Morning Briefing Archive (2022)
Why Are Oil Prices Falling?
August 16 (Tuesday)
Commodities: Crude Thoughts. Is the price of petroleum products falling because the Biden administration has been releasing crude oil from the US Strategic Petroleum Reserve (SPR)? Or is the drop attributable to less demand in response to high prices? Consider the following:
(1) SPR. At the beginning of April, President Joe Biden announced a “historic” release from the SPR of 1 million barrels a day (mbd) for six months. An April 7 press release by the White House said it would be in coordination with other countries’ release of an additional 60 million barrels onto the market: “Together with the United States’ commitment, this will add a combined global amount of 240 million barrels. It is both the largest release from the United States and the largest release from other IEA [International Energy Agency] countries in history and will support American consumers and the global economy.”
In the US, the SPR was 569 million barrels during the last week of March (Fig. 1 and Fig. 2). It fell by 107 million barrels to 462 million barrels during the August 5 week. The press release implies that the White House intends to reduce the SPR by a total of 180 million barrels by the end of September.
(2) Global demand. On August 9, the IEA estimated that 98.8 mbd of petroleum and liquid fuels was consumed globally in July 2022, an increase of 0.9 mbd from July 2021. The IEA forecast that global consumption of petroleum and liquid fuels will average 99.4 mbd for all of 2022, which is a 2.1 mbd increase from 2021. In addition, the IEA forecast that global consumption of petroleum and liquid fuels will increase by another 2.1 mbd in 2023 to average 101.5 mbd.
In other words, at the consumption rate of 99 mbd worldwide, the release of 240 million barrels over the next six months amounts to a grand total of 2.4 days of extra fuel to run the global economy. Whoop-de-doo!
(3) US inventories. During the August 5 week, US inventories of crude oil & petroleum products totaled 1.19 billion barrels (Fig. 3). So the SPR is currently just 39% as large as US inventories excluding the SPR, which are currently 3.8% below the year-ago level.
(4) US production. High crude oil prices have stimulated more US oil field production, which rose to 12.3 mbd during the August 5 week, the highest pace since the end of March 2020 (Fig. 4). We derive a total imputed US production series by subtracting net imports from total petroleum products supplied (including crude oil), which is also used as a measure of total US demand (Fig. 5).
Our series shows that the US has been petroleum independent since late 2019, when net imports dropped to zero. During the August 5 week, our implied production series was at a recent near-record 21.1 mbd, while products supplied (usage) was 20.1 mbd. The US exported 1.0 mbd more than was imported that week.
(5) US consumption. The data on US petroleum products supplied show that during the August 5 week, it was 400,000 mbd below a year ago (Fig. 6). That was mostly attributable to weaker gasoline usage of 8.9 mbd, which was 500,000 below the year-ago usage. Americans have cut back on their consumption of gasoline in response to high prices.
(6) Prices. The price of a barrel of Brent crude oil peaked this year at $127.98 per barrel on March 8 (Fig. 7). It fell to $94.98 yesterday. The national average retail price of a gallon of gasoline peaked at $5.11 during the June 13 week. It was down to $4.15 during the August 8 week (Fig. 8).
(7) Conclusion. Our analysis of the data strongly suggests that the Biden administration’s release of crude oil from the SPR amounts to a drop in the bucket and doesn’t begin to explain why petroleum prices have been falling. Much more significant reasons are the drop in gasoline usage in the US and the ongoing recovery in US crude oil production. Both have occurred in reaction to high petroleum prices. Probably even more significant has been the drop in China’s oil demand, as the country seems to be slipping into a recession, as we discuss below.
Global Economy: Is Godot Hiding Overseas? Debbie and I have often observed that if the US economy is sinking into a recession or soon will do so, it will be the most widely anticipated recession of all times. It might already have started during the first half of this year since real GDP fell 1.6% during Q1 and 0.9% during Q2. Then again, these declines could easily be revised upward to show that the Bureau of Economic Analysis got the magnitudes right but the signs wrong.
It’s possible that we might all collectively talk ourselves into a recession. It’s also possible that we are all hunkering down just enough that any recession will be mild since there won’t be too many excesses to worsen it. The downturn could be what we called a “rolling recession” during the mid-1980s for the US.
Only yesterday morning, we suggested that waiting for the next recession was like waiting for Godot, who never showed up on stage in the play by Samuel Beckett. But also yesterday morning, we learned that Godot might be hiding in plain sight in China or New York. Before we go there, let’s look at the OECD’s recently released batch of leading economic indicators for July:
(1) Total OECD. The OECD leading indicator has been falling for the past 11 months through July (Fig. 9). It fell below 100.0 in April of this year and was down to 99.2 in July. So far, that’s more of a soft landing than a hard one for the OECD countries. The major economies of Europe (98.9), Japan (100.5), and the US (99.0) are mostly in sync, though Japan does stand out with a reading above 100.0.
(2) BICs. The OECD also compiles leading indicators for Brazil (98.0), China (98.5), and India (100.0) (Fig. 10). Yesterday’s batch of economic indicators for China suggests that the country’s economy might be weakening more rapidly than shown by its OECD leading indicator, as we discuss in the next section.
China Economy: Hitting The Skids? A month ago, on July 14, China announced that its real GDP rose just 0.4% y/y during Q2. That was weaker than the 1.0% consensus forecast. It implied that real GDP plunged 11.0% q/q (saar) (Fig. 11). The bursting of China’s property bubble and its zero Covid restrictions have hammered the economy. July data released yesterday suggest that Q3 could also be a very weak quarter for China’s economy. Consider the following:
(1) Retail sales. Retail sales rose 2.7% y/y in July, and so did the CPI, so real retail sales were unchanged y/y (Fig. 12).
(2) Industrial production. Industrial production, meanwhile, rose only 3.8% y/y in July, marginally slower than June’s 3.9%, while growth in fixed-asset investments slowed to 5.1% y/y.
(3) Social financing. On Friday, we also learned that total social financing, which includes bank loans and is the broadest measure of credit in the economy, was extremely weak in July (Fig. 13 and Fig. 14).
(4) Policy response. The People’s Bank of China cut its one-year rate by 10bps to 2.75% after the country’s sales and production data for July both fell short of expectations. It also trimmed its seven-day reverse repo rate.
(5) Blackouts. Beijing is facing a major energy crisis after sweltering heat led to soaring electricity demand across the country as families fired up air conditioners.
Yesterday, all industrial users of electricity in China’s Sichuan province—including factories producing metals, chemicals, and other industrial products—were told to shut down or curb their output in a bid to ration power consumption and prevent blackouts among residential populations. The entire province spans 485,000 square kilometers, which is nearly twice as big as the UK.
(6) Dr. Copper. The nearby futures price of copper is a very sensitive indicator of global economic activity, particularly in China. It plunged 35.0% from this year’s high of $4.94 on March 4 to this year’s low of $3.21 on June 14. It rose to $3.71 on August 11 but was back down to $3.61 on the disappointing news out of China.
US Economy: New York State Of Mind. Yesterday, we might have spotted Godot in New York. The Federal Reserve Bank of New York released its July regional business survey. It was shockingly weak, as we reviewed in yesterday’s QuickTakes.
The headline general business conditions index plummeted 42.4 points to -31.3. New orders and shipments plunged, and unfilled orders declined. Delivery times held steady for the first time in nearly two years, and inventories edged higher. Labor market indicators pointed to a small increase in employment but a decline in the average workweek. The only good news was that the region’s prices-paid and prices-received indexes declined sharply last month.
We concluded: “Let’s see August’s business survey for the Fed’s Philly district on Thursday before jumping to any conclusions. If it is as bad as the NY one, recession fears could make a fast comeback, which would weigh on stock prices, commodity prices, bond yields, and the dollar.” Let us know if you happen to see Godot anywhere else.
Waiting For Godot
August 15 (Monday)
YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.
US Economy I: Is The Recession (Risk) Over Yet? The S&P 500 fell 23.6% from its record high on January 3 through June 16. It did so on fears that the Fed’s increasing hawkishness, sparked when inflation turned out to be persistent rather than transitory, would end in a recession. The S&P 500 is now up 16.7% since June 16 through Friday’s close. Does that mean that investors no longer fear a recession? Apparently so, but Debbie and I think that fears of a recession might make a comeback later this year or early next year. After all, this is the most widely anticipated recession ever, which is why it might be like waiting for Godot!
Consider the following:
(1) A “technical” recession? Everyone not working in the Biden administration seems to agree that the US experienced a “technical” recession during the first half of this year simply because real GDP dropped for two consecutive quarters during Q1 (-1.6%) and Q2 (-0.9%). In last Monday’s Morning Briefing, we explained that there is a good chance that one or both of these quarters will be revised up because the spread between Gross Domestic Income and Gross Domestic Product has been widening significantly in recent quarters, with the former growing faster than the latter (Fig. 1 and Fig. 2).
(2) Coincident indicators. We also explained last Monday that there is no recession evident in the Index of Coincident Economic Indicators (CEI), which rose to a record high in June and probably continued to do so in July (Fig. 3). That’s because payroll employment is one of the four components of the CEI, and it rose every single month during the first seven months of this year by a cumulative 3.3 million to a record 152.5 million during July (Fig. 4).
(By the way, over this same period, the household measure of employment rose by 2.3 million. The household measure counts the number of people with one or more jobs including the self-employed, while the payroll measure counts the number of jobs excluding the self-employed.)
Another component of the CEI is real personal income excluding government transfer payments. From July’s employment report, we know that our Earned Income Proxy (EIP) for private wages and salaries in personal income rose 0.8% m/m and 9.6% y/y during July to a new record high (Fig. 5). However, on an inflation-adjusted basis, it was up just 2.9% y/y through June.
Nevertheless, July’s CPI, which was unchanged during the month, suggests that both our EIP and real private wages and salaries in personal income rose solidly last month. Indeed, a separate Labor Department report last Wednesday showed real average weekly earnings rose 0.5% in July, the first monthly increase since last September and the largest gain since January 2021. This suggests that July’s real retail sales, which will be released on Wednesday, should show a solid gain and boost the real manufacturing and trade component of the CEI.
The fourth component of the CEI is industrial production. From July’s employment report, we know that aggregate weekly hours edged up 0.4% during July, suggesting that industrial production was a positive contributor to the CEI last month (Fig. 6). We will find out on Tuesday what it actually did.
(3) Leading indicators. The bad news is that the Index of Leading Economic Indicators (LEI) peaked at a record high during February and is down 1.9% through June, with four consecutive monthly declines through June. Such weakness in the LEI has been a fairly reliable early warning signal of a recession, with an average lead time of 14 months prior to the past seven business cycle peaks, excluding the peak just before the lockdown recession of 2020. The lead time from the LEI’s peaks and the peaks of subsequent economic activity has been nine to 22 months. This suggests that the next recession might start next spring but could begin as early as the end of this year.
Then again, we might learn that July’s LEI was up but not enough to match February’s peak. After all, the S&P 500 is one of the 10 components of the LEI, and its monthly average of daily data rose 0.3% m/m during July after falling 3.5% in June (Fig. 7). On average, it has peaked five months before the previous 11 business cycle peaks excluding the 2020 pandemic cycle. This time, it peaked on January 3, arguably anticipating the technical recession of H1-2022. If so, then the rally since June 16 may be signaling better times ahead for the economy, unless it turns out to be a bear-market rally.
What else do we know so far about the components of July’s LEI? Initial unemployment claims will likely be a negative contributor. It recently bottomed at 166,000 during the March 19 week and rose to 262,000 during the August 6 week (Fig. 8). We know that the expectations component of the Consumer Sentiment Index, which is included in the LEI, jumped from 47.3 during July—which was the lowest reading since spring 1980—to 54.9 in early August (Fig. 9).
The yield-curve spread between the 10-year US Treasury bond yield and the federal funds rate should be a big negative LEI contributor in either July or August because it narrowed dramatically when the Fed raised the federal funds rate by 75bps on July 27 (Fig. 10).
By the way, a useful leading indicator for this spread is the one between the 10-year and 2-year yields, which turned negative in early July, signaling that a recession is still possible in coming months. Melissa and I believe that the 2-year yield mirrors the market’s prediction for the federal funds rate over the next 12 months. It currently shows a peak rate around 3.25%.
(4) Hawkish Fed heads. Ever since Fed Chair Jerome Powell’s July 27 press conference, Fed officials have been scrambling to clarify his comment that the federal funds rate range of 2.25%-2.50% is “right in the range of what we think is neutral.” He added, “now that we’re at neutral, as the process goes on, at some point, it will be appropriate to slow down” the pace of rate hikes. The financial markets optimistically interpreted that to mean that the Fed may even cut interest rates next year. The other Fed officials have been walking back Powell’s suggestion that the Fed is nearly done tightening and trying to stick a pin in the market’s notion that the Fed may be cutting interest rates next year.
Following last Wednesday’s news of a drop in the CPI inflation rate, Minneapolis Federal Reserve Bank President Neel Kashkari said that despite the “welcome” news in the CPI report, the Fed is “far, far away from declaring victory” on inflation. Kashkari, who has always been among the most dovish Fed officials, said he hasn’t “seen anything that changes” the need to raise the Fed’s policy rate to 3.90% by year-end and to 4.40% by the end of 2023. That probably makes him the most hawkish member of the FOMC.
Kashkari did acknowledge that raising rates so quickly could push the economy into recession, and that a recession could even occur in the “near future.” But most of Kashkari’s 18 colleagues think a little less policy tightening may be enough to bring prices under better control without causing a recession.
Among them is Chicago Fed President Charles Evans. While calling inflation “unacceptably high,” he set his target rate hikes at 3.25%-3.50% this year and 3.75%-4.00% by the end of next year, still somewhat higher than Powell signaled after the Fed’s latest meeting in July.
(5) The Chair’s guidance. Powell did offer a bit of guidance during his July 27 presser. He said, “And I think you can still think of the destination as broadly in line with the June SEP. Because it’s only six weeks old.”
“SEP” stands for the “Summary of Economic Projections,” which shows the consensus forecasts of the FOMC participants for the federal funds rate, the unemployment rate, real GDP, headline PCED inflation, and core PCED inflation. Back in June, they expected the federal funds rate would be raised to 3.40% by the end of this year and 3.80% by the end of next year. (See our FOMC Economic Projections.)
According to the SEP, that’s restrictive enough to bring inflation down but without causing a recession. More specifically, real GDP is expected to grow 1.7% this year and next year, with the unemployment rate rising to only 3.9% next year. The PCED inflation rate is expected to fall from 5.2% this year to 2.6% in 2023 and 2.2% in 2024.
(6) Dr. Copper. The CRB all commodities and raw industrials spot price indexes peaked at record highs on May 4 and April 4, respectively, and are down 8.3% and 11.3% through Friday (Fig. 11). For now, we think that’s a better omen of lower inflation than an imminent recession.
The price of copper is widely watched as an indicator of economic activity. So its plunge during the first half of the year seemed to confirm recession fears (Fig. 12). However, it is a better measure of economic activity in China than in the US. China’s economy was depressed during the first half of this year by renewed pandemic lockdowns and the popping of its property bubble. The price of copper has rallied in recent days.
(7) Money supply and QT. What about M2? It has declined for two of the past three months by a total of $72.4 billion, while the total deposits of all commercial banks has decreased by $146 billion from its record high during the April 13 week through the August 3 week (Fig. 13).
That doesn’t worry us, for now. M2 remains about $2 trillion above its pre-pandemic trend. We might get more concerned if it were to fall too rapidly toward that trend or below it. It is falling because the Fed pivoted from QE to QT (quantitative easing to quantitative tightening) starting in June. Meanwhile, commercial bank loans have been rising in record-high territory recently, with new loans funded by the banks’ sale of securities such as Treasury bonds (Fig. 14).
(8) Recession odds. So what are the recession odds now? They’ve been reduced, in our opinion, by the easing of financial conditions in the capital markets. The labor market remains strong. Consumers still have about $2 trillion in excess savings, and their real wages may be starting to get a lift from lower price inflation. Capital spending is slowing but not falling. Residential investment is in a recession, led by the single-family housing market, while the multi-family sector remains solid. Europe faces an energy crisis this winter but is still growing currently.
So Debbie and I are more sanguine about the economic outlook now than we have been in recent months. We think that economic growth will be weak during H2-2022 but positive around 1.5% (saar). Next year should be a year of recovery (not recession) from this year’s mid-cycle slowdown. Real GDP next year should be up 2.5%.
So here are our new subjective probabilities: We place 60% odds on this slow-go scenario and 35% odds on a recession, more likely next year than this year. We give 5% to a boom scenario. In the recession scenario, inflation remains persistently high, forcing the Fed to raise rates to levels that cause a recession.
US Economy II: Has Inflation Peaked? Of course, notwithstanding the favorable response last week to the apparent peaking in the CPI and PPI inflation rates, the jury is still out on whether they’ve actually peaked. We’ve been predicting that inflation would moderate during H2-2022. So far so good, but we need to see more evidence to know definitively that’s the case.
Movie. “Elvis” (+ + +) (link) is a long movie about the all-too-short life of Elvis Presley and his convoluted relationship with his manager, Colonel Tom Parker. Austin Butler plays Elvis brilliantly. Tom Hanks’ performance as the Colonel is a bit annoying, but that’s the way the Colonel was apparently. During the 1950s, Elvis started a musical revolution by popularizing traditional genres such as blues, country, and bluegrass. His vocal energy and then-scandalous hip swings and body contortions drove his concert audiences into a frenzy. He was without a doubt “The King of Rock & Roll.”
Health Care, Earnings & Uncle Sam
August 11 (Thursday)
Health Care: Among The Best. The S&P 500 Health Care sector has been holding its own this year to date, despite the bear market from January 3 through June 16. The industry has benefitted from a healthy dose of M&A, with pharmaceutical companies strengthening their drug benches and tech companies eyeing the health care industry’s inefficiencies and demand for cloud services.
Some health care companies have enjoyed the return to normalcy post-Covid, while others have been hurt by it. Now that Covid cases have receded, patients have resumed going to their annual doctor appointments and undergoing non-urgent medical procedures, but they’ve also stopped getting Covid vaccines and using related supplies.
Here’s the share price performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Energy (35.0%), Utilities (4.9), Consumer Staples (-3.9), Health Care (-6.9), Industrials (-9.6), S&P 500 (-13.5), Financials (-13.6), Real Estate (-14.5), Materials (-14.8), Information Technology (-17.4), Consumer Discretionary (-20.5), and Communication Services (-27.4) (Fig. 1).
The Health Care sector has been dragged down by one of its larger industries, Health Care Equipment, which has watched what was a high forward P/E multiple last year melt as interest rates rose this year. Here are how the S&P 500 Heath Care industries’ share prices have performed ytd through Tuesday’s close: Health Care Distributors (24.5%), Managed Health Care (6.8), Health Care Services (2.7), Biotechnology (-0.7), Pharmaceuticals (-1.0), Health Care Sector (-6.9), Health Care Facilities (-17.8), Life Sciences & Tools (-19.0), and Health Care Equipment (-20.3), Health Care Supplies (-45.6) (Fig. 2).
Let’s take a look at some of the recent M&A activity driving health care stocks higher and the Inflation Reduction Act’s future impact on drug manufacturers:
(1) Giants jump in. Amazon, CVS Health, and Oracle each have either announced or completed large health care acquisitions this year that are aimed at using technology to improve health care services.
CVS reportedly plans to bid for Signify Health, according to recent headlines. Signify is a home health care company that uses technology and data to help health plans, employers, and providers offer in-home care. With a market value of $5.2 billion, multiple bidders in addition to CVS are expected. The deal would help CVS offer primary care services at home and potentially in the real estate its drug stores already occupy.
CVS’s urgency to expand into primary care may have increased after Amazon agreed in July to purchase 1Life Healthcare’s subscription health services company One Medical for $3.9 billion. The company has 204 primary care clinics and thousands of caregivers who can provide services to Amazon’s Prime members. That deal followed Amazon’s $753 million acquisition of online pharmacy PillPack in 2018. Amazon also has developed a telehealth service, Amazon Care, which is a 24/7 texting, video, and in-person care service initially offered in 2019 just to Amazon employees and this year opened up to customers nationwide along with Amazon’s network of walk-in clinics.
Oracle’s $28.3 billion acquisition of Cerner, an electronic health records company, closed in June. Oracle intends to offer Cerner customers ways to access information in Oracle’s cloud using a hands-free voice interface. The improved medical information systems will “lower the administrative workload burdening our medical professionals, improve patient privacy and outcomes, and lower overall healthcare costs,” stated Chairman and CTO Larry Ellison.
The Oracle deal followed Microsoft’s March $16 billion purchase of Nuance Communications. Nuance is an artificial intelligence company specializing in voice recognition and related software and services for health care and other industries. The acquisition will capitalize on Microsoft’s cloud services.
CVS shares, which are essentially flat so far this year, reside in the S&P 500 Health Care Services industry, which is up 2.7% ytd (Fig. 3). Earnings estimates for the industry have been revised down sharply this year. Analysts’ consensus earnings estimate for 2022 represented a 4.9% y/y gain when 2021 began, which since has fallen to a 2.5% decline (Fig. 4). Next year’s earnings estimates have been cut also, but the growth implied remains in positive territory at 6.0%. Over the past 20 years, the industry’s forward P/E has contracted from north of 20 to a recent 11.6 (Fig. 5).
(2) Drug M&A happening too. Acquisitions also have heated up in the pharmaceuticals industry, as large drug companies are looking to replace revenue from drugs going off patent and to expand their offerings. Amgen agreed earlier this month to buy ChemoCentryx for $3.7 billion. The company has a treatment for bone disease and potential treatments for inflammatory disorders and immune disorders. Amgen may be looking to offset declining sales of its arthritis drug Enbrel, which meant the company’s total revenue increased by only 1% in Q2, an August 4 Reuters article reported.
Separately, Pfizer has agreed to pay $5.4 billion for Global Blood Therapeutics, which produces drugs to treat sickle-cell disease. The deal follows Pfizer’s April agreement to buy ReViral, a privately held company that develops drugs for respiratory virus. And late last year, the company announced plans to buy Arena Pharmaceuticals for $6.7 billion. Arena’s drug etrasimod is being studied for its use in treating ulcerative colitis, and Pfizer plans to consider its use to treat other immune-inflammatory diseases as well, a December 13 WSJ article reported. Pfizer is well heeled enough to play offense thanks to the success of its Covid-19 vaccines.
ChemoCentryx and Global Blood Therapeutics are too small to be in the S&P 500 Biotechnology index, but they are in the iShares Biotechnology ETF, or the IBB, which has fallen 14.9% ytd. The ETF may have hit bottom on June 16, when it was down 30.7%, as it has rallied since. Conversely, the S&P 500 Biotechnology index is essentially flat so far this year (Fig. 6). After the industry’s earnings rose 39.6% in 2021, they are expected to fall this year and next by -4.0% and -13.8% (Fig. 7). And the industry’s forward P/E has fallen from north of 20 in 2013 and 2014 to a recent 12.4 (Fig. 8).
(3) Drug bill better than feared. The final version of the Inflation Reduction Act, which allows Medicare to negotiate a limited number of drug prices, wasn’t as bad for the industry as earlier iterations of the legislation. In fiscal 2026, Medicare will be able to negotiate the prices of the 10 most used drugs covered under Part D, expanding to 15 Part D drugs in 2027. Newly approved drugs won’t be subject to negotiation for nine to 13 years after their market introduction, an August 8 CNBC article reported.
It’s unknown which drugs will be subject to negotiated prices, but last year the government spent $9.9 billion on blood-clotting treatment Eliquis, $5.4 billion to $5.7 billion on cancer treatment Revlimid (both produced by Bristol-Myers Squibb), and $4.7 billion on the blood clotting drug Xarelto (Johnson & Johnson).
The legislation also caps monthly costs for Medicare recipients’ insulin at $35 a month starting next year. Also next year, drugmakers that raise prices faster than general inflation will have to pay the government in rebates.
With a ytd decline of just 1.0%, the S&P 500 Pharmaceuticals industry index actually has outperformed the broader market so far this year (Fig. 9). But its earnings prospects for next year aren’t great: After climbing by 23.7% in 2021 and an estimated 15.8% in 2022, earnings are expected to drop by 3.0% in 2023 (Fig. 10). At 13.5, the industry’s forward P/E suggests that investors aren’t banking on much positivity.
Earnings: Flipping The Calendar To 2023. While analysts aren’t optimistic about the S&P 500 Health Care sector’s earnings for next year, they are quite enthusiastic about next year’s earnings in other sectors. For estimates to materialize though, the consumer will need to keep spending, traveling, and doing all the things that will help other industries levered to economic growth pick up the pace of earnings growth from the current year’s miserable clip.
Here are analysts’ 2023 earnings estimates for the S&P 500 and its sectors: Consumer Discretionary (35.2%), Industrials (17.5), Financials (13.4), Communication Services (13.4), Information Technology (8.6), Utilities (7.8), S&P 500 (7.6), Consumer Staples (6.3), Real Estate (0.7), Health Care (-0.6), Materials (-8.3), and Energy (-12.7) (Table 1).
Analysts are counting on consumer spending and traveling remaining robust. In 2023, the S&P 500 Hotels industry’s earnings are expected to bounce back from losses this year, rising 555.3%, as the S&P 500 Airlines’ earnings increase an estimated 206.3%, also from losses. Our return to watching the big screen is expected to help the Movies & Entertainment industry grow earnings 43.3% next year after an expected earnings gain of 1.0% this year. The S&P 500 Footwear, Apparel Retail, Apparel & Accessories, and Restaurants industries each are expected to grow earnings by roughly 12.7%-22.0% in 2023.
Given all the uncertainty in the world, it’s not surprising that the S&P 500 Aerospace & Defense industry is expected to grow earnings by 35.7% in 2023. And after this year of monetary tightening, the S&P 500 Financials sector should see earnings grow nicely. Here are the earnings growth rates analysts expect in 2023 by industry: Reinsurance (26.9%), Property & Casualty Insurance (22.7), Multi-Line Insurance (21.4), Investment Banking & Brokerage (16.6), Regional Banks (15.7), Diversified Banks (13.9), Financial Exchanges & Data (12.2), Asset Management & Custody Banks (11.7), and Insurance Brokers (10.9).
At the other end of the spectrum, industries in the S&P 500 Energy sector will be hard pressed to exceed their 2022 earnings next year. The Oil & Gas Refining & Marketing industry is expected to see earnings fall 38.2%, followed by a drop in the earnings of Integrated Oil & Gas (-13.6%), and Oil & Gas Exploration & Production (-6.1).
The Energy sector’s dim hopes of earnings growth combined with the 2023 earnings drops projected for Steel (-59.7%), Copper (-23.9), and Homebuilding (-13.7) underscore the message that all’s not well in the economy, particularly not in the homebuilding industry.
Disruptive Technology l: Uncle Sam Goes Green. The Inflation Reduction Act really has more to do with the environment than it does inflation. A better name might have been “The Save the Planet Act” or “The Going Green Act.” Senate Democrats believe the bill will help the US reduce carbon emissions 40% by 2030. We’ll be interested to see if the government will be able to successfully oversee the spending of this labyrinthian bill.
Here are some of the green things that the act aims to encourage by offering funding or tax breaks:
(1) Capturing carbon. The Inflation Reduction Act extends an existing tax credit for carbon capture projects to those that begin construction prior to 2033. It also lowers the carbon capture thresholds required to qualify for the credit. The actual tax credit for capturing carbon spewed by a plant is increased to $85 per ton, up from the current $50 per ton.
The Act also includes a $180-per-ton tax credit for carbon that’s captured directly from the air, not specifically related to an industrial plant per se. “Because most technologies in today’s market are early stage or experimental in nature, the additional increase in 45Q tax credits for DAC facilities is aimed at creating synthetic economics for these projects to allow them to receive additional capital to help develop DAC technologies at scale and eventually make DAC businesses widespread and profitable,” a paper by law firm McDermott Will & Emery explained.
(2) Reducing emissions. The Inflation Reduction Act establishes several grant programs at the Environmental Protection Agency and other agencies to reduce emissions. A $6 billion Advanced Industrial Facilities Deployment Program is established to reduce emissions from industrial emitters, like chemical, steel, and cement plants. There is also $3 billion in grants to reduce air pollution at ports by encouraging the purchase and use of zero-emission equipment and technology.
A Methane Emissions Reduction Program is established to reduce the leaks from the production and distribution of natural gas. And there’s a $27 billion “clean energy technology accelerator to support deployment of technologies to reduce emissions, especially in disadvantaged communities.”
(3) EV buyers benefit. Under the Inflation Reduction Act, low- to middle-income consumers can receive a $4,000 tax credit when purchasing a used electric vehicle (EV) and get up to $7,500 for a new EV. The Postal Service is given $3 billion to buy zero-emission vehicles as part of a larger $9 billion program that funds the federal purchase of American-made clean energy technologies. And there’s $1 billion for clean heavy-duty vehicles, like busses and garbage trucks. Tax credits and grants also are established to develop and use clean fuels and clean commercial vehicles throughout the transportation sector.
(4) Green manufacturers win. The Act offers production tax credits valued at $30 billion to accelerate US manufacturing of solar panels, wind turbines, batteries, and the minerals used in making those items. It provides another $10 billion in investment tax credit to build manufacturing facilities that produce EVs, wind turbines, and solar panels. Auto manufacturers are given $2 billion in grants to retool existing plants to manufacture “clean vehicles.” They can also receive $20 billion in loans to build new clean vehicle manufacturing plants in the US.
(5) Energy efficiency at home. The Act offers low-income consumers $9 billion in rebates to electrify home appliances and buy energy efficient appliances. It also offers 10 years of consumer tax credits to make homes energy efficient and run on “clean” energy, including heat pumps, solar, and electric HVAC and water heaters. The Act also establishes a $1 billion grant program to make affordable housing more energy efficient.
(6) Green on the grid. The Act provides $30 billion in grants and loans to states and electric utilities to accelerate the transition to “clean” electricity. It encourages the use of renewable energy sources and increasing energy storage. There are also tax credits to keep nuclear power plants running.
(7) Green on the farm and in the lab. More than $20 billion was earmarked to support “climate-smart” agriculture practices. There are also tax credits and grants to support the domestic production of biofuels and the related infrastructure. And finally, the National Laboratories in the Department of Energy will receive $2 billion to accelerate breakthrough energy research.
Disruptive Technology II: Uncle Sam Spending On Chips. In an unusually productive summer for Washington DC, the CHIPS and Science Act was signed into law this week. It provides $50 billion to fund the construction of new semiconductor chip manufacturing facilities, related R&D, and workforce development.
As if on cue, the importance of the Act was emphasized by Chinese war games going on uncomfortably close to Taiwan’s shores. The new law had the desired effect of eliciting promises from manufacturers to build chips in the US of A: Micron will spend $40 billion to build a memory chip plant, Qualcomm and Global Foundries will expand GlobalFoundries’ upstate New York plant, and Intel earlier this year unveiled plans to spend $100 billion on a new chip complex in Ohio.
Ironically, these plans are being announced just as the semiconductor industry appears oversupplied. That said, the plants will take years to come online, and US security demands may make risking an oversupplied market unavoidable.
Like the sprawling Inflation Reduction Act, the $280 billion CHIPS Act doles out dollars like a drunken sailor. There’s $170 billion for scientific research and development. Another $10 billion funds “regional innovation and technology hubs” across the US to bring together state and local governments, universities, labor unions, businesses, and community-based organizations to create regional partnerships to develop the technology, innovation, and manufacturing sectors.
Another $13 billion will be used to fund science, technology, engineering, and mathematics (STEM) education and workforce development from kindergarten through graduate schools. Additional funds will go to NASA with the goal of sending astronauts to Mars, sending the first woman of color to the Moon, and extending US participation in the International Space Station through 2030.
Earnings & Productivity
August 10 (Wednesday)
Strategy: Analysts Cutting Estimates. Industry analysts have been lowering their 2022 and 2023 earnings estimates for S&P 500 companies since the end of June. While the latest earnings reporting season—which ran from early July until about now—showed that their companies generally performed well during Q2, many managements provided cautious forward guidance during their calls with analysts. Let’s have a closer look:
(1) Q2 results to date. So far, 87% of S&P 500 companies have reported revenues and earnings for Q2-2022. The revenue and earnings surprises are historically strong but near their lowest readings since the pandemic recovery began. Revenues are beating the consensus forecast by 2.8% and earnings by 6.0% (Fig. 1 and Fig. 2).
The 435 companies that have reported Q2 earnings through mid-day Monday have a y/y revenue gain of 15.4% and a y/y earnings gain of 11.2%. These figures are bound to change as more Q2 results are reported in the coming few weeks, particularly from the struggling retailers.
(2) Q2 and the next six quarters. Better-than-expected results by some of the big-cap technology names last week caused Q2’s blended earnings—i.e., including actual results and estimated ones—to jump during the first week of August (Fig. 3). At the end of June, just before earnings season began, analysts expected Q2 earnings to grow by 4.9% y/y. Now the blended growth rate is 8.9%. That’s the good news.
The bad news is that analysts have lowered their estimates for each of the next six quarters (Fig. 4). They’ve been doing so since the start of the current earnings season. So their 2022 and 2023 earnings estimates have been falling. As a result, forward earnings—which is the time-weighted average of analysts’ consensus earnings-per-share estimates for the current year and coming year—peaked at a record high of $239.93 per share during the June 23 week, and is now down 1.3% to $236.74 during the August 4 week (Fig. 5).
(3) Annual growth rate estimates. As of the August 4 week, industry analysts estimated that 2022 and 2023 earnings per share will be $225.50 and $244.36, up 10.1% and 7.7% on a y/y basis (Fig. 6).
(4) Back to the old normal. Industry analysts typically lower their estimates for both revenues and earnings over time because their initial projections are too optimistic. We can see this tendency in the weekly “squiggles” charts for S&P 500 revenues and earnings starting in 2009 (Fig. 7 and Fig. 8).
This time, after slashing their estimates for both revenues and earnings during the lockdown recession in March and April 2020, they scrambled to raise their estimates during the V-shaped economic recovery through the end of last year. Then during the first half of this year, economic growth stalled, yet the analysts continued to raise their estimates to new record highs. Some of that optimistic forecasting reflected higher-than-expected inflation, which boosted revenues estimates. It also boosted earnings estimates, as industry analysts assumed that profit margins would remain high because companies were successfully passing rapidly rising costs through to their selling prices.
(5) Profit margin estimates falling fast. During the current earnings reporting season, company managements have been guiding down analysts’ expectations, particularly for profit margins. We derive the annual consensus estimates of the profit margins of the S&P 500 by dividing analysts’ consensus earnings estimates by their consensus revenues estimates. The 2022 and 2023 profit margin estimates have dropped from 13.2% and 13.8% at the start of this year to 12.8% and 13.3% during the July 28 week (Fig. 9).
(6) Our outlook. In our Sunday, August 7 QuickTakes, we explained why the valuation-led stock market rally since June 16 might sputter for a while. It’s mostly because forward earnings has probably started to flatten in recent weeks as a result of the economy’s current growth recession. In addition, the S&P 500’s forward P/E bottomed at 15.3 on June 16 and rebounded to 17.4 on Friday (Fig. 10). We reckon that the forward P/E will be range-bound between 15.5 and 17.5 for a while, especially if the 10-year US Treasury bond yield sputters around 2.50%-3.00% for a while, as we expect.
(7) Feshbach’s market call. I checked in with our friend Joe Feshbach for his latest assessment of the action in stocks: “The market should continue to move higher. However, new buying should be put on hold. Narrowing breadth and improving sentiment raise the risks of a short-term pullback offering up lower prices.”
US Economy: Why Is Productivity Falling? The pandemic certainly has disrupted and upset almost every aspect of our lives. That might explain the extraordinary drop in productivity during the first half of this year. The pandemic exacerbated pre-existing labor shortage problems. After the pandemic, companies might have concluded that labor shortages would persist and therefore have hoarded scarce workers without having enough for them to do, especially if supply-chain disruptions disrupted operations.
The recent productivity drop certainly challenges our thesis that chronic labor shortages will force companies to increase their capital spending on technology to boost the productivity of the available labor force. That’s our story for the “Roaring 2020s,” and we are sticking to it. We have a few more years before the end of the decade. Meanwhile, let’s review the latest data, which were released yesterday:
(1) Productivity. Nonfarm business productivity fell 4.6% (saar) during Q2 following Q1’s 7.4% plunge. It is a volatile series. Nevertheless, it was down 2.5% y/y through Q2, the weakest reading since the start of the data in 1947 (Fig. 11).
Keep in mind that productivity soared after the lockdown recession of 2020 by 10.3% during Q2 and 6.2% during Q3. The latest reading brings productivity back to where it was during the first half of 2020. So it should resume rising along its pre-pandemic trendline.
(2) Statistical discrepancy. Productivity is the ratio of nonfarm business output and total hours worked by labor. The numerator is based on GDP, which has been rising at a slower pace than gross domestic income. This suggests that GDP might eventually be revised higher, showing that both productivity and overall economic activity have been stronger than the preliminary data show.
(3) Unit labor costs. Then again, unit labor costs (ULC) jumped 9.5% y/y during Q2, the most since Q1-1982, as productivity plunged 2.5% and hourly compensation soared 6.7% (Fig. 12). The CPI inflation rate is highly correlated with ULC inflation, both on a y/y basis (Fig. 13). The former was up 9.1% through June.
US Households I: Golden Age Of Moving Out. Since the beginning of 2020, there’s been a remarkably sharp drop followed by a remarkably quick rebound in the US household headship rate—i.e., the number of households divided by the number of adults in the population. This rebound has contributed to the huge increase in housing demand. Over this period, house prices and rents have soared to record highs.
America quickly lost 1.8 million households during September 2020, when the total fell to 125.5 million (Fig. 14). But by June of this year, the US had regained all the lost households and added 812,000 more! That’s according to recent Census Bureau data.
A few years ago, it was generally expected that household formation would rise moving into the 2020s as many Millennials in their late 20s and early 30s moved out on their own after delaying “adulting.” According to a 2021 report from the National Association of Realtors, the typical first-time home buyer was 33 years old. The pandemic temporarily dented household formation by Millennials, but it has quickly recovered. As the pandemic ended, as employment has increased, and as unmarried singles in the population have continued to rise, roommates have been parting ways.
Looking ahead, an erosion in affordability for both homebuyers and renters and the slowing growth in the population could pressure household formation. Slowing immigration in particular could offset any Millennials-led growth in household formation. That’s important because household formation drives housing demand, rents, and prices! Already, the housing market has begun to turn south and is unlikely to recover in the foreseeable future, as we discussed in our July 27 Morning Briefing.
(1) Living together during the pandemic. Changes in the composition of living arrangements since 2019 show that at the onset of the pandemic, many adults living alone or with roommates abruptly moved in with older family members or with a spouse or partner. Additionally, some who were living with family members delayed moving out due to the health and financial concerns surrounding the pandemic. That’s according to a May FEDS Notes piece written by two of the Fed’s household economists.
(2) Young adults moved in and out. Gradually, the Fed economists wrote, the pandemic-induced changes in living arrangements have receded as the fraction of adults living with their original family and the fraction living with a spouse or partner have returned to pre-pandemic levels. The initial pandemic-onset-induced drop in headship rates was especially sharp for 16- to 30-year-olds who moved in with older relatives, but the trend for that group has retraced some. Older Americans’ headship rates have been relatively resilient.
(3) More separations post-pandemic. In a new development, more adults are living alone and fewer with roommates, boosting the headship rate. Because of the pandemic, people started spending more time at home and together, straining relationships. More than half a million roommate households separated in 2020, but that was below pre-pandemic levels, according to a July analysis of Census data from Apartment List. The percent of single persons in the civilian noninstitutional working-age population continued to rise from pre-pandemic rates above 50.0% after briefly falling below that level during the pandemic (Fig. 15).
Generational trends also may drive the growth in sole-person households. Baby Boomers made up 39% of sole-person households in 2020, and their share is likely to rise because of divorces and deaths of spouses/partners, wrote Freddie Mac in a research note last August.
(4) Employment driving headship. Likely, the ongoing recovery of the labor market has contributed to the rebound in headship rates, as headship is higher among the employed than unemployed, the Fed economists surmised. That’s confirmed by our chart of the total households (as a percent of the working age population) and the Civilian Labor Force Participation Rate, which has dramatically improved, demonstrating labor market tightening, since the onset of the pandemic (Fig. 16). However, these drivers of the headship rate could be outweighed by weakening US population growth.
(5) Population growth slowdown. From 2010 to 2016, the number of adults in the US grew by 2.3 million per year, on average, the FEDS Notes article observed. But since 2016, population growth has slowed—to about 1.5 million in 2021—largely because of reduced immigration (Fig. 17). In recent years, actual immigration growth has come in far below the Census Bureau’s low estimate.
(6) Immigration the underlying offset. Under Census’ low immigration projection, the FEDS Notes piece highlighted, the adult population in 2030 would be about 5.5 million lower than would be expected assuming historically consistent immigration levels—implying roughly 2.75 million fewer households at the current headship rate. The lower headship rate suggests either many more vacant units by then and/or less housing construction, the Fed economists expect.
US Households II: Golden Age for Landlords. The post-pandemic era has been called the “Golden Age” for multifamily housing, and we think that’s true, as we’ve often discussed. Landlords have been a big beneficiary of household formation following the pandemic. Rental vacancy rates hit 5.6% during Q2, the lowest in over 30 years, according to Census Bureau data (Fig. 18). In turn, landlords have been afforded the opportunity to raise rents pretty darn high (Fig. 19). Generational trends also point toward greater growth of renters than homeowners. Consider the following:
(1) Millennials & Boomers living alone. Most younger adults moving out of their parents’ homes after the pandemic are moving into rentals. Mostly that’s because owning a home has become increasingly unaffordable. Seniors living on their own because of recent family circumstances also tend to rent rather than purchase a home. These trends are apparent in the Census data on post-pandemic household formation by renters versus homeowners (Fig. 20 and Fig. 21).
(2) Zoomers want to zoom into homes. Generation Z, colloquially known as “Zoomers,” will be the next generation to age into moving out. Nearly 90% of those born between 1997 and 2012 want to buy a home, and nearly half of them want to do it within the next five years, according to a survey by Rocket Mortgage. But desire and ability are two different things. Millennials think they have it tough, but Gen Zers are facing the steepest housing prices in years, especially relative to their starting incomes, wrote a Gen Zer for Next Advisor. Like Millennials, Gen Zers too are saddled with debt and limited savings. In other words, Gen Zers are likely to be doing Zoom calls out of their rentals as they age in place.
Around The World
August 09 (Tuesday)
Global Economy I: Our TINAC Thesis & Stay Home Strategy. Our basic premise about the outlook for the global economy through the end of 2023 is that a recession is more likely to occur in Europe and China than in the US. Of course, a global recession that starts abroad could push the US economy into a recession if it is already vulnerable to one. On the other hand, global investors might conclude that the US is the only major safe harbor from storms blowing around the world. If so, then their capital inflows could help to insulate the US economy from a global recession.
Granted, that would be an unusual development since economic booms and busts around the world tend to be synchronized ones. However, the US could buck a global recessionary cycle if enough global investors embrace our “TINAC” thesis—i.e., “there is no alternative country.” Melissa, Jackie, and I believe that TINAC has already been in play so far this year given the strength of the dollar and solid net capital inflows. If TINAC continues to insulate the US from the troubles of the rest of the world, then our “Stay Home” investment strategy should continue to outperform the “Go Global” alternative, as it has since 2009.
Consider the following big picture:
(1) Leading and coincident indicators. This morning, the OECD will release its July leading indicators for its 36 member countries, which tend to have developed economies, along with a few for the big emerging market economies (EMEs) that aren’t OECD members. The series starts in mid-1961.
June data show that the overall index fell from a recent peak of 101.0 in July 2021 to 99.5, the lowest reading since December 2020 (Fig. 1). Dominating the index are the US (99.4), Europe (99.3), and Japan (100.6) (Fig. 2). Generally, the business cycles of these major economies tend to be synchronized, but there have been times when one of the three major economies outperformed or underperformed the other two.
Similar synchronization can be seen among the major and minor European economies (Fig. 3 and Fig. 4). They all have been rolling over during the first six months of this year, with OECD leading indicator index readings either close to 100 or slightly below it. Both Australia (98.3) and Canada (99.6) are also rolling over (Fig. 5). And the same can be said of the BICs: Brazil (98.1), India (100.1), and China (98.3) (Fig. 6). (The BICs are not members of the OECD.)
The bottom line of the OECD data is that the global economy has been weakening during the first six months of this year but hasn’t fallen into a recession so far. Neither the US nor any other major OECD economy stands out from the pack as a leader or a laggard.
(2) Global PMIs. We have access to the JP Morgan global purchasing managers indexes (PMIs) since January 2018 through July of this year (Fig. 7 and Fig. 8). Not surprisingly, the global composite PMI is highly correlated with the OECD’s leading indicator. This global C-PMI has been falling in a sawtooth pattern from a high of 58.5 during May 2021 to 50.8 during July, the lowest since June 2020. So it too is signaling a global slowdown rather than a recession.
The global manufacturing PMI fell to 51.1 in July from 54.3 at the start of the year. The global nonmanufacturing PMI fell to 51.1 in July from 54.7 at the start of this year. All of these readings are consistent with a global slowdown. They might be pointing toward a recession, though certainly not definitively.
(3) Commodity prices. The same can be said about industrial commodity prices, especially the price of copper. Since the start of the year through Friday of last week, the CRB raw industrials spot price index is down 6%, while the nearby futures price of copper is down 20% (Fig. 9). Copper is especially sensitive to housing and auto sales. The world economy may not be in a recession, but housing activity almost certainly is in a recession around the world. Auto sales have been depressed by a shortage of auto inventories because supply-chain disruptions have disrupted auto production.
Interestingly, the CRB raw industrials spot price index tends to track the Emerging Markets MSCI stock price index (in dollars) very closely (Fig. 10). The latter is down 19% since the start of this year through Friday. This relationship suggests that most emerging markets haven’t emerged from their dependence on producing and exporting commodities.
(4) World production and exports. The CPB Netherlands Bureau for Economic Policy compiles monthly indexes of world industrial production and world volume of exports. Both are available from January 1991 through May of this year. The production index peaked at a record high in February of this year (Fig. 11). It is down 2.9% since then through May. The volume of exports reached a new record high in May.
(5) Capital flows. Previously, we observed that US private net capital inflows from overseas totaled a near-recent record high of $1.6 trillion over the 12 months through May, while official net capital flows were -$226 billion (Fig. 12). On balance over this period, private foreigners purchased $797 billion in US bonds, $331 billion in US bank liabilities, and $73 billion in US Treasury bills. They sold $162 billion of US equities. (See our Treasury International Capital System.)
This certainly helps to explain the strength of the US dollar index (ticker symbol DXY), which is up 18% since May of last year.
(6) Staying home. From a valuation perspective, the All Country World (ACW) ex-US MSCI was selling at a 32% discount relative to the US MSCI at the end of July (Fig. 13 and Fig. 14). From 2002 through 2015, the normal discount was 15% on average. The former tends to trade more like the S&P 500 Value index and is currently at a valuation discount of 20% to it rather than the normal discount of 0%-10% (Fig. 15 and Fig. 16).
From a fundamental perspective, both the forward revenues and forward earnings of the US MSCI have been significantly outperforming the comparable stats for the MSCIs of the Emerging Markets, EMU, and the UK (Fig. 17 and Fig. 18). The ratio of the US MSCI’s forward earnings to the ACW ex-US MSCI’s forward earnings has nearly doubled since early 2000 from 3.5 to 6.6 currently (Fig. 19). This certainly explains why the comparable ratios of the two stock price indexes (in both local currencies and in US dollars) remain on their strong uptrends that started in 2009 (Fig. 20). In other words, Stay Home continues to outperform Go Global. We recommend continuing to overweight the US in global portfolios.
Global Economy II: Europe In General, Germany In Particular. Real GDP in the Eurozone rose 2.0% (saar) during Q1 and 2.8% during Q2. At the same time, real GDP fell 1.6% and 0.9% in the US. The difference has mostly been attributed to the fact that the Eurozone economy was reopened from the Covid lockdowns after the US economy was reopened. In any event, it is now widely expected that the Eurozone faces a cold and dark winter because Russia has cut back its deliveries of natural gas to the region.
Germany is the country most dependent on Russian gas and most likely to fall into a severe recession. Consider the following recent economic developments in Germany:
(1) German data have actually been mixed, with manufacturing production up 0.8% m/m in June and manufacturing new orders down 0.4% m/m (Fig. 21). Both are volume rather than value indexes, which explains why German exports have been soaring during the first six months of this year to a new record high in June. The prices of those exports have been soaring.
