Author: Colin Twiggs

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S&P 500 rallies while consumer sentiment falls

The University of Michigan Index of Consumer Sentiment declined to 61.3 for November. Levels below 70 in the past have signaled a recession.

University of Michigan Consumer Sentiment

Consumer sentiment is in sharp contrast to robust personal consumption expenditures which at 93% of disposable personal income are well above pre-pandemic levels.

Personal Consumption Expenditure/Disposable Personal Income

Mortgage rates above 7.0% failed to dampen discretionary spending, with most households having locked in low fixed mortgage rates over the pandemic.

30-Year Mortgage Rate

Home Sales

Existing home sales declined to an annual rate of 3.8 million, with households are reluctant to give up their cheap fixed-rate mortgages.

Existing Home Sales

New home sales surged as a result, boosting residential construction.

New One-Unit Home Sales

Inflation Expectations

The University of Michigan November survey shows 1-year inflation expectations increased to 4.50%.

University of Michigan Inflation Expectations 1-Year

Five-year expectations increased to 3.2%, with the 3-month moving average of 3.0% well above the Fed’s 2.0% target.

University of Michigan Inflation Expectations 5-Year

Rising inflation expectations mean that the Fed is unlikely to cut interest rates in the foreseeable future.

Interest Rates

10-Year Treasury yields continue to test support at 4.40% after Treasury weighted new issuance towards the front-end of the yield curve — largely funded by money market funds currently invested in repo. Breach of support would offer a target of 4.0% — bearish for the Dollar.

10-Year Treasury Yield

Stocks

The S&P 500 is testing its July high of 4600. Breakout is uncertain but would not signal a bull market unless confirmed by other indices.

S&P 500

The S&P 500 Equal-Weighted Index ($IQX) has recovered less than 60% of its last decline.

S&P 500 Equal-Weighted Index

The Russell 2000 Small Caps ETF (IWM) is even weaker, retracing less than 50% of its last decline, suggesting that investors have little appetite for risk.

Russell 2000 Small Caps Index iShares ETF (IWM)

Dow Jones Transportation Average has also retraced less than 50%. The Trend Index below zero continues to warn of selling pressure.

Dow Jones Transportation Average ($DJT)

Gold and the Dollar

The Dollar Index retraced to test resistance at 104. Respect is likely and breakout below 103 would offer a target of 100.

Dollar Index

The weakening Dollar is bullish for Gold which is testing resistance at $2000 per ounce. Breakout would offer a short-term target of the previous high at $2050.

Spot Gold

Commodities

Dow Jones Industrial Metals Index ($BIM) fell sharply, warning of another test of primary support at 153. Breach would warn of a global recession, especially if mirrored by a similar breach in Copper.

Dow Jones Industrial Metals Index ($BIM)

Copper is testing its descending trendline at 8300. Reversal below primary support at 7800 would warn of a global recession. China consumes about 50% of the world’s copper production, most of it used in construction. So a lot depends on China’s efforts to rescue their ailing property sector.

Copper

The downward spiral of China’s ailing property sector shows no sign of abating despite the government’s rollout of a seemingly endless series of supportive but as yet ineffective measures, with the crisis stretching for over three years…..

The market for Chinese developers’ dollar-denominated bonds has seen a meltdown over the past two years, losing 87% of its value. The rout has wiped out $135.5 billion of value from $154.9 billion of outstanding notes, according to analysis by Debtwire. (Caixin)

Brent crude is testing resistance at $83 per barrel. Respect would warn of another downward leg to $72 and strengthen a bear market warning from Copper and base metals.

Brent Crude

Conclusion

Personal consumption expenditures remain strong despite falling consumer sentiment. The S&P 500 is testing resistance at 4600 but the advance is narrow, with investors avoiding risk in the broader market.

The Dollar weakened on the back of falling long-term Treasury yields, boosting demand for Gold which is testing resistance at $2000 per ounce. Breakout would offer a short-term target of $2050.

Copper and base metals are expected to again test primary support as doubts remain over China’s ailing property sector. Breach of support would warn of a global recession.

Inflation expectations remain persistent, with five-year expectations at 3.0% in the November University of Michigan consumer survey, well above the Fed’s target of 2.0%. The likelihood of rate cuts in early 2024 is remote unless a major collapse in financial markets forces the Fed’s hand.

Acknowledgements

Macrobusiness: China’s property black hole sucks in the CCP.

