Respect The Lags And Pay Attention To The Message From Market Internals
It was another nothing burger of a week for markets which stoically digested weaker consumer sentiment, a tick-up in inflation expectations in the University of Michigan survey, an uneventful progression in the regional bank crisis, and additional theatrics in the debt-ceiling debate. Those monitoring the economic backdrop are seeing a long string of disappointing economic data, with the Citi Surprise Index (CESI) for the U.S. sinking further into a downtrend that has been underway for the past two months (hitting its lowest level since February). To be fair the CESI is far from levels that should be of concern. From a contrarian standpoint this is a constructive development in that it resets forecasters’ expectations going forward and creates the potential for positive surprises. However, the jump in jobless claims last week was noteworthy and deserves focused attention on upcoming prints over the next couple weeks to see if it was a one off or something more sinister is unfolding in the labor market.
As for the data behind what I’m talking about, initial jobless claims shot up in the May 6th week as the array of job layoff announcements many of us have been reading about finally began to percolate in the official data. Claims rose from 242k to 264k in the sharpest increase in two months and to the highest level since October 30th, 2021. A +24k jump in a four-week span doesn’t happen all that often – although officials in Massachusetts question the validity of the significant jump in its state claims data. The four-week moving average hooked higher by 6k to 245.25k, an eighteen-month high – and the move up from the cycle low (+55k) has just about matched the average increase in the past (+62k) that marked the start of a recession.
This morning we got the first of the regional manufacturing indices with the NY Empire Manufacturing Survey laying an egg at -31.8 versus +10.8 last month. The -41-point month-over-month decline in May marked the largest sequential decline since the heart of the pandemic trapdoor which saw NY Empire Index drop -56.7 pts M/M. At the least, the first regional Fed survey of the month is signaling the continuation of trend deceleration in the industrial-mfg economy and is probably not a harbinger of asymmetric upside for the national PMI/ISM readings already mired in contraction.
As for the equity market, the S&P 500 continues to trade in a tight 100-point range with the strength in the mega-caps holding up the broader index at a time when many other parts of the equity market are exhibiting considerable weakness. Take a look below at the performance of a broad array of cyclical sectors from their respective peaks:
Automotive: -55%
Entertainment: -44%
Employment Services: -42%
Media: -40%
Banks: -39%
Containers/Packaging: -33%
Consumer Finance: -32%
Consumer Discretionary: -30%
Real Estate: -28%
Capital Markets: -26%
Transports: -20%
Electrical Equipment: -19%
Materials: -14%
Machinery: -9%
Those focused solely on the mega-cap Tech dominated S&P 500 up +7% ytd are missing the forest for the trees when claiming that at a forward P/E multiple of 18x on stocks isn’t pricing in the rising probability of a recession. The construction of the S&P 500 and its valuation multiple have become a figment of distortion and investors crowding into seven of the highest quality balance sheet companies in the index which collectively command a greater than 25% weighting. Moreover, all of them trade at a multiple higher than the S&P 500 with the majority having a multiple above 30x. Small cap stocks, which are more closely tied to economic activity, are negative on the year with the Russell 2000 just 4% above its October low. Since February 2nd it’s down more than 12% and down more than 28% from its November 2021 peak. The relative strength of the Russell 2000 versus the S&P 500 is nearing where it got to in March 2020 and in February 2008. Just as the depth and duration of the yield curve inversion have signaled an oncoming recession, so to has the most economic-sensitive areas in the equity market.
Mind the policy lags. Oxford defines the word lag as follows: a period of time between one event or phenomenon and another. They use the following example to illustrate: “there was a time lag between the commission of the crime and its reporting to the police”. It’s a similar process for the monetary and fiscal policy changes impacting the economy. However, it’s easy to forget this relationship given they can be ‘long and varied’. Making it even easier to forget are market price signals that don’t align in the moment. Here is a list of lags from various metrics I’ve jotted done while reading David Rosenberg’s recent musings and what they tell us about where we are in the cycle:
The Fed’s first interest rate hike traditionally leads recessions by fifteen months. Not to mention this Fed has also been hiking into an inverted yield curve since last July. (First rate hike was March 2022)
Speaking of the yield curve, it leads recessions on average by twelve months (inversions across various parts of the curve started as early as last May)
Real M2 Growth leads by twenty months. Real M2 growth started to fall in February 2021 and went negative in April 2022).
The index of Leading Economic Indicators leads recessions by fifteen months. The rate of change in the LEI peaked in April 2021 and slipped into negative territory in July 2022.
