“Handle with Care”

by | Jul 22, 2022 | Weekly Summary

Weekly Summary: July 18 – July 22, 2022


Key Observations:

  1. All of the U.S. housing surveys disclosed this week continued to show a weakening housing market that was impacted by elevated inflation and higher mortgage rates that affected the “affordability” of buying a home. Rental rates should continue to rise under pressure as well.
  2. Business and consumer surveys reinforced our assumption of a weakening trend in U.S. economic data. Expectations about future business activity were typically even less sanguine. Although remaining elevated, there were also indications that prices were beginning to show signs of a decline. Employment growth also showed signs that it was beginning to slow. Perhaps the U.S. labor market is not as tight as most investors and analysts assume.
  3. We assume that the natural gas flow from Russia to Europe through the Nord Stream 1 (NS1) pipeline will remain variable and might even be halted at some point. Headline news concerning natural gas flows into Europe could lead to continued volatility in financial markets. The lower the flow rate of natural gas into Europe, the more likely that European economies will slow with increasing probabilities of recession. This is particularly true of Germany. Political turmoil in Italy could exacerbate these probabilities.
  4. The European Central Bank (ECB) surprised financial markets on Thursday with a 50-basis-points (bps) hike to bring its key policy rate to zero, and out of negative territory for the first time since 2014. The ECB also announced a new bond buying “anti-fragmentation” tool that is aimed at containing widening yield spreads of some European countries’ bond yields relative to those of Germany. The most recent focus has been on the increasing yields of Italian bonds.


The Upshot:

At yesterday’s closing prices, we no longer think that the risk/reward justifies holding most of technology shares, including semiconductor stocks that we recommended in mid-June. Since June 16, the Nasdaq has outperformed the Dow Jones Industrial Average and the S&P 500 as it has gained over 13% since that date at yesterday’s closing prices. For those long-term investors who bought close to the June 16 levels, we still think that they will be rewarded further over time. We caution, however, that these longer-term investors should be prepared to live with volatility. Stock selection remains key to relative outperformance. We are focused increasingly on the variability of natural gas flows into Europe from Russia through the Nord Stream 1 pipeline. We anticipate that Russia’s president Vladimir Putin will continue to make statements and take actions in regard to the flows of natural gas through this pipeline that will help to ensure continued volatility across financial markets. To the extent that natural gas flows into Europe from Russia are diminished or cut off, Europe will be more prone to the risk of inflation. German industrial production could be adversely affected by diminished accessibility to natural gas. This would have a tendency to disrupt supply chains, lessen economic growth and lead to increased inflationary pressures. Since Germany is the world’s fourth largest economy, we would expect that this would have global implications.

Some companies are beginning to revise lower their earnings and margins outlook. This is one of the elements that we have been waiting patiently for. We believe that financial market volatility will persist for at least as long as the Russia-Ukraine war endures. But our focus is now on the variability of Russian natural gas inflows into Europe. We foresee that market volatility could be exacerbated surrounding this variability. We have highlighted for quite some time the relative illiquidity and low volumes of many financial markets. Such conditions should exacerbate market volatility. In our opinion, the reduction of natural gas flows into Europe will only serve to enhance recession probabilities worldwide and increase inflationary pressures on a global scale. In general, we continue to favor big cap high-quality stocks with strong balance sheets as well as relatively stable cash flows and margins. We will search across all sectors to find stocks that meet these characteristics. We also favor at least some commodity exposure in a diversified portfolio.


Current Circumstances

Most of the economic data we have highlighted over the past few weeks have pointed to a slowing U.S. economy, as well as a slowing global economy. This has been true particularly in regard to “leading” economic indicators such as new orders, backlogs, consumers and business expectations, and initial jobless claims. We also have highlighted the weakening U.S. housing market over the past few weeks. The focus of this week’s release of economic data has been mostly related to housing, which continues to point to further weakness. Natural gas flows into Europe (EU) through the NS1 pipeline from Russia controlled by the Russian energy company Gazprom has become increasingly precarious and unreliable. The lower the natural gas flows into EU, the greater the risk of energy rationing in EU and the greater the risk of recession. The German and Italian economies appear to be most at risk for a recession within the next twelve months, if not sooner. The prime minister of Italy Mario Draghi has been unable to form a coalition government, which will cause even more political turmoil in Italy. Draghi then resigned as prime minister Thursday morning. Italian elections should occur later this year. This has further complicated the task of the ECB this week in formulating its monetary policy. As interest rates have risen, the spread between Italian and German bond yields have widened. Italy carries a heavy debt load, and its ability to service its debt has been questioned increasingly as interest rates have risen. It was expected that the ECB would announce an “anti-fragmentation tool” that would essentially be authorized to buy Italian bonds to contain any further rise in Italian interest rates relative to those of Germany. The ECB announced such a tool on Thursday. The same rationale would apply to other heavily indebted EU countries whose yields widened significantly relative to Germany. Headline June inflation rates in the U.S. and many other countries hit multi-decade highs. The Federal Reserve (Fed) meets next week to decide on the latest formulation of a more restrictive monetary policy to help rein in inflation. Given the decrease in energy prices and food related prices in July, we expect a decline in U.S. headline inflation measures in July.


“Handle with Care”

It is against this backdrop that we admonish the Fed to “handle with care” the current economic environment. The Traveling Wilburys’ song “Handle with Care” provides what we consider to be an apt description of how the Fed, investors and analysts must feel this year: “Been beat up and battered ‘round; Been sent up, and … been shot down; … been fobbed off and … been fooled.” Ideally, many investors would like to ask the Fed: “Won’t you show me that you really care?” We don’t see a favorable response to this hypothetical question as the Fed focuses on its task of reining in inflation. Ideally, we also hope that “everybody’s got somebody to lean on,” but we just don’t think it’s the Fed. We continue to foresee the Fed hiking the federal funds rate 75 bps at its next meeting at the end of July.


NAHB Survey

The U.S. housing related data released this week continued to show a deteriorating U.S. housing market. The National Association of Home Builders (NAHB) survey was lower for the seventh consecutive month in July to hit its lowest level since May 2020. The survey’s twelve-point drop month-over-month (m/m) to 55 was the second largest monthly drop ever recorded in this survey. The largest drop occurred in April 2020. The sub-indexes for sales, buyer traffic and sales expectations over the next six months all declined. NAHB’s chairman summarized many concerns of homebuilders: “Production bottlenecks, rising home building costs and high inflation were causing many homebuilders to halt construction because the cost of land, construction and financing exceeds the market value of the home. In another sign of a softening market, 13% of builders in the HMI (Housing Market Index) survey reported reducing home prices in the last month to bolster sales and/or limit cancellations.” Elevated inflation and higher borrowing costs were reducing customer traffic in their search for buying a home.

Source: J.P. Morgan US: NAHB survey disappoints in July with big drop (7/18/2022)


Housing Starts

According to the U.S. Census Bureau, housing starts declined for the second consecutive month, and fell 2% m/m versus an expected increase of 2% in June to their lowest level since last September. The more important starts for single family homes were much worse as they fell 8.1% m/m. The strength in the much more volatile multi-family starts partially offset the single family weakness. Building permits in June declined 0.6% but were much better than the 2.7% m/m expected decrease. But building permits still fell to a two-year low. Single family permits decreased 8.0% m/m. Evidently, higher interest rates were having the Fed’s desired effect of reducing demand – in this case, housing demand.

Source: U.S. Census Bureau and the U.S. Department of Housing and Urban Development: Monthly New Residential Construction, June 2022 (7/19/2022)


Existing Home Sales

Mid-week, the National Association of Realtors released June data that showed a 5.4% m/m decrease of existing home sales, which was the slowest sales pace since June 2020 and was the fifth straight month of sales declines. The monthly sales decline in June was worse than the expected monthly decline of 1.1% and worse than May’s decline of 3.4%. Although sales declined 14.2% y/y, the median sales price for existing home sales appreciated 13.4% y/y. The inventory of existing homes for sale expanded 2.4% y/y, which was the first annual expansion of inventory in three years. Inventory levels at June’s end showed a three-month supply of sales at the current pace. This was still a tight housing market, with properties remaining on the market a low fourteen days in June.

Seasonally Adjusted Annual Rate (SAAR) – A rate adjustment used in business to account for changes in data due to seasonal variations. By adjusting data that is affected by seasons, more accurate comparisons can be made between different time periods.

Non-Seasonally Adjusted (NSA) – Rates that do not take into account seasonal ebbs and flows. Concerning a set of information, NSA data corresponds to the information’s annual rate.

Source: J.P. Morgan US: Existing home sales continue to lose ground (7/20/2022)


Business Leaders Survey – More Signs of Slowing Business Activity

The New York Fed conducted the survey of service firms in the New York area. The July survey reflected responses that were collected between July 5 and July 11. The headline business activity index fell 13 points to -10.7. This was the first negative reading in over a year. Employment growth slowed and wage increases remained widespread. While moving “notably” lower, prices paid and received were still elevated. Service firms no longer expected business activity to increase over the next six months.


Philadelphia Fed Manufacturing Index –Weakening Trends

From responses collected between July 11 to July 18, the Philadelphia Fed Manufacturing Index survey of manufacturers in the Pennsylvania region showed a decline in current general activity for the fourth consecutive month, and it was down nine points to -10.4. New orders decreased for the second month in a row, down from -12.4 to an even more negative -24.8. The indexes for current inventories and unfilled orders were also negative. Although employment increased, the employment index fell 9 points lower to 19.4, which is the lowest reading since May 2021. The average workweek decreased for the fourth consecutive month. Price increases remained widespread, but the prices paid index decreased to its lowest level since January 2021. Current prices received also decreased but remained elevated. In summary, “indicators for future general activity and new orders remained negative, suggesting that respondents expect overall declines over the next six months.”


Conference Board Leading Indicators

The Conference Board’s Leading Economic Index (LEI) decreased 0.8% m/m to 117.1, which was the worst reading since April 2020. The expected 0.6% decrease would have matched May’s figures. The LEI was 1.8% lower over first half of 2022 vs. a gain of 3.3% in the second half of 2021. June’s decrease was the fourth consecutive month of decreases. The senior director of economic research stated: “Consumer pessimism about future business conditions, moderating labor market conditions, falling stock prices, and weaker manufacturing new orders drove LEI’s decline in June.” The Conference Board concluded that a U.S. recession “around the end of this year and early next year was now likely.”


Status of U.S. Labor Market – Maybe Less Tight than Many Believe

According to Bloomberg Law on July 21, initial jobless claims rose by 7,000 to 251,000 for the week that ended July 16, versus an expected level of 240,000. This was the third consecutive week of rising initial jobless claims, as they rose to their highest level since November 2021. Continued claims also increased more than expected. These recent increases point to a weakening in the U.S. labor market. In our recent commentaries we have also highlighted other indications of a less tight labor market. These indicators include falling of recent job openings and Quit rates, declining to contractionary levels of ISM employment indexes in both manufacturing and service sectors, and many publicly traded companies announcing reductions in their hiring plans over concerns of a slowing economy.

Most analysts and investors, including us, rely on the employment data from the U.S. Bureau of Labor Statistics (BLS) payroll report as an indication of jobs growth that is included in our determination of the tightness of the U.S. labor market. But according to Goldman Sachs’ July 17 report, the much less followed household survey of employment has recently shown a much less robust labor market in the past few months. Goldman Sachs has estimated that the past three months have shown that the household employment survey has averaged 490,000 per month lower than the BLS payroll-based survey. The current divergence is the largest since the spring of 2020. These surveys have historically tracked each other “reasonably well.” We mention this divergence in the calculation of job growth to illustrate that there are many ways to measure job growth and the tightness of the labor market. When we view all of the above trends related to labor in their totality, we conclude that the labor market is most likely less tight than many investors and analysts assume.





Source: Goldman Sachs US Economics Analyst: When Will Payroll Job Growth Slow Down? (Briggs) (7/17/2022)



Source: J.P. Morgan US: Another increase for initial claims (7/21/2022)


Russian Nord Stream 1 Natural Gas Pipeline into Europe – an Uncertain Future

The NS1 pipeline controlled by the Russian energy company Gazprom has been recently the principal means through which Russia supplies Europe with a much-needed supply of natural gas. The flow of natural gas through this pipeline was suspended between July 11 and July 21 for scheduled maintenance. Just prior this scheduled maintenance, the flow rate of natural gas through NS1 was at 40% of capacity. During the ten-day shutdown, there was increasing speculation that the Russians would further delay the flow of natural gas to Europe beyond July 21 or alternatively, that the flow rate would be even further reduced from the already-low rate of 40%.

On Wednesday, the day before the scheduled resumption of the flow of natural gas on July 21, the European Commission (EC) – the executive arm of Europe – announced a proposal to deal with the uncertain future of gas supplies from Russia. EC’s president Ursula von der Leyen, proposed that all 27 European nations voluntarily cut their natural gas consumption by 15% between August 1 and March 31, 2023. Ms. Leyen stated that she thought it “highly likely” that at some point Russia would cease supplying natural gas to Europe. Gazprom had also recently tried to claim force majeure as the reason for their shortfall in supplying the EU with natural. At a Wednesday news conference, EC’s president stated: “Russia is blackmailing us, Russia is using energy as a weapon. And therefore in any event, whether a partial major cutoff of Russian gas or a total cutoff of Russian gas, Europe needs to be ready.” The EC thought that in a scenario of severe gas shortages, it could make its proposal mandatory. A Reuters’ story based on two knowledgeable sources disclosed on Tuesday that NS1 would resume operations on July 21 as scheduled. This appeared to provide a large impetus for a strong U.S. equity rally on that day. The Russian president Vladimir Putin wasted no time in warning the EU on Wednesday that Russia would fulfill its commitment to supply EU with natural gas, but that the gas flows might be “curbed” if sanctions prevented additional maintenance on its components. Putin said that another turbine had to go for further maintenance on July 26 and claimed that the flow of natural gas could then fall to 20% of capacity as early as next week. It is our contention that the uncertainty of Russian natural gas supply will continue for quite some time and that such uncertainty could easily exacerbate volatility across financial markets.

To the extent that Russian flow of natural gas is curbed or shut off, the probabilities of a European recession will be increased. Recessions in Germany and Italy are perhaps most likely. An insufficient flow of natural gas into Germany could reduce its industrial production, which could further constrain supply chains that could slow global economic growth and raise inflationary pressures. Europe looks like it’s headed for more turmoil as Italian Prime Minister Mario Draghi was “forced” to resign Thursday morning after he was unable to form a coalition government. As a consequence, Italian elections will be held later this year – hopefully no later than September. An unstable Italian government would serve to enhance the unpredictability of EU’s economic trajectory.

Source: Goldman Sachs US Daily: Recession Spillover from European Gas Shortages (Hill) (7/18/2022)


European Central Bank Monetary Policy

On Thursday, the ECB surprised financial markets by hiking its key policy rate by 50 bps in lieu of an expected 25-bps hike. This was the ECB’s first interest rate hike in eleven years. The 50-bps hike enabled its key policy level to achieve a zero level and to escape a negative rate for the first time since 2014. The interest rate hike will take effect July 27. The ECB explained that the higher-than-expected hike was based on an “updated assessment of inflation risks.” ECB’s president Christine Lagarde stated: “Inflation continues to be undesirably high and is expected to stay above our target for quite some time.” Lagarde pledged that from now on the ECB will be “data dependent” in its determination of changes to its monetary policy. The ECB thought that a 50 bps hike would help “strengthen the anchoring of inflation expectations.” The ECB also chose to address the increasing concerns of “fragmentation” of EU bond yields between German yields and yields of more indebted counties, such as Italy. Given the size of Italy’s bond markets, the widening spreads between German and Italian yields as interest rates were rising were becoming increasingly worrisome, particularly for bonds of longer duration. The ECB announced a new bond buying “tool” to help alleviate these issues. Many had already dubbed this tool as an “anti-fragmentation tool.” The ECB called this tool a “Transmission Protection Instrument” (TPI). The TPI “can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.” It is intended that the TPI would be used when a country would experience surge in their borrowing costs when it was “deemed” not to be that country’s fault. We thought that perhaps the ECB was worried increasingly about a possible EU recession and further widening of interest rate spreads among EU countries and so it had to “front-run” such developments. It would probably have been more difficult for the ECB to hike rates into a more obvious decelerating EU economy. The euro and equities rose on the ECB announcements.


Bottom Line

We assume continued volatility across virtually all financial markets for at least as long as the Russia-Ukraine war persists. Additionally, we are focused increasingly on the variability of natural gas flows into Europe from Russia through the NS1 pipeline. Furthermore, we assume more market volatility surrounding announcements on natural gas flows through this pipeline. Diminished natural gas flows into Europe could