation of 0.4 percent or above, this rate dropped by half in June, to 0.2 percent. This is welcome news, but one data point does not make a trend. Inflation briefly slowed in the summer of 2021 before getting much worse, so I am going to need to see this improvement sustained before I am confident that inflation has decelerated. …

“While I expect inflation to eventually settle near our 2 percent target because of our policy actions, we have to make sure what we saw in yesterday’s inflation report feeds through broadly across goods and services and that we do not revert back to what has been persistently high core inflation. The robust strength of the labor market and the solid overall performance of the U.S. economy gives us room to tighten policy further.”

Waller sees a 25bps hike in the federal funds rate at next week’s meeting of the FOMC. He sees another 25bps before year-end if the economy remains strong, the labor market remains tight, and inflation shows signs of heating up rather than cooling off.

US Economy IV: One of Powell’s Favorite Charts. While the CPI inflation rate is showing more signs of being transitory for both goods and services, wage inflation remains relatively persistent. Fed Chair Jerome Powell addressed this issue in a November 30, 2022 speech titled “Inflation and the Labor Market.”

Powell observed: “In the labor market, demand for workers far exceeds the supply of available workers, and nominal wages have been growing at a pace well above what would be consistent with 2 percent inflation over time. Thus, another condition we are looking for is the restoration of balance between supply and demand in the labor market.”

He provided an interesting chart comparing supply and demand for labor. The former is simply the same as the size of the labor force, while the latter is the sum of household employment and job openings (Fig. 5). It shows that over the past two years or so, demand for labor has well exceeded its supply. That’s boosting wage inflation.

The spread between labor demand and supply is reasonably well correlated with wage inflation, using either the average hourly earnings for all production and nonsupervisory workers (AHE-P&NS) or wages and salaries in the Employment Cost Index (ECI) (Fig. 6 and Fig. 7). The former is available monthly since 1964 and accounts for about 80% of payroll employment, while the latter is quarterly and available since mid-1975 (Fig. 8). Here are their latest readings:

(1) AHE-P&NS rose 4.7% y/y through June. It is down from last year’s peak of 7.0% during March.

(2) ECI wages and salaries rose 5.1% y/y during Q1-2023, down from last year’s peak of 5.7% y/y during Q2-2022.

In his recent press conferences, Powell has said that he would like to see wage inflation down to around 3.0% y/y, consistent with 2.0% price inflation plus 1.0% growth in productivity. Then again, at his May 3 presser, he ambiguated as follows: “I do not think that wages are the principal driver of inflation. … I think there are many things. I think wages and prices tend to move together. And it’s very hard to say what’s causing what. … I’ve never said that … wages are really the principal driver, because I don’t think that’s really right.”

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Transitory Inflation Sets Stage For Immaculate Disinflation

July 17 (Monday)

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

US Economy I: Dimon in the Rough. Some of the largest banks in the country— JPMorgan Chase, Wells Fargo, and Citigroup—kicked off the official start to earnings season on Friday with relatively upbeat results and comments from their top managements. All three banks beat earnings expectations for Q2. BlackRock did so as well.

In June 2022, JPMorgan Chase CEO Jamie Dimon warned that the economy could be in a recession by about now. Now he sounds more optimistic. American consumers are still driving the US economy, which “continues to be resilient,” Dimon stated on Friday. “Consumer balance sheets remain healthy, and consumers are spending, albeit a little more slowly,” he said. However, he once again noted that consumers’ excess savings are slowly being drained. While job growth remains strong, he said there are still “salient risks in the immediate view,” including stubborn inflation, the risk of more rate hikes from the Federal Reserve, and geopolitical tensions. “While we cannot predict with any certainty how these factors will play out, we are currently managing the firm to reliably meet the needs of our customers and clients in all environments,” he said.

Asked whether moderating inflation has made him more optimistic that a recession could be avoided, Dimon said, “I don’t know if it’s going to lead to a soft landing, a mild recession or a hard recession.” He cited “tailwinds” in the economy that “are receding over time,” including the strength of consumer spending amid fiscal and monetary stimulus. Headwinds he sees include inflation, high US government debt, high interest rates, the Fed’s efforts to shrink its balance sheet, and the war in Ukraine. He noted that the war has been going on for 500 days and could still “get worse.”

Last June, Dimon contributed to investors’ fears of a recession and a prolonged bear market in stocks by saying he was certain that a hurricane was coming, though how bad a hurricane he didn’t know: “That hurricane is right out there down the road coming our way.” But nobody knows if it’s “a minor one or Superstorm Sandy.”

US Economy II: Consumers Still Doing What They Do Best. There’s not much left for the bears to growl about, but Jamie Dimon continues to side with them. There are two versions of the bearish script now: Either consumers run out of excess savings, resulting in a consumer-led recession, or the Fed continues to tighten, fearing that a more resilient-than-expected economy will keep inflation above its 2.0% target. The bears don’t believe in immaculate disinflation, the idea that inflation can come down without a recession pulling it down. We do.

Let’s challenge the first bearish script before turning to the second one:

(1) Consumers still have lots of cash. Dimon is right, of course, about consumers’ excess savings. By most estimates, they accumulated about $3.0 trillion of it during the pandemic, including what they saved during the lockdown and what they didn’t immediately spend of their government pandemic relief checks (Fig. 1). Now it is widely estimated that they have $0.5 trillion left, which should be depleted over the next few months. Then watch out for a consumer-led recession.

This is essentially the same argument made by today’s latter-day monetarists, who observe that M2 peaked at $21.7 trillion during July 2022 and fell by $897 billion through May, led by a $737 billion drop in commercial banks’ total deposits from the final week of July 2022 through the week of July 28 (Fig. 2). Today’s monetarists correctly observe that some of the decline in deposits is attributable to the Fed’s ongoing quantitative tightening program.

Nevertheless, M2 is still about $1.0 trillion above its pre-pandemic trendline, and its demand deposits component is a whopping $2.0 trillion above its pre-pandemic trendline. The sum of total banks deposits plus money market mutual funds (MMMF) rose to a record $22.8 trillion during the July 5 week and is still $2.0 trillion above its pre-pandemic trendline (Fig. 3).

Previously, we observed that the Baby Boom generation held $8.9 trillion in demand deposits and MMMFs at the end of Q1-2023, or about $2.5 trillion more than at the end of Q4-2019, just before the pandemic (Fig. 4). That’s about $1.5 trillion above its pre-pandemic trend. (See our “Baby Boomers Retiring On $75 Trillion In Net Worth,” Morning Briefing, June 26, 2023.)

(2) Consumers have lots of income. We’ve also countered the consumers’ doubters by observing that both inflation-adjusted wages and total disposable income have been rising again in recent months after mostly stagnating during 2021 and 2022. Real average hourly earnings rose 1.5% over the past 11 months through May (Fig. 5). This series is once again climbing along its 1.2% annual growth trendline, as it has been since the mid-1990s.

Real disposable personal income mostly fell during H2-2021 and H1-2022 as price inflation outpaced wage inflation. It has been trending higher since June 2022 and is up 4.4% since then through May (Fig. 6).

Consumers also have other sources of record unearned income including (during May, at a seasonally adjusted annual rate [saar]): proprietor’s income ($1.9 trillion), interest income ($1.8 trillion), dividend income ($1.7 trillion), Social Security benefits ($1.4 trillion), and rental income ($0.9 trillion) (Fig. 7). May’s total was $7.7 trillion, equivalent to 65% of wages and salaries (Fig. 8).

(3) Consumers are turning more optimistic. We’ve often observed that American consumers spend money when they are happy and spend even more money when they are depressed, if they have money to spend (as they certainly do currently). We note that the Consumer Sentiment Index (CSI) fell to a record low of 50.0 during June 2022, which was well below the 2020 lockdown low of 71.8 during April 2020. The CSI rose to 72.6 during the first half of July (Fig. 9). That was just above its pandemic low. Inflation has clearly been depressing consumers and more than offsetting the positive effects of the strong labor market.

What have consumers been doing to counter their depression? They’ve been going shopping to release some dopamine in their brains to make themselves feel better. After the Covid lockdowns, they went on a buying binge for goods. Over the past year, they’ve pivoted to purchasing more services (Fig. 10).

(4) Corporations have lots of cash. Consumers aren’t the only ones with tons of cash. Corporate cash flow rose to a record high during Q4-2022 and edged down to $3.1 trillion (saar) during Q1-2023 (Fig. 11). The Fed’s measure of liquid assets held by nonfinancial corporate business was a near-record $6.5 trillion and $3.6 trillion with and without their holdings of equities and mutual fund shares (Fig. 12).

(5) The federal government’s deficit is widening again. Meanwhile, the federal government continues to pump liquidity into the economy with its huge and widening budget deficit. It rose to $2.3 trillion over the 12 months through June, as outlays increased while revenues decreased (Fig. 13 and Fig. 14).