(2) The Economic Sentiment Indicators for Germany are also mixed. The industrial and services components remained relatively high in July, with readings of 11.1 and 11.7 (Fig. 22). However, the consumer and retail trade components have crashed recently to readings of -25.2 and -18.4.
Global Economy III: EMs In General, China In Particular. Many emerging markets may be at risk of political and social instability, as inflation around the world has significantly boosted the cost of food and fuel. A few benefitted from the jump in commodity prices over the past couple of years, but many of those commodity prices seem to have peaked around mid-June.
China seems to be dodging these global problems. However, it has homegrown problems that are weighing on its economy, including the bursting of the country’s massive housing bubble, the ongoing pandemic-related lockdowns, and a rapidly aging demographic profile.
The country’s saber-rattling about Taiwan runs the risk of triggering a war between China and Taiwan, including whatever allies decide to join the fray directly or indirectly. China also has chosen to take sides with President Vladimir Putin over his war with Ukraine, which could spread to all of Europe.
Currently, the country continues to experience a trade boom, with record exports and a record trade surplus thanks in large measure to American and European consumers (Fig. 23 and Fig. 24). China’s geopolitical aspirations and reckless behavior are jeopardizing trade, one of the few remaining sources of economic growth available to the country.
No Recession In Labor Market
August 08 (Monday)
YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.
US Economy I: Lots of Jobs. Friday’s employment report was all good news for consumers and the economy. It was bad news for the fixed-income securities market, since it increases the odds that the Fed will raise the federal funds rate by 75bps rather than 50bps at the next meeting of the FOMC, in late September. It was mixed news for the stock market since it reduces the odds of a recession during the rest of 2022 but increases the odds of one in 2023 if the Fed will have to raise interest rates to levels that cause a recession to bring inflation down.
How does all this change our economic outlook? Not much for now. Consider the following:
(1) GDP vs GDI. Debbie and I believe that what the economy is going through is a mid-cycle slowdown, not a recession. The so called “technical recession” during the first half of this year—with real GDP down slightly during Q1 and Q2—is unlikely to make it into the record books as an “official” recession. Indeed, either one or both quarters’ GDP results could be revised upward to show positive growth, especially because Gross Domestic Income (GDI) has been much stronger than GDP in recent quarters (Fig. 1 and Fig. 2). GDP is based on the demand side of the economy, while GDI is based on the income side and is widely deemed to be a more accurate measure of economic activity.
In any case, we now expect that real GDP will grow around 1.0% (saar) during Q3 and Q4, consistent with our view that the economy is in a “growth recession” this year. Next year should be a recovery year, with real GDP up around 2.5%.
(2) Leading indicators. The Index of Coincident Economic Indicators (CEI) rose to a record high during June, and payroll employment is one of its four components (Fig. 3). Payroll employment jumped 528,000 during July to a new record high. That suggests that the CEI’s other three components also rose in July because they are driven by employment.
Industrial production is also one of the four components of the CEI. Manufacturing output likely rose during July, since the employment report showed that aggregate hours worked in manufacturing rose 0.2% m/m last month after falling 0.1% during May.
Nevertheless, the Index of Leading Economic Indicators has been trending downward through June after peaking in February. So it is still signaling that a recession is likely sometime early next year (Fig. 4). That’s not our forecast currently, but we remain on high alert for compelling signs of a recession.
(3) Inflation eroding purchasing power. July’s strong employment report meant that our Earned Income Proxy (EIP) for private-sector wages and salaries jumped 0.8% in current dollars as aggregate hours worked increased 0.3% and average hourly earnings rose 0.5% (Fig. 5). So why aren’t we more optimistic about the near-term economic outlook given the strength in July’s employment report?
The problem is that inflation has been eroding the purchasing power of nominal wages and salaries. As a result, while our EIP is up 9.8% y/y through June, it is up just 2.9% y/y on an inflation-adjusted basis using the PCED. The good news is that inflation might have moderated during July, led by a drop in gasoline prices, thus leaving consumers with more purchasing power during the month.
(4) Broad-based job gains. Total payroll employment has recovered 22.0 million jobs since bottoming in April 2020, moving above its pre-pandemic level by 32,000 (Fig. 6). The payroll employment diffusion index, which tracks the percentage of industries reporting higher private payrolls, was 68.6% on a one-month basis and 74.4% on a three-month basis (Fig. 7). Industries posting the largest gains during July were leisure & hospitality (96,000), professional & business services (89,000), health care (70,000), construction (32,000), manufacturing (30,000), and transportation (22,500).
The gain in construction jobs is surprising since homebuilders are selling fewer homes. Also surprising is the gain in information technology (13,000), since some tech companies recently announced hiring freezes and layoffs. Not surprising is that warehouse employment fell 1,600, as retailers are slashing their prices to reduce their bloated inventories.
US Economy II: The Fed Isn’t Done. As noted above, Friday’s employment report increased the odds that the Fed will raise the federal funds rate by 75bps rather than 50bps when the FOMC meets in late September. In addition to a strong increase in payrolls, wages continue to spiral higher along with prices. Consider the following:
(1) The spiral. Average hourly earnings for all workers in July increased 0.5% m/m and 5.2% y/y. July’s wage inflation rate remained well below the latest available price inflation data, for June, of 9.1% y/y and 6.8% y/y in the CPI and PCED measures, respectively (Fig. 8). Real wages have been stagnating since early 2021 (Fig. 9). However, the wage-price-rent spiral continues to spiral.
(2) Fed heads. Last week, even before the jobs report was released, a few of the talking Fed heads clearly were on a damage-control campaign to clarify Fed Chair Jerome Powell’s comment at his presser on July 27 that the federal funds rate range of 2.25%-2.50% is “right in the range of what we think is neutral.” He added, “now that we’re at neutral, as the process goes on, at some point, it will be appropriate to slow down” the pace of rate hikes.
Last week, five regional Fed bank officials scrambled to walk back the notion that the Fed was nearly done tightening. San Francisco’s Mary Daly said that the central bank is “nowhere near” being almost done cracking down on inflation. Cleveland’s Loretta Mester said she’s still awaiting persuasive evidence that price pressures are moderating, and Chicago’s Charles Evans said the kind of data that would confirm policymakers are on the right track is a few reports away.
Minneapolis Fed Bank President Neel Kashkari said that the Fed reacted to inflation too slowly last year because policymakers believed higher prices would be transitory. When asked about a potential recession, he said that navigating a soft landing is still possible.
Kashkari also shot down the notion that the Fed could cut interest rates in 2023 to spur economic growth: “Some financial markets are indicating they expect us to cut interest rates next year,” he said. “I don’t want to say it’s impossible, but it seems like that’s a very unlikely scenario right now given what I know about the underlying inflation dynamics. The more likely scenario is we would continue raising (interest rates), and then we would sit there until we have a lot of confidence that inflation is well on its way back down to 2 percent.”
Also on August 3, in a CNBC interview, St. Louis Fed Bank President James Bullard said the Fed might need to keep interest rates “higher for longer” until there’s enough evidence showing that inflation is easing. “We’re going to need to see convincing evidence across the board, headline and other measures of core inflation, all coming down convincingly before we’ll be able to feel like we’re doing enough.”
On Saturday, Fed Governor Michelle Bowman suggested that she would vote for another 75bps rate hike at the next FOMC meeting: “Based on current economic conditions and the outlook I just described, I supported the FOMC’s decision last week to raise the federal funds rate another 75 basis points. I also support the Committee’s view that ‘ongoing increases’ would be appropriate at coming meetings. My view is that similarly-sized increases should be on the table until we see inflation declining in a consistent, meaningful, and lasting way.”
(3) Market reaction. By the end of last week, the 2-year Treasury note yield, which is a good indicator of market expectations for the federal funds rate over the coming year, rose to 3.24% on Friday, up 39 bps from its recent low of 2.85% on July 28 (Fig. 10). The yield-curve spread between the 10-year and 2-year Treasury notes fell to -35bps on Friday—the lowest reading since early September 2000—signaling that if the Fed continues to tighten, a recession is likely (Fig. 11).
US Employment III: Churn To Earn More. The labor market is remarkably dynamic. Over the past 12 months, hirings and quits rose to record highs. Many people are quitting their old jobs to take new ones that pay more. The problem they face is that price inflation has been eroding most, if not all, of their wage gains. Consider the following remarkable turnover in the labor market:
(2) Hiring. Over this same period, according to the JOLTS report, hiring totaled a whopping 78.3 million, or 51.5% of July’s payrolls (Fig. 14 and Fig. 15). That’s right: Half of payroll employment was attributable to newly hired workers, i.e., hired over the past 12 months!
(3) Quits. Over this same period, separations totaled 72.2 million (47.5%), consisting of 51.4 million quits (33.8%) and 16.4 million layoffs (16.4%) (Fig. 16 and Fig. 17). That’s right: A third of workers quit their jobs over the past 12 months!
(4) Job openings. All this churning can partly explain why there are a near-record 1.8 job openings for every unemployed worker. Jobs open up when workers quit. But the rapid pace of hiring suggests that jobs get filled fairly quickly after opening up.
(5) Switching. Some of this incredible churning in the labor market undoubtedly reflects workers’ perceptions that the labor market is tight and that they can get paid more by switching jobs. They are right, according to the Atlanta Fed’s wage growth tracker (WGT). During June, the wages of job switchers rose 7.9% y/y, while the wages of job stayers rose 6.1% (Fig. 18).
(6) Eroding. Meanwhile, the PCED inflation rate was 6.8% y/y through June. So in real terms, the WGT rose just 1.1% for switchers and fell 0.7% for stayers (Fig. 19).
Emerging Markets, Oil Refiners & Nuclear Power Plants
August 04 (Thursday)
Emerging Markets: Facing Challenges. Even though the S&P 500 has fallen 14.2% ytd through Tuesday’s close, the US has been one of the safest places in the world to invest so far this year (a theme we call “TINAC,” for “there is no alternative country”). Its currency is strong, the 10-year US Treasury offers a more attractive yield than other developed nations’ benchmark bonds, and today’s global challenges seem more surmountable here than in many other places around the world.
Unfortunately, what has helped the US has hurt many emerging market countries, particularly poor nations that face increasingly expensive dollar-denominated debt repayments and whose citizens can’t afford the higher cost of food and energy. Investors have responded by pulling funds out of the emerging markets in each of the past five months. Outflows from emerging market stock and bond funds hit $9.8 billion in July, bringing the total outflows to almost $40 billion since March, according to an August 3 WSJ article citing Institute of International Finance data.
As a result, the US MSCI, which has lost 15.2% ytd through Tuesday’s close, has outperformed the MSCI All Emerging Markets index, which has fallen 20.1% in dollars and dropped 16.0% in local currencies (Fig. 1).
As for the country-specific emerging market MSCIs, the indexes of those countries that export goods priced in dollars generally have fared better than the rest. The Brazil MSCI index is up 2.7% ytd in dollars and down 3.4% in local currency, outperforming most of its counterparts. The country is a large exporter of soybeans, iron ore, and oil.
The MSCI indexes of countries that benefit from tourism also have outperformed this year, helped by the resumption of international travel. Thailand’s MSCI has fallen 7.5% ytd measured in dollars and is flat ytd in the local currency.
Conversely, other countries—e.g., Sri Lanka—are scrambling to pay for imported goods and meet their dollar-denominated debt payments, as they lack access to dollars. The MSCI of that Asian nation has fallen 68.2% ytd measured in dollars and 43.5% ytd in the local currency.
Let’s take a quick world tour:
(1) Interest rates: High, but not too high. The 10-year US Treasury yield has risen to 2.75%, up from 1.19% a year ago. That’s far more attractive than the yields on other developed countries’ 10-year bonds: UK (1.91%), France (1.43), Sweden (1.38), Germany (0.81), and Japan (0.18) (Fig. 2).
And high US interest rates have helped boost the value of the US dollar relative to other currencies around the world (Fig. 3). However, a surging dollar has made soaring food and oil prices even more expensive to purchase for emerging countries that import those goods.
(2) Uneven economic growth. The manufacturing purchasing managers index (M-PMI) for emerging economies has weakened only modestly over the past two years. After peaking at 53.9 in November 2020, the emerging markets’ M-PMI was 50.8 in July. It’s moderately below the developed markets’ M-PMI of 51.3 (Fig. 4).
But lumping all emerging markets into one basket obscures substantial differences among the economies. European emerging economies have been battered by the war in Ukraine. Here are their July M-PMIs: Kazakhstan (52.8), Turkey (46.9), Czech Republic (46.8), and Poland (42.1) (Fig. 5). The Ukraine war and high-stakes natural gas games with Russia have taken a toll on several developed European countries as well. Here is a handful that have seen their M-PMIs drop below the 50.0 level indicating contraction: France (49.5), Germany (49.3), Greece (49.1), Spain (48.7), Italy (48.5), and Denmark (38.0).
Manufacturing PMIs for Latin American countries vary quite a bit, with Brazil’s M-PMI jumping sharply (54.0) and Columbia’s (49.5) and Mexico’s (48.5) M-PMIs contracting slightly in July (Fig. 6). Brazil benefits from the dollars earned by Petrobras, the state-run oil company, and the country’s miners. Mexico, on the other hand, is expected to be dragged into a recession, due in part to its close economic ties to the US, where demand for goods (including imported ones) seems to be slowing.
Meanwhile, July’s PMIs held up relatively well in most emerging Asian countries: India (56.4), Thailand (52.4), Indonesia (51.3), Vietnam (51.2), Philippines (50.8), Malaysia (50.6), and China (50.4) (Fig. 7).
(3) Descending into turmoil. Some emerging market countries might wish that their worst problem was a PMI below 50.0. Panama and Sri Lanka, for example, suffer from inflation, capital outflows, and civil unrest. Panama’s dollar-denominated market is down 18.4% ytd through Tuesday’s close. Sri Lanka’s has fallen by 43.5% ytd in local currency and by 68.2% ytd in dollars.
Sri Lanka has been plagued by inflation running north of 50% and a lack of foreign currency, which has led to shortages of fuel, food, and other imported goods. Last year, the government prohibited the importing of chemical fertilizer, which led to crop failures among the nation’s farmers. The country then had to buy food from abroad, worsening its financial situation.
Sri Lanka suffers from political instability, as its President fled to Singapore last month. The Prime Minister declared a state of emergency across the country as protesters filled the streets and even stormed the presidential palace. The country failed to make an interest payment on its foreign debt in May, and it owes more than $51 billion to foreign lenders, including $6.5 billion to China.
Protestors are also hitting the streets in Panama. They too are upset about inflation and the prices of food and gasoline, which rose from $3.73 a gallon in January to $5.75 in July, a July 20 FT article stated. Protestors are also upset by politicians who have special advisors being paid for ambiguous services and by a video of “lawmakers celebrating the beginning of the legislative period with $340 bottles of Macallan whisky.”
Argentina, Latin America’s second largest country, has struggled with inflation north of 60%, shrinking currency reserves, a falling currency, and too much debt. The country has a deeply divided government, and the top economic position has changed hands three times over the past month. The cost of Argentina’s imports has surged due to the rising price of energy. Meanwhile, its exports have been hurt by grain exporters who are “hoarding their harvest because they fear an imminent devaluation,” a July 25 FT article reported.
Having watched inflation erode their savings and earnings, Argentinians have been protesting for a minimum living wage. And there are questions about whether the country can live up to a negotiated restructuring of the $44 billion of debt it owes the International Monetary Fund.
Energy: Refiners Reporting Riches. Over the past week, oil refiners reported banner Q2 earnings, boosted by high gasoline prices and a wide crack spread. Valero Energy’s adjusted Q2 earnings was $4.6 billion, or $11.36 a share, up from $260 million, or 63 cents a share in Q2-2021. Marathon Petroleum’s adjusted net income came in at $5.7 billion, or $10.61 a share, up from $437 million, or 67 cents a share in Q2-2021. The company’s refining and marketing margin surged to $37.54, triple the $12.45 margin in the year-ago quarter. Here’s a look at what drove results:
(1) Running full tilt. Refiners ran their operations non-stop to meet demand for gasoline during the summer driving season and for airplane fuel now that travelers have returned to the skies. Valero refinery’s utilization rate increased to 94% in Q2, up from 89% in Q1 and 90% in Q2-2021. Marathon Petroleum’s refineries ran at 100% utilization processing in Q2, up from 94% in Q2-2021. The company expects its utilization rate will return to 94% in Q3 as it performs maintenance in September.
(2) Cash is flowing. The jump in earnings also meant a surge in cash flow for the two refiners. Valero’s business threw off adjusted net cash of $5.2 billion in Q2. Marathon reported EBITDA from continuing operations of $9.1 billion, up from $1.9 billion a year earlier.
Despite the billions of earnings and cash flow generated, capital spent to expand the traditional refining business was relatively minimal. At Valero, $355 million was used to grow the business in Q2, $300 million was used to reduce debt, and about $2.2 billion paid dividends and bought back stock. Cash on the balance sheet rose by $2.8 billion.
The company said on the earnings conference call that it will earmark about $800 million for capital investments to grow the company, and half of that will be put into expanding Valero’s low-carbon fuels business. That leaves only $400 million earmarked for expanding Valero’s traditional refining operations in 2022.
Marathon used $313 million to pay dividends and $3.3 billion to repurchase shares in the quarter. The company spent $546 million on capital expenditures, some of which is earmarked to expand its Galveston Bay refinery capacity by 40,000 a day.
Both companies are spending to build renewable fuel facilities, which can take animal fats, used cooking oil, and corn oil and process them into diesel that can be used in engines on the road today. The renewable diesel produced at the Valero facility claims that it reduces greenhouse gas emissions by up to 80% compared with traditional diesel fuel.
(3) A look at the numbers. At its peak on June 7, the S&P 500 Oil & Gas Refining & Marketing stock price index was up 73.4% from the start of 2022. Since peaking, the index has fallen 20.0%, leaving it up 39.0% ytd through Tuesday’s close (Fig. 8). The shares appear to be following the crack spread of West Texas Intermediate crude oil, which peaked at $69.20 per barrel on April 28 and has since fallen to $39.40 (Fig. 9).
The industry’s revenue climbed 69.8% last year and is expected to grow again by 41.2% this year before falling by 11.0% in 2023, according to analysts’ consensus estimates (Fig. 10). Earnings follow a similar pattern. Analysts expect earnings to soar 400.0% this year, only to fall by 39.7% in 2023 (Fig. 11). The industry’s forward P/E has fallen to only 6.8 from a peak of 170.4 in November 2020, when the industry was barely profitable (Fig. 12).
Disruptive Technologies: Small Nuclear Gets The Nod. The US Nuclear Regulatory Commission plans to certify the small modular reactor (SMR) designed by NuScale Power Corp. Even though it’s far smaller than a traditional nuclear reactor, it is expected to generate nuclear power more easily and safely.
SMRs are “small enough that they can be assembled on a factory floor and then shipped to a site where they will operate, eliminating many of the challenges of on-site construction. In addition they’re structured in a way to allow passive safety, where no operator actions are necessary to shut the reactor down if problems occur,” ARS Technica reported on July 29.
NuScale is working with the Utah Associated Municipal Power Systems to deploy a SMR system in 2029. NuScale also received a $15 million private investment from Nucor, the steel manufacturer, which presumably is looking for ways to produce large amounts of electricity to run its mills without producing CO2. And NuScale completed a reverse merger in May with a special-purpose acquisition company, Spring Valley Acquisition Corp. The new company’s ticker: SMR, of course
We noted in the February 18, 2021 Morning Briefing that Bill Gates has embraced SMRs. He’s an investor in and the chairman of TerraPower, which is building a small nuclear plant in Wyoming that uses molten salt to store energy.
US Earnings & European Gas
August 03 (Wednesday)
Strategy: Analysts Are Shaving Earnings. Investors spent most of the first six months of this year worrying about a recession and selling stocks. They did so even as industry analysts raised their earnings estimates. Investors, apparently fearing that the analysts might be delusional, slashed the valuation multiples they were willing to pay for analysts’ earnings estimates. Now that analysts finally have started to lower their earnings estimates, investors seem to have concluded that the economic outlook may not be as bad as they feared. So stocks have rebounded sharply since they bottomed on June 16.
Let’s see what analysts have been up to recently:
(1) Earnings. Joe and I shaved our earnings estimates on July 5 (see that day’s Morning Briefing). We reduced our S&P 500 operating earnings-per-share forecast for 2022 by $10 to $215 and for 2023 by $5 to $235 (Fig. 1). Industry analysts also have started shaving recently. Their comparable consensus estimates peaked at $229.57 and $251.99 during the week of June 16. They lowered them to $227.02 and $246.33 during the July 28 week.
(2) Revenues. S&P 500 revenues-per-share data for 2022 and 2023 consensus estimates are available with a one-week lag through the July 21 week. They remain on solid uptrends in record-high territory, though both flattened during the latest week (Fig. 2). We expect that they will continue to rise, boosted by inflation, as they have been doing for the past year. There’s certainly still no sign that analysts are shaving their earnings estimates because they see a recession given their upbeat outlook for revenues.
(3) Margins. The main reason that analysts have been trimming their earnings estimates is that they have lowered their sights for profit margins, which we can tell because we impute the profit margins they expect simply by dividing their consensus earnings estimates by their consensus revenues estimates (Fig. 3). Nevertheless, their latest profit margin estimates, at 12.9% and 13.4% for this year and next year, are higher than our estimates of 12.3% and 12.5%—suggesting that they may have further shaving of margin and earnings estimates to do if our numbers are closer to the mark.
Of course, both their estimates and ours are too optimistic if a severe recession unfolds over the rest of this year and/or next year. During the Great Financial Crisis, the aggregate profit margin for S&P 500 companies fell into the mid-single digits. During the Great Virus Crisis, it fell into the low double digits.
(4) Forward earnings. Our projections for the S&P 500 price index are based on our projections for the forward P/E and forward E—i.e., the time-weighted average of the analysts’ consensus earnings-per-share estimates for this year and next year. We are predicting that forward earnings will be $235 per share at the end of this year. During the July 28 week, it was down to $238.16 from a recent record high of $239.84 during the July 7 week (Fig. 4).
(5) Quarterly earnings estimates. Joe and I also track the weekly series of analysts’ consensus estimates for the quarterly earnings of the S&P 500 companies for the current year and the coming one. Data through the July 28 week show that their estimate at the start of the Q2 earnings season remains close to the mark of around $55 per share for the quarter (Fig. 5).
However, since the annual consensus estimates peaked on June 16, analysts have shaved their Q3 and Q4 estimates by $3.07 altogether. At the same time, they’ve also been shaving their earnings estimates for each of next year’s four quarters by $6.15 altogether (Fig. 6).
(6) Revenues & earnings growth. As noted above, there’s no recession in analysts’ consensus expectations for revenues. They’ve actually raised their expectations for 2022 revenues growth from 7.5% at the start of this year to 12.0% during the July 21 week (Fig. 7). The revenues boost from higher-than-expected inflation was undoubtedly the reason. However, their revenues growth estimate for 2023 is down to 4.2% from 5.3% at the start of this year. Apparently, they expect to see a moderation in inflation since we doubt that they are collectively anticipating a recession next year.
And what are they expecting for earnings growth? During the July 21 week, their earnings projections represented growth rates of 10.6% this year and 8.2% next year, which compares to their 8.7% and 10.1% projections at the start of this year (Fig. 8).
Europe I: Running Out Of Gas. The European Union’s political leaders are accusing Russian President Vladimir Putin of using energy as a weapon of war because he has slowed the flow of Russian natural gas to Europe in what appears to be retaliation for the EU’s war sanctions on his country. EU nations are preparing to reduce their dependence on Russian gas but likely won’t be able to meet their needs this winter if Russia further slows gas flows or cuts them off entirely.
The EU’s precarious gas situation could quickly turn into a crisis and a recession. Before reductions in deliveries to Europe of about 20% of previous capacity, Russia supplied about 40% of Europe’s natural gas.
Here’s a timeline of major recent developments related to the flow of natural gas from Russia to Europe:
(1) On June 24, Politico reported that Russia’s state-run Gazprom has previously stopped or reduced deliveries to 12 EU countries in retaliation for Western sanctions against Russia over the invasion of Ukraine. Deliveries were halted to Poland, Bulgaria, the Netherlands, Finland, and Denmark. To compensate, the impacted countries are relying on alternative sources, including coal and nuclear-powered plants. That was after those Russia-designated “unfriendly countries” refused to pay for deliveries in rubles instead of the contractual euros or dollars.
(2) On July 11, Gazprom closed its critical Nord Stream pipeline gas flow to Europe, claiming force majeure for technical maintenance over a 10-day period. As promised, the energy major reopened the taps on July 21. Even before the maintenance period began, however, Moscow already had reduced the flow of gas through Nord Stream to about 40% of its capacity on June 14, the retroactive effective date of the contract clause. But a spokesperson for Germany’s economic ministry said the reason for the maintenance was a replacement part that was meant to be used only from September onward.
(3) On July 19, Putin said that the Kremlin would keep good on its natural gas commitments to Europe, but at the same time warned of putting a squeeze on capacity due to Western sanctions.
(4) On July 20, the European Commission (EC) released a plan to push governments to prepare for a gas shortage this winter. The EC is aiming to get countries to voluntarily reduce their gas consumption by 15% by early next year. If countries do not abide by the timeline, the EC could force the reductions. Russian gas supplies to Europe in June were less than 30% of the average sent to the EU over the previous five years, the Commission said.
(5) On July 27, gas flows through the pipeline were further reduced to about 20% of the pipeline’s capacity from an already low 40%, again with Gazprom citing maintenance issues. Ukraine President Volodymyr Zelenskyy said the move was equivalent to a “gas war” with Europe. Germany’s economy minister said the maintenance “excuse” was a “farce.” It is unclear whether this will be a temporary supply restriction or Gazprom will continue sending only 20% of supplies.
(6) On Monday, European gas futures jumped after Gazprom announced it had stopped sending natural gas to Latvia. Gazprom said it did so because of a “violation of the conditions for gas withdrawal” with no further details. Latvian officials said Gazprom's move would have little effect given that Latvia has already decided to ban Russian gas imports starting January 1, 2023.
(7) Bloomberg calculations published Monday showed that Gazprom’s daily deliveries were down 22% in July from June. That was the lowest seen since at least 2014 even as daily flows to China set multiple records in July.
Europe II: Winter Of Their Discontent? European officials have said that Russia’s squeeze on Europe’s gas supply will result in a “clear cut” recession for the region. The latest economic indicators are already pointing in that direction. Energy prices are soaring and depressing consumer and business sentiment. Here are the latest updates on the European economy:
(1) Energy leading CPI inflation to record highs. In July, the Eurozone’s flash CPI inflation rate jumped to a record 8.9% y/y (Fig. 9). The flash core rate (excluding food and energy) was 4.0%, also the highest on record looking back to 2000.
(2) Energy prices leading. Not surprisingly, energy prices led the way up for the headline number with a rate of 39.7% y/y, down only slightly from the record rate of 44.3% during March (Fig. 10).
(3) European sentiment souring. In July, the European Economic Sentiment Indicators (ESIs) for both the EU and Eurozone fell just below 100 for the first time since recovering from the pandemic (Fig. 11). So far, Europeans are not nearly as pessimistic about the economy as they were during the pandemic. But they could soon be if limited gas this winter plunges them into the cold and dark.
The overall ESI is derived from the industrial (weight 40%), service (30%), consumer (20%), construction (5%), and retail trade (5%) confidence indicators. Of the components, consumer sentiment fell most dramatically in July (Fig. 12). Consumers are most concerned over the next 12 months about the general economic situation, while their expectations about the job market remain strong (Fig. 13).
(4) Real GDP to weaken. The Eurozone’s ESI does not bode well for real GDP growth, as the former tends to be a leading indicator for the latter. During Q2, the Eurozone’s real GDP rose 4.0% y/y (Fig. 14). The ESI suggests that GDP growth could weaken significantly during the rest of this year and early next year.
(5) European stocks drop. The EMU MSCI index fell 16.2% (in local currency) from its record high on November 17 through Monday’s close (Fig. 15). The index is trading at a low forward P/E multiple of just below 12.0, down from just over 18.0 in mid-2020 when pandemic lockdowns began to lift (Fig. 16).
Forward earnings continued to rise through the July 21 week. Leading the way in earnings growth expectations is the EMU MSCI’s Energy sector, which makes sense given that Europe is becoming much more dependent on domestic energy firms than it was before the war. Forward earnings for most other sectors have either flatlined or edged downward through July 21.
The EMU MSCI sectors’ forward profit margins also remain near recent record highs, led by the Energy sector with a record-high forward profit margin of 9.7%. That suggests that energy firms are having no problems passing the increases from rising costs through to their selling prices. That doesn’t appear to be the case for companies in most other sectors, however, as their forward profit margins recently have turned downward. (See our EMU MSCI Sectors.)
Valuation, M-PMI & Consumers
August 02 (Tuesday)
Strategy I: Tweaking Our Valuation Multiples. In line with our view that the S&P 500 might have bottomed on June 16 at 3666, Joe and I are raising our target ranges for the index’s forward P/E valuation multiples from 14.0-17.0 to 15.5-18.0 this year and from 15.0-18.0 to 16.0-19.0 next year.
We are sticking with our forward earnings forecasts of $235 per share for year-end 2022 and $255 per share for year-end 2023. As a result, our projected ranges for the S&P 500 stock price index are now 3642-4230 by the end of this year and 4080-4845 by the end of next year. (See our updated YRI S&P 500 Earnings Forecasts.) (FYI: Forward earnings is the time-weighted average of analysts’ consensus earnings-per-share estimates for this year and next.)
Could the S&P 500 rise to a new record high of 4800 by the end of this year, rather than at the end of next year as we expect? These days, anything is possible, we suppose. However, during the July 21 week, forward earnings was $239. We are expecting it to be essentially flat over the remainder of this year assuming, as we do, that the current growth recession continues over the rest of the year.
For the S&P 500 to get to 4800 with our year-end forecast of $235 for forward earnings would require that the forward P/E jumps back to 20.4 from Friday’s level of 17.2. If the current multiple remains unchanged at 17.2 by the end of the year, forward earnings would have to rise to $279 by the end of this year for the S&P 500 to hit 4800.
In other words, a new record high in the S&P 500 by the end of this year seems unlikely to us. It is more likely to happen by the end of next year. But we won’t object if it happens sooner.
Strategy II: Why Equity Investors Care About The M-PMI. Yesterday’s M-PMI report for July was fully consistent with our view that the economy is in a growth recession, supply-chain disruptions are abating, and unintended inventory accumulation is putting downward pressure on prices (Fig. 1). On balance, it was bullish for stocks. Consider the following:
(1) M-PMI and S&P 500. The S&P 500 on a y/y basis closely tracks the M-PMI (Fig. 2). The former was down 10.4% y/y during July. July’s M-PMI reading of 52.8 suggests that the S&P 500 should be up by about as much.
Not surprisingly, the M-PMI is also highly correlated with the y/y growth rate in S&P 500 operating earnings per share (Fig. 3). So far, the former is consistent with a slowdown in the latter rather than a hard landing with negative y/y comparisons.
(2) Production & new orders. The M-PMI production index remained solidly above 50.0 during July at 53.5 (Fig. 4). However, the M-PMI new orders index dipped to 48.0, which is consistent with previous slowdowns rather than recessions.
(3) Supply chains. The M-PMI’s supplier-deliveries and backlog-of-orders components both fell sharply to readings of 55.2 and 51.3, respectively, indicating that supply-chain disruptions are easing (Fig. 5).
(4) Inflation indicator. The M-PMI’s prices-paid index dropped from 87.1 during March to 60.0 during July (Fig. 6). That’s the lowest since August 2020. In the past, similar declines occurred during recessions, identified as such by the Dating Committee of the National Bureau of Economic Research. This time might be different if the current slowdown isn’t bad enough to be counted as an “official recession.”
Consumers I: ‘Inflation Tax’ Flattens Real Incomes. Over the past 12 months through June, personal income less government social benefits to persons, in current dollars, rose $1,346 billion to a record $17.9 trillion (Fig. 7). Over that same period, inflation-adjusted income (on a comparable basis) rose just $184 billion to $14.5 trillion. So in effect, the “inflation tax” reduced the purchasing power of pre-tax personal income by $1,162 billion.
A similar analysis of disposable personal income (DPI) shows that it rose $602 billion in current dollars and fell $498 billion on an inflation-adjusted basis. So the inflation tax reduced the purchasing power of DPI by $1,100 billion (Fig. 8).
In percentage terms on a y/y basis, real personal income with and without government social benefits fell 1.0% and rose 1.3% through June. On a m/m basis, they fell 0.3% and 0.2% during June. Real DPI fell by 0.3% m/m and 3.2% y/y through June. Any way that we slice and dice the data, the inflation tax has dramatically eroded the purchasing power of consumers over the past 12 months.
It’s no wonder that the Consumer Sentiment Index (CSI), the Consumer Confidence Index (CCI), and the Consumer Optimism Index (COI) all show that consumers are very depressed (Fig. 9). The COI, which is the average of the CSI and the CCI, fell in July to the lowest reading since November 2013.
Consumers II: Saving Less To Boost Spending. In an effort to prop up their spending, especially on essentials, consumers have cut back on their saving and increased their borrowing. The personal saving rate fell from 9.5% last June to 5.1% this June (Fig. 10). Over this period, current-dollar personal saving fell $769 billion, while inflation-adjusted personal saving fell $718 billion (Fig. 11).
In current dollars, consumer revolving credit increased $131 billion over the past 12 months through May (Fig. 12). But again, on an inflation-adjusted basis, the real purchasing power of that borrowing increased by only $57 billion.
By saving less and borrowing more, consumers have managed to spend more but at a slower pace than during past periods when inflation wasn’t eroding their purchasing power as much as it is now. Consider the following:
(1) Real consumption. Personal consumption expenditures (PCE) is up 8.4% y/y through June in current dollars but only 1.6% on an inflation-adjusted basis (Fig. 13). In other words, their nominal PCE has increased by $1,334 billion over the past 12 months to $17.1 trillion, but that’s barely allowed them to increase their real spending—because of the inflation tax.
(2) Pivoting from goods to services. Over the past 12 months through June, real PCE on goods fell 3.0%, while real PCE on services rose 4.1%. Following the lockdown recession in early 2020 through mid-2021, consumers splurged on goods while most services were still unavailable. Now they’ve satiated their pent-up demand for goods and reverted to spending more on services.
(3) Budget shares. We can gain some additional insights into consumer spending by examining current-dollar spending categories as a percentage of DPI. Total PCE as a percent of DPI edged up to 92.1% during June, the highest since August 2008 (Fig. 14). This ratio is roughly the mirror image of the personal saving rate. (Personal saving equals DPI less PCE less personal interest payments less personal current transfer payments.)
From 2009 through 2019, consumers consistently spent between 9% and 10% of their DPI on durable goods. During the lockdown recession, this percentage plunged to 6.3%. Since then, it has rebounded to about 11.5%. Odds are that it will decline as the service percentage rises from 60% currently closer to the 62% pre-pandemic reading.
Spending on nondurable goods including groceries and gasoline had been on a downward trend from 1990 through 2019. Rapidly rising prices of food and fuel have forced consumers to spend 17.1% of their DPI on these essentials during June, the highest since March 2013 (Fig. 15). Similar trends have unfolded for the DPI share of clothing and footwear (Fig. 16).
Consumers have managed to pay for more of their essentials mostly by saving less and borrowing more, as noted above. That’s disturbing. Even more disturbing is that many consumers might also be reducing the share of their DPI budgets spent on health care, which was down to 19.4% during June, compared to 21.2% before the pandemic (Fig. 17).
(4) Nota bene. Comparing nominal and real-time series is a bit like comparing apples and oranges because of indexing issues raised by using the price deflator. Nevertheless, the basic conclusions above make sense to us.
Switching Planets: Investors Now From Venus, Analysts From Mars
August 01 (Monday)
YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.
Strategy I: Trading Places. Since our June 24 QuickTakes, we’ve been making the case that the bear market in the S&P 500 might have ended on June 16, when it was down 23.6% to 3666 from its record high of 4796 on January 3. We wrote: “[S]entiment indicators were so bearish that they were bullish. … On a fundamental basis, we’ve noted that commodity prices are showing signs of peaking, suggesting that inflation may be doing the same. Bond market indicators have also turned more bullish recently. For now, we see the 3666 level as a possible bear-market bottom.”
So far, so good. The S&P 500 is up 12.6% since June 16 through Friday’s close (Fig. 1). It is down only 13.9% from its record high. So far, it has remained in bear-market territory—i.e., with a decline of 20% or more—for only 21 calendar days of the 207 days since its record high. If June 16 marked the bottom, then the index bottomed 164 days into the latest bear market (Fig. 2). Let’s have a closer look at the recent happy developments:
(1) Different planets. Here is the performance derby of the 11 sectors of the S&P 500 since June 16 through Friday’s close and during the bear market from January 3 through June 16 (sorted by the former): Consumer Discretionary (21.8%, -36.4%), Information Technology (17.2, -30.2), Real Estate (14.8, -24.9), Utilities (13.7, -8.3 ), S&P 500 (12.6, -23.6), Industrials (11.8, -18.6), Health Care (10.7, -14.4), Financials (9.6, -22.4), Consumer Staples (8.2, -11.2), Communication Services (6.4, -32.7), Materials (4.7, -16.5), and Energy (1.8, 35.0). (See Table 1 and Table 2.)
That’s quite a reversal of fortune among the 11 sectors of the S&P 500. Similarly, industry analysts and investors seem to have traded places. During the bear market, Joe and I maintained that industry analysts were from Venus, while investors were from Mars. The former didn’t seem to have a care in the world and kept raising their estimates for the revenues and earnings of the S&P 500 companies for 2022 and 2023. At the same time, investors, fearing a recession caused by the Fed’s tightening of monetary policy to fight inflation, slashed the valuation multiples they were willing to pay for what they deemed to be the delusional earnings estimates provided by the analysts.
(2) Analysts from Mars. In the past couple of weeks, we’ve observed that analysts may finally have started to shave their estimates to reflect the mild recession that occurred during the first half of this year, with real GDP falling modestly during Q1 and Q2 (Fig. 3). S&P 500 forward earnings—i.e., the time-weighted average of analysts’ consensus earnings estimates for this year and next year—rose 7.5% since the start of this year to a record high during the week of July 7 as the analysts raised their 2022 and 2023 estimates. They’ve been cutting their annual estimates for the past five weeks through the July 21 week, so forward earnings has flattened around $239 per share.
(3) Investors from Venus. Meanwhile, since June 16, investors seem to have concluded that they might have been too bearish about the outlook for both Fed policy and earnings. The S&P 500’s forward P/E, which started the year at 21.4, bottomed at 15.3 on June 16 and was back up to 17.2 on Friday (Fig. 4).
Previously, we had observed that the June 16 low coincided with the peak of the S&P GSCI commodity price index on June 8 and the peak of the 10-year Treasury bond yield on June 14, at 3.48%. After June’s worse-than-expected CPI came out on July 13, we observed that the market had held up well compared to the dive it took when May’s number was released on June 10. That suggested to us that the market was starting to discount the possibility that June’s CPI might have marked peak inflation, as we discussed in our July 12 QuickTakes titled “Will June’s CPI Inflation Rate Be the Peak?”
(4) Feshbach on the market. I checked in with my friend Joe Feshbach on his latest market call. We seem to be on the same planet lately. In his opinion: “Sentiment indicators proved reliable once again. Nasdaq breadth was a bit shaky Friday, so that could lead to temporary profit-taking. However, the put/call ratios I monitor showed skepticism on the rally, which should be a nice clue that the market will work its way higher after any pullback.”
Strategy II: The Fed Is From Outer Space. In addition to discounting peak inflation, the market seems to have discounted peak Fed hawkishness last week on Wednesday afternoon during Fed Chair Jerome Powell’s press conference right after the FOMC voted to hike the federal funds rate by 75bps to a range of 2.25%-2.50%. Consider the following:
(1) Neutral debate. In his brief prepared remarks, Powell started out saying: “My colleagues and I are strongly committed to bringing inflation back down, and we are moving expeditiously to do so. … It is essential that we bring inflation down to our 2% goal if we are to have a sustained period of strong labor market conditions that benefit all.” He reiterated that the Fed remains on course to “significantly reducing the size of our balance sheet.”
Then, in his unscripted remarks, he responded to a reporter asking “how far into restrictive territory rates may need to go?” He said, “[W]e’ve been saying we would move expeditiously to get to the range of neutral. And I think we’ve done that now. We’re at 2.25 to 2.50, and that’s right in the range of what we think is neutral.” Apparently, his suggestions that the Fed is on the borderline of restrictive territory and therefore closer to being done tightening were all it took to move more investors from Mars to Venus.
On Friday, former Treasury Secretary Lawrence Summers accused Powell of coming from outer space. He said that the Fed is engaging in “wishful thinking” similar to the Fed’s delusion last year that inflation would be transitory. He accused Powell of saying things “that, to be blunt, were analytically indefensible.” He added, “There is no conceivable way that a 2.5% interest rate, in an economy inflating like this, is anywhere near neutral.” Former Federal Reserve Bank of New York President William Dudley said on Wednesday that, given the level of uncertainty, “I’d be a bit more skeptical” in saying policymakers had reached neutral.
(2) Safe passage. Investors were also delighted to hear Powell say, “We’re not trying to have a recession. And we don’t think we have to. We think there’s a path for us to be able to bring inflation down while sustaining a strong labor market ... along with—in all likelihood—some softening in labor market conditions. So … that’s what we’re trying to achieve, and we continue to think that there’s a path to that.”
However, he reiterated that “restoring price stability is just something that we have to do. There isn’t an option to fail to do that.” Investors clearly chose to cherry-pick Powell’s dovish comments and ignore his hawkish ones, now that they are on Venus.
(3) No more guidance. Apparently, investors were also happy that Powell said that the Fed’s decisions going forward will be totally data dependent, and the Fed will no longer provide forward guidance (until further notice): “In terms of September, we’re going to watch the data and the evolving outlook very carefully. … I’m not really going to provide any specific guidance about what that might be. But I mentioned that we might do another unusually large rate increase, but that’s not a decision that we’ve made at all.”
Again, investors chose to interpret that as leading to a happy potential outcome, namely, that the data will show weakening economic activity and peaking inflation, thus bringing the Fed’s monetary policy tightening cycle to an end sooner rather than later.
(4) Playbook from Venus. Powell did offer a bit of guidance. He said, “And I think you can still think of the destination as broadly in line with the June SEP. Because it’s only six weeks old.”
“SEP” stands for the “Summary of Economic Projections,” which shows the consensus forecasts of the FOMC participants for the federal funds rate, the unemployment rate, real GDP, headline PCED inflation, and core PCED inflation. Back in June, they expected the federal funds rate would be raised to 3.40% by the end of this year and 3.80% by the end of next year. (See our FOMC Economic Projections.)
According to the SEP, that’s restrictive enough to bring inflation down but without causing a recession. More specifically, real GDP is expected to grow 1.7% this year and next year, with the unemployment rising to only 3.9% next year. The PCED inflation rate is expected to fall from 5.2% this year to 2.6% in 2023 and 2.2% in 2024.
On Venus, there are only happy endings.
Credit: The Bond Vigilantes Are From Venus Too. Joining stock investors on Venus are the Bond Vigilantes. Consider the following:
(1) Bullish indicators. As noted above, the US Treasury bond yield peaked this year (so far) at 3.49% on June 14, falling to 2.67% on Friday. That’s surprising given that inflation remains so high. But we aren’t surprised. As we’ve pointed out before, the bond yield closely tracks the copper/gold price ratio and the Citigroup Economic Surprise Index (Fig. 5 and Fig. 6). Both remain bullish for the bond market, with the copper/gold price ratio signaling that the yield should be closer to 2.00%.
(2) The dollar, QT2 & the yield curve. As we noted in last Tuesday’s Morning Briefing, the strong dollar combined with the Fed’s intention to proceed with QT2 may be equivalent to a hike in the federal funds rate of at least 100bps. The Fed’s critics seem to overlook this important point. A 2.50% federal funds rate in fact may be at the neutral rate under the circumstances!
This view is corroborated by the inversion of the yield curve. The yield spread between the 10-year and 2-year US Treasury notes turned negative on July 6 and was down to -22bps on Friday (Fig. 7). That certainly is signaling that bond investors believe that interest rates are already high enough to weaken economic growth and bring inflation down.
The 2-year yield—which tends to be an indicator of the market’s expectations for the federal funds rate over the next 12 months—peaked this year at 3.45% on June 14 (Fig. 8). It was down to 2.89% on Friday. It currently implies “one and done,” i.e., that one more federal funds rate hike of 50bps to a range of 2.75%-3.00% in September should be the end of the Fed’s rate hiking.
That may seem absurdly low to the Fed’s critics, but they’ve been ignoring the restrictive impact of the strong dollar and QT2. Fed officials undoubtedly have run their econometric model to determine the equivalence of these restrictive developments to the magnitude of a rate hike. They should share that information with the public.
(3) Flow of funds. The rally in the bond market has been especially impressive given that bond mutual funds experienced net withdrawals of $83.2 billion over the past 12 months through June (Fig. 9). That may be a good contrary indicator given that investors piled into these funds at a record 12-month pace of $766 billion during April 2021, the worst possible time to be buying bonds as it turned out.
Previously, we observed that net capital inflows into the US from abroad added up to $1.3 trillion over the 12 months through May (Fig. 10). Over that same period, private foreigners’ net purchases of US bonds was $796.8 billion (Fig. 11). On the other hand, foreign investors sold $162.4 billion in US equities, on balance, over this same period.
(4) TINAC. The above suggests that global investors have concluded that the US represents a safe haven for their money in a world that’s going mad. Their mantra is “there is no alternative country” (TINAC). That explains why the dollar has been so strong since the start of this year, as they’ve been buying lots of US bonds. Now they may also be buying US stocks. If not, their bond purchases certainly have helped to lower the bond yield here, which seems to be providing support for valuation multiples in the stock market.
Inflation: Hopefully Peaking. So is inflation peaking or not? There are mounting signs that it is peaking, but not enough of them to be certain. It didn’t peak in June, as the headline PCED inflation rate rose to 6.8%, the highest since January 1982 (Fig. 12). The core inflation rate was 4.8%. We are still predicting that the headline rate will moderate to 4%-5% during H2. We should see it get closer to this range when July’s PCED is released on August 26 for the following reasons:
(1) Food & energy. Agricultural commodity prices dropped during July, suggesting some moderation in food inflation, which was 11.2% y/y during June in the PCED (Fig. 13). The same can be said about energy inflation, with the exception of natural gas prices, which moved higher in July. The energy component of the PCED was up a whopping 43.5% y/y during June.
(2) Core inflation. The three-month annualized inflation rates for both durable and nondurable goods (excluding food and energy) moderated significantly through June (Fig. 14). Retailers have been forced to liquidate their bulging inventories by slashing their prices. We also expect to see further weakness in the prices of household furniture and appliances as a result of the housing recession (Fig. 15).
Debbie and I anticipated that some of the progress likely to be made in durable and nondurable goods inflation will be offset by the rent components of the PCED services sector. Sure enough, rent of primary residence and owners’ equivalent rent are rising at faster rates, of 5.8% and 5.4% y/y through June (Fig. 16). The comparable three-month annualized rates are even higher at 7.9% and 7.1%.
(3) Employment costs. In his presser, Fed Chair Powell said that among the more important inflation indicators is the Employment Cost Index (ECI). It came out on Friday, and it showed no signs of peaking. The ECI inflation rate continued to move higher during Q2 with a gain of 5.5% y/y, led by a 5.7% increase in wages and salaries, while benefits rose 5.3% (Fig. 17).
The wage-price-rent spiral was still spiraling through June.
The Fed, Earnings, Chips & AI
July 2 8 (Thursday)
The Fed: No Surprises From Powell. The S&P 500 soared 2.6% yesterday to close at 4023.61, 9.7% above its June 16 bear-market low of 3666.77. It is still 16.1% below its record high on January 3. Yesterday’s rally was boosted by Fed Chair Jerome Powell’s no-surprises press conference. The Fed hiked the federal funds rate by 75bps as widely expected. Powell reiterated that he believes that the Fed has a path toward moderating inflation without causing a recession.
Joe and I believe that TINAC has been a major contributor to the rebound in the bond and stock markets recently. “TINAC” stands for “there is no alternative country.” As the world seems to be spinning out of control, the US looks like a safe haven for global investors.
That explains the strength of the US dollar. Previously, we’ve observed that monthly net capital inflows data collected by the US Treasury show that foreigners have been big buyers of US fixed-income securities in recent months. That may have helped to stabilize the bond yield around 3.00%, stopping the freefall in valuation multiples in the stock market.
