Overstand, not understand

What’s that supposed to mean? Lots of philosophical thoughts in my travels this week. First stop, Wheeling, W.Va., for a large CPA annual event that was abbreviated for two years by Covid. Small talk before my turn at the podium included a warning that the previous speaker made a Trump joke that was not well received. Noted. Lots of discussion around efforts to get people back into the office five days a week—one global financial institution is offering a free lunch to office show-ups through year-end. The retirement of 3 million baby boomers, continuing Covid fears and the growing comfort associated with WFH are behind the current worker supply shock. The baby boom generation that had a huge effect on the economy for more than four decades, pushing the share of the labor force 55 years of age or older from 13% in 2000 to 24% in 2020, pulled out in droves during the pandemic and isn’t coming back. It’s been great for many. In the last three months, wage growth for those who changed jobs was almost 8%. Gains for those at the bottom-half of the income distribution topped 7%. Both represent 25-year highs. But this structural underpinning suggests the path back to 2% inflation will be anything but smooth. A recession may be the only thing that can bring the labor market—and wage costs—back into balance. History tells us markets rarely trough until recessions do. My colleague bemoaned that tickets to a Steelers game used to entice clients to come out. Now, “I’d rather shoot myself than go to a Steelers game,” said one advisor. Hey! Kenny will be huge one day!

Let’s think positive! Stocks started a historically bullish seasonal stretch with major averages double bottoming atop structural support, yields and the dollar reversing extreme 1-way moves, AAII sentiment near record lows and policy uncertainty higher than most any time since 1987. All bullish. Good things tend to happen when off-sides positioning turns into fear of missing out as end-of-year performance marks loom. The weeks leading up to and following midterm elections also often are bullish. A GOP sweep (more below) could add another catalyst. Leuthold Group finds that, since 1987, when sentiment and policy uncertainty start improving together, the S&P 500 has risen at a 33% annualized pace. At this writing, the market has broken through resistance at 3,850 (the 50-day moving average), with the 200-day moving average lurking at 4,115. Net selling has accelerated but has yet to reach net year-to-date buying, a sign of full capitulation. (Tell that to Meta and Amazon shareholders….) The best opportunity may be in Treasuries, where the technical position has seldom been so favorable, with valuations back in neutral territory for the first time since 2018. Earnings remain a big concern. While consensus Q3 EPS has rolled over to a $216 annual run rate, forward expectations have yet to move much and are pricing little to no event risk. Hard to see this holding amid growing signs of a slowdown (more below).

Much depends on inflation—and the Fed. Inflation expectations remain anchored. Signs this week on whether price pressures are easing were mixed (more below). Futures are pricing a softening in the Fed’s hawkish stance (more below). But wholesale gasoline futures are running at August highs, a sign retail prices may soon follow. Gas prices are critical to inflation expectations. Moreover, in the past few weeks, high yield spreads have compressed, the dollar came off its high and the S&P has rallied—all signs of loosening financial conditions. Not something the Fed wants (though GDP growth curiously improved over the summer as financial conditions tightened). There is very limited evidence to date that the Fed has “broken” the labor market, the primary conduit for achieving its inflation goals. Ironically, the drop in home prices (more below) is coming as people are shunning homeownership, pushing them into renting and pushing up rental costs. This should keep “sticky” rents elevated. As former New York Fed President Dudley continues to note publicly, to the chagrin of former colleagues, median inflation continues to move up on a year-over-year (y/y) basis, suggesting the Fed may be forced to take interest rates higher than futures suggest. Not a message the market is pricing. To finish the week, I took a 3-hour Uber ride to Hershey for another annual speaking event. My Jamaican driver shared his philosophy and positivity. “I try not to say negative things. Not to even think negative things. You can do better than just understand. See the big picture, and overstand!” Now that’s philosophical! And the cherry in the positive talk—for the second week in a row, I was asked to deliver my cryptocurrency presentation. Cryptos are in winter, but spring will come!

Positives

• Have money, will spend Q3 consumer spending slowed on particularly weak outlays for goods. Still, services expenditures held up, September consumer spending surprised, matching an upwardly revised August, final October Michigan sentiment rose and total retail and food service spending increased 12% each of the last four weeks, according to Bureau of Economic Analysis. Moreover, disposable personal income growth accelerated to 6% in Q3, and real disposable personal income was up vs. Q2’s decline.
• It's a start The Q3 GDP price deflator rose 4.1%, less than half Q2’s 9.1%, Q3 employment costs moderated and September’s increase in y/y core PCE was a tick below consensus. Also, FHFA and Case-Shiller price declines deepened (the biggest on record for the latter). Evercore ISI proprietary surveys show rent increases have nearly halved since March. Futures are now pricing a 50 basis-point hike in December (vs. next week’s baked-in 75-point jump), with quarter-point increases in Q1 2023 capping the cycle. The first cut is seen coming as soon as July.
• Recession averted … The initial estimate of Q3 GDP surprised to the upside with 2.6% real and 6.7% nominal growth. A surge in capex (particularly R&D) and shrinking trade deficit drove the improvement. Other measures (more below) suggested underlying softness.

Negatives

• … for now S&P Global (formerly Markit) PMIs for manufacturing and services fell into contraction territory in October, and Amazon warned of a significant slowing in holiday spending. Also, the final take on Q3 GDP appears headed for downward revision as September’s goods trade deficit widened, ending a 5-month string of improvement, and retail and wholesale inventories grew less than consensus.
• Housing in recession New home sales fell again in September and have plunged 27% year-to-date. Pending sales also fell more than expected and are down 31% y/y. This week, purchase applications hit a 7-year low as the 30-year mortgage rate topped a 21-year high 7%. Housing’s struggles drove Q3’s 4.9% annualized drop in private fixed investment, the biggest detractor to real GDP during the quarter.
• Peak tight labor market? Labor market components notably softened in October’s Conference Board consumer confidence report, with the jobs hard/easy to get differential worsening the most in one month since December 2020 to its highest level since April 2021. Overall confidence hit a 3-month low, also hurt by concerns about future incomes, another sign wage pressures may be easing. Average hourly earnings have trended down since March’s cycle peak, and 4-week average claims have risen four straight weeks.

What else

Markets would love this If the GOP pulls a midterm sweep, as polls increasingly suggest, Piper Sandler sees: 1) tax increases on corporations and others off the table, 2) defense spending going up, 3) increases in energy infrastructure permitting and other modest pro-fossil fuel legislation and 4) lower odds of legislation regulating tech companies. If it’s a big enough wave to make a 2024 Democratic sweep unlikely, Medicare for All and carbon-cap initiatives could be dead for the foreseeable future.

This is what a “flush” looks like That’s how Strategas Research describes the plunge in Chinese and Hong Kong equity markets, which it says is as bad as it’s seen anywhere in a long time. Notably, the yuan per dollar has busted through long-held trading parameters set by China as investors wrestle with the implications of an unprecedented third term for President Xi, who is viewed as focused more on shoring up his hold on the country than on stimulating the economy.

Progressing toward recession The y/y growth rate of quarterly EPS fell significantly into negative territory in Q2, which historically has not often occurred outside of a recession. Also, S&P operating profit margins peaked in Q4 2021, which has been a reliable leading indicator of a recession by approximately four-to-five quarters on average.

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