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Market volatility in spades this week! On Tuesday, markets were all a-twitter (oops, can’t use that word!) over the large and unexpected rise in April’s retail sales (+0.8%). That sparked a +2.0% rally in the S&P 500. What market commentators neglected to mention was that, when adjusted for price increases, the “real” number was negative (see chart above – red line).
On Tuesday, Fed Chair Powell said that they would continue to tighten financial conditions until “we see inflation coming down,” and that it might not be easy and could come at the expense of a higher unemployment rate. “You’d still have a strong labor market,” he said, “if unemployment were to move up a few ticks. I would say there are a-number-of plausible paths to have a soft, as I said, softish, landing.” Note the reference to higher unemployment and the use of the word “softish” instead of “soft” indicating that the Fed might not be able to tame inflation without issues for the economy.
On Wednesday, then, markets took Powell’s words to heart and the S&P retreated -4.0% and the DJIA fell more than a thousand points (-1,165), clearly now beginning to recognize the reality of the “R” word. Volatility continued Thursday, with markets fluctuating between gains and losses, finally closing to the downside with the S&P 500 edging ever closer to “Bear Market” territory (more than 20% down from its peak). Then on Friday, more volatility with markets deep in the red most of the day, only to finish near the flat line. At one point, the S&P 500, was down -2.3%. If it had closed there, the fall from the high would have been -20.6%. But there was a rally into the close, and as the table below shows, it remained in “Correction” at -18.7%.
No Control Over Supply
We note here that the Fed has no control over the supply of goods/services. It only has influence over demand via the jolt that interest rates have on demand and the impact of money printing on the financial markets. The biggest worry that we have, and we suspect similar worries on the part of other market participants, is that supply issues continue to push inflation to higher levels, especially events like total city lockdowns in China, and rising oil and food prices due to real or perceived shortages (Russia).
As a result, in order for the Fed to achieve its 2% inflation target, it would have to impact the 80% of the economy that is not energy or food based. That, according to Wall Street Economist David Rosenberg would require a deep recession (-3% GDP contraction) and a rise in the unemployment rate to 7%. Under those conditions, expect a deep “Bear Market.”
The best-case scenario is that the supply side continues to heal and there is evidence that it is doing so. For example, recent data for order backlogs from the Institute for Supply Management’s (ISM) monthly manufacturing survey show a sharp falloff, indicating an easing in the supply chain.
Similarly, freight volumes have fallen back to “normal” levels as shown in the Cass Freight Volume Index. The following came from Cass with the release of the index: “After a nearly two-year cycle of surging freight volumes, the freight cycle has downshifted with a thud.”
We note that auto production rose +3.9% in April, indicating that the chip shortages that closed assembly plants have eased. Also, the number of ships at anchor off California ports recently fell to 29, the lowest number since last August. But what really caught our eye was the chart of the monthly CPI and PPI which, in April, showed much lower monthly increases than those of the recent past. The right-hand side of the chart shows that April’s inflation was quite tame compared to recent months.
We note that multi-family building continued at a torrid pace (+22.5% Y/Y) which should quell the rise in rents as the year progresses.
It would be nice if the Fed recognized these inflation trends and became less hawkish.
Not So Optimistic Scenarios
But we don’t think that is likely, at least not until the recession presents itself in the concurrent and lagging indicators. But the oncoming recession is real. Here’s why:
- Incomes are not keeping up with inflation. Real Average Weekly Earnings are down more than -4% Y/Y and that causes lower income families to have to divert spending from discretionary items toward necessities, as told to markets by the WMT and TGT
Q1 results. WMT said that nominal purchases of grocery and health care items (i.e., staples) rose. And both companies said that expected sales of discretionary items were lower. Clearly the budgets of their shoppers (lower and middle income) have been impacted, and WMT cut its full year profit guidance. And with those two reports, markets sank 3.5% to 4.5% on Wednesday alone, as the reality of Recession (with a capital “R”) finally rankled them. Note that the stock prices of both companies experienced their worst week since October 1987.
- The market downtrend isn’t new. It’s been percolating for several months, just either not recognized or not believed by media pundits. We already mentioned the change in tone from Fed Chair Powell regarding the economic outlook, but readers of this blog know that the data has been staring us in the face for quite some time.
- The chart below shows the monthly change in real GDP. As you can see, there hasn’t been a positive month for GDP since October, yet we have heard how “strong” the economy has been. Remember that markets ignored the -1.4% Q1 real GDP print because the decline didn’t come directly from consumption. Per WMT and TGT, markets are now changing their tune. It is noteworthy that a run of this many months without a positive GDP number has never occurred without an ensuing recession.
- The next chart shows the University of Michigan’s consumer survey of their Auto Buying Intentions. The chart for Home Buying Intentions looks similar.
- Note the relationship between this survey and recessions (shown as the gray shaded areas). When Buying Intentions tank, a recession normally occurs. In this case, the downdraft is at record levels.
- Instead of looking at consumer intentions, markets have been watching the auto production numbers as if those are in some way prescient of future sales. In fact, production is playing “catch-up” due to prior chip shortages. Those production numbers will fall when consumers stop buying and inventories of new cars swell.
- One of the surest signs of trouble ahead for consumption occurs when, as a last gasp, consumers max out their credit cards. The chart shows that in April, revolving credit rose at a 21% annual rate after rising at a 14% rate in March and a 10% rate in February.
- And then there is the rest of the world. Europe is grappling with Russia’s aggression, but what caught our eye was what has happened in China since the Zero-Covid city lockdowns. On the chart, 50 represents the demarcation line between expansion and contraction. The situation shown for April is extraordinary for China with both manufacturing and services shrinking. In addition, Japan reported a negative real GDP for Q1. With the world’s largest economies in, or on, the brink of recession, and with the value of the dollar strengthening against the currencies of these areas, the demand for U.S. exports is sure to fall. And while Wall Street might dismiss a widening trade deficit as irrelevant, it is anything but. Exports are items produced in the U.S. If such sales are falling, it means lower production (lower GDP) and that directly impacts jobs and income.
Markets have now realized that Recession (with a capital “R”) is a significant possibility (we think highly likely), and Powell has now acknowledged such (post-confirmation). So far, employment is holding up. Weekly unemployment claims continue to show employment resiliency, and there still appears to be shortages of service sector workers, especially at the lower wage levels. But, as the Recession unfolds, that, too, will change. Small businesses are more sensitive to economic changes, at the margin, than are large ones. In its May 4 data release, ADP, America’s largest payroll processor, reported -120K fewer payrolls in April for its small business segment.
And the National Federation of Independent Business’ (NFIB) small business outlook is equally gloomy. These are leading indicators, and, as a result, we expect the unemployment rate to begin to rise in Q3.
Finally, we haven’t even touched on the impact that a “Bear Market” in equities might have on household spending. In this cycle, American households’ holdings of equities have risen to $45 trillion (12/31/21) from $31 trillion just two years earlier. There is bound to be an impact on household psyche and spending. Of course, most of the equity wealth resides in higher income households, but those are the households that support cyclical spending. While WMT and TGT have already told us what is happening to the spending patterns of lower/middle income families, we suspect that the spending pull-back from higher income families will also be non-trivial. Along those lines, also consider what might happen to consumer spending if (when) home prices turn down!
We suspect that the Fed will remain hawkish until the employment data turns and will become dovish when consumption sputters. We note at this time that Jim Bullard, the Fed’s biggest hawk, has suddenly gone silent. Maybe the economists at the St. Louis Fed see the reality that we see.
(Joshua Barone contributed to this blog.)