As we note in the next section, the Q2 earnings reporting season so far reflects a slowing economy, but not a recession. Analysts are shaving some earnings estimates, but certainly not slashing them. For now, the market seems to be siding with Powell’s view (and ours) that a soft landing is possible.
Earnings: So Far, So Good. Despite all the handwringing about Fed tightening and high energy prices, analysts continue to call for solid earnings growth this year and next. Their consensus forecasts for S&P 500 companies collectively imply earnings growth of 10.6% this year and 8.2% in 2023 (Fig. 1). Granted, the jump in the S&P 500 Energy sector’s expected earnings for this year has boosted the S&P 500’s projected 2022 earnings growth, but next year the Energy sector will weigh on the broader index’s 2023 earnings growth. Excluding the Energy sector, S&P 500 earnings are expected to grow 4.4% in 2022 and 10.6% in 2023.
Higher interest rates and gasoline prices did take a toll on consumer spending in Q2, based on earnings reports this week from Walmart, McDonald’s, and Shopify. That pressure won’t let up anytime soon given the Fed’s federal funds rate increase yesterday. Conversely, corporations have continued spending on technology, but have pulled back on ad spending, if Microsoft’s earnings report is any indication.
Here’s a quick look at some of the notable Q2 corporate earnings reports from this week:
(1) Consumers hit speed bump. Retailers warned that inflation and higher interest rates had started to affect consumers’ shopping patterns. Walmart’s customers are spending more on necessities like food and less on clothing and electronics because inflation is pinching their pocketbooks, the retailer said as it made a Q2 earnings preannouncement this week that shocked investors.
While Walmart said same-store sales rose 6% in Q2, the shift in consumer spending left the retailer with excess inventory that needed to be aggressively marked down. The retailer lowered its 2022 earnings forecast to a decline of 11%-13%, much greater than the 1% decline it previously signaled. Walmart shares dropped 7.6% on the news Tuesday and are down 15.7% ytd through Tuesday’s close. That’s actually better than the S&P 500 Consumer Discretionary sector’s 31.4% decline ytd.
McDonald’s CEO Chris Kempczinski sounded very gloomy in a conference call, noting that war, inflation, and high interest rates are “contributing to weak consumer sentiment around the world and the possibility of a global recession,” a July 26 CNBC article reported. Lower-income customers are opting for more value offerings, and the company is gaining customers who are trading down from sit-down and fast-casual restaurants. Q2 earnings—excluding charges from the closure of McDonald’s business in Russia and other unusual expenses—came in at $2.55 a share, up 8% y/y.
Shopify warned that 2022’s online sales will “reset to the pre-Covid trend line and is now pressured by persistent high inflation.” While Shopify’s revenue rose 16% y/y, it posted an adjusted loss of three cents a share, missing analysts’ consensus target and below Q2-2021’s adjusted earnings per share of 22 cents. Losses are expected to continue during H2 as well. Shopify, which helps companies set up their e-commerce websites, announced it will cut 1,000 jobs. Its shares have fallen roughly 75% ytd.
(2) Microsoft saves the day. In the current economic environment, all tech is not created equal. The shares of many tech companies that rely on advertising like Snap and Meta Technologies are down sharply ytd, as advertising is often the first thing that customers cut during uncertain economic times. With the consumer facing the pressure of higher gasoline prices, higher interest rates, and higher inflation, tech companies selling online to consumers face headwinds as well.
Microsoft does have consumer exposure through its Xbox gaming business, which saw revenue drop 6% in its fiscal Q4 ended June 30. But Microsoft’s Azure and other cloud services revenue grew 40% y/y. All in, the company reported a 12.4% y/y jump in Q4 revenue, a 7.5% rise in operating income, and a 2.8% jump in earnings per share despite the war in Ukraine, factory shutdowns in China, and the drag of a strong dollar.
Microsoft’s forecast of double-digit currency-adjusted growth in revenue and operating income for fiscal 2023 sent its shares 6.7% higher Wednesday. Despite the current economic turmoil, IT spending will increase because “every business is trying to fortify itself with digital tech to in some sense navigate this macro environment,” said CEO Satya Nadella, a July 26 WSJ article reported.
Technology: Semis Fear Gluts. The S&P 500 Semiconductors industry has had a terrible year, with its stock price index falling 30.8% ytd through Tuesday’s close, almost twice the S&P 500’s 17.7% decline (Fig. 2). Investors are concerned that demand for semiconductors will slow sharply if customers find themselves with excess inventory because they’ve been double-ordering during the recent shortages. There’s also concern that demand could slow if the economy falls into a recession. Already, there are signs that the demand is softening in the consumer technology area, as few consumers need a new computer or phone, having bought new ones during the pandemic.
Despite these fears, demand for chips remains robust in the industrial and automotive segments based on the Q2 earnings calls of NXP Semiconductors and Texas Instruments this week. Let’s take a look at what they had to say and the legislation winding its way through Congress that could encourage more chip manufacturers to build fabs in the US of A:
(1) Semis still selling. Despite the handwringing, global sales of semiconductors continued to rise in May, by 18.0% y/y to $51.8 billion (using a three-month moving average). Sales were up y/y in all geographies: Americas (36.9%), Japan (19.8), Europe (16.1), Asia Pacific/All other (15.8), and China (9.1) (Fig. 3). On a m/m basis, sales were up in most regions: Japan (3.9%), Americas (2.9), China (1.7), Asia Pacific/All Other (1.1), and Europe (-0.7).
Wall Street analysts continue to call for the industry’s revenue and earnings to grow. Revenue is expected to climb 17.4% this year and 5.2% in 2023 (Fig. 4). Even earnings are expected to increase by 13.2% this year and 3.8% in 2023 (Fig. 5).
Despite optimistic expectations, the S&P 500 Semiconductors index’s forward P/E has tumbled from a peak of 25.0 last November to a recent 16.0 (Fig. 6). The last time the industry faced an extended selloff was in 2009, and it didn’t end until analysts started cutting the industry’s earnings forecasts sharply and the index’s forward P/E spiked. In cyclical sectors, the optimal time to buy is often when earnings have fallen sharply and P/Es have jumped.
(2) Inventory worries. NXP Semiconductors batted away concerns about customers’ inventory levels on its Tuesday conference call. It did confirm that demand has slowed for chips used in low-end Android handset markets; but demand remains hot in the auto and industrial segments. Even though NXP has “gradually and incrementally” increased its supply capabilities, it is still only able to meet 80% of demand from customers and requires customers place non-cancelable, non-returnable orders through 2023.
“When looking at customer inventory, we continue to see a dysfunctional supply chain, which struggles to get the right product mix and complete kits to the correct location in the extended automotive and industrial markets,” said CEO Kurt Sievers.
The company, which said it is sold out for 2022, gave Q3 revenue guidance of $3.35 billion to $3.50 billion, a 17%-22% jump y/y and above analysts’ consensus forecast of $3.32 billion. NXP’s own inventory increased to 94 days, up five days sequentially and close to its target of 95 days. The company was optimistic that car production would pick up from depressed levels, and it noted that the number of semiconductors in cars continues to increase.
Texas Instruments (TI), which sells chips into a broader range of end markets than NXP, noted that Q2 revenue was up y/y in automotive (more than 20%), industrial (high-single-digits percentage), communications equipment (about 25%), and enterprise systems (mid-teens percentage). The weakest link was personal electronics, which only grew in the low single digits. TI believes weak demand in the personal electronics category will continue in Q3. Nonetheless, the company is forecasting Q3 revenue of $4.9 billion to $5.3 billion and Q3 earnings per share of $2.23 to $2.51. Both targets are above analysts’ consensus forecasts of $4.94 billion and $2.26, respectively.
TI has seen clear signs that its customers have been building inventory in recent quarters, but whether they will operate with larger inventories going forward or bring inventories back down remains a question. TI continues to build its own inventory levels, which will be easier as three factories come on online, one each in 2022, 2023, and 2025.
(3) Washington spends on chips. On Wednesday, the Senate approved The CHIPS and Science Act of 2022, a $280 billion package of subsidies and funding aimed at boosting US competitiveness in semiconductors and advanced technology, a July 27 WSJ article reported. The bill heads to the House of Representatives, where it’s expected to be approved.
The bill contains funding to encourage companies to build semiconductor plants in the US to reduce America’s dependence on semi production in Taiwan and other countries. Intel, SK Group, and Samsung each have indicated they plan to build plants in the US. The bill also includes funding for scientific research to be conducted primarily by the federal government over the next decade, the WSJ reported.
Disruptive Technologies: AI & Drug Development. Some call it “pharmatech.” Others dub it “digital biology” or “medtech.” Regardless of the name, the use of huge data sets and artificial intelligence (AI) in drug discovery and development has gone mainstream. Started in the labs of leading universities, AI is now used by startup companies that often partner with the industry’s pharmaceutical giants in hopes of developing new drugs faster and more cheaply.
One of the industry’s leaders is DeepMind, a unit of Alphabet focused on AI development. DeepMind has developed AlphaFold, an open-source software program that predicts the structure of existing proteins, can develop new proteins, and can find treatments using proteins. Since AlphaFold’s software became available to the public last year, scientists have been using it in all manner of research.
Alphabet isn’t completely altruistic. Last November, the company announced the creation of a new company, Isomorphic Labs, which plans to use AlphaFold to develop drugs. Like many of the startups in this area, Isomorphic throws together traditional scientists and technology professionals. Its top management team includes a chief science officer, chief technology officer, and a director of machine learning working together to develop drugs.
Here are a few of the industry’s other players and their achievements:
(1) BenevolentAI. BenevolentAI uses AI to develop drugs with a higher probability of clinical success than if it had used traditional drug development methods. The company has an in-house pipeline of more than 20 drugs, with one for atopic dermatitis in phase two trials. The company says its AI tools were used to search through approved drugs to find one that could treat Covid-19. By focusing on drugs that block the viral infection process, it identified baricitinib, an Eli Lilly drug for rheumatoid arthritis that was ultimately approved to treat Covid as well. BenevolentAI is also collaborating with AstraZeneca to develop drugs for idiopathic pulmonary fibrosis and chronic kidney disease.
BenevolentAI went public through a merger with Odyssey Acquisition on April 22, when the shares traded at €9.90, and they’ve fallen to €6.50 as of Tuesday’s close. The deal gave BenevolentAI access to €225 million, a company press release stated.
(2) Owkin. Owkin applies AI to the patient data it gathers from 18 academic medical centers across the world to develop new drugs and aid in the treatment of patients. The privately held French company partnered in June with Bristol-Myers Squibb to design and optimize cardiovascular drug trials in a deal that could be valued at $180 million if certain milestones are met. This follows the $180 million deal Owkin struck with Sanofi to collaborate on cancer research, a June 9 article posted on Fierce Biotech reported. “In a study published in 2020, for example, the firm used two deep learning algorithms to build models for predicting the survival of patients with hepatocellular carcinoma treated by surgical resection.”
(3) Exscientia. Founded in 2012, Exscientia uses AI to design medicines and run experiments rapidly and efficiently. “We trust the algorithms to generate hypothesis, generate ideas and select which molecules we should make and test,” said CEO Andrew Hopkins. The UK-based, publicly traded company has an oncology drug and a psychiatry drug in phase one trials, along with a number of other drugs in earlier stages of development.
Exscienta, which is expected to lose $0.89 a share this year, has a drug discovery deal with Bristol-Myers Squibb that could pay out up to $1.2 billion or more, a May 19, 2021 Fierce Biotech article stated. The company also works with Bayer, Sanofi, Dainippon Sumitomo, and the Gates Foundation and has raised funding from investors that include Softbank, Bristol-Myers Squibb, and BlackRock. Exscientia’s ADRs traded as high as $27.10 on October 1 but since have fallen to $10.05 as of Tuesday’s close.
(4) Insitro & Schrodinger’s. Insitro builds large datasets optimized for machine learning and develops models used in drug development. In 2020, the company entered a five-year collaboration with Bristol-Myers Squibb to develop treatments for amyotrophic lateral sclerosis (ALS) and frontotemporal dementia. Insitro was founded in 2018 by CEO Daphne Koller, who was a Stanford computer science professor, founded the education technology company Coursera, and was the chief computing officer of Calico, an Alphabet healthcare company.
Schrodinger’s software allows customers to simulate physical interactions between chemical compounds and molecular targets, making drug development more efficient, explained a June 13 article posted on TheStreet.com. The publicly traded company had 20 of the largest pharmaceutical companies as customers last year, and it is also developing drugs to create its own pipeline. Schrodinger, which analysts expect will lose $2.02 a share this year and lose $1.47 in 2023, has watched its shares fall from a high of $110.18 on February 2021 to a recent $31.50.
All About Housing
July 27 (Wednesday)
US Housing I: From Boom To Caboom? The pandemic-induced housing boom is over. Would-be homebuyers no longer are lining up out the door for open houses and jumping into bidding wars within hours of first listing. In fact, one of the ugliest charts on the block right now shows the index for traffic of prospective buyers of new homes. It has plunged from 71 at the start of this year to 37 during July (Fig. 1). Just as ugly is the chart showing the sharp declines so far this year in the Housing Market Index (for new homes) and the Pending Home Sales Index (for existing homes) (Fig. 2).
Until recently, a shortage of housing inventory held back strong sales volume and caused home prices to soar. Now inventory-to-sales ratios are rising, as declining affordability is depressing sales volume from the demand side. Contracts are being canceled mid-deal because buyers who hadn’t locked in their mortgage rates can’t afford the monthly mortgage payments that are so much higher than they expected to pay when they first started looking for a house. Buyers also are wary of purchasing a home that could now depreciate in value. Sellers looking to get out while prices are still elevated and before interest rates rise further have started lowering their listing prices.
Nevertheless, Melissa and I don’t expect a housing crash the likes of the Great Financial Crisis (GFC) saw, even though national measures of home prices are likely to fall in coming months. That’s because demand for housing is likely to remain elevated due to the demographic trends discussed below and because mortgage lending standards were tighter in recent years than the historically lax standards that prevailed in the years before the GFC. Consider the following:
(1) Sales decrease as inventories increase. Total existing home sales (including single-family homes and condominiums) plunged 21% since January to 5.1 million units (saar) during June, the slowest pace since June 2020 (Fig. 3). New home sales peaked at 1.04 million units (saar) during August 2020 and fell 43% to 590,000 units in June of this year (Fig. 4).
The recent weakness in sales largely reflects the surge in mortgage rates since the start of the year combined with the jump in home prices since the end of the lockdown recession in 2020. The inventory-to-sales ratios of both existing and new homes are rising as sales fall.
During June, there were 1.26 million existing homes for sales, well below the record high of 4.04 million during July 2007 (Fig. 5). As a result of this year’s sales drop, the month’s supply of existing homes on the market rose from a record low of 1.6 months during January to 3.0 months during June. During the GFC, readings above 10 months were the new abnormal.
A similar analysis shows that new homes for sale rose 16% from 394,000 units in January to 457,000 units in June, the highest inventory of such housing since spring 2008 (Fig. 6). The months’ supply rose from a record low of 3.3 months during August 2020 to 9.3 months in June, the highest since May 2010.
(2) Pending deals come undone. Pending existing home sales data for June will be out this morning. The National Association of Realtors’ (NAR) Pending Home Sales Index ticked up in May but still was about as low as it was in March 2020, when the Covid lockdowns started (Fig. 7).
The index tends to be a leading indicator for existing home sales. But a wave of cancelations suggests that sales could be weaker than the index suggests. The share of sales agreements on existing homes canceled in June was about 15% of all homes under contract, according to a July 11 report from Redfin. That was the most deals undone since early 2020, when the residential real estate market essentially froze during the lockdown.
(3) Rising rates & prices leaving buyers out in the cold. Mortgage applications for new purchases fell dramatically by 25% ytd through July 15 (Fig. 8). Over the same period, the 30-year mortgage rate shot up from 3.30% to nearly 6.00%.
Remarkably, over the past 24 months through June, the median existing home price is up 42.1% (Fig. 9). Over the 24 months ending May, the median new home price was up 40.2% (Fig. 10). But yesterday, we learned that this price plunged 9.5% m/m during June. So the median price increase over the past 24 months through June is now 18.0%.
Altogether, housing has become much less affordable in recent months. Through May, the NAR’s Housing Affordability Index based on a 30-year fixed rate mortgage dropped to the lowest seen since July 2006 (Fig. 11).
(4) Tighter lending standards. Fortunately, mortgage lending standards have been tightened significantly since the GFC. During Q1-2022, the percent of mortgages delinquent by 90 days or more remained at a record low of 0.5% (Fig. 12). The similar delinquency rate for home equity loans was 0.8%. Both were well below the delinquency rates on auto loans (4.0%), student loans (4.7%), and credit cards (8.4%).
US Housing II: Homebuilders Getting Squeezed. Q2’s real GDP will be released tomorrow. According to the Atlanta Fed’s GDPNow tracking model, it is likely to show a small decline of 1.6% (saar) led by a large 10.1% drop in residential investment, which is highly correlated with both total housing starts and housing completions (Fig. 13 and Fig. 14). Consider the following:
(1) Starts mixed by type. Single-family housing starts can be volatile, but June’s 8.1% drop to 982,000 units (saar) appeared to be a clear weakening of the post-pandemic uptrend in homebuilders’ breaking ground (Fig. 15). Single-family permits, a leading indicator for starts, fell 7.7% in June to 970,000 units (saar) (Fig. 16).
Multi-family starts and permits increased, however. Likely that reflects builders’ recognition of the demand for more affordable units for purchase and for rent, as buyers are priced out of the single-family market.
(2) Homebuilders’ margins at record high. While new home prices have risen significantly, the increase isn’t all going into homebuilders’ margins; much is going to the increased costs of building materials and labor. Global supply-chain disruptions and shortages of building materials along with generally rising prices in the US have led to higher costs to build.
The PPI for final demand in construction rose 19.2% y/y during June (Fig. 17). Homebuilders have gotten a bit of a reprieve in the price of lumber but still may be working to offset the skyrocketing cost of lumber that occurred just a few months ago.
Nevertheless, the forward profit margin of the S&P 500 Homebuilding industry has increased significantly from 8.9% at the start of 2020, just before the pandemic, to a record high of 15.1% recently (Fig. 18). However, both forward revenues and forward earnings seem to have peaked in recent weeks. (See our S&P 500 Industry Briefing: Homebuilding.) June’s drop in the median new home prices suggests that the industry’s profit margin may be about to head south quickly.
US Housing III: Millennials Forming Households. Leading up to the pandemic, the number of households surged; then during the pandemic, it fell as many extended families moved in together to share costs and commiserate during the lockdowns. Following the pandemic, household growth again is on the rise, albeit more slowly than before (Fig. 19).
Prior to the pandemic, many Millennials started purchasing their first homes. But as affordability has become a real challenge for many of them recently, the number of rental households increased from Q3-2021 through Q1-2022, while the number of owner-occupier ones decreased (Fig. 20). These developments are likely to boost multi-family housing starts, while depressing single-family housing starts.
Harvard’s Joint Center for Housing’s recently released “The State of the Nation’s Housing Report 2022” included an interesting section on demographics. Here are a couple of excerpts from the report’s fact sheet:
(1) “Household growth has been strong during the pandemic, increasing by 3.2 million between Q1 2020 and Q1 2022. This has been driven in part by the large millennial generation aging into prime years of household formation. The peak of the millennial generation (born 1985–2004) was age 31 in 2021. As a result, there were 46 million adults aged 25–34 in 2021, a record-high number for the age group most likely to form households.”
(2) “The aging of the baby boom generation is resulting in a meteoric rise in the number of older adult households. The peak of the baby boom generation (born 1946–1964) was age 59 in 2021, and the oldest members of the generation were age 75. The number of householders age 65 and over rose by 10.0 million from 2011 to 2021 and is projected to rise by 1.1 million annually until 2028. This growth in older households will result in a more pressing need for accessible and affordable housing as well as supportive services to meet the changing needs of this demographic.”
US Housing IV: Urban Exodus. Many owner-occupier households have skirted the housing affordability hurdle by moving to cheaper areas. The remote work trend, outlasting the pandemic, has provided workers with the flexibility to live in more affordable areas as well as save time and money on commutes. As a result, mass migration has occurred from urban areas into more rural less expensive ones.
The Harvard housing report observed: “Though overall residential mobility continues to decline, pre-pandemic trends in migration away from large urban areas continued during the pandemic. In total, the core counties of large metro areas lost 1.2 million people to domestic migration last year, while suburban counties of these large metros gained 428,000 people from domestic moves. Counties in small- and medium-sized metros added a net total of 539,000 migrants, and rural nonmetropolitan counties gained 235,000 people from net domestic migration last year—reversing a decade-long trend in net domestic outflows.”
Recently, one of our accounts asked a great question: Is the mass exodus out of the more expensive areas reflected in the latest housing inflation data?
Our answer: Based on the following resources, population size by geographic location is factored into the Consumer Price Index (CPI) for owner-occupied and tenant rent. However, the sample size is constant for a period. The latest data reflect the 2018 geographic CPI pricing areas (based on the 2010 Census population size). So, no, the CPI for rent would not factor in the exodus from more expensive geographies to cheaper ones (by way of weighting the cheaper ones more).
That means that if the geographies were reweighted against the population, it’s possible that the CPI would be lower. But keep in mind that the “cheaper” regions have experienced rental increases following increased housing demand. Also, the fact that the Bureau of Labor Statistics collects “existing” rent information (as opposed to the prices for new listings) for the CPI makes it a lagging indicator, which more than likely means that CPI for rent currently is vastly understated. (See BLS Handbook of Methods and this NBER working paper by economist Larry Summers et al.)
How Much Rate Hiking Does QT2 Equal?
July 26 (Tuesday)
YRI Webcast. Replays of Dr. Ed’s Monday webcasts are available here.
The Fed I: Waiting For An Answer From Talking Fed Heads. Melissa and I have been wondering how much federal funds rate hiking does the current round of quantitative tightening (QT2) equal? Last week, in the July 20 Morning Briefing, we asked a similar question about the 10% increase in the US dollar index (DXY) since the start of this year.
Let’s just say that each equates to a 50bps rate hike, so collectively they exert the equivalent of 100bps of rate hiking, at least. Now let’s say that absent these two non-rate-related tightening sources, the Fed’s current monetary tightening cycle would take the federal funds rate to a peak of 4.00% from 1.50% currently. Then with these two sources in place, the peak would be only 3.00%.
Fed officials have been remarkably silent on this question. They were much more talkative and informative about similar developments in the past when they were justifying their ultra-easy monetary policies:
(1) William Dudley on QE2. In my 2020 book Fed Watching For Fun & Profit, I wrote: “William Dudley, the president of the Federal Reserve Bank of New York, gave a speech on October 1, 2010 favoring another round of QE with specific numbers: ‘[S]ome simple calculations based on recent experience suggest that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point.’” His basic argument was that despite the downside of additional QE, it was the only tool the Fed had left to meet its congressional mandate to reduce the unemployment rate since the federal funds rate was at the “lower bound.” (Back then in 2010, I argued that if the Fed’s econometric model was calling for a negative official policy rate, then either there was something wrong with the model or the Fed was trying to fix economic problems that could not be fixed with monetary policy.)
(2) Lael Brainard on the strong dollar. As we noted in the July 20 Morning Briefing linked above, on September 12, 2016, Fed Governor Lael Brainard presented a speech titled “The ‘New Normal’ and What It Means for Monetary Policy,” calling for “prudence in the removal of policy accommodation.” She listed several reasons for this, including a very specific estimate of the impact of the strong dollar on the economy. She said, “In particular, estimates from the FRB/US model suggest that the nearly 20 percent appreciation of the dollar from June 2014 to January of this year could be having an effect on US economic activity roughly equivalent to a 200-basis-point increase in the federal funds rate.”
In a December 1, 2015 speech titled “Normalizing Monetary Policy When the Neutral Interest Rate Is Low,” Brainard stated, “According to the Board’s FRB/US model, it would require lowering the path of the federal funds rate by roughly 1 percentage point over the medium term to insulate domestic employment from the 15 percent stronger exchange rate in inflation adjusted terms” that had occurred since June 2014. Again, she called for prudence in normalizing monetary policy: “In effect, this spillover from abroad implies some limitations on the extent to which U.S. monetary conditions can diverge from global conditions.”
(3) Bottom line. We conclude that the peak in the federal funds rate during the current monetary tightening cycle will be lower than otherwise because the combination of QT2 and the strong dollar are equivalent to at least a 100bps increase in the federal funds rate. In addition, the extraordinary jump in both short-term and long-term interest rates in the fixed-income markets has already accomplished much of the tightening for the Fed. The markets have already discounted a peak federal funds rate of 3.00%-3.25%, which is where it will be assuming that the Fed hikes the rate by 75bps on Wednesday and 75bps again at the end of September, as widely expected.
The Fed II: The Markets Have An Answer. The financial markets are currently signaling that the peak in the federal funds rate is likely to be 3.00%, according to the 2-year US Treasury yield, which tends to lead the federal funds rate by about six to 12 months (Fig. 1 and Fig. 2). The 2-year yield peaked at 3.45% on June 14. It was down to 3.04% yesterday. In addition, the yield-curve spread between the 10-year and 2-year Treasury notes turned negative last week, falling to -20bps on Friday (Fig. 3). That signals that bond investors believe that the Fed’s monetary tightening cycle will end sooner rather than later, as the economy slows.
While the Fed has raised the federal funds rate by only 150bps so far during the current monetary policy tightening cycle, the credit markets seem to have discounted the full tightening cycle. In other words, if the Fed proceeds with a 75bps rate hike right after Wednesday’s meeting of the FOMC and follows up with another 75bps at the September meeting of the FOMC, yields might not follow suit since they’ve already anticipated these moves, as noted in the previous section.
In addition, the credit markets seem to have discounted QT2, especially the mortgage market. Consider the following:
(1) Mortgage rates go vertical. Mortgage rates have soared much faster and much higher than can be explained by the actual and expected hikes in the federal funds rate since the start of this year, in our opinion. Soaring mortgage rates combined with record-high home prices have depressed housing, accounting for much of the recent weakness of the economy.
The 30-year fixed-rate mortgage yield jumped from 3.29% at the start of this year to 5.73% on Friday (Fig. 4). Its spread with the 10-year Treasury yield soared from 177bps at the start of the year to 296bps on Friday (Fig. 5). This spread tends to hover between 150bps and 200bps during normal times.
(2) Feddie shutting down mortgage business. The jump in the mortgage yield spread is reminiscent of similar ascents in this yield during the Great Financial Crisis (GFC) and the Great Virus Crisis (GVC). The obvious explanation for this year’s extravaganza is that the December 2021 minutes of the FOMC, released on January 5 of this year, indicated that the Fed was getting closer to ending QE4 and starting QT2. In addition, the minutes signaled that “Feddie” (the distant cousin of Fannie Mae and Freddie Mac since the GFC through the GVC) was getting out of the mortgage financing business:
“Consistent with the previous normalization principles, some participants expressed a preference for the Federal Reserve’s asset holdings to consist primarily of Treasury securities in the longer run. To achieve such a composition, some participants favored reinvesting principal from agency MBS into Treasury securities relatively soon or letting agency MBS run off the balance sheet faster than Treasury securities.”
(3) QT2 unveiled. Following the May 3-4 meeting of the FOMC, the Fed issued a press release titled “Plans for Reducing the Size of the Federal Reserve’s Balance Sheet.” During June through August, the Fed will reduce its balance sheet by running off maturing securities, which will drop its holdings of Treasury securities by $30.0 billion per month and its holdings of agency debt and mortgage-backed securities (MBS) by $17.5 billion per month. So that’s a decline of $142.5 billion over those first three months of QT2.
Starting in September, the runoff will be set at $60 billion for Treasury holdings and $35 billion for agency debt and MBS. That’s $95 billion per month. There’s no amount set or termination date specified for QT2. The press release simply states that “the Committee intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves.”
Assuming that QT2 is terminated at the end of 2024, the Fed’s holdings of securities would decline by $2.7 trillion, to $5.8 trillion from $8.5 trillion in May. Its holdings of Treasuries and MBS would decline by $1.7 trillion and 1.0 trillion, respectively, by the end of 2024 (Fig. 6, Fig. 7, and Fig. 8).
In our opinion, the extraordinary jump in mortgage rates and in the mortgage yield spread since the start of this year can be largely explained by the market’s anticipation of QT2 in addition to the Fed’s rate hiking (Fig. 9 and Fig. 10).
(4) Demand destruction in the housing market. The Fed’s goal is to slow demand relative to supply to bring down inflation. It is doing so in the housing market and in the market for housing-related goods and services. The mortgage index for purchasing homes dropped 22.4% since the start of the year through the July 15 week (Fig. 11). The sum of new plus existing single-family home sales dropped 16.5% during the past four months through May. Housing-related retail sales have weakened in recent months, especially on an inflation-adjusted basis (Fig. 12).
The Fed III: A Fed Study Has An Answer. Last but not least, we found a recent study titled “How Many Rate Hikes Does Quantitative Tightening Equal?” It is by Bin Wei, a research economist and adviser in the Research Department at the Federal Reserve Bank of Atlanta. He summarized his findings as follows: “In this article, I examine the question of how to quantify the equivalence between interest rate hikes and quantitative tightening (QT). Using a simple ‘preferred habit’ model I estimate that a $2.2 trillion passive roll-off of nominal Treasury securities from the Federal Reserve’s balance sheet over three years is equivalent to an increase of 29 basis points in the current federal funds rate at normal times, but 74 basis points during turbulent periods.” (Hat tip to Doug Vogt for sharing that study.)
Anatomy Of A Mid-Cycle Slowdown
July 25 (Monday)
Strategy I: Time To Be Less Afraid? Sentiment indicators continue to show that fear is rampant in the equity markets. That’s because there have been lots of fearsome developments since the start of the pandemic, including the global spread of Covid, supply-chain disruptions, Russia’s invasion of Ukraine, the persistence of inflation, and increasingly hawkish central bankers. This litany of woes adds up to increasing risks of a global recession. That’s triggered a significant drop in valuation multiples in global stock markets and fears that the second shoe, i.e., aggregate corporate earnings, is about to drop.
The fears have included apocalyptic ones, mostly associated with the war in Ukraine. At the start of the war, Russian President Vladimir Putin implied that he would not rule out using nuclear tactical missiles. Russia’s blockade of Ukrainian ports on the Black Sea halted the country’s grain exports, causing food prices to soar and raising fears of famine and social upheaval, particularly in Africa. The war also reduced the availability of Russian fertilizer, also heightening the risk of a global food shortage. Now, there is mounting concern that Russia will shut off gas supplies to its customers in Western Europe during the winter with dire consequences for the region’s people and industry. The war has united the NATO nations, but it is also uniting an Axis of Evil including Russia, China, and Iran. And now we have new variants of Covid and even Monkeypox to worry about.
Notwithstanding all that, there is some good news (maybe) on a few of these fronts:
(1) Russian gas. An article posted July 22 by BBC News reported: “Russia has resumed pumping gas to Europe through its biggest pipeline after warnings it could curb or halt supplies altogether. The Nord Stream 1 pipeline restarted following a 10-day maintenance break but at a reduced level. On Wednesday, the European Commission urged countries to cut gas use by 15% over the next seven months in case Russia switched off Europe’s supply. Russia supplied Europe with 40% of its natural gas last year. Germany was the continent’s largest importer in 2020, but has reduced its dependence on Russian gas from 55% to 35%.”
(2) Ukrainian grain. An article posted July 22 by NYT reported: “After three months of talks that often seemed doomed, Russia and Ukraine signed an agreement on Friday to free more than 20 million tons of grain stuck in Ukraine’s blockaded Black Sea ports, a deal with global implications for bringing down high food prices and alleviating shortages and a mounting hunger crisis. Senior United Nations officials said that the first shipments out of Odesa and neighboring ports were only weeks away and could quickly bring five million tons of Ukrainian food to the world market each month, freeing up storage space for Ukraine’s fresh harvests.”
Nevertheless, the article warned: “It remains to be seen whether the deal works as planned. With each side deeply suspicious of the other, there will be plenty of chances for the agreement to break down.” Sure enough, on Saturday, Russian missiles hit Odesa, just one day after Ukraine and Russia agreed on the deal that would allow the resumption of vital grain exports from the region.
(3) Checks and balances. A major contributor to the jump in the inflation rate since March 2021 was the Biden administration’s American Rescue Plan. It provided a third round of Economic Impact Payments, which stimulated a demand shock in the US that overwhelmed global supply chains. Senator Joe Manchin (D-WV) voted for the stimulus package. But now the senator has been accused by many in his party of sabotaging the President’s agenda. Manchin is most concerned about the inflationary consequences of additional government spending. Without his support, the Democrats don’t have the votes they need for the additional spending programs championed by Biden. The Founding Fathers based our government on a constitutional system of checks and balances, which continues to work relatively well.
Strategy II: The Current Earnings Reporting Season. While investors have plenty left to worry about, their main concern currently is focused on the current Q2-2022 earnings reporting season and company managements’ earnings guidance for the rest of the year.
The S&P 500 fell 0.9% on Friday on disappointing earnings news from Snap. Its shares plunged by more than a third on Friday as reports of the social-media company’s weakest-ever quarterly sales growth fanned fresh concerns about a slowdown in the digital advertising industry. The S&P 500 Communication Services sector fell 4.3%, and the Information Technology sector lost 1.4% (Table 1). Nevertheless, the S&P 500 is up 8.0% from its recent bottom of 3666.77 on June 16 through Friday’s close of 3961.63 (Table 2). It is now down 17.4% from its record high on January 3.
The fear is that this rebound is an unsustainable short-covering rally in a bear market because analysts are just starting to reduce their earnings estimates for the rest of this year and next year to reflect weakening economic growth. But Joe and I still think that June 16’s low could turn out to be the low for the latest bear market, a case we made a week ago in the July 18 Morning Briefing. Our basic premise is that inflation is peaking, and so is the 10-year US Treasury bond yield, so there shouldn’t be much more downside risk in valuation multiples.
So what about earnings risk? We believe that the economy is in the midst of a mild recession (a.k.a. a mid-cycle slowdown), which suggests that downward earnings revisions should flatten forward earnings—whereas in a conventional recession, forward earnings would tank. As a result, the S&P 500 could meander in a trading range for several months, say between 3666 and 4150, before moving higher, possibly to a new record high in late 2023. Needless to say, lots could go wrong to subvert this scenario, as we reviewed a week ago. But for now consider the following:
(1) Quarterly consensus estimates for S&P 500. The Q2-2022 earnings reporting season started at the beginning of this month and will end around mid-August. So far, the S&P 500’s blended earnings, combining actual reported results and estimated ones, edged down during the July 14 week but remains relatively flat since the end of the previous earnings season (Fig. 1). However, Q3 and Q4 estimates have been cut slightly over the past four weeks, reflecting weaker guidance. The same can be said about the S&P 400’s and S&P 600’s estimates for the next two quarters. The growth rate of Q2’s S&P 500 earnings is currently expected to be 4.5%, down from the 5.2% estimate during the July 7 week (Fig. 2).
(2) Annual consensus estimates for S&P 500. Analysts’ consensus expectations for S&P 500 revenues during 2023 and 2024 remained on solid uptrends through the July 14 week (Fig. 3). So forward revenues, the time-weighted average of the two, remained near a record high that week. On the other hand, forward earnings may be starting to flatten out after rising to a record high during the June 16 week, as 2023 and 2024 earnings estimates are just starting to look toppy.
The consensus analysts’ data so far suggest that they still aren’t seeing a recession, since their revenues estimates continue to rise. Rather, they are finally seeing reasons to be concerned about profit margins. They’ve been lowering their 2022 and 2023 profit margin estimates since the start of this year and only now is that starting to weigh on the forward profit margin.
(3) Annual consensus estimates for S&P 500 sectors. Joe has put together a handy-dandy chart publication, Revenues, Earnings, & Profit Margin Squiggles. Flipping through it, we see the following ytd percent changes in the forward revenues, forward earnings, and forward profit margins, respectively, of the 11 sectors of the S&P 500 (sorted by magnitude of margins’ percent changes):
Energy (33.5%, 75.4%, 31.4%), Real Estate (5.1, 16.9,11.2), Information Technology (6.9, 7.7, 0.7), Industrials (8.2, 8.6, 0.4), Financials (5.0, 4.6, -0.4), S&P 500 (7.6, 7.7, -0.5), Materials (10.3, 8.2, -1.9), Consumer Staples (5.0, 1.9, -3.0), Health Care (4.5, 0.4, -4.0), Communication Services (4.3, 0.2, -4.0), Utilities (10.0, 4.1, -5.3), and Consumer Discretionary (4.9, -0.6, -5.2). Seven of the sectors are showing margin compression since the start of this year.
(See also Tables 2R and 2E in our Performance Derby: S&P 500 Sectors & Industries Forward Earnings & Revenues and Table 7 in our Performance Derby: S&P 500 Sectors & Industries Forward Profit Margin.)
US Economy: Less Growth, Maybe Less Inflation Too. The S&P 500 composite includes corporations that produce goods and services. The earnings of goods producers tend to fluctuate along with the business cycle, while those of the services producers do so as well but with less amplitude. That explains why the y/y growth rates of S&P 500 revenues per share and operating earnings per share are highly correlated with the M-PMI, the manufacturing purchasing managers index compiled monthly by the Institute for Supply Management (Fig. 4 and Fig. 5). Consider the following:
(1) M-PMI, revenues & earnings. The M-PMI peaked at a cyclical high of 63.7 during March 2021, falling to 53.0 during June. The revenues growth rate peaked at 21.8% during Q2-2021. It was down to 13.6% during Q1-2022, which wasn’t as weak as suggested by the M-PMI because inflation has been boosting revenues over the past year.
S&P 500 operating earnings growth peaked at 88.6% during Q2-2021, much more than suggested by the coincident peak in the M-PMI because profit margins tend to rebound more when the M-PMI is rising than when it is falling. Earnings growth fell to 11.8% y/y during Q1-2022.
(2) Flash PMIs. On Friday, S&P Global released July flash estimates for the US M-PMI and NM-PMI, which is the purchasing managers index of the nonmanufacturing sector (Fig. 6 and Fig. 7). Not surprisingly, they tend to track the ISM’s versions of these two indexes relatively closely.
July’s S&P Global M-PMI for the US edged down from 52.7 in June to 52.3 in July. The drop in the comparable NM-PMI from 52.7 in June to 47.0 in July was surprisingly weak. On balance, Debbie and I believe that these numbers are consistent with our mid-cycle slowdown outlook (with 55% odds of a mild recession and 25% odds of a growth recession, leaving 10% for a boom and 10% for a bust).
(3) Two regional business surveys. Two of the regional business surveys conducted by five of the 12 Federal Reserve district banks are out for July. The average of the NY and Philly surveys’ composite business activity indexes closely tracks the national M-PMI (Fig. 8). It suggests that July’s M-PMI is likely to fall closer to 50.0; we’ll see when it is reported at the start of next month.
Again, that would be consistent with a soft landing of the economy, rather than a hard one. Of course, the M-PMI could fall significantly below 50.0 in a hard landing, but that’s not our most likely outlook.
The same can be said about the two regional surveys’ comparable new orders indexes: July’s two-regions average suggests that the national orders index, which was 49.2 in June, might have been somewhat weaker in July (Fig. 9).
(4) LEI & CEI. The Index of Leading Economic Indicators (LEI) peaked at a record high during February and is now down four months in a row through June (Fig. 10). On average, it has peaked 12 months prior to the peaks of the past eight business cycles. That suggests that the next recession will start early next year.
Again, that’s not our forecast. But it is the forecast of the LEI. Meanwhile, the Index of Coincident Economic Indicators (CEI) rose to a new record high in June. If the LEI proves to be prescient, then the CEI, which peaks when the business cycle peaks (i.e., just before recessions) might do so during February 2023.
(5) Yield curve & credit-quality yield spreads. One of the LEI’s 10 components is the spread between the 10-year Treasury bond yield and the federal funds rate. Perversely, it was one of the four positive contributors to June’s LEI. Most investors have ignored it and focused on the recession signal emitted by the spread between the yields of the 10-year Treasury and 2-year Treasury; that spread has diverged from the official LEI interest-rate spread by falling since the start of the year and turning slightly negative last week (Fig. 11).
We are also keeping a close watch on the yield spread between the high-yield corporate bond composite and the 10-year Treasury bond (Fig. 12). The spread has widened from 283bps at the start of this year to 506bps on Friday. So far, it is signaling that credit conditions have tightened, but not to the extent of previous credit crunches that triggered severe recessions.
(6) Less inflation, maybe. The good news in July’s two regional business surveys is that supply-chain disruptions are abating, as evidenced in recent months by the drops in the NY delivery-time index and the Philly unfilled-orders index (Fig. 13). This undoubtedly also reflects some slowing in demand for goods. The result is that the prices-paid and prices-received indexes in both regions have turned down over the past couple of months from their elevated readings of the past year (Fig. 14).
(7) Bottom line. Debbie and I have found that inflation-adjusted S&P 500 forward earnings is a good coincident indicator of the US economy (Fig. 15 and Fig. 16). It rose to a record high during June, though at a slower pace since the start of this year than during its V-shaped recovery from the pandemic lockdown recession. Its growth rate has slowed to 9.6% y/y through June from a recent peak of 35.2% during May 2021.
In the mid-cycle slowdowns of the mid-1980s, mid-1990s, and mid-2010s, the growth rates of both nominal and real forward earnings dropped to zero, but not much below that before moving higher again.
In our current mid-cycle slowdown outlook, we expect that S&P 500 forward earnings will also flatten out for several months and that the forward P/E bottomed on June 16. In this scenario, the S&P 500 would have bottomed on June 16 at 3666 and remain range bound above that level for a few months, say between 3666 and 4150, until better economic growth boosts forward earnings again.
(8) Feshbach on the market. Finally, I checked in with my friend Joe Feshbach on his latest market call. In his opinion, “The sentiment indicators got to extreme bearish levels and indicate little major downside risk. Even if there is another retest of the low, it should be successful. As I said previously, if I was running a $5 billion fund I’d be increasing exposure to stocks on weakness. The put/call ratio got sloppy on this initial rally phase but started to improve again during the second half of last week. The US dollar is showing signs of topping, which would also be a plus for the stock market.”
Financials, China & Russian Gas
July 21 (Thursday)
Financials: An Eye on Deposits. Going into the Q2 earnings season, it was fairly clear that banks with large capital markets businesses would face tough y/y comparisons. With the S&P 500 down 20.6% in the first half of 2022, the IPO market slowed to a crawl and even bond underwriting was down sharply y/y. Traditional banking businesses fared better, however, with demand for consumer and commercial loans growing briskly and credit quality remaining strong.
Banks’ next challenge may be navigating the jump in interest rates. So far, consumer deposits largely have stayed put, even though the interest rates offered on bank deposits remain close to zero while the yield on the three-month Treasury bill has risen to 2.51%. Let’s take a look at how higher interest rates are affecting banks’ assets and liabilities:
(1) Deposits rose during Covid. When Covid struck in 2020, the federal government supported US citizens with a flood of free money. Some of that money was spent, but some of it wound up in bank accounts. More deposits came from people who continued to work but were unable to go out and spend because they feared catching the virus. So in 2020, total deposits at banks surged by $2.9 trillion y/y (21.8%), followed by a $1.8 trillion y/y increase in 2021 (11.4%) (Fig. 1).
This year, with Covid-related government financial support ended and consumers able to spend money more freely in a reopened world, the rate of deposit growth has slowed sharply. Only $166 billion of deposits has found its way into banks’ coffers in the first half of this year, and total deposits appears to have plateaued around $18.0 trillion (Fig. 2).
(2) Higher-yielding alternatives now. During the Covid crisis, there were few good alternatives to low-yielding bank deposits because the Federal Reserve lowered interest rates sharply and rapidly when the economy was closed. The federal funds rate was cut to a low of 0.00%-0.25% on March 15, 2020 and stayed there until March 16, 2022 (Fig. 3). Interest rates on Treasuries and other bonds fell in tandem.
But faced with rising inflation, the Fed started raising interest rates this year. The federal funds rate stands now in a range of 1.50%-1.75%, and 12-month federal funds futures have jumped to 3.44% in anticipation of additional interest-rate hikes to come. Treasury bond yields have risen as well. The six-month Treasury bill now yields 3.04%, and the three-year Treasury note yields 2.51% (Fig. 4).
While Treasury yields have risen, the interest being offered on many bank deposits has barely budged. Bank of America (BofA) paid 0.02% on deposits in Q2, unchanged from a year ago, and JPMorgan’s interest bearing deposits sport a 0.2% interest rate. This raises the following question: When will depositors start shifting out of deposits that pay next to nothing into higher-yielding alternatives? And: How high will banks need to raise rates to retain deposits?
(3) Loans on the rise. In 2020 and 2021, banks took funds from surging deposits and invested in Treasuries because there was tepid consumer and commercial loan demand. US Treasury and agency securities held by banks rose from $3.0 trillion at the start of 2020 to a peak of $4.7 trillion at the end of this February (Fig. 5). Since late May 2021, the yearly change in bank purchases of Treasury and agency securities has slowed sharply, from a peak of $982 billion to $401 billion in early July (Fig. 6).
Instead of buying Treasuries and agencies, banks are making more commercial and consumer loans. Commercial & industrial (C&I) loans spiked at the start of the pandemic as companies quickly borrowed funds as a precautionary measure. C&I loans then fell sharply for most of 2021, only to rise again this year. In an indication that the economy may be stronger than expected, C&I loans have risen $207 billion ytd to $2.7 trillion (Fig. 7 and Fig. 8).
Likewise, consumer borrowing has been strong. Consumer credit outstanding was $4.6 trillion as of May, up 7.3% y/y (Fig. 9). Car loans have risen sharply, as have student loans (Fig. 10). After bottoming in January 2021, consumer revolving credit has jumped 14.4% to $1.1 trillion (Fig. 11). And home mortgage debt has increased gradually but consistently throughout the pandemic and this year (Fig. 12).
(4) Improving NIM. As interest rates on loans and Treasuries have increased and interest rates on deposit rates have remained low, banks’ net interest margin (NIM) has improved from historically low levels. The average NIM fell to a low of 2.50% in Q2-2021, and it rose to 2.54% in Q1. A more “normal” NIM is north of 3.0% (Fig. 13).
If NIM continues to improve, the upside opportunity is substantial. At BofA, the net interest yield on loans rose to 1.86% during Q2, up from 1.69% in Q1 and 1.61% in Q2-2021, according to the bank’s earnings press release. As a result, the bank’s net interest income jumped by 22% y/y in Q2, or $2.2 billion, to $12.4 billion due to higher interest rates, lower premium amortization, and loan growth.
The bank calculated that a 100bps parallel shift in the interest-rate yield curve would boost net interest income by $5.0 billion over the next 12 months. The key word in that sentence is “parallel.” It looks like banks may have to raise interest rates on their deposits if consumers ever wake up from their slumber. At BofA, total deposits at the end of Q2 were $1.98 trillion, down from $2.07 trillion in Q1 but up y/y from $1.91 trillion in Q2-2021. The bank attributed the q/q decline to customers paying their taxes, a normal seasonal event.
As the Fed continues to raise interest rates, we’ll be watching to see how banks react and their depositors respond.
China: Ramifications of Siding with Russia. When the Ukraine war broke out, we thought China was more likely to stay neutral or side with its largest trading partners: the European Union (14.9% of Chinese exports) and the US (16.3%) (Fig. 14). While Russia is another authoritarian nation, it purchases only 1.5% of China’s exports. However, China has used the Ukraine war as an opportunity to buy Russian oil on the cheap and encourage the construction of new gas pipelines between the two countries.
China may not have counted on the Ukraine war’s impact on emerging markets. The war sent the prices of food and oil surging, and the Fed’s tightening response to subdue the inflation boosted the dollar’s value. The stronger dollar and higher food and oil prices have hurt overleveraged emerging market nations. Some of those nations have begun restructuring their debt, which is bad news for China and its banking institutions—collectively the world’s largest creditor.
Here’s a look at one of the Ukraine war’s unintended consequences and an update on Covid cases in China:
(1) Debt & dollar headaches. Since the Ukraine war intensified on February 24, the Fed has raised interest rates, and the US trade-weighted dollar has gained 7.4% (Fig. 15). Unfortunately, what benefits the dollar doesn’t benefit emerging market countries that have struggled with rising food and oil prices and owe dollar-denominated debt.
Bonds in more than a dozen countries are trading at distressed levels, the weakest of which will likely default. China, as the biggest bilateral creditor in the world, will get dragged into these restructurings. “Poorest countries face $35 billion in debt-service payments to official and private sector creditors in 2022, with over 40% of the total due to China,” according to the World Bank,” a July 4 Reuters article stated. Due to its Belt and Road Initiative, China is owed $1.5 trillion in debt and trade credits by more than 150 countries, a February 26, 2020 Harvard Business Review (HBR) article estimated.
