Savings rate still declining - forces GDP back to old trend line

Personal savings have fallen below the post Great Financial Crisis average and is currently at 4.4%. The Pandemic and fiscal stimulus kept and put a lot of money in pockets. The pandemic stopped spending and fiscal policy added to household budgets. The first savings spike was the pandemic shock, and the second spike was the fiscal policy shock. The spending downtrend has been reversed and balance sheets have been improved. Revolving consumer credit declined and is only now reaching 2020 levels.

This is not like 2005-2008 when there was a combination of low savings and poor balance sheets, yet a savings decline means there is less funds available for discretionary spending. The equity market decline cuts into household wealth. Together these two effects will translate into a consumer spending slowdown. Even if this is does not lead to a recession, GDP will fall to the old pre-pandemic trend line. 

 

The Fed has been tightening financial conditions (Chicago Fed ANFCI index)

Financial conditions are tied to the stock market. As stress increases, stocks should decline. Looking at the Chicago Fed Adjusted Financial Conditions Index ANFCI and the SPX over one month shows a strong relationship. This is. due to the construction of the index which includes market prices for many fixed income instruments. This index provides a strong indication as to the impact of Fed policy on financial stress. Clearly, raising rates will tighten conditions. Another way of viewing financial conditions is through a swirligram — a combination of level and changes for a variable. Positive (negative) ANFCI indicator, the vertical axis, will represent tight (loose) conditions. The horizontal axis represents the change in ANFCI. A negative (positive) number will mean deteriorating (improving) conditions. 

Since the beginning of the year, we have seen a steady deterioration of conditions and a movement from loose to tight. There has been an ebb and flow with this decline in conditions with changes in market reaction to Fed statements and policy, but the pull to tightening as been consistent all year.

The highest weights for the ANFCI index which includes over 100 indicators. Th complete list of indicators ANFCI index can found here.

 

Inventory to sales data suggest further retail adjustments - A business cycle indicator to watch

 

Analysts are often looking for that right macro signal to be first with calling a market change. Inventory builds is a good signal that production will have to be adjusted and prices will have to fall to clear market excesses. We are seeing an increase in inventory to sales ratios over the last year especially for retailers. We already got a splash of cold water from retail stocks last week which was after these numbers were presented by the Census Bureau. Manufacturing inventory to sales yearly changes have been flatter but still trending higher. However, if we look at the inventory to sales ratio from the pre-pandemic level, retail is lower and manufacturing is higher. This suggests a bullwhip effect for retail and production mistakes for manufacturing.

Given the greater focus on services, inventory adjustment business cycles have not been as important as financial crises as key recession drivers over the last few recessions, but that does not mean that inventories should not be watched closely. A continued trend through the summer will be a clear indication of a slowdown and will have the further impact of slowing price increases especially for durable goods.  

Stagflation thinking peaking at highest levels since 2008

Markets are often driven by narrative, themes, and memes and right now the mist discussed theme is stagflation. Slower growth expectations are causing a revision of earnings. Slower growth thinking over inflation fears is driving the Treasury rally. Higher inflation is causing a repricing of equities and has caused the horrible year to date performance in bonds. 

Following the top narrative may not be the best forward-looking approach, but it is a variation on following the trend or being a part of the herd. Acting on the herd mentality will usually get you ahead of the pack that may be talking about themes but not forming decisions. As long as the current stagflation theme is in place, equity and bond trends will continue.

The inflation - equity valuation trade-off is not attractive

 

Valuation is closely tied to inflation, but it is not a linear relationship. High valuation is associated with lower inflation levels. There are two key reasons for this link: an earnings effect and a discount rate effect. Lower expected inflation is associated with lower yields or discount rates which will boost earnings. Lower inflation is associated with an improvement in real earnings growth. Additionally, lower inflation is also associated with lower price volatility so there is more certainty about potential revenue, investment decisions, and pricing decisions. 

The inflation valuation trade-off exists even though the classic discount rate model suggests that inflation is neutral. Given the current location on the curve, equities are overvalued and will have to come down even if inflation moves higher or marginally lower. Repricing of inflation expectations leads to repricing of equity values.