US Economy III: The Case for Immaculate Disinflation. The second bearish script is that it takes a recession to bring inflation down. Here’s how that narrative goes: While inflation has moderated since last summer, it remains well above the Fed’s 2.0% target. So the Fed will have to raise interest rates further until that causes a recession, which would bring inflation down to 2.0% for sure. A few Fed officials suggested as much in reaction to last week’s better-than-expected CPI and PPI inflation readings for June. They apparently agree with the bears that expecting an immaculate disinflation (i.e., without a recession) is delusional. We don’t agree.

Consider the following counterpoints:

(1) So far, so good for goods. Last week was a good one for disinflationists. June’s reports on expected inflation, the CPI, and the PPI showed that inflation continues to moderate without an economy-wide recession. According to the University of Michigan’s Survey Research Center, consumers’ one-year-ahead expected inflation fell to 3.3% last month, the lowest readings since March 2021; it was little changed at 3.4% in mid-July. On a y/y basis, the headline and core CPI inflation rates fell to 3.0% and 4.8%, the lowest readings since March 2021 and October 2021. The PPI for final demand was up just 0.1%.

(2) Transitory after all. The CPI inflation rate for goods has turned out to be transitory, peaking last summer and falling to -1.2% y/y, with the CPI durable and nondurable goods down 0.8% and 1.3% respectively during June (Fig. 15). Inflation has been one of the shockwaves unleashed by the pandemic that is abating.

Excessively stimulative fiscal and monetary policies during the pandemic resulted in a buying binge for goods that overwhelmed global supply chains, as can be seen in the New York Fed’s Global Supply Chain Pressure Index (Fig. 16). This index soared from 0.11 during October 2020 to 4.31 during December 2021. It was down to -1.20 during June.

(3) Rent inflation is also transitory. In the CPI, rent inflation tends to be a laggard because it reflects rents on all outstanding leases. It is only now showing signs of peaking, while inflation in indexes of new rental leases peaked in early 2022 and are down sharply since then (Fig. 17). The headline and core CPI inflation rates excluding shelter were down to only 1.7% and 2.7% during June (Fig. 18).

(4) One counter example. The naysayers say that that the history of the CPI inflation rate since 1921 shows that the only way to bring inflation down is with a recession (Fig. 19). There was just one exception, immediately following the end of World War II. We are arguing that the current situation may turn out to be the second historical exception.

(5) Inflation isn’t always and everywhere just a monetary phenomenon. What’s different this time is that the high inflation was mostly caused by transitory shockwaves related to the pandemic. As they abate, so does inflation. Monetary policy is an important driver of inflation, but it isn’t the only cause of inflation. Even the Great Inflation of the 1970s was attributable to various developments, including commodity shortages, two oil price shocks, and a widening federal budget deficit.

(6) Inflation is usually symmetrical. The history of the CPI inflation rate suggests that inflation tends to be very symmetric. Once it peaks, it tends to fall at the same pace as it went up. It’s doing so again during the current inflation cycle.

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Travel, Banks & AI

July 13 (Thursday)

Consumer Discretionary: Everyone’s Got a Ticket To Ride. After being trapped at home during the Covid pandemic, “revenge travel” kicked in last year and continues to accelerate this summer. Everyone seems to be jetting off somewhere fabulous, ditching the Hamptons for a European holiday.

For the five days ending July 4, AAA predicted that 50.7 million Americans would travel 50 miles or more from home over the holiday—a new record surpassing the previous record of 49 million travelers in 2019. AAA also predicted that 4.17 million Americans would fly to their destination, 11.2% higher than in 2022 and 6.6% above the previous record of 3.9 million in 2019, a June 26 AAA press release stated.

Consumers’ travel bug is not news to investors, who have sent the share prices of travel-related companies to recent highs. Here’s the ytd price performance derby for some of the S&P 500’s travel-related industry indexes through Tuesday’s close: Hotels, Resorts & Cruise Lines (41.8%), Passenger Airlines (37.4), and Casinos & Gaming (28.5). All handily beat the S&P 500’s 15.6% ytd advance.

Their outperformance is just as dramatic when measured from the S&P 500’s low on October 12: Casinos & Gaming (58.2%), Hotels, Resorts & Cruise Lines (55.8), Passenger Airlines (48.3), and S&P 500 (24.1). Each of the three travel industries are among the top 11 performing industries in the S&P 500 since the 2022 market low.

Given the giddy optimism surrounding the industry, we thought it might be time to look for some clouds. Possible ice on the wings of travel stocks could be higher oil prices, rising expenses, or satiated demand. Here’s Jackie’s look at what could create turbulence that prevents travel stocks from flying higher:

(1) Oil prices could rise. The airline industry has benefitted from the sharp decline in fuel prices last year. The price of Brent crude futures has fallen 38% from its 2022 peak to its recent price of $79.40 a barrel (Fig. 1).

However, OPEC+ has made clear its intent to cut production to boost the price of oil. The organization has cut production by a total of 3.7 million barrels per day (mbd) in two different cuts in late 2022 and in April that will both extend through the end of 2024 (Fig. 2). That was followed in June by Saudi Arabia’s announcement that it will cut its production by roughly 1mbd to 9mbd through August. The oil producers must hope that their cuts will offset the unexpected increases in oil production from Russia and the US (Fig. 3). So far, their moves appear to have put a floor under the price of crude, which has edged higher in recent days.

(2) Expenses getting more expensive. Carnival Cruise Lines had lots of good news to report during its Q2 earnings release. Booking volumes were at an all-time high and 17% higher than they were in 2019. The company is making progress reducing its debt, and it has been able to increase prices.

However, the market initially focused on costs that the company warned would be higher than initially expected. It attributed the increase to incentive compensation programs, an increase in advertising, and a “slower-than-expected ramp-down in inflationary pressures than previously anticipated, particularly in the area of port costs, freight, crew travel due to air costs, and crew compensation,” said CFO David Bernstein on the company’s earnings conference call.

The company expects revenue to increase faster than expenses, allowing it to return to profitability in Q3 with earnings in the expected range of 70-77 cents per share. The forecast’s midpoint fell short of analysts’ 76-cent consensus, sending Carnival shares down 11% the day earnings were reported, a June 26 Reuters article reported.

Since then, the shares have rebounded, hitting a 52-week high, and analysts have increased their Q3 earnings estimate to 78 cents a share—higher than the company’s guidance. Carnival shares are up 134.5% ytd through Tuesday’s close, trumping the 104.9% ytd return turned in by Royal Caribbean shares and the S&P 500’s 15.6% ytd gain.

(3) Life after revenge travel. What happens after consumers take a revenge vacation or three? We have no doubt that vacations will still be taken, but perhaps spending on travel will increase more slowly or even plateau in 2024.

A breather certainly seems due. Personal consumption of air transportation has surged 38.0% from its pre-Covid record high in December 2019 of $124.7 billion (saar) to $172.1 billion this May. Likewise, spending on hotels and motels was $157.9 billion (saar) in May, up 26.5% from its December 2019 record high of $124.8 billion (Fig. 4).

(4) Analysts are awfully bullish. Travel industry analysts are optimistic that the industry’s good times will continue. They’re expecting strong earnings growth this year and next: S&P 500 Passenger Airlines (155.8% in 2023 and 19.1% in 2024), S&P 500 Hotels, Resorts & Cruise Lines (returning to a profit, 31.6%), and S&P Casinos & Gaming (returning to a profit, 73.6%) (Fig. 5, Fig. 6 and Fig. 7).

Because share prices have risen more sharply than earnings, forward P/E multiples in travel-related industries are lofty. The S&P 500 Casinos & Gaming industry’s forward P/E is 23.1, the highest of the three travel industries and near highest levels of the past two decades (Fig. 8). The S&P 500 Hotels, Resorts & Cruise Lines’ forward P/E is 18.6, not far from peaks of 20-23 in years past (Fig. 9). And the S&P 500 Passenger Airlines’ forward P/E is only 7.1, reflecting the industry’s cyclical nature (Fig. 10). (FYI: “Forward P/E” refers to the P/E based on forward earnings, which is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for the current year and following year.)

Financials: Is Bigger That Much Better? Bank earnings start to roll in later this week, and we’ll finally learn the impact that commercial real estate loans and higher interest rates are having on loan portfolios and profits. Entering this reporting season, big banks’ stocks are sharply outperforming the stocks of their much smaller counterparts, which were tarred by the bankruptcies of Silicon Valley Bank, Signature Bank, and First Republic Bank this spring.

The S&P 500 Diversified Banks stock price index is essentially flat ytd through Tuesday’s close, while the S&P 500 Regional Banks index has fallen 33.9% ytd. The recent performance of the two industries is more similar. Over the past four weeks, the Diversified Banks stock price index is up 1.1% while the S&P 500 Regional Banks stock price index is up 0.6%.

Let’s take a look at some of the similarities and differences between the two industries:

(1) Revenue. The revenue of banks in Diversified Banks is expected to grow faster than that of their regional counterparts. The Diversified Banks typically have large capital markets and asset management businesses that can help offset troubles in commercial and retail lending. Smaller banks are typically more reliant on revenue thrown off by their loan books.