And the debt is growing quickly. The HBR article states: “For the 50 main developing country recipients, we estimate that the average stock of debt owed to China has increased from less than 1% of debtor country GDP in 2005 to more than 15% in 2017. A dozen of these countries owe debt of at least 20% of their nominal GDP to China (Djibouti, Tonga, Maldives, the Republic of the Congo, Kyrgyzstan, Cambodia, Niger, Laos, Zambia, Samoa, Vanuatu, and Mongolia).”
Chinese lending, which is done mostly by state-controlled agencies and policy banks, was described as “opaque” by Reuters. Countries may be required to keep the loans confidential and give them seniority, which means that other lenders may be providing loans based on inaccurate information. HBR notes that the Chinese loans are typically made at market rates, unlike the subsidized lending and grants provided by other large nations.
(2) China learns to restructure. China is new to the world of restructuring sovereign debt, but it’s going to have to learn the ropes on the fly. Zambia’s debt restructuring is one of the first involving China, and it’s taking longer than expected. It has been two years since Zambia defaulted on $17 billion of external debt, about a third of which is owed to China, a May 31 Reuters article reported. China’s central bank reportedly was willing to move ahead with the restructuring, but the country’s finance ministry was concerned that if it accepted losses on its loans the restructuring would set “a costly precedent” for China’s other debtors.
A June 28 FT article noted that Chinese lenders often are willing to extend maturities or grant payment holidays to debtors, but they don’t like to reduce the amount of debt owed for fear of a “political backlash in Beijing”—which “puts them at odds with commercial creditors such as bondholders.”
Sri Lanka defaulted earlier this year on $12 billion of overseas debt, of which China is owed $6.5 billion. Various Chinese lenders invested in the country’s highways, a port, airport, and coal power plant, an April 28 Reuters article reported. Some critics are blaming the country’s current crisis on the excessive debt that China made available. Treasury Secretary Janet Yellen has said she will push China to restructure loans to countries facing unsustainable debt burdens, a July 14 WSJ article reported.
(3) Covid cases escalating. On another note, China’s Covid-19 cases surged past 1,000 on Wednesday for the first time since May 20, rising from 776 cases a day earlier, a July 20 Reuters article reported. With China’s zero-Covid policy remaining in force, lockdowns are increasing. “About 264 million people in 41 cities are currently under full or partial lockdowns or living under other measures, analysts at Nomura, the Japanese bank, wrote in a note on Monday. Last week, the figure was about 247 million in 31 cities,” a July 19 NYT article reported.
One dramatic situation involved 2,000 tourists visiting Weizhou Island who were caught up in a surprise lockdown after 700 cases were discovered over the past week. There are multiple areas where mass testing is being required, including Shanghai.
Disruptive Technologies: Replacing Russian Gas. Russia’s game of cat and mouse continues, with the European Union’s energy security and Ukraine’s independence at stake. Russian President Vladimir Putin indicated yesterday that Russia would send natural gas through the Nord Stream pipeline to Europe, but he was cagey about the amount. Gazprom, the pipeline’s Russian-controlled majority shareholder, will “fulfill all of its obligations,” said Putin, but natural gas flows may be only 20% of the pipeline’s capacity next week if a turbine being repaired in Canada isn’t returned to Russia soon. The turbine is reportedly in transit back to the pipeline operator. Another turbine requires maintenance on July 26.
Also yesterday, Russia’s foreign minister announced that Moscow’s goals for the Ukraine invasion have moved beyond liberating the eastern Donbas border region. Moscow now also aims to control the provinces of Kherson and Zaporizhzhia in southern Ukraine and a number of other territories. He warned that Russia would go further if the West continues to supply Ukraine with advanced weapons, a July 20 FT article reported.
This is occurring as Europe swelters during a major heatwave that is causing fires across the continent. Yesterday, the EU called upon member nations to cut natural gas use by 15% from August 1 through March 2023 in anticipation of supply disruptions this winter. That’s the equivalent of about 45 billion cubic meters of natural gas. Europe has looked overseas for additional sources of natural gas, and it has plans to increase its reliance on coal- and nuclear-fired power plants.
Meanwhile, entrepreneurs are working on new ways to approach this old problem. Here are some ideas being explored for generating and storing energy:
(1) Solar on balconies. Serial entrepreneurs Karolina Attspodina and Qian Qin have developed a way to put the charming balconies on European buildings to good use. Their company, WeDoSolar, has developed vertical solar panels that weigh 1kg each and plug into a standard power socket. “The WeDoSolar Microinverter then pushes the power into the home grid, allowing the panels to power home appliances ahead of using the normal grid,” a July 18 article in TechCrunch reported. The company claims they will reduce electricity bills by up to 25% per year. An eight-panel set costs €1,299 or it can be rented by electric vehicle owners in exchange for CO2 certificates.
(2) Solar from Africa. Russian natural gas imports could theoretically be replaced by large solar farms in the Sahara desert, a March 22 article by the Institute for Security Studies suggested. Solar farms can be assembled more quickly than liquified natural gas terminals, and they are more environmentally sustainable. Undersea cables would need to be laid to transmit the electricity from Northern Africa to Southern Europe.
Already, Tunisia and Algeria are planning underwater links to Italy and Spain, and Greece and Egypt are in discussions to lay a cable between the two countries. Such a large solar farm would generate so much heat that local temperatures could rise by 1.5 degrees Celsius, the article states. The impact might be minimized by spacing out the solar panels and improving their efficiency. Electricity from such a large project might also be used to desalinize water in North Africa or power green hydrogen projects.
Africa also has hydroelectric power and oil and natural gas resources that Europe may want to consider tapping.
(3) Energy storage in oil wells. The intermittency of solar and wind energy remains a hurdle that has entrepreneurs looking for new ways to store excess energy. Hyperlight Energy plans to solve the problem by storing excess solar energy in existing oil wells. The goal is to “store solar-produced heat in rock formations below the (earth’s) surface, creating a solar-generated geothermal resource in which heat is stored for meaningful durations,” Daniel Codd, a researcher at the University of California, San Diego said in a March 14 IEEE Spectrum article. The stored energy can be used as heat energy or harnessed to produce electricity.
The Dollar & Earnings
July 20 (Wednesday)
The Dollar I: Above All Else. Since I began my career on Wall Street in 1978, the only time the dollar was discussed much at FOMC meetings was during 2015 and early 2016. The 26% appreciation of the trade-weighted dollar from mid-2014 through early 2017 certainly raised some concerns about its negative impact on exports at a time when the Fed was worrying about the slow pace of economic activity (Fig 1). In addition, the strong dollar weighed on import prices and inflation at a time when the Fed was hoping that its policies would boost inflation toward its 2.0% target.
The Fed began to normalize monetary policy in late 2014 when it terminated QE3 at the end of October and hiked the federal funds rate by 25 basis points during December 2015 (Fig. 2). Meanwhile, the other major central banks continued to pursue their ultra-easy monetary policies. As a result, the dollar soared just as the Fed was achieving its dual mandate, with the unemployment rate down to around 5.0% and core inflation approaching 2.0%. Fed officials mentioned their concerns about the adverse impact of a strong dollar on their dual-mandate mission but expected the impact to be transitory, passing once the dollar had peaked.
On September 12, 2016, Fed Governor Lael Brainard presented a speech titled “The ‘New Normal’ and What It Means for Monetary Policy,” calling for “prudence in the removal of policy accommodation.” She listed several reasons for this, including a very specific estimate of the impact of the strong dollar on the economy. She said, “In particular, estimates from the FRB/US model suggest that the nearly 20 percent appreciation of the dollar from June 2014 to January of this year could be having an effect on US economic activity roughly equivalent to a 200-basis-point increase in the federal funds rate.”
I had been making the same point since late 2015. It was good to see in 2016 a top Fed official acknowledge that the foreign-exchange value of the dollar matters. There was much angst when the dollar continued to move higher through early 2017.
So what about now? Consider the following:
(1) Fed is ahead of the pack. The trade-weighted dollar is up 8% y/y through yesterday. Is that equivalent to a 100bps hike in the federal funds rate? The foreign-exchange value of the dollar was mentioned just once and only in passing during the June 14-15 FOMC meeting, according to the minutes. Melissa and I don’t recall Brainard or any other Fed official raising this issue recently.
A big reason for the dollar’s recent strength is that the Fed has turned more hawkish than the European Central Bank (ECB) since the start of this year. So the euro has plunged 13% y/y through yesterday (Fig. 3). The Fed has already raised the federal funds rate from a range of 0.00%-0.25% to 1.50%-1.75% and is expected to add 75bps to that at the end of this month. The ECB previously flagged that it would just start raising rates by 25bps at its policy meeting this morning to contain record-high inflation. Yesterday, the financial press reported that the ECB might go for a 50bps hike. That would increase the ECB’s deposit facility rate from -0.50% all the way up to 0.00% (Fig. 4).
Meanwhile, the Bank of Japan remains committed to its ultra-easy monetary policy, including pegging the government’s 10-year bond yield at zero. As a result, the yen is down 20% y/y through Monday (Fig. 5).
(2) Quantitative tightening. Fed officials’ muteness on the strong dollar’s economic impact is matched by their silence on another economically important development: They also haven’t quantified the impact of the termination of QE4ever and the start of the latest round of quantitative tightening (QT2). The first round, QT1, started on October 1, 2017 and ended on July 31, 2019 (Fig. 6). The Fed’s balance sheet was pared by $675 billion. That undoubtedly contributed to the economic slowdown that occurred during 2018 and 2019. The Fed terminated QT1 well ahead of normalizing its balance sheet as a result of illiquidity problems in the repo market in late 2019 and the pandemic in early 2020.
No one knows how long QT2 will last. It will take a very long time to reduce the Fed’s mortgage-backed securities portfolio from $2.7 trillion during May back down to zero, which is the intention suggested by some Fed officials. The same can be said about reducing the Fed’s holdings of Treasuries from $5.8 trillion during May to $2.4 trillion, which is where Treasury holdings stood during January 2020 just before the pandemic (Fig. 7, Fig. 8, and Fig. 9).
If the Fed succeeds in reducing its balance sheet by $2.8 trillion to $5.7 trillion by the end of 2024 under QT2, would the tightening impact be comparable to raising the federal funds rate by 100bps, 200bps, 300bps, or more? Fed officials undoubtedly have run their econometric model to come up with some estimates. But they haven’t shared the results with the public.
(3) Double whammy. The 10% appreciation of the dollar and QT2 undoubtedly will lower the federal-funds-rate endpoint of this tightening cycle. But what will that point be? It’s conceivable that two more rate hikes of 75bps each at the next two meetings of the FOMC will be enough given the additional tightening of credit conditions attributable to the strong dollar and to QT2!
The Dollar II: TINAC & TICS. As we observed yesterday, the geopolitical mess around the world continues to favor the US dollar, suggesting increasing net capital inflows from overseas into the US financial markets. That helps to explain the recent peaking of the bond yield, which should provide some support to the valuation multiples of stocks.
There is no end in sight for the Ukraine war. Europeans are preparing for a possible permanent shutoff of Russian gas. China continues to struggle with Covid and a bursting housing bubble. Emerging markets are facing soaring prices for energy and food and shortages of both, which are triggering political instability. So lots of global investors may be concluding that they must overweight US securities in their portfolios since there is no alternative country (TINAC).
Data compiled by the Treasury International Capital System (TICS) show that the US is experiencing massive net capital inflows, which have been boosting the dollar in the face of record current-account deficits. The monthly data show that total net capital inflows added up to $1.3 trillion during the 12 months through May, near the record high of $1.4 trillion during February (Fig. 10). Over this same period, the total private net capital inflows rose to $1.6 trillion, while the total official net capital inflows was -$226 billion (Fig. 11).
Here are the major components of the 12-month private net capital inflows through May: total ($1.6 trillion), all bonds ($797 billion), Treasury bonds ($583 billion), government agency bonds ($104 billion), corporate bonds ($110 billion), equities (-162 billion), Treasury bills ($73 billion), and other negotiable instruments ($336 billion) (Fig. 12).
The Dollar III: Stay Home vs Go Global. So while foreigners have bought lots of dollars over the past year, they invested them in US fixed-income securities and were net sellers of US equities. They were probably turned off by the relatively high forward P/E of the US MSCI stock price index compared to the All Country World (ACW) ex US forward P/E (Fig. 13). The ratio of the two shows that the former has been selling at a 40%-50% premium to the latter (Fig. 14). The current premium is 45%.
The forward P/Es of the major MSCI indexes around the world are much lower currently than those of the comparable US index (Fig. 15). Here were their latest readings during the week of July 7: US (16.5), Japan (12.3), EMU (10.8), Emerging Markets (10.9), and UK (9.5).
This year, through July 18, the US MSCI is down 20.7%, while the ACW ex US is down 12.8%. On the other hand, the ACW ex US is down 20.3% in dollar terms. The upward trends in the ratios of the US MSCI to the ACW ex US MSCI since 2009 in dollars and in local currencies remain intact (Fig. 16). We continue to recommend overweighting a Stay Home rather than Go Global investment strategy since the US still looks like a safe haven given the new world disorder.
The Dollar IV: Weighing on Earnings. Many US companies do lots of business overseas. By investing in these companies, US investors indirectly accrue plenty of exposure to the global economy. Many of these corporations not only export goods and services made in America but also generate profits from their overseas subsidiaries. Accordingly, the foreign-exchange value of the dollar greatly affects the profits of many US companies. Currency impacts are often discussed during quarterly earnings calls held by corporate managements with investors and industry analysts. Available data can provide some perspective:
(1) Revenues from abroad. On average, the S&P 500 companies derive roughly half of their revenues and profits from abroad. In 2016, the actual percentage of S&P 500 companies’ sales from foreign countries was 43% of their total sales, down from 44% in 2015 and 48% in 2014. Importantly, however, S&P 500 foreign sales represent only goods and services produced and sold outside of the United States; they don’t include US-made products that are exported and sold abroad.
(2) Earnings from abroad. Standard & Poor’s provides no comparable figures for the percentage of profits earned overseas by the S&P 500 companies. However, it’s likely to be close to the percentage of revenues from abroad. The National Income and Product Accounts of the United States does have a data series on pretax corporate profits receipts from the rest of the world. It has risen from $3 billion at the start of 1959, accounting for 5.7% of total pretax profits, to $988 billion during Q1-2022, accounting for 34.3% of profits (Fig. 17 and Fig. 18).
If all else were equal, one could expect a straightforward, consistent impact of currency-exchange effects on corporate profits: 10% appreciation (or depreciation) of the dollar should decrease (or increase) S&P 500 profits by 4%, assuming that roughly 40% of the index companies’ earnings come from abroad. But the fact that Standard & Poor’s excludes export revenues in its calculation of revenues from abroad—lumping export sales together with domestic sales—means that all else isn’t equal; there’s more to the story, because export revenues are affected by currency impacts as well. In other words, there is no simple rule of thumb for estimating the impact of a currency’s move on either overall profits or an individual company’s earnings.
More On Inflation
July 19 (Tuesday)
Inflation I: Wages. Debbie and I have some good news and some bad news on the inflation front. Wage inflation appears to be moderating according to the average hourly earnings (AHE) measure of wages but is still moving higher based on the Atlanta Fed’s wage growth tracker (WGT). Consider the following:
(1) AHE. The AHE is available for all workers since March 2006 and for production and nonsupervisory (PNS) workers since January 1964. This measure reflects not only changes in basic hourly and incentive wage rates but also such variable factors as premium pay for overtime and late-shift work and changes in the output of workers paid on an incentive plan. It also reflects shifts in the number of employees between relatively high-paid and low-paid work and changes in workers’ earnings in individual establishments.
The AHE inflation rate for all workers moderated from a recent peak of 5.6% y/y during March to 5.1% during June (Fig. 1). For PNS workers, who account for 81.5% of payroll employment, it moderated from 6.8% to 6.4% (Fig. 2). Both series have been very volatile since the pandemic. During the lockdowns, more of the lower-wage PNS workers lost their jobs than higher-wage workers, who could work from home. That misleadingly boosted the AHE measure of wage inflation. Then the AHE misleadingly went the other way when the lockdown ended, allowing more of the lower-wage workers to find jobs again.
By now, the AHE measure should be a more accurate measure of underlying wage inflation. If so, then it is showing that wage inflation may be moderating. During June, when the AHE rose 5.1% y/y, it rose 4.2% on a three-month percentage-change basis, suggesting that inflationary pressures are subsiding (Fig. 3). Interestingly, lower-wage workers have been getting bigger wage increases than higher-wage workers, with the former up 6.4% y/y (and 5.8% over the past three months) through June and the latter up 2.5% (but just 0.6% over the past three months) (Fig. 4).
(2) WGT. The WGT series tracks the median wage growth rate, not the median wage. It calculates the wage growth of surveyed people who were working over the course of a year and constructs a distribution of growth rates, which is used to calculate three-month moving-average medians. As a result, the WGT has been less volatile than the AHE measure of wage inflation (Fig. 5).
According to the WGT, wage inflation hasn’t yet slowed down; it rose to 6.7% during June from 6.2% during May. There are also no signs of moderating wage pressures in the WGT’s various components. For example, during June, the WGT for job switchers and job stayers jumped to 7.9% and 6.1%, respectively (Fig. 6). That 1.8ppt differential certainly explains why so many workers have been quitting their jobs for better paying ones (Fig. 7).
According to the WGT, on a 12-month moving average basis through June, wages are up 5.4%. For younger workers, they’re soaring, with gains of 12.5% for 16- to 24-year-olds versus 5.6% for 25- to 54-year-olds and 3.7% for workers 55 and older (Fig. 8). By industry, the 12-month gains are: leisure & hospitality (6.4%), trade & transportation (5.9), manufacturing (5.8), finance & business services (5.5), construction & mining (4.9), education & health (4.9), and public administration (4.6).
(3) Real wages. In a perfect world, wages would be rising at a moderate pace that exceeds price inflation by the growth rate in productivity. During a wage-price spiral, productivity growth suffers as wages and prices spiral higher. So real wages tend to stagnate. That’s what is happening currently: On an inflation-adjusted basis, AHE for all private workers is down -1.0% y/y through May, while AHE for PNS workers is up just 0.1% (Fig. 9 and Fig. 10).
Inflation II: Rents. As we’ve previously discussed, the wage-price spiral is really a wage-price-rent spiral. While there are a few glimmers of moderating wage inflation in the AHE measure, there’s no sign of relief from the uptrend in rent inflation that started during March 2021. Consider the following:
(1) Home prices & rents. The Fed’s ultra-easy monetary policies in response to the pandemic caused home prices to soar, and now rents are soaring. Over the 24 months through May, the median single-family existing home price is up an astonishing 44.5% (Fig. 11).
This year's jump in mortgage rates only exacerbated the affordability problem facing would-be first-time homebuyers, leaving many of them with no choice but to rent. That’s reflected by the jump in the Zillow Observed Rent Index, which was tracking around 3% y/y before the pandemic; it fell close to 0% in late 2020 and early 2021 before shooting up to peak at 17.2% during February 2022 (Fig. 12). It declined slightly to 14.8% in June.
(2) Rent measures. The CPI includes rent of primary residence and owners’ equivalent rent of primary residence (OER). The former measures tenant rents, while the OER measure imputes the rent that homeowners would have to pay to themselves if they were their own landlords. This strange concept makes sense since owner-occupied housing provides a service that is consumed every day, i.e., shelter. On the other hand, when rents go up, tenants have to pay more for rent, while nothing really changes for homeowners—unless higher rents are the result of higher home prices; in that case, they benefit.
Tenant rent in the CPI is based on a sample of all existing leases, not based on new leases. New lease rents will show up in the CPI over the coming 12-24 months depending on the renewal terms of those leases. The Bureau of Labor Statistics uses statistical techniques to infer OER using rental prices for similar units in the area. As a result, the OER inflation rate tends to closely follow the tenant rent inflation rate (Fig. 13).
(3) Rent inflation. Tenant rent inflation in the CPI rose from a 2021 low of 1.8% y/y during March through May to 5.8% during June of this year, the highest since July 1986. The OER measure rose to 5.5% during June, the highest since September 1990.
Economist Larry Summers coauthored a February 2022 study titled “The Coming Rise In Residential Inflation.” It concluded that these rent inflation measures are likely to move close to 7% during 2022, and to remain high during 2023. The authors base that prediction on private-sector data on home prices and rents on new leases. They observe, “Historically, the year-over-year growth in home prices and market rents have been powerful leading indicators for OER inflation and [tenant] rent inflation [in the CPI].”
Rent of primary residence (a.k.a. tenant rent) and OER account for 7% and 24% of the headline CPI, 9% and 31% of the core CPI, and 12% and 40% of CPI services. So both together account for 31% of the headline CPI, 40% of the core CPI, and 52% of CPI services.
Rent of primary residence and OER account for 4% and 11% of the headline PCED, 5% and 13% of the core PCED, and 6% and 17% of PCED services. So both together account for 15% of the headline PCED, 18% of the core PCED, and 23% of PCED services.
As a result of the different weights, the Summers study concludes that “housing will make a significant contribution to overall inflation in 2022, ranging from one percentage point for headline PCED to 2.6 percentage points for core CPI.”
That all makes sense to us. Nevertheless, we expect to see inflation rates moderating for both nondurable and durable goods during H2. So we are sticking with our forecast that the headline PCED inflation rate will ease from 6%-7% during H1-2022 to 4%-5% during H2-2022 and get down to 3%-4% next year. Our inflation rate projections would be lower but for the upward pressure from the rent components of the consumer price measures.
(5) Rents & wages. The risk for any optimistic outlook on inflation is that the wage-price-rent spiral continues to spiral. The CPI tenant rent component, on a y/y basis, closely tracks the WGT (Fig. 16). If inflation doesn’t cool off during the second half of this year, Fed Chair Jerome Powell may have no choice but to “go Volcker” and push interest rates up to whatever level it takes to cause a recession, as former Fed Chair Paul Volcker did during the 1970s. History shows that recessions do break the back of inflation.
Bear Market Rally Or A New Bull Market?
July 18 (Monday)
Strategy I: Calling Bottoms. Early in my career, when I was at Prudential-Bache Securities, I worked as the firm’s chief economist alongside its chief investment strategist, Greg Smith. On Monday, August 16, 1982, we called the bottom in the stock market, which actually had bottomed four days earlier on Thursday, August 12, it was later determined. On August 17, Solomon Brothers’ renowned chief economist, Henry Kaufman, also turned bullish. My weekly commentary that week was titled “Fed-Led Recovery Now Seems Likely.” (Greg was a great professional mentor and personal friend. Sadly, he passed away earlier this year.)
Five years later, the stock market crash on Black Monday, October 19, 1987 stress-tested the conviction of bulls like Greg and myself. Nevertheless, we spent much of that day reassuring our sales force that this was unlikely to be the beginning of a long-lasting bear market. The bear market ended on December 4 of that year. Fed Chair Alan Greenspan came to the rescue with what came to be known as the “Fed Put.”
In the late 1990s, I was bearish on technology stocks because they seemed overvalued. I was particularly concerned when Greenspan, in his January 28, 1999 congressional testimony, compared investing in tech stocks to playing the lottery. In addition, I expected a recession triggered by the Y2K problem. There was a tech-led bear market from March 24, 2000 to October 9, 2002. There was also a recession at the time that resulted from too much Y2K-related spending on technology; the spending fixed the Y2K problem but also triggered a downturn when tech spending suddenly dropped off at the start of the new millennium.
I didn’t call the stock market bottom that occurred in late 2002, but I did turn increasingly bullish on commodities and on China. I didn’t anticipate the magnitude of the Great Financial Crisis because I didn’t expect that the US government would let Lehman fail. However, I did cut my rating on the S&P 500 Financials from overweight to underweight on June 25, 2007. Lehman was allowed to fail on September 15, 2008, and the Financials led the bear market lower through early March 2009.
On March 16, 2009, I wrote that the devilish intraday low of 666 on the S&P 500 on March 6 might have marked the end of the bear market, which did end on March 9. As a symbolist, I relied on the Da Vinci Code for that insight. As a fundamentalist, I observed that on March 16, the Fed’s first round of quantitative easing was expanded to $1.25 trillion in mortgage-related securities and $300 billion in Treasury bonds. The Fed Put was back, bigger than ever.
At the end of 2019, I anticipated a 10%-20% stock market correction in early 2020. I didn’t expect a pandemic and the resulting lockdowns. But when these events rapidly unfolded in February and March, I argued that it was too late to panic. I expected that the Fed would come to the rescue by slashing interest rates and suggested that the Fed might even purchase corporate bonds. When the Fed announced QE4Ever on March 23, I declared that this gigantic Fed Put made the bottom.
It’s time once again to look for a bottom in the latest bear market. Until recently, I was in the correction camp. My June 14 QuickTakes was titled “It’s Officially a Bear Market.” I conceded the obvious, i.e., that the S&P 500 had entered bear market territory when it was down 21.8% on Monday, June 11 from its record high on January 3.
So where are we now? The bear market low so far was made on June 16, down 23.6% from the January 3 peak. That low was 3666. Is that a freaky Da Vinci Code coincidence or what? The answer will be “yes, it is” if 3666 turns out to be the bear market low. The S&P 500 is up 5.4% since June 16 (Fig. 1 and Fig. 2). That gain could certainly reflect just a short-covering rally in a bear market rather than the beginning of a new bull market. The following two sections examine the alternative scenarios promoted first by the bulls (including us), then by the bears.
Strategy II: It’s A New Bull Market. The central assumption of the bulls is that while the bear market did an excellent job of anticipating the bad news that unfolded during the first half of this year, the stock market now will focus on the likely economic outlook for the remainder of this year—which still may be challenging but no more so than that of the first half of this year, while the outlook for 2023 is likely to be brighter.
So there shouldn’t be much more downside in the S&P 500’s forward P/E, which bottomed at 15.3 on June 16, and was back up to 16.1 on Friday (Fig. 3). The S&P 400 and S&P 600 are especially undervalued relative to the S&P 500 with forward P/Es of 11.6 and 11.4 on Friday. Of course, the bulls also assume that any recession will be a mild one, so there shouldn’t be a lot of downside in the stock market stemming from downward earnings revisions. Consider the following:
(1) Inflation is peaking. The bullish case makes sense only if inflation moderates significantly during H2-2022 as the economy slows modestly—i.e., not enough to fall into a severe recession that forces analysts to slash their earnings estimates. June’s CPI and PPI provided only a few glimmers of hope for inflation optimists like ourselves. The CPI durable goods inflation rate peaked at 18.7% y/y during February, falling to 8.4% during June (Fig. 4).
While the headline PPI for finished goods soared to 18.6% y/y during June, its core rate (excluding food and energy) was unchanged at 8.8%. More encouraging are the sharp declines from January through June in the core rates of the PPI for intermediate goods (from 23.3% to 13.5%) and the PPI for crude goods (from 23.1% to 7.1%) (Fig. 5). Another encouraging sign on the inflation front is that the S&P GSCI Commodity Price Index has dropped 20% since it peaked on June 8 through Friday of last week (Fig. 6).
So far, we have one of the five business surveys conducted by the Federal Reserve’s district banks for July. The New York delivery index has dropped sharply since the start of this year (from 23.1 to 8.7), suggesting that supply-chain disruptions are abating quickly (Fig. 7). Over the same period, the prices received index fell (from 44.6 to 31.3), and so did the prices paid index (from 80.2 to 64.3).
(2) Fed tightening will be over soon. The FOMC is on course to raise the federal funds rate by 75bps at the July 26-27 meeting of the committee and is likely to do so again at the September 20-21 meeting. That would bring the federal funds rate range up to 3.00%-3.25%, a level that probably has been discounted by the financial markets. That should be enough to weaken demand (which is already slowing), contributing to the moderation in inflation expected by equity bulls.
Previously, in our June 28 Morning Briefing, Melissa and I argued that the Fed’s quantitative tightening (QT) may be equivalent to at least a 50bps-100bps increase in the federal funds rate. We concluded, “In other words, while QT has been widely feared by investors as additional monetary tightening, it might very well lower the peak federal funds rate during the current monetary tightening cycle!” We also observed, “The S&P 500 was quite volatile during the previous QT period, which included a taper tantrum during the last three months of 2018. But it managed to rise 18.3% nonetheless over the QT period” (Fig. 8 and Fig. 9).
(3) Mid-cycle slowdown underway. In our July 5 Morning Briefing, Debbie and I raised our odds of a mild recession from 45% to 55% with real GDP already down about 1.5% (saar) during H1-2022 and another 2.0% decline likely during H2-2022, followed by a solid recovery in 2023. Last week, we distributed the remaining odds with 35% to a growth recession (i.e., no growth in real GDP), 10% to a boom, and 10% to a bust. So our economic outlook with an 80% subjective probability is comparable to the mid-cycle slowdowns that occurred in the mid-1980s, the mid-1990s, and the mid-2010s, when the y/y growth rate in S&P 500 forward earnings fell to zero for a short spell without a recession, but also without a bear market (Fig. 10 and Fig. 11).
This scenario for the economy was supported on Friday with the release of June’s retail sales and industrial production reports. As we noted in the July 15 QuickTakes, inflation-adjusted retail sales fell 0.3% m/m during June following a 1.1% decline in May (Fig. 12). Manufacturing output fell 0.5% m/m during May and again in June (Fig. 13). Both series are reflected in the Index of Coincident Economic Indicators.
The S&P 500, which is one of the 10 components of the Index of Leading Economic Indicators, rallied 1.9% on Friday’s news. It was down just 0.9% last week despite higher-than-expected CPI and PPI reports for June on Wednesday and Thursday. In our opinion, if the mid-cycle slowdown (i.e., either a growth recession or a mild downturn) scenario gains credibility, that would increase the odds that the bear market bottom occurred on June 16. Confirming this outlook are the recent peaks in commodity prices (May 4) and the bond yield (June 14).
(4) TINAC. The geopolitical mess around the world continues to favor the US dollar, suggesting increasing net capital inflows from overseas into the US financial markets. That helps to explain the recent peaking of the bond yield, which should provide some support to the valuation multiples of stocks.
There is no end in sight for the Ukraine war. Europeans are preparing for a possible permanent shutoff of Russian gas. China continues to struggle with Covid and a bursting housing bubble. Emerging markets are facing soaring prices for energy and food and shortages of both, which are triggering political instability. So lots of global investors may be concluding that they must overweight the US in their portfolios since there is no alternative country (TINAC).
(5) Too many bears. Last week’s muted response to the latest unpleasant surprises in June’s CPI and PPI inflation rates suggests that lots of investors already bailed out of the stock market during the first half of the year. Sentiment remains very bearish, which is bullish from a contrarian perspective. The Investors Intelligence Bull/Bear Ratio was 0.89 during the July 12 week, the 11th consecutive weekly reading below 1.00. During past bear markets, such readings persisted as stock prices continued to fall, but such negative sentiment set the stage for sharp rebounds during the ensuing bull markets (Fig. 14).
Strategy III: It’s A Bear Market Rally. The stock market’s rally since June 16 has been led by the sectors that were the biggest losers during the bear market so far from January 3 through June 16. Here is the performance derby of the 11 sectors of the S&P 500 from January 3 through June 16 and since then through Friday’s close: Health Care (-14.4%, 8.9%), Consumer Discretionary (-36.4%, 8.0), Information Technology (-30.2, 7.6), Utilities (-8.3, 7.3), Real Estate (-24.9, 6.3), Consumer Staples (-11.2, 6.1), S&P 500 (-23.6, 5.4), Communication Services (-32.7, 5.0), Financials (-22.4, 3.5), Industrials (-18.6, 1.6), Materials (-16.5, -3.4), and Energy (35.0, -10.9). (See Table 1 and Table 2.)
So it’s possible that the rebound is a short-covering rally that won’t last much longer. In addition, stocks are certainly cheaper than they were at the start of the year, thus attracting value buyers. However, stock owners might still regret their purchases no matter when they were made if the following occur:
(1) Protracted inflation. Inflation was widely deemed to be transitory last year. But by the end of 2021, everyone agreed that it had turned into a more persistent problem. Now the fear is that it might be even more protracted than expected. Some question whether the Fed’s tightening will have much impact on inflation for a couple of reasons. One is that the inflation problem seems to have a significant supply-side component that tightening doesn’t address. Specifically, the Ukraine war continues to put upward pressure on energy and food prices, and some pandemic-related supply-chain problems remain challenging. Another reason is that price increases continue to spiral into wages and rents, a spiral that’s difficult to halt.
(2) Fed’s ‘Volcker Moment 2.0.’ Previously, I’ve noted lots of similarities between now and the Great Inflation of the 1970s. However, I’ve also noted that watching recent developments has been like watching That ’70s Show on fast-forward. If the analogy proves valid, then the surge in inflation over the past year might soon convince Fed Chair Jerome Powell that inflation is becoming a more pernicious and protracted problem. He might have no choice but to find his inner Paul Volcker, raising interest rates much faster and much higher to break the back of inflation as his predecessor of the 1970s did. That would also cause a severe recession, sending the S&P 500 below the June 16 bottom, with possible support at 3386, which was the record high on February 19, just before the pandemic started.
(3) A severe European recession ahead. Jackie, Melissa, and I have become increasingly concerned about the vulnerability of European nations should Russia shut off natural gas to the region in retaliation for their support of Ukraine. That would trigger a brutal recession and winter in Europe with consequences that could depress the US economy significantly. We aren’t alone with this concern. The euro has dropped 11% since Russia invaded Ukraine on February 24 of this year. For more on this, see the July 14 Morning Briefing titled “Europe Sans Gaz (ESG).”
(4) Earnings shoes starting to drop. The bears, particularly those who see a deep and long recession ahead, contend that there is still much more downside ahead for stocks since industry analysts are only now starting to cut their earnings estimates for this year and next year. That means that there is also more downside for the stock market’s valuation multiple.
Industry analysts might have just started to shave their S&P 500 earnings estimates for 2022 and 2023 during the July 7 week (Fig. 15). They are likely to continue to do so over the remainder of this year. During the July 7 week, they projected S&P 500 earnings per share of $229 this year and $250 next year. We are forecasting $215 this year, which would be unchanged from last year and consistent with a growth recession outlook. We are predicting $235 for next year, a 9.0% y/y gain. In a deep and long recession, earnings would likely fall below $200 both this year and next year.
Strategy IV: It’s Neither Of The Above. Whether 3666 or some other lower number turns out to be the low, that number won’t necessarily mark the beginning of a bull market. After all, the stock market can drift sideways for a while. That’s what it did during the Great Inflation of the 1970s.
Now fast-forwarding past this scenario, we see a possibility that a new bull market may be underway in a few months, with the S&P 500 first meandering in a trading range north of 3666 over the next few months and then rising again, making it to new record highs by late 2023.
Europe Sans Gaz (ESG)
July 14 (Thursday)
Energy: European Crisis Ahead? An energy crisis in Europe this winter isn’t a forgone conclusion, but things aren’t looking good. Towns in Germany plan to set up warming centers for people who can’t afford to heat their homes. Cities have proactively started conserving energy in public facilities, a July 12 article in The Local reported. German residents are buying anything that heats without using natural gas, so wood-burning ovens and heat pumps have become hot commodities, a July 10 article in The Guardian reported.
The latest reason to worry emerged on Monday when Russia shut down the Nord Stream 1 natural gas pipeline to Germany for maintenance. Industry watchers fear Russia will keep the taps closed to retaliate against the West for its economic sanctions against Russia because of the Ukraine war.
Let’s look at how Europe is positioned during this period of energy uncertainty:
(1) Prices on the rise. The US is blessed with the ability to produce more natural gas than it needs: 34.6 trillion cubic feet of production versus 30.8 trillion cubic feet of consumption, based on the 12-month sum through April (Fig. 1). Over the same period, the US had net exports of 4.0 trillion cubic feet of natural gas.
Limited capacity to turn natural gas into liquified natural gas (LNG) has kept the vast preponderance of the US’s natural gas at home. An explosion at the Freeport LNG terminal in Texas on June 8 took a fifth of US export capacity offline, and it’s not expected to resume until October at the earliest. Historically, the terminal’s exports headed to Asia, but higher prices in Europe recently have lured shipments to Europe’s shores. With the Freeport LNG plant off line, more natural gas remains in the US, so the price of natural gas fell sharply from north of $9 mmBTU prior to the explosion to $6.16 mmBTU on Tuesday (Fig. 2).
The lower price of US natural gas does not mean that all’s well in the world. The Freeport plant’s explosion—and dwindling supplies from Russia—have sent natural gas prices up to $51 mmBTU in Europe. That’s better than this spring, when prices topped $70, but far above the $7-$9 the price that natural gas fetched in “normal” times before the Ukraine war and Covid.
In addition, spot prices at dates further out the natural gas futures curve have been on the rise, which is sure to affect companies looking to hedge their natural gas exposure. “Back in March, a German manufacturer could lock in gas prices for all of 2023 at about 80 euros per megawatt hour; now, it has to pay a record high 145 euros to hedge the same price risk,” a July 11 Bloomberg opinion piece noted.
As European nations have scrambled to buy LNG, the price of LNG in East Asia has risen to $38.43/mmBTU as of last week, up from $13.17 a year ago, according to EIA data. And as US capacity increases to export LNG in coming years, the US price for natural gas will probably rise as well.
(2) Russia squeezes tight. Last year, the EU imported about 140 billion cubic metres (bcm) of natural gas from Russia via pipelines, or about 40% of the EU’s natural gas needs. Among EU nations, Germany is the biggest purchaser of natural gas, consuming 100 bcm of natural gas last year.
More than half of Germany’s gas, about 55 bcm, is purchased from Russia and flows through the Nord Stream 1 pipeline. In June, Russia reduced the flow of natural gas to only 40% of the pipeline’s capacity. Russia said the reduction occurred because a turbine was being fixed by Germany’s Siemens Energy in Canada. Under sanctions, the turbine should not have been returned to Russia. But Canada made an exception and will allow the return of the repaired turbine to Russia because doing so supports Europe’s ability to access reliable and affordable energy.
The situation grew more tenuous on Monday when Russia stopped the flow of ALL natural gas through the pipeline to do routine maintenance. The pipeline is expected to reopen on July 21. Officials who are concerned that Russia won’t restart gas flows through the pipeline will be watching this date very, very closely. If Russia doesn’t restart Nord Stream 1, Germany will likely need to institute natural gas rationing to ensure sufficient supplies this winter.
(3) Planning for winter. Germany’s natural gas storage facilities were 52% full in mid-June, a June 16 Reuters article reported. The country’s goal is to have them 80% full by October and 90% full by November to prepare for winter. The longer Nord Stream 1 stays shut, the less likely reaching those goals becomes.
Germany doesn’t have any LNG terminals, but plans to bring in four floating terminals, two of which should operate this year. It also plans to build traditional LNG facilities over the next three to five years. Taken together, the country will develop LNG importing capacity of 68 bcm, more than the Russian gas that needs to be replaced, stated an April 28 article in Climate Change News. Germany is also pushing through legislation to restart coal-fired power plants and plans to conserve energy as temporary fixes.
As for the rest of Europe, natural gas inventories are at about 62% of capacity, just below the five-year average, a July 12 article in Natural Gas Intelligence reported. The EU would like each country to have their natural gas storage at 80% of capacity by November 1.
The EU’s goals are to cut imports of natural gas from Russia by two-thirds by year’s end and to phase out Russian gas entirely by 2027. The EU will stop buying Russian coal in August and stop buying Russian oil in six months, a July 6 PBS article explained. The aim is to reduce the $850 million per day in revenue Russia received from European energy sales prior to the Ukraine war.
(4) Russia cuts off customers. While Germany may be in the most dire position, it’s not alone. Russia cut off natural gas sales to Denmark, Poland, and Bulgaria in April after those nations refused to pay in rubles. In May, Russia cut off supplies to Finland, after the country announced its intention to join NATO. And Russian gas supplies to Italy have been halved.
Poland is fortunate to have an LNG terminal that’s running at full capacity. Poland’s natural gas storage facilities, holding 3.2 bcm, were 97% full, a June 30 Reuters article reported. The country plans to expand its storage capacity 25% to 4.0 bcm to better serve the nation’s annual consumption of about 20 bcm, or 2 bcm of gas per month in the winter.
Bulgaria plans to get natural gas from a pipeline that starts in Greece and delivers gas from Azerbaijan. Deliveries are expected to begin on October 1, an AP article reported on July 8.
Natural gas represents 19% of the energy Denmark consumes each year, and the country produced about three-quarters of the natural gas it needed in 2019. At the end of last month, the country’s gas stocks filled about 75% of storage capacity, a June 21 The Local article reported. Only 5% of total energy consumed by Finland is natural gas, a May 21 PBS article explained. The country can also tap the natural gas delivered via the Balticconnector gas pipeline between Finland and Estonia.
The UK gets only 4% of its natural gas from Russia, but the country is being hurt nonetheless because its natural gas imports have grown exponentially more expensive as the competition for natural gas has surged. UK households’ gas and electric bills are expected to increase 65% this winter to more than £3,200 a year and may rise further early into next year, energy consultant Cornwall Insight reported in a July 8 FT article.
(5) Signs of stress. The impact of higher gas prices is being felt in the business community. Utilities that use natural gas to produce electricity are hurting as the price of a primary expense surges. Germany’s utility Uniper has requested a government bailout. And a small British household energy supplier, UK Energy Incubator Hub, has collapsed.
There’s also concern that sharply higher natural gas prices could permanently damage some of Germany’s largest industries—producers of aluminum, glass, and chemicals—which are large consumers of natural gas. According to the country’s plan, industrial users of natural gas would be the first to be forced to cut back consumption in a crisis.
Uncertainty about the future of European natural gas and the potential for a European recession is pressuring the euro, which has fallen 17% since hitting a high in 2021 (Fig. 3). It is at parity with the dollar, which last occurred in December 2002. Ironically, the lower the euro falls against the US dollar, the more expensive natural gas becomes for European buyers, because it’s typically sold in dollars.
The pall cast by the natural gas market and the risk of recession have hurt many European stock markets too. Here’s a performance derby for the ytd through Tuesday’s close for many of the European stock markets (in local currencies): Hungary (-34.0%), Ireland (-29.6), Poland (-28.3), Netherlands (-27.8), Germany (-24.0), Sweden (-22.1), Italy (-20.8), France (-15.0), Switzerland (-14.9), Finland (-14.3), and Greece (-12.1).
China: Developments To Watch. Europe is not the only region facing difficulties. China continues to watch its real estate market deflate and its Covid cases inflate, while worries about its banking system grow. No wonder the recent rally in Chinese shares came to an abrupt halt (Fig. 4). Here’s some news that caught our eye:
(1) Housing troubles spread. We’ve been tracking Chinese property developers that have filed for bankruptcy protection after borrowing too much. Now their customers are showing signs of distress too. Buyers of 35 projects across 22 Chinese cities have stopped paying their mortgages as of July 12 due to project delays and a drop in real estate prices, a July 13 Bloomberg article reported, citing research from Citigroup. Average selling prices of properties in nearby projects were 15% lower than the purchase price over the past three years, the research states.
Mortgage defaults could reach 561 billion yuan ($83 billion), or about 1.4% of outstanding mortgage balances, according to the article. China Construction Bank, Postal Savings Bank of China, and Industrial & Commercial Bank of China may have outsized exposure to mortgage loans.
(2) More banking troubles. Investigators froze accounts in April at five rural banks in Henan province under investigation for fraud. About 1,000 angry customers protested on Sunday, demanding access to their deposits. A video in a July 14 South China Morning Post article shows a surprisingly unruly crowd for the normally subdued country.
The China Bank and Insurance Regulatory Commission subsequently said that individuals with deposits of up to 50,000 yuan ($7,430) will be repaid first, and those with larger deposits will need to wait, a July 12 Bloomberg article reported. Whether this is a one-off situation or a sign of problems lurking in China’s banking system is unclear. The country’s nearly 4,000 small and medium-sized banks control less than 1% of the industry’s total assets, Bloomberg reports, so most banking in China involves large banks.
(3) Covid continues. China remains consumed by its zero-Covid policy. One Covid case prompted the lockdown of 320,000 people in Wugang, a city known for steelmaking, a July 12 NDTV article reported. Nearly 250 million people face some form of restriction, according to Nomura data cited in the article. That’s twice the number of people who were under Covid restrictions the prior week.
Macau’s casinos are shut, and the cities of Xi’an, Lanzhou, and Haikou recently imposed partial lockdowns with nonessential businesses closed due to Covid cases, a July 11 NYT article reported. And with new daily Covid cases in the double digits—too far above zero for the government’s comfort—most of Shanghai’s residents were ordered to get two Covid tests between Tuesday and Thursday. Buying in bulk has resumed.
Disruptive Technology: Battery Recycling. Last Thursday’s Morning Briefing looked at the dirty business of manufacturing lithium batteries, which are used in electric vehicles (EVs) and many consumer electronics. With the raw materials expensive and difficult to extract from the earth, you’d think recycling lithium batteries would be a must. Yet less than 1% of lithium ion batteries are recycled in the US versus 99% of lead-acid batteries (used in cars and power grids).
However, about two dozen entrepreneurs in North America and Europe are setting up recycling facilities. Recycling may help ease the shortage of metals needed to make the batteries, and it will keep these flammable materials out of landfills. In coming years, these new companies will have plentiful supplies of used batteries to recycle: While only 10 million EVs are on the road today, that’s expected to rise 30-fold by 2030 to 300 million, according to IEA data cited in a June 13 WSJ article.
Here’s a look at some of the US players in lithium ion battery recycling business:
(1) Tesla co-founder sets up shop. JB Straubel, co-founder of Tesla, left the EV manufacturer in 2019 to launch Redwood Materials, a lithium ion battery recycler. With more than 300 employees, it has supply contracts with Ford and Panasonic, which makes batteries for Tesla.
While waiting for used EV battery supply to increase, the company is recycling the lithium ion batteries used in consumer products like lawnmowers, cell phones, and toothbrushes, Straubel told the AP in a January 31 interview. While Redwood Materials isn’t profitable yet because it’s investing in its growth, the process of recycling is profitable, he said.
The metals in batteries—lithium, copper, nickel, cobalt, and manganese—can be reused and do not degrade. So once the US fleet of EVs is built, not much more mining will be necessary if the materials are recycled, Straubel contends.
(2) Another Tesla alum. Ryan Melsert helped develop the batteries and the battery factory Tesla uses. Now he’s building a battery recycler, American Battery Technology. When the company’s factory in Nevada is completed at the end of this year, it should take in 20,000 metric tons of recyclable material annually, about a fifth of which would be raw lithium, an April 19 article in ARS Technica reported. Anywhere you can buy a lead acid battery, you can also recycle one. Melsert suggests that a similar system be established for lithium ion batteries.
(3) Repurposing batteries. Before being recycled, some used EV lithium ion batteries are used to store energy on the electric grid. Electricity generated by wind and solar panels is intermittent. So old EV batteries can store excess solar power by day that can be used if needed at night.
“Drivers can expect upward of 100,000 miles of use before a battery loses 20% or more of its capacity, roughly the point at which performance drops noticeably, experts say. But they remain useful for grid storage until their capacity drops to around 60%, potentially giving them another 10 to 15 years of service,” Hans Eric Melin, founder of Circular Energy Storage Research and Consulting, said in the WSJ article noted above.
There will be challenges. Unlike batteries in a gas-powered car, the format of EV batteries is not uniform across different car models. Batteries’ shapes and technology continue to change rapidly, adding a layer of complexity to recycling. But with the price of raw materials elevated, lithium batteries are too valuable to become landfill.
Earnings, Inflation & Europe
July 13 (Wednesday)
Earnings I: Recession or Margin Squeeze? Joe and I tend to be optimists. Nevertheless, we marvel at the remarkable optimism of industry analysts about company prospects despite the mounting recession concerns that have fed the valuation-led bear market in stocks so far this year. Indeed, the S&P 500’s forward earnings has been making new highs almost every week this year (through the June 30 week), though the ascent has started to look a bit toppy over the past three weeks (Fig. 1). All but two S&P 500 sectors (Communication Services and Consumer Discretionary) have forward earnings at or near recent record highs.