 

One of the better non-investment investment books - Think Again by Adam Grant

 

Some of the better investment books have nothing to do directly with investing. The book Think Again: The Power of Knowing What you Don't Know by Grant Adams is a perfect example. The focus is on how to keep an open mind and accept alternative points of view. We have to unlearn what is wrong and learn how to accept alternative views and ideas. If all we do is reinforce or original thinking, we are not really thinking. The book focuses on the idea that we have to think like scientists filled with skepticism and constantly focused  on the evidence to disprove our beliefs. If you are not questioning long held assumptions, you really are not effectively thinking. Our experience and expertise are helpful but they should not dampen our questioning mind.  

Thinkers or arguers can be classified as preachers (no proof required), politicians (no training required), prosecutors (too much training required), or scientists (experiments required). Smart people can fail because they do not question; they only assert or look for confirmation to their logic. There is nothing wrong with being wrong, if you learn from the experience what is right.

Most investing is learning to accept being wrong, not holding a single point of view, and working to discover what is not known. It is forcing yourself to be the ultimate scientist. Grant presents this open learning in an accessible way that engages readers.                                    

Inflation measures and company margins; follow the CPI-PPI difference

 

A quick way to assess the direction of company margins is to compare CPI against PPI rates. The CPI represents output prices while the PPI reflects input prices. When the CPI - PPI is positive margins should be increasing while if CPI-PPI is negative input prices are rising faster and margins should be falling. Currently, there is a strong negative bias which suggests that margins should be compressed or falling. 

This difference also tells us something about sector differences. Mining, materials, and energy companies should be doing better than the market when the CPI-PPI difference is negative. While the relationship against the market overall is weak, the relationship strengthens when there are large deviations or extremes. The cross-sectional relationships are stronger.

The Conference Board LEI index forecasts slower growth

 

The Conference Board Leading Economic Indicators index is currently falling and indicating that real GDP should slow. The index has peaked since the pandemic recession. The index may not be calling for a recession at this time, but there are clear indications that the US economy will likely move to the 2% range. 

 

The ten components of the index for the U.S. include: Average weekly hours in manufacturing; Average weekly initial claims for unemployment insurance; Manufacturers’ new orders for consumer goods and materials; ISM Index of New Orders; Manufacturers’ new orders for non-defense capital goods excluding aircraft orders; Building permits for new private housing units; S&P 500 Index of Stock Prices; Leading Credit Index; Interest rate spread (10-year Treasury bonds less federal funds rate); Average consumer expectations for business conditions.

Credit spreads and the equity decline - corporate risk abounds

Equity is the residual value of the firm and will be sensitive to changes in cash flow. As equities go, so should corporate spreads especially for highly levered (high yield) firms. The sell-off in equities this year is closely correlated with the increases in high yield spreads. The same concerns about margin, leverage, and earnings hit both equity and corporate bondholders.

Looking backwards at default rates will not help investors. It looks like defaults were all put on hold as the economy improved, low rates still dominated, and equities remained strong, but the world has now changed. Defaults during the mini-recession are likely under a stagflation environment, so spread repricing should be expected.

 

An office market debacle is still ahead of us

Look at current office (availability) vacancies data in major cities. Those number are high and have gotten higher in the last year. The economy is back from lockdown, but that does not mean that workers are going back to the office. Workers do not want to go back, and corporations cannot make them in the current labor market. Hence, the need for office space will be declining as firms rationalize their square footage. 

Economic growth will take us out of this problem and in this market, it is hard to have any pricing power if you are a landlord. Prime real estate may do better on a relative basis, but for buildings that are not class A space, it is going to be a ghost town. 

The chart below shows default rates. By this measure, the market looks good, but there is a delay between increases in availability and the repricing of rents. This is all occurring in a rising interest rate environment. Inflation may increase the value of buildings but that is only under the assumptions that it is occupied and rates rising with inflation. Office CMBS will be a dangerous credit market.

 

What is the optimal inflation target - Not what you may think

Would it surprise you to find out that there is no agreement that a 2% inflation target is the right number? In fact, a careful review of all the academic papers on monetary policy and inflation target suggest that the best number is zero. There is no magic with a 2% target. There is limited rationale for that number so there should not be any magic goal to get back to 2%. There still is a relentless fall in purchasing power even at the 2% number.  See Fed economist, Anthony Diercks, "The Reader's Guide to Optimal Monetary Policy", also see his interactive app on optimal monetary policy research. 

I just found this research and it is very provocative given it is a summation of all work on this topic. We have picked an inflation target that may not match research. Does this help us today? No, but we should place less stock in what the Fed may tell us as optimal. 