Analysts expect Diversified Banks’ revenue to grow by 9.2% in 2023 and to decline by 0.2% in 2024 compared to Regional Banks’ expected revenue growth of 5.3% this year and a decline of 1.3% in 2024.

(2) Earnings. Earnings at smaller banks may take a bigger hit than at their larger competitors if reserves for commercial real estate loans need to increase. Commercial real estate makes up a larger percentage of small banks’ loan books (44.2%) than large banks’ (13.4%).

Here are some of the different loan categories and the percentages they represent in large and small bank loan portfolios: C&I loans (large banks: 22.4%, small banks: 16.3%), residential real estate loans (23.9, 20.9), commercial real estate loans (13.4, 44.2), consumer loans (20.9, 11.6), credit cards & revolving credit (11.9, 4.7), automobile loans (6.5, 1.8), and construction & land development (2.0, 7.7) (Fig. 11).

Analysts expect earnings for companies in the S&P 500 Diversified Banks index collectively to grow 12.0% this year and dip by 1.1% in 2024. The Regional Banks’ earnings are forecast to drop slightly for two years in a row, by 3.2% this year and 2.5% in 2024 (Fig. 12 and Fig. 13).

(3) Valuation. The S&P 500 Diversified Banks and Regional Banks indexes have depressed forward P/Es of 9.1 and 7.5, respectively. Both forward P/Es are close to levels normally reached during a financial crisis, indicating a lot of bad news is priced in. If earnings reports are even slightly better than expected, these industries’ stocks seem positioned to benefit (Fig. 14 and Fig. 15).

Disruptive Technologies: AI Develops Drugs. Scientists are grabbing onto artificial intelligence (AI) as a new tool in their quest to develop drugs faster and less expensively. The latest news on this front arrived yesterday from Recursion, a self-described “techbio” company. It received a $50 million investment from Nvidia, and the two companies will work together to accelerate the development of Recursion’s “AI foundation models” for biology and chemistry that it intends to distribute to biotechnology companies using Nvidia’s cloud services.

“With our powerful dataset and NVIDIA’s accelerated computing capabilities, we intend to create groundbreaking foundation models in biology and chemistry at a scale unlike anything that has ever been released in the biological space,” said Recursion CEO Chris Gibson in a press release.

Here’s a look at how Recursion and other researchers are harnessing AI:

(1) Nvidia provides biotech services. BioNeMo Service is a group of AI models developed by various companies that Nvidia is hosting in its cloud to help scientists understand and develop new proteins, small molecules, and DNA. The service allows scientists to focus on the structure of the drug candidates instead of dealing with the supercomputing infrastructure that Nvidia offers.

Nvidia’s AI offerings to predict proteins’ 3D structures include AlphaFold2, which was developed by Google’s DeepMind, and ESMFold, which was developed by Meta. Users can access MegaMolBART, which was developed by AstraZenca and Nvidia to design small molecules, or DiffDock, designed by MIT’s Jameel Clinic to predict the binding structure of a small molecule ligand to a protein. These and other AI applications are focused on accelerating drug discovery, according to a March 21 Nvidia blog.

(2) Baker Lab’s AI offerings. The University of Washington’s Baker Lab has developed RFdiffusion, a model for generating new proteins that it claims is better than existing protein design methods. The scientists parlayed the theories behind an AI program to create pictures to develop a program that facilitates protein discovery.

“The software tool DALL-E produces high-quality images that have never existed before using something called a diffusion model, which is a machine-learning algorithm that specializes in adding and removing noise. Diffusion models for image generation begin with grainy bits of static and gradually remove noise until a clear picture is formed. Additional pieces of software guide this de-noising process so that the new images end up matching what was asked for,” explains a July 11 publication on the lab’s website. “We have developed a guided diffusion model for generating new proteins called RFdiffusion. With prior design methods, tens of thousands of molecules may have to be tested before finding a single one that performs as intended. Using the new method, the team had to test as little as one per design challenge.”

(3) Powerful proteins. Scientists are focusing on harnessing vast amounts of computing power to design new proteins because many believe that proteins can cure what ails us. In the February 25, 2021 Morning Briefing, we discussed how scientists were targeting proteins responsible for ailments like cancer, Parkinson’s, and Alzheimer’s—which could point the way to potential cures for those diseases as well.

These new AI platforms will speed up research into those areas, with some caveats. For example, scientists will need to understand what causes a disease if they hope to cure it. Not understanding exactly what causes Alzheimer’s makes it difficult to design a protein that treats the disease, explained David Baker of the University of Washington’s Baker lab in an interesting EL PAÍS interview dated February 20. But if the cause of the disease is known, a cure can be arrived at quickly using the AI models.

The Baker Lab has designed a nasal spray that protects humans against Covid-19. Within the next year, they expect to learn whether the spray is efficacious; if so, they would be able to develop other nasal sprays to fight other viruses. Developing proteins using this technology happens in weeks, not months, which means it could be an important tool in fighting future pandemics.

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Sunny Or Cloudy Earnings Season?

July 12 (Wednesday)

US Inflation: Moderating Expectations. Monday was a sunny day for stocks and bonds following a few stormy days. That’s even though two Federal Reserve Bank (FRB) district presidents—Mary Daly, FRB-San Francisco and Loretta Mester, FRB-Cleveland—said that inflation remains too high and that more rate hikes will probably be necessary to bring it down. On the other hand, Raphael Bostic, president of FRB-Atlanta said the Fed’s “policy right now is clearly in the restrictive territory.” He is willing to be patient. We side with Bostic.

Monday’s good news on the economic front was that the FRB-New York’s survey of consumer expectations showed that the one-year-ahead inflationary expectations fell to 3.8%, the lowest since April 2021 and well below last summer’s readings of more than 6.5%. The three-years-ahead expectations edged down to 3.0% (Fig. 1). The one-year-ahead expectations series has been tracking the PCED inflation rate very closely since early 2021 (Fig. 2).

The question is whether the next batch of inflation data will be sunny as well. The same question applies to the Q2 earnings reporting season, which starts this week. For now, Joe and I are inclined to have sunny dispositions. Let’s see if we can keep them that way through this week’s inflation releases and the next few weeks’ earnings season.

US Earnings Season I: Low Expectations. The good news is that Q2 earnings expectations might be too negative for companies in the S&P 500/400/600 indexes (Fig. 3). Here are their actual Q1 and expected Q2, Q3, and Q4 y/y growth rates: the S&P 500 (-2.8%, -8.9%, -0.5%, 8.3%), S&P 400 (-7.2, -22.4, -5.7, 4.2), and S&P 600 (-3.0, -24.2, -10.5, 3.5). During periods of economic expansion, analysts tend to be too pessimistic at the start of earnings season. We expect that will be the case again this time.

Now let’s have a look at their annual forecasts:

(1) Earnings. Industry analysts are also still lowering their earnings estimates for S&P 500/400/600 for this year and for next year (Fig. 4). Here are their latest consensus expectations for earnings growth in 2023 and 2024: S&P 500 (0.5%, 11.7%), S&P 400 (-10.3, 13.0), and S&P 600 (-9.5, 13.5). The good news is that the forward earnings of the S&P 500/400/600 seem to be bottoming, as the higher expectations for next year’s earnings are getting more weight day by day.

(2) Revenues. Interestingly, there’s no recession in the analysts’ consensus expectations for S&P 500/400 revenues, though the same cannot be said for S&P 600 revenues (Fig. 5). The forward revenues of the S&P 500/400 rose to new record highs during the June 29 week. The forward revenues of the S&P 600 has been moving sideways in record-high territory since early 2022.

(3) Profit margins. So the earnings recession of the past year has been relatively mild and attributable to falling profit margins rather than falling revenues (Fig. 6). However, in recent weeks the forward profit margins of the S&P 500/400/600 seem to be bottoming, which explains why forward earnings are doing the same.

(FYI: “Forward earnings” and “forward revenues” are the time-weighted average of analysts’ consensus estimates for the current year and the following one. “Forward profit margins” are the margins calculated from forward earnings and forward revenues.)

US Earnings Season II: The Macro Environment. The weekly series for S&P 500 forward revenues is a very good coincident indicator of actual S&P 500 revenues (Fig. 7). Again, the former rose to a record high during the June 29 week.

Aggregate S&P 500 revenues is also highly correlated with business sales of goods and nominal GDP of goods (Fig. 8). There has been a growth recession among goods-producing industries since early last year. However, the S&P 500 also includes plenty of service-providing industries that have been doing very well. They’ve more than offset the weakness among the goods producers, which is why nominal GDP rose 7.2% y/y during Q1 to a record high.