The ratio of the RSI between the small-cap S&P 600 and the S&P 500, historically peaks 24 months prior to the recession. It peaked in March 2021.
Put it all together and this collection of metrics put a bullseye on a recession occurring as early as this quarter and no later than Q3. Without question, nothing is guaranteed in this social science that dawns the label of economics, but succeeding in the world of investing is very much a function of correctly identifying probabilities and positioning accordingly. Not an easy task by any means, hence, why I think price action in markets has become low on conviction and high on uncertainty. Would a stock market where either the bulls or the bears have the upper hand be at a level that is unchanged over the last two years? The S&P 500 is trading at the same level today that it was in April 2021. The S&P equal-weighted index is at the same level as it was in March 2021. We’re talking two years of a lot of hot air spewed by talking heads (me included) where the major averages have done nada, zilch, zippo…except for kicking off the dividend. I can surely appreciate that you’re as tired of reading about this backdrop as I am of writing about it, but ‘it is what it is’; at least back during periods of 2021 and 2022 there was a little excitement. Over the past three months, price action in capital markets has been remarkably boring despite political theatrics, a regional banking crisis, ongoing Fed tightening, and terrible sentiment.
The best advice I can provide now is patience. I know, that sounds a lot like the boredom that’s frustrated us all over the past several months, but sometimes that’s precisely what investing is. Waiting. Warren Buffet’s right-hand man, Charlie Munger, is credited with an investment quote that I’ve come to appreciate more and more as time passes: “the big money is not in the buying and the selling, but in the waiting.” Investing is more than just trying to buy something for a dollar and selling it for two. Sure, that’s an acceptable outcome we’d all like to repeat with the investments we make, but there are a lot of variables in the mix to achieve such an outcome with time being a significant one.
The key for the next few days and frankly until it is resolved is going to be the ongoing debt ceiling deliberations between the President and congressional leaders (Janet Yellen indicated that there have been “some areas of agreement” over the weekend). The situation reminds me of the U.S./China trade talks where we got daily headlines that “trade talks are going well” from the Trump administration, who were knowingly using such verbiage to manage the equity market. I don’t get the impression that Biden is as sensitive to the level of the S&P 500, but I could be wrong.
The prevailing view among investors is that after some huffing and puffing eventually the brinksmanship will give way and yet again we’ll get another last-minute resolution. However, we all must be aware of material risk at play today from the extreme factions of each of the respective political parties. In the GOP we have a small group of renegades that have little interest in compromising their principles of fiscal discipline; so much so that it would cost Speaker McCarthy his leadership post if he doesn’t deliver some goodies to this group. Same goes for left-leaning grass roots in the Democratic party who believe they hold more power than they actually do. The fact that both these factions on each side are willing to put America’s creditworthiness at risk to validate their reason for being is a scary proposition.
Republicans are demanding a raft of spending cuts in exchange for lifting the ceiling. President Biden and the Democrats are not denying that it is important to restore some modicum of fiscal probity – just that such a debate should be happening in the context of the normal lawmaking process (that approving the debt ceiling increase should take place separately from debates over spending). There is this growing sense that the President will merely invoke the 14th Amendment, which states that the government is constitutionally bound to meet its debt obligations – the public debt “shall not be questioned”. Such a development raises the question as to how this would hold up in court. Bottomline, compromise is a must for this situation. I don’t want to go too far down this rabbit hole as no matter how I try to deliver a balanced assessment, it always invites some level of feedback arguing an inaccurate interpretation of the situation. Either way, whether we get a resolution or the worst-case scenario of a default, I don’t see it as being constructive for markets or the economy.
The easiest scenario to handicap is the default scenario in that it’s never happened before. There is no precedent for it as the U.S. has never defaulted, and it is against the Constitution. That being said, it seems to me that if we did default (and for such a foolish reason as not raising the debt ceiling) it would create havoc in markets. Interest rates, equity markets, credit markets, and the U.S. dollar would be severely impacted. It’s likely that only gold and the VIX would perform well. Everything else would see its risk premium rise.
As an aside, the reason why the Treasury announced an early date for when it hits the debt ceiling is because tax revenues have come in $250 billion short of expectations so far this year. What comes out of this mess is fiscal contraction piled onto a banking sector credit squeeze and fifteen months and counting of monetary tightening in the rearview mirror. I understand that fiscal discipline has to start somewhere, but it’s not as though the table scraps the GOP gets in this showdown are going to have much of an impact on the expanding federal debt profile. I say that because interest payments on the mountain of government debt is fast approaching $1 trillion – just think of the implications when debt-service charges begin to surpass the Pentagon’s budget, which is exactly what recently happened. Not to mention that the deficit continues to balloon and is already nearly $1 trillion through the first seven months of the fiscal year or +236% above where it was this time last year.
