“All Along the Watchtower”

by | Aug 12, 2022 | Weekly Summary

Weekly Summary: August 8 – August 12, 2022

Key Observations:

  1. U.S. inflation most likely peaked in July. Although we foresee a downward trajectory of inflation rates, we assume that they will come down in an erratic pattern and take quite some time before the Federal Reserve’s (Fed) 2% target is within sight. We project volatile energy prices going forward.
  2. The Fed’s tighter monetary policies are already slowing the U.S. economy. At some point, we expect an accelerating downturn to help rein in inflation. We maintain our view that the Fed will raise the federal funds rate by 50 basis points (bps) at its next meeting in September, barring any “surprise” data.
  3. Both the two-year Treasury yield and 10-year yield fluctuated on the days when the Consumer Price Index (CPI) and the Producer Price Index (PPI) were announced – CPI and PPI days. Both reversed initial downturns in their yields to close near their highest yields for the day. But the 10-year rose relative to the two-year Treasury yield, particularly after PPI to steepen the yield curve from a very inverted level. The dramatic reversal of the 10-year yield might portend an upward reversal to its recent downward trajectory. This could put pressure on tech and growth stocks in general.
  4. The recent decreases in U.S. labor productivity could either pressure inflation higher or squeeze profit margins – particularly in the services sectors of the economy.

The Upshot: Our general investment approach remains the same as depicted in last week’s commentary. A significant part of our recommendation to buy tech and growth stocks on June 16, was that we thought that the 10-year yield peaked at least in the medium term at just under 3.5% on June 14, that we were close to a peak in headline inflation and that the U.S. and global economies were slowing. After the upward yield reversals of the two-year and 10-year Treasuries on CPI and PPI days, we now foresee an increased probability that the 10-year yield will continue to rise. This was particularly the case after the 10-year yield steepened noticeably relative to the two-year yield. We have observed many instances when such reversals indicated a reversal in the most recent trend. This could raise real rates and, on the margin, put pressure on growth and tech stocks, many of which appeared to “stall” on PPI day, before resuming their general upward trajectory the next day. Crude prices also reversed on PPI day to close higher, which catapulted energy stocks to the top performing S&P 500 sector on that day. Once again, “our notion that energy securities could act as a hedge against high quality tech and growth stocks appeared to be ‘working.’” We would also wish to single out bank stocks, which continued their recent price outperformance over the past few weeks. In fact, the financial sector was the second-best-performing sector on PPI day. Mike Mayo, a top-rated bank analyst with Wells Fargo, this week reiterated his favorable views on bank stocks as he noted that because of adoption of many technological advances, their productivity might be the best in ninety years. This is quite a contrast to the latest U.S. productivity levels. But to the extent the U.S. would enter a severe recession, fears of credit delinquencies would then pressure bank stocks lower.

We highlighted in our July 29 weekly that after missing consensus expectations for revenues and earnings, both Microsoft (MSFT) and Alphabet (GOOGL) traded substantially higher. We took this as a sign that too much “bad” news was priced into their share prices. “We found this to be an encouraging sign for these individual stocks, as well as an encouraging sign for U.S. equities in general. We were not surprised at all when stocks traded higher the next day. This was true particularly with respect to quality high-tech and growth stocks as typified by the Nasdaq index, which had its best day of appreciation since November 2020.” As U.S. equity prices continued their ascent on CPI day, we became increasingly concerned that on a risk and reward basis, selected stock positions might be suitable for “trimming.” This concern was exacerbated by the upward interest rate reversals on CPI and PPI days, but especially on PPI day. In the meantime, stocks look poised to continue their ascent. Due to low levels of long “positioning,” the “pain” trade appears to be higher equity prices. Each investor should be comfortable with their risk tolerance of holding certain positions in light of expected volatility.