So the macroeconomic environment should support the S&P 500’s Q2 revenues at a record high. Let’s briefly look at the macro variables that drive the revenues (and earnings) of selected industries:

(1) Banking. The Q2 earnings season starts off this week with the major banks reporting their results. Based on weekly data provided by the Fed, we know that loans and leases at the large domestic banks rose 3.0% y/y through the end of June (Fig. 9). We also know that allowances for losses increased 16.9% over the same period (Fig. 10). Banks undoubtedly responded to the banking crisis in early March by raising their deposit rates. That probably squeezed their net interest margins. Investment banking fees probably remained weak during Q2 given that the 12-month sum of new issues of US corporate bonds and stocks was $1.37 trillion, little changed from May’s $1.30 trillion, which was the lowest since fall 2012 (Fig. 11).

(2) Transportation. The airlines and cruise ships are packed with tourists. The restaurants and Taylor Swift concerts are also packed. The service-providing industries that cater to consumers are booming.

The trucks and railcars that haul merchandise to be sold by wholesalers and retailers to consumers aren’t doing as well, and their costs have gone up over the past year. Both the ATA truck tonnage index and intermodal container traffic have been weak lately, consistent with a growth recession in the goods-producing and distribution industries. Inflation-adjusted real consumer spending on goods has been flat since the second half of 2021 (Fig. 12).

(3) Industrials. Demand for civilian aircraft is booming. Orders for construction machinery are up 13.5% y/y through May to the highest reading since March 2008 (Fig. 13). They undoubtedly are getting a boost from the onshoring of manufacturing and public spending on infrastructure. Industrial machinery orders are down 6.4% y/y but should be rising soon, reflecting the boom in construction of manufacturing facilities.

(4) Semiconductors & high-tech hardware. The upturn in the forward earnings of the S&P 500 Semiconductors industry suggests that worldwide semiconductor sales have bottomed and should be on the rise over the rest of this year (Fig. 14). US industrial production of high-tech equipment rose to a new record high in May, led by an 11.1% y/y increase in computer & peripheral equipment output (Fig. 15).

(5) Restaurants & retailers. Restaurant sales are booming. Retail sales of food services & drinking places rose 8.0% y/y through May (Fig. 16). They now exceed spending on food consumed at home. Retail sales excluding building materials and food services have been flat since the second half of 2021. Sales of warehouse clubs and super stores also were flat y/y in April. The same can be said for housing-related retail sales (Fig. 17).

US Earnings Season III: A Sweet & Sour Outlook. Joe has been tracking the analysts’ consensus S&P 500’s quarterly earnings forecast each week since the series started in Q1-1994. Each quarter typically begins with analysts cutting their estimates gradually until reality sets in during the quarter’s final month, when some companies warn of weaker results. The combination of reduced forecasts for poorly performing companies and steady forecasts for companies quietly keeping good news close to their vests inevitably leads to an “earnings hook” in the charted data series, a.k.a. a positive surprise, when the results are released during the subsequent earnings reporting season.

During the strong recovery following the Great Virus Crisis (GVC), analysts scrambled to raise their forecasts for six straight quarters from Q2-2020 through Q3-2021, but they still didn’t come close to the actual earnings. The S&P 500 recorded unusually high double-digit percentage earnings beats for the first time since the aftermath of the Great Financial Crisis (GFC). The tide turned after Q1-2022. But signs of a turnaround in the y/y growth rates are emerging amid a slower pace of estimate cutting.

I asked Joe to separate the good news from the bad news:

(1) Less drastic estimate cutting. After falling slightly during H1-2022, the pace of estimate declines throughout the quarter accelerated in Q3-2022, when it dropped 6.6%. The pace of declines remained elevated during Q4-2022 and Q1-2023 but has abated for Q2-2023. The Q4-2022 estimate was down 5.9% during the runup to its earnings season; the Q1-2023 estimate was down a nearly similar 6.2%. The Q2-2023 estimate has dropped just 2.5% in its slowest decline since Q2-2022.

Q2-2023’s meager estimate decline marks a return to estimate cutting as usual. In the 105 quarters from Q2-1994 to the GVC in Q2-2020, the estimate fell during 90 quarters in the runup to earnings season, or more than 85% of the time. Half of the gains occurred following the GFC, when shell-shocked analysts mistimed the recovery.

Similarly, since the GVC, the quarterly estimate rose for six straight quarters through Q4-2021, before the earnings recovery began to run out of steam during H1-2022. Including Q2-2023, the quarterly estimate has now declined for six straight quarters.

(2) Fewer sectors have falling estimates now. Analysts had been too bullish and overestimated the length of the post-GVC boom in earnings, resulting in very broad quarterly earnings declines at the sector level during their runup to the earnings seasons through Q1-2023. At the peak of optimism in Q2-2021, nine of the 11 S&P 500 sectors had their quarterly estimate rise during the quarter. By Q1-2022, that count was down to five sectors (Energy, Financials, Real Estate, Tech, and Utilities) before dwindling to just one sector during Q3-2022 (Energy), Q4-2022 (Utilities), and Q1-2023 (Utilities). The broad sector declines have ended with the upcoming Q2-2023 season, with the Q2 estimate rising for four sectors (Fig. 18).

Among the four sectors, Industrials’ Q2-2023 estimate has risen 2.9% since the end of Q1-2023, edging out Communication Services (2.8%) and well ahead of Tech (0.7) and Consumer Discretionary (0.3). Financials has held up surprisingly well despite the regional bank crisis in early March, while Energy’s declines have accelerated.

Here's how much each sectors’ Q2-2023 estimate changed over the course of the quarter: Industrials (2.9%), Communication Services (2.8), Tech (0.7), Consumer Discretionary (0.3), Utilities (-2.9), Financials (-3.1), Health Care (-4.4), Real Estate (-6.2), Consumer Staples (-7.3), Materials (-8.0), and Energy (-15.2).

(3) More sectors to show y/y growth in Q2-2023, but Energy drags down the S&P 500. Six sectors are expected to record positive y/y percentage earnings growth in Q2-2023, up from five sectors doing so in Q1-2023 and only two sectors in Q4-2022 (Energy and Industrials). With 26.6% expected y/y growth for Q2-2023, Consumer Discretionary is the only sector projected to be a double-digit percentage grower. A distant second is Communication Services (9.3%), followed by Industrials (6.7), Financials (5.4), Consumer Staples (1.9), and Utilities (1.6).

Despite the rising number of sectors with positive y/y growth, analysts expect the S&P 500’s earnings growth rate to be negative on a frozen actual basis for a third straight quarter in Q2-2023, weakening to -8.9% y/y from -2.8% in Q1-2023 and -1.6% in Q4-2022. On a pro forma basis, they expect earnings to decline 5.7% in Q2-2023 following a surprising 0.1% gain in Q1-2023 and a 3.2% decline in Q4-2022.

Excluding the Energy sector, S&P 500 earnings are expected to decline just 0.7% y/y in Q2—the fifth straight y/y decline in this data series but less of a drop than the 1.6% decline in Q1-2023 and the 7.4% drop in Q4-2022. A strong surprise could result in positive y/y growth for the S&P 500 on a pro forma basis yet remain negative on a frozen actual basis.

Here are the five sectors expected to report a y/y earnings decline in Q2: Energy (-45.5%), Materials (-29.0), Health Care (-15.9), Real Estate (-4.9), and Tech (-3.0).

(4) Y/y growth streaks: winners and losers. The S&P 500 is expected to record its third straight quarter of y/y earnings declines in Q2-2023 on a frozen actual basis. The Industrials sector remains on a strong positive earnings growth path, with Q2-2023 possibly marking nine straight quarters of growth. Communication Services is expected to rise y/y in Q2-2023 for the first time in six quarters, but Materials and Tech are expected to mark their fourth straight y/y decline in quarterly earnings. However, a strong earnings beat could turn Tech’s growth rate positive.

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Stay Home Or Go Global?

July 11 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Global Strategy I: Weak Growth, Strong Stocks. The All Country World MSCI stock price index is up 11.2% in dollars so far this year through July 7 (Fig. 1). The US MSCI is up 14.8% over this period (Fig. 2). It makes sense that the US index would be up more than the global one since the US economy has been growing faster than most expected at the beginning of this year. More surprising is that the All Country World ex US MSCI is up 5.6% in local currency and 5.8% in dollars since the start of the year notwithstanding weaker-than-expected economic growth in Europe and China (Fig. 3).

That’s all quite impressive, especially in the face of the ongoing tightening of monetary policy by the major central banks around the world. Some of the bullishness among global stock market investors may reflect relief that global economic activity hasn’t weakened as much as was feared in response to the tightening of global monetary policies since early last year.

The dire consensus views on several major economies of the world during the second half of last year failed to pan out. It was widely believed that the US would fall into a recession in early 2023 as consumers ran out of excess savings accumulated during the pandemic, that the shortage of natural gas resulting from Russia’s invasion of Ukraine would cause Western European economies to freeze in the dark last winter, and that the Chinese government’s severe pandemic lockdowns would depress China’s economy, exacerbate the country’s property crisis, and disrupt global supply chains.