Why do I think that reaching a deal on the debt limit is not a positive development for markets or the economy, other than it takes the chaos of an outright default off the table? Because a deal likely comes with fiscal spending cuts attached to it. The bill recently passed by the GOP in the house would raise the debt ceiling, but it includes a plan that reduces the deficit by nearly $500 billion annually for the next decade. That is nearly a 2% hit to aggregate demand at an annual rate. This would be a meaningful hit to GDP which is already trending down to a growth rate of 1- 1.5% in Q2 and weakening. So, you see, the GOP isn’t opposed to raising the debt ceiling – they just want to do it on their terms. Not much different than the way most of us think when faced with a negotiation.
The other element of a resolution to the debt ceiling is the liquidity impacts on financial markets. It’s easy to forget, but the market has been contending with a liquidity headwind since early 2022 when the Fed started reducing the size of its balance sheet by $95 billion per month via QT. This approach aimed to systematically decrease the quantity of base money in circulation, reducing liquidity within the financial system. However, it's worth noting that a portion of this liquidity drain by the Fed has been offset by Janet Yellen drawing down the Treasury General Account (TGA). Currently, the TGA stands at $154 billion, marking a significant decrease from its May 2022 value of $964 billion. Ever since Uncle Sam hit the debt ceiling, Secretary Yellen has been operating the Federal government’s purse strings via extraordinary measures. As a result, the issuance of Treasury bonds has been limited and the reduction of the TGA balance has netted out as a liquidity injection into the economy and financial markets.
When this situation is reversed following the raising of the debt ceiling, Yellen will go back to issuing more Treasury debt to refill the TGA. Estimates peg $600 billion as the level Yellen would like to restore the TGA to (building back up the TGA withdrawals liquidity from the economy and financial system). So, for the first time in over a year the economy and markets will have to digest the full brunt of tightening from both the Treasury and Fed.
I’m going to end this week’s missive with a couple thoughts on the housing market and the state of stasis its moving into. First, let me start with some data from the St. Louis Fed that I think helps explain why housing in the U.S. feels too expensive for many households. From 1984 to 2021 median household income increased from $55,800 to $70,800 (+27%). Compare this to the median price of a home increasing an eye-popping 373% (from $78,200 to $369,800) over the same time period. The home price to income ratio changed from 140% in 1984 to 522% in 2021. You can see a visual depiction of this data in the chart below.
It goes without saying that this is a disturbing setup for new household formation and why so many who want to be homeowners are discouraged by their inability to afford a home. Even with the historically low mortgage rates available in 2020 and 2021, most households could not afford to finance the purchase of a home. Suffice it to say the doubling in mortgage rates since early 2022 has not helped matters.
The backdrop for existing homes remains challenged. Households who locked in their mortgage rates at or near the lows are now prisoners in their own homes, which explains the dearth of new listings. They now can’t move or upgrade without a significant financial penalty.
This is why mobility has been so constrained – underlined by the fact that volume spending in moving/storage/freight services has seen its YoY growth rate plunge from +14.6% a year ago to basically flat this past April. The New York Fed’s measure of household mobility – plans to move to a new home – is in a well-defined downtrend and in May was in the bottom 10% of the lowest readings in the history of this series.
This situation was captured quite well in the WSJ last week, “Quandary For Home Buyers: Nobody’s Selling”. Of course, this is what has the housing bulls believing that home prices simply have nowhere to go but up. But the problem is that with mortgage rates as elevated as they are, homeowner affordability is more than one standard deviation above historic norms. We have an affordability crisis on our hands that can only end up being resolved with rampant income growth, lower interest rates, or sharply lower home prices. Pick your poison. And if we get that income boom, I can guarantee you that this would not be met with any interest rate relief. At issue here is the throngs of existing homeowner mortgage borrowers who locked in their rates at or near the lows, so now if they decide to move, they risk that benefit and would see as much as a 300 basis point jump in their financing costs if compelled to take on a new mortgage. This is yet another distortion by the Fed’s decision to cut rates as low as it did and pledge (in mistaken fashion) that borrowing costs would remain near the floor through 2023. So, one of the distortions we have on our hands is that people have become prisoners of their own homes — and what comes with that is a far less mobile population. Not the most ideal situation.
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