The market has been volatile this week! On Tuesday, there was an uproar in the market (oops, can’t use that word!) as retail sales unexpectedly increased significantly in April (+0.8%). That sparked a 2.0% gain in the S&P 500. What market commentators don’t mention is that after adjusting for price increases, the “true” figure is negative (see chart above – red line).
On Tuesday, Fed Chairman Jerome Powell said they would continue to tighten financial conditions until “we see inflation coming down,” which may not be easy and may come at the expense of higher unemployment. “You’ll still have a strong labor market,” he said, “if the unemployment rate goes up a few ticks. I’d say there are many plausible paths to a soft landing, as I said, a soft landing.” The mention of higher unemployment and the use of the word “soft” instead of “soft” suggests the Fed may not be able to control inflation without economic problems.
Markets took Powell’s words to heart on Wednesday, with the S&P retreating -4.0% and the Dow Jones Industrial Average down more than a thousand points (-1,165), apparently now starting to recognize the reality of the “R” word. The volatility continued on Thursday, with the market swinging between gains and losses, eventually closing lower, with the S&P 500 getting closer and closer to “bear market” territory (down more than 20% from its peak). Then on Friday, as the market sank deep into the red for most of the day with more volatility, it ended up closing near the flat line. The S&P 500 fell -2.3% at one point. If it closes there, the decline from the high would be -20.6%. But there was a rebound at the close, and as the chart below shows, it was still in “correction” at -18.7%.
Unable to control supply
We note here that the Fed cannot control the supply of goods/services. It affects demand only through the impact of interest rates on demand and the impact of money printing on financial markets. Our biggest concern, and we suspect other market participants share similar concerns, is that supply issues continue to push inflation higher, especially with China’s blanket lockdown of cities, and events like rising oil and food prices. Or perceived shortage (Russia).
Therefore, for the Fed to achieve its 2% inflation target, it would have to affect 80% of the non-energy or food economy. According to Wall Street economist David Rosenberg, that would require a deep recession (-3% GDP contraction) and unemployment rising to 7%. In this case, a deep “bear market” is expected.
The best case scenario is that the supply side continues to recover and there is evidence that it is recovering. For example, the latest order backlog data from the Institute for Supply Management’s (ISM) monthly manufacturing survey showed a sharp drop, suggesting supply chain easing.
Likewise, freight volumes have fallen back to “normal” levels, as indicated by the Cass Freight Volume Index. The following is from a release from Cass Index: “After a nearly two-year cycle of surging freight volumes, the freight cycle has fallen sharply.”
We note that auto production rose 3.9% in April, indicating an easing of chip shortages as assembly plants closed. In addition, the number of ships berthed at California ports recently fell to 29, the lowest level since last August. But what really caught our attention was the monthly CPI and PPI charts, where the monthly gains in April were much lower than recent gains. The right side of the chart shows that inflation was fairly benign in April compared to recent months.
We note that multi-family housing continues to grow at a blistering pace (up 22.5% year over year), which should quell rental increases over time.
It would be nice if the Fed recognized these inflationary trends and became less hawkish.
less optimistic situation
But we think that’s unlikely, at least not until a recession appears in both simultaneous and lagging indicators. But the coming recession is real. The reasons are as follows:
- Income cannot keep up with inflation.As WMT and TGT tell the market, real average weekly income is down more than -4% year over year, leading low-income households to shift spending from discretionary items to necessities
gas turbinefirst quarter results. Nominal purchases of groceries and health supplements (i.e. staples) increased, WMT said. Both companies said expected sales of non-essential items were lower. Clearly, the budgets of their shoppers (low and middle income) have suffered, and WMT lowered its full-year profit guidance. With these two reports, markets fell between 3.5% and 4.5% on Wednesday alone, as the reality of a recession (capital “R”) finally angered them. Note that both companies had their worst week since October 1987.
- Market downtrends are not new. It’s been infiltrating for months, just not recognized or believed by media pundits. We’ve already mentioned Fed Chair Powell’s change in tone on the economic outlook, but readers of this blog know that these data have been haunting us for a long time.
- The chart below shows the monthly change in real GDP. As you can see, GDP hasn’t had a first month since October, but we hear how “strong” the economy is. Keep in mind that the market ignored the -1.4% real GDP in the first quarter because the decline did not come directly from consumption. According to WMT and TGT, the market is now changing their tune. It is worth noting that for so many consecutive months without a positive GDP, there has never been a recession that followed.
- The next chart shows the University of Michigan’s consumer survey of their car purchase intentions. The homebuying intentions graph looks similar.
- Note the relationship between this survey and the recession (shown as gray shaded area). A recession usually occurs when buying intentions drop. In this case, the downtrend is at record levels.
- Rather than focus on consumer intent, the market focuses on vehicle production data as if the data were somehow prescient about future sales. In fact, production is “catching up” due to previous chip shortages. Those volumes will fall when consumers stop buying and new vehicle inventories build up.
- One of the clearest signs of consumer distress is when, as a last respite, consumers run out of credit card limits. The chart shows that revolving credit grew at an annual rate of 21% in April after rising at 14% and 10% in March and February, respectively.
- And then the rest of the world. Europe is grappling with Russian aggression, but what has caught our attention is what has happened in China since zero coronavirus city lockdowns. On the chart, 50 represents the dividing line between expansion and contraction. The situation in April was extraordinary for China, both in manufacturing and Service shrinks. Additionally, Japan reported negative real GDP in the first quarter. With the world’s largest economies at or on the verge of recession, and the dollar appreciates against those regional currencies, demand for U.S. exports is sure to decline. While Wall Street may think the widening trade deficit doesn’t matter, it doesn’t. Exports are products produced in the United States. If such sales fall, it means lower production (lower GDP), directly affecting employment and income.
The market has now recognized that a recession (capital “R”) is a big possibility (we think it is likely), and Powell has now acknowledged it (after confirmation). Employment has held steady so far. Weekly jobless claims continue to show employment resilience, and service sector workers still appear to be in short supply, especially at lower wage levels. However, that will also change as the recession unfolds. Small businesses are more sensitive to economic changes than large businesses. In data released on May 4, ADP, the largest payroll processor in the U.S., reported that payrolls in its small business division fell by -120,000 in April.
The outlook for small businesses is similarly bleak for the National Federation of Independent Business (NFIB). These are leading indicators, so we expect the unemployment rate to start rising in the third quarter.
Finally, we’re not even talking about the impact a “bear market” in the stock market might have on household spending. During this cycle, U.S. household equity holdings increased to $45 trillion from $31 trillion two years ago (12/31/21). There will definitely be an impact on family psychology and spending. Of course, most of the equity wealth resides in high-income households, but these households support cyclical spending. While the WMT and TGT have already told us what is changing in the spending patterns of low- and middle-income households, we suspect that a pullback in spending by high-income households will also be significant. Along these lines, also consider what might happen to consumer spending if (and when) house prices fall!
We doubt the Fed will continue Hawks until the employment data becomes dove When consumption splashes. We noticed that Jim Bullard, the biggest hawk of the Fed, was suddenly silent at this time. Perhaps the economists at the St. Louis Fed saw the reality of what we saw.
(Joshua Barone contributed to this blog.)