But on closer inspection, it seems that a few analysts now might have gotten the recession memo from the companies they follow:
(1) Consensus earnings estimates for 2022 & 2023. Here are the ytd percent changes in analysts’ consensus estimates for the 2022 and 2023 earnings of the S&P 500 and its 11 sectors through the June 30 week: Energy (79.4%, 65.2%), Real Estate (15.1, 5.2), Materials (14.4, 10.3), S&P 500 (2.9, 1.9), Information Technology (2.7, 2.0), Health Care (0.6, -1.7),Utilities (-0.4, 0.5), Financials (-1.3, 0.3), Industrials (-1.4, 0.8), Consumer Staples (-1.6, -2.2), Communication Services (-7.5, -6.8), and Consumer Discretionary (-15.7, -7.9). (See Tables 7E and 8E in our Performance Derby: S&P 500 Sectors & Industries Forward Earnings & Revenues.) Six of the sector estimates for this year and four of them for next year show downward revisions (ytd).
(2) Forward revenues boosted by inflation. Remarkably, the forward revenues of the 11 sectors all have been rising since the start of this year, with all but three of them at record highs (Fig. 2). Obviously, any hint of a possible recession in forward revenues has been more than offset by the positive impact of rapidly rising price inflation on revenues.
(3) Profit margins. We have to conclude from the available data that the analysts who have been cutting their earnings outlook aren’t doing so because they’ve received recession memos from the companies they follow but rather memos on profit margin squeezes being experienced (Fig. 3).
Here is are the ytd percentage changes in the forward profit margins of the S&P 500 and its 11 sectors through the June 30 week and the latest readings of those margins: Energy (up 27.7%, 11.7%), Real Estate (11.0, 18.1), Information Technology (0.9, 25.2), Materials (0.2, 13.3), Financials (-0.3, 18.7), S&P 500 (-0.4, 13.3), Industrials (-0.6, 10.3), Consumer Staples (-3.0, 7.4), Health Care (-3.9, 10.9), Communication Services (-4.5, 16.0), Utilities (-5.9, 13.8), and Consumer Discretionary (-7.9, 7.5). (See Table 3 and Table 1 in Performance Derby: S&P 500 Sectors & Industries Forward Profit Margins.) Forward profit margins have been revised down for six of the 11 sectors of the S&P 500.
US Inflation: Persisting for Now. June’s CPI report is coming out this morning. Bloomberg is showing consensus estimates of up 1.1% (8.8% y/y) for the headline and 0.6% (5.8% y/y) for the core inflation rates. There’s no peak represented by these numbers given that the headline and core CPI inflation rates on a y/y basis were 8.6% and 6.0% in May. The same can be said of other recently released measures of inflation, though a few do support our view that inflation should moderate during H2-2022.
We are forecasting that the headline PCED measure of inflation, which ranged between 6% and 7% y/y during H1-2022, will ease to 4%-5% during H2-2022 and to 3%-4% during 2023 (Fig. 4). We don’t expect that getting there will require a hard landing for the economy. Rather, our base-case economic outlook (with a 55% subjective probability) is a short and shallow recession (Fig. 5). Let’s review the latest inflation readings:
(1) Inflationary expectations. The New York Federal Reserve Bank has been conducting a monthly survey of consumers’ inflationary expectations since mid-2013 (Fig. 6). June’s one-year-ahead expectations rose to a record 6.8%, while three-year ahead expectations edged down to 3.6%. Fed officials are likely to conclude that they must proceed with their tightening of monetary policy since longer-term inflationary expectations are being held down by expectations that the Fed will do just that until actual inflation subsides.
(2) Wage inflation. A recent survey from Insight Global found that 78% of US workers would be worried about job security if the US enters another recession. The staffing company surveyed over 1,000 workers in mostly white-collar professions. The survey found that 54% of workers said they would take a pay cut if it meant not getting laid off. All the talk about a possible recession may be starting to moderate wage inflation. June’s average hourly earnings (AHE) measure of inflation was up 5.1% y/y, but the three-month annualized rate was 4.2% (Fig. 7).
Here are the major industries where the AHE year-over-year rates are above their annualized three-month percent changes (suggesting that inflationary pressures are easing): education & health services (6.1%, 5.8%), utilities (6.1, 4.6), professional & business services (5.8, 3.2), transportation & warehousing (5.3, 0.7), wholesale trade (4.5, 4.1), retail trade (4.4, 1.1), durable goods manufacturing (4.3, 3.1), nondurable goods manufacturing (3.8, 3.4), and financial activities (2.4, 0.7).
Here are the major industries where the year-over-year rates are below their three-month annualized rates (suggesting that inflationary pressures are persisting): leisure & hospitality (9.1%, 10.2%), construction (5.6, 6.3), information services (4.4, 8.8), and other services (2.9, 3.6), with the natural resources’ (3.7, 3.8) rates virtually even.
(3) Small business owners survey. The National Federation of Independent Business conducts a monthly survey of small business owners. They are a very unhappy lot indeed. On balance, a net -61% of them expect that the economic outlook over the next six months is better rather than worse than now (Fig. 8). This measure has been falling to record lows since March. That’s mostly because 34% of them said that inflation is their number-one problem (Fig. 9).
They are also complaining about a shortage of workers, as 50% of them have job openings and 60% reported that there are few or no qualified applicants for their open positions (Fig. 10). As a result, 28% of small business owners are planning to raise worker compensation in the next three months (Fig. 11). Meanwhile, a whopping 69% are raising their average selling prices, while 44% are planning to do so (Fig. 12).
(4) Freight rates. About a year ago, the cost to ship containers from China to the US had jumped from $2,000 pre-pandemic to $20,000. According to one report, Flexport, a tech-enabled freight forwarder, has seen rates drop from highs of around $20,000 per container to $10,000.
(5) Used car prices. The Manheim index of wholesale used car prices fell to 9.7% y/y during June. That’s down from a recent high of 46.6% during December and the lowest since mid-2020 (Fig. 13). The used-car component of the CPI has been a major contributor to measures of consumer price inflation over the past year.
(6) Food and energy commodity prices. Finally, the S&P GSCI energy and agricultural commodity price indexes are down 15.4% and 23.0% from their most recent peaks on June 9 and May 17 through July 11 (Fig. 14). This augurs well for a moderation of the energy and food inflation components of July’s CPI. The overall S&P GSCI index is down 15.3% from its recent peak on March 8 through July 11 (Fig. 15). These developments suggest that inflation may be peaking and help to explain why the S&P 500 bottomed on June 16.
Europe Credit I: Positives for Highly Indebted Sovereigns. After the European Central Bank’s (ECB) June 9 policy meeting, a huge sell-off in the European high-yield bond and other credit markets occurred as investors reacted negatively to the ECB’s super-hawkish tone.
The 10-year German bund yield hit a recent high of 1.76% following the release of the ECB’s June 9 Monetary Policy Statement (Fig. 16). “Given the dramatic bund move, the all-in cost for borrowers is not just wider spreads, but much higher base rates,” said a high-yield fund manager quoted in an S&P Global article.
To address the sudden rise in high-yield bonds and spreads, the ECB announced on June 15 that it would accelerate the completion of a new anti-fragmentation instrument to direct funds toward heavily indebted European countries, even as it tightens monetary policy overall to combat inflation. Bond market reactions suggest cautious optimism that the new policy tool will help to stave off a recurrent European debt crisis.
The next day, Christian Lindner, Germany’s finance minister, also attempted to quell market jitters when he told CNBC: “Yes, of course we are witnessing some rising spreads amongst the member states, but there is no need for any concern.” And on June 27, Germany’s financial stability committee said that the effects of Russia’s war on Ukraine are manageable.
So far, the European Commission (EC) has said nothing officially about a possible Eurozone recession. But speaking to CNBC, EU Economics Commissioner Paolo Gentiloni admitted that “We are navigating troubled waters” but said a recession isn’t inevitable. He added that the situation “means that we will have to concentrate our fiscal policies, in reforms, in investments, in a prudent policy, especially for countries with a high level of debt.”
Europe’s financial situation indeed is fragmented by country. Greece and Italy had the two highest debt-to-GDP ratios at year-end 2021—of 193% and 151%, respectively, versus 69% for the more austere Germany and 96% for the Eurozone overall. But Melissa and I found a surprising number of positives in the recent credit profiles of Europe’s two most heavily indebted countries:
(1) Fitch’s positive outlook on Greece. On July 8, Fitch affirmed Greece’s sovereign debt rating of “BB” with a “Positive Outlook.” Fitch’s ratings release noted: “The Positive Outlook reflects a sustained expected decline in public sector indebtedness, in the context of still low average borrowing costs, despite the sharp rise in government bond yields this year. Greek banks have made substantial progress on asset quality improvement, sharply reducing the level of [non-performing loans] in the banking sector.”
The government’s debt-to-GDP ratio is projected to fall further to about 172% by 2024 from about 193%, “driven by improving primary balances and favorable growth-interest costs dynamics.” While the debt ratio in 2024 is still forecast to be among the highest of Fitch-rated sovereigns, mitigating factors support debt sustainability: substantial liquidity, low debt-servicing costs, and manageable amortization schedules.
The 10-year government bond yield for Greece rose sharply from 1.3% at the end of 2021 to average around 4.0% in June 2022 (Fig. 17). However, at around 20 years, the average maturity of Greek debt is among the longest of any sovereign, and the debt is mostly fixed rate, limiting the impact of market interest-rate rises.
Despite the improving credit outlook, however, Greece’s macroeconomic outlook has worsened because of the war. That’s especially because Greece is vulnerable to further energy price shocks, as it relies on Russia for around 40% of overall gas imports.
(2) Italian déjà vu with differences. “Whatever it takes [to rescue the euro],” was former ECB President Mario Draghi’s famous pledge at the height of the 2012 sovereign debt crisis. That reassurance and his follow-up actions—“mop[ping] up a fifth of Italian bonds,” in Reuters’ words—calmed investor fears, causing Italy’s 10-year bond yield to drop.
The ECB’s June 15 reassurances about a new tool to help troubled states worked like Draghi’s magic words: On June 14, Italy's 10-year government bond spiked above 4.0%, the highest since 2013, on renewed concerns about Italy’s ability to sustain its debt under macroeconomic pressure (Fig. 18). The ECB’s announcement the next day brought Italian benchmark yields back toward 3.0%.
We think the rise above the 4.0% threshold was concerning; but notably, back in 2011 Italian 10-year yields rose above 7.0%. Italian banks remain heavily exposed to domestic sovereign debt but not as much so as in the past. For Italy’s top five banks, the ratio of domestic bond holdings to core capital is 148%, according to JPMorgan’s data cited by Reuters, but that’s a lot less than the 261% hit in 2017.
Italy’s bank restructuring that began during the 2012 sovereign debt crisis has progressed but remains incomplete. The top two lenders are sound, noted former ECB executive Ignazio Angeloni at a conference in June, but the mid-sized banks are not yet fully stabilized. Problem loans “could rise again as businesses face higher lending costs, record prices for energy and raw materials as well as disrupted supply chains and the phasing out of COVID support measures,” the Reuters article noted.
Europe Credit II: High Stakes, Low Defaults in High-Yield. In the aftermath of the recent bond scare, investors have been shying away from higher-yielding European debt assets in general. “European high-yield bond issuance is set for the lowest first-half total since the global financial crisis, as volatile interest rates and fears over rising inflation forced investors to assess the impact of a global recession on the asset class,” wrote S&P Global in a June 22 article. Here’s more:
(1) Investors orderly fleeing high yields. The selling of riskier bonds isn’t frantic but orderly. Starting in February, a 10-week closure of the primary market was triggered by the Ukraine war, which escalated fears over inflation and rising interest rates. As a result, the European high-yield asset class faced outflows of 15.6% of assets under management through June 20, according to Spread Research data cited in the S&P Global piece. European high-yield issuance of €15.3 billion in H1-2022 was the lowest since H1-2009, when markets were reacting to the Global Financial Crisis, according to Leveraged Commentary & Data noted S&P Global’s article.
(2) High-yields ascend to double digits. Meanwhile, yields in Europe’s secondary credit markets rose, according to July 20 data from Spread Research. At the lowest end of the ratings spectrum, the CCC yield was quoted at 11.7%. “The current generous pricing in some deals currently in the high yield market is fine if we assume the default rate will remain below the historical average of 4% over the next two years,” Sergio Grasso, director at iason, wrote in a June 28 report. However, “if the current and future restrictive monetary policies will tilt the economies into recession,” then even the current risk on pricing is still “not enough.”
(3) Defaults expected to remain low. The good news is that while European high-yield bond and leveraged loan default rates will increase in 2023 (to 2.5% from 1.5% and to 3.0% from 2.5%, respectively), they’re still expected to remain below 4.0% and below long-term historical levels, according to a June 15 Fitch Ratings report. Fitch does not expect a “severe near-term recession that would lead to wholesale downgrades of credits, unlike the pandemic impact.”
(4) Pain beyond high yield. Even so, the anticipation of higher interest rates ahead is causing pain in not only the high-yield market but also the investment-grade debt market. An index of investment-grade European debt has suffered a record 12.9% loss over the past 12 months, observed Bloomberg on June 24. According to the Bloomberg index, the average yield on euro corporate bonds has risen 2.9 percentage points this year to 3.4%. That compares to a rise of 1.62 points in 2008, the next highest. “We could see earnings impacted because of this rather unexpected rise in the cost of debt,” said ING credit strategist Timothy Rahill.
Thumbs Up or Down For Q2 Earnings?
July 12 (Tuesday)
Strategy I: Clash of the Titans. As the Roman emperors once said: “Let the games begin!” The latest earnings reporting season is about to begin. The games in the Roman Colosseum usually were brutal. The question today is whether investors are about to face a brutal earnings season if the actual results turn out to be much worse than industry analysts have been predicting. Investors have been fearing such an outcome since the S&P 500 peaked on January 3 of this year and the Nasdaq peaked on November 19, 2021.
The earnings outlook has been thumbs down as far as investors are concerned, as evidenced by the freefalls in the forward P/E multiples of the S&P 500, S&P 400, and S&P 600 indexes since the start of this year (Fig. 1). Yet industry analysts have kept up the good fight, raising their annual revenues and earnings estimates for 2021 and 2022 since the start of this year.
As a result, the forward revenues and forward earnings of the S&P 500/400/600 indexes have been rising to record highs all year (Fig. 2 and Fig. 3). The forward profit margins (i.e., forward earnings divided by forward revenues) hovered at record highs during H1-2022 (Fig. 4). (FYI: “Forward” earnings and revenues are the time-weighted average of analysts’ estimates for the current and next years.)
Let’s have a closer look:
(1) Earnings vs valuation. Here are the percent changes in the forward P/Es and forward earnings of the S&P stock indexes on a y/y basis through July 7: S&P 500 (-24.4%, 18.0%), S&P 400 (-34.2, 30.3), and S&P 600 (-34.5, 28.4) (Fig. 5). These comparisons confirm what we’ve been saying for the past few months: Investors and industry analysts are from different planets, with the former from Mars and the latter from Venus.
(2) Revenues. Here are the current consensus expected growth rates for revenues per share this year and next year: S&P 500 (11.5%, 4.6%), S&P 400 (13.3, 3.8), and S&P 600 (13.4, 3.6). These estimates undoubtedly are boosted by analysts’ expectations that inflation will remain elevated this year and moderate next year. Most importantly, analysts collectively clearly aren’t expecting a recession either this year or next year, while investors have been fretting about the recession scenario all year.
(3) Earnings. Here are the current consensus expected growth rates for operating earnings per share this year and next year: S&P 500 (9.9%, 9.3%), S&P 400 (14.3, 6.3), and S&P 600 (10.8, 11.4). Notwithstanding these upbeat forecasts, during the past couple of weeks, analysts’ consensus earnings projections for this year and next year have started to look a wee bit toppy. Joe observes that for a second straight week through the July 7 week, none of these three indexes had forward earnings at a record high. That hasn’t happened since January 2021.
(4) Margins. The forward profit margins of the S&P 500/400/600 at the end of June were 13.3%, 8.9%, and 7.0%. All three have been fluctuating at record highs since the start of this year. Collectively, industry analysts are implying that profit margins have been holding up remarkably well under the circumstances.
Strategy II: A Guide to the Games. On their Q2 earnings calls, most company managements are likely to report that they are concerned about a recession but aren’t seeing it in their businesses so far. We think they’ll say that inflation is boosting their revenues and that the Fed’s tighter monetary policies in response to inflation aren’t depressing their unit sales so far. That would certainly explain why analysts have been raising their estimates for revenues.
Analysts also have been raising their earnings estimates along with their revenues estimates, implying that overall profit margins are holding firm and not getting squeezed by rapidly rising labor and materials costs or by labor and parts shortages. So it will be interesting to see whether that’s actually been the case during Q2. Other key points that corporate managements undoubtedly will be discussing are the impacts on revenues, earnings, and margins of labor shortages, supply-chain problems, inventory issues, the strong dollar, China’s zero Covid policy, and the Ukraine war.
Joe and I expect company managements to say that while labor shortages are weighing on their companies’ expansion plans, productivity gains are providing some relief. Furthermore, they are likely to report that supply-chain challenges are easing, though that may reflect weakening demand in some cases. Unintended inventories may be piling up, especially among retailers, requiring price cuts to clear them.
The managements of US multinationals undoubtedly will confirm that the strong dollar is weighing on their revenues and earnings from overseas. Geopolitical concerns are challenging the globalization of business. China’s pandemic-related lockdowns are depressing sales in that important market for many companies. We expect to hear increasing concerns that Europe is likely to fall into a severe recession as a result of the region’s energy crisis caused by the Ukraine war.
Now let’s consider the outlook for the S&P 500’s major sectors as the Q2 earnings reporting games are about to begin:
(1) S&P 500 sectors. Joe reports the following consensus expected y/y growth rates for the revenues and earnings of the S&P 500 and its 11 sectors as of the July 8 week (i.e., the start of the earnings reporting season): S&P 500 (10.6%, 5.7%), Communication Services (3.9, -14.4), Consumer Discretionary (10.9, -5.5), Consumer Staples (5.6, -1.7), Energy (59.2, 239.1), Financials (-4.0, -20.8), Health Care (7.0, 1.6), Industrials (12.9, 30.8), Information Technology (7.8, 2.5), Materials (15.7, 17.4), Real Estate (15.4, 4.2), and Utilities (0.7, -12.2). (See our Earnings Season Monitor tables.)
(2) Consumer Discretionary. As we observed yesterday, solid payroll and wage gains are bolstering nominal personal income. However, consumers’ purchasing power continues to be eroded by inflation. That’s depressed spending on consumer discretionary goods as households are forced to spend more on essentials such as food, fuel, and rent. In addition, consumers’ pent-up demand for discretionary goods has been satiated by the post-lockdown buying binge of 2020 and 2021, and now they are pivoting toward spending more on services.
Retailers report their results near the tail end of earnings seasons. Many of them have seen their inventories rising relative to sales as consumers have reduced their spending on discretionary goods. Here is the inventory-to-sales ratios of various retailers during April and a year ago: all retailers (1.18, 1.09), motor vehicle & parts dealers (1.28, 1.22), furniture, home furnishings, electronic & appliance stores (1.62, 1.27), building materials, garden equipment & supplies (1.87, 1.58), and general merchandise stores (1.58, 1.19) (Fig. 6).
The retailers have been forced to discount their excess inventories to clear them. Industry analysts have slashed their earnings expectations for the industry. As a result, the forward profit margin of S&P 500 General Merchandise Stores has dropped by more than a percentage point in recent weeks to 5.2% at the end of June (Fig. 7).
(3) Energy. May’s value of petroleum shipped by US refineries rose $45.8 billion since its April 2020 bottom, to its highest level since August 2014 (Fig. 8). This series is highly correlated with the forward earnings of the S&P 500 Energy sector. Despite the recent weakness in crude oil prices, industry analysts continue to raise their 2021 and 2022 revenues and earnings estimates for the sector. That’s partly because crack spreads remained very high during June. (See our S&P 500 Industry Briefing: Energy.)
(4) Financials. The big banks will report their earnings this week. JPMorgan Chase and Morgan Stanley go first on Thursday, followed by Citigroup and Wells Fargo on Friday. On June 1, JPMorgan Chase CEO Jamie Dimon said he is preparing the biggest US bank for an economic hurricane on the horizon. Presumably, he is tightening up lending standards and boosting loan loss reserves.
If the big banks increase these reserves, that will weigh on their earnings. However, Jackie and I monitor the weekly data compiled by the Fed on US commercial banks’ allowances for losses, and they’ve continued to decline during Q2 as they did during Q1 (Fig. 9). In addition, demand for commercial and industrial loans has increased every week but one since mid-February, and the banks have obviously been accommodating it (Fig. 10).
(5) Industrials. The S&P 500 Industrials sector includes lots of multinational corporations that are likely to report that a strong dollar has eroded their overseas profits. They may also report that the Ukraine war has wiped out their business in Russia, while China’s lockdowns have slowed their sales in that country. Both the S&P 500 Agricultural & Farm Machinery and Construction & Engineering industries undoubtedly were hit by these developments during Q2.
Nevertheless, new orders for construction, farm, and mining machinery have been rising during the first five months of this year. New orders for industrial, metalworking, and materials handling equipment have remained near their record highs at the beginning of the year (Fig. 11).
Transportation corporations are also included in the S&P 500 Industrials sector. Trucking continues to enjoy a booming business. The industry’s forward earnings rose to another record high at the end of June as its forward profit margin recently rose to a record high of 11.2%. The trucking companies clearly are passing soaring labor and fuel costs on to their customers. (See our S&P 500 Industry Briefing:Trucking.)
(6) Information Technology. The Q2 earnings of the S&P 500 Information Technology sector will also be negatively impacted by the strong dollar. The slowdown in China’s economic growth rate is another negative. Yet data through May showed worldwide semiconductor sales soared to another record high in May (Fig. 12). In the US, industrial production of high-tech equipment remained on the solid uptrend that started after the 2020 lockdown recession through May of this year (Fig. 13).
Strategy III: No Recession in Forward Revenues. S&P 500 forward revenues per share is up 14.5% y/y in current dollars (through the June 30 week) and 5.9% on an inflation-adjusted basis (through May using the CPI) (Fig. 14 and Fig. 15). Both are at record highs. The same can be said for forward earnings. It is up 18.0% y/y in current dollars (through the July 7 week) and 10.8% on an inflation-adjusted basis (through May) (Fig. 16 and Fig. 17). They’re both at record highs too.
So there’s no recession yet evident in either forward revenues or forward earnings. Their growth rates are likely to fall closer to zero but avoid falling into the negative territory consistent with past “official” recessions. That’s if our base-case economic outlook plays out with an “unofficial” mild recession scenario, as we discussed yesterday. That would be consistent with similar mid-cycle slowdowns like the ones during the mid-1980s and mid-2010s.
Reassessing the ‘Banana’ Scenario
July 11 (Monday)
YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the Monday webinars are available here.
US Economy: Leading vs Coincident Indicators. Last week, Debbie and I wrote about the divergence in recent months between the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI). The LEI peaked at a record high during February (Fig. 1). It is down 0.9% since then through May.
As we discussed in the July 6 Morning Briefing, we already know that four of the LEI’s 10 components weighed on it during June—namely, the S&P 500, the M-PMI new orders subindex, a measure of consumer expectations, and initial unemployment claims. The LEI increasingly has been signaling a recession, though not necessarily an imminent one since it peaked by 12 months, on average, before the onset of the past eight recessions.
On the other hand, there is no recession in the CEI, which rose to a record high during May. It includes four components: payroll employment, real personal income less transfer payments, real manufacturing & trade sales, and industrial production. June’s employment report was released on Friday. It provided a mixed picture for the first two CEI components:
(1) Payroll employment. Friday’s report showed a larger-than-expected increase of 372,000 in payroll employment (Fig. 2). The more volatile household measure of employment fell 315,000. However, it is the payroll measure that is included in the CEI, and it is only 0.5% below its record high during February 2020. There’s certainly no recession evident in this coincident indicator.
(2) Personal income. Friday’s employment report also showed moderating wage inflation, as the average hourly earnings (AHE) measure of wages rose 0.3% m/m during June. The bad news is that the consumer price inflation rate (based on the headline PCED) over the past 12 months through May was 6.3%, exceeding the 5.1% increase in the AHE over the same period. So workers’ purchasing power has stagnated over this period (Fig. 3). Odds are that inflation significantly eroded the purchasing power of wages again during June.
This doesn’t augur well for June’s real personal income excluding transfer payments, which is one of the four components of the CEI (Fig. 4). This measure of total consumer purchasing power has been eroded by consumer price inflation too; it is up 8.3% y/y in nominal terms, but only 1.8% in real terms, through May.
Debbie and I calculate our Earned Income Proxy (EIP) for private wages and salaries in personal income when the monthly employment report is released (Fig. 5). It is simply AHE multiplied by aggregate hours worked, which reflects payroll employment and the average length of the workweek. The average workweek (which is one of the components of the LEI, by the way) was flat during June, while aggregate hours worked during the month rose to a record 4.48 billion.
Our EIP rose 0.6% m/m during June (Fig. 6). However, it undoubtedly was eroded by higher consumer price inflation. Over the past 12 months through May, the nominal and real versions of the EIP are up 9.4% and 2.9%.
(3) Subjective probabilities. So according to the LEI, the economy is heading toward a recession. According to the CEI, everything is just swell. Following the release of the jobs report on Friday, the Atlanta Fed’s GDPNow tracking model showed that real GDP fell 1.2% (saar) during Q2, an upward revision from down 1.9%. Real consumer spending growth was revised up from 1.3% to 1.9%, while real gross private domestic investment increased from -14.9% to -13.7%. So real GDP is on track to fall for the second quarter in a row, having decreased 1.6% during Q1.
Last week, we raised our odds of a short and shallow recession from 45% to 55%, with real GDP falling by 2.0% during H2-2022. So a mild recession is our base-case scenario currently. The second-most-likely alternative scenario, with a 25% subjective probability, is a soft landing, with real GDP growing between 0.0% and 2.0% during H2-2022. That puts the odds that real GDP will grow between -2.0% and 2.0% for the foreseeable future at 80%. For now, we assign 10% odds to a hard landing and 10% to a boom.
(4) The “banana” scenario. “Between 1973 and 1975 we had the deepest banana that we had in 35 years, and yet inflation dipped only very briefly,” the economist Alfred Kahn, who headed the Carter administration’s task force to fight inflation, once said. He substituted “banana” for the word “recession.” The reason, he amiably explained, was that references to recessions seemed to make people nervous and irritable. Of course, one of the people made most irritable was his boss, President Jimmy Carter.
In the February 15 Morning Briefing, we wrote: “Debbie and I have been thinking more about the banana scenario. For now, we are singing the 1923 hit song with the ambivalent message ‘Yes! We Have No Bananas.’” We observed that the following factors suggested a low risk of a recession: the LEI and CEI were rising, consumers were in relatively good shape, corporations were also ship-shape, the risk of a credit crunch was low, and the air was coming out of various speculative bubbles in an orderly fashion.
Back then, we identified the main risk as follows: “If the prices of bananas continue to soar along with other food prices and most items in the CPI, then the Fed will have no choice but to implement Volcker’s solution, ushering in the Volcker 2.0 scenario.”
Last Thursday, two Fed officials opined that it should be full-steam ahead for another 75bps hike in the federal funds rate at the end of this month followed by one of 50bps-75bps in September. June’s employment report certainly wouldn’t have changed their minds. Let’s see if June’s CPI report released on Wednesday will take any steam out of the Fed’s current tightening monetary course, or add even more steam.
The 2-year US Treasury note yield is a good year-ahead leading indicator of the federal funds rate, which is currently at 1.63% (Fig. 7). After soaring from 0.73% at the start of the year to a recent high of 3.45% during June 14, it has been back down bouncing around 3.00% since then.
For now, Fed officials remain on course to tighten monetary policy through September, even at the risk of an economic squished banana. Needless to say, the word “banana” did not appear in the FOMC’s June minutes. Neither did the word “recession,” not even once. Instead, the minutes noted: “Most participants assessed that the risks to the outlook for economic growth were skewed to the downside. Downside risks included the possibility that a further tightening in financial conditions would have a larger negative effect on economic activity than anticipated as well as the possibilities that the Russian invasion of Ukraine and the COVID-related lockdowns in China would have larger-than-expected effects on economic growth.”
Strategy I: The S&P 500 as a Leading Indicator. The stock market has predicted nine of the past five recessions. That’s a joke told by master Keynesian of decades ago Paul Samuelson. As noted above, the S&P 500 is one of the 10 components of the monthly LEI. It tends to peak ahead of recessions but has provided a few false alarms as well. However, since 1945, every bear market in the S&P 500 with the exception of the one during 1987 has been associated with a recession (Fig. 8 and Fig. 9).
The question is whether the current bear market might not be a precursor of a recession after all? The answer is that it might not if the recession turns out to be short and shallow as we currently expect. It’s conceivable that such a recession might not make the grade as an official recession as determined by the Dating Committee of the National Bureau of Economic Research. It’s conceivable that the current experience will make the history books as a growth recession or a mid-cycle slowdown, but not an “official” recession.
Since 1945, bear markets in the S&P 500 started, on average, five months before recessions started. The range of the lead time has been 12 months before to one month after the 12 recessions since 1945 (Fig. 10).
Strategy II: The Da Vinci Code. Joe and I remain hopeful that the Da Vinci Code (DVC) will be right again in calling a major market bottom. The S&P 500 fell to 666 on an intra-day basis on March 6, 2009. That devilish number marked the bottom in the previous bear market. On June 16 of this year, the S&P 500 closed at 3666, down 23.6% from its record high on January 3. That marked the bottom to date in the current bear market. The index is up 6.3% since then and down 18.7% since its January 3 peak (Fig. 11).
Of course, we are fundamentalists, not DVC symbolists. The S&P GSCI commodities index is down 14.8% from its recent peak on June 8 through Friday’s close. Over this same period, its energy and agricultural commodities subindexes are each down 15.6%. The price of copper is down 19.8% over this period.
The drop in commodity prices triggered a significant decline in the 10-year US Treasury bond yield from this year’s peak of 3.48% on June 14 to 3.09% on Friday.
All these developments signal that inflation might be peaking and therefore that the Fed’s monetary policy tightening cycle might be over sooner rather than later. If so, then the forward P/E of the S&P 500 might have bottomed on June 16 at 15.3. On the other hand, all these developments might also be signaling a recession, which would be bad news for S&P 500 earnings and could very well push the forward P/E below its June 16 low. Given that a mild recession (which might not even make the history books) is our base-case scenario, we think the Da Vinci Code has a shot of having called the bottom.
Strategy III: Are Earnings Real? The recession question for investors is now focusing on the Q2-2022 earnings reporting season, which starts this week. The relative weakness of the economy will be judged by its impact on earnings during Q2 and by the guidance provided by corporate managements during their upcoming earnings calls. The results will help investors decide whether industry analysts have been too optimistic, if not totally delusional, about earnings. Here is our guidance for the earnings reporting season ahead:
(1) Quarterly earnings. Industry analysts lowered their Q2 estimates for S&P 500 earnings slightly during April when Q1 earnings were being reported, but not by much and haven’t changed their estimates since then (Fig. 12). During the June 30 week, they estimated that earnings rose 4.9% y/y through Q2 (Fig. 13). History suggests that analysts tend to be too pessimistic just before earnings seasons begin, as the actual results turn out to be better. We will be monitoring their estimates for Q3 and Q4 to see how Q2’s results and guidance affect their outlook.
(2) Annual earnings. Industry analysts remain totally oblivious to all the chatter about a recession, as evidenced by the record highs in both S&P 500 forward revenues and earnings during the June 30 week (Fig. 14). The forward profit margin remains at its record-high reading of about 13.3% since the end of last year.
(3) Adjusting for inflation. One of our accounts recently asked us if the strength in forward revenues and earnings might be attributable mostly or solely to inflation. Data available through May show that real forward earnings has been rising every month to new records since May 2021 (Fig. 15). Real S&P 500 forward earnings was up 10.8% y/y through May, while nominal forward earnings was up 18.4% y/y through the June 30 week (Fig. 16).
During recessions, the growth rates of both nominal and real forward earnings tend to be negative on a y/y basis. We aren’t there yet, and we might not get there.
Movie. “Staircase” (+ +) (link) is an HBO Max TV mini-series inspired by the truly bizarre story of Michael Peterson, a crime novelist. He was found guilty of killing his wife Kathleen. During the trial, his defense lawyer claimed that she died falling down the back staircase at their home. The prosecution argued that her head injuries showed that she was hit several times by her husband after she might have threatened to leave him because she might have discovered that he was cheating on her. The jury sided with the prosecutors partly because Michael had had numerous affairs and a history of lying about his past. The relationships between Michael, Kathleen, and their five children both before and after her death is an interesting aspect of this crime story, which has lots of twists and turns. Colin Firth admirably plays Michael playing everyone around him. Toni Collette plays his very unhappy wife.
China, Earnings & Batteries
July 07 (Thursday)
China: Real Estate Woes Continue. Just over a year ago, it was widely expected that President Xi Jinping would secure an unprecedented third term when the Chinese Communist Party meets this fall. That was before a number of headwinds hurt the once-unstoppable Chinese economy, casting doubt on Xi’s prospects. Xi’s zero-tolerance Covid policy placed major cities under quarantine for months at a time when Covid cases were detected. Some of the country’s largest real estate developers have filed for bankruptcy protection, unable to make interest payments on their billions in outstanding debt. And now the global economy is slowing, jeopardizing China’s exports.
The Chinese government hasn’t sat on its hands. It provided fiscal stimulus with the latest round of government-funded infrastructure projects, announced last week, and monetary stimulus by lowering reserve requirements for banks. Also, China’s central bankers have kept its prime lending rate steady instead of raising it to fight inflation, as many other major central banks have done (Fig. 1 and Fig. 2). Moreover, President Xi has softened his disastrous anti-business policies, giving investors hope that a more business-friendly environment has arrived—at least until the CCP meets.
These business-friendly moves are reflected in the stock market’s recent performance. After falling 54.5% from its peak on February 17, 2021 through its trough on March 15, China’s MSCI stock market index has rebounded sharply this year, rising 27.0% from its lows (Fig. 3). And on July 4, the Caixin services purchasing managers’ index jumped to 54.5 in June, up from 41.4 in May.
But we remain concerned about three matters over which even Xi has little control: The potential for new Covid cases and related quarantines, China’s high real estate debt, and a recession in the US and Europe hurting Chinese exports. The continuation of Xi’s zero-tolerance Covid policy seems unsustainable, and restructuring billions of dollars of debt across many companies could take longer than Xi would like.
Here’s a look at some of the recent developments:
(1) Deflating real estate bubble. China’s housing sales have fallen y/y for 11 months in a row, yet the unwinding of China’s real estate market continues. The most recent casualty is Chinese developer Shimao, which defaulted on $1 billion of dollar-denominated bonds when it missed a payment on Sunday. The country’s 14th largest builder (as measured by contracted sales) has about $5.5 billion of offshore bonds outstanding, a July 3 Bloomberg article reported.
In May, China’s third-largest property developer, Sunac China Holdings, defaulted on a $750 million bond. Sunac’s aggregated sales in March and April fell 65% from a year ago due to Covid outbreaks in various cities, and its refinancing and asset disposal plans did not materialize after a series of rating downgrades earlier this year, a May 12 Reuters article reported.
The largest real estate developer to default is China Evergrande Group, which filed for bankruptcy in December. Roughly $300 billion of the company’s debt will need to be restructured.
All told, nineteen Chinese real estate developers have defaulted on billions of dollars of debt, and their woes are weighing on Chinese economic growth. Real estate and related sectors account for 28% of China’s GDP, according to Moody’s Investors Service.
Consider just the sale of land by municipalities to land developers. Last year, property developers and others paid 8.7 trillion yuan to local governments for land purchases. Revenue from land sales represented 42% of the total revenue generated by local governments excluding funding from the central government. Local governments’ land sale revenue grew tremendously over the past decade. In 2011, it was only 3.3 trillion yuan, or 36.7% of their revenue, according to a May 21 South China Morning Post (SCMP) article. And for some cities, land sales brought in more revenue than taxes.
This year, land sales—and the revenue they bring to local governments—are down sharply. Land sales in yuan terms fell by 14%-91% in 17 of the 19 cities surveyed in a May 21 SCMP article compared to a year ago. Here are a few cities mentioned with the change in their land sales over the same period: Tianjin (91%), Wuhan (89), Guangzhou (-63), Beijing (-56), and Shanghai (-48).
The Chinese government has taken some actions to help the real estate sector. The five-year loan prime rate was cut by 15bps to 4.45% on May 20, which was more than expected and the greatest reduction in that rate by since 2019, a May 20 Reuters article reported. It was the second rate cut this year. Additionally, the government has given buyers subsidies and required smaller down payments. Relaxation of Covid restrictions also has helped.
These moves appear to hit their mark: New home prices in 100 cities stopped falling in May and June, according to data from the China Index Academy, an independent real estate research firm quoted in a July 1 Reuters article. Of the 100 cities surveyed, 47 experienced price growth m/m, up from 40 cities in May.
But it’s hard to get a true read on prices, as more than 22 cities have set limits on price cuts since the second half of last year. Prices are further distorted by developers who are offering additional perks or accepting food in lieu of cash to pay for apartments. One developer accepted watermelons to reduce the price on the apartment by $14,935, a June 29 Reuters article stated. It noted that “Among 100 major real estate firms, most achieved less than 30% of their sales targets as of the end of May.” China’s April property sales fell 47% y/y and 43% m/m.
(2) Covid still percolating. Just as occurred in the US, China’s economy undoubtedly will receive a boost now that the Covid-related lockdowns have been lifted in Shanghai and Beijing. But there certainly are no guarantees that lockdowns won’t occur again in those cities or elsewhere, as Xi’s zero-tolerance policy continues.
Mainland China reported 418 new Covid cases on July 4 and 460 cases the prior day, according to a July 5 Reuters article. Beijing and Shanghai each reported three new cases on July 4, and there have been reports of cases in smaller cities around China.
Wuxi, a manufacturing city near Shanghai, closed many shops and supermarkets and suspended in-restaurant dining after 42 asymptomatic cases were discovered Saturday, a July 3 New York Post (NYP) article reported. Residents were asked to work from home and not leave the city unless absolutely necessary.
Si, a city of 760,000, is locked down after 288 cases were found Saturday, the NYP relayed. And flights from Yiwu to Beijing were canceled indefinitely after the smaller city reported three new Covid cases over the past week.
Two port workers in Wuhan came down with Covid, a June 30 Bloomberg article reported. And there were more than 570 Covid cases in Macau, where more than 7,000 people are in mandatory quarantine, a June 30 Reuters article reported. People have been asked to stay at home as much as possible, and bars, hair salons, outdoor parks, and other venues are closed. Casinos, though largely empty, are open. In Hong Kong, cases jumped to more than 2,000 a day in June.
As of March, only about half of China’s people aged 80 and over were fully vaccinated, and fewer than 20% had gotten a booster shot, according to Statista data. Until China’s population is better protected, Covid will continue to pose a threat to the country’s economy and its people.
(3) Exports to US/Europe slowing. Chinese exports are a major engine of the country’s economic growth, contributing 20% to 2021 GDP. Exports to the US surged 44.0% from the recent bottom to $827.5 billion (saar) through February, while exports to Europe jumped 44.3% from their recent bottom to $705.5 billion also through February. Since then, exports to both regions have fallen sharply, to $621.7 billion to the US and $580.4 billion to Europe both through May (Fig. 4 and Fig. 5). Post Covid, US consumers have opted to spend more on experiences outside of the home than on stuff for inside the home.
Analysts have been slashing their revenues and earnings estimates to new lows for companies in the China MSCI index. The consensus revenue per share estimate for 2022 has fallen 19.7% since it peaked in November 2020. And the consensus per share estimate for 2022 earnings is down 31.2% over the same time period (Fig. 6).
Earnings: A Look at Revisions. In the first half of 2022, there was a major disconnect between the S&P 500’s performance and analysts’ earnings estimates. The S&P 500 has fallen 19.6% ytd through Tuesday’s close, yet industry analysts forecast S&P 500 companies will log earnings growth of 10.8% this year and 9.1% in 2023.
Analysts have a lot of estimate slashing to do if the stock market is correct. So we decided to kick off the second half of the year by looking at which sectors and industries have had estimate cuts already this year, for perhaps those analysts are ahead of the curve.
First, here’s how much earnings growth analysts currently project for companies in the S&P 500 and its 11 sectors this year and next: Energy (121.4%, -11.7%), Industrials (36.5, 19.5), Materials (20.2, -5.8), Information Technology (13.0, 11.2), Consumer Discretionary (11.0, 32.7), S&P 500 (10.8, 9.1), Health Care (5.9, 0.0), Consumer Staples (3.9, 7.3), Utilities (2.2, 7.9), Communications Services (-4.5, 15.6), Real Estate (-10.3, 3.0), and Financials (-10.6, 13.5) (Table 1).
Earnings estimates for 2022 have been revised upwards so far this year for Energy (79.4%), Real Estate (15.1), Materials (14.4), S&P 500 (2.9), Information Technology (2.7), and Health Care (0.6). There’s no disconnect in the Energy sector’s earnings revision direction and stock market performance, as its stock price index is up 25.5% ytd. But the stock price indexes of the four other sectors with upward revisions have suffered ytd declines, including the Technology sector’s sharp 26.2% ytd drop (Table 2).
Conversely, analysts have trimmed their 2022 earnings estimates for the following sectors so far this year: Utilities (-0.4%), Financials (-1.3), Industrials (-1.4), Consumer Staples (-1.6), Communications Services (-7.5), and Consumer Discretionary (-15.7).
And they’ve cut their 2022 estimates for the following S&P 500 industries by more than 10% since the start of the year: Internet & Direct Marketing Retail (-70.7%), Hotels (-61.2), Broadcasting (-29.1), Airlines (-20.7), Office REITs (-20.5), Health Care Supplies (-20.2), General Merchandise Stores (-19.2), Footwear (-18.2), Interactive Home Entertainment (-15.6), Wireless Telecommunication Services (-14.8), Auto Parts & Equipment (-14.1), Movies & Entertainment (-14.1), Aerospace & Defense (-12.7), and Apparel Retail (-12.1).
Among S&P 500 sectors, some of the more dramatic reductions in forward earnings have occurred during the past 13 weeks: Consumer Discretionary (-5.2%), Health Care (-1.6), and Communications Services (-1.2). Among S&P 500 industries, the handful with the sharpest forward earnings declines are: Internet & Direct Marketing Retail (-37.3%), General Merchandise Stores (-17.5), Broadcasting (-15.0), Health Care Supplies (-13.3), Footwear (-10.8), and Copper (Table 3).
Disruptive Technologies: Dirty EVs. The surge in gasoline prices this year has accelerated interest in plug-in vehicles, both hybrid and solely electric. Almost 700,000 plug-in electric cars were registered globally in May, up 55% y/y, a July 6 InsideEVs article reported. As a result, the global plug-in vehicle’s share of the overall global auto market grew to 12% in May.
Before environmentalists can rejoice over the increasing electrification of automobile transportation, however, they need to address the damage caused by the mining, processing, and disposing of the minerals used in batteries even as demand for those materials increases. By 2030, worldwide demand for lithium is expected to grow to six times the 2020 level of 350,000 tons, a March 28 PBS article reported.
Here’s a quick look at some of the problems the industry will need to quickly address:
(1) Damage from the beginning. The US has 4% of the world’s reserves of lithium, but there’s only one mine in the US, first opened in the 1960s. It produces 5,000 tons of lithium a year, or 2% of the world’s annual supply, the PBS article noted. California has so much of the mineral that Governor Gavin Newsom has called the state the “Saudi Arabia of lithium.” There are various projects being developed in Maine, North Carolina, California, and Nevada. But right now, most of the raw lithium used in the US is mined in Latin America or Australia and processed in China, a May 6, 2021 NYT article stated.
Mining for lithium involves either open-pit mining, which uses ground water, can contaminate the water that remains in the ground, and leaves behind waste. The alternative involves extracting lithium from a mineral-rich brine that’s pumped to the surface. “Opponents, including the Sierra Club have raised concerns that the projects could harm sacred indigenous lands and jeopardize fragile ecosystems and wildlife,” the PBS article stated.
Lithium America plans an open pit mine in Nevada that may ultimately be 370 feet deep and produce 66,000 tons a year of battery-grade lithium. The company has said the mine will use 3,224 gallons of water per minute, which could cause the local water table to drop by about 12 feet, the NYTs article reported. Federal documents say the mine may contaminate the groundwater with antimony, arsenic and other metals.
It gets worse. Per the NYT’s: “The lithium will be extracted by mixing clay dug out from the mountainside with as much as 5,800 tons a day of sulfuric acid. This whole process will also create 354 million cubic yards of mining waste that will be loaded with discharge from the sulfuric acid treatment, and may contain modestly radioactive uranium, permit documents disclose.”
(2) How green is your electricity? How much good an electric vehicle does for the environment depends largely on where it’s charged. If the utility providing electricity burns coal to generate electricity, the benefit isn’t nearly as good as it could be if the utility uses renewable sources, like solar, wind or hydro. So the benefit of driving an EV in the US, where 21.9% of electricity is generated using coal and 38.4% is generated using natural gas, is less than it would be if the EV was driven in Iceland, where the electric grid runs almost entirely on hydro, geothermal and solar energy.
(3) Batteries filling landfills. Batteries are built to last for a solid amount of time. Tesla’s CEO Elon Musk Tweeted in 2019 that the Model 3’s battery should last 300,000 to 500,000 miles and that “replacement modules” will cost between $5,000 and $7,000. The Model 3 contains four modules, but Musk says replacing 2 or 3 modules will allow the car to drive for up to 1 million miles, an April 13, 2019 Electrek article reported
Tesla has backed up its promises with various warranties on its Model 3 and Model Y high-voltage batteries. The warrantees range from eight years or 100,000 miles to 10 years and 150,000 miles in California, a July 5 JD Power article reported. The car company guarantees that the two cars will retain 70% of their original battery capacity for the duration of the battery warranty period.
But eventually even Tesla’s batteries run out of juice. The car maker says that none of its scrapped batteries go to landfilling and 100% are recycled. The company doesn’t explain exactly what that means. Is every piece of the battery reused by Tesla or do all of its batteries get sent to a recycler that manages to recycle some percentage of the battery only to throw what remains in a landfill?
Recycling lithium is tricky because it’s tough to separate from other elements in batteries, like nickel, cobalt, and aluminum. The material can also be flammable, and has caused landfill fires that emit toxic gasses, an August 16, 2021 article in Vice reported. Historically it has been cheaper to mine for new lithium than it has been to recycle and reuse it.
Fortunately, there are many companies who are working to perfect lithium battery recycling. Will visit that subject next week.
A Recession: To Be or Not To Be?
July 06 (Wednesday)
Strategy: Earnings Forecasts & Market Targets. Yesterday, Debbie and I lowered our outlook for real GDP to reflect a short and shallow recession in the US this year and a recovery next year. We are raising the odds of this scenario from 45% to 55%. So we might still skirt an outright recession. Let’s review the implications for the fundamentals of the stock market:
(1) S&P 500 annual & forward earnings. Joe and I revised our S&P 500 operating earnings per share downward by $10 to $215 for this year and by $5 to $235 in yesterday’s Morning Briefing (Fig. 1). (We had the correct numbers in yesterday’s chart but typos in the text; a corrected version is available here.) We also lowered our S&P 500 forward operating earnings per share forecast to $235 per share at the end of this year and $255 per share at the end of next year (Fig. 2). Both are down $20 from our previous estimates. Forward earnings stood at $240 per share during the week of June 30. (Forward earnings is the time-weighted average of industry analysts’ consensus estimates for the current year and the coming year.)
(2) S&P 500 valuation & targets. In our work, the stock market equation (i.e., P = P/E x E) is based on our projections of both forward earnings (determined by analysts) and the forward P/E (determined by investors). When we formulate year-end targets for the S&P 500, we do so by multiplying our projection of analysts’ consensus forward earnings by our subjective assessments of a plausible range for the forward P/E at the end of the year.
For 2022, we are using projected forward earnings per share of $235 by the end of this year and a forward P/E range of 14-17, which yields a year-end S&P 500 target range of 3290-3995 (Fig. 3 and Fig. 4).
For 2023, we are using projected forward earnings per share of $255 by the end of next year and a forward P/E range of 15-18, which yields a year-end S&P 500 target range of 3825-4590.
We conclude that the S&P 500 will recover next year, coming close to its January 3, 2022 record high of 4796.56 but probably not exceeding it until 2024.
(3) S&P 500 revenues & margins. For 2022 and 2023, we are still forecasting that S&P 500 revenues per share will increase 11.6% to $1,750, and 7.1% to $1,875 as inflation continues to boost business sales this year and an economic recovery does the same next year (Fig. 5). As a result, we are projecting that the profit margin of the S&P 500 will fall from 13.4% last year to 12.3% this year and edge up to 12.5% next year (Fig. 6). Industry analysts are currently projecting profit margins of 13.0% this year and 13.5% next year. (See YRI S&P 500 Earnings Forecast.)