Philadelphia survey shows significant change in forecasts

The forecasts for 2022 have all shifted lower even with the median in the same range of 2.5-3.9%. This is a significant move over the last quarter. The 2023 forecasts also show a shift lower with a greater 10% of recession, a more than doubling from the last survey. 

The projections for inflation over the next 10 years is well above 2.5% and the highest since the late 1990's. Core PCE for 2023 has shifted higher with only a 20% chance that inflation will be lower than the target.  

Higher inflation and lower growth forecasts are the consensus relative to what the Fed is forecasting. The Fed forecasts have lost creditability.  

 

Living with a 60/40 portfolio - Ouch!

 

Some facts about the combination of 60% SPY and 40% AGG. No protection from the classic diversification portfolio.

Through April 2022, the -11.5% return is the worst year ever recorded from a start date of 1977. This is 730 bp below the next worse year, 1977. It looks like the 60/40 portfolio is down 13% through the market close today.

There has never been a down SPY with the AGG also being negative. This year both are stocks and bonds are down double digits. There is no diversification benefit. The return to risk ratio is more negative for bonds than stocks in 2022.

This the first time the SPY and AGG are both in double digit drawdowns at the same time.

April was the worst month for the NASDAQ composite in 20 years; Investors have to go back to the tech bubble burst in 2021.

On a year to date basis, SPY is down the most since 1939. 

Inflation is at the highest level (CPI YOY) since 1981 which has been a significant drag on bonds.

Other assets have reflected bubble behavior. Median home prices to household income is at the highest level ever recorded at 6.5. It was at 4.8 just two years ago. The average new home price is approximately $524,000, up 26% in one year. Home prices are up 114% by the Case-Shiller index since the low in 2012.

Learning and the unfolding of disaster events on market prices

We are faced with an uncertain environment where we don't know whether this is just a bear market that will be corrected, or whether we are headed for a real economic disaster and major market selloff. Some will argue we are already there.

There can be a good story for each, but since these scenarios having changing probabilities the pricing of these disasters only unfolds over time. We often do not know whether we are facing a Great Depression or a Great Recession. Mild or severe, a future disaster is not clear given that the market faces imperfect information. Ex post, the signs may seem obvious, but not ex ante when information is unclear and strong beliefs are hard to form.

The result is that equity prices will only gradually react to consumption declines as investors learn, uncertainty is resolved, and imperfect information is clarified. See "Learning, Slowly Unfolding Disasters, and Asset Prices". I will not go through all the specifics of the model but point out the key point that when there is imperfect information and learning about a large potential disaster, the price asset price paths will often be slow to discount these big moves. 

In this type of environment, the world is not efficient in the traditional sense but subject to trends as risk is repriced through time. The slow revealing of information and learning means that deep out of the money downside put protection may not serve investors well because the gradual adjustment does not allow the full put value to be realized. It also means that the VIX, and variance risk premia will only slowly adjust to a pending disaster. Consumption will be affected differently if market prices slowly adjust, a slow grind of a negative wealth effect.

The dynamic of this model fit well with the current environment. I am not suggesting a disaster, but a soft or hard landing, overshooting of policy, or a changing inflation environment is only being revealed slowly and prices are reacting in a similar fashion.

Fed "Behind the Curve" Template - A measure of what the Fed needs to do

 

A simple Fed "behind the curve" template can provide context for a discussion on what the Fed needs to do to get back to a neutral policy that is consistent with long-term inflation and growth objectives. We look at the MPS (monetary policy stance), the Taylor rule using the inputs form St Louis Fed president Bullard, and the inflation rate above target. We also include the shape of the yield curve on the front-end and the expectations embedded in the Fed funds futures. 

The MPS is equal to the real Fed fund rate minus r-star which we estimate given other studies as being approximately .5. The MPS is minus 5% when in a normal environment it should be above zero. Clearly, the Fed stance is not hawkish or restrictive on inflation. 

The Taylor Rule is modified to account for a very conservative estimate based work from the St Louis Fed. Again the result suggest that rates should be a lot higher. If we assume that the 2-year rate gives a forward estimate of what the market expects, there still is a further Fed increases necessary albeit the gap is less than what would be given using current Fed funds. 

The inflation numbers are all above the target level and actually moving away from 2%. 