On August 12, J.P. Morgan (JPM) observed that as of Tuesday’s close, before the equity rally on CPI day, that its Tactical Positioning Monitor (TPM) showed a ”significant positive increase… Historically, a significant positive change in the TPM has been followed by further SPX gains, suggestive of a positive momentum shift taking place.” After more closely examining the historical data on this topic, JPM concluded that “over a 10-60 day period, SPX future returns have been positive the vast majority of the time. Positioning levels today are the lowest we’ve seen when the positive signal was triggered.” Historically, when positioning has been this low, “five-day returns tend to be relatively weak, but returns improve afterwards.” JPM concluded that the current TPM therefore indicates an upward bias. As we have highlighted many times, financial markets do not just trade on fundamentals. Positioning and liquidity factors can sometimes overwhelm fundamental factors.

We continue to foresee financial market volatility and we maintain out conviction that equities should only be purchased on market downturns.

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Source: JP Morgan, Equity Strategy (8-8-2022)

Peak U.S. Inflation, 50 bps Rate Hike Likely in September, Financial Market Reaction

The most anticipated U.S. economic data this week was the CPI for July, followed by the PPI for July. Neither index disappointed, as both were less than expected. In general, U.S. equities rallied on the news and the two-year-to-10-year Treasury yield spread steepened after fluctuating. Treasury yields initially traded lower before rebounding. This was particularly true for the 10-year yield, which traded higher and caused the two-year-to-10-year yield spread to steepen from a very inverted yield curve position. The equity rally on CPI day was very broad based but faded during the PPI day after a solid opening. The USD weakened as exemplified by U.S. Dollar Index (DXY) before rebounding on Friday. The July CPI and PPI data appeared to confirm our view that we most likely have seen peak inflation rates for the U.S. However, we do not hold that view for most foreign countries – particularly European nations. As we noted last week, the Bank of England (BOE) anticipates peak inflation of over 13% in October. This forecast was reiterated by the chief economist at BOE this week who also noted that monetary policy operates with a lag that could be as long as twelve months. Although there will be much more additional data before the Fed’s next meeting in September, this week’s data makes us more comfortable with our forecast of a 50-bps hike in the federal funds rate at the September meeting in lieu of 75 bps. Also, let’s not forget that the Fed’s quantitative tightening (QT) program will double beginning in September. The Fed’s balance sheet would then shrink by $60 billion per month in Treasury securities and $35 billion per month in mortgage-backed securities (MBS). This will further drain liquidity from the financial system, thereby further tightening financial conditions. Now that the Fed has attained its “neutral” rate of about 2.5%, the Fed does not have to continue “expeditiously” raising rates. Nevertheless, we do expect the Fed to continue to raise rates.

Discerning the Abruptness of an Economic Downturn

We have stressed repeatedly that since the pandemic began, rapidity of change has continued to surprise. Since Russia’s invasion of Ukraine on February 24, this has been true even more. According to Goldman Sachs on August 11, a recent Fed research paper notes that “the economy sometimes slows too abruptly at the start of recessions for policymakers to accurately track current conditions.” Goldman Sachs found that historically initial estimates of payrolls, household employment and consumption growth at the start of recessions tend to be revised down later. We suppose the Fed will prefer to be somewhat more measured in its future hikes as it waits to see the effects of its tighter monetary policy through tighter financial conditions. We have observed in our prior commentary, that some of these effects are already evident.

Financial Market Indicators Quick to Change According to Latest Data

After last week’s much-better-than-expected U.S. jobs data for July, the financial markets were very quick to price in a 75-bps rate hike at the Fed’s September meeting, even though payroll data is thought generally to be a “lagging” indicator for future economic activity. The markets were just as quick to drop to a 50-bps expectation after the lower-than-expected CPI data was released. Initial unemployment insurance claims are considered generally to be a rather good “leading” indicator. But because of recent changes in the methodology of seasonally adjusting this data, it is rather likely that the rise in initial jobless claims has been overstated since March by as much as 50,000. It appears that the more recent data probably is more accurate. For the week that ended August 6, initial claims increased by 14,000 to 262,000 from a downwardly revised level for the prior week. Even with this change, we still suppose that the labor market is becoming less tight. Since the onset of the pandemic, seasonal adjustments have become problematic in general due to the unusual economic patterns and their timing. This is yet another reason for the need to require many data points before any forecasts should be attempted. A less tight labor market is a critical component to a lower inflation trajectory.