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Moody’s negative outlook and falling consumer sentiment

Ten-year Treasury yields continue to respect support at 4.50%. We expect another test of resistance at 5.0%.

10-Year Treasury Yield

Moody’s kept their AAA rating for the US government but changed their outlook from stable to negative. The reasons cited  — large deficits and a polarized ineffective Congress — are strong arguments for higher Treasury yields:

Moody's Rating

Japan has also broken above 150 yen to the Dollar, increasing pressure on the BoJ to relax their cap on long-term JGB yields. Any move to relax yield curve control would be likely to cause an outflow from US Treasuries and the Dollar, driving down prices.

USDJPY

Inflation

Inflation expectations are rising, with University of Michigan 1-year expectations jumping to 4.4% — and the 3-month moving average to 3.9%.

University of Michigan Inflation expectations 1-Year

Five-year expectations are also rising, reaching 3.2% in October, with the 3-month moving average at 3.0%.

University of Michigan Inflation expectations 5-Year

Higher inflation expectations add to upward pressure on long-term yields.

Financial Conditions

Financial conditions remain loose — despite the strong rise in long-term yields — with the spread between Baa corporate bonds and the equivalent Treasury yield at a low 1.84%.
Moody's Baa Corporate Bond Spreads

Economic Outlook

Low consumer sentiment, with the University of Michigan Index at 64, continues to warn of a recession.
University of Michigan Consumer Sentiment

Heavy truck sales — a reliable leading indicator — are falling steeply. A fall below 35,000 units would be cause for concern.

Heavy Truck Sales

Stocks

The S&P 500 ended the week stronger, with a bullish candle testing resistance at 4400.

S&P 500

Small caps continue to warn of weakness, however, with the Russell 2000 iShares ETF (IWM) likely to test primary support at 162. Trend Index peaks below zero warn of strong selling pressure. Small caps tend to outperform large caps by a wide margin in the first phase of a bull market — clearly not the case here.

Russell 2000 Small Caps iShares ETF (IWM)

Global Economy

Copper is retracing for another test of primary support at $7800 per metric ton. Breach would warn of a global recession.

Copper

Gold

Gold broke support at $1900 per ounce, indicating a test of $1900. Rising long-term interest rates are undermining investor demand for Gold.

Spot Gold

But Gold is supported by strong central bank purchases, led by China.

Central Bank Gold Purchases & Sales

Australia

The ASX 200 retreated below 7000 on Friday but a bullish close on the S&P 500 should see retracement to test resistance. Declining Trend index peaks, however, warn of rising selling pressure.

ASX 200

Conclusion

We expect upward pressure on long-term Treasury yields to continue, boosted by Moody’s negative outlook for the US, a weakening Japanese Yen and rising inflation expectations.

Declining heavy truck sales and weak consumer sentiment are bearish for the economy. The S&P 500 remains bullish but small caps are more bearish, warning that this is not a broad-based recovery.

Copper breach of $7800 per metric ton would warn of a global recession.

We remain overweight cash, money market funds, short-duration term deposits and financial securities (up to 12 months), defensive stocks, critical materials and gold.

Acknowledgements

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Long-term outlook: How does it all end?

What economic path are the US and major allies likely to take over the next decade? Here is my take on how this is likely to pan out.

First, let’s start with a template of what a healthy, growing economy looks like.

A Virtuous Cycle

Growth is dependent on two factors:

  • Demographics — that is a growing, skilled workforce; and
  • Productivity — where output grows at a faster rate than the workforce.

Growth requires not only a growing population but a growing workforce. An ageing population or large population under the age of 25 is unlikely to contribute much to output. What is needed are people of 25 to 55 who hold down productive jobs. We also need to ensure that they have the necessary skills — productivity tends to rise with education levels. Education that is skills-based is worth a lot more than a barista with a bachelors degree.

The most important source of productivity growth, however, is investment. More specifically, private investment — government investment tends to provide a short-term boost to the economy but acts as a long-term drag on growth (Dr Lacy Hunt). Mechanization and automation increase the output per worker, boosting productivity.

The chart below shows US private domestic non-residential investment (blue) at a healthy 13.5% of GDP, while productivity (magenta), calculated as real GDP/total non-farm employees, has grown steadily since the 1950s.