US Economy: Falling Leading Indicators. Prior to Tuesday’s Morning Briefing, our subjective probability of a recession was 45% for this year and next year. The latest batch of leading economic indicators suggests that several coincident economic indicators might soon begin to fall. So we now place the odds of a mild recession at 55%, making it our base-case outlook.
Let’s review what we have so far for June’s Index of Leading Economic Indicators (LEI) and May's Index of Coincident Economic Indicators (CEI):
(1) Timing issue. While it is widely believed that the LEI tends to peak three consecutive months prior to recessions, the average lead time between the LEI peak and the CEI peak has been 12 months during the previous eight business cycles, with a range of 2-22 months (Fig. 7). The CEI cycle has coincided with both the official peaks and troughs of the previous eight business cycles, as determined by the Dating Committee of the National Bureau of Economic Research.
The CEI tracks the growth rate of real GDP, both on a y/y basis, very closely (Fig. 8). The former was up 3.0% during May, while the latter was up 3.5% during Q1.
(2) Three strikes. The LEI fell for the third month in a row in May, and that makes four declines in the last five months. We already know that three of the 10 LEI components were down in June, i.e., the S&P 500, the M-PMI new orders subindex, and the average of the CCI and CSI consumer expectations measures (Fig. 9). Also weighing on the LEI during June was an increase in initial unemployment claims. Odds are that nondefense capital goods orders excluding aircraft lowered June’s LEI as well.
(3) Recession or not? So real GDP apparently fell two quarters in a row during H1-2022. The LEI has dropped for three consecutive months through May. The jury is out on whether this will turn out to be an official recession, especially since the CEI rose to a record high in May and since it peaked 12 months, on average, after the LEI peaked during the past eight business cycles, as noted above. For now, we are raising the odds of a recession from 45% to 55%. In any event, industry analysts are likely to be cutting their earnings estimates during H2-2022.
Global Food I: The Price of a Burger. The soaring price of food no doubt was a big conversation topic at last weekend’s Fourth of July barbeques, with a prime example sizzling on the grill. This year’s cookout was 17% more expensive than last year’s, according to a new report from the American Farm Bureau Federation. The price of ground beef rose especially high.
US households are spending $341 more a month to purchase the same goods and services as last year, according to an analysis by Moody’s Analytics, reported CNBC on May 12. And a lot of that increase is for food. In the US, the Consumer Price Index for food rose 10.1% y/y during May (Fig. 10). The increase is the highest seen since the 1980s. Why?
“[T]he broader question is ‘What is not contributing to higher food prices?,’” Jennifer Hatcher of The Food Industry Association said at The Heritage Foundation’s June 28 podcast on inflation across the food supply chain. She attributed rising food prices to energy costs, transportation costs, supply-chain bottlenecks, the labor shortage, and ingredient shortages. According to a June 7 article in Vox, Tyson Foods, America’s largest meat producer, would add two additional items to that list: higher demand for meat and the rise in the price of grain fed to farm animals.
In our view, the problems cited above are mainly attributable to the pandemic and to Russia’s war on Ukraine. How long they will be inflating food prices is the question. Melissa and I think the pandemic’s inflationary impacts could persist for a while. The impacts of the war on food prices in the US and globally are hard to assess; but the longer the war lasts, the worse the consequences for food prices. While most Americans won’t experience a shortage of bread on our shelves, that’s not the case for many developing countries that depend on food supply from the Black Sea region.
Before we delve further into the war’s impacts on global food supply, let’s explore some of the key challenges impacting the supply of, as well as rising demand for, food, leading to higher prices in the US:
(1) Food production & inputs. The US Department of Agriculture (USDA) expects wholesale prices for meat, dairy, and flour to be up at rates in the double digits this year. During the pandemic, many food manufacturing plants, meat processing ones in particular, were forced to close due to Covid outbreaks among workers. To keep those workers safe and prevent future closures, many manufacturers are investing more in automated technologies and remote capabilities for workers.
That investment aside, input costs are up overall for manufacturers. In May, the producer’s price index (PPI) for final demand goods and services rose 10.8% y/y (Fig. 11). Contributing to the rising cost of meat is the rising cost of prepared animal feed—up nearly 13% since last year, according to a Bank of America analysis. Farmers are paying more for agricultural chemicals, especially for fertilizers and pesticides. Fertilizers and chemicals represent 10%-20% of US farmers’ total costs, Bank of America said. The energy-intensive nature of fertilizer production makes it especially costly.
(2) Food demand. Higher meat prices reflect a supply that can barely meet record-setting demand, which remained high even after the pandemic, said Mark Dopp of the North American Meat Institute at the Heritage event. Some of the demand is panic buying, he added. Many consumers continue to buy more than they need, to have supply on hand if stores run out of certain items as during the pandemic. More folks eat more often at home than before the pandemic, which can mean eating more frequently.
(3) Energy, transport, and labor. Rising fuel costs and the state of the transportation industry also are boosting food costs across the supply chain. The transportation of freight index, which measures the cost of shipping goods in the US, jumped 25.8% y/y during May (Fig. 12). There’s a problem when it comes to finding capacity necessary to move product, Tom Madrecki of Consumer Brands Association noted during the Heritage event. Madrecki cited the truck driver shortage as a major contributor to transportation costs; it’s difficult to both find and retain drivers.
Global Food II: The Price of War. Outright food shortages are possible in 2023 if Russia continues to block Ukraine’s crop exports, the head of the United Nations World Food Program warned according to an article covering the WSJ Global Food Forum on June 28. The forum comments suggest—as we did in our April 27 Morning Briefing—that most people in the developed world will not suffer from a shortage of food, but many will suffer from the inflated cost of purchasing it, for the reasons discussed above in addition to the war.
However, developing countries, particularly those most dependent on Ukrainian food imports, face a potential humanitarian hunger calamity. Reduced food exports from Ukraine, one of the world’s largest harvesters of wheat and food oils, are hitting their food supplies at a time when the supplies are already depressed by climate-change challenges. Here’s the latest on the situation:
(1) Russia blockades. Russia has been accused of weaponizing food prices and capitalizing on food shortages. Before Russia’s invasion, nearly all of Ukraine’s grain exports transited through ports on the Black Sea, reported a June 5 WSJ article. But a Russian naval blockade has stopped traffic at those ports, and key export infrastructure has been targeted by Russian attacks. Not many good options are available for shipping Ukrainian harvested grain through the Black Sea.
Russia has been accused of stealing Ukrainian grain and exporting it, but authorities in Turkey are working with the Ukrainian government to prevent stolen grain from leaving ports. Russia continues to export its own grain, and the Food and Agriculture Organization (FAO) expects it to reap a record wheat crop in September. However, Western financial sanctions on Russia could hinder exports. Fewer shipments than usual are booked to depart Russian Black Sea ports after July.
(2) Developing dependencies. Before the war, the Ukraine supplied one-third of global wheat exports; that has been halved, according to USDA, as the June 28 WSJ article reported. Four countries imported over 50% of their wheat supplies from the Ukraine, including Lebanon, Pakistan, Djibouti, and Somalia, according to the FAO, observed the June 5 WSJ.
Most other countries that depend on Ukraine for 10%–50% of their imports are developing ones in Africa, the Middle East, and Southeast Asia. Turkey, Egypt, and Somalia also depend heavily on wheat exports from Russia, typically the world’s largest wheat exporter. But the two countries produce just 7.0% of the world’s wheat, observed the WSJ, so the impact of lower grain exports from Ukraine and Russia shouldn’t be exaggerated.
On a hopeful note, in a recent small but significant victory for Ukraine, Russian soldiers withdrew last Thursday from Snake Island, an outpost in the Black Sea. The retreat could weaken the Kremlin’s Black Sea blockade.
The Second Half of 2022
July 05 (Tuesday)
YRI Weekly Webcast. Join Dr. Ed’s live Q&A webinar today at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays of the weekly webinars are available here.
US Economy: A Mild Recession. The economy is falling into a recession. Debbie and I are lowering our forecast for real GDP growth from 1.1% this year to -1.9%, based on the Q4/Q4 percent change (Fig. 1). So it is likely to be a relatively mild and short one but a recession nonetheless. Next year, we expect growth to resume, with a 2.9% increase projected.
The good news is that under this scenario of weaker economic growth, there’s a greater likelihood that inflation will decline during the second half of this year and in 2023, as we’ve been projecting. So we aren’t revising our inflation forecast. We see the headline PCED inflation rate falling from 6.3% y/y during May to 4.0%-5.0% during H2-2022 and to 3.0%-4.0% during 2023 (Fig. 2).
Melissa and I are still anticipating that the FOMC will increase the federal funds rate on July 27 by 75bps and again on September 21 by that amount (or now possibly less). In any event, two more rate hikes should conclude the Fed’s current monetary policy tightening cycle for a while.
This outlook supports our view that the 10-year US Treasury bond yield should stabilize for a while around 3.00%, a view confirmed recently by the ratio of the nearby futures prices of copper to gold (Fig. 3). Actually, the ratio is now more consistent with a bond yield closer to 2.00%. Its weakness in recent days confirms the recession scenario and the recent top in the yield (at 3.49% on June 14), as does the Citibank Economic Surprise Index (Fig. 4). It is down from 17.9% at the start of this year to -75.8% on Friday.
Before Joe and I discuss the implications for the stock market of our revised economic outlook, let’s review the past week’s batch of recessionary data that caused us to lower our estimates for real GDP for the rest of this year:
(1) GDP. Q1’s real GDP was revised down slightly to -1.6% (saar) by the Bureau of Economic Analysis on Wednesday, but it was still up 3.5% y/y (Fig. 5). During mild recessions, this growth rate tends to fall to zero. During severe recessions, it falls well below zero. In our current forecast, the y/y growth rate in real GDP bottoms at -1.9% during Q4 of this year. That’s somewhere in between a soft and hard landing.
Most of Q1’s weakness was attributable to an unusually large widening of the goods and services trade deficit (Fig. 6). Real final sales to domestic purchasers rose 2.0% (saar) during the quarter, led by a 1.8% increase in real consumer spending, with outlays on goods and services down 0.3% and up 3.0%, respectively. Capital spending rose 10.0% (saar) to a record high, led by a 14.1% increase in spending on equipment (with information processing up 24.7%, industrial up 13.0%, but transportation down 7.9%). On the downside was total government spending, which fell 2.9%.
That doesn’t really add up to a very recessionary quarter even though real GDP fell. Q2, however, is moving more in the recessionary direction with weakness in final demand, led by residential investment. Consumer and capital spending are slowing as well.
At the start of last week, the Atlanta Fed’s GDPNow tracking model showed that real GDP was unchanged during Q2; that dropped to -2.1% by the end of the week. Real consumer spending was revised down from 1.7% to 0.8%, and real gross private investment growth was lowered from -13.2% to -15.2%. Leading the decline is still residential investment (-12.0%), followed by nonresidential structures (-6.6%) and capital equipment (-4.5%).
(2) Consumer confidence & spending. Contributing greatly to last week’s downward revision in the GDPNow tracking estimate, as well as to our revised outlook for the economy, were last week’s latest readings on the consumer sector. On Tuesday, June’s Consumer Confidence Index (CCI) confirmed the weakness in the month’s Consumer Sentiment Index (CSI). The former tends to be more sensitive to employment, while the latter tends to be more affected by inflation. Notwithstanding the strength of the labor market, both were very weak last month (Fig. 7).
Inflation is clearly depressing consumers. It has been eroding their purchasing power, essentially offsetting what seem to be solid increases in nominal wages. In other words, the wage-price spiral is making consumers’ heads spin. Inflation-adjusted personal income is actually down 1.0% y/y through May (Fig. 8). That comparison is skewed by the pandemic-related government support provided a year ago. Excluding these benefits shows that inflation-adjusted personal income is up, but by a relatively meager 1.8% y/y through May.
Real personal consumption expenditures (PCE) increased 2.0% y/y through May (Fig. 9). The post-lockdown spending binge on goods during 2020 and 2021 has been followed by a 2.7% y/y decline in real spending on them. That’s been more than offset by a 4.7% increase on real spending on services. May’s data suggest that strength in spending on services may no longer be more than offsetting weakness in spending on goods. Real PCE decreased 0.4%, with goods down 1.6% and services up 0.3%. In addition, March and April real PCE were revised downward from 0.5% to 0.3% and from 0.7% to 0.3%.
Inflation has been skewed toward essentials including groceries, gasoline, and rents. Consumers offset that squeeze by lowering their personal saving rate, which had been boosted in 2020 and 2021 by the government support payments (Fig. 10 and Fig. 11). There might not be much more room for the personal saving rate to fall; it was down from 10.4% a year ago to 5.4% in May, holding near April’s 5.2%, which was the lowest since October 2009.
Keep in mind that the average of the expectations components of the CCI and CSI is one of the 10 components of the Index of Leading Economic Indicators (LEI). This average dropped to 56.9 during June, the lowest since October 2011. That’s a recessionary reading.
(3) Business surveys. Friday’s release of June’s manufacturing purchasing managers index (M-PMI)—and the underlying survey conducted by the Institute for Supply Management (ISM)—was a major contributor to the downward revision in the GDPNow estimate. The M-PMI was down from May’s 56.1 to 53.0, the lowest since June 2020 (Fig. 12).
The ISM report stated: “This figure indicates expansion in the overall economy for the 25th month in a row after a contraction in April and May 2020.” (Anything above 48.7 indicates expansion according to the report.) However, the new orders index dropped sharply from May’s 55.1, to 49.2. The report stated: “This indicates that new order volumes contracted after growing for 24 consecutive months.”
The M-PMI’s new orders subindex is also one of the 10 components of the LEI. It tends to be highly correlated with the y/y growth rate of new orders for nondefense capital goods ex aircraft (Fig. 13). The latter was up 9.8% during May, but that probably reflects a relatively high inflation rate for such orders. In any event, the M-PMI new orders index suggests that the growth of new orders for capital goods slowed significantly during June.
The picture is darker looking at the average of the business surveys conducted by five of the 12 district Federal Reserve Banks. The composite regional business index dropped further below zero in June—to -4.2 from -0.4 in May—which was the first negative reading since May 2020. June’s regional index was the lowest since last May and a more recessionary reading than that of the latest M-PMI (Fig. 14). The average of the regional new orders indexes was -9.7%, also the lowest since May 2020 and consistent with the M-PMI new orders index (Fig. 15).
The regional business surveys can be used to construct averages of their current and future indexes of capital spending (Fig. 16). Both averages peaked last year and have been heading lower since then. But they remained in solidly positive territory during June, at 12.0% for the current average index and 19.4% for the future average index. The regional and national business surveys suggest that supply-chain problems are abating (Fig. 17). That’s probably a result of weakening demand and improving supply-chain logistics.
(4) The Dating Committee. It is widely believed that two consecutive declines in quarterly real GDP is a good rule of thumb for determining recessions. The first two quarters of this year are shaping up that way, even though Q1’s underlying performance actually was reasonably good, as discussed above. Another rule of thumb is that a string of three consecutive declines in the LEI foreshadows an imminent recession. The LEI fell for the third month in a row in May, and that makes four declines in the last five months. We already know that three of the 10 LEI components were down in June, i.e., the S&P 500, the M-PMI new orders subindex, and the average of the CCI and CSI consumer expectations measures.
While we can declare unofficially that a recession may have started in June, we can’t be certain of it. It will be up to the Dating Committee of the National Bureau of Economic Research to make the official determination. They do so after the fact. Therefore, they focus more on the Index of Coincident Economic Indicators (CEI) than the LEI. The CEI rose to a new record high during May, casting doubt on the notion that a recession has begun; however, if the LEI’s signals are on the mark, the latest business cycle might have peaked in June. (The CEI includes payroll employment, real personal income less transfer payments, real manufacturing & trade sales, and industrial production.)
Strategy I: Getting Closer to the Bottom. Given all the above, it’s no wonder that pessimism is in fashion. It’s certainly getting harder to be an optimist these days. The CSI is the lowest it has ever been since the start of the series in 1952. As we recently observed, Investor Intelligence Bull/Bear Ratio fell to 0.60 during the June 21 week, the lowest since the March 10, 2009 week, which was the bottom of the bear market caused by the Great Financial Crisis.
But for stock investing, this pessimism is potentially good news from a contrarian perspective. Investor sentiment should improve at some point once inflation peaks definitively and the Fed ends its monetary tightening cycle. Along the way, the recession will end. When all that happens, the stock market should bottom.
That may happen sooner rather than later based on our reading of the relationship between the yearly percentage change in the S&P 500 and the M-PMI, which are highly correlated (Fig. 18). The former was -8.0% during June, essentially already anticipating that the M-PMI (at 53.0 in June) will fall below 50.0 in July and August.
An even tighter relationship is the one between the yearly percentage change in the S&P 500 and the composite regional general business index (Fig. 19).
The aforementioned business-cycle indicators are signaling that the economy is in a recession or falling rapidly toward one. It is certainly premature to declare that they’ve bottomed or soon will do so. But they are getting closer to doing so, and therefore so is the stock market.
Strategy II: Recession Memo Is on the Way. During the first half of this year, Joe and I have observed that industry analysts didn’t receive the recession memo. Odds are that more of them will be getting it and lowering their 2022 and 2023 earnings estimates in coming months. Consider the following:
(1) Revenues, earnings estimate revisions & the M-PMI. The weakness in June’s M-PMI (along with the even weaker regional data) point to a significant slowdown in S&P 500 revenues and earnings growth on a y/y basis over the rest of this year (Fig. 20 and Fig. 21). The M-PMI is also highly correlated with both our Net Revenues Revisions Index (a.k.a. NRRI) and Net Earnings Revisions Index (NERI) for the S&P 500. Both of the latter already have declined sharply since the start of the year, though they remained positive during June at 5.0% and 1.5% (Fig. 22 and Fig. 23). They are likely to turn slightly negative in coming months.
(2) Annual & forward earnings estimates. Now that we too have received the recession memo, we are lowering our estimates for S&P 500 companies’ earnings in 2022 and 2023. We expect analysts will be doing the same.
We are reducing our S&P 500 operating earnings-per-share forecast for 2022 by $10 to $215 and for 2023 by $5 to $235 (Fig. 24). During the June 23 week, industry analysts were estimating $229 and $251.
We are lowering our forward earnings forecast to $235 per share at the end of this year and $255 per share at the end of next year (Fig. 25). Both are down $20 from our previous estimates. Forward earnings stood at $240 per share during the week of June 30. (FYI: “Forward earnings” is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for the current year and the next one; at year-ends, they align with analysts’ next-year estimates.)
Health Care, Finance & Batteries
June 30 (Thursday)
Health Care: Mending? For years, the S&P 500 Health Care sector hasn’t gotten any respect, but a bear market has a way of shaking things up. This year, the sector has been an outperformer during the market’s ytd slide, and it has led the market in the days since the S&P 500 hit its most recent low on June 16.
Here’s the performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Energy (36.6%), Utilities (-3.1), Consumer Staples (-7.2), Health Care (-9.6), Materials (-17.1), Industrials (-17.2), Financials (-18.2), S&P 500 (-19.8), Real Estate (-20.7), Information Technology (-26.4), Communication Services (-29.5), and Consumer Discretionary (-32.0) (Fig. 1).
Here’s the performance derby for the S&P 500 and its sectors from June 16 through Tuesday’s close: Health Care (6.7%), Utilities (6.7), Real Estate (6.6), Consumer Staples (4.5), Information Technology (4.4), S&P 500 (4.2), Communication Services (4.1), Financials (4.0), Consumer Discretionary (4.0), Industrials (2.5), Materials (0.7), and Energy (-1.0) (Table 1).
There’s lots to like about the Health Care sector, especially given the market’s turmoil. The Health Care sector sports a dividend yield of 1.5%, and its forward P/E of 14.8 is lower than the S&P 500’s forward P/E of 15.9, both as of June 16 (Fig. 2).
The sector’s earnings as a percentage of the S&P 500’s total earnings routinely has exceeded its market capitalization as a percentage of the S&P 500’s total market capitalization. As of June 16, the Health Care sector’s earnings share was 15.4%, while its capitalization share was only 14.4%. The difference was even wider in November 2020, when its earnings share was 18.9% and its capitalization share was 13.5% (Fig. 3). The Health Care sector’s market-cap share wasn’t always lower than its earnings share. In the 20-plus years before 2008, the sector almost always had a capitalization share that was north of its earnings share.
There is, of course, a hitch. After growing 27.2% in 2021, the sector’s earnings are expected to increase by only 5.8% this year and experience no growth in 2023 (Fig. 4). Let’s take a look at which industries within the Health Care sector are outperforming the market and which do—and don’t—have prospects for earnings growth this year and next:
(1) Tracking the movers. The industries that have propelled the S&P 500 Health Care sector to the top of the list since the S&P 500’s June 16 low include Managed Health Care (9.8%), Biotechnology (8.8), and Pharmaceuticals (6.9). Health Care Services (5.2), Life Sciences Tools & Services (4.8), Health Care Distributors (4.7) and Health Care Equipment (4.5) are also beating the S&P 500’s 4.2% return over the same period. Only Health Care Supplies (4.0) and Health Care Facilities (2.8) are lagging the S&P 500 (Fig. 5).
(2) The right medicine. Some of the largest companies in the S&P 500 Pharmaceuticals industry have turned in the strongest share price performances this year. Bristol Myers Squibb shares have gained 7.8% since the market low on June 16 and 26.2% ytd, both through Tuesday’s close. Investors who once were concerned about Bristol Myers’ lost patent protection on Revlimid are now focused on new drug approvals and drugs under development, a May 31 Barron’s article concluded. The company is expected to earn $7.56 per share in 2022 and $8.12 in 2023, giving the shares a P/E based on the 2023 estimate of only 9.7.
Merck shares also have outperformed, gaining 8.6% since the market’s June 16 low and 19.9% ytd, both through Tuesday’s close. The company has benefitted from its drug to treat Covid, and it’s in the middle of negotiations to buy Seagen, which develops cancer drugs. Its earnings are barely expected to grow from $7.39 a share this year to $7.43 next year.
Eli Lilly is expected to grow its earnings by more than 30% next year, from a projected $8.37 a share this year to $9.46 in 2023. However, its shares trade at a high 33.6 times that 2023 estimate as of Tuesday’s close. Lilly shares have climbed 8.4% from the market’s low and 15.0% ytd.
In the Biotech space, share price performances since the S&P 500’s recent low have been more impressive than the ytd returns. AbbVie’s shares rallied 10.4% from the June 16 low and 12.6% ytd. Not far behind is the 10.3% gain in Incyte’s share price from the June 16 market low, but its ytd rise is a much lower 3.0%. Incyte is facing a patent expiration on its largest drug, Jakafi; but the company recently received approval for an atopic dermatitis drug and has applications in for three drugs treating non-Hodgkin’s lymphoma.
Moderna—one of the companies that developed a Covid-19 vaccine—gained 10.6% since the June 16 low, but its shares are down 44.0% ytd. Investors are wondering if Moderna’s earnings will fall now that the government is no longer paying for Covid vaccinations and US cases remain moderately low.
(3) One eye on DC. Senator Joe Manchin (D-WV) killed President Joe Biden’s “Build Back Better” (BBB) bill in December, disapproving of the massive spending involved. But in recent weeks, he reportedly has been supporting a “slimmed-down version” of BBB, a June 17 WSJ article reported. The original bill contained drug-pricing reform, allowing Medicare to negotiate drug prices with pharma companies.
Negotiations are expected to continue over the summer and might leave the bill stripped down to include only the drug-pricing changes. Regeneron and Amgen have the most to lose, according to the WSJ. “Direct Medicare negotiations for Regeneron’s Eylea could trim the company’s revenue by 5% to 15%, according to Morgan Stanley estimates.”
(4) Another eye on earnings. While the Pharmaceutical and Biotechnology indexes have been among the top performers this year, both industries’ earnings next year are expected to fall. Now at the halfway point of 2022, investors should be starting to eye 2023 earnings prospects. And next year, the earnings in the Health Care Supplies and Health Care Facilities industries are expected to be the fastest growers in the sector.
Here’s the performance derby of the Health Care industries’ earnings this year and next, ranked based on 2023 estimates: Health Care Supplies (-9.0, 16.7), Health Care Facilities (-1.4, 16.2), Managed Health Care (13.3, 13.9), Life Sciences Tools & Services (-3.4, 8.5), Health Care Equipment (-2.3, 7.2), Health Care Services (-3.7, 7.1), Health Care Distributors (0.0, 7.0), Health Care Sector (5.8, 0.0), Pharmaceuticals (18.2, -2.6), and Biotechnology (-2.9, -14.6).
The Fed: Mastering Master Accounts. One of the benefits of being a regulated bank is the ability to have a bank account with one of the Federal Reserve’s regional banks. This master account gives the account holder access to the Fed’s payments system. As fintechs grow in size and number, there has been an uproar over which should and shouldn’t have a master account at the Fed. In May 2021, the Federal Reserve laid out new guidelines to govern the process, on which it asked for comments.
Here’s a quick look at what caused the controversy and how the Fed’s proposed rules would address the issue:
(1) Controversy around Reserve Trust. Two recent events have thrust the obscure master account into the headlines. The first revolves around a Colorado-based fintech, Reserve Trust.
Its 2017 application for a master account was originally rejected by the Kansas City Federal Reserve. Sarah Bloom Raskin--a former Fed governor who in 2017 sat on Reserve Trust’s board--called Kansas City Fed President Esther George about the application, according to Senator Pat Toomey (R-PA), and the application was subsequently granted in 2018. The reason given for the reversal was that the firm had changed its business model, a June 9 Reuters article stated. Then earlier this month, Reserve Trust’s master account was revoked, and Toomey sent a letter asking George to explain why.
Whether or not ethical lines were breached, the denial, granting, then revocation of Reserve Trust’s master account collectively raise questions about the Fed’s process for approving master accounts at a time when many fintech and crypto firms are pressing for access to the Fed account.
(2) Controversy around Custodia. In June, Custodia, a Wyoming-based bank, sued the Federal Reserve Bank of Kansas City and the Federal Reserve Board of Governors because they failed to address the bank’s 2020 application to open a master account. Custodia is a special purpose depository institution. Its deposits are not FDIC-insured, but it does have to meet bank-level capital requirements and compliance requirements, its website states. Founded by Caitlin Long, former Morgan Stanley managing director, the bank’s trust department would act as a custodian holding cryptocurrencies for customers and the bank plans to hold all deposits in cash.
In its lawsuit, Custodia claims the defendants are preventing the bank from introducing innovative and competitive services that threaten established financial institutions whose interests are represented by the members of the Kansas City Fed’s board of directors, a June 13 CoinGeek article reported.
(3) Fed’s proposal. The Fed put forth in May 2021 a list of rules to govern the process of granting master accounts. The goals are to ensure the safety of the banking system, effectively implement monetary policy, foster financial stability, protect consumers, and promote a safe, efficient, inclusive, and innovative payment system.
Some firms dealing with cryptocurrencies lack know-your-customer practices and may find it difficult to meet the Fed’s requirement that firms with master accounts not facilitate money laundering, terrorism financing, fraud, cybercrimes, or other illicit activity.
By proposing a set of rules, the Fed aims to have a consistent and transparent process for evaluating applications across the entire Federal Reserve Bank system. That would prevent applicants from submitting applications to the Fed Bank that they believe is most lenient. And it would mean that individual Fed Banks’ decisions don’t become precedents by which the rest of the Fed Banks must abide.
Last month, the Fed provided a supplement to last year’s proposal that lays out the master account review process. Basically, the less regulated the institution is, the more it will be reviewed. Regulated institutions with federal deposit insurance would receive a more streamlined review compared with institutions that don’t have federal deposit insurance and aren’t regulated by a federal bank regulatory agency.
Disruptive Technologies: Tesla, the Battery Company. Beyond offering snazzy electric cars, Tesla sells wall-mounted batteries used in homes and huge batteries in shipping containers used by utilities. The batteries—both small and large—are augmenting various parts of the US electric generation system. It’s hoped that they can smooth out electricity available when it’s produced by windmills and solar panels, which can be variable, or provide needed power at moments of peak demand. Here’s a look at what the renowned car manufacturer is doing in the world of batteries:
(1) VPPs spreading. Tesla was among the first to create a virtual power plant (VPP) when it won a contract in 2018 to install solar panels and Powerwall batteries in 50,000 Australian homes by 2022, as we discussed in the August 15, 2019 Morning Briefing. When extra power is needed by utilities, the Powerwalls can sell electricity back into the electric grid, helping to stabilize the system. Powerwalls can also be used by the homeowner to store energy generated by solar panels during the day for use at night. Alternatively, energy in the Powerwall can be tapped by the homeowner if there’s a disruption to electric service. The company recently announced that it was expanding its VPP beyond South Australia and Victoria to New South Wales, South-East Queensland, and the Australian Capital Territory.
We also discussed VPPs in the April 28 Morning Briefing, noting that Vermont’s utility, Green Mountain Power, had created a VPP that taps into Tesla’s Powerwalls in about 4,000 homes. Tesla and Pacific Gas & Electric (PG&E) have launched a VPP that will pay homeowners with a Powerwall $2 for every kilowatt hour delivered back into the California electric system when it’s needed. Contributors will receive a notification before and during the event with details of the expected duration. “A fully-charged Powerwall with 20% backup reserve that typically serves 3kWh of energy during event hours, for example, could deliver an additional 7.8kWh to the grid, earning its owner $15.60,” a June 24 PC Magazine article reported.
Last year, Hawaii tapped Swell Energy to design a VPP that uses Tesla Powerwalls in 6,000 homes in Oahu, Maui, and Hawaii. And Tesla is testing a VPP in Texas to convince grid officials to permit utilities to bid on energy provided by homeowners’ Powerwalls. Without the rule change, homeowners can’t be compensated for joining the program, but they may receive a $40 Tesla gift card. They also have to let Tesla control 80% of the capacity of their Powerwalls, a June 13 Electrek article reported.
(2) Bigger batteries spread too. Tesla also makes giant batteries for industrial use. They’ve been installed in Australia and by PG&E in Monterey County, California. The California project, which went into operation last year, is expected to expand to 1.1 GWh of capacity.
Up next: Hawaii announced that the island would use Tesla’s Megapacks. The batteries are expected to hold electricity generated by solar panels and windmills and replace the island’s last remaining coal-fired power plant. The Kapolei Energy Storage facility will have a capacity of 185 megawatts/565 megawatt hours, making it one of the largest battery systems in the world. The system will have 158 Tesla Megapacks, each with a capacity of up to 3MWh.
(3) Stronger car batteries coming. We’ve long contended that Tesla’s market position would be safe as long as its cars’ batteries permit driving further on a charge than the batteries of competitors’ cars. Fortunately, Tesla is a client of Chinese battery maker CATL, which recently announced that next year it will start producing a battery that gives a car 620 miles of driving range, a June 28 Business Insider article reported.
That would top the 520 miles that Lucid Air’s $169,000 sedan travels and the 405 miles that Tesla’s Model S travels on a single charge. CATL, also notes that its batteries will charge faster than batteries currently on the market because it has devised a way to cool the battery cells more quickly. As a result, the battery’s charge can be increased from 10% to 80% full in 10 minutes. Now that would be welcome progress.
Relative Valuation & Dalio’s Big Short
June 29 (Wednesday)
Valuation: It’s All Relative. As we’ve often observed, valuation—like beauty—is in the eye of the beholder. Since early last year, we’ve beheld significant declines in valuation multiples around the world. Investors have become increasingly concerned about inflation. It’s turned out to be higher and more persistent than was widely anticipated. As a result, the major central banks (except for the Bank of Japan and the People’s Bank of China) have been forced to pivot from their ultra-dovish monetary policy stances of the past several years to uber-hawkish ones. Rapidly tightening credit conditions have raised fears of a global recession.
So higher inflation and interest rates have weighed on valuation multiples. In addition, mounting worries about a recession have reduced the multiples that investors are willing pay for analysts’ consensus expectations for earnings, which have been rising to record highs notwithstanding the rising risk of a recession. If a recession actually unfolds, valuation multiples could fall even lower along as analysts scramble to slash their earnings forecasts.
We’ve been covering this story for over a year now. Now, let’s briefly update our regular comparison of forward earnings and forward P/Es on a relative basis (FYI: “forward earnings” is the time-weighted average of analysts’ consensus estimates for this year and next, and “forward P/E” is the multiple based on forward earnings):
(1) S&P 500 LargeCaps vs ‘SMidCaps.’ Since mid-2020, just after the lockdown recession during March and April of that year, industry analysts have been raising their forward earnings estimates for the S&P 500, S&P 400, and S&P 600 companies (the latter two a.k.a. SMidCaps) (Fig. 1). Converting all three forward earnings series to indexes equal to zero during the week of March 5, 2009 shows that they all dropped from their record highs just before the pandemic to about 100 around the end of May. Since then, they are up as follows through the June 23 week: S&P 500 (to 263.3), S&P 400 (to 389.6), and S&P 600 (to 507.3) (Fig. 2).
Forward earnings that strong are truly remarkable, though some of the recent strength in earnings obviously reflects the astonishing surge in inflation over the past year. Also remarkable have been the freefalls in the forward P/Es of the S&P 500/400/600 indexes, notwithstanding their soaring forward earnings (Fig. 3). Here are their forward P/Es as of Monday’s close versus at the start of this year: S&P 500 (16.3, 22.5), S&P 400 (11.8, 19.7), and S&P 600 (11.5, 19.2).
The current ratios of the forward P/Es of the S&P 400 and S&P 600 to the S&P 500 both are down to 0.70 currently, the lowest in over 20 years (Fig. 4 and Fig. 5). They had been over 1.00 from 2004-18. They are at significant discounts indeed given that the ratios of the forward earnings of the S&P 400 and S&P 600 to the S&P 500 have been rising since mid-2020.
(2) S&P 600 vs Russell 2000. By the way, the plunge in the forward P/E of the Russell 2000 has been much greater than that for the S&P 600 (Fig. 6). The former is down 51% since the start of last year through the June 16 week, while the latter is down 44% over this same period. The Russell 2000 has a lot more stocks of companies that are unprofitable than does the S&P 600. That explains why the former’s valuation multiple has always been much higher than the latter’s.
(3) S&P 500 Growth vs Value. Similarly, the forward P/E of the S&P 500 Growth index typically has exceeded that of the S&P 500 Value index (Fig. 7). The former has tumbled relative to the latter so far this year. The ratio of the forward P/Es of Value to Growth is up from 0.60 at the start of this year to 0.72 currently (Fig. 8). Some Growth index stocks have tumbled so much that investors, as well as index provider FTSE Russell, are starting to consider them to be value stocks.
(4) Stay Home vs Go Global. While forward earnings continue to soar into record-high territory for the US MSCI stock price index, they’ve been declining for the All Country World (ACW) ex-US MSCI, led by the Emerging Markets MSCI, since the start of this year (Fig. 9). On the other hand, they continue to climb in record-high territory for the UK and EMU MSCI indexes.
The forward P/Es of the major MSCI indexes around the world are much lower currently than those of the comparable US index (Fig. 10). Here were their latest readings during the week of June 16: US (16.3), Japan (12.4), EMU (11.3), Emerging Markets (11.1), and UK (9.8).
The valuation discrepancy is less comparing the forward P/E of the S&P 500 Value index (at 14.1 yesterday) to the ACW-ex US forward P/E (at 11.9) (Fig. 11). The severe selloff of growth stocks in the US—especially technology stocks, and particularly the MegaCap-8 stocks—has siphoned more air out of the valuation multiple of the US MSCI than out of the ACW ex US MSCI, which has fewer growth and more value components.
Europe I: On the Brink. Because of the energy shock resulting from the Ukraine war, Melissa and I see increasing odds that a recession is much more likely in Europe than in the US, as we wrote in Monday’s Morning Briefing. Russia is reducing its exports of natural gas to Western Europe in retaliation for Europeans’ support of Ukraine in its war against Russia.
Indeed, the FT reported last Wednesday: “The International Energy Agency has warned that Europe must prepare immediately for the complete severance of Russian gas exports this winter, urging governments to take measures to cut demand and keep ageing nuclear power stations open.” Europeans could be forced to ration their available supplies of natural gas.
Even so, the European Commission (EC) forecasted on May 16 that the Eurozone’s GDP will expand by 2.7% this year in the agency’s first economic forecast since the war in Ukraine began. However, the forecast was made before Russia began significantly throttling back on its gas exports to Europe. In other words, any sudden cutoff of natural gas flows to Europe could result in yet another jump in energy prices and slower economic growth. Producers who depend on natural gas for energy or as an input could be forced to cut production or to shut down altogether in the event of major gas supply disruptions and rationing.
When we last reviewed the latest macroeconomic indicators for the Eurozone, on June 8, we wrote that the reopening of Europe following the era of Covid restrictions could offset some of the negative economic impacts of the Ukrainian war. Except for inflation, the latest data were not overly worrisome at that point, but we anticipated that the outlook could darken before it improves, especially if Russia turns off the gas taps.
Despite the plethora of negative outcomes outlined in media headlines, analysts’ estimates for Eurozone revenues and earnings remain upbeat, as we noted on Monday. Let’s hope that reality does not catch the analysts off guard. European Central Bank (ECB) President Christine Lagarde recently warned: “While the correction in asset prices has so far been orderly, the risk of a further and possibly abrupt fall in asset prices remains severe.”
Here’s a recap of the latest unfavorable updates that heighten the potential for a worsening European energy crisis and recession:
(1) Germany’s alarm. Germany, Europe’s largest importer of Russian gas, has experienced a 60% drop in Russian natural gas supplies since early June. Gas networks in France and Italy also reported significant drops in recent weeks, according to the WSJ. Ukraine has been lobbying to join the European Union (EU), and its candidacy was officially accepted by the EU (along with Moldova’s) on June 23. It could take Ukraine a decade or more to meet the criteria for joining the EU, according to Reuters. Surely, President Vladmir Putin was none too pleased by the EU’s move, likely prompting the sharp reduction in gas flow.
On June 22, Berlin declared a phase-two emergency of its three-phase gas plan because Gazprom, Russia’s state-run energy supplier, slowed its contractual deliveries to 40% of capacity in the previous week. Rationing would come in the third step. Germany also could allow utilities producers to automatically pass higher energy prices on to consumers in a push to lower demand. For now, Germany’s gas storage remains slightly below target at 59% capacity since the last cold season. But Germany aims to reach 90% capacity ahead of winter, a goal in jeopardy if supplies fail to return to normal.
Economy Minister Robert Habeck called the restriction by Moscow “an economic attack.” (CNBC reported on June 20 that Gazprom cited conflicting technical issues for the supply cuts.) Whatever the cause, increased use of coal in power stations has been ordered by Mr. Habeck, a Green Party leader, in keeping with the emergency energy plan. Political leaders also are debating delaying the closure of the three remaining nuclear reactors in Germany to help mitigate the shock.
Germany is scrambling to reduce its dependence on Russian gas. Nevertheless, German think tanks have calculated that a shutdown of Russian gas could trigger a hit of up to €220 billion in 2022 and 2023, or 6% of this year’s GDP. (That’s mostly according to a June 24 article in Reuters unless otherwise noted.) Germany’s IFO index, a survey of business confidence, continued to trend lower in June, with the expectations component leading the way down.
Scrambling to find alternative gas sources, Germany is seeking emergency delivery solutions for liquefied natural gas (LNG). Reuters reported on June 24 that Gazprom’s recently completed and unused Nord Stream 2 pipeline, intended for Russian gas to flow directly to Germany, could be converted for carrying LNG to Germany from elsewhere.
(2) Households squeezed. Household spending could suffer dramatically from the rise in gas prices against a backdrop of stagnant wage growth and rising consumer prices across the board. For example, the WSJ reported that union wages in Germany excluding one-time payments rose just 1.1% in Q1, well below the increase in consumer prices. Europe’s job retention schemes during the pandemic meant that there was not as much wage negotiation going on as there would have been if more layoffs, quits, and rehiring occurred.
Meanwhile, the German government warned last week that households could see their natural gas bills triple from last year—on top of the broader consumer inflation also happening. Certainly, the squeeze on European households is not limited to Germany.
Indeed, one of the most troubling inputs to the Eurozone’s Q1 GDP was the decline in household spending (Fig. 12). Despite being pressured by squeezed households, the Eurozone’s real GDP expanded 0.6% (not annualized) during Q1, twice the 0.3% previous estimate and above Q4-2021’s downwardly revised pace of 0.2%. Still, growth is considerably below the 2.3% and 2.2% rates posted during Q3 and Q2, respectively, following Q1-2021’s 0.1% dip.
(3) Producers pressured. Europe’s producers of chemicals, fertilizer, steel, and other energy-intensive goods have come under pressure since Russia’s invasion, wrote the WSJ. Manufacturers need natural gas not only as an energy source, but also as a raw material in production. Natural gas sets the price of electricity in Europe, “hitting factories with a double-whammy” as gas prices increase, the article observed. In the event of energy rationing, the country likely would require industrial firms to ration before private households and critical services, putting manufacturers at risk of disruption or closure.
Indeed, new figures on manufacturing and services activity darkened for Europe, as it faces not only supply shortages left over from the pandemic, but also a looming Energy crisis and the prospect of higher interest rates ahead. S&P Global reported on June 23 that Europe’s composite purchasing managers index—which covers activity in both the manufacturing and services sectors—fell to a 16-month low of 51.9 in June from 54.8 in May (Fig. 13). The index is barely holding above the 50.0 mark between expansion (above) and contraction (below). June’s slowdown was the sharpest recorded since November 2008, during the peak of the financial crisis, observed S&P Global’s Chris Williamson, according to the WSJ.
Europe II: The Big Short. On June 23 Bloomberg reported that “Ray Dalio’s Bridgewater Associates has built a $10.5 billion bet against European companies, almost doubling its wager in the past week to its most bearish stance against the region’s stocks in two years.” Given the concerns we discussed above, it seems like a good strategy to short Europe over the near term, especially if tensions between Russia and Europe escalate.
For those with a long-term investment horizon, however, now may be a good time to buy and hold European stocks given how cheap they’re trading relative to recent history. But it could take some time for the gas shortage, rising interest rates, resulting inflation, and a likely recession to shake out.
Recently, lots of downside action has been occurring in Europe’s financial markets as the ECB has turned increasingly hawkish:
(1) ECB’s tightening spree. Financial conditions are tightening. On June 9, the ECB signaled that it would make its first interest rate hike since 2011 at its July 20-21 meeting, with a larger move likely on September 8, followed by further gradual hikes. The ECB also will end its large-scale bond-purchasing program on July 1, but reducing the bank’s balance sheet isn’t currently on the table.
However, the policy-setting situation in Europe just became more complex when heavily indebted countries’ bond yields suddenly went vertical. On June 15, the ECB held an emergency meeting to address the sharp rise in the Italian 10-year government bond yield to nearly 4.0%, or 204bps above Germany’s 10-year yield, in advance of the ECB’s actions (Fig. 14).
As an interim measure, the ECB said it would sell some pandemic-stimulus-purchased bonds and buy up weak Eurozone countries’ bonds instead, to stimulate those asset prices and lower yields. Over the longer term, the ECB promised to implement an “anti-fragmentation instrument” to lessen the divergence in yields. Lagarde tried to temper expectations for the new instrument, however, arguing that the ECB’s job is to achieve price stability, not favorable financing conditions or budgets.
Yesterday at an ECB forum, Lagarde said that any beneficial financing conditions afforded to weaker Eurozone countries would come with “safeguards” to preserve “sound fiscal policy,” reported Reuters. Sources also told Reuters that the ECB “would likely drain cash from the banking system to offset the new bond purchases, so as not to increase the overall amount of liquidity.”
(2) Prices sink ahead of earnings. The EMU MSCI index fell 20.1% (in local currency) from its record high on November 27 through Friday’s close (Fig. 15). The index dropped below its 200-day moving average on February 11 and was trading 12.4% below it at Friday’s end. Interestingly, all of the index’s sectors are trading at or below their 200-day moving averages except Communication Services and Energy, which are trading just above it.
The EMU MSCI index is trading at a low forward P/E multiple of just below 12, down from just over 17 in mid-2020 when pandemic lockdowns began to lift. In fact, forward earnings expectations continued to rise through June 16, as noted above.
Leading the way in earnings expectations is the EMU MSCI’s Energy sector, which makes sense given that Europe is about to become much more dependent on domestic energy firms than it was before the war. Most sectors’ earnings expectations also are on the way up or flatlining except for those of Real Estate and Communications Services.
The EMU MSCI sectors’ profit margin estimates (which we calculate from analysts’ consensus revenues and earnings estimates) also remain near recent record highs, led by energy firms. That suggests that most European firms are having no problems passing their inflation-boosted costs through to their selling prices.
Right & Wrong Tracks
June 28 (Tuesday)
Strategy I: On the Right Track. What could go right or wrong over the rest of this year? The year is half over. It has been an annus horribilis so far. Will it continue to be so during the second half of the year? Or will we see a gradual improvement that might set the stage for an annus mirabilis in 2023? The only investment strategies that have worked out well so far this year have been ones that focused either on capital preservation or on shorting stocks and bonds. These may continue to outperform long-only strategies for a while longer, though we think that the stock and bond market selloffs have created excellent buying opportunities for long-term investors.
As is our nature, we are leaning toward better times ahead. However, optimism isn’t an alternative to realism. Neither is pessimism. Both have to be disciplined by reality. Let’s be disciplined and start with the realities that might turn out to be bullish for the economy and the financial markets over the rest of this year, then update the bearish ones:
(1) Sentiment. Both investor and consumer sentiment readings are remarkably pessimistic. Extreme sentiment readings tend to be prescient contrary indicators. Currently, they are so extremely pessimistic that they may be signaling better times ahead.
Last week, Joe and I were dumbfounded by the Investor Intelligence Bull/Bear Ratio. It fell to 0.60 during the June 21 week (Fig. 1). That’s the lowest it’s been since the March 9 week in 2009 during the Great Financial Crisis (GFC), when the ratio stood at 0.56. Back then, the S&P 500 bear market bottomed on March 9, 2009, after the index had fallen 56.8% from its October 9, 2007 peak.
This year’s stock market weakness has been much less severe so far: The S&P 500 fell 23.6% from its January 3 peak through its most recent bottom on June 16. Yet sentiment is as depressed as it was at the bottom of the bear market of the GFC! By the way, during the June 21 week, the percent of bears was 44.1%, which is the most since early October 2011, while the percent of bulls was 26.5%, the least since mid-February 2016.
Also extremely depressed is the Consumer Sentiment Index (CSI), which was down to 50.0 during June, the lowest reading since the start of the monthly data in 1978, and the yearly data in 1952 (Fig. 2). Its expectations component—which dropped to 47.5, not far from its record low of 44.2 in July 1979—is included in one of the components of the Index of Leading Indicators. So using it as a contrary indicator might not be a good idea. After all, while many Americans go shopping when they are depressed, this time might be different if excessively pessimistic consumers decide to retrench.
(2) Labor market. The CSI tends to be inversely correlated with the unemployment rate (Fig. 3). What’s different this time, so far, is that the jobless rate was 3.6% during May, around previous cyclical lows. It’s soaring inflation, rather than rising unemployment, that’s depressing consumers. Inflation hasn’t been a significant factor in driving the CSI since the 1970s. However, if consumers do retrench, that could cause a recession, boost unemployment, and depress the CSI further.
The good news is that the ratio of job openings to the number of unemployed workers was 1.9 during April, down only slightly from the record 2.0 during March (Fig. 4). There are roughly two openings for every unemployed worker. That means that even if the number of openings drops as a result of slower economic growth, there will still be plenty of opportunities for the unemployed to find jobs. Some of them might decide to take jobs offered to them more readily if they perceive that such opportunities are dwindling. In other words, in a mild recession, the jobless rate is likely to remain low.
(3) Productivity. If labor remains relatively hard to get even in an economic slowdown (including a mild recession), many company managements may conclude that paying workers more won’t make hiring them easier or keep them from quitting. The only viable long-term solution to chronic labor shortages is to increase capital spending to boost productivity. That’s been our story for the past year, and Debbie and I are sticking to it. However, the sharp drop in productivity during Q1 is likely to be followed by another decline during Q2. We view these as setbacks rather than game changers for our optimistic outlook for productivity, a.k.a. the Roaring 2020s scenario.
(4) The Fed. Since the start of this year, Fed officials have turned increasingly hawkish in their discussions of the outlook for monetary policy. They followed up with a 25bps hike in the federal funds rate range on March 16, a 50bps hike on May 4, and a 75bps hike on June 15 to 1.50%-1.75%. We are expecting two more hikes of 75bps each in July and September, raising the range to 3.00%-3.25%.
