The Labor Market Takes Center Stage For Where We Go From Here
The first two weeks of August have gotten off to a rocky start. When I look at my market monitor, I see a wave of red ink for the month with only the Energy, Healthcare, and Telecom sectors in the black. The dollar is higher by 1.24% and uranium miners (one of our long-time favorites and still the case) have bucked the trend with a positive 3.5% return so far this month. Otherwise, the S&P 500 is off -2.7% over the past two weeks, the Nasdaq Composite is down -4.9%, Russell 2000 -3.9%, the 10-year T-Bond is off -1.7%, the long-end of the Treasury bond curve (20+ year Treasury) has dropped -4.7%, Investment grade corporates -2.6%, European equities -3.4%, Emerging Market equities -5.4%, and Gold has slipped -2.6% for the month.
The Nasdaq, which has been the leader of the rally year-to-date has notched its first consecutive weekly losses for the first time this year while undercutting its 50-day moving average in the process. Energy and commodities have picked up of late on the back of tightening supplies with RBOB gasoline futures hitting their highest level in 10 months, while natural gas futures are pushing up against 5-month highs. Interest rates at the long-end of the curve have pressed up to the highs of last Fall but look to be running out of momentum. Should rates breakout to new cycle highs it should serve as a warning signal for investors to de-risk (for those that haven’t already). Such a move would likely prop up the dollar and tighten financial conditions, thereby putting downward pressure on all assets (a reminder of the nightmare that was 2022).
As for the correction underway in the equity market, the S&P 500 is threatening to take out its 50-day moving average in what is a clear sign of waning momentum. As of Friday, the percentage of S&P 500 constituents trading above their 50-day moving averages has collapsed to 53% from 90% just three weeks ago. The low volatility regime that’s played out for most of this year (the vix started out the year in the low-to-mid-20’s and has since settled into a low-teens level) has caused CTA’s and volatility targeting investment strategies to raise their equity exposure to near-max levels. This a problem as long as the low volatility regime persists, but these strategies are in a very similar position to where they were prior to selloffs in 2017, late-2018, and early-2020 – periods where the backdrop shifted slowly and then suddenly causing a swift and massive unwinding of risk-oriented positioning. That’s what these funds do without pausing to think about ‘why’ or ‘what’. They follow their programmed rules where a rise in volatility says “sell” just as a fall in volatility “says” buy. This dynamic is the equivalent of loading the spring on a mouse trap.
Given the loss of momentum, the reset in sentiment and positioning, and option dealers finding themselves in a negative gamma environment the 4,400 level on the S&P 500 has become pivotal. Lacking any meaningful catalyst, it’s likely the S&P 500 remains range bound between 4,400 – 4,600 with a lot of sideways chop chewing up traders. However, should the 4,400-level give way it’s highly likely this correction deepens to 4,200 (a nearly 9% correction from the July 27 high at 4,607) and could slip all the way down to 4,000 (13% correction). Having said that and acknowledging my negative bias at the moment, I don’t see this as anything more than run of the mill correction. Below I’ll get into some of the macro fundamentals that have me concerned over the next six to twelve months, but if I’m being objective, I see downside tail risks and upside tails risks as roughly equal. Stated more clearly, the probability of the S&P 500 trading as low as 4,000 is similar to it trading up to 5,000. That doesn’t mean that I think a move up to 5,000 would be fundamentally justified, but the market doesn’t care much about my fundamental analysis.
A major contributing factor to my balanced view at the moment (while acknowledging that I think a correction is underway) is the fact that credit markets are showing very little sign of stress. Kevin Muir posted the following charts in his Macro Tourist weekend Wrap Up piece, and rather than recreating them myself I’m just borrowing his. Here is the Investment Grade OAS chart (option adjusted spread – the extra yield that investors are demanding over treasuries to lend to investment grade corporations). It’s at its average level for the past decade.
It’s a similar picture in the high yield space with the OAS recently hitting a new low (tight). This is where you would expect to see the first signals of stress revealing themselves, but they remain calm (for now).
As with anything, if/when the facts change, I’ll change my mind, but the necessary ingredients just aren’t there yet for the bears to get excited. Sure, they have ‘some’ of the recipe, but ‘some’ doesn’t get you invited back to the bake sale because no one enjoyed your cookies. One of the more compelling arguments supporting the bears is the rich relative to history valuation multiples. The S&P 500 is up a little over 16% ytd with earnings roughly flat from 2022 through 2023, as a result the forward P/E multiple has increased to 19x from 17x at the end of 2022. According to Credit Suisse, almost 90% of this year’s total return through July came from valuation expansion and barely more than 10% has been due to improved earnings estimates. Heightening the intrigue is that the increase in multiple is occurring alongside a backdrop of rising interest rates and continued Fed tightening. Just goes to show you that the stock market does not always make sense.
As for the economy and what I’m paying attention to over the next several months/quarters: the labor market and consumer spending. Inflation is and has been yesterday’s news for several quarters now. Last week’s CPI and PPI are perfect illustrations. Both reports were in line with expectations (PPI a little hotter) and for the most part markets reacted with little more than a yawn. Interest rates rose for the week, but I think they are still working through the lingering effects of the upsized Treasury issuance of coupons over the rest of the year. Barring something unexpected, the path for inflation remains directionally lower over the next twelve months with the futures market expecting inflation prints will have a 2-handle before year-end. This will provide cover for the Fed to continue to talk tough (if they choose to), but not have to take action to back it up.