As these worst-case scenarios didn’t play out, stock markets climbed the wall of worry impressively. In addition, foreign stock markets were extremely undervalued relative to the US. So they had more upside room from a valuation perspective. Consider the following:

(1) Lackluster global growth. Debbie and I like to monitor our daily Global Growth Barometer (GGB) to assess whether global economic activity is growing or slowing (Fig. 4). The GGB is the average of the Brent crude oil nearby futures price and the CRB raw industrials index (multiplied by 2 and divided by 10). Our GGB closely tracks the S&P Goldman Sachs commodity index (Fig. 5). However, we prefer our GGB because it does not include agricultural and lumber prices and because we can track the contributions of the CRB index (which does not include energy, food, or lumber commodities) and the price of oil to our GGB (Fig. 6).

Our GGB peaked near the beginning of last year at 130.7 on March 8. It fell to 99.9 by the end of 2022. On Friday, July 7, it was down to 94.5. By the way, both our GGB and the S&P Goldman Sachs index are inversely correlated with the trade-weighted dollar (Fig. 7 and Fig. 8). The dollar tends to be strong (weak) when the global economy is relatively weak (strong) compared to the US. The dollar has been range-bound since the start of the year, even though the US economy has performed relatively well compared to the rest of the world.

(2) European recession. Figures from Eurostat, the EU’s statistical agency, showed that the Eurozone’s real GDP fell by 0.1% during Q1-2023 and Q4-2022 after revisions to earlier estimates. A technical recession is generally defined as two consecutive quarters of negative growth. With consumers under pressure from the higher energy and food prices, household final consumption dragged down GDP across the Eurozone by 0.3% after a larger 1.0% drop in the previous quarter.

On a y/y basis, the region’s real GDP rose by 1.0%, the weakest since Q1-2021. This series is highly correlated with the Eurozone’s economic sentiment indicator, which has been fluctuating below 100 since July 2022 (Fig. 9). Germany’s IFO business confidence index also remained relatively depressed in June, at 88.5, led by weakness in its expectations index (83.6); its current situation index edged down to 88.5 (Fig. 10).

These recent results were not as bad as was widely anticipated last summer.

(3) China’s anemic recovery. The Chinese government lifted its strict pandemic lockdown requirements at the end of last year. The widely expected strong rebound in the country’s economy was disappointing. The official manufacturing index rose above 50.0 during the first three months of this year (Fig. 11). It has been back under that breakeven level since then through June. The services PMI rebounded more significantly, to a high of 56.9 during March, but was back down to 52.8 in June.

On Monday, we learned that China’s PPI for total industrial products fell deeper into deflationary territory with a reading of -5.4% y/y (Fig. 12). The CPI was flat y/y during June and could also turn negative in coming months.

The price of copper tends to be especially highly correlated with China’s economic activity and MSCI stock price index (Fig. 13). Both prices rose sharply when the government ended the lockdowns but have given back much of those gains in recent months.

China has at least two chronic problems that are likely to weigh on economic growth for several years. The country’s rapidly aging demographic profile is already depressing retail sales growth (Fig. 14). China's property sector has been thrust into a severe debt crisis over the past two years. It was initially triggered by government moves to rein in ballooning debt, with many developers defaulting on payments as they struggled to sell apartments and raise funds. The country’s real estate property crisis is likely to persist.

(4) Submerging emerging economies. The weakness in China’s stock market has weighed on the Emerging Markets MSCI stock price index, which is up just 2.5% ytd in local currency and 3.3% in dollars (Fig. 15). The CRB raw industrials spot price index is highly correlated with the Emerging Markets MSCI in both local currency and in dollars (Fig. 16). The latter doesn’t do well when industrial commodity prices are weak, as they are currently.

Global Strategy II: US vs the World. Let’s have a closer look at the performance of the US MSCI to the rest of the world:

(1) Performance derby. Since the start of the bull market on October 12, 2022, the US MSCI is up 22.8%. Here is the performance derby in dollars and in local currency for the major MSCI stock price indexes: EMU (39.3%, 23.5%), Europe (30.7, 15.9), US (22.8, 22.8), Japan (25.7, 21.7), All Country World (22.4, 19.2), UK (22.0, 5.3), All Country World ex US (21.7,13.7), and Emerging Markets (13.3, 10.7).

(2) Relative performance. Joe and I track the ratios of the US MSCI to the ACW ex US in both local currency and in dollars (Fig. 17). Both ratios have been on uptrends since 2009, confirming our preference for a Stay Home investment strategy over a Go Global one. That’s especially true for the ratio in dollars.

We’re sticking with our Stay Home strategy recommendation.

(3) Valuation. We may be overstaying our welcome in the Stay Home approach of overweighting the US in global portfolios. After all, the forward P/E of the US MSCI was 19.4 at the end of June, well above those of the UK (10.2), EMU (12.1), Emerging Markets (12.2), and Japan (14.6) (Fig. 18). The ratio of the US forward P/E to the ACW ex-US valuation multiple remains historically high at 1.52 (Fig. 19). That’s still true if we remove the MegaCap-8 stocks from the US MSCI: The index’s forward P/E is 19.4 with them and 16.5 without them.

Japan I: Hot Stock Market. One of the hottest markets in the world in recent weeks has been Japan’s Nikkei (Fig. 20). This index has a strong inverse correlation with the yen, which has been very weak recently because the Bank of Japan (BOJ) is lagging all the other major central banks in normalizing its monetary policy, as Melissa discusses below.

The Japan MSCI soared 7.6% during June as its forward P/E jumped from 14.0 to 14.6. The rally was fueled by news on Monday, June 19 that Warren Buffett’s Berkshire Hathaway added to its holdings in Japan’s five biggest trading houses. That likely underpinned the strong buying momentum that propelled the nation’s stock market to multi-year highs.

Japan II: BOJ Policy Uncertainties. On June 16 in its Statement on Monetary Policy, the BOJ upheld its long-standing ultra-loose monetary policy, including its yield curve control (YCC) bond-purchasing plan. Financial market participants are wondering how long it will keep doing so.

Inflation in Japan has been surpassing the BOJ’s 2.0% inflation target in recent months, as discussed below, and recent wage inflation has been substantial. In April, when Governor Kazuo Ueda took his post, the BOJ removed its promise to keep interest rates at current or lower levels. That was widely viewed as a first step toward normalizing monetary policy. But Governor Ueda defended the BOJ’s decision not to change rates or the YCC in June.

Now market watchers are carefully scanning the horizon for hints of the BOJ tweaking its YCC policy, by slowing the pace of bond purchases or eliminating the aspect of the program that targets long-term interest rates altogether. Likely, this change is forthcoming. YCC will have to end eventually, as already the BOJ owns a large share of the Japanese bond market, a Bloomberg article recently observed. The BOJ’s new quarterly growth and inflation projections are due at its next rate review on July 27-28.

Let’s dive into where the BOJ currently stands:

(1) Unchanged policy. The BOJ maintained its ultra-loose monetary policy last month, keeping the short-term interest rate target at -0.1% intact and not changing its YCC policy. Governor Ueda championed the BOJ’s stance, highlighting underlying inflationary softness despite headline inflation exceeding 3.0%. Notably, Japan’s CPI inflation rate excluding fresh food has consistently overshot the BOJ’s 2.0% target for the past 14 months (Fig. 21).

(2) Uncertain inflation. Governor Ueda cautiously articulated a guarded outlook on inflation stability in the years ahead. Nevertheless, he acknowledged that once the central bank attains sufficient confidence that it can achieve a sustainable rate of inflation, that could potentially serve as a catalyst for policy adjustments.

Paving the way for wage inflation to surge, workers have been basking this year in the glow of the most substantial pay hikes witnessed in 30 years, courtesy of annual negotiations with premier Japanese firms. That’s according to a survey conducted by Rengo, Japan's umbrella trade union group, Reuters reported on July 5. But the bank will want to see real wages consistently rising as inflation stabilizes. Real contractual earnings per employee per month in Japan declined 1.5% on a yearly basis through May (Fig. 22). Nominally, the same figure rose 1.7%.

(3) U-shaped recovery? The bank expects a measured recovery in Japan’s economy around the midpoint of fiscal 2023, propelled by pent-up demand. Earlier this month, Q1 growth in Japan was revised upward to an annualized 2.7% from estimates of 1.6%, according to a Reuters survey. Real GDP rose 1.8% y/y through Q1 (Fig. 23). Factors such as fluctuating commodity prices and the deceleration of overseas economies loom large as potential impediments to growth, according to the BOJ’s statement.

(4) Uncertain curve. On June 25, a summary of opinions from the BOJ’s June meeting showed that a BOJ policymaker called for an early revision to its controversial YCC, reported Reuters. The policymaker said that the bank needs to prevent sharp fluctuations in interest rates in the future phase of an exit from current monetary policy. Like the April statement change, any shift in the YCC policy could indicate that the tide slowly could be turning for the BOJ’s ultra-loose monetary policy. The YCC aims to anchor 10-year Japanese government bond yields around the zero mark through appropriate purchases of government bonds.

