Stocks: Winter is coming

GDP grew by a solid 10.64% for the 12 months ended March ’22 but that is in nominal terms.

GDP

GDP for the quarter slowed to 1.58%, while real GDP fell to -0.36%. Not only is growth slowing but inflation is taking a bigger bite.

GDP & Real GDP

The implicit price deflator climbed to 1.94% for the quarter — almost 8.0% when annualized.

GDP Implicit Price Deflator

Growth is expected to decline further as long-term interest rates rise.

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

Conventional monetary policy would be for the Fed to hike the funds rate (gray below) above CPI (red). But, with CPI at 8.56% for the 12 months to March and FFR at 0.20%, the Fed may be tempted to try unconventional methods to ease inflationary pressures.

Fed Funds Rate & CPI

That includes shrinking its $9 trillion balance sheet (QT).

During the pandemic, the Fed purchased almost $5 trillion of securities. The resulting shortage of Treasuries and mortgage-backed securities (MBS) caused long-terms yields to fall and a migration of investors to equities in search of yield.

The Fed is expected to commence QT in May at the rate of $95 billion per month — $60 billion in Treasuries and $35 billion in MBS — after a phase-in over the first three months. Long-term Treasury yields are likely to rise even faster, accompanied by a reverse flow from equities into bonds.

S&P 500 & Fed Total Assets

S&P 500 breach of support at 4200, signaling a bear market, would anticipate this.

Conclusion

Fed rate hikes combined with QT are expected to drive long-term interest rates higher and cause an outflow from equities into bonds.

A bear market (Winter) is coming.

Retail sales, missing workers and the inflation threat

The October labor report shows hours worked were roughly unchanged from September and still 100K below the pre-pandemic high (5.25m). But GDP of 19.5 trillion is up slightly when compared to 19.2T in Q3 2019, indicating that productivity has improved.

Real GDP & Hours Worked

Monthly retail sales for September, on the other hand, were way above trend.

Retail Sales

People are spending Dollars they didn’t earn, courtesy of record government stimulus.

That is one of the primary causes of rising consumer prices (red below): when demand outstrips supply.

Average Hourly Earnings & CPI

A rising CPI in turn causes second run inflation through higher wage demands (green and gray above) if central banks fail to act quickly. They become embedded and difficult to dislodge.

The combined effect of the pandemic and government stimulus has had a profound impact on the US labor market. The economy added 5.8 million jobs in the 10 months to October, at an average of 580K per month. That rate is likely to slow as the economy reopens and enhanced unemployment benefits end.

We are missing 4.2 million employees, compared to the pre-pandemic peak of 152.5m jobs, and seem unlikely to find them, judging by the 10.4 million job openings in September. High levels of job openings are likely to exert continuing upward pressure on wages.

Non-farm Payroll & Job Openings

The missing workers — aided by government handouts — have either retired, quit their jobs to day-trade Tesla and crypto-currencies, or have re-assessed their work-life priorities. No doubt there will be a trickle back to the workforce — as day-traders encounter reversion to the mean and/or savings run low — but the Fed needs to reassess its full employment target. Failure to do so would leave interest rates too low for too long and allow second run inflation to become entrenched. The only way to then dislodge it is with the kind of drastic measures that Paul Volcker used in the early eighties, with the fed funds rate peaking at 20%.

Fed Funds Rate under Paul Volcker

Labor market turmoil

Pundits are wringing their hands about the poor jobs report, with +266K of new jobs in April compared to 1M estimated. Non-farm jobs recovered to 144.3 million in April, compared to 152.5m in Feb 2020, a shortfall of 5.4%.

Non-farm Payroll

Hours worked has done slightly better, at 5.05 billion in April, compared to 5.25bn in Feb 2020, a shortfall of 3.8%.

Real GDP and Hours Worked

The rate of increase (in hours worked) slowed significantly from March 2021, but that is to be expected. It will be difficult to match the recovery rates achieved at the re-opening and we suspect that the +1m new jobs estimate for April was over-optimistic.

Increase in Hours Worked

Manufacturing

Manufacturing jobs are not fully recovered either, at 12.3m in April, a 4.0% shortfall from the 12.8m in Feb 2020. But manufacturing production in March 2021 (104.3) was only 1.7% below its Feb 2020 reading and is expected to close the gap even further in April. A sign that productivity is improving.

Manufacturing Jobs & Industrial Production

Average hourly wage rates continue to grow between 2.5% and 3.5% (YoY). A sign that employers are able to fill job openings.