“Relief” Could be Finally Headed the Fed’s Way

Given the summary above, we have little doubt that the Fed must have been thinking many times that they could have joined Jimi Hendrix singing Bob Dylan’s song “All Along the Watchtower.” More specifically, “There must be some kind of way outta here [lowering inflation]; … There’s too much confusion; I can’t get no relief.” We suppose that with this week’s economic data, along with other recent economic data we recently analyzed, “relief” is finally on the way to help the Fed rein in elevated rates of inflation. Additionally, we anticipate this “relief” to continue by way of the Fed raising rates further, by a tightening of financial conditions and by slowing economic growth. As we have noted before, equity rallies are a form of financial conditions loosening – not what the Fed wants at this point.

New York Fed Survey Indicates Inflation Expectations Lessen

The New York Fed’s July national survey of consumers’ expectations seemed to have anticipated the recent more-benign inflation numbers for July. The one-year expected rate of inflation dropped from 6.8% in June to 6.2% in July. The expected three-year rate of inflation dropped from 3.6% to 3.2%. The five-year expected rate of inflation declined 0.5% to 2.3%. Home prices were now expected to rise 3.5% over the next year, down from a predicted home prices increase of 4.4% expected in June. This was the lowest projected gain since November 2020. Overall household spending was expected to decline by 1.5% from June’s expectations to an increase of 6.9% over the next year. This was the largest monthly decline in the survey’s history. Record spending increases were expected to be 9% in May. The Fed’s restrictive monetary policies and their impact on tightening financial conditions were having an impact. We note the rapidity of change once again in consumers’ expectations. We have little doubt that the dramatic fall in gasoline prices from the June highs played a significant role in diminished inflation expectations.

CPI Inflation

As we expected, headline U.S. July CPI inflation rate slowed from a 40-year high actual reading of 9.1% year-over-year (y/y) in June and an expected rate of 8.7% for July, to 8.5%. Headline CPI inflation remained unchanged (rose zero % m/m) as a monthly decline of 7.7% in gasoline prices offset gains in the food and shelter indexes. The CPI energy index was 4.6% lower month-over-month (m/m). The electricity index was 1.6% higher m/m, which was the third month of at least 1.3% m/m increases. Electricity was 15.2% higher y/y. The CPI core index – excluding food and energy – rose by a lower-than-expected 0.3% m/m. This was the slowest m/m gain since September. The core CPI inflation rate rose 5.9% y/y, matching June’s increase but was lower than the expected increase rate of 6.1% y/y. The indexes for shelter, medical care, motor vehicle insurance, household furnishings and operations, and new vehicles all rose. Airline fares were 7.8% lower m/m and used trucks and vehicles were also among the items that declined on a month-over-month basis. The shelter index rose 5.7% y/y in July. This accounted for about 40% of the total increase in all items – excluding food and energy. The shelter index rose 0.5% m/m versus June’s gain of 0.6%. Rent rose 0.7% m/m and owners’ equivalent rent rose 0.6% m/m. The index for lodging away from home was 2.7% lower m/m. Shelter costs are generally considered the most persistent type of core inflation. Given vacancy rates outlined in our last weekly commentary, we assume that shelter inflation will come down very slowly. We also assume that many of the items that gained in price in July could also be very persistent for quite some time.

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Source: JP Morgan, US: July CPI Inflation Weaker than Expected, Core Still Firm (8-10-2022)

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Source: U.S. Berau of Labor Statistics, Consumer Price Index – July 2022 (8-10-2022)

CPI Inflation Trajectory Most Likely Lower but Erratic

Although we believe that we have now seen peak inflation rates in the U.S., we suppose that the path lower could be rather erratic. We expect energy prices to be volatile, which could account for future spikes in inflation rates. Furthermore, we suspect that the U.S. and global economies are in a downward trajectory that could lower demand for many goods and services and thus lower inflation rates. Supply chain constraints appear to be in an easing pattern, but that could change as well. China lockdowns can be rather unpredictable. Germany is now suffering a drought. The Rhine River in Germany ships about 80% of Germany’s goods. The drought might affect shipping on this river. That could be yet another strain on supply chains, which could increase inflation rates and dampen global economic growth.

PPI Inflation

Headline PPI for July was 0.5% lower m/m. This was the first month-over-month decline since April 2020. Headline PPI rose 9.8% y/y compared to an increase of 11.3% in June and the record high of 11.7% in March. The July annual increase was the smallest since October 2021. The monthly negative reading was attributable to an 1.8% decrease in final demand goods while services increased only 0.1%. The decrease in final goods demand was mostly attributable to the monthly 16.7% decline in gasoline prices that was included in a 9.0% drop in energy demand. The 9.0% drop in energy demand accounted for 80% of the 1.8% drop in final goods demand. The monthly decline of 1.8% was the largest since the April 2020 decrease of 2.7%. The core PPI – excluding food, energy and trade services – rose 0.2% m/m versus an expected increase of 0.4% and a June increase of 0.3%. Core PPI was 5.8% higher y/y. We expect PPI to improve as supply chain constraints lessen. The effects of such improvements could take up to three months before being reflected in CPI readings. This PPI report again shows the possible rapidity of change on a monthly basis, especially when it comes to commodity prices. We suppose that commodity prices will continue to be very volatile. We would also not be surprised to see U.S. and global economies slowing at an accelerating rate at some point. Presumably, this might accelerate deflationary pressures as well. Nevertheless, we assume that it will take quite some time before the Fed’s 2% targeted rate of inflation can be achieved.

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Source: JP Morgan, US Food Producers and Retailers: Analysis of PPI Data (8-11-2022)

U.S. Labor Productivity Lower Generally – More Inflation or Profit Margin Squeeze?

U.S. nonfarm business sector labor productivity continued its disappointing downward trajectory in Q2, alongside an increase in unit labor costs. Labor productivity decreased 4.6% in Q2 quarter-over-quarter (q/q) as output decreased 2.1% and hours worked increased 2.6%. When compared to Q2 2021, labor productivity decreased 2.5%, reflecting a 1.5% increase in output and an increase of 4.1% in hours worked. The annual decline in labor productivity was the largest since this series began in 1948. The unit labor costs in the nonfarm business sector increased 10.8% in Q2 q/q reflecting a 5.7% increase in hourly compensation and a 4.6% decrease in productivity. Unit labor costs increased 9.5% over the last four quarters, which is the largest four-quarter increase since a 10.6% increase in Q1 1982. Real hourly compensation in Q2 decreased 4.4%. But taking the manufacturing sector in isolation, labor productivity increased 5.5% as output increased 4.3% and hours worked decreased 1.1%. Unit labor costs in the manufacturing sector decreased 0.5% in Q2, reflecting an increase of 4.9% in hourly compensation and a 5.5% increase in productivity. As U.S. economic growth becomes more concentrated in service sectors while the goods sectors languish, the lowered productivity issue becomes more problematic. Either services inflation will continue to rise or profit margins will come under pressure. At some point, we think the latter is the more likely outcome.

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Source: JP Morgan, US: Productivity Falls in 2Q as Unit Labor Costs Surge (8-9-2022)

Bottom Line

For the time being we are maintaining our basis investment approach as expressed in last week’s commentary. We will continue to favor high quality big-cap stocks with good balance sheets, as well as relatively stable cash flows and profit margins. For long-term investors who are prepared to tolerate volatility, we still maintain a preference for selected high-quality big-cap tech and growth stocks, as well as energy shares. Again, we only would add to positions on downturns. We assume continued volatility across virtually all financial market. Many uncertainties remain. We continue to forecast very rapid changes in economic trends, many of which could be “surprising.”

Definitions

SPX The SPX options are based off the prices of the S&P 500 index.

NASDAQ The Nasdaq Composite Index is the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange.

S&P 500 The S&P 500 is a total return index that reflects both changes in the prices of stocks in the S&P 500 Index as well as the reinvestment of the dividend income from its underlying stocks.

Core Consumer Price Index (Core CPI) Core inflation removes the CPI components that can exhibit large amounts of volatility from month to month, which can cause unwanted distortion to the headline figure. The most commonly removed factors are those relating to the costs of food and energy. Food prices can be affected by factors outside of those attributed to the economy, such as environmental shifts that cause issues in the growth of crops. Energy costs, such as oil production, can be affected by forces outside of traditional supply and demand, such as political dissent.

Headline Consumer Price Index (Headline CPI) Headline inflation is the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics (BLS). The CPI calculates the cost to purchase a fixed basket of goods to determine how much inflation is occurring in the broad economy. The CPI uses a base year and indexes the current year’s prices, according to the base year’s values.

Producer Price Index (PPI) – The producer price index (PPI), published by the Bureau of Labor Statistics (BLS), is a group of indexes that calculates and represents the average movement in selling prices from domestic production over time. It is a measure of inflation based on input costs to producers.

Productivity – Productivity measures output per unit of input, such as labor, capital, or any other resource. It is often calculated for the economy as a ratio of gross domestic product (GDP) to hours worked.

Growth Stock – A growth stock is any share in a company that is anticipated to grow at a rate significantly above the average growth for the market. These companies generally do not pay dividends, instead growth stocks tend to reinvest any earnings they accrue in order to accelerate growth in the short term.

U.S. Dollar Index (DXY) – The U.S. dollar index is a measure of the value of the U.S. dollar relative to a basket of foreign currencies.

Quantitative Tightening (QT) – Quantitative tightening refers to monetary policies that contract, or reduce, the Federal Reserve System’s balance sheet.

Mortgage-Backed Security (MBS) – A mortgage-backed security is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them. Investors in MBS receive periodic payments similar to bond coupon payments.

Owners’ Equivalent Rent (OER) – Owners’ equivalent rent is the amount of rent that would have to be paid in order to substitute a currently owned house as a rental property. This value is also referred to as rental equivalent.

IMPORTANT DISCLOSURES

The views and opinions included in these materials belong to their author and do not necessarily reflect the views and opinions of NewEdge Capital Group, LLC.

This information is general in nature and has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy.

NewEdge and its affiliates do not render advice on legal, tax and/or tax accounting matters.  You should consult your personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation.

The trademarks and service marks contained herein are the property of their respective owners. Unless otherwise specifically indicated, all information with respect to any third party not affiliated with NewEdge has been provided by, and is the sole responsibility of, such third party and has not been independently verified by NewEdge, its affiliates or any other independent third party. No representation is given with respect to its accuracy or completeness, and such information and opinions may change without notice.

Investing involves risk, including possible loss of principal.  Past performance is no guarantee of future results.

Any forward-looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No assurance can be given that investment objectives or target returns will be achieved. Future returns may be higher or lower than the estimates presented herein.

An investment cannot be made directly in an index. Indices are unmanaged and have no fees or expenses. You can obtain information about many indices online at a variety of sources including:  https://www.sec.gov/fast-answers/answersindiceshtm.html or http://www.nasdaq.com/reference/index-descriptions.aspx.

All data is subject to change without notice.

© 2022 NewEdge Capital Group, LLC

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