Markets See Imminent Recession – Fed Sees ‘Soft’ Landing
Market volatility in spades this week! On Tuesday, the markets were all on Twitter (oops, I can’t use that word!) in the face of April’s large and unexpected rise in retail sales (+0.8%). This sparked a +2.0% rally in the S&P 500. What market commentators neglected to mention was that, when adjusted for price increases, the “true” number was negative. (see graph above – red line).
On Tuesday, Fed Chairman Powell said they would continue to tighten financial conditions until “we see inflation come down,” and that might not be easy and could come at the expense of the economy. a higher unemployment rate. “You would still have a strong labor market,” he said, “if unemployment were to rise a few ticks. I would say there are a number of plausible pathways to having a soft landing, like I said, soft. Note the reference to higher unemployment and the use of the word “softish” instead of “soft” indicating that the Fed may not be able to bring inflation under control without problems for the economy.
On Wednesday, then, markets took Powell’s words to heart and the S&P fell -4.0% and the DJIA fell more than a thousand points (-1,165), clearly beginning to recognize the reality of the word ” R”. Volatility continued on Thursday, with markets fluctuating between gains and losses, eventually closing lower with the S&P 500 moving ever closer to “bear market” territory (more than 20% below its peak). . Then Friday more volatility with markets deep in the red most of the day, ending near the flat line. At one point, the S&P 500 was down -2.3%. Had it closed there, the drop from the top would have been -20.6%. But there was a rally at the close, and as the chart below shows, it remained in “Correction” at -18.7%.
No control over supply
Note here that the Fed has no control over the supply of goods/services. It only influences demand through the shock of interest rates on demand and the impact of money printing on the financial markets. The biggest worry we have, and we suspect similar worries from other market participants, is that supply issues continue to push inflation higher, especially events such as the total lockdown of cities in China and rising oil and food prices due to real or perceived shortages (Russia).
Therefore, for the Fed to hit its 2% inflation target, it would need to impact the 80% of the economy that is not energy or food based. This, according to Wall Street economist David Rosenberg, would require a deep recession (-3% contraction in GDP) and a rise in the unemployment rate to 7%. Under these conditions, expect a deep “bear market”.
In the best case, the supply continues to recover and there is evidence that it does. For example, recent order book data from the Institute for Supply Management’s (ISM) monthly manufacturing survey shows a sharp decline, indicating a loosening supply chain.
Likewise, freight volumes have returned to “normal” levels, as shown by the Cass Freight Volume Index. The following came from Cass with the index release: “After a nearly two-year cycle of increasing freight volumes, the freight cycle has fallen back with a thud.”
We note that car production increased by +3.9% in April, indicating that the shortages of chips which closed assembly plants have eased. Additionally, the number of vessels at anchor off California ports recently fell to 29, the lowest number since last August. But what really grabbed our attention was the monthly CPI and PPI chart, which in April showed much lower monthly increases than in the recent past. The right side of the chart shows that April inflation was quite subdued compared to recent months.
We note that the construction of collective housing continued at a frantic pace (+22.5% over one year) which should calm the rise in rents over the year.
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’s likely, at least not before the recession shows up in the simultaneous and lagging indicators. But the impending recession is real. Here’s why:
- Income does not keep up with inflation. Real average weekly incomes are down more than -4% year-on-year, forcing low-income families to shift spending away from discretionary items towards basic necessities, as markets were told by WMT and the TGT.
Results Q1. WMT said nominal purchases of groceries and health care (i.e. basic commodities) items increased. And both companies said expected sales of discretionary items were lower. Clearly, the budgets of their clients (low and middle income) have been affected and WMT has reduced its full year profit forecast. And with those two reports, markets fell 3.5% to 4.5% on Wednesday alone, as the reality of the recession (with a capital ‘R’) finally rocked them. Note that the share prices of the two companies had their worst week since October 1987.
- The downtrend in the market is not new. It has been percolating for several months, simply unrecognized or unbelieved by media experts. We’ve already mentioned Fed Chairman Powell’s change in tone regarding the economic outlook, but readers of this blog know that the data has been staring us in the face for 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’ve heard how “strong” the economy is. Keep in mind that markets ignored the first quarter real GDP print of -1.4% as the decline did not come directly from consumption. According to WMT and TGT, the markets are now changing tone. It should be noted that a string of so many months without a positive GDP figure never happened without an ensuing recession.
- The following chart shows the University of Michigan consumer survey of auto purchase intentions. The graph for home purchase intentions is similar.
- Note the relationship between this survey and recessions (indicated by the shaded areas). When you buy an intention tank, a recession normally occurs. In this case, the downdraft is at record highs.
- Instead of examining consumer intentions, markets have been watching auto production numbers as if they were somehow prescient of future sales. In fact, production is “catching up” due to earlier chip shortages. Those production numbers will drop as consumers stop buying and new car inventories rise.
- One of the surest signs of trouble ahead for consumption occurs when, at the last gasp, consumers max out their credit cards. The graph shows that in April, revolving credit increased at an annual rate of 21% after increasing at a rate of 14% in March and at a rate of 10% in February.
- And then there is the rest of the world. Europe is grappling with aggression from Russia, but what caught our attention is what has happened in China since the Zero-Covid city lockdowns. On the chart, 50 represents the dividing line between expansion and contraction. The situation shown for April is extraordinary for China with both manufacturing and declining service. Additionally, Japan reported negative real GDP for the first quarter. As the world’s largest economies teeter or edge into recession and the value of the dollar strengthens against the currencies of those regions, demand for US exports is sure to fall. And while Wall Street might dismiss a growing trade deficit as irrelevant, it is anything but. Exports are items produced in the United States. If these sales decrease, it means lower production (lower GDP) and this has a direct impact on jobs and incomes.
Markets have now realized that recession (with a capital ‘R’) is a significant possibility (we think it’s very likely), and Powell has now acknowledged that (post-confirmation). For now, employment is holding steady. Weekly jobless claims continue to show employment resilience, and there still appear to be shortages of service-sector workers, particularly at lower wage levels. But, as the recession unfolds, that too will change. Small companies are more sensitive to economic changes, at the margin, than large ones. In its May 4 data release, ADP, the largest US payroll processor, announced -120,000 fewer payrolls in April for its small business segment.
And the outlook for the National Federation of Independent Businesses (NFIB) small businesses is equally bleak. These are leading indicators and therefore we expect the unemployment rate to start rising in the third quarter.
Finally, we haven’t even touched on the impact that a “bear market” in equities could have on household spending. In this cycle, US household equity holdings rose to $45 trillion (12/31/21), from $31 trillion two years earlier. There will inevitably be an impact on the psyche and household spending. Of course, most equity wealth resides in high-income households, but it is these households that are driving cyclical spending. While WMT and TGT have already told us what is happening to the spending habits of low/middle income families, we suspect that the pullback in spending by high income families will also be significant. Along those lines, also think about what might happen to consumer spending if (when) house prices drop!
We think the Fed will stay falcon until the employment data changes and becomes dovish when consumption spits. We note at this point that Jim Bullard, the Fed’s biggest hawk, suddenly went silent. Maybe the St. Louis Fed economists see the reality we see.
(Joshua Barone contributed to this blog.)