Manufacturing Hourly Wage Rates

Job Openings

Outside of manufacturing, job openings are growing. A sign that wage rates are likely to follow.

Job Openings

We suspect that job openings are concentrated in low paid jobs where the pandemic and higher unemployment benefits are likely to have the most impact on participation rates.

Low Participation

Low Participation

Unemployment Benefits

Bond Market

After momentary panic, the bond market seems to have decided that the weak jobs report is a non-event and unlikely to reduce inflation or require increased Fed intervention. The 10-year Treasury yield dropped to 1.525% in the morning but recovered to 1.572% by the close.

10-Year Treasury Yields

Conclusion

The labor participation rate has been declining for 20 years and the COVID-19 pandemic may have accelerated the decline. Participation rates may never fully recover to pre-pandemic levels.

Declining Labor Participation

But as long as the difference is made up by rising productivity (output/jobs), boosted by increased automation, then the economy is expected to make a full recovery.

Manufacturing Production/Jobs

Higher unemployment benefits and a lower participation rate are likely to drive up wages for unskilled jobs, while de-coupling from China and on-shoring of critical supply chains is expected to lead to skills shortages, driving up wages for higher-paid employees. The Fed will be reluctant to increase interest rates to cool the economic recovery, allowing inflation to rise.

When the (inflation) train starts to roll, it is difficult to stop. Sharp pressure on the (interest rate) brake is then required, but would cause havoc in bond and equity markets.

S&P 500: Leaders no longer leading

Daily new cases of COVID-19 continue to spike upwards, warning of further shutdowns as medical facilities are overrun.

USA: Daily COVID-19 cases

Payrolls

The latest labor report disappointed, especially as the November survey came before the latest round of layoffs after states imposed tighter restrictions.

Payroll growth flattened, leaving total payroll down 5.99% compared to November last year.

Payrolls Annual Change

Hours worked are slightly more encouraging, down 4.68% on an annual basis, compared to -2.9% change in real GDP.

Real GDP & Hours Worked

Vaccines

Encouraging news on the vaccine front but “when you hear the cavalry is coming to your rescue, you don’t stop shooting. You redouble your efforts.” (Dr Anthony Fauci)

Now This News

Stocks

Progress in manufacturing vaccines that will soon be widely available has buoyed stocks despite the dismal economic outlook. The S&P 500 made new highs, assisted by hopes of further stimulus and ultra-low interest rates. The large megaphone pattern is a poor indicator of future direction but does flag unusual volatility.

S&P 500 SPDR (SPY)

Growth in the big five technology stocks has slowed in recent months, with only Alphabet (GOOGL) breaking above its September high. Too early to tell, but failure of market leaders to make new highs is typical of the late stages of a bull market.

AAPL, AMZN, GOOGL, MSFT, FB

Conclusion

Vaccines should succeed in flattening the third wave and suppressing future outbreaks but are unlikely to succeed in restoring the economy to normalcy.

Federal debt is at a record 123% of GDP and growing. Further stimulus is required to support the still-fragile recovery.

The Fed will continue to expand its balance sheet to support Treasury issuance.

Ultra-low interest rates are likely to stay for a number of years.

If massive federal debt, QE and ultra-low interest rates does not cause a spike in inflation, that will encourage authorities to push the envelope even further (we fear this would have disastrous consequences).

Unemployment is expected to remain high and GDP growth likely to remain low.

Zombie corporations and commercial real estate with unsustainable debt levels will continue to be a drag on economic growth.

Growth stocks are expected to remain overpriced relative to current and future earnings.

Jobs and GDP growth

The view is often promoted that low GDP growth over the past decade is caused by low interest rates and balance sheet expansion (QE) by central banks. That is putting the cart before the horse. Central banks have tried to stimulate their economies, with massive QE and low interest rates, because of low GDP growth. Not the other way around.

The real cause of low GDP growth is low job growth, as the chart below illustrates.

Real GDP and Nonfarm Payroll Growth

[click here for full screen image]

Offshoring jobs means offshoring growth.

The last time that the US had employment growth above 5.0% is 1984 which also the last time that we saw real GDP growth at 7.5%. Since then, job growth has progressively weakened — and GDP with it.

In the last decade, employment growth peaked at 2.27% and GDP at 3.98% in Q1 of 2015.

Real GDP and Nonfarm Payroll Growth

We now expect job growth to fall to -20% in April, four times the -5% trough in 2009, and a sharp GDP contraction.