The FOMC’s Summary of Economic Projections dated June 15 shows that the committee’s median forecast is that the federal funds rate will be raised to 3.40% this year and 3.80% next year. Melissa and I aren’t convinced that the Fed will have to raise the rate above 3.25% during the current tightening cycle. That’s because unlike tightening cycles in the past (with the sole exception of 2018-19), the Fed’s balance sheet is on course for a significant reduction as the Fed’s holdings of bonds mature under its quantitative tightening program (QT) (Fig. 5). We reckon that QT is equivalent to at least a 50bps-100bps increase in the federal funds rate.
In other words, while QT has been widely feared by investors as additional monetary tightening, it might very well lower the peak federal funds rate during the current monetary tightening cycle! The Fed’s forward guidance on its rate hike and QT, first issued back on January 5, sent interest rates soaring in the US and around the world. Financial conditions have tightened significantly as a result, reducing the need for the Fed to raise the federal funds rate by much more than has already been discounted by the markets, in our opinion. Since the start of the year, there have been huge hikes in the two-year Treasury yield (234bps to 3.08%), the 10-year Treasury yield (166bps to 3.17%), the 30-year mortgage rate (268bps to 5.96%), and the high-yield corporate bond yield (413bps to 8.43%) (Fig. 6).
(5) Balance sheets. Our subjective probability of a recession over the rest of this year through next year remains at 45%. If a recession occurs, it would likely be a mild one. That’s because the financial system, especially the banking system, is mostly well capitalized. On June 24, Reuters reported: “Shares in the biggest U.S. banks rallied on Friday after they passed the Federal Reserve’s annual health check, but Bank of America (BAC.N) underperformed with test results implying it needs a larger-than-expected capital buffer, which could limit share buybacks and dividends.”
The test measures how the big banks would fare in a hypothetical severe economic downturn. The results of the Fed’s annual “stress test” show that the banks have enough capital to weather a severe economic downturn and paves the way for them to issue share buybacks and pay dividends. The 34 lenders with more than $100 billion in assets that the Fed oversees would suffer a combined $612 billion in losses under a hypothetical severe downturn, the central bank said. But that would still leave them with roughly twice the amount of capital required under its rules.
The balance sheets of consumers and businesses are also in relatively good shape. Most of the stress in the economy currently is on consumer incomes, as their purchasing power has been eroded by inflation, causing them to reduce their personal saving rate. They’ve also been cutting back spending on consumer durable goods, which has left some retailers with unintended inventories. Consumers’ cutbacks may continue to slow economic growth, in our opinion, but without causing a recession—and (almost) certainly not a severe one.
(6) Commodity prices. The commodity prices included in the broadest S&P Goldman Sachs Commodity Indexes have been soaring since the end of the lockdown recession in the US during the spring of 2020 (Fig. 7 and Fig. 8). They’ve plunged in recent days. The same can be said about the CRB indexes, especially the basic metals (including copper) index (Fig. 9 and Fig. 10).
This development confirms the adage often quoted by commodity traders that the best cure for high commodity prices is high commodity prices. The bad news is that the recent drop may reflect rapidly slowing global economic growth, which could turn into a recession. On the other hand, the drop may mark a peak in inflation, which will reduce the amount of central bank tightening required to bring it down. We are in the latter camp. For now.
(7) CFO Put. Joe and I have suggested that the “CFO Put” (i.e., the boost to share prices courtesy of company decisions like share buybacks, dividends, and mergers and acquisitions) may somewhat offset the fact that the “Fed Put” (the boost to stocks courtesy of the Fed’s years of very easy monetary policy) is kaput. Bloomberg’s Lu Wang reported on June 15: “While hedge funds were busy bailing from stocks at a record pace as the S&P 500 plunged into a bear market, Corporate America was furiously buying.” She also reported:
“Regardless, corporate buys don’t look set to slow when judging by announced plans. American firms have advertised the intention to buy back $709 billion of their own shares since January, 22% above the planned total at this time last year, data compiled by Birinyi Associates show. David Kostin, chief U.S. equity strategist at Goldman, predicts actual buybacks this year will rise 12% to a record $1 trillion.”
Strategy II: On the Wrong Track. On the other hand (as two-handed economists often say), the economy and financial markets could remain on the wrong track over the rest of this year. Inflation could remain protracted and stubbornly high. In this case, the Fed would have no choice but to continue tightening monetary policy until the result is a recession. In this scenario, industry analysts would have to scramble to cut their earnings estimates for this year and next year, sending valuation multiples lower. Domestic political and geopolitical developments could provide plenty of more bad news. Consider the following:
(1) Inflation. Debbie and I are still predicting that the PCED measure of inflation should peak between 6.0% and 7.0% during the first half of this year. It was still elevated at 6.3% y/y during April, down only slightly from the year’s high of 6.6% y/y during March (Fig. 11). We are projecting that the headline rate should fall to 4%-5% during H2 on its way to 3%-4% next year.
May’s PCED inflation rate will be reported on Thursday. May’s CPI, which was reported on June 10, showed that energy and food inflation rates remain hot (Fig. 12). As noted in the previous section, commodity prices suggest that energy and food inflation rates might have moderated in June. In addition, durable goods inflation moderated according to May’s CPI (Fig. 13). Unintended inventories of consumer discretionary goods piled up during March and April, forcing retailers to cut their prices to clear them out in May and June. While used car price inflation has dropped sharply in recent months, new car prices continue to rise at a faster pace, according to May’s CPI (Fig. 14). Meanwhile, rent inflation continues to get warmer.
As we all saw on June 10, when May’s worse-than-expected CPI report was released, any setback in the moderating-inflation scenario can hammer both stock and bond prices.
(2) The Fed. Now that the Fed is “unconditionally” committed to bringing inflation back down to 2%, the risk is that it will do so even if that requires a policy-engineered recession. Last Wednesday, Federal Reserve Chairman Jerome Powell testified before the Senate Banking Committee on monetary policy. He was no longer talking about a “softish” or “bumpy” landing. Instead, he acknowledged that a recession may be hard to avoid and that there still isn’t any “compelling evidence” that inflation is coming down. He stated, “Recession is certainly a possibility.”
(3) Recession. Of course, the weakest economic sector currently is housing, which is in a recession. Residential investment spending in real GDP was flat during Q1 and is on track to fall by 10.0% (saar) during Q2, according to the Atlanta Fed’s GDPNow tracking model. Home prices are likely to fall, but they aren’t likely to have the same negative impact on the economy as they had during the GFC.
Nevertheless, the weakness in housing activity is one of the main reasons that the economy is on the edge of a recession. The GDPNow model, currently showing Q2 growth at 0.3%, could fall into negative territory this week. Real GDP fell 1.5% during Q1. A widely believed rule of thumb is that two consecutive negative quarters of real GDP growth mark a recession; in fact, it is up to the Dating Committee of the National Bureau of Economic Analysis to make recession calls. But by the time it makes that call, the recession could be over!
We are still putting the odds of an outright (earnings-depressing) recession at 45%. However, the economy is currently certainly mired in a mid-cycle growth recession. As noted above, inflation has been eroding consumers’ purchasing power, forcing them to reduce their personal saving rate to support their spending. Real personal consumption expenditures rose 3.1% (saar) during Q1 and is currently on track to increase 2.7% during Q2. But, as also noted above, we can’t rule out the possibility that consumers will retrench given the record low in the CSI.
(4) Credit crunch. A recession could trigger a credit crunch, exacerbating the downturn, even though the banking system is in very good shape. We are watching the yield spread between the high-yield corporate bond composite and the 10-year US Treasury bond (Fig. 15). It has widened from 279bps at the beginning of the year to 519bps on Friday. That’s disconcerting, but not alarming. However, this yield spread has a history of going from disconcerting to alarming in a matter of days.
(5) Earnings and valuation. Stock investors fear recessions because they force analysts to scramble to cut their earnings estimates for the current year and coming one. At times in the past, industry analysts have lowered these estimates during economic expansions simply because they were too optimistic. But S&P 500 forward earnings continues to rise because the coming year’s consensus estimate remained above the current year’s consensus estimate even as both were revised downward. However, during recessions, forward earnings has always declined (Fig. 16 and Fig. 17). The forward P/E, which fell sharply during H1 this year, would certainly have more downside if a recession unfolded during H2 (Fig. 18).
(6) Midterm elections. Many political observers have been expecting that the Republicans would gain lots of seats in Congress during the mid-term elections later this year. Investors have widely expected that such an outcome would be bullish because gridlock is widely viewed as bullish. But now the Supreme Court’s ruling on abortion may have improved Democrats’ prospects in many congressional races.
(7) Europe and climate activism. As we discussed in yesterday’s Morning Briefing, the Russians are retaliating against European sanctions on Russian oil by reducing exports of their natural gas to Europe. Europeans may be forced to ration natural gas usage, especially as winter approaches. The result could be a recession in Europe. Real GDP was up 5.4% y/y in the Eurozone during Q1 (Fig. 19). But the region’s Economic Sentiment Indicator (ESI) has been falling rapidly in recent months, suggesting that real GDP growth could do the same. (June data for the ESI will be released tomorrow.)
As we also discussed yesterday, climate activists have succeeded in convincing western governments to impose severe regulations on their fossil fuel industries to reduce supplies. However, they’ve been naïve in anticipating that the transition from dirty to clean energy sources could happen quickly and without a great deal of economic pain. An ongoing shortage of fossil fuels, while renewable sources of energy remain unreliable, could cause a prolonged period of global stagflation.
(8) The war. Last, but not least, is Russia’s war on Ukraine. The longer it lasts, the more that it too is likely to contribute to a prolonged period of global stagflation, including global famine.
Green Bad Deal
June 27 (Monday)
YRI Monday Webcast. Dr. Ed’s webinar for Monday will be prerecorded. Replays of the Monday webinars are available here.
Global Economy: Energy Wars. Climate activists: Beware of what you wish for—and work toward! Climate activists have been working assiduously to reduce the supplies of fossil fuels such as oil and natural gas. They’ve been quite successful at convincing many Western governments to impose more and more onerous regulations on the production of fossil fuels. The results have been less production of fossil fuels and soaring fossil fuel prices, exacerbated by unintended (and certainly naively unexpected) adverse geopolitical consequences.
The activists welcomed the higher prices for “dirty” fossil fuels, expecting that higher prices would significantly boost the supply of and demand for “clean” (i.e., renewable) energy sources. In other words, they thought their Big Government intervention in the global energy markets would result in a fast and smooth transition from dirty to clean energy thanks to the “free” market response to their meddling. Pain on the fossil fuel side of the transition equation, they believed, would be more than offset by gain on the renewables side.
That was all wishful thinking. In reality, the transition has been painfully slow, on balance, with the pain well exceeding the gain. Climate activists’ naivety has brought them some serious political backlash as a result. Another result: Fossil fuel sources are making a remarkable comeback. Consider the following developments:
(1) Pain at the pump. According to the Hedges Company, there were 286.9 million registered cars in the US in 2020. Just over a million of these were electric vehicles (EVs). So almost all Americans who drive a motor vehicle are using gasoline to fuel them. They’ve all been very unhappy to see the national retail average pump price more than double from $2.48 per gallon during January 2021, when President Joe Biden was inaugurated, to just over $5.00 recently. Many of them blame the Biden administration, while the Biden administration blames Russian President Vladimir Putin, observing that the price was $3.45 during January 2022, just before Putin invaded Ukraine (Fig. 1).
A more refined view of the problem is that gasoline demand rebounded rapidly from the lockdown recession in early 2020 (Fig. 2). However, US operable crude oil distillation capacity dropped from a record high of 19.0mbd during the first four months of 2020 to 17.9mbd during March of this year (Fig. 3). There isn’t enough refining capacity to meet gasoline and diesel demand, as evidenced by soaring crack spreads (Fig. 4). The jump in gasoline and diesel demand and the decline in refining capacity started when Donald Trump was president and has continued under Biden, whose energy policies have exacerbated the fossil fuel supply problem.
While Washington is playing the blame game, Americans spent $445.4 billion (saar) on gasoline during April, down slightly from the March record high. The average American household spent a record $3,724 (saar) on gasoline during March, up from $2,444 a year ago (Fig. 5). Debbie and I previously calculated that at $5.00 a gallon, the average American household is now spending at an annual rate of $5,460 on gasoline, up by roughly $3,000 from a year ago (Fig. 6).
(2) Depressing confidence. Consumption of energy goods and services still accounted for only 4.3% of disposable personal income (DPI) during April, with gasoline accounting for just 2.4% of DPI (Fig. 7). However, rapidly rising energy costs have boosted the prices of lots of other consumer goods and services. Consumers have responded to the squeeze by reducing their personal saving rate to 4.4% during April, the lowest since September 2008 (Fig. 8).
Meanwhile, the Consumer Sentiment Index, which is much more sensitive to inflation (and gasoline prices) than is the Consumer Confidence Index (which is more sensitive to unemployment), has dropped to new record lows (Fig. 9). This raises the risk that consumers might soon respond to higher inflation by cutting their spending even though the labor market remains strong.
(3) Tit-for-tat letter writing. On June 3, Chevron Chief Executive Michael Wirth said in a webcast, “I personally don’t believe there will be a new petroleum refinery ever built in this country.” On June 10, Biden blasted oil companies for making record profits and urged them to increase oil production and refining capacity to alleviate gasoline price inflation. Earlier this month, he also accused Exxon Mobil of making “more money than God” and not drilling enough.
On June 14, the American Petroleum Institute sent a letter to Biden stating: “While members of your administration have recently discussed the need for additional supplies to solve the energy crisis, your administration has restricted oil and natural gas development, canceled energy infrastructure projects, imposed regulatory uncertainty, and proposed new tax increases on American oil and gas producers competing globally. Respectfully, the American people need a different direction to solve this crisis.” The letter included a 10-point plan “to help address our current energy challenges by increasing supply and underscoring the connection between energy security and national security.”
On June 15, the American Fuel & Petrochemical Manufacturers sent Biden a letter with basically the same message: “To protect and foster U.S. energy security and refining capacity, we urge to you to take steps to encourage more domestic energy production, including promoting infrastructure development, addressing escalating regulatory compliance costs, allowing all technologies to compete to reduce emissions, modernizing fuels policies, and ensuring capital markets are functioning for all participants.” The letter explained the challenges facing the refining industry, including the President’s campaign promise to “end fossil fuel” and his administration’s various efforts to end the sale of new gasoline-powered vehicles in the not-too-distant future.
On June 15, Biden sent a letter to seven major oil refiners blasting them for their record profits. He reprimanded them for their historically high profit margins for refining oil into gasoline, diesel, and other products. The letter called for an emergency meeting with company executives and administration officials: “The crunch that families are facing deserves immediate action. Your companies need to work with my Administration to bring forward concrete, near-term solutions that address the crisis and respect the critical equities of energy workers and fence-line communities.”
On June 21, Wirth rebutted White House officials’ criticism of the oil industry over energy costs, saying reducing fuel prices will require “a change in approach” by the government. “Your administration has largely sought to criticize, and at times vilify, our industry,” Wirth said in a letter to Biden. “These actions are not beneficial to meeting the challenges we face.” A couple of hours later, Biden told reporters in Washington that the executive was being too sensitive. “I didn’t know they’d get their feelings hurt that easily,” the President said, when asked about Wirth’s letter.
(4) US production rising, and so are exports. Notwithstanding the oil industry’s frustration with the Biden administration, high oil prices are stimulating more oil production in the US. Petroleum output rose to 19.4mbd during April, with crude oil field production rising to 11.9mbd, natural gas liquids to 5.4mbd, biofuels to 1.1mbd, and processing gain to 1.0mbd (Fig. 10). Weekly data show that crude oil field production rose to 12.1mbd during the June 10 week as the oil rig count continued to rise (Fig. 11). Meanwhile, high petroleum prices are weighing on US demand, as shown by total petroleum products supplied, which has stalled around 20.0mbd since the start of the year (Fig. 12).
The good news is that the US remains energy independent, as net imports of crude oil and petroleum products has been slightly negative since 2019 (Fig. 13). In fact, exports of crude oil and petroleum products remained in record territory at 9.7mbd during the June 10 week.
(5) Lots of global puzzle pieces. Some of those US exports are heading to Western Europe to replace sanctioned Russian oil. However, the Russians are selling more of their output at discounted prices to China and India. Meanwhile, at its last meeting on June 2, OPEC+ agreed to boost output by 648,000 barrels per day (bpd) in July and by the same amount in August, up from the initial plan to add 432,000 bpd a month over three months until September. OPEC+ holds its next meeting on June 30, when it will most likely focus on August output policies. In July, Biden will make his first visit to Riyadh after two years of strained relations because of disagreements over human rights, the war in Yemen, and U.S. weapons supplies to the kingdom.
(6) ‘Carrying coal to Newcastle.’ The biggest impact on the global oil market over the next six to 18 months could be a recession in Europe caused by a shortage of natural gas. Russia is reducing its exports of natural gas to Western Europe in retaliation for Europeans’ support of Ukraine in its war against Russia. Europeans could be forced to ration their available supplies of natural gas. Europe could fall into a recession, which would also depress oil demand and oil prices. Indeed, the FT reported on Wednesday: “The International Energy Agency has warned that Europe must prepare immediately for the complete severance of Russian gas exports this winter, urging governments to take measures to cut demand and keep ageing nuclear power stations open.”
In recent years, climate activists have convinced European governments—especially in Germany, Italy, and the UK—that they should reduce domestic production of fossil fuels. As a result, during the transition to a utopian world of clean energy, Europe became increasingly dependent on fossil fuels imported from Russia. That gave a whole new meaning to “carrying coal to Newcastle.” This British idiom describes a pointless action, since Newcastle already produced more coal than the town needed. Burning fossil fuel imported from Russia does as much environmental damage as burning fossil fuel produced in Europe and has exposed Europe to Russian funded corruption and now extortion.
This past week, Reuters reported that Germany, Italy, Austria, and the Netherlands all have signaled that coal-fired power plants could help see the continent through a crisis that has sent gas prices surging and added to the challenge facing policymakers battling inflation.
Strategy: Are European Analysts Delusional? Debbie and I have observed that if a recession unfolds over the rest of this year or next year, it will be the most widely anticipated downturn in US economic history. Nevertheless, as Joe and I have observed since the start of this year, industry analysts continue to blithely up their 2022 and 2023 revenues and earnings estimates for the S&P 500 (Fig. 14).
Apparently, the analysts have yet to get recession memos from the managements of the US companies they follow. That’s because most of them aren’t experiencing a recession so far. On the other hand, Melissa and I have concluded that a recession is much more likely in Europe as a result of the energy shock resulting from the Ukraine war.
Yet the analysts covering the companies in the EMU MSCI index have been doing the same as their American counterparts, i.e., raising both their revenues and earnings estimates (Fig. 15). Their profit margin estimates (which we calculate from their revenues and earnings estimates) also remain near recent record highs, suggesting that European companies, like American ones, are having no problems passing through their inflation-boosted costs to their selling prices.
Joe did similar “squiggles” analyses (tracking the squiggly trajectories of analysts’ consensus weekly estimates for annual revenues, earnings, and margins) for the Japan, UK, and Emerging Market Economies MSCI indexes. Only the last one has seen analysts cutting their estimates for 2022 and 2023 (Fig. 16).
Energy, EVs & Crypto
June 23 (Thursday)
Energy: US Production Heading Up. In his testimony before Congress yesterday, Fed Chair Jerome Powell conceded that the Fed’s recent moves to fight inflation could cause a recession. Higher interest rates have quickly taken a toll on both the stock market and the housing market, where mortgage rates have jumped past 6% and home sales activity is slowing sharply.
Wary investors also may have noticed the recent sharp increase in US oil production to 12.1 million barrels per day (mbd) from 11.3 mbd in mid-March (Fig. 1). As more oil rigs have returned to service, production has moved sharply off its mid-February 2021 low of 9.8 mbd and is heading north toward its previous peak of 13.1 mbd in late February 2020 (Fig. 2).
The jump in US production combined with fears of a recession—and the lower oil demand that usually results—have halted the recent runup in the price of oil, pushing the price of West Texas Intermediate (WTI) crude oil down from a recent peak of $122.11 on June 8 to $110.65 per barrel Tuesday (Fig. 3).
Before the bears declare victory, numerous bullish trends continue to support elevated oil prices. US travelers hitting the road and the skies this summer has pushed up demand. China’s post-Covid reopening is sure to boost demand too. And a lack of US refining capacity may also keep prices elevated.
Let’s take a look at some of the pricing action in the industry as well as the impact of trends in the refining industry:
(1) Blame backwardation. Despite today’s high prices, the market is forecasting lower crude oil prices a year or two in the future. The one-year futures price for WTI is $92.13 per barrel, and the two-year futures price is $83.13 per barrel (Fig. 4). The market’s backwardation doesn’t encourage companies to fill up storage tanks. Why buy oil today if the market is saying it will be less expensive in the future? At 397.5 million barrels, US stocks of crude oil are lower than they’ve been in over six years even as demand for and production of crude have grown sharply over those years (Fig. 5).
(2) Refiners going green and maxing out. Adding to the pain of high crude oil prices are the high prices refiners are fetching to turn crude into usable products like fuel for planes or cars. The crack spread—or the difference between the price of a barrel of crude oil and the price of all the refined products produced from that barrel of crude oil—is up dramatically to $50-$60 a barrel from the $15-$25 range of recent years because there’s limited capacity in the refining market and companies are running full tilt.
Some of the industry’s largest refiners are operating at capacity utilization rates in the 90%s. Marathon Petroleum’s capacity utilization was 91% in Q1, and the company forecasts it will be 95% in Q2. Valero Energy’s capacity utilization was 89% in Q1, up from 77% in Q1-2021. “It’s hard to see that refinery utilization can increase much,” said an executive on Valero’s Q1 earnings conference call. “Although we’ve been able to hit 93% utilization, generally, you can’t sustain it for long periods of time. So, I don’t think there’s a lot of room on refinery utilization in terms of increasing supply. I think the markets will have to balance more on the demand side.”
The US Energy Information Administration (EIA) reported refining capacity declined by 125,790 barrels per day (bpd) in 2021 and by 800,000 bpd in 2020, a June 21 Reuters article stated. Since peaking in 2019, refining capacity has fallen by 5.4%, or 1.0mbd, to 17.9mbd.
The industry has seen several plants close over the past few years. An Alliance, Louisiana refinery that had capacity of 255,600 bpd closed after damage from last year’s Hurricane Ida. Additional capacity is expected to exit the market in December 2023 when LyondellBasell Industries plans to shutter or repurpose a 263,776 bpd refinery that it hasn’t been able to sell because it needs substantial investment.
(3) Refiners going green. Instead of increasing capacity to produce traditional diesel, gasoline, and other products, some refiners have focused on increasing their capacity to produce green products. Renewable diesel is made from animal fats, food wastes, and plant oil and is the chemical equivalent of petroleum-based diesel. Marathon Petroleum’s 166,000 bpd refinery and Phillips 66’s 120,200 bpd refinery, both in California, have converted to produce renewable diesel. Shell is considering converting its Convent, Louisiana refinery to produce renewable diesel.
“There are at least 12 renewable diesel projects worth more than $9 billion under construction, with another nine proposed. The 12, along with existing plants, are expected to produce about 135,000 [bpd] of renewable diesel by 2025 according to EIA data, from around 80,000 bpd now,” a June 21 Reuters article reported. That’s not enough to offset the reduced production of traditional diesel, however.
LyondellBasell is considering using the refinery that it can’t sell to recycle plastics. “Our exit of the refining business advances the company’s decarbonization goals, and the site’s prime location gives us more options for advancing our future strategic objectives, including circularity,” said Ken Lane, Lyondell’s interim CEO, according to an April 29 Reuters article. Circularity is the process of collecting used plastic containers and using them as the raw material needed by chemical plants.
(4) Conversely, Europe’s green fades. Last week, Europe’s fears that Russia would use its natural gas supplies as a weapon came to fruition when Russia cut capacity on its main gas export line to Germany by 60%. European nations looking for alternative sources to replace Russia’s natural gas apparently have backburnered their good intentions to reduce CO2 emissions in favor of meeting more pressing needs.
The German government announced Sunday that it would pass emergency laws to reopen closed coal plants for electricity generation for up to two years, a June 19 FT article reported. Previously, the country had planned to phase out the use of coal completely by 2030. The country also plans to install four floating liquified natural gas terminals and has encouraged conservation.
Germany isn’t alone. Austria also announced plans to reopen mothballed coal-fired electric plants, and the Netherlands is changing laws that limited coal plants to operating at a maximum of 35% capacity. Italy is expected to follow suit, and we expect more announcements to come.
(5) Analysts not so sanguine. Despite oil and gas prices that are through the roof, analysts seem to be taking their cue from the forward curve for oil prices and expect earnings for many of the S&P 500 Energy sector’s industries to fall in 2023. Here are some of the Energy industries we follow and analysts’ consensus earnings forecasts for 2022 and 2023: Oil & Gas Exploration & Production (139.5%, -9.1%), Refining & Marketing (249.4, -26.1), Integrated Oil & Gas (111.5, -14.1) (Fig. 6, Fig. 7, and Fig. 8).
Exceptions to this trend: the S&P 500 Oil & Gas Equipment & Services industry, for which analysts are forecasting earnings growth of 60.7% this year and 43.2% in 2023, and Oil & Gas Storage & Transportation, with forecasts for earnings growth of 2.5% this year and 5.8% next year (Fig. 9 and Fig. 10).
Materials: Higher Prices Hit EVs. Electric vehicles (EVs) have slowly but steadily been increasing their market share. In May, EVs represented 6.1% of new car sales, up from 2.7% a year ago. The roadblock to greater EV penetration may be rising commodity prices. The materials used to make batteries—nickel, cobalt, and lithium—are often difficult to mine, and some prices have jumped sharply. Here’s a look at recent developments:
(1) Most commodity prices rising. The materials used in EV batteries are often hard to access and extract. And so far, supply has not risen in step with demand. The price of nickel has fallen 44% from its March 16 peak but is still up 60% from last year’s bottom in early March. Meanwhile, the price of cobalt is up 59% y/y, and the price of lithium is up 437% y/y, both according to data from Trading Economics. EVs’ average raw material cost has jumped to $8,255 per vehicle, up 144% from $3,381 in March 2020, a June 22 CNBC article reported. Some of those raw materials are also used in cars with internal combustion engines. Commodities used specifically in EVs have jumped in cost to $4,500 per vehicle from about $2,000.
(2) Most EV prices rising too. Most EV manufacturers have passed along their higher commodity costs to consumers. Tesla increased prices twice in March in addition to other times over the past year. The cheapest standard range Model 3 starts at $46,990 in the US, up 23% from $38,190 in February 2021, a May 21 CNBC article reported.
Tesla isn’t alone. Rivian increased the price of the R1T 18% to $79,500 and the R1S 21% to $84,500 in March. Lucid and General Motors have also increased EV prices. The price tag on GM’s Hummer rose $6,250 earlier this month.
So far, Ford has opted to eat the higher costs of commodities used in its EV trucks, but that has wiped out the profit Ford expected to make on the electric Mustang Mach-E.
(3) Could it get worse? Stellantis CEO Carlos Tavares expects shortages of EV batteries by 2024-25, followed by a lack of raw materials needed for EVs, which he believes will slow the availability and adoption of EVs by 2027-28, a May 24 CNBC article reported. He contends that regulators have pushed the transition from traditional vehicles to EVs too hard, and the supply chain hasn’t had enough time to catch up to the change in demand. Despite his concerns, Stellantis is investing $35 billion in EVs and expects all of its European sales and 50% of its North American sales to be EVs by 2030.
(4) Miners keep wallets shut. Critics would counter that the suppliers have had plenty of time to adjust to the change in demand for EV materials. They just prefer to pay shareholders higher dividends and buy back increasing number of shares instead. “Project spending by 10 large mining companies including Rio Tinto PLC, BHP Group, and Glencore PLC, is expected to stay at roughly $40 billion this year and next year,” a June 19 WSJ article stated, citing Bank of America data. That leaves spending far below the 2012 peak of $80 billion.
Disruptive Technologies: Anatomy of a Crypto Winter. It has been amazing to watch the hundreds of small, entrepreneurial companies hoping to break into the cryptocurrency space. Companies back the more than 19,000 cryptocurrencies in existence, and there are also dozens of blockchain platforms on which to trade, borrow, and lend, a June 3 CNBC article reported.
Let’s assume that the “crypto winter”—i.e., an extended downturn in crypto prices and trading—is survived by industry leaders Bitcoin, Ethereum, FTC, Coinbase, and about half of the rest of the cryptocurrencies out there, or 9,500 of them to be more precise. What will happen to the other 9,500 cryptocurrencies and the companies supporting them? Here are some ideas:
(1) Ad budgets getting slashed. Crypto companies looking to make a splash have spent a lot on marketing and advertising. Much has been made of the companies that ponied up millions to advertise during this year’s Super Bowl and hired the likes of Larry David (FTX), LeBron James (Crypto.com), and Matt Damon (Crypto.com). Since November, crypto brands’ ad spending on digital platforms like Facebook, YouTube, and Hulu has fallen 90% or more, according to Sensor Tower data cited in a June 20 WSJ article.
Crypto companies also spent lavishly on sports marketing deals, including the $700 million that Crypto.com purportedly spent on the rights to rename the former Staples Center. Crypto brands spent more than $130 million on NBA sponsorships this season, up from less than $2 million last season, according to a consultant quoted in a June 17 CNN article.
(2) Tech spending at risk. Every little tech company had to buy technology equipment. They theoretically needed computers and servers—or at least server space in the cloud. Miners spent on computers and electricity. Ethereum miners alone spent $15 billion on GPUs over the past one and a half years—and that doesn’t include spending on other equipment they likely needed including CPUs, PSUs, and chassis, a June 19 Techradar article reported. Ethereum miners may have purchased about 10% of the total GPU supply over the past two years, helping to push up GPU prices over that period.
(3) Layoffs disbursed. One positive thing about the crypto market is that its thousands of companies are spread around the world. Terra was a coin run by a South Korean company. Celsius’s headquarters is in Hoboken, and Crypto.com’s in Singapore. So unlike the 2008 housing collapse, with mainly US-based corporate casualties, crypto companies—the giants and the minnows alike—are spread out around the world. That may limit the impacts to any particular region if the crypto winter indeed has begun.
(4) Digital tulips. In the May 11, 2021 Morning Briefing, I wrote: “I had been thinking of cryptocurrencies as ‘digital tulips,’ reminiscent of the 17th century tulip mania in Amsterdam that drove up tulip prices beyond reason. The difference is that cryptocurrencies are traded 24-by-7 around the world. On second thought, they might be more like a financial virus that won’t stop until enough speculators have been infected that herd immunity is achieved.” Bitcoin rose to its record high of $67,625 on November 9, 2021. It was down to $19,870 yesterday (Fig. 11).
The Latest Business Cycle
June 22 (Wednesday)
US Economy: How’s Business? Every month, the Census Bureau releases its “Advance Monthly Sales for Retail and Food Services.” The latest report was released on June 15 at 8:30 a.m. An hour and a half later every month, the Census Bureau releases its “Manufacturing and Trade Inventories and Sales” report—for the previous month. In other words, on June 15, Census reported retail sales through May and business sales of goods through April. The retail sales report tends to get all the attention by the media and by economists because it is one month more current than the more comprehensive business sales report. But Debbie and I find that there is a wealth of useful information about the economy in the latter report.
What we see in the business sales report is increasing signs that inflation has been boosting the nominal value of these sales but weighing on their inflation-adjusted value. Real inventories are starting to rise relative to sales, especially among some retailers. These businesses are likely to respond to unintended inventory accumulation as they always do, i.e., by cutting prices to clear them. So the good news is that some of the economy’s inflationary pressures should abate. The bad news is that economic growth will suffer, increasing the risks of a typical goods-led recession.
Let’s examine the latest business sales and inventories data, both nominal (available through April) and real (through March).
(1) Business sales. Manufacturing and trade sales rose 13.8% y/y to a record-high $21.8 trillion (saar) during April (Fig. 1). However, real business sales was unchanged on a y/y basis over the three months through March (Fig. 2). That’s down from the post-lockdown high of 16.2% during May 2021. This growth rate in real business sales closely tracks the growth rate in real GDP of goods, which was up 4.5% y/y through Q1.
Here are the y/y growth rates in current dollars and inflation-adjusted dollars for the three major components of business sales through March: manufacturing shipments (13.9%, -2.7%), wholesale sales (22.3, 2.5), and retail sales (5.2, -7.0) (Fig. 3 and Fig. 4).
(2) Business inflation. The Census Bureau compiles price deflators for business sales and its components. The one for the aggregate measure of business sales rose by an astonishing 16.7% y/y through March, the highest since January 1975 (Fig. 5). Data available since 1968 show that this series tends to rise near the end of economic expansions and to fall during recessions. Here are the latest inflation rates through March and their readings a year ago for manufacturing (17.6%, 7.9%), wholesale sales (17.6, 10.4), and retail sales (12.2, 3.3) (Fig. 6). These are truly astonishing inflation rates.
(3) Business inventories. Manufacturing and trade inventories rose 15.1% y/y to a record high of $2.3 trillion through March (Fig. 7). Over this same period, real business inventories rose 2.0% to the highest level since March 2020. Here are the current-dollar and inflation-adjusted growth rates through March of the three major categories of business inventories: manufacturing (10.5%, -2.5%), wholesale (22.5, 9.3), and retail (12.3, 1.2) (Fig. 8 and Fig. 9).
Investors recently have fretted over unintended inventory pileups, especially in the major department stores. It’s hard to see much of a problem in the inflation-adjusted inventories-to-sales ratios for overall business or the three major components of the aggregate (Fig. 10 and Fig. 11). All four ratios have jumped during the first three months of this year but are within their normal ranges of recent years. However, the current-dollar ratio for general merchandise stores did make a large jump during April, to 1.58 from 1.19 a year ago (Fig. 12).
(4) Business cycle correlations. We have often observed that the y/y growth rate in business sales (in current dollars) closely tracks the growth rate in S&P 500 aggregate revenues (Fig. 13). The former rose 13.7% through April, while the latter was up 13.4% through Q1. The surge in the inflation rate over the past year has been fully reflected in S&P 500 revenues. Remarkably, S&P 500 earnings have kept pace with inflation too, suggesting that profit margins are holding up well in the face of rapidly rising costs.
Another strong business cycle correlation is the one between the growth rate of real business sales (on a y/y basis using the three-month average of the series) and the level of the M-PMI (Fig. 14). A similarly tight fit exists between the growth rate of real business sales and the level of the average of the general business indexes of the regional business surveys conducted by five of the 12 regional Federal Reserve Banks (Fig. 15).
May’s regional surveys confirmed that the goods sector of the economy has stopped growing. We expect that June’s surveys will do so as well. We expect that June’s M-PMI will fall close to 50.0 from May’s surprisingly robust 56.1.
Global Central Banks: Fighting Their Own Battles. Central bankers’ flood-like monetary stimulus during the pandemic sent their balance sheets to dizzying heights and their interest rates close to zero or slightly less (Fig. 16 and Fig. 17). Now that global inflation is surging—owing largely to overly accommodative monetary policy for too long—the Fed and European Central Bank (ECB) are tightening to cool their overheated economies. With the economies of China and Japan still weak, however, the People’s Bank of China (PBOC) and Bank of Japan (BOJ) haven’t followed suit.
For perspective, the US CPI inflation rate reached 8.6% y/y in May, the highest since December 1981 (Fig. 18). The other three economies’ most recent inflation readings are as follows: Eurozone (8.1% y/y in May, the highest on record and quadruple the ECB’s 2.0% target), Japan (2.5% in April, but with a core rate of just 0.1%), and China (2.1% in May).
Below, we examine the factors influencing each central bank’s policy decision-making:
(1) Fed vs Taylor Rule. On June 15, the Federal Open Market Committee raised the federal funds rate by 75 bps and indicated that it would push rates higher by another 50-75 bps at its next meeting on July 26-27. Fed Chair Jerome Powell said during his post-meeting press conference on June 15 that the Fed needed to move more aggressively to bring inflation down. Going further, he said that he wouldn’t “declare victory” over inflation until inflation has been falling for months.
Fed officials’ median projections for the federal funds rate now stand at 3.4% this year and 3.8% in 2023, with the former 150bps above their March projection of 1.9% and the latter 100bps above their 2.8% March projection. Powell emphasized that the Fed continues to target a 2.0% inflation rate while acknowledging that higher interest rates might push the unemployment rate up slightly. The Fed’s median projections for the inflation rate, based on the personal consumption deflator, now stand at 5.2% this year and 2.6% in 2023 versus its March projections of 4.3% and 2.7%, respectively.
“We don’t seek to put people out of work,” Powell said at his presser, adding that the central bank was “not trying to induce a recession.” But that could be the result of its actions: The Fed’s median projections for the unemployment rate were upped to 3.7% this year and 3.9% in 2023 from 3.5% for both back in March. Aiming for a “soft landing” for the US economy despite rising rates, the Fed’s median projections for output were lowered to 1.7% for both 2022 and 2023 from 2.8% and 2.2%, respectively.
Adding to the risk of a bumpy landing, the Fed also is starting to allow maturing securities to run off its balance sheet. This will reduce its holdings of Treasury securities by $30.0 billion per month and its holdings of agency debt and mortgage-backed securities by $17.5 billion per month from June through August—for a combined three-month decline of $142.5 billion. Starting in September, the runoff will be set at $60 billion for Treasury holdings and $35 billion for agency debt and mortgage-backed securities, or $95 billion per month, for a total of $1.14 trillion over a 12-month period.
Financial markets have reacted to these plans with widely anticipated volatility. Likely, the wild ride will continue, as the Fed shows no signs of relenting in its fight against inflation anytime soon.
Notably, Fed officials have long rejected the Taylor Rule, a formula-based approach to setting monetary policy, in favor of a more subjective approach based on a variety of variables (with a recent emphasis on the labor market). Had the Fed given some weight to the Taylor Rule, arguably rates wouldn’t have stayed so low so long and inflation wouldn’t be as great a problem as it is today. (Since its inception in the 1990s, the Taylor Rule has had varying degrees of influence over policy-setting, as discussed in this 2013 CEPR article.)
(2) ECB vs itself. At its February 3 meeting, the ECB held rates steady, but ECB President Christine Lagarde acknowledged that “the situation has indeed changed,” indicating a rate increase was coming this year. On June 9, the ECB signaled that it would make its first interest rate hike since 2011 at its July 20-21 meeting, with a possible larger move on September 8 followed by further gradual hikes. The ECB also will end its large-scale bond purchasing program on July 1, but reducing its balance sheet isn’t currently on the table.
However, the policy-setting situation in Europe just became much more complicated when the ECB got a wakeup call on how raising rates could impact heavily indebted European economies: Those countries’ bond yields suddenly went vertical. On June 15, the ECB held an emergency meeting to address the sharp rise in the Italian 10-year government bond yield to over 4.0%, or nearly 250 bps above Germany’s 10-year yield, in advance of the ECB’s actions.
As an interim measure, the ECB said it would sell some pandemic-stimulus-purchased bonds and buy up weak Eurozone countries’ bonds instead, to stimulate those asset prices and lower yields. Indeed, Italian government bond yields moved lower following the announcement. But that move is seen as incrementally helpful.
Over the longer term, the ECB promised to implement an “anti-fragmentation instrument” to lessen the divergence in yields between the richer and poorer member countries of the monetary union. The ECB faces a challenging policy conundrum: how to lower borrowing costs in troubled economies while raising rates in other countries.
Lagarde tried to temper expectations for the new instrument, however, arguing that the ECB’s job is to achieve price stability, not favorable financing conditions or budgets. “We cannot surrender to fiscal dominance,” Lagarde said at a forum in London, reported Reuters. “Neither can we surrender to finance dominance; we have to deliver on our mandate.”
(3) BOJ vs the Bond Samurais. Japan is not immune to inflationary pressures but has been less affected by them than other major economies. Yield curve control (YCC), the BOJ’s policy to control long-term interest rates, has been in force since 2016. And the BOJ is sticking to it.
On June 17, the BOJ reiterated its firm cap on 10-year Japanese government bond (JGB) yields at 0.25% by purchasing an unlimited number of bonds to prevent rising global yields from pushing up domestic borrowing costs. The BOJ maintained its -0.1% target for short-term rates. “It is not appropriate to tighten monetary policy at this point,” said BOJ Governor Haruhiko Kuroda. “If we raise interest rates, the economy will move in a negative direction.”
However, it’s anticipated that the BOJ eventually will be forced to raise its bond yield ceiling in surrender to the Bond Samurais (a.k.a. Vigilantes) who are pushing yields higher. The 10-year JGB yield hit a six-year high of 0.268% in trading on Friday, before recovering to 0.22% after the BOJ’s decision. But to remain successful at its YCC, the BOJ would have to buy up more and more government bonds should investors shun them.
For now, the BOJ is aggressively intervening to enforce the cap. The BOJ bought 10.9 trillion yen in JGBs this week, or more than $82 billion, marking the largest weekly purchase on record, according to Bloomberg. For comparison, ECB asset purchases averaged about $27 billion per month this year through May.
The BOJ certainly can defend its policies given the weakness in its economy, but the effectiveness of its policies is not easy to defend. Headline inflation has risen above 2.0% for the first time since 2015, but Japan’s core rate remains well below that target. That’s with rates near zero and a balance sheet of over $5 trillion. In other words, the bank does not have much left it can do to stimulate domestic “animal spirits.” While the Fed and ECB are moving toward monetary tightening, the BOJ likely will remain an outlier in a holding pattern, unless and until it has no choice but to raise its YCC cap.
(4) PBOC vs the rest of world. While the Fed and ECB rush to tighten and the BOJ hangs on, the PBOC is the only major central bank with the possibility of future easing on the horizon. China’s economy has been battered by its extended authoritarian lockdown measures to contain the pandemic. Chinese central bankers are caught between the risk of further incenting the capital flight that’s been occurring and the risk that households and businesses remain wary of taking on new loans.
Nevertheless, China held its benchmark interest rates unchanged at its monthly fixing on Monday, June 20. The one-year loan prime rate (LPR) was kept at 3.70%, and the five-year was unchanged at 4.45% Previously, in an unexpected policy move on May 20, the PBOC had cut its LPR.
Divergent policies among the major central banks certainly are creating plenty of volatility in global asset prices and likely will continue to do so.
Revisiting Venus and Mars
June 21 (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.
Strategy I: Report on Q1 Earnings Reporting Season. The results are in for the S&P 500’s Q1 earnings reporting season. It turned out to be a walk in the park. The industry analysts who cover the S&P 500 companies weren’t bullish enough; the actual results beat their expectations. Nevertheless, the park has been increasingly invaded by bears from the investment community.
Analysts and investors are so far apart in their perceptions of reality these days that it’s as if they’re from two different planets. And if there were an interplanetary battle raging for control of the stock market, we could say hands down that the bullish analysts from Venus are losing to the bearish investors from Mars.
But before exploring that further, let’s review the aggregated data from S&P 500 companies’ Q1 earnings reports:
(1) Revenues, earnings, and margins. The only negative surprise in the overall results was that S&P 500 revenues per share fell 2.3% q/q (Fig. 1). The analysts’ weekly forward revenues per share—which is the time-weighted average of analysts’ consensus estimates for this year and next and which has been a very good coincident indicator of the actual quarterly revenues series in the past—has been rising into record-high territory since the start of this year.
Operating earnings per share edged up 2.2% q/q to a new record high of $219.60 (annualized). The comparable weekly forward earnings-per-share series tends to be a year-ahead leading indicator of the quarterly series. It rose to a record high of $239.28 during the June 9 week. That will turn out to be close to what happens a year from now unless a recession occurs before then, in which case analysts will have to scramble to slash their estimates.
The profit margin edged up from 12.8% during 2021’s final quarter to 13.3% during Q1. The forward profit margin has been hovering at a record high around 13.4% since the start of the year. That’s remarkable given rapidly rising labor and materials costs.
(2) Revenues and earnings growth rates. On a y/y basis, S&P 500 revenues per share and earnings per share rose 13.6% and 11.8% during Q1 (Fig. 2 and Fig. 3). The latter growth rate was about twice as fast as industry analysts had expected at the start of the latest earnings season. Nevertheless, investors weren’t impressed and proceeded to pummel stock prices as they rerated forward P/Es downwards.
(3) S&P 500 sector revenues. The weakness in the S&P 500’s Q1 revenues was attributable to six of the 11 sectors of the S&P 500 (Fig. 4). Here are the y/y and q/q growth rates in S&P 500 revenues per share for the index’s 11 sectors during Q1: S&P 500 (13.6%, -2.3%), Communication Services (8.1, -6.6), Consumer Discretionary (8.6, -8.2), Consumer Staples (9.3, -1.7), Energy (56.1, 7.1), Financials (-0.6, -10.2), Health Care (13.8, 1.6), Industrials (16.0, -1.3), Information Technology (12.1, -3.1), Materials (26.0, 3.2), Real Estate (16.9, 0.0), and Utilities (11.4, 9.3).
(4) S&P 500 sector earnings. Here are the y/y and q/q growth rates in S&P 500 earnings per share for the index’s 11 sectors during Q1: S&P 500 (11.8%, 1.6%), Communication Services (-0.7, -6.8), Consumer Discretionary (-30.5, -40.3), Consumer Staples (7.1, -1.7), Energy (274.9, 17.5), Financials (-19.2, -4.8), Health Care (15.3, 13.9), Industrials (35.3, -0.8), Information Technology (13.5, -10.1), Materials (44.9, 9.1), Real Estate (29.4, 15.0), and Utilities (25.2, 73.6) (Fig. 5).
(5) S&P 500 sector profit margins. Among the 11 S&P 500 sectors, profit margins were most notably squeezed on a q/q basis in the Consumer Discretionary and Information Technology sectors, while they widened the most in Energy and Health Care (Fig. 6). Since they are not seasonally adjusted, let’s compare the margins during Q1 versus a year ago: S&P 500 (13.3%, 13.5%), Communication Services (17.1, 18.6), Consumer Discretionary (5.0, 7.9), Consumer Staples (7.3, 7.4), Energy (10.6, 4.4), Financials (17.9, 22.0), Health Care (11.8, 11.7), Industrials (7.9, 6.8), Information Technology (24.8, 24.5), Materials (13.5, 11.8), Real Estate (31.1, 28.1), and Utilities (15.0, 13.4). Again, on balance, that’s very impressive considering how rapidly costs are rising.
Strategy II: MegaCap-8 from Meltup to Meltdown. During 2020 and 2021, Joe and I often referred to the MegaCap-8 stocks in the S&P 500 as the “Magnificent 8” for their impressive collective share price performance and the great degree to which that performance lifted the performances of the broader indexes (e.g., S&P 500 and S&P 500 Growth) of which they are a part. Well, they haven’t been magnificent since they collectively peaked on December 27, 2021. Their capitalizations are also no longer as mega as they once were either.
Let’s revisit the pandemic-related rise and the post-pandemic fall of the MegaCap-8, as well as their impact on the S&P 500’s rise and fall since March 23, 2020. That was when the S&P 500 bottomed in response to the lockdown recession. It then soared to a record high on January 3 of this year, before falling into an official bear market on June 13.
(1) The bigger they are, the harder they fall. The MegaCap-8 includes Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla. Tesla was added to the S&P 500 on December 21, 2020. At that time, these eight stocks were the ones with the highest market capitalizations of the S&P 500 Growth index. They are widely viewed as technology companies; but, in fact, only three of them are in the S&P 500’s Information Technology sector (Apple, Microsoft, and Nvidia), three are in the Communication Services sector (Alphabet, Meta, and Netflix), and two are in the Consumer Discretionary sector (Amazon and Tesla).
At their collective peak on December 27, 2021, the MegaCap-8 stocks accounted for 26% of the market cap of the S&P 500 and 48% of the S&P 500 Growth index (Fig. 7 and Fig. 8). Since its peak last year, the market cap of the MegaCap-8 has dropped 34% through Friday’s close. Since the S&P 500 peaked on January 3, the index’s market cap is down $9.5 trillion through Friday’s close. The MegaCap-8 has accounted for 38% of the drop in the S&P 500’s market cap.
Here are the declines in the market caps of the individual MegaCap-8 stocks since January 3, in dollars and on a percent-change basis, through Friday’s close: Alphabet (-$510 billion, -26%), Amazon (-$648 billion, -37%), Apple (-$844 billion, -28%), Meta (-$499 billion, -53%), Microsoft (-$661 billion, -26%), Netflix (-$187 billion, -71%), Nvidia (-$356 billion, -47%), and Tesla (-$531 billion, -44%).
