Your Monday Recap: Expect the Unexpected
Last week was relatively light in terms of economic reports but it did continue the trend of very weak consumer confidence amidst a U.S. economy that still seems resilient. University of Michigan Sentiment survey results stayed at near all-time lows, a reflection of consumers battling high food and gas prices. At the same time, initial weekly jobless claims came in slightly below expectations, with continuing claims continuing to hover near 50-year lows. Reads on the housing market came in better than expected.
Collectively, these factors present a paradox: consumers feel awful but with job and wealth prospects hanging in there, maybe the U.S. economy can trundle through this growth slowdown without falling into recession.
Home Sales Down
May existing home sales beat analyst estimates although they were still down 3.4% month over month. Inventories were +12.6% on the month as potential sellers try to take advantage of what may be a generational price increase that is beginning to wane. Inventory of new homes is now at 2.6 months vs. 2.2 months in April which may allow the year over year price increase, which was 14.8% in May, to slow over the remainder of the year.
May new home sales saw a big beat of estimates at 696K, +10.7% from the upwardly revised 629K seen in April. Notably, the average price of a new home declined to $511k from $569k in April. We may be at an inflection point in housing and rental inflation although the magnitude and timing of improvement remain to be seen.
A Survey of the Surveys
The June S&P Global preliminary national manufacturing survey came in light at 52.4, notably below the 56.3E and the 57.0 reported in May – this is the lowest level for the survey in two years with production growth lower and new orders in contraction at 48.4. Encouragingly, the slowdown in manufacturing is being accompanied by improved supply chain metrics and a 14-month low in prices paid. The services survey also came in below expectations at 51.6 vs. 53.6E and 53.4 in May.
The aforementioned fiscal cliff and the popping of the stay-at-home bubble are slowing the economy. The increase in short and intermediate bond rates in addition to energy prices will further dampen demand in the economy.
The University of Michigan final June survey came in at 50.0, slightly lower than the 50.2 reported a couple of weeks ago, but substantially below the 58.4 recorded in May and down to a record low in the history of the survey. In a search for a silver lining in this dour report, both the 5 year and 1 year inflation expectations declined from the preliminary survey.
Slightly lower gasoline prices may be at play here, but consumers are still expected to be buoyed somewhat by continued strong employment growth.
Inflation and the Fed
Fed Chairman Jerome Powell’s testimony before the House of Representatives and Senate laid bare once again that the Fed’s focus is on raising interest rates until inflation comes down meaningfully. With that in mind, it is helpful that will get a read on PCE for the month of May this coming Thursday. The core PCE is the Fed’s preferred measure of inflation. That said, this week’s reading will be for the month of May, for which we already have CPI/PPI readings that were higher than expected.
While the Fed will be paying attention to May PCE, market attention may be shifting to June inflation figures, for which there won’t be indications until the CPI comes out on July 13th. There are some preliminary signs that inflation has peaked. Commodity prices have come off peak levels, notably for copper, lumber, steel, and wheat. Crude oil and gasoline prices are also off highs, but not by much and the continuing war in Ukraine leaves declines in the energy sector vulnerable to reversal.
OPEC will be meeting this week, but expectations are low for them to bail out the West with production increases. For one thing, OPEC doesn’t have that much spare capacity. For another, political tensions between OPEC and the West, particularly the U.S., are high. So while inflation may have peaked, its decline is neither assured nor its speed known. It is also worth noting that many market and economic commentators have been suggesting for some time that inflation has peaked, only to be disappointed with each inflation data release.
Europe and Russia
Europe’s economy continues to struggle with a new energy regime due to the war in Ukraine and sanctions on Russia. Germany has implemented the second phase of its natural gas alarm program. This is in response to Russia dramatically decreasing the flow of natural gas to the continent as a reaction to sanctions. The next level of the German response includes rationing to end users.