How long the recession/depression will continue is uncertain. But, in the long-term, it is unlikely that the US can achieve +5% real GDP growth unless employment growth recovers close to +3.0%.

S&P 500 recovers but employment gains sluggish

Short retracement on the S&P 500 that respected support at 3000 strengthens the bull signal. Further gains are expected in the short- to medium-term.

S&P 500

Corporate profits before tax continue to decline after adjusting for inflation, exposing the vulnerability of high earnings multiples.

S&P 500

Hours worked (non-farm payroll x average weekly hours) for November also point to low annual GDP growth of around 1.5% after inflation.

Real GDP and Hours Worked

Employment growth for the 12 months to November came in at a similar 1.48%.

Employment Growth & Fed Funds Rate

Not enough to justify a P/E multiple of 23.25.

Average hourly earnings growth is increasing, especially for production & non-supervisory employees (3.65% for 12 months to November), but in the present environment the Fed seems unconcerned about inflationary pressures.

Average Hourly Earnings

Patience

Patience is required. We have had a weak S&P 500 retracement confirm the breakout but there is minimal up-turn in November employment indicators to support the bull signal. Market risk is elevated and investors should exercise caution.

“The world has a way of undermining complex plans. This is particularly true in fast moving environments. A fast moving environment can evolve more quickly than a complex plan can be adapted to it….”
~ Carl Von Clausewitz, Vom Kriege (On War) (1780-1831)

S&P 500 survives but risk is elevated

Our recession indicator, a 3-month TMO of seasonally adjusted non-farm payrolls, ticked up slightly to 0.52%. This reflects a slight improvement in monthly employment data but the indicator remains precariously close to the amber (high risk) warning level of 0.50%. The red warning level of 0.30% would signal extreme risk of recession.

Non-Farm Payrolls Recession Indicator

During the week we discussed the high cost of uncertainty and how this impacts on business investment and consumer spending. Slowing growth in hours worked suggests that real GDP growth is likely to slow towards an annual rate of 1.0%. This would obviously be a drag on stock earnings.

Real GDP and Hours Worked

The S&P 500 retreated from resistance at 3000 but a long tail on this week’s candle indicates buying support. Another test of 3000 is likely. Breach of 2800 is unlikely at present but would signal a reversal with a target of 2400.

S&P 500

21-Day Volatility remains high and the recent trough above 1.0% warns of elevated risk.

S&P 500 21-Day Volatility

The plunge on 10-Year Treasury Yields, testing support at 1.5%, also warns of a risk-off environment.

10-Year Treasury Yields

On the global stage, low manufacturing purchasing managers index (PMI)  warn that Europe is at risk of recession.  DJ Euro Stoxx 600 is retracing to test support at 360/366. Breach would signal a primary down-trend.

DJ Euro Stoxx 600

The Footsie is similarly testing support at 7000.

FTSE 100

Nymex Crude is heading for a test of support at $50/barrel. Trend Index peaks below zero warn of selling pressure. Breach of support would signal a primary down-trend — suggesting a contraction in global demand.

Nymex Light Crude

The outlook for the global economy is bearish and we have reduced our equity exposure for International Growth to 34% of portfolio value.

S&P 500 buying pressure but payrolls disappoint

August labor stats, released today, point to low real GDP growth for Q3. Growth in weekly hours worked came in at a low 1.09% and GDP is likely to follow.

Real GDP and Hours Worked

While inflation is not the primary concern at the Fed right now, rising annual hourly wage rate growth (3.46% for total private) flags an increase in underlying inflationary pressure. This may make the Fed more hesitant about cutting rates despite Donald Trump’s tweet storm.

Average Hourly Wage Rate

Most important is the continued decline in annual payroll growth. At 1.38% for August, further weakness is likely and a fall below 1.0% would warn of an economic slow-down.

Real GDP and Hours Worked

The S&P 500 is headed for another test of resistance at 3000. The Trend Index oscillating above zero for the last 9 months indicates buying pressure but I expect strong resistance at 3000. Upside is limited while downside risks are expanding.

S&P 500

Semiconductors are doing better than expected, despite the trade war, but I suspect will weaken when the surge in orders ahead of tariffs tails off.

Semiconductors

Retail has stalled since late 2018 and bearish divergence on the Trend Index suggests selling pressure.

Retail

Automobiles, in a decline since 2017, have rallied over the last 6 months. But, again, further weakness is expected.

Automobiles

On the global front, weak crude oil prices flag an anticipated slow-down in the global economy. Breach of support at $50/$51 per barrel would be a strong bear signal, warning of a decline to $40 per barrel.