Private Investment/GDP & Real GDP/Total Non-farm Payroll

Savings are needed to fund private investment. Either domestic savings or offshore borrowings. Domestic savings are better than foreign debt, especially if debt is denominated in a second currency which can cause volatile short-term capital flows. Workers tend to consume what they earn, with low rates of savings, while the wealthy tend to have far higher savings rates. High levels of inequality increases the amount of saving but depresses consumption. Low consumption leads to fewer investment opportunities, so it is important to get the balance right. Forcing workers to save (e.g. through compulsory superannuation) is one solution.

Low deficits are essential to ensure that government borrowing does not crowd out private investment. Government investment — as we mentioned earlier — is no substitute for private investment as it leads to low productivity and low growth.

Monetary policy is often used to prime the pump — stimulating consumption and investment through low interest rates. But cheap debt has short-term benefits and long-term costs that are often not carefully considered. First, low interest rates discourage private savings which are the lifeblood of a healthy economy. Second, low interest rates are effected by the Fed (or central bank) growing the supply of money at a faster rate than output (GDP). But that causes inflation after a lag of one to two years, forcing the Fed to contract the supply of money and destabilize growth. Third, cheap debt and high inflation (with negative real interest rates) encourage malinvestment in speculative assets that are expected to grow in price without necessarily growing output. The net result is that productive investment is crowded out by both malinvestment (speculation) and government deficits, harming long-term growth.

There is also a fourth, far more insidious factor, that operates with much greater lags. Home prices tend to grow at a much faster rate than incomes during times of low interest rates, reducing access to homes by younger workers entering the workforce. New household formation slows and so does the birth rate, undermining long-term demographics. This can be remedied to some extent by skilled immigration but often migrants are unskilled and face both language and cultural challenges that lead to poor assimilation and a two-tier economy.

In summary, what is needed is a growing, skilled workforce with rising productivity from healthy private investment. Private investment requires stable growth — to facilitate reliable projections rather than unstable boom-bust cycles — and sufficient funding from private saving. Government deficits need to be kept low and real interest rates reasonably high (say 3%) to ensure low inflation and encourage efficient allocation of capital (to productive private investment).

In the Wilderness

We are a long way from the above ideal.

The chart below shows the decline in 10-year average real GDP growth, since 1960, and rising debt relative to nominal GDP.

Total Debt/GDP & Real GDP Growth

Growth is slowing due to poor demographics, rising government deficits, and malinvestment from negative real interest rates. Geopolitical tensions and the need to secure supply chains and sources of energy mean that government spending is likely to exceed tax revenues by a wide margin for the foreseeable future.

Ballooning government debt is likely to crowd out private investment, ensuring low future growth. The chart below shows CBO projections of debt-to-GDP for the next thirty years.

CBO Projection of Debt/GDP

The Fed will likely have no choice but to suppress long-term interest rates in order to assist government in servicing the massive interest burden on its debt. That is likely to lead to high inflation, negative real interest rates, malinvestment in speculative assets, low growth, and rising instability (Hyman Minsky).

Conclusion

We are likely to face a decade of stagflation, with low growth, high inflation and unstable financial markets.

Hopefully, inflation will boost nominal GDP relative to government debt, increasing serviceability, over time. That would provide an opportunity to reduce fiscal deficits and establish healthy monetary policy.

In the meantime, don’t fight the Fed. When interest rates are low and inflation is high, invest in real assets. Look for value — with stable income streams which can withstand tempestuous cycles — rather than speculative growth.

Acknowledgements

Professor Percy Allan, University of Technology Sydney: Looking Beyond 2024

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Dr Lacy Hunt: The impending recession

Not the best interviewer but you always get your money’s worth from Dr Lacy Hunt, former chief economist at the Dallas Fed.

The highlights:

  • Dr Hunt warns of a hard landing.
  • Recent GDP gains are led by consumer spending (+4%) but real disposable income declined (-1%). Personal saving depressed at 3.4%, compared to the GFC low of 2.4%.
  • UOM consumer sentiment is below level of previous recessions.
  • A sharp surge in the economy often occurs just before recession.
  • Dollar is too strong for global stability. It will fall as US goes into recession but then stabilize as the impact flows through to rest of the world.
  • Three signs of weakness:
    • Negative net national saving has never occurred before in a period where GDP is rising (economy is weaker than we think).
    • Bank credit is already contracting. This normally only occurs when the economy is already in recession.
    • Inflation is likewise falling before the recession.