The problem for Europe is its goal to have enough gas in storage to heat homes during the upcoming winter season. With curtailed flows from Russia and the length of time needed to get liquified natural gas supplies from the U.S., the European economy may need to limit economic output to make sure people don’t freeze in their homes. An explosion at an important U.S. LNG export facility two weeks ago is exacerbating the problem.
Impact of SCOTUS
Here in the U.S. sentiment is also souring because of two recent Supreme Court rulings on gun control and women’s reproductive rights. While these may not have a direct economic impact, the tone in society is decidedly negative and may curtail increased spending. Or not. As one of our research economists, Ed Yardeni, says: when times are good Americans spend, and when they feel depressed, they spend more! However, there are government actions that the markets are fixated on.
The prospects are rising of higher taxes through a Build Back Smaller deal being negotiated by Senate Democrats and Sen. Joe Machin (D-WV). On a related note, Intel noted that it may delay groundbreaking on its huge chip plant in Ohio if Congress does not pass the China competitiveness act that has been being negotiated for some time. This has negative implications for our thesis that supply chain onshoring will cause the economy to recover in 2H ’22 and into 2023.
Congress can help or hinder the economy with potential legislation. Fiscal Policy will be mostly restrictive this year and next given there are no special Covid related payments this year and the increased potential for a scaled-back version of the president’s tax and spending ambitions.
But President Biden did call for a three-month suspension of the gasoline tax and he called on states to also suspend their fuel taxes. Even in the extremely unlikely event the federal measure passes, it would only amount to a $0.18 decline in gasoline prices with the primary benefit being a small optical political win before the mid-term elections.
Investor Outlook: Expect Volatility
The solid equity market rally last week and on Friday has investors wondering: is the worst over or was it just another head-fake bear market rally? Preventing answering that question are two unknowns:
One is whether inflation has peaked (as discussed above) and the other is whether earnings estimates for this year and next are wildly over-optimistic. On the latter point, one can take a little bit of comfort from FedEx’s guidance last week. And there are reports coming this week from Nike and Micron that may shed further light. However, these are only three companies that operate on a May quarter-end so they don’t capture the economic slowing in June.
Second quarter earnings will start in earnest in about two weeks. Analyst estimates really haven’t budged all year while the economy has slowed. Unfortunately, the answer to the question of last week’s rally’s stability won’t become clear for a couple of weeks. Until then, the rally can continue, even if it is a bear market rally, but expect volatility to continue. That could be the title for the year, at least so far: Expect Volatility. In fact, that has been our mantra since the beginning of the year.
Decline in Treasury Rates
Of interest is the marked decline in treasury rates last week, as well as expectations for future Fed Funds Rate hikes. The 10-year yield has dropped 30 basis points in less than two weeks. Fed Funds Futures markets are peaking at 3.4%.
Clearly the markets believe the Fed will be forced to abandon its rate hike campaign before reaching the 3.8% level in its “dot plot” from two weeks ago. Whether this is because inflation comes down more rapidly, something breaks in the financial markets, or the economy tumbles into recession are the questions the markets will be wrestling with in coming weeks.
On that note, we are in a bad-news-is-good-news environment where indications of slowing economic growth will be welcomed for their impact on the Fed. It is wise to be careful about this sort of environment. Too much of a good thing – or too much of a bad thing masquerading as a good thing – can be a bad thing. A little labor market weakness would be welcome for its effect on inflation. A lot of market weakness would not be welcome because of its impact on consumption. Therein lies the conundrum the Fed faces as it tries to stick the (soft) landing.
Expect the Unexpected
One last note, it looks like Russia has defaulted on its debt. The problem is not a lack of funds but rather an inability to transfer funds due to economic sanctions. Given that markets have had four months to prepare for this, we should expect minimal impact to the functioning of the financial markets.
Still, those of a certain age remember the impact of Russian debt issues on Long Term Capital Management in 1998 and the subsequent market turmoil. That should not be the case here but 2022 is turning out to be an expect-the-unexpected kind of year.
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