The estimates for the Fed funds futures for December suggest that the Fed has to raise rates 175 bps to just be consistent with market expectations. This is also consistent with the difference between current and 1-year forward eurodollar futures and the spread between 2-year Treasuries and current EFFR. 

So when asked, "Is the Fed behind the curve?", you can place some context and numbers with that statement. 

Corporate bond issuance and trading impacted by Fed policy and inflation

The market focus has been on credit and fixed income (Treasuries), but credit should not be forgotten. The Fed rate increases will impact issuance, spreads, and trading is this large market sector. 

Corporate bond issuance has slowed especially for high yield. The market is less friendly on an absolute and spread basis.

Investors are rebalancing their corporate bond exposures as measured by trading volume. Large increases in trading occurred around the March pandemic surge and during the first quarter of 2021 when expectations for improved growth hit the market.

Spreads are widening and cost of capital is increasing with more rate increases coming. Corporate treasurers are cautious about raising new funds until the inflation and rate environment stabilizes. Higher bond volatility as proxy for uncertainty leads to financing delays.  

 

Removing the punchbowl moment with QT - Impact not as strong as inflation expectations

 

The Fed QT plan is measured and cautious; however, the last QT program only occurred well after the beginning of the Fed rate hikes. Now, we are having the beginning of the rate hikes and QT occurring within 3 months of each other. The plan is an initial roll-off of Treasuries and mortgages with a ramp-up in September when the cap for reductions will be $90 billion. 

Past evidence suggests higher volatility in bond markets like what we are seeing now, but that was associated with poorer forward guidance from the Fed, and we have more inflation risk. Currently, the announcement of the QT plan has been linked with the equity and bond selloffs, yet correlation is not causality when there really is no sample of past action. 

The decline in the Fed balance sheet through 2023 will only take levels back to the summer of 2020 and will not reverse any of the initial pandemic stimulus, so there should be limited reason to expect a strong bond sell-off from the decline. Additionally, given fiscal policy has slowed, the demands for the Treasury to raise funds will not be as strong as in 2020-21. Finally, the bond sell-off has started to make current US Treasury yields attractive to investors. The question is always what the incremental pressure on yields will be. Can the bond market take a reduction? At this point, there are other more pressing risks for bonds. 

Where are consumers spending? It matters for markets

Where are consumers spending money? It matters given the overall market weakness. We should expect greater dispersion in equities because the there is greater dispersion in expenditures. There has been greater spending on gasoline because of the oil price shock and this has been reflected in integrated oil companies. The big switch is from buying things to doing things - goods to service switch.

Consumers are traveling which reflects the switch from goods to services.

                    

The switch is reflected in the relatively better performance of staples over durable equity indices and the strong performance of energy. However, spending comes at a cost, a decline in savings. During the pandemic the combination of restrictions and fiscal policy lead to spike in savings; nevertheless, we are now at the lowest savings in a decade. Inflation forces spending to move forward, but a decline in wealth will cause savings to increase with a reduction in spending.

Relating spending to equity choices requires both absolute and relative analysis.

                                        

Can we measure whether the Fed is "behind the curve"

The Fed is behind the curve with respect to fighting inflation.  I believe it and so do many others, but can some number be put to this belief. Of course, we can look at the difference between some inflation measure and Fed funds. Whether CPI, PCE, core, or trimmed, inflation is high versus short rates and real rates are at extreme negative values, yet we can be more precise about being behind the curve. 

St Louis Fed president Bullard has done a good presentation last month on this issue that is short, clear, and easy to read. It was updated and presented at the Hoover Institute this week, see "Is the Fed behind the curve? Two Interpretations". It takes a conservative approach and shows that by using a simple Taylor Rule, the Fed is behind and has a lot of wood to chop. 

If you account for the market moves out the curve as a response to forward guidance, the Fed is still behind the curve. The gap has closed slightly since March given the fixed income sell-off, but there is still more rate increases necessary. 

The question is not whether the Fed is behind the curve, it is, but what is the cost of closing the gap and how fast should it be done. It can be done quickly or slowly but the path does matter. Right now, the Fed has provided guidance on the path. A fast path may work but at the expense of financial markets. A slow path may cause inflation expectations to be driven higher.

China tail risk for global economy

An underpriced economic tail risk facing investors is from the China slowdown associated with zero tolerance COVID lockdowns. The CAIXIN China composite PMI fell to below 40 this week, the worst reading since the beginning of the pandemic. 

