She rocked those hats!

Off to Cincinnati this week, speaking before a large group of advisors, with just 30 minutes to deliver lots of “You can’t make this up” national and global challenges and outlook. Only one thing to do—talk quickly! And my host agreed afterward that I shall have more of the clock the next time. Great questions, but most memorable: “OK, so what are we to root for to get to an investible bottom? Inflation or recession worries?” Answer: “Root for a 40 VIX.” Inflation of late has clearly decelerated—consensus expects a second straight monthly decline in next week’s August CPI. Gasoline prices have fallen 88 straight days, oil is 37% off its peak and pipeline price pressures are easing. The percentage of ISM respondents reporting “lower prices paid” in August surveys was higher than their long-term averages. Getting from 9% to 5% headline inflation isn’t the issue. It’s getting from 5% to the Fed’s 2% target. Prices for natural gas, which accounts for nearly 40% of U.S. electricity and is Europe’s dominant heating source, have doubled in the U.S. and soared even more in Europe. With winter just months away, the war continuing and with it, the European Union (EU) energy embargo, energy prices seem certain to reaccelerate. There’s also no way around sticky wages and rents. Q2 trend unit labor costs exploded 9.3% year-over-year (y/y) and given the extremely tight labor market, are unlikely to slow dramatically next year. Housing prices lead rents (which account for roughly a third of CPI) and are up an astounding 18.7% y/y. My view is the market underestimates the persistence of higher-than-acceptable inflation. It also expects the Fed to stop at 4%. I wonder. Fedspeak has been resolute. They aren’t stopping until inflation risk has evaporated. Sounds like “higher for longer.’’ Markets aren’t priced for that. The clock’s ticking.

Positives

Q3 earnings season could be the next catalyst. Forward earnings topped out in late June and Q2 reporting season saw the Street start shaving estimates for this year and next. Since mid-June, bottom-up estimates for Q3 and next year are down 5.5% and 3.7%. One reason they haven’t fallen further: earnings tend to hold up best when inflation is elevated. Yardeni Group expects forward earnings of the three S&P stock composites—S&P 500, MidCap 400 and SmallCap 600—to move sideways for the rest of this year before resuming their climb. Fundstrat isn’t so sure. Its research suggests earnings expectations remain too high and may bleed lower through 2023’s first half unless the pace and magnitude of revisions accelerate. At 21% above normalized trend levels, earnings are likely to slow dramatically or even turn negative outside Energy, Deutsche Bank says. Along with lower multiples and recession risk, this makes a sustained rally difficult. With a “dovish Fed pivot” gone, cuts in earnings projections will matter and, from a relative perspective, should be better for Value stocks, which are once again cheaper than Growth. For a durable stock market bottom, Evercore ISI thinks both the dollar and 10-year Treasury yields must top. Both are still in uptrends but possibly nearing inflections, with the dollar-to-yen more overbought than it ever has been and the 10-year yield near resistance where stocks bottomed in June.

Citigroup sees rising risks of a “stagflationary episode” one of two ways: a sustained period of high inflation and weak (or negative) growth, similar to the late 1970s and early 1980s, or the possibility of “transitionary stagflation’’ in which slowing global growth runs ahead of the retreat in inflation for a quarter or two. The actions of central banks will be determinative. Will they be late to stop? Another question asked in Cincinnati. My response: “It takes about a year for rate changes to be felt in the economy, so the Fed is always guessing.” Will the Fed go too far? Who knows, but they always have …. Clearly if you think a soft landing is likely, then history would suggest maybe the June lows were the bottom. Even though September tends to be the worst month for stocks, some technicals are favoring them, with bullish sentiment tumbling to lows seen in early 2016. Yardeni sees more of a sideways market, with big up moves followed by big down moves, going nowhere in the end until there’s more clarity on inflation, recession, earnings. Meanwhile, the world lost Queen Elizabeth II this week. One of my female idols as a child and then young professional entering a mostly male-dominated business (lots of progress since then!). Lamenting no “Queen” of England on the horizon, long live the King. As for markets, we’ve got cash. Cash is Queen!

• Another ISM surprise Just like ISM manufacturing last week, the ISM services gauge for August came in well above forecasts with its best reading in four months as business activity and new orders accelerated. Employment also perked up while price increases moderated at their slowest pace since January 2021. The report contrasted sharply with S&P Global’s final take on August, which found service activity contracted at its fastest pace since May 2020 despite rising business confidence and easing prices. Regional surveys also were weaker than the services ISM.
• King dollar The year-to-date 14.5% jump represents the strongest move for the dollar since 1988, surpassing the 1997 run-up that eventually led to the Asian currency crisis. Some of the move relates to actions taken by the Bank of Japan and the European Central Bank to suppress interest-rate volatility, causing their currencies to function as pressure relief valves. Historically, a rising dollar has favored domestic equities relative to international and emerging market equities, though it threatens profits of U.S. multinationals, where overseas receipts represent roughly 40% of S&P sales.
• Trade a bright spot July’s trade deficit narrowed to a 9-month low as exports rose to an all-time high while imports fell. Wall Street analysts believe the shrinking trade gap could boost Q3 GDP by as much as 1.5 percentage points.

Negatives

• Housing is getting worse Mortgage purchase applications plunged to their lowest level since the pandemic outbreak as tight supplies, high prices and a doubling in the 30-year mortgage rate to 6% kept potential buyers at bay.
• A bad house in a worse neighborhood That’s how my colleague Martin Schulz describes the U.S relative to the rest of the world as Europe appears to be creeping into recession; China is struggling with debt, overbuilding and the effects of its strict Covid lockdown policies; and other emerging markets are being hurt by the muscular dollar (more below). According to JP Morgan surveys, the U.S. was the major source of global strength in the past month while the global composite PMI posted its first contractionary reading since 2020, primarily due to services.
• At the mercy of meteorologists Even with vastly increased storage and a planned 20% demand reduction for natural gas vs. last year, eurozone storage could be virtually depleted before the end of heating season, Deutsche Bank estimates. If gas flows from Russia stay at zero, it’s likely some compulsory rationing will be needed to get through the season. Winter’s weather is probably the biggest swing factor, putting Europe and global financial markets at the mercy of meteorologists.

What else

Another reason wage increases may be sticky At 71%, U.S. approval of labor unions is at its highest point since 1965, an Aug. 30 Gallup annual report on unions shows. Up from 68% last year, this aligns with Google trends, which show searches for “join a union” on the rise.

On watch for the next black swan event While the relationship between money supply and inflation has been less stable in recent decades, even critics of the monetarist linkage between money growth and prices agree last year’s nearly 30% y/y growth in M2 contributed to inflation’s surge. Now, M2 is undergoing unprecedented deceleration and, with the Fed this month doubling quantitative tightening by allowing $95 billion of Treasury and mortgage debt to roll off its balance sheet monthly, is on track to turn negative for the first time since the 1930s. How should markets quantify this in their inflation outlooks?

On watch for the next black swan event Slowing global growth, China struggles and European energy austerity are commonly cited reasons. But the Institutional Strategist notes that Equinor, a Norwegian firm, is estimating margin calls of at least $1.5 trillion were floating around. It thinks it’s possible the EU or Asia were buying futures to secure supplies and price, only to see energy trade back to January levels, sticking some energy trading firms with long positions they are now having to liquidate.

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