Nymex Light Crude

We maintain our bearish outlook and have reduced equity exposure for international stocks to 40% of portfolio value.

S&P 500: Donald Trump and the next recession

Treasury yields continue to fall, with the 10-Year testing long-term lows at 1.50%. A sign that investors are growing increasingly risk averse.

10-Year Treasury Yields

Crude oil prices remain weak; a bearish signal for the global economy. Breach of support at $50/$51 per barrel would warn of a decline to $40.

Nymex Light Crude

Volatility (21-Day) above 1.0% on the S&P 500 is flashing an amber warning. Breakout above 2940 is likely and would signal another test of 3000. But expect stubborn resistance at our 3000 target level.

S&P 500 Volatility

Bearish divergence (13-Trend Index) on the Nasdaq 100 warns of secondary selling pressure. Breach of 7400 would warn of a test of primary support at 7000.

Nasdaq 100

Robert Shiller maintains that Donald Trump is unlikely to survive a recession:

“So far, with his flashy lifestyle, the US president has been a resounding inspiration to many consumers and investors. But his personal narrative is unlikely to survive an economic downturn….the end of confidence in Trump’s narrative is likely to be associated with a recession.

During a recession, people pull back and reassess their views. Consumers spend less, avoiding purchases that can be postponed: a new car, home renovations, and expensive vacations. Businesses spend less on new factories and equipment, and put off hiring. They don’t have to explain their ultimate reasons for doing this. Their gut feelings and emotions can be enough.”

I would go further and argue that Trump’s management style is likely to cause a recession.

Some of the aims the President is attempting, like addressing China’s unfair trade practices, are vitally important to long-term US interests and he should be given credit for tackling them. But his constant hyperbole, erratic behavior, with a constant mix of bouquets and brickbats, and on-again-off-again tactics, has elevated global uncertainty. Consumers are likely to increase savings and cut back on expenditure, while corporations may cut back on hiring and new investment, which could tip the economy into recession.

GDP growth contracted to 2.3% in the second quarter, while growth in hours worked contracted to 0.92% for the year ended July 2019, pointing to further falls in GDP growth for the third quarter.

Real GDP and Hours Worked

August employment figures are due for release next week and will either confirm or allay our fears.

We maintain our bearish outlook and have reduced equity exposure for international stocks to 40% of portfolio value.

S&P 500: Treasuries reflect flight to safety

10-Year Treasury yields plunged below 2.0% on Donald Trump’s announcement of further tariffs (10% on $300bn) on China. The fall reflects rising demand for Treasuries as a safe haven in these turbulent times.

10-Year Treasury Yield

The spread between 10-Year and 3-Month Treasuries recovered above zero. This is a bearish sign: recession normally follows the recovery and not the initial inversion.

10-Year 3-Month Treasury Spread

The S&P 500 retreated below 3000 on Trump’s announcement, strengthening the bearish divergence signal on Twiggs Money Flow which warns of a correction. A test of support at 2750 is likely.

S&P 500

The Russell 2000 ETF (IWM) is expected to test primary support at 145. Small cap stocks have lagged the S&P 500 this year, highlighting risk aversion.

Russell 2000 Small Caps Index

Dow Jones Euro Stoxx 600, reflecting large cap stocks in the European Union, is similarly headed for a test of primary support at 365. Strong bearish divergence on the Trend Index warns of a reversal.

DJ Euro Stoxx 600

Falling commodity prices reflect market concerns for the global economy. A Nymex Light Crude breach of $51/barrel would signal a primary down-trend. Declining peaks on the Trend Index warn of selling pressure.

Nymex Light Crude

The DJ-UBS Commodity Index is similarly headed for a test of support at 75. Breach would signal a primary down-trend. A peak near zero on the Trend Index warns of strong selling pressure.

DJ-UBS Commodity Index

Dr Copper, often used as a barometer of the global economy, has breached primary support at 5800, signaling a decline. Again, a Trend Index peak below zero warns of strong selling pressure.

Copper

Employment stats for July have improved slightly, with Average Hourly Wages growth easing to 3.3% (Total Private).

Average Hourly Wage

And annual payroll growth ticked up to 1.5%

Employment Growth & FFR

But weekly hours worked are declining, warning that real GDP will decline further, after printing 2.3% for the second quarter.

Real GDP & Weekly Hours Worked

I have warned my clients to cut exposure to the market. It’s a good time to be cautious.

“Price is what you pay; value is what you get.”

~ Benjamin Graham