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Debt reduction, buybacks and S&P 500 P/E multiples

There is a rising trend — especially in the telecommunications, utilities, and REITs sectors — of selling off non-core assets and using the proceeds to reduce debt. Rising long-term interest rates are likely to accelerate this trend.

Debt reduction reduces funds available for stock buybacks. This chart from S&P Dow Jones Indices shows buybacks on the S&P 500 have been declining since Q2 of last year.

S&P 500 Buybacks

Without buybacks, S&P 500 earnings growth is expected to follow declining year-on-year sales growth, removing the justification for high earnings multiples.

S&P 500 Sales Growth

Price-earnings multiple for the S&P 500 is expected to decline towards its 50-year average of 16.4.

S&P 500 Price/Highest Trailing Earnings

Conclusion

Debt reduction is likely to accelerate the decline of stock buybacks, eroding support for elevated price-earnings multiples.

Declining sales growth is likely to reduce earnings growth and further erode the justification for high earnings multiples.

The price-earnings multiple for the S&P 500 is expected to decline towards its 50-year average of 16.4 (based on highest trailing earnings).

Acknowledgements

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Stan Druckenmiller’s macro outlook

“….We need to make an adjustment fundamentally and price wise. And if you look at the market, in the non-QE world, free world, 15 times earnings was about right. We’re at 20 times earnings. I don’t know what we’re doing 20 times earnings. It’s hard for me to get excited about the long side of the overall market with the market, say, 20% above its normal valuation. When you have a federal fiscal recklessness problem, you have supply chain problems, you have the worst geopolitical situation I’ve seen in my lifetime.

’78, ’79 was bad. But I mean, for the first time, it’s a very low probability, but you gotta put the potential outcome of World War on the table. Not exactly an environment that excites me about paying 20 to 30%, above the multiple for equity prices. The next six months, who knows? And we’re certainly washed out to some extent.”

Acknowledgements

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Rising long-term rates could spoil the party

Real GDP for the September quarter reflects an annual growth rate of 2.9% for the US, well below the Atlanta Fed GDPNow estimate of 5.4%. Growth in weekly hours worked declined to 1.5% for the 12 months ended September, indicating that GDP is likely to slow further in the fourth quarter.

Real GDP & Estimated Total Weekly Hours

New Orders

Manufacturers’ new orders for durable goods, adjusted for inflation, shows signs of strengthening.

Manufacturers' New Orders: Durable Goods

Transport

Transport indicators show a long-term down-trend but truck tonnage has grown since May 2023.

Truck Tonnage

Container (intermodal) rail freight likewise grew for several months but then turned down in August..

Rail Freight

Growth in weekly payrolls of transport and warehousing employees slowed to an annual rate of 3.6% in September but remains positive.

Transport & Warehousing Weekly Payrolls

Consumer Cyclical

Light vehicle sales continue to trend higher, suggesting consumer confidence.

Light Vehicle Sales

Housing

New housing starts (purple) have been trending lower since their peak in 2022 but new permits (green) are now strengthening.

Housing Starts & Permits

New single family houses sold are trending higher.

New Home Sales

Despite a steep rise in mortgage rates. In a strange twist, higher rates have reduced the turnover of existing homes on the market, with owners reluctant to give up their low fixed rate mortgages. Low supply of existing homes has boosted sales of new homes, lifting employment in residential construction.

30-Year Mortgage Rate

The National Association of Home Builders Housing Market Index (HMI), however, reflects falling sentiment — likely to be followed by declining new home sales and housing starts.

NAHB/Wells Fargo Housing Market Index

HMI is a weighted average of three separate component indices. A monthly survey of NAHB members asks respondents to rate market conditions for the sale of new homes at the present time; sales in the next six months; and the traffic of prospective buyers. (NAHB)

Financial Markets

The ratio of bank loans and leases to GDP declined to 0.44 in the third quarter but remains elevated compared to levels prior to 2000.

Bank Loans & Leases

The cause of ballooning debt is not hard to find, with negative real interest rates for large parts of the past two decades.

Real Fed Funds Rate

Now real rates are again positive and money supply is contracting relative to GDP, the days of easy credit are at an end. A significant contraction of credit is likely unless the Fed intervenes, either by cutting rates or expanding its balance sheet to inject more liquidity into the system.

M2 Money Supply/GDP

Commercial banks continued to raise lending standards in Q3, making credit less accessible.

