Markets like gridlock

The last time the 10-year Treasury yield was above 4.20%—fall 2007—IBM had a larger market-cap than Apple. Early this week, I gave a now-rare virtual presentation to a group of financial advisors and one asked how savings would be affected by rising rates. As my theme “Revenge of the boomers’’ suggests, after years of financial repression, finally savers will be paid! And there’s more to come, with futures pricing at least another 125 basis points of hikes at November and December Fed meetings. This is driving up recession odds—a Bloomberg survey puts them at 100% over the next 12 months—and the value proposition of longer-dated bonds. They began a year-long sell-off with the 10-year at 1.51%. A lot of similarities with 2007. In the fall of that year, the yield curve was inverted (check), the economy was on the verge of recession (check), housing was cratering (check) and the Fed was coming off a 3-year tightening cycle that pushed the funds rate up by 425 basis points (check). If fed funds rise as expected the rest of this year, the increases would reach 450 points in just nine months! Volcker like. Many worry the Fed is playing with fire. Seeking to atone for last year’s policy error, when it put off tightening amid rising inflation, could it be committing another one, only this time hiking too much, too fast? Rate hikes hit with a 6-9 months’ lag, and the first and smallest (a quarter point) was just in March.

There definitely are cracks in the economy. Housing is the most obvious, though its issues aren’t oversupply and rampant speculation, as was the case in 2007, but tight inventories and priced-out buyers. With 30-year mortgage rates more than doubling to above 7%, affordability is near the zero percentile, an all-time low, and Piper Sandler doesn’t think housing will bottom until it gets at least back to the 50th percentile. It views plummeting builder confidence, which has halved in the past six months, as a critical indicator for the broad economy. The NAHB gauge almost always has led changes in PMIs, earnings and employment. The Fed’s regional outlooks grew more pessimistic amid weakening demand and customer pushback from higher prices. Some firms reported a hesitancy to hire. While September manufacturing surprised (more below), New York and Philly Fed activity contracted further in October and Conference Board leading indicators slid. Consumers nonetheless remain resilient. Card activity shows retail and food service spending up 12.3% in the latest week vs. the pre-pandemic baseline, and airline traffic and OpenTable reservations are back to pre-pandemic levels. But with real wages declining, consumers increasingly are dipping into stimulus-fed savings to support this spending. JPMorgan Chase CEO Jamie Dimon estimates they’ll run through these reserves in 6-9 months. They’re also taking on more debt, with consumer credit balances running $60 billion above pre-2020 levels. The squeeze could tighten further this winter as heating bills are expected to jump 28% above a year ago.

I finished the week in Manhattan, Kansas, home of Kansas State and the Wildcats, a top 25 football team this year. Sat next to a farmer on the plane. He worked on his father’s farm in the ’70s, “a great decade where lots of money was made and lots was borrowed.” But in the early ’80s, as Volker raised rates to break the back of inflation, the family farm was lost. This gentleman started anew and now has a farm and a homebuilding company. “Our building backlog is tremendous, the supplies are available, but the labor is not to be found. Nobody wants to work!” The U.K. hullabaloo over the gilt and unfunded stimulus made clear bond vigilantes are back after “nearly 14 years of financial repression that allowed politicians to escape the economic consequences of their actions without fear of retribution from the frontier justice of free markets,’’ Strategas Research said. The Q3 reporting season has had an OK start, largely because expectations were so beaten down going in. But the pace of declines in forward S&P 500 earnings estimates has started to accelerate. EPS is now below $240 for 2023, and a figure closer to $200 seems reasonable. The market typically doesn’t put in a bottom until downward revisions start to slow. That hasn’t happened yet, suggesting a move below the June/October 3,600 double bottom is quite possible, if not by year-end, then sometime in 2023. That said, midterm seasonal support—a force in markets over the last 70+ years—tends to kick in about now, abetted this year by renewed expectations for a midterm Red Wave (more below). Polls say voters have never been more divided. That’s fine with the markets. They like gridlock.

Positives

• Peak inflation? Median wage growth decelerated to 6.3% in September on a 3-month moving average basis, following three consecutive months at 6.7%, according to the Atlanta Fed’s Wage Growth Tracker. It marked the first deceleration since October 2021 (when the gauge edged down from 4.2% to 4.1% before reaccelerating). Also, asking rents on new leases have decelerated sharply, to an annualized growth rate of 3%, according to a Goldman Sachs analysis. But because of so many existing leases, this impact hits with a significant lag, meaning rent pressures on CPI likely will continue through spring 2023.
• September strengthening September’s increase in industrial production rose the most since April and well above consensus, led by a jump in manufacturing as auto production rebounded. Motor vehicle assembly reached 10.7 units annualized, up from 7.7 million a year ago, indicating strong momentum. The improvement in factory activity went beyond autos, cutting across several durable goods sectors.
• Mild contrarian positives Bank of American indicators are sending uber-bearish signals, as is the AAII sentiment survey. Of course, actions speak louder than words, and on both fronts, investors flows and allocations are hardly screaming capitulation as equity investors have yet to fully unwind their run-up in holdings that peaked in November 2021.

Negatives

• Housing worsens Existing home sales fell an eight straight month in September, dropping the year-over-year decline to 21.6%. Starts also decreased, with single-family activity reversing August’s bump and multi-family’s fall-off offsetting about half the prior month’s rise. Overall permits ticked up but single-family contracted, remaining in a prolonged slump. The downtrend looks to continue as mortgage purchase applications have tumbled to an 8-year low.
• Pessimism in the C-suite Conference Board CEO Confidence has fallen to lows last seen during the depths of the global financial crisis. Asked to describe anticipated economic conditions over the next 12-18 months, 98% said they were preparing for a U.S. recession and 99% said they were preparing for an EU recession.
• October softening Philly and New York area manufacturing activity contracted again in October, according to the Philly Fed and Empire surveys. Underlying components were somewhat mixed but generally pointed to continuing softness.

What’s next

This would be market friendly Late summer polling that suggested Democrats may beat the odds (U.S. voters have removed the party in power in seven of the past eight elections) by holding the Senate and paring GOP gains in the House in midterm elections are starting to reverse. Betting odds now put a 65% probability on Republicans retaking both houses of Congress.

Speaking of this crazy world we live in The world spends more than 10 billion hours using social media every single day. There are more obese children/adolescents worldwide than there are Americans. And the British pound, which has been around for 1,000 years, is now nearly more unstable (30-day volatility) than bitcoin, which has only been around for around 10 years.

Small caps if there’s a recession? That’s what Strategas suggests, noting small caps outperformed large-cap stocks in the six recessions since 1980. On a forward 12-month basis, the outperformance averaged more than 1,400 basis points from the recession’s trough (as designated by the National Bureau of Economic Research). A key reason: small cap stocks are typically more levered to fluctuations in the U.S. economic cycle’s rate-of-change than large-cap stocks.

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