(2) Forward revenues and forward earnings mostly on uptrends. During the pandemic of 2020 and 2021, the MegaCap-8 stocks were widely viewed as the “tech” companies most likely to benefit greatly from lots of radical changes in our lives as more of us were working, going to school, and getting entertained from home. However, so far this year, industry analysts have had to trim their heady expectations for the earnings outlook of some of these companies. Here are the y/y percent changes in the forward earnings of the MegaCap-8 through the June 17 week: Alphabet (33.5%), Amazon (-45.9), Apple (21.4), Meta (-9.7), Microsoft (28.6), Netflix (-2.8), Nvidia (43.0), and Tesla (160.7).
(3) Diving forward P/Es. Investors responded to the pandemic by aggressively rerating the forward P/E of the MegaCap-8 to the upside. It was 29.0 just before the pandemic (Fig. 9). It plunged to 21.6 during the March 20 week of 2020 in response to the lockdown recession, then rebounded to 38.5 during the August 28 week of that year. By the end of that year, it was still elevated at 36.1. Since then, it has tumbled to 22.2 during the June 17 week.
The same pattern applies to the forward price-to-sales (P/S) ratio of the MegaCap-8 (Fig. 10). It plunged from last year’s high of 7.2 to 4.4 during the June 17 week.
Keep in mind that at the start of 2013, the MegaCap-8’s forward P/E was around 12.5, while its forward P/S was around 2.7. In other words, these two valuation multiples have come down a lot—with both now below their pre-pandemic highs—but they still aren’t cheap. And investors have been rerating these multiples, particularly for Growth stocks, downward as a result of rapidly rising interest rates and increasing risks of a recession.
Since the start of this year through the June 10 week, the S&P 500’s forward P/E with and without the MegaCap-8 has dropped from 21.4 to 17.3 and from 19.1 to 16.1 (Fig. 11). The comparable changes in the forward P/S over this period were from 2.88 to 2.32 and from 2.38 to 2.04 (Fig. 12).
(4) Our conclusions. The MegaCap-8 stocks still aren’t cheap. Arguably, they might be fairly valued. In any event, they aren’t uniformly as magnificent as they were during 2020 and 2021. The S&P 500 excluding the MegaCap-8 is certainly fairly valued as long as we can be certain that a recession isn’t around the corner. However, we can’t be certain of that, so there might be some more downside risk in the stock market until there is clear evidence that the Fed is done raising interest rates because inflation has petered out. We expect to see more evidence of that later this year.
Strategy III: Investors Are Still from Mars. Our May 18 Morning Briefing was titled “Analysts Are from Venus; Investors Are from Mars.” We wrote:
“Stock market investors seem to believe that industry analysts are becoming increasingly delusional. The latter have been raising their revenues and earnings estimates since the start of the year, while the former have been cutting the valuation multiples they are willing to pay for those estimates. And both actions have been in response to the same development, raging inflation.
“The analysts seem to be raising their projections partly to reflect rapidly rising prices, while the investors have been worrying that higher inflation will force the Fed to tighten until a recession occurs. A recession would force analysts to scramble to cut their estimates. In this scenario, investors would continue to slash valuation multiples—and they would have ‘we told you so’ bragging rights.”
As we updated in the previous section, investors have been pounding valuation multiples downward since the start of this year. They’ve been doing so as inflation has turned out to be less transitory and more persistent than was widely expected last year. This year, especially after May’s CPI shocker was released on June 10, investors have concluded that inflation may be much more protracted than previously thought and that the Fed tightening cycle will last for a while. They are all chanting the same mantra now: “Don’t fight the Fed when the Fed is fighting inflation.” As a result, this year’s correction in the S&P 500 morphed into a bear market on June 13.
Many investors also have become increasingly concerned that a recession is imminent. In this scenario, industry analysts would have to slash their earnings estimates for this year and next year from their current record-high estimates. As noted above, barring a recession scenario, the S&P 500—especially excluding the MegaCap-8—appears reasonably valued to us. As we’ve noted in the past, during previous recessions, P/Es fell well below 15.0 and could do so again if a recession occurs.
Our base case, to which we assign a probability of 55%, calls for slow growth with inflation actually boosting both revenues and earnings. So we view the current level of the S&P 500’s forward P/E as a fair one. However, there are a couple of valuation models that remain concerning:
(1) The Buffett Ratio. Warren Buffett likes to compare the market capitalization of the stock market to nominal GNP (Fig 13). He would much rather be buying stocks when the ratio is closer to 1.0 than 2.0. The ratio rose to a record 2.8 during Q4-2021. It edged down to 2.6 during Q1-2022.
The ratio of the S&P 500’s market capitalization to S&P 500 quarterly revenues closely tracks the Buffett Ratio, and so does the index’s daily forward P/S ratio. The daily ratio is down from a record 2.9 on January 3 to 2.1 on Friday, which is still a highly elevated reading. The forward P/S is at odds with the S&P 500 forward P/E, which dropped to a much fairer value of 15.5 at the end of last week.
The forward P/S and P/E ratios have diverged since 2018, when the profit margin began a steady climb to new record highs. As a result, earnings generally have been rising faster than revenues (Fig. 14). That’s boosted the P/S relative to the P/E. In a recession, the Buffett Ratio would fall faster than the P/E ratio as earnings would fall faster than revenues because the profit margin would plunge.
(2) The Real Earnings Yield. The S&P 500 earnings yield (using quarterly reported earnings) was 4.11% during Q1, while the CPI inflation rate (on a y/y basis) jumped to 7.97% (Fig. 15). We have the data back to 1935, which show that several of the bear markets in the S&P 500 since then have been associated with a drop in the real earnings yield often below zero (Fig. 16). Interestingly, the real earnings yield is positively correlated with the yearly percent change in the Index of Leading Economic Indicators, which was up 3.0% y/y during May, signaling neither a recession nor a bear market (Fig. 17).
Strategy IV: Analysts Are Still from Venus. Meanwhile, industry analysts continue to raise their revenues and earnings estimates for 2022 and 2023. As a result, forward revenues and forward earnings continue to rise in record-high territory (Fig. 18). Most years in the past during economic expansions, analysts were too optimistic and had to lower their annual earnings estimates for the current year, but forward earnings continued to rise. During the current economic expansion since the lockdown recession, they've been raising their earnings estimates for this year as well as next. Over the past year, inflation has undoubtedly boosted earnings projections.
The Fed: Demanding Unconditional Surrender. The Fed released its latest Monetary Policy Report on Friday. In the summary section of the report, the Fed pledged to fight inflation to the death: “The Committee is acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials. The Committee’s commitment to restoring price stability—which is necessary for sustaining a strong labor market—is unconditional.” In other words, the Fed is fighting for the unconditional surrender of inflation. The only question is: Will it have to kill the economy before accomplishing that mission?
Movie. “Jurassic World: Dominion” (- - -) (link) is the sixth installment in the Jurassic Park franchise. Let’s hope it’s the last. This one was widely panned as the worst of the lot. I agree. The acting was terrible. The story was trite. The baby dinosaurs were cute, but so was Dino in The Flintstones. The theme of this movie is that we should learn to coexist with other animals, even dinosaurs. It’s simply a matter of learning to respect one another. It’s time to bury this franchise. Make it extinct so that only the fossils are left. By the way, the villain looks a lot like Timothy Cook, Apple’s CEO, and the headquarters of his evil enterprise sure looks the doughnut-shaped headquarters that Cook built for Apple in Cupertino, California. Go figure.
Damage Assessments: Stocks & Crypto
June 16 (Thursday)
Stocks: Surveying the Damage. The Federal Reserve raised the federal funds rate by 0.75ppt yesterday and indicated that it would push rates higher by another 0.50-0.75ppts at its next meeting on July 26-27 (Fig. 1). Fed Chair Jerome Powell noted in his comments to the press yesterday that the Fed wasn’t seeing progress in its efforts to reduce inflation, so it opted to move more quickly this week than was previously expected. Fed officials’ median projection now places the federal funds rate at 3.4% this year and 3.8% in 2023. Next year’s projection is one percentage point higher than where it stood in March.
Powell emphasized that the Fed continues to target a 2.0% inflation rate while acknowledging that higher interest rates might push the unemployment rate up slightly. Even as the monetary punch bowl was being taken away, the stock market rallied yesterday for the first time in five days. The S&P 500 gained 54.51 points on Wednesday, but that barely begins to reverse its incredibly sharp ytd loss of 976 points.
With the S&P 500 in a bear market, nine of its 11 sectors are down by at least 10%, and five by more than 20%, from the index’s peak on January 3 through Tuesday’s close. Here’s a look at the wreckage: Energy (46.1%), Utilities (-7.1), Consumer Staples (-10.6), Materials (-13.3), Health Care (-14.0), Industrials (-16.6), Financials (-21.3), S&P 500 (-22.1), Real Estate (-24.7), Information Technology (-28.8), Communication Services (-31.9), and Consumer Discretionary (-35.2).
The good news in that is that stocks have become less expensive with their forward P/Es having fallen sharply over the past year. Stocks could keep falling if P/Es continue their downward path or if analysts start slashing their earnings forecasts. (FYI: “Forward P/Es” are the P/Es using “forward earnings,” which is the time-weighted average of analysts’ earnings-per-share estimates for this year and next.)
That said, let’s take a look at how far the market and valuations have fallen in what has been a horrible, no-good, very-bad year so far:
(1) A look at the underperformers. Of the 122 S&P 500 industries we follow, 27 have suffered losses of more than 30%. Here are the 10 worst-performing industries from the market’s January 3 peak through Tuesday’s close: Movies & Entertainment (-55.2%), Health Care Supplies (-49.5), Automobile Manufacturers (-44.8), Internet & Direct Marketing Retail (-40.3), Casinos & Gaming (-39.1), Auto Parts & Equipment (-38.9), Apparel, Accessories & Luxury Goods (-36.4), Application Software (-35.5), Homebuilding (-35.4), and Real Estate Services (-35.1).
The jump in interest rates has made buying homes more expensive and hurt the Homebuilding and Real Estate Services industries. Higher rates have also taken a toll on tech shares that had lofty P/Es. Many of the industries at the bottom of the barrel contain members of the MegaCap-8 group of stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla), which is down 34.8% from January 3 through Tuesday's close (Fig. 2).
Netflix (-72.2% ytd) is in the Movies & Entertainment industry, Amazon (-38.6% ytd) is in Internet & Direct Marketing Retail, and Tesla (-37.3%) is in Automobile Manufacturers. Meta (-51.3%) and Alphabet (-25.9%) have dragged down the Interactive Media & Services Industry, which missed our list of bottom 10 performers ytd by a hair, as it has fallen 34.3% ytd.
(2) Shelter in a storm. Given this year’s surge in oil and gas prices, it’s no surprise that the S&P 500 Energy sector and energy-related industries are among the top performers from the market’s peak through Tuesday’s close. So here are the top-performing S&P 500 industries that are not in the Energy sector: Agricultural Products (21.8%), Fertilizers & Agricultural Chemicals (20.6), Health Care Distributors (11.5), Food Retail (11.5), Construction & Engineering (10.0), Wireless Telecommunication Services (9.2), Brewers (8.5), Property & Casualty Insurance (6.2), Commodity Chemicals (5.4), and Gold (3.5).
The war in Ukraine has influenced the top of the list. The country is a major producer of fertilizer and wheat, but exporting the products during the war is difficult. Lower exports have boosted the prices of those commodities, and stocks of US companies that make fertilizer and handle wheat have benefitted. The top of the list also includes traditionally defensive S&P 500 industries, like Food Retail, home of supermarket Kroger, and Brewers, because we all could use a beverage these days. And while inflation and higher interest rates have hurt the S&P 500 Homebuilders, they’ve propped up the price of gold, benefitting the S&P 500 Gold industry.
(3) Shrinking P/Es. The bear market has taken some of the froth out of valuations. The S&P 500’s weekly forward P/E is 17.3, down from a peak of 23.1 on September 2, 2020. If the MegaCap-8 stocks are excluded from the calculation, the S&P 500’s forward P/E declines further, to 16.1 (Fig. 3).
Here is a comparison of forward P/Es for the S&P 500 and its 11 sectors as of June 9, 2022—the most recent available—and one year earlier, June 10, 2021: Real Estate (37.9, 53.6), Consumer Discretionary (23.5, 30.2), Information Technology (20.7, 24.9), Utilities (20.5, 19.4), Consumer Staples (20.2, 20.5), S&P 500 (17.3, 21.2), Industrials (17.2, 23.7), Health Care (15.9, 16.6), Communication Services (15.7, 21.9), Materials (14.5, 18.8), Financials (12.3, 14.5), and Energy (11.0, 17.9).
Most of the valuations for the S&P 500’s 10 worst-performing industries have fallen too. Here’s a comparison of their forward P/Es on June 9 of this year and June 10 of last year: Movies & Entertainment (19.7, 42.4), Health Care Supplies (21.9, 36.2), Automobile Manufacturers (24.0, 34.7), Internet & Direct Marketing Retail (67.9, 48.0), Casinos & Gaming (58.8, 309.3), Auto Parts & Equipment (16.0, 24.2), Apparel, Accessories & Luxury Goods (11.1, 18.9), Application Software (31.4, 44.4), Homebuilding (4.8, 8.5), and Real Estate Services (12.1, 21.6).
The S&P 500 Internet & Direct Marketing Retail industry’s forward P/E jumped over the past year because analysts’ earnings estimates for Amazon have fallen even more dramatically than the sharp drop in the company’s stock price. Conversely, the forward P/E for Casinos & Gaming has plummeted because the industry’s earnings have rebounded from last year when Covid was prevalent and traveling rare. The same is true for the Hotel industry, where the forward P/E has fallen to 26.0 from 348.9 a year ago.
The forward P/Es for many of the S&P 500’s home-related industries have fallen over the past year. Here are their June 9 and year-ago levels: Homebuilding (4.8, 8.5), Household Appliances (6.7, 9.8), Home Furnishings (8.6, 15.6), Housewares & Specialties (10.3, 15.5), Building Products (15.6, 21.9), and Home Improvement Retail (16.2, 19.7).
The same can be said for the forward P/Es of industries in the S&P 500 Financials sector. Here are some of the y/y comparisons that caught our eye: Reinsurance (7.5, 9.3), Consumer Finance (9.3, 12.1), Diversified Banks (9.8, 12.4), Multi-Line Insurance (10.0, 11.5), Regional Banks (10.2, 13.5), and Investment Banking & Brokerage (10.4, 13.1).
Cryptocurrencies: Celsius Heats Up. For the second month in a row, the crypto market was rocked by a blowup. Celsius, a crypto lender that was offering double-digit interest rates on deposits, announced last weekend that it was halting withdrawals. The firm blamed extreme market conditions and on Tuesday hired a restructuring law firm.
Last month, we learned that stable coins aren’t always stable: TerraUSD broke the buck and now trades at less than a penny. The one-two punch has the crypto markets on edge. The price of bitcoin fell 20% Monday and Tuesday. It’s down 53% ytd and 68% from its November 8, 2021 high (Fig. 4).
Let’s take a look at the latest blowup and its ripple effects:
(1) The Wild West of lending. Crypto lending offers lucrative interest rates on deposits but little information on how those deposits are being used and no federal insurance to provide a safety net for depositors.
Celsius often has offered interest rates on crypto lending that were in the double digits and sometimes as high as 18%. However, the only information about the use of Celsius deposits we found was in a risk disclosure document on its website: “Celsius deploys digital assets that you loan to Celsius through the Earn service in a variety of income generating activities, including lending such digital assets to third parties and transferring them to external platforms and systems.”
According to a June 14 FT article, Celsius has made loans to crypto market makers, hedge funds, and decentralized finance projects. The firm, which had $24 billion of crypto assets under management as of December, was hit with $2.5 billion in withdrawals in March and had $12 billion of assets in May. Celsius since has stopped disclosing its assets. The company’s own crypto token, CEL, has fallen to $0.58 down from $8.02 last year.
(2) Many crypto lenders. Celsius isn’t the only firm that has taken deposits and made loans with cryptocurrencies. There are tons of small defi (distributed finance) companies out there. Sometimes, they call the accounts “savings accounts.” Sometimes, they call the lending “crypto renting.” But the upshot is the same: Cryptocurrencies are lent out, and investors receive above-market interest rates.
Abra, Aave, BlockFi, CoinLoan, CoinRabbit, Compound, Crypto.com, Genesis, Hodlnaut, MakerDAO, Nebeus, Nexo, SpectroCoin, and YouHodler are some of the names we came across. If anyone knows how much in total loans these firms have outstanding, give us a shout! There doesn’t seem to be anyone collecting that data.
The process is often compared to securities lending. In one example we saw, it was explained like this: When you buy a stock at Schwab, the firm is allowed to lend it out to institutional investors for a fee that the firm keeps. With crypto lending, the little guy gets to keep the fee, not the Wall Street firm. But that little guy assumes a lot more risk because these entities aren’t regulated.
(3) Layoffs start. Crypto exchange Coinbase announced plans to cut 18% of its 6,100 workers by June 30. Coinbase CEO Brian Armstrong attributed the move to the company’s too-rapid growth and prospects that the economy may enter a recession, which could lead to a “crypto winter” for an extended period. This announcement was quite a reversal from the company’s messaging earlier this year, when it announced plans to triple headcount, a June 14 Yahoo Finance article stated.
Coinbase shares, which hit $357.39 on November 9, closed at $51.58 on Tuesday, hurt by the drop in crypto prices and trading volumes. Three months ago, analysts expected the company would earn $1.98 a share this year. Now they expect the company to report a loss of $7.30.
Coinbase isn’t the only shop experiencing layoffs. BlockFi plans to lay off 20% of its 850 workers, and Crypto.com plans to cut 260 employees, or 5% of its total workforce. Gemini, the exchange and custodian led by the Winklevoss twins, said it’s cutting 10% of its workers, a June 14 CoinDesk article reported.
(4) Feds on alert. Securities and Exchange Commission (SEC) Chairman Gary Gensler warned investors to be wary of the double-digit interest rates being offered by crypto lenders. “They’re operating a little bit like banks,” he said according to a June 14 Bloomberg article. “I caution the public.”
The SEC has taken some action. Coinbase Global decided against offering a lending product when the SEC threatened to sue. And BlockFi paid a $100 million fine to the SEC and state regulators without admitting or denying allegations that the firm was paying customers high interest rates to lend out their digital tokens. But in an April 4 speech, Gensler seemed ready to take additional action:
“Crypto may offer new ways for entrepreneurs to raise capital and for investors to trade, but we still need investor and market protection. We already have robust ways to protect investors trading on platforms. And we have robust ways to protect investors when entrepreneurs want to raise money from the public. We ought to apply these same protections in the crypto markets.”
Disruptive Technologies: Sharing Cars. Are Americans ready to share their cars with strangers? We’re about to find out. Companies like Turo, Getaround, and HiyaCar have become the Airbnbs of car rental. Individuals can sign up to rent out their cars, and consumers can sign up to rent a car using the apps. With inventory tight at rental car companies, this may be the summer that desperate vacationers give these services a shot.
Turo filed a prospectus for its planned IPO. The document doesn’t include pricing information, but it does layout some details on the business. Here’s a quick look at what the new-aged car rental company has to say:
(1) Better experience. Three trends are working in Turo’s favor. First, consumers have grown accustomed to the sharing economy, whether it be scooter sharing, bike sharing, or house sharing. Second, cars have grown increasingly expensive, and they sit idle 95% of the time. And finally, people don’t love the experience of renting a car from some of the established car rental companies, turned off by lines, often out-of-the-way locations, and generic inventory, Turo contends.
“[A]ccording to XM Institute’s annual net promoter score benchmark study, the car rental industry’s average customer net promoter score is 5 (out of a maximum of 100). By contrast Turo’s net promoter score for the 12 months ended December 31, 2021 and March 31, 2022 was 73 and 75 respectively,” the prospectus states.
(2) Business growing. Launched in 2010, Turo operates in more than 8,000 cities in the US, Canada, and the UK. It had more than 114,000 active hosts (who are willing to rent their cars), 1.9 million active guests (who have rented a car), and 217,000 active listings as of March 31.
The company posted $469.0 million of revenue last year, up from $149.9 million in 2020, and its loss shrunk to $40.4 million, down from $97.1 million. In the first quarter of this year, revenue jumped to $142.9 million, up from $56.2 million in Q1-2021, and the net loss shrunk to $7.0 million in Q1-2022 from the $62.0 million loss in Q1-2021. The company does offer insurance plans that can be purchased by car providers and renters.
(3) Some growing pains, too. A quick search of articles about Turo brought up some issues that may be problematic if not remedied.
A Denver resident complained about the sudden lack of parking in his neighborhood in a December 21 9NEWS article. He discovered that someone was renting out more than 30 cars through Turo and parking them on the street. It was in violation of Turo’s policy requiring that cars be parked on private property, and the company said violations could result in restricted vehicles and accounts. The host subsequently moved his vehicles.
Residents in Hawaii were also complaining that their streets “have become parking lots for rental vehicles,” a June 23, 2021 Associated Press article reported. Their complaints prompted the Tax Department to look into who was renting cars and whether they were paying the taxes and surcharges required in Hawaii.
Rental customers have also complained that they were charged for smoking in the rental vehicles when they’d never smoked in them, a June 8 Channel 2 Action News article reported. One rider said the smoking fine came after he gave the car renter a poor review.
It’s Fed Day!
June 15 (Wednesday)
Yellowstone: Timing Is Everything. “Après moi, le deluge!” means “After me, the deluge!”—with “deluge” referring to a flood of troubles. The declaration is often attributed to French King Louis XV. Of course, he was remarkably prescient: He was succeeded by Louis XVI, who was beheaded during the French Revolution.
Today, we can attribute the declaration to Fed Chair Jerome Powell, who flooded the financial system with liquidity in response to the pandemic. Both presidents Donald Trump and Joe Biden also flooded the economy with helicopter money in response to the pandemic. Now we are all paying the price for their royal excesses with a deluge of rapidly rising prices.
You can also attribute the declaration to me. One week after my wife and I visited Yellowstone National Park, all entrances to the park were temporarily closed due to what the National Park Service deemed “extremely hazardous conditions,” including heavy flooding and rockslides. There has been no inbound visitor traffic at any of the park's five entrances through at least today. Après moi, le deluge!
The Fed I: Heads Up! It’s Fed Day! Following the release of May’s CPI shocker on Friday, Melissa and I concluded that the FOMC is more likely to raise the federal funds rate by 75bps than by 50bps today. Our expectation was confirmed on Monday by a WSJ article by Nick Timiraos titled “Fed Likely to Consider 0.75-Percentage-Point Rate Rise This Week.” Nick is the Journal’s ace Fed watcher. In the past, Fed chairs have often provided the markets with a heads-up by leaking their latest views to the WSJ. The article starts as follows:
“A string of troubling inflation reports in recent days is likely to lead Federal Reserve officials to consider surprising markets with a larger-than-expected 0.75-percentage-point interest-rate increase at their meeting this week. Before officials began their premeeting quiet period on June 4, they had signaled they were prepared to raise interest rates by a half percentage point this week and again at their meeting in July. But they also had said their outlook depended on the economy evolving as they expected. Last week’s inflation report from the Labor Department showed a bigger jump in prices in May than officials had anticipated.”
In other words, don’t be surprised if the Fed hikes by 75bps today instead of 50bps. We have been forewarned. The FOMC last raised the federal funds rate by 75bps at a meeting in 1994, when the Fed was rapidly raising rates to pre-empt a potential rise in inflation. It was one of the few times when monetary policy tightening did not lead to a recession (Fig. 1 and Fig. 2).
The two-year US Treasury note yield rocketed to 3.40% on Monday (Fig. 3). The 12-month forward federal funds rate futures jumped to 3.96% on Monday as well (Fig. 4).
The Fed II: No Longer Woke for Now. In Monday’s Morning Briefing, Melissa and I wrote: “Perhaps the most important similarity between the 1970s and recent events is the lame response of the Fed to the wage-price-rent spiral. The Fed was well behind the inflation curve during most of the 1970s and is now once again. In many ways, the Fed exacerbated the current spiral. Most importantly, under Fed Chair Jerome Powell’s leadership, the Fed turned woke and prioritized ‘inclusive’ maximum employment over its stated 2.0% inflation target in its August 2020 statement on its long-run goals and strategy. Also in that statement, the Fed embraced flexible average inflation targeting, indicating that it now would tolerate inflation overshoots to compensate for prior inflation shortfalls.
“By maintaining ultra-easy monetary policies through the start of this year, the Fed succeeded in lowering the unemployment rate to a recent low of 3.6% over the past three months through May. In addition, the ratio of job openings to unemployed workers rose to a record 2.0 during March. The result has been a significant increase in wage inflation, which has spiraled into price inflation, thus eroding the purchasing power of all workers. That has been the unintended consequence of the Fed’s wokeness!”
The rebound in inflation has forced Fed officials to turn less woke and to refocus on bringing inflation down. At his post-meeting press conference today, Powell is likely to be more hawkish than usual and indicate that similarly sized hikes following the FOMC’s next two meetings, in July and September, could take the range up to 2.25%-2.50% next month and then to 3.00%-3.25% in September, in line with the predictions of both the two-year Treasury bond yield and the 12-month futures rate.
By the way, on April 21, in pre-recorded remarks at a special briefing of the Volcker Alliance and Penn Institute for Urban Research, Powell called former Fed boss Paul Volcker, who battled high inflation in the 1970s and 1980s, “the greatest economic public servant” of the era. Volcker raised interest rates to a record 20% in the 1980s in response to the nation’s double-digit inflation. Volcker had known that to save the economy, he needed to stay that controversial course and couldn’t be swayed by political opinion. No one ever accused Volker of being woke or anything like that. Powell’s Volcker Moment may have arrived.
The Fed III: Talking Heads. About a month ago, Fed Chair Powell said at a May 17 WSJ web event: “What we need to see is clear and convincing evidence that inflation pressures are abating and inflation is coming down—and if we don’t see that, then we’ll have to consider moving more aggressively. If we do see that, then we can consider moving to a slower pace.” Powell and his colleagues had hoped that supply-chain problems would abate to help lower inflation over time.
But investors’ hopes for an imminent sign of the clear inflation peak Powell is awaiting were dashed on Friday with the release of May’s CPI report. Now, the prevailing view is that global commodity supply shock associated with Russia’s war on Ukraine is expected to worsen supply-chain bottlenecks and further raise price inflation for food and energy. China’s Covid lockdowns are also exacerbating supply-chain problems.
So far this year, the FOMC has raised the target range for the federal funds rate by 75pbs. Forward guidance in the May FOMC statement said the Committee “anticipates that ongoing increases in the target range will be appropriate.” The Fed clearly needs to be more aggressive to bring US aggregate demand more in balance with available supplies.
After the May meeting, Powell suggested that at least two 50bps hikes are coming and repeated that message to the WSJ on May 17. But more aggressive hikes over the near term now are likely given the persistence of inflation with May’s CPI report. Additionally, by September the Fed anticipates about $95 billion of securities rolling off the balance sheet every month. That would reduce the Fed’s assets by about $1 trillion over the next year, which various Fed officials have suggested would have a tightening effect equivalent to two or three more rate hikes of 25bps each.
Let’s review some of the key views expressed by various Fed officials prior to the blackout period that preceded the June 14-15 FOMC meeting:
(1) Measured hikes. Before the March FOMC meeting, St. Louis FRB President James Bullard was the first to come out and say that the FOMC could raise the policy rate 50bps. Others, including San Francisco FRB President Mary Daly and Cleveland FRB President Loretta Mester, had said they would prefer not to be quite that aggressive, recounted former Fed advisor Ellen Meade during an interview with Bloomberg.
During a May 30 speech in Germany, Fed Governor Christopher Waller said he supports tightening policy by another 50bps for the next several meetings. By the end of this year, Waller wants to raise rates above “neutral” to lower demand for products and labor and bring it in line with supply. At the time, he noted that financial markets expect 50bps hikes at each of the FOMC’s next two meetings and a 2.65% federal funds rate at year-end, implying 2.5 percentage points of tightening this year. But that was prior to the release of May’s CPI numbers. Waller said that his plan is in line with markets’ expectations but is “prepared to do more” if “the data suggest that inflation is stubbornly high.”
During a June 2 CNBC appearance, Fed Governor Lael Brainard said: “We’ve still got a lot of work to do to get inflation down to our 2% target.” She said it was reasonable to expect two 50bps rate hikes at the next two meetings. Brainard emphasized that she did not see the case for pausing the rate hiking after that, but said it was too early to make that call.
The possibility of pausing hikes after two more of 50bps each this summer has been floated by a couple of Fed officials, including Atlanta Fed President Raphael Bostic and San Francisco FRB President Mary Daly. Daly said on CNBC on June 1 that she backs raising interest rates by 50bps for the next couple of meetings, followed by taking “a look around” to see “what else is going on.”
(2) Soft landing. Waller attempted to explain how the Fed might achieve a “soft landing” for the economy and subdue inflation without harming the labor market in his May 30 speech. In his view, layoffs wouldn’t increase as labor demand cools during an economic slowdown because job vacancies currently are high. He would expect to see fewer job openings, but not higher unemployment. Brainard similarly told CNBC that tightening shouldn’t harm an economy in which household and corporate balance sheets are as strong as they are now.
(3) Employment priority. At least, Fed officials are no longer delusional in their thinking that employment should be prioritized over inflation, as they had outlined in their August 2020 revised Statement on Longer-Run Goals and Monetary Policy Strategy. Fed officials supposed at that time that if they allowed inflation to rise as the labor market ran hotter, then labor market participation would continue to pick up as opportunities improved for marginalized Americans but inflation would not get out of hand.
Brainard, a chief proponent of prioritizing the employment mandate, clearly has changed her thinking in recent months. She said in an April speech: “All Americans are confronting higher prices, particularly for food and gasoline, but the burden is particularly great for households with more limited resources.” Now, she says: “getting inflation down is our most important task.” Waller agreed in his May 30 speech that “the Fed’s top priority” is “inflation” even though the labor market participation has not fully recovered from the pandemic.
(4) Not behind. In an earlier, May 6 speech in California, Waller had defended the Fed’s perceived inaction during 2021—saying that even though the Fed did not change the federal funds rate last year, it did in its September statement provide forward guidance on tapering Fed assets as a precursor to this year’s rate hikes. But during his May 30 speech in Germany, Waller acknowledged that inflation has remained “alarmingly high.” Core inflation is “not coming down enough to meet the Fed’s target anytime soon,” he said, adding “we are not meeting the FOMC’s price stability mandate.”
Inflation: More of It. Tuesday’s inflation numbers mostly showed that inflation isn’t getting worse, but it isn’t getting better either. Fed officials have rightly observed that their forward guidance has tightened credit conditions. However, they haven’t done enough yet to actually bring inflation down. Consider the following:
(1) PPI. The PPI for final demand actually edged down during May to 10.8% y/y from 10.9% during April and 11.5% during March, its most recent high (Fig. 5). The inflation rates of the PPI for final demand of goods rose to a new high of 16.6%, while services edged down to 7.6% from its recent high of 9.2% during March.
Much of the improvement in services occurred in the PPI for trade services, which measures markups of wholesalers and retailers (Fig. 6). It fell from 18.2% in March to 13.6% in May. Most disconcerting is that the inflation rate of PPI for transportation & warehouse services moved still higher to 23.9%.
The inflation rate of the PPI for personal consumption excluding food and energy is down from 8.0% in March to 6.5% in May (Fig. 7). That seems to confirm that the core PCED inflation rate may be peaking, as we’ve been expecting. However, the PPI for final demand energy and food remain very high at 45.3% y/y and 13.0% y/y (Fig. 8).
(2) Inflation expectations. On Friday, the consumer sentiment survey, conducted by the University of Michigan, found that respondents said they expect inflation to rise 5.4% over the next year, up from 5.3% a month earlier. They expect prices to advance 3.3% over the next five to 10 years, the most since 2008 and up from 3.0% in May.
May’s survey of consumers’ inflation expectations, conducted by the Federal Reserve Bank of New York, shows one-year ahead and three-year ahead readings of 6.6% and 3.9% (Fig. 9). The former is much higher than its 4.0% rate a year ago, while the latter is up from last May’s 3.6%.
(3) Small business survey. There’s no relief in sight for inflation in May’s survey of small business owners, conducted by the National Federation of Independent Business. It found that 72% of them are raising their selling prices currently, while 47% are planning to do so over the next three months (Fig. 10). The former is back up at its record high, while the latter isn’t far from November's record 54%.
On the other hand, the percentage of small business owners planning to raise worker compensation in the next three months was down to 25% from a record high of 32% during each of the final three months of 2021 (Fig. 11). This series is well correlated with the Employment Cost Index on a y/y basis. Nevertheless, during May, a record high 51% of small business owners said that they have job openings (Fig. 12).
Bull Market, R.I.P.
June 14 (Tuesday)
Strategy I: Equities in Bear Territory. Yesterday, the S&P 500’s correction turned into an outright bear market. The index peaked at a record 4796.56 on January 3. It had been down between 10%-20% since April 22 until yesterday, when it closed down 21.8% from its record high.
The correction started on expectations that the Fed would be tightening monetary policy this year in an effort to bring inflation down. There was a growing recognition that unlike the previous 72 short-lived panic attacks (which included five corrections and the lockdown selloff) that occurred during the bull market—which started on March 9, 2009 and ended on January 3, 2022—this time is different (Fig. 1). The major difference is that the Fed Put is kaput. The Fed has no choice now but to tighten monetary policy given the persistence of inflation.
Nevertheless, investors also expected that inflation might show some signs of peaking by the middle of the year, which would moderate the Fed’s tightening cycle and reduce the risk of a recession. We did too. There were a few signs of that happening in April’s CPI report, released on May 11. But hopes for a clear inflation peak were dashed on Friday with the release of May’s CPI report. As a result, investors concluded that the Fed would have to tighten more aggressively, thus increasing the odds of a recession. On Friday, the S&P 500 closed down 18.7% from its record high. On Monday, it closed down 21.8% from that peak.
Yesterday, we raised our odds of a mild recession from 40% to 45%, which is partly why we didn’t change our forecast that inflation will moderate during the second half of this year—i.e., a recession would help to moderate it.
The two-year US Treasury yield jumped 23bps on Friday to 3.06% (Fig. 2). Yesterday, it rose another 34bps to 3.40%. The 12-month-forward federal funds rate (FFR) futures jumped to 3.34% on Friday. Both have exceeded their 2018 peaks. Both tend to be year-ahead leading indicators for the FFR, which remains at only 0.88%.
It won’t remain there for long. The FOMC is widely expected tomorrow to raise the FFR range by 75bps from 0.75%-1.00% currently to 1.50%-1.75%. At his post-meeting press conference tomorrow, Fed Chair Jerome Powell is likely to be more hawkish than usual and indicate that similarly sized hikes following the FOMC’s next two meetings, in July and September, could take the range up to 2.25%-2.50% next month and then to 3.00%-3.25% in September, in line with the predictions of both the two-year Treasury bond yield and the 12-month futures rate. Powell may have no choice but to show his inner Volcker.
This week’s economic calendar is likely to bring plenty of news that could push the S&P 500 deeper into bear market territory:
(1) Inflation. May’s PPI will be out today. It was up 11.0% y/y during April (Fig. 3). Like May’s CPI, it is likely to show that rising energy costs are spreading to lots of other prices. Also coming today, the national survey of small business owners, conducted by the National Federation of Independent Business, will include data on the percentage of them raising their prices last month. The same goes for June’s business surveys conducted by the Federal Reserve Banks of New York and Philadelphia, which will be released on Wednesday and Thursday, respectively. All these business surveys are likely to confirm that inflation remains a pesky and persistent problem.
(2) Regional business activity. There are five regional surveys conducted by five of the 12 Federal Reserve district banks coming out this month for June, and the average of their composite indexes tends to closely track the yearly percent change in the S&P 500, which is now down 11.9% as of Monday’s close (Fig. 4). The average of the five regional composite indexes was -0.5% during May and is likely to be more negative in June given the S&P 500’s performance.
(3) Consumers. May’s retail sales report on Wednesday should be weak on an inflation-adjusted basis, especially if consumers are spending less on goods and more on services, as widely believed. While the report may heighten recession fears, Debbie and I believe that consumers actually might continue to keep the economy growing for a while longer. Granted, they’ve been forced to spend more on gasoline and food. These essentials accounted for 16.7% of disposable personal income (DPI) during April, the highest since early 2014 (Fig. 5). However, to deal with the rapid increases in the prices of gas and groceries, consumers have reduced personal saving as a percentage of DPI to 4.4%, the lowest since late 2008 (Fig. 6).
We estimate that consumers accumulated about $1.0 trillion of excess saving since the lockdown recession of 2020. Over the past 24 months, personal saving totaled $2.3 trillion, exceeding the pre-pandemic trend of this series by roughly $1.0 trillion. Much of that was “free” money deposited in consumers’ bank accounts by Uncle Sam. Now we are all paying the price for all that free money with rapidly rising inflation, which is eroding inflation-adjusted DPI and forcing consumers to spend less to maintain their spending.
(4) Housing and production. Mortgage applications on Wednesday will likely continue to fall. However, Thursday’s housing starts might surprise on the upside if builders are scrambling to develop more multi-family rental properties in response to soaring rents (Fig. 7). Multi-family building permits jumped 11.2% during the two months through March and were little changed in April.
On Friday, May’s industrial production should be up modestly, while the month’s Index of Leading Economic Indicators (LEI) is likely to be relatively weak. Among the weakest of the 10 components of the LEI is likely to be the S&P 500 as well as the average of the expectations components of the Consumer Sentiment Index and the Consumer Confidence Index (Fig. 8). Both will be even weaker in June’s LEI, which will be released next month.
Strategy II: Bear Markets, Recessions & Earnings. Bear markets almost always have been associated with recessions (Fig. 9 and Fig. 10). The one exception was the S&P 500’s bear market in late 1987, when the index dropped 33.5%. It didn’t last very long (only 101 days) because there was no recession (Fig. 11). The S&P 500’s forward earnings per share continued to grow back then, but its forward P/E dropped from 14.8 during August to 10.5 during December (Fig. 12 and Fig. 13).
During the current bear market, the S&P 500’s forward earnings has continued to rise in record-high territory—and so have analysts’ consensus expectations for 2022 and 2023 (Fig. 14). However, the forward P/E was much higher on January 3 of this year, at 21.5, than it was just before the 1987 bear market (Fig. 15). Now it is down to 15.7 as of Monday’s close, which is still above the 15.0 level that is widely deemed to represent fair value during economic expansions. During the recessions since 1935, both the four-quarter trailing P/E and the forward P/E have fallen well below 15.0.
In a recession scenario, there would be more downside in the current bear market as the forward P/E continues to fall along with analysts’ earnings projections. Currently, industry analysts are projecting that S&P 500 earnings per share will grow 10.7% this year and 9.5% next year to $229.35 and $251.79 (Fig. 16).
We aren’t in the recession camp, yet. We did increase our odds of a recession from 30% to 40% earlier this year, and to 45% on Monday in response the May’s CPI shocker. This revised assessment has prompted us to change our target ranges for the S&P 500’s forward P/E and price level this year:
(1) Annual earnings outlook. We continue to project S&P 500 earnings per share of $225 this year and $240 next year (Fig. 17). Our growth rates of 7.9% and 6.7% are below the analysts’ current expectations, but they are still positive ones. If we conclude that a recession is the most likely scenario, we will have to lower our estimates. If a recession occurs, we won’t be the only ones with negative earnings growth projections.
(2) Forward earnings outlook. We are still projecting that forward earnings will rise from $238.53 per share currently to $255.00 at the end of this year and $275.00 at the end of next year (Fig. 18). The former would match analysts’ consensus expectations for 2023, and the latter their expectations for 2024 (since forward earnings are the time-weighted average of analysts’ consensus forecasts for this year and next, at year-ends they match analysts’ expectations for the upcoming year). In a mild recession scenario, those numbers would probably be closer to $200 to $220.
(3) Forward P/E outlook. We are lowering our target forward P/E ranges from 15.0-17.0 to 13.0-16.0 for this year, and from 16.0-18.0 to 15.0-17.0 for next year (Fig. 19).
(4) S&P 500 outlook. Multiplying our outlook for forward earnings by those forward P/E ranges yields the following S&P 500 stock price target ranges, with the lower ones more likely to precede the higher ones in both years: 3315-4080 (down from our previous estimates of 3825-4335) for 2022 and 4125-4675 (down from 4400-4950) for 2023 (Fig. 20).
In other words, it’s possible that the S&P 500 will retest its pre-pandemic record high of 3380.16 of February 12, 2020. It’s less likely that the S&P 500 will be at a new record high in 2023, as we had been projecting, but it could get close to there by the end of next year.
That ’70s Show On Fast-Forward
June 13 (Monday)
YRI Monday Webcast. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Dr. Ed’s presentation lasts about 15 minutes with another 15 minutes for Q&A. Replays of the Monday webinars are available here. You can view a replay of Dr. Ed’s recent one-hour webcast on “Predicting Inflation” here.
Strategy I: Rising Recession Risk. Debbie and I aren’t changing our peaking-soon outlook for inflation as a result of Friday’s higher-than-expected CPI inflation rate for May. But we are slightly raising the odds of a mild recession from 40% to 45%. On balance, May’s CPI report convinced investors that the Fed remains well behind the inflation curve, which isn’t showing any significant signs of peaking yet. Nevertheless, we continue to forecast that the headline PCED inflation rate will peak around 6%-7% during H1-2022 before falling to 4%-5% during H2-2022 and 3%-4% next year (Fig. 1).
The latest CPI report also convinced investors that the FOMC will have to raise the federal funds rate more aggressively than just 50bps at the committee’s meeting on Tuesday and Wednesday. The expectations are now for a 75bps hike, which might be followed by a similarly sized hike at the FOMC’s July meeting. That makes sense to us. The two-year US Treasury note yield jumped 23bps on Friday to 3.06%, implying investor expectations that the FOMC will have to raise the federal funds rate by at least another 200bps over the next 12 months (Fig. 2).
As a result of Friday’s CPI, Fed Chair Jerome Powell undoubtedly will sound even more hawkish at his press conference on Wednesday than he has been anytime this year. On the other hand, he is likely to contend that the Fed can’t increase the supplies of food and energy to bring their prices down. In effect, he will have to concede that the one and only tool in the Fed’s toolbox for combating inflation is to raise interest rates to levels that depress demand for all goods and services even if that increases the risks of a recession.
Indeed, the yield-curve spread between the 10-year and 2-year US Treasury notes narrowed to just 9bps on Friday, suggesting that investors are increasingly concerned that the Fed will be forced to tighten more aggressively, thus increasing the risk of a recession (Fig. 3). We agree with that assessment, which is why we are slightly raising our already high odds of a recession while maintaining our inflation outlook.
It’s certainly hard to see much upside for the stock market other than trading rallies under the current circumstances. Sentiment remains very bearish, which in the past was bullish from a contrarian perspective. However, fighting the Fed when it is fighting inflation is not a good idea whether one is a contrarian or not. We still expect to see the stock market higher next year, possibly at new highs. But for now, while there are certainly plenty of attractive buying opportunities for long-term investors, there’s no rush to buy them. We have to wait for inflation to peak and for the Fed to complete its tightening cycle for a resumption of the current bull market or, alternatively, for the beginning of the next bull market in the event that the S&P 500 falls 20% below its January 3 record high. On Friday, it was 18.7% below that peak.
Strategy II: Valuation & Consumer Sentiment. By the way, also depressing the stock market on Friday was the release of June’s preliminary Consumer Sentiment Index (CSI). It fell to 50.2, the lowest in the series’ history since 1952 (Fig. 4). This index tends to be much more sensitive to inflation than is the Consumer Confidence Index, which is more sensitive to unemployment (Fig. 5).
In any event, the CSI, and especially its expectations component, is correlated with the forward P/E of the S&P 500, which dropped to 16.4 on Friday, matching recent lows (Fig. 6). The CSI is a bearish leading indicator for the economy, which is why it depressed the forward P/E on Friday.
Joe and I are still targeting a forward P/E range on the S&P 500 of 15.0-17.0 for this year. The latest CSI suggests it could go lower; but probably that would occur only if a recession unfolds.
I checked in with Joe Feshbach on his current trader’s view of the stock market. In his opinion: “Obviously, the news was bad, and anyone can see the tape was awful the last two days; but the key question is whether this is start of new serious down leg. I say no and am in the camp that views it as more of a retest of lows. Each time the market has attacked the old lows while sentiment was highly bearish, it led to a sharp short-term rally. My belief is that, with everything looking terrible, the same will happen again.” Our go-to insider-trading guru Michael Brush reports that insiders failed to show much interest in Friday’s weakness, at least insomuch as was apparent from the reporting so far.
US Economy: Dueling Decades. In the February 14 Morning Briefing, titled “Putin & Inflation Remain Persistent,” Debbie and I updated our discussion comparing the current decade to the Roaring 1920s and the Great Inflation of the 1970s. We reiterated that this two-scenario paradigm doesn’t mean that only one scenario will get the entire decade right: “The outcome may be some mix of the two scenarios, with one prevailing part of the decade and the other the rest. Nonetheless, assigning subjective probabilities is helpful for showing which of the two seems most likely to us. So, we also reiterated our subjective probabilities for the two scenarios. We assigned 65% to the Roaring 2020s and 35% to the Great Inflation 2.0. Now, to reflect our near-term concerns about the persistence of inflation, we are changing the probabilities to 60/40.”
Admittedly, developments in recent weeks suggest that we should switch the odds to 40/60. The current decade is increasingly looking like the Great Inflation 2.0. Consider the following:
(1) Commodity prices. Energy prices are soaring partly as a result of a geopolitical crisis. President Joe Biden’s policy response to the current crisis, triggered by Putin’s war on Ukraine, seems as lame as was President Jimmy Carter’s response to the energy crisis triggered by the Ayatollah Khomeini’s Iranian Revolution (Fig. 7). Another similarity between then and now is soaring food prices (Fig. 8).
(2) Wage-price-rent spiral. During the 1970s, there was a wage-price-rent spiral. Soaring food and energy prices boosted wages through cost-of-living-adjustments (COLAs) in labor union contracts. Rapidly rising wages caused other prices and rents to rise quickly as well (Fig. 9 and Fig. 10). This time, the wage-price-rent spiral seems to be spinning even faster even though COLAs no longer exist. Indeed, everything about the current Great Inflation seems to be playing out faster than That ’70s Show.
(3) Monetary policy. Perhaps the most important similarity between the 1970s and recent events is the lame response of the Fed to the wage-price-rent spiral. The Fed was well behind the inflation curve during most of the 1970s and is now once again (Fig. 11 and Fig. 12).
In many ways, the Fed exacerbated the current spiral. Most importantly, under Fed Chair Jerome Powell’s leadership, the Fed turned woke and prioritized “inclusive” maximum employment over its stated 2.0% inflation target in its August 2020 statement on its long-run goals and strategy. Also in that statement, the Fed embraced flexible average inflation targeting, indicating that it now would tolerate inflation overshoots to compensate for prior inflation shortfalls.
By maintaining ultra-easy monetary policies through the start of this year, the Fed succeeded in lowering the unemployment rate to a recent low of 3.6% over the past three months through May (Fig. 13). In addition, the ratio of job openings to unemployed workers rose to a record 2.0 during March (Fig. 14). The result has been a significant increase in wage inflation, which has spiraled into price inflation, thus eroding the purchasing power of all workers. That has been the unintended consequence of the Fed’s wokeness!
(4) Home prices and rents. Under Powell’s leadership, the Fed’s near-zero interest rate policies caused home prices to appreciate rapidly (Fig. 15). Following the lockdown recession of 2020, home prices soared as urban renters scrambled to become homeowners in the suburbs. The Fed remained focused on inclusive maximum employment, which meant that mortgage rates remained near record lows during 2020 and 2021. As a result, the median price of a single-family existing home soared 37.7% over the past 24 months through April (Fig. 16).
As the Fed’s policy focus started to pivot toward heightened inflation concerns late last year, the mortgage rate jumped from a low of 2.83% during February 9, 2021 to 5.62% currently. The combination of record home prices and rising mortgage rates clobbered housing affordability. That led to lots of upward pressure on rents.
During the 1970s, rent inflation was mostly driven by wage inflation. That’s true now as well, but this time a second big contributor has been the drop in the affordability of purchasing homes.
(5) Fiscal policy. 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 in 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, then chief-of-staff in the Obama administration).
(6) Different this time. What’s different this time is that the US dollar is strong. Most importantly, productivity growth collapsed during the 1970s. It has been trending higher since the end of 2015—when it was 0.5% at an annual rate—reaching 1.5% during Q1-2022 (Fig. 17). Labor growth was high during the 1970s (around 2.5%-3.0% annualized) as the Baby Boomers entered the labor market. This time, it is much weaker (around 0.5%) (