Bank Lending Standards

Conclusion

This is not a normal market cycle and investors need to be prepared for sudden shifts in financial markets.

The US economy is slowing but cyclical elements like light vehicle sales and new home sales are holding up well.

The rise in long-term Treasury yields, however, is likely to cause a sharp credit contraction if the Fed does not intervene by cutting rates or expanding its balance sheet (QE).

10-Year Treasury Yields

The Fed is reluctant to intervene because this would undermine their efforts to curb inflation. But they may be forced to if there is a credit event that unsettles financial markets.

Moody's Baa Corporate Bond Yield minus 10-Year Treasury Yield

Fed intervention is unlikely without a steep rise in credit spreads. But would be especially bullish for Gold.

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Westpac and CBA call a rate hike

Luci Ellis, new Chief Economist at Westpac, believes the inflation overshoot in September was enough to expect an RBA rate hike:

Last week we noted that the RBA would leave rates unchanged so long as they saw inflation coming down as they had expected. But if the data flow showed inflation declining slower than that, they would raise rates. This message was reinforced in the Governor’s first speech, on Tuesday, where she said “The Board will not hesitate to raise the cash rate further if there is a material upward revision to the outlook for inflation.” The September quarter CPI release was always going to be crucial.

Has the RBA seen enough to move? At 1.2% in the quarter, both headline and trimmed mean inflation was a little higher than the Westpac team expected (see Westpac Senior Economist Justin Smirk’s note). We assessed that it would take a significant upside surprise to induce the RBA Board to raise rates at the November meeting. A 0.1% difference might not seem like a lot, but the underlying detail was sobering.

So yes, I’ve seen enough to make my first-ever rate call to be a prediction of a hike. (Westpac)

Gareth Aird and Stephen Wu at CBA expect the RBA to raise the cash rate by 25bp (to 4.35%) on Melbourne Cup day:

The RBA has a hiking bias. And on Tuesday night, RBA Governor Bullock stated, “the Board will not hesitate to raise the cash rate further if there is a material upward revision to the outlook for inflation”.

We are not sure what constitutes a ‘material upward revision’ to the RBA’s inflation forecasts. But we consider the lift in underlying inflation over Q3 23 to be sufficiently strong for the RBA to act on their hiking bias at the upcoming Board meeting. (Commbank Research)

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Strong US retail activity unlikely to last

Real retail sales remain strong, holding above the pre-pandemic trend (dotted line) in September.

Real Retail Sales

Supported by a strong jobs market, with low unemployment.

Unemployment Rate

The labor market remains tight, with employers holding on to staff — cutting weekly hours rather than resorting to layoffs.

Average Weekly Hours Worked

The consumer sentiment trough in June 2022 coincided with a peak in gasoline prices. Sentiment has been rising over the past 12 months but this could be derailed by a spike in gas prices.

University of Michigan Consumer Sentiment & Gasoline Prices

The up-trend in light vehicle sales reflects growing consumer confidence.

Light Vehicle Sales

The NAHB homebuilder sentiment index (blue below) is falling sharply, however, warning that the recent recovery in new building permits (red) is about to reverse. Residential housing is a major cyclical employer and a collapse of building activity would warn that recession is imminent.

NAHB Sentiment Index

Industry & Transport

Industry indicators show gradually slowing activity but no alarming signs yet. CSBS Community Bank Sentiment index indicates slightly improved business conditions in Q3.

CSBS Community Banks Index - Business Sentiment

Investment in heavy trucks — a useful leading indicator — remains strong.

Heavy Truck Sales

Intermodal rail freight traffic — mainly containers — declined in August after a four-month rally. But the longer-term trend is down.

Rail Freight

Truck tonnage increased in August for the fifth month but earlier breach of the long-term up-trend (green) warns of weakness ahead.

Truck Tonnage

Manufacturers new orders for capital goods, adjusted by PPI, indicates declining activity which is likely to weigh on future growth.

Manufacturing Orders: Capital Goods

Conclusion

The tight labor market supports strong consumer spending but high mortgage rates are likely to slow homebuilding activity causing a rise in cyclical employment. A sharp increase in crude oil could also cause higher gasoline prices which would damage consumer sentiment.

Industry and transport activity is gradually weakening but has not yet caused alarm.

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually, then suddenly.”

~ Ernest Hemingway: The Sun Also Rises

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