In December, the BOJ widened the band around its yield target. The central bank stressed that this change was not a step toward abandoning the YCC but was intended to strengthen market functioning. Meanwhile, the assets on the bank’s balance sheet remain unprecedentedly high, having risen from around 450 trillion yen during 2016 at YCC’s start to nearly 750 trillion yen today (Fig. 24).

(5) Unconventional contrasts. In stark contrast to the BOJ’s unyielding ultra-easy policy stance, the US Federal Reserve has been tightening over the past year—most recently keeping rates unchanged after an aggressive series of hikes—while the European Central Bank has taken the bold step of raising its main rates to their loftiest levels in over two decades. It’s likely that the BOJ won’t be as aggressive as those two counterparts but will be on a normalizing path soon too.

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Fully Employed

July 10 (Monday)

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

US Labor Market I: Another Soft-Landing Month. Friday’s employment report released by the Bureau of Labor Statistics (BLS) suggests that the Index of Coincident Economic Indicators (CEI) probably rose slightly in June, by 0.2%, to yet another record high. The CEI has posted only one decline over the past 11 months, climbing 1.9% over the period. That’s even though the Index of Leading Economic Indicators (LEI, which historically has predicted changes in the economic cycle by an average of 12 months in advance) has fallen sharply since peaking during December 2021 (Fig. 1). Real GDP growth on a y/y basis tracks the comparable growth rate of the CEI (Fig. 2). The former was up 1.8% during Q1, while the latter was up by the same amount through May.

Let’s review the outlook for June’s CEI based on what we know from June’s employment report:

(1) Payroll employment is one of the four components of the CEI (Fig. 3). It rose 209,000 m/m during June to a new record high. It counts the number of jobs both full-time and part-time. Among payroll employment, the following industries rose to record highs during June: construction, educational services, financial activities, heavy & civil engineering construction, health care & social assistance, hospitals, professional & business services, transportation & warehousing, and wholesale trade.

The household measure of employment, which measures the number of workers with one or more jobs, rose 273,000 during June, led by a 382,000 increase in full-time employment to a record high (Fig. 4). The labor force rose less than household employment; it rose by 133,000, so the unemployment rate fell from 3.7% in May to 3.6% in June. The labor market’s performance continues to be very impressive indeed.

(2) Real personal income less transfer payments rose 0.3% m/m during May. The biggest component of this CEI series is wages and salaries. In June, our Earned Income Proxy (EIP) for private-sector wages and salaries rose 0.8% m/m in current dollars as the workweek rose 0.3%, payrolls increased 0.1%, and average hourly earnings increased 0.4% (Fig. 5). It’s likely that the headline PCED rose 0.2% m/m in June. If so, then our inflation adjusted EIP rose by a solid 0.6% to a new record high in June (Fig. 6).

Also likely rising to a new record high in both nominal and real terms during June is the sum of the following components of personal income: dividend income, interest income, proprietor’s income, and rental income (Fig. 7 and Fig. 8). During May, these four sources of income totaled $6.3 trillion compared to $11.7 trillion for wages and salaries, and the four together accounted for 27.3% of personal income. Collectively, they were up 0.3% m/m and 5.5% y/y during May to yet another record high.

(3) Real manufacturing & trade sales is an estimated component of the CEI. It includes retail sales, which will be released for June on July 20. At the same time, the sales of total manufacturing and trade will be released only through May. In the past, inflation adjusted retail sales was highly correlated with our EIP since the main source of purchasing power for most Americans is wages and salaries (Fig. 9).

However, real retail sales has been flat on a record-high plateau since early 2022 following consumers’ goods-buying binge during the pandemic. Real retail sales probably rose slightly in June. We do know that retail motor vehicle sales rose 4.4% m/m during June to 15.8 million units (saar) (Fig. 10).

(4) Industrial production is the fourth component of the CEI. Again, June’s employment report provides a good clue for what it did last month. Aggregate weekly hours worked in manufacturing was flat during June, suggesting the month’s industrial production will be flat too (Fig. 11). That’s confirmed by the weakness in the M-PMI’s production and new orders components during June (Fig. 12).

(5) Bottom line. June’s CEI is likely to confirm that real GDP continued to grow by around 2.0% y/y during Q2. As of July 6, the Atlanta Fed’s GDPNow tracking model predicted that real GDP rose 2.1% q/q (saar) during Q2.

On the other hand, the LEI likely fell again in June. In our opinion, the LEI has been a misleading indicator lately. Even so, a recession remains possible, maybe next year, if the Fed continues to tighten monetary policy because the economy remains resilient (as demonstrated by the CEI) and inflation remains persistent. Nevertheless, our subjective odds of a soft-versus-hard landing remain at 75/25 through the end of next year, for now.

US Labor Market II: Wage Inflation Still on Moderating Trend. Friday’s employment report didn’t provide much relief on the inflation front. Average hourly earnings (AHE) for all workers rose 4.4% y/y during June, the same as in May (Fig. 13). However, that’s down from last year’s peak of 5.9% during March. AHE for production and nonsupervisory workers peaked last year at 7.0% and was down to 4.7% in June.

Fed Chair Jerome Powell frequently has said that wage inflation around 3.0% would be more consistent with the Fed’s 2.0% target for consumer price inflation. We think that both can get to those levels with the current restrictiveness of monetary policy and without a recession. Another 50bps hike in the federal funds rate during the second half of this year wouldn’t change our view. A hike greater than that would.

The good news is that inflation adjusted AHE for production and nonsupervisory workers, who account for about 80% of payroll employment, has been rising along its long-term 1.2% annualized growth rate again for the past six months after stagnating over the past three years (Fig. 14). We’ve contended that consumers’ spending will continue to grow even once they deplete their excess saving (accumulated during the pandemic) because we expect that real wages will grow. So far, so good. By the way, rising real wages suggests that productivity growth is making a comeback.

US Labor Market III: Revisions, Job Openings, Quits & ADP. It was hard to find anything wrong with June’s employment report. But the nattering nabobs of negativism pounced on the 196,000 downward revisions in payroll employment during the first five months of this year (Fig. 15). Even so, payrolls rose by 1.46 million over that period.

Among Fed Chair Powell’s favorite labor market indicators is job openings. The latest reading is for May (Fig. 16). It edged down but remained elevated at 9.8 million, or 1.6 jobs for each unemployed worker. Meanwhile, we know that job openings remained high during June based on the “jobs plentiful” series included in the consumer confidence survey and the “small business with job openings” series from the National Federation of Independent Business’s survey of small business owners. The jobs plentiful series is also highly correlated with quits, which rose in May and remained elevated at 4.0 million (Fig. 17).

Finally, the following table compares June’s BLS and ADP measures of employment on a m/m and y/y basis. They can differ quite a bit on a m/m basis and even on a y/y basis. The devil definitely is in the detail. Our conclusion is that the labor market remains strong, but not as strong as suggested by June’s ADP report.

Movie. “The Diplomat” (+ +) (link) is an eight-part mini-series on Netflix starring Keri Russell, who plays a career diplomat sent to London to be the US ambassador to the United Kingdom during an international crisis. Her husband, played by Rufus Sewell, is a retired high-profile diplomat in his own right, but is the ambassador’s “wife,” who is constantly meddling in her professional affairs. The series starts off slowly but picks up steam by the third episode.

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Getting Harder To Be A Contrarian

July 06 (Thursday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

US Economy I: Godot Watch. One of our accounts sent me an email on July 4 alerting me to several recent stories in the financial press declaring that there won’t be a recession after all. He asked: “How much are you worried about stories like the attached, where the conventional wisdom seems to have already converged to your view in news articles widely by now? What are the prospects that this is close to spoiling the party soon enough?”

Here are the articles he flagged and my brief summaries of their upbeat assessments:

(1) “The case for a 2023 US recession is crumbling” (CNN, June 5). Matt Egan observes that this was the year that was widely expected to be a recessionary one. But he notes that “the case for a 2023 US recession is crumbling for a simple reason: America’s jobs market is way too strong.” However, he ends his upbeat article by warning that the resilient economy might force the Fed “to slam the brakes even harder.” That could set the stage for a recession in 2024.

(2) “Where’s the Recession We Were Promised?” (WSJ, June 23). James Mackintosh starts his column by reporting, “The 2023 recession is missing in action.” He argues that there were two “pieces of surprisingly good news.” First, in his opinion, is that energy prices dropped as Europe was able to replace Russian gas with alternative sources. Second, the US economy has been remarkably resilient in the face of the tightening of Fed policy. Mackintosh attributes that to the fact that borrowers locked in historically low rates during the pandemic. Under the circumstances, he isn’t convinced that the inverted yield curve will be followed by a recession: “The key lesson of the yield curve is that inversion doesn’t guarantee recession, but it is foolish to dismiss it.”

Sure enough, mortgage applications for refinancing and for home purchases rose sharply during 2020 and 2021 when mortgage rates fell to record lows (Fig. 1 and Fig. 2). Nonfinancial corporations raised a record amount in the bond market during 2020 and 2021, with much of those funds used to refinance outstanding debt at record-low interest rates (Fig. 3 and Fig. 4).