In the months ahead it will be the labor market that takes centerstage and holds the keys for the economy, Fed policy, and asset prices. It’s hard to get to recession without a material weakening in labor markets. It’s hard to get a large, sustained decline in earnings and the stock market without a recession. Looking at the ISM manufacturing index, one could conclude that the manufacturing sector is in the midst of a contraction. The services sector is slowing, but from an elevated level of activity, while investment, industrial production, and real final sales are all in various stages of deceleration. And we all know government spending is on full tilt, but until the labor market breaks, it’s hard to get negative on asset prices or the economy. As for the government spending working its way through the system the editorial board penned an informative piece in the WSJ from last Wednesday (A Peacetime Fiscal Blowout) highlighting the more than doubling of the budget deficit in the first ten months of this fiscal year compared to last year ($1.62 trillion vs. $726 billion). This is occurring with an unemployment rate at 3.5%, no less – gone is the notion that deficits are supposed to decline during periods of full employment. This also puts the Fed in a tough spot of having to overcome the stimulative impacts of fiscal policy to accomplish its fight against inflation, weaken the economy, and slowdown the labor market. All of which are being achieved at the moment, but time will be the ultimate arbitrator of how well a balance was struck.
To wit from the WSJ:
“The biggest increase in outlays so far this year has been net interest on the soaring federal debt: a rise of $146 billion to $572 billion, or 34%. That interest total is nearly double all corporate tax revenue so far this year of $319 billion. Interest on the debt this fiscal year has climbed to 15.5% of all federal revenue, and most of the 10 months through July were well before interest rates hit their current levels. Interest payments will keep soaring as Treasury is scheduled to issue $1 trillion in new debt at higher rates in the current fiscal quarter. Much more debt will be needed to finance the Biden spending binge that has only begun for the Inflation Reduction Act, the Chips Act and the infrastructure bill.”
As for the labor market, more cracks are appearing along the surface as this year progresses. The July jobs report, reported two weeks ago, saw the softest back-to-back showing in job creation since the end of 2020. This report also marked the second consecutive month where payrolls came in below estimates. But what was most striking about this jobs report was the message from the leading indicators in the internals:
The revisions in the past two months totaled -49k. Revisions are considered a pro-cyclical indicator in that they get revised higher in an accelerating/expanding growth environment and get revised lower in a decelerating/contracting growth environment. A very important detail that hasn’t received its due attention this year is that every payroll report in 2023 has been revised lower after the initial print (by a total of 245k). You know, that print that everyone trades off of and then forgets about because who actually cares about analysis these days.
The workweek contracted to the lowest level since April 2020. Jobs x Hours x Wages = Aggregate Earnings. It’s aggregate earnings that is the most important factor in the labor market. If jobs remain steady but the sum total of hours worked decline then aggregate earnings fall, which likely means spending is lower (ceteris paribus).
Temp agency employment fell -22k and is down six months in a row by a cumulative -83k. Temp hiring or the lack thereof leads the labor market.
Beyond the monthly employment report which still shows a labor market that is firm albeit while losing momentum, we are seeing jobless claims on a steady rise to 245k from sub-200k at the start of the year. To be fair, 245k is not a concerning level (north of 300k and alarm bells should be ringing), but the rising trend is something investors should be paying attention to.
A material degradation in the labor market would be the nail in the coffin for a consumer backdrop that is already feeling the pinch from the spike in inflation over the past eighteen months and the recent reacceleration in food and gasoline prices. Not to mention the resumption of student loan payments starting in October. Credit Karma recently conducted a survey where the results were eye opening.
More than 2 in 5 (45% of federal student loan borrowers expect to go delinquent on their student loan payments once forbearance ends.
Even though they have not been making student loan payments, 53% of federal student loan borrowers say they are struggling to pay other bills – i.e.) auto loan, mortgage, credit cards, etc.
More than half of federal student loan borrowers (56%) say they will need to choose between making their student loan payments or paying for necessities – i.e.) rent, bills, groceries.
Looking ahead, this week will be focused on the consumer with retail sales on deck and earnings reports from some prominent big box stores (Walmart, Home Depot, and Target). On Friday, President Biden is set to meet with the South Korean President and the Japanese Prime Minister where expectations are that the trio will focus on “friend-shoring” as well as joint military exercises (two themes we think are investable). This summit is set to become a yearly event as relations between South Korea and Japan have improved significantly relative to two years ago where they were barely on speaking terms. This alliance will help the U.S. keep tabs on North Korea and China.
As for my closing thoughts on the markets. Treasury yields and the U.S. dollar are two market prices at the top of my watch list given both are at the upper end of their ranges. Should either or both break out to the topside then I would expect a more intense episode of risk-off trading to commence. In such a sequence, I would look to be increasing equity exposure (assuming the S&P 500 moved below 4,400) around the 4,200 level and more aggressively so in the 4,100 – 4,000 range. Should yields fail to move higher from current levels, I’d see it as an indication that Treasury rates have peaked. That just may entice me to go back to being a buyer of longer duration securities on a slide in yields – particularly if it was the result of the economic data taking another leg lower. Gold would fare well in such development as well. Otherwise, I think we’re in the dog days of summer where markets chop sideways into September. Be patient, we’ve experienced large moves in equities and interest rates so far in 2023 – a period of consolidation to digest these moves would be par for the course.
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