Not to be a grinch
Many reasons for a rally but don't expect it to last.
A Pennsylvania week, with talks outside Pittsburgh and in Hershey. For a blue state, the comments were quite conservative. At an annual meeting with a large group of bankers (still bankers’ season), heads nodded as I suggested a defensive positioning for the new year. There’s a big mess to clean up! The piper will have to be paid for unprecedented fiscal and monetary stimulus. Excitement over the past two weeks’ inflation prints brought some respite for weary bulls. Last Thursday’s big CPI surprise unleashed massive short covering. Fundstrat estimates the most-shorted names gained 18% over four days through Tuesday as the bottom quintile of year-to-date performers outperformed the top quintile by 1,700 basis points. It’s not just short covering. The market has some wind at its back. Favorable seasonality, contrarian sentiment (the put/call ratio recently hit its highest level on record), loosening financial conditions (on a weakening dollar, contracting yields and rising market), “meh” Q3 earnings and guidance, typical behavior into and following midterm elections, and now, divided government. All of this helped equity inflows accelerate in the past week at their fastest pace in eight months. Many are drawing parallels to the market’s behavior after the 2020 election and vaccine efficacy news.
Not to be a grinch, but those up-trends didn’t last. Two big worries hang over this rally, which has yet to break through resistance at the 200-day moving average (around 4,070 on the S&P 500 at this writing). Stubborn inflation that keeps the Fed higher for longer and the potential for a hard landing, i.e., a deeper and longer-than-expected recession. The market hasn’t priced either. While recent inflation prints reflect a downtrend (more below), wages and rents look to remain elevated even as they come off the boil heading into the new year. For headline inflation to collapse from last July’s 9.1% to around 3% by late next year, even as real interest rates remain negative or zero and unemployment stays near record lows, would be unprecedented in economic history. (Don’t care for those odds.) This has Gavekal Research thinking high inflation will remain a dominant threat to economic stability and financial assets for years. Fed officials this week suggested they are aware of this threat as they talked down market expectations for an early pause or end to rate hikes. So far, longer-term inflation expectations, while creeping up, show little sign of breaking out. Still, past Fed tightening cycles, particularly the few as aggressive and rapid as this one, coupled with similarly aggressive global central banks, suggest a financial shock/crisis is almost certain to occur somewhere. And it’s probably not just FTX/crypto.
Private markets are one place to watch. Their assets have grown at a 12% compound rate over the last decade, well ahead of the 5% growth rate for bank assets and 7% for non-bank financial assets. Much of this asset class is illiquid, often levered, has opaque disclosure and interconnectedness, and lacks good data which makes it hard to regulate. Deutsche Bank notes this mix has caused trouble for markets before. With Eli Manning seeing “great deal flow in private equity” and Taylor Swift ticket prices soaring in the secondary market, if one can get them, it seems clear that the Fed has more work to do! As M2 growth continues to collapse, GDP growth is certain to follow—the most reliable recession indicator, the 3-month/10-year Treasury curve, inverted 50 basis points this week—undercutting corporate revenues and ultimately profits. The analyst community is starting to lower forward earnings estimates, but 2023 consensus EPS is still far above our $200 forecast. That suggests a lot more pain ahead. The grinch probably won’t ruin the holidays. But soon thereafter, Q4 earnings will start to pour in. Leuthold Group notes that, only five weeks ago, the NYSE Composite and Russell 2000 briefly traded below their respective 2018 highs—no progress in more than four years! If the S&P were to sink to valuations that accompanied the “priciest” bear-market low in history, it, too, would flirt with levels first printed in 2018. Call me a grinch if you like. But please not a Karen.
- Shopping is therapeutic Despite sour consumer moods, rising interest rates and elevated inflation, October retail sales surged a broad-based 1.3%, the most since February, and real consumer spending accelerated from a 3.6% annual pace in August to 3.8% in September and 8% in October. The surprise lifted the Atlanta Fed’s tracking of Q4 PCE growth to a very robust 4.8% (and with consumers accounting for nearly 70% of the economy, its Q4 GDPNow tracker rose to 4.2%), dampening hopes for a lower terminal Fed rate.
- Peak inflation Like CPI, October PPI also surprised, unchanged at the core level and rising a muted 0.2% at the headline level, half consensus expectations and off a downwardly revised September. At a respective 5.4% and 8%, year-over-year (y/y) rates for both are now their lowest since the summer of 2021. Import and export prices also moderated, as did prices paid in the Philly Fed survey (more below).
- Peak rent It takes about a year for market rents to show up in CPI, where they have an outsized impact (roughly 40% of the core number). Rental market aggregator RealPage says October rents slowed to 7.6% y/y, about half their year-ago pace, and Evercore ISI’s proprietary survey indicates they’ve fallen further this month to 7% y/y. If they continue to decelerate at this rate, rent increases could run at just 1% y/y by next spring. The Fed would love that.
- Peak growth? Evercore ISI’s proprietary survey of retailers suggests October may have been the zenith as retail sales plunged 11% the first two weeks of this month. Accelerating layoffs, plummeting container freight rates, housing’s deepening recession (more below), softening manufacturing (more below) and a deepening decline in Conference Board leading indicators also point to weakness as the holidays approach. According to the Philly Fed’s survey of forecasters, the probability of a decline in real GDP in Q4 is 36.3%, the highest since the pandemic.
- Manufacturing downshifts The Philly Fed gauge cratered this month to its lowest level since May 2020, while New York’s companion Empire gauge flipped back to expansion but saw a key forward-looking indicator, orders minus inventories, plummet. An oft-cited global indicator, Japanese machine orders, also contracted. Meanwhile, October manufacturing eked out a fourth straight gain but industrial production overall declined as warmer-than-usual weather cut into utility output.
- Housing’s recession October existing home sales tumbled to 2011 lows, and housing starts fell more than expected. The weakness was centered in single-family homes as multi-family starts are holding at a high level—essentially unchanged for the last three months—and permits, which declined slightly but off an upwardly revised September, remain where they’ve been all year. Builder sentiment fell an 11th straight month to April 2020 lows.
Make politics boring again In competitive seats, candidates whose ideology and temperament fit inside the 40-yard lines on either side of the field did well, Cowen notes. GOP governors massively outperformed MAGA Senate candidates and won reelection in New Hampshire, Ohio and Georgia, as did a wave of Democratic governors (Pennsylvania, Wisconsin, Arizona) and secretary of states. When Democrats went with more high-profile progressives (a U.S. Senate seat in Wisconsin and House seat in Oregon), they lost.
Feast or famine The National Association of Realtors says in the U.S., there are more than 1.6 million Realtors. That surpasses the prior peak of 1.35 million at the height of the housing bubble in 2006, which subsequently shrank by 26% over the next six, bottoming in 2012 along with the Case-Shiller national home-price index, which just began to moderate this past spring.
The piper will be paid In the back half of the 20th century, when the global population was booming (1964 was the peak) and sovereign debt levels were low, governments banked on continuing growth to pay for real-time promises. But over time, it was only possible to keep the promises by breaking the Bretton Woods gold-based system (1971) and moving to deficit financing. With population growth in the developed world now grinding to a halt, young and future citizens are being stuck with the bill.