The COVID economic crisis has come full circle back to China and this adds another supply shock to the global economy. The congestion, both inbound and outbound, at ports in China is significant. Deliveries within China have been curtailed. Factories have been shut. This disrupts global manufacturing supply chains and trade. Commodity prices are being capped based on the lower demand in China. 

The China contribution to global GDP has been significantly greater than the US, so a slowdown will have spillover effects.

The financial flows have decidedly turned against China like other economic crises. The currency has been devalued, but with a supply shock the price does not matter if the goods cannot be produced or shipped. While there has been a focus on inflation and the financial shock, the real economy will still be driven by real events like COVID shutdowns. 

Bond Vigilantes - They are back

 

What defines a bond vigilante? Where have they been? Why are they out riding now? Regardless of what you call the marginal sellers of bonds, they certainly are back. There are no marginal buyers that are independent of market reality. Central bankers were the marginal buyers, but they are gone. The Fed will be reversing their bond portfolio starting next month.

The bond vigilantes are traders willing to call out policymakers who are failing at their core mandate through moving capital out of harm's way. You can have your own opinions but not your own facts.

The Fed missed on their inflation forecasts and have neither recognized nor accepted that stronger action is required. The gap between the CPI and Fed funds tells us with clarity the problem. Rates should rise quickly even if supply shocks represent a strong portion of current inflation. If they don't, inflation will continue. There is either pain required today or more tomorrow.

The Fed knows this but is unwilling to focus on the problem. There are rumblings like the comments by Minneapolis Fed president Kashkari that the Fed may have to push long-term real rates into restrictive territory. The comments of former Fed vice-chairman Clarida who stated that rates will have to go above 3.5% if inflation is hovering higher than 3% is what the vigilantes are thinking.  

What a difference a day makes - Major reversal after Fed rate hike

What a difference a day makes 

24 little hours

Brought the sun and the flowers

Where there used to be rain

- Dinah Washington, jazz singer  

What a difference a day makes from an equity rally to an equity sell-off after the Fed raised rates 50 bps. Yesterday, immediate reaction from the FOMC announcement was indifference as though the 50 bps rise was baked into market prices. the We have commented that the rally started after Fed Chairman Powell stated that a 75 bp rise was not under consideration. The tail event of a Fed rate shock was taken off the table for the near-term and markets viewed this as good news. The short-term probabilities for the size of the next rate hike changed massively.  

Today was a different story as the combination of a 50 bps rate hike, the growing belief that the Fed is behind the curve, the relentless rise in inflation, and the overhang of stagflation all weighed on investors who sold risk assets and fixed income alike. Bonds were not a safe asset albeit did not decline as much as stocks. 

Markets are fragile and the story for repricing is still strong. One the discount rates for cash flows are going higher even if only through 50 bps hikes. Investors are less optimistic of a soft-landing story. The Fed has little creditability as a forecaster. However, our view of what is most important is the behind the curve story of the Fed. Not considering large hikes and following what seems like a slow QT roll-off program suggests that the Fed is still not serious about curtailing inflation relative to ensuring aggregate demand. Unfortunately, an inflation-shocked economy may slow - the stagflation story seems to be the dominant thinking of investors.  

The forward guidance - Fed not actively considering 75 bp hike

 

Fed forward guidance changes the behavior of investors. "Listen to what I say, and I will tell you where we are headed". The focus is on the words of the Fed Chairman and not just Fed action. The Fed action like today was clearly telegraphed. The reaction from the announcement was minimal before Chairman Powell spoke; nevertheless, he provided the magic words that a 75 bps rise was not being actively considered. As soon as the announcement was made, the stock market was moving higher, yields moving down, and the dollar selling off. 

Was the comment intentional? Powell is very careful with his comments, so my impression is yes, but it is restrictive and shows the Fed as not a serious inflation fighter. 

Asset class performance - Nothing good about the numbers

Returns for April across all major asset classes and styles showed negative returns. Commodity indices are the only stand-out for the year. This is not a US problem but a global problem. 

The energy and consumer stables sectors show positive performance for 2022, but energy is just a proxy for the oil supply shock. Technology and consumer discretionary firms are the big losers. 

Country equity indices are down across the board except Brazil. Two commodity focused country indices, Canada and Australia, are outperforming the other country indices.

There was no relief from holding fixed income although credit and short duration funds have weathered the inflation and rate storm better than long Treasury indices.