(3) “There Won’t Be a Recession This Year. You Can Take That to the Bank” (Barron’s, June 23). In his column, Andy Serwer states, “What I’m doing, of course, is ridiculing the most widely predicted economic event in modern history—which seems pretty certain not to happen.” He observes that a recession seems very unlikely during the rest of this year given the strength of the labor market, the crowded airports, the rebounding of consumer confidence, and the biggest boost in Social Security benefits since 1981.

We’ve been making the point that fiscal policy has never been this stimulative prior to previous recessions, thus reducing the likelihood that another one is imminent. Serwer agrees: “But the most positive fact, certainly over the longer term, is the underrecognized $2 trillion of spending from Washington in three bills: the Infrastructure Investment and Jobs Act, the Creating Helpful Incentives to Produce Semiconductors and Science Act, and the Inflation Reduction Act.”

Spending by federal, state, and local governments on goods and services in real GDP rose 3.1% over the past three quarters through Q1 (Fig. 5). This is just the beginning of a significant upturn in such government outlays.

(4) “Is it Time to Cancel the Recession Altogether?” (Bloomberg, June 27). Jonathan Levin reports that the “US economy keeps surprising the doomsayers.” He lists three better-than-expected economic indicators released on June 27. He quotes me as follows: “Here’s Yardeni Research’s Ed Yardeni’s spot-on take on the numbers (emphasis mine): ‘The permabears will have to postpone their imminent recession yet again based on today’s batch of US economic indicators, which suggest that our “rolling recession” is turning into a ‘rolling expansion.’”

Levin notes: “For the past 15 months or so, economists and strategists have been obsessed with Federal Reserve history and the yield curve.” That blinded them to the strength of household and business balance sheets as well as the strong job market, which was recently confirmed by three measures of job openings (Fig. 6).

(5) “Waiting for the Godot Recession” (Bloomberg, June 28). John Authers writes: “That the US economy is expected to plunge into a recession later this year is perhaps the most anticipated downturn on record. The last two years have been a chronicle of a recession foretold. But global investors who had positioned their portfolios for the slowdown have been left twiddling their thumbs (and losing out) as the economy shows one sign of strength after another.”

(6) Bottom line. Our no-hard-landing scenario has been at odds with the consensus hard-landing scenario since early last year. Indeed, it was mocked by a few of the permabears as obviously “delusional.” Just to be clear, we’ve been arguing that the US has been in a recession since early last year, i.e., a rolling recession. Now we are seeing signs of a rolling recovery in the sectors that were hardest hit by the tightening of monetary policy and consumers’ pivot to purchasing more services while buying fewer goods.

Nevertheless, the tables have turned, as evidenced by the articles listed above. The hard-landing scenario now seems to be the delusional one. As a result, our contrarian defensive mechanisms have been activated. We’re sticking with the change we made last week in our subjective probabilities of a soft-versus-hard landing from 70/30 to 75/25. But we are on high alert for what could go wrong now that everything seems to be going better than had widely been expected.

In this light, let’s consider what still could go wrong, resulting in a recession perhaps in 2024. We do so in the next section.

US Economy II: What Could Go Wrong? Ed Hyman, our good friend (and role model), is chairman of Evercore ISI and vice chairman of Evercore. He heads Evercore ISI’s Economic Research Team. He appeared on “Bloomberg Surveillance” Wednesday morning.

Ed is convinced that a recession is coming for three reasons. First is the inversion of the yield curve. Second is the drop in M2. Third is the significant tightening of monetary policy resulting from the increase in the federal funds rate combined with quantitative tightening (QT). Meanwhile, our friends at BCA Research warn that consumers’ excess saving could run out as soon as September.

A more immediate risk to the economy is a possible strike by 300,000 UPS workers. Bloomberg (July 5) reports: “Weeks of talks between UPS and the Teamsters fell apart early Wednesday morning in Washington after stretching through the July 4 holiday, with beleaguered negotiators emerging just after 4 a.m. to say the talks had collapsed.” A union spokesperson said that union employees will not work beyond July 31 when the current contract expires.

Let’s revisit our upbeat response to the most frequently cited reasons to be worried about a recession:

(1) Falling leading indicators and M-PMI. The Index of Leading Economic Indicators (LEI) peaked at a record high during December 2021 (Fig. 7). It is down 9.4% since then through May. The LEI correctly anticipated the previous eight recessions with an average lead time of 12 months.

We’ve previously shown that the LEI is biased, giving more weight to the manufacturing than the services sectors of the economy. The y/y percent change in the LEI (which was down 7.9% in May) closely tracks the M-PMI (which fell to 46.0 during June) (Fig. 8). Both are consistent with our rolling recession scenario, with the recession currently rolling through the goods sector. That’s confirmed by the weakness in the ATA truck tonnage index and railcar loadings of intermodal containers over the past year (Fig. 9).

(2) Inverted yield curve. Melissa and I “wrote the book” on the yield curve in 2019. It is titled The Yield Curve: What Is It Really Predicting?. We concluded that inverted yield curves signal that investors believe that the Fed’s continued tightening of monetary policy would result in a financial crisis, which could turn into an economy-wide credit crunch and recession. It is credit crunches that cause recessions, not inverted yield curves that anticipate these events.

This time, the yield curve inverted last summer. It once again correctly anticipated a banking crisis, which occurred in March. What is different this time, so far, is that the Fed responded very quickly with an emergency bank liquidity facility, which has worked to avert an economy-wide run on the banks and a credit crunch, so far (Fig. 10).

So there has been no recession, so far. There still could be if the banking crisis slowly turns into a credit crunch. That’s why Melissa and I are closely monitoring the weekly commercial banks’ balance-sheet data (Fig. 11). They show that bank deposits peaked at a record $18.2 trillion during the week of April 13, 2022 and fell to $17.3 trillion during the June 21, 2023 week. Yet bank loans remained at a record high of $12.1 trillion during the June 21 week. Banks held a record $5.8 trillion in securities during the week of April 13, 2022. This sum has dropped by $645 billion to $5.2 trillion as the securities have matured. Banks are using the proceeds to offset the weakness in their deposits and to make loans.

(3) Declining M2. Monetarists seem to be making a comeback, and they are sounding the alarm that the recent weakness in the M2 measure of money is confirming that monetary policy already is tight enough to cause a recession. We’ve addressed this issue in the past, and we still aren’t alarmed.

The money supply as measured by M2 climbed $130.9 billion in May after falling the prior nine months by $1.0 trillion (Fig. 12). It is down $897 billion since it rose to a record high during July 2022. It is down 4.0% y/y. However, M2’s decline follows a $6.3 trillion (41%) increase from January 2020 (just before the start of the pandemic) through its record high. M2 still remains about $2 trillion above its pre-pandemic uptrend!

As we noted above, the weakness in bank deposits has been partly offset by the proceeds from maturing securities held by the banks. Meanwhile, demand deposits in M2 totaled $5.0 trillion during May. We reckon that’s $1.5 trillion above the pre-pandemic trendline in deposits. Demand deposits currently account for 24% of M2, up from 10.3% during January 2020 (Fig. 13). M2 hasn’t been this liquid since September 1972!

(4) Running out of excess savings. The yearly change in M2 has been closely tracking the 12-month moving sum of personal savings, suggesting that there’s still plenty of excess savings left based on our analysis of M2 above (Fig. 14).

This conclusion is confirmed by Fed data on the ownership of deposits plus money market funds by generation cohorts. Here are their Q1 holdings and the increases since Q4-2019 in these liquid assets: Silent ($2.6 trillion, -$65 billion), Baby Boomer ($8.9 trillion, +$2.5 trillion), GenX ($3.9 trillion, +$1.1 trillion), and Millennial ($1.6 trillion, +$625 billion) (Fig. 15).

Again, we reckon that the excess liquid assets held by the Baby Boomers alone ranged between $1.0-$2.0 trillion at the end of Q1.

(5) Tightening monetary policy. Ed Hyman is certainly right about monetary policy. It is very restrictive, especially considering the tightening of lending standards in reaction to the March banking crisis as well as the ongoing QT program. He expects that the Fed’s rate hiking is “one and done.” Presumably, mounting evidence of an impending recession and disinflation would stop the Fed from implementing additional rate hikes.

I would counter that tight monetary policy has been offset somewhat by very stimulative fiscal policy. In the past, fiscal stimulus usually occurred at the tail end of recessions or even once they were over. This time, plenty of fiscal stimulus has been enacted before the next recession. That’s another reason why the next recession has been a no-show so far.

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Rolling Recovery

July 03 (Monday)

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

US Economy: Rolling Along. The Fed has raised the federal funds rate by 500bps since March of last year and seems to be on course to raise it by another 50bps over the rest of this year. Despite the monetary tightening, the US economy has avoided falling into an economy-wide recession. Instead, it has been experiencing a rolling recession since early last year, rolling through various industries at various times.

Now the economy is showing signs of experiencing a rolling recovery. Growing confidence in the resilience of the economy has been one of the main reasons why the stock market has been so strong since October 12, with the S&P 500 up 24.4%, the Nasdaq up 32.4%, and the S&P 500 Transportation index up 21.0% since that date.

Let’s review some of the signs of that resilience and why we think that the rolling recession is turning into a rolling expansion:

(1) GDP growth has slowed but remained positive. It has been a soft-landing for real GDP so far. Here are the q/q increases over the past three quarters at a seasonally adjusted annual rate (saar): Q3-2022 (3.2%), Q4-2022 (2.6%), and Q1-2023 (2.0%). The most recent quarter’s number was revised up from an initial estimate of 1.1% (Fig. 1).

Real final sales growth rates for the past three quarters were mostly strong at 4.5%, 1.1%, and 4.2% (Fig. 2). Real consumer spending remained remarkably resilient at 2.3%, 1.0%, and 4.2% notwithstanding rapidly rising interest rates. That’s because employment gains remained robust and consumers spent some of the excess saving they had accumulated during the pandemic.

(2) Residential investment has been in a recession for the past eight quarters, except for multi-family housing. It first turned negative during Q2-2021, before the Fed started raising interest rates during March 2022. It fell 22.3% through Q1-2023 (Fig. 3). Contributing to the decline over this period were single-family housing (-25.6%), home improvements (-17.9%), and real estate brokers’ commission (-33.6%). On the other hand, multi-family housing held up well, rising 5.4%.

Both new home sales and single-family housing starts soared during May by 12.2% and 18.5% m/m, respectively (Fig. 4). There’s lots of pent-up demand for housing and a significant shortage of inventory. That may be enough to end the housing recession even if mortgage interest rates remain elevated. The Atlanta Fed’s GDPNow tracking model is currently estimating a 0.7% increase in residential investment during Q2, up from -4.0% during Q1.

(3) Capital spending on structures declined for six quarters (Q2-2021 through Q3-2022), but has risen for the past two quarters (through Q1-2023) (Fig. 5). The latest rolling recession in capital structures was in spending on commercial, health, power, and communications facilities (Fig. 6). That weakness was partially offset by mining exploration, shafts, and wells structures. Spending on manufacturing plants was flat and depressed following the pandemic lockdowns, but it has surged over the past couple of quarters thanks to onshoring.

(4) Capital spending on equipment declined during the past two quarters, but R&D and software spending have been strong (Fig. 7). The weakness was widespread among information processing, industrial, transportation, and other equipment (Fig. 8). We are expecting information processing equipment spending to turn up soon. Meanwhile, business spending on software and R&D in real GDP rose to new record highs and should continue to do so. The Atlanta Fed GDPNow model is currently estimating that business equipment spending rose 6.7% (saar) during Q2.

(5) Inventories rose sharply from Q4-2021 through Q4-2023, but inventories should no longer be a drag on real GDP going forward (Fig. 8). Much of that was unintended, as consumers pivoted from buying goods to purchasing services. Their goods buying binge during 2021 depleted inventories, causing wholesalers and retailers to order more merchandise, which piled up as unintended inventories when they finally arrived. Inventory investment in real GDP dropped sharply from $136.5 billion (saar) during Q4-2022 to $3.5 billion during Q1-2023, suggesting that the inventory overhang has been resolved. That drop in inventory investment reduced real GDP during Q1 by 2.14 ppts. Inventories won’t be a negative contributor to real GDP growth over the remainder of this year, in our opinion.

(6) Total government spending on goods and services in real GDP has been rising fast for three quarters (through Q1-2023) after falling for five (Q2-2021 through Q2-2022) (Fig. 9). It has been rising at a faster pace than real GDP for the past three quarters, at 3.7%, 3.8%, and 5.0%. That’s likely to continue as the Biden administration’s program to rebuild national infrastructure cranks up.

(7) Consumers’ spending on services should continue to rise, more than offsetting any weakness in their spending on goods. The latter peaked at a record high during March 2021 (Fig. 10). It was down 3.9% through May of this year, though it has been essentially flat since H2-2021. Over this same period (since goods spending peaked), spending on services rose 9.5% to a new record high. Actually, during Q1-2023, consumers’ spending on goods in real GDP rose 6.0% (saar), led by a 16.3% jump in spending on durable goods (Fig. 11). Their spending on services rose 3.2%.

Inflation-adjusted disposable personal income (DPI) has been trending higher over the past 11 months through May (Fig. 12). We expect that real DPI will continue to rise along with employment and real wages. We also predict that the personal saving rate will remain relatively low (Fig. 13). It is widely expected that it will move higher and depress consumers’ spending once they deplete the excess savings they accumulated during the pandemic. We disagree, because retiring Baby Boomers have accumulated a much greater $75 trillion in “excess” net worth and we believe they intend to spend quite a bit of it during their retirement years.

(8) Our rolling recovery scenario adds up to no recession ahead. We are updating our soft-versus-hard-landing subjective odds from 70/30 to 75/25. We are raising our forecast for Q2’s real GDP from 1.0% to 2.0% and maintaining this growth-rate projection for H2-2023 (Fig. 14).

We might have to return to 70/30 or even 60/40 for 2024 if the Fed turns too hawkish in response to the resilience of the economy in general and the labor market in particular. Of course, much will depend on inflation. If the headline inflation rate continues to moderate and the core rate shows more signs of moderating, then the Fed should become less hawkish even if the economy continues to defy the recession forecasters.

Let’s turn now to an update of the inflation situation and outlook.

US Inflation: Headline Moderating, Core Stalling. The headline PCED inflation rate fell to 3.8% y/y during May, down from last year’s peak of 7.0% y/y during June 2022 (Fig. 15). So it is now at the top end of our 3.0%-4.0% forecast range for 2023. We expect to see it closer to 3.0% by the end of this year. That would require the core PCED inflation rate to moderate. It has been stuck around May’s reading of 4.6% y/y for the past five months.

Let’s drill down into the latest inflation numbers:

(1) PCED durable goods. The PCED inflation rate for durable goods peaked at 10.5% y/y during February 2022 (Fig. 16). It was down to just 0.7% y/y in May of this year. It has a history of deflating from the mid-1990s through 2020. We think it could continue to be a negative contributor to inflation over the rest of this year.

(2) PCED nondurable goods. The PCED inflation rate for nondurable goods tends to be volatile and hard to predict (Fig. 17). That’s mostly because food and energy prices tend to be volatile and unpredictable. Nevertheless, the three-month annualized percent changes and the y/y percent changes in energy (-25.8%, -11.7%) and food (1.0%, 6.7%) through May suggest that their y/y rates are likely to continue to fall (Fig. 18).

On the other hand, the inflation components in the core nondurable goods category remain persistently high: personal care (7.8% y/y), household supplies (7.3), magazines, newspapers & stationary (5.4), recreational items (5.0), and clothing & footwear (2.9) (Fig. 19).

(3) PCED services. The core PCED services inflation rate is also stalling (Fig. 20). It was 5.3% in May. Rent of shelter accounts for 23% of the core services PCED. The three-month annualized inflation rates versus the y/y rates for rent of primary residence (6.2%, 8.7%) and owners’ equivalent rent (6.3%, 8.1%) suggest that they should moderate over the rest of this year.

The problem is that the PCED for core services excluding housing has stalled around 4.5% for the past several months (Fig. 21). Here are the y/y PCED inflation rates of the major core PCED services components: personal care (10.0%), housing (8.3) transportation (7.1), recreation (4.7), health care (2.7), education (2.6), and communication (0.0) (Fig. 22).

(4) Bottom line. The headline PCED inflation rate has moderated significantly. The core PCED inflation rate has been stickier. Both remain well above the Fed’s 2.0% inflation target. The core rate’s stickiness isn’t attributable just to rent inflation. Core nondurable goods inflation was 5.3% in May, while the core services inflation rate excluding housing was 4.5%.

So why is the stock market so bubbly? Investors seem to have concluded that another 50bps increase in the federal funds rate won’t knock our resilient economy into a recession, since it has already withstood a 500bps increase since last March. Yet investors must believe that even the stickier inflation components will moderate over the rest of the year. We agree.

Movie. “Ghosts of Beirut” (+ + +) (link) is an excellent docudrama about the efforts of the CIA and Mossad over several years to kill Imad Mughniyey, alias al-Hajj Radwan. He was the founding member of Lebanon's Islamic Jihad Organization and number two in Hezbollah's command. He was often referred to as an “untraceable ghost.” US and Israeli officials accused him of orchestrating numerous terrorist attacks including the Beirut barracks bombing and US embassy bombings, both of which took place in 1983 and killed over 350, as well as the kidnapping of dozens of foreigners in Lebanon in the 1980s. He was indicted in Argentina for his alleged role in the 1992 Israeli embassy attack in Buenos Aires. He was accused of killing more US citizens than any other man prior to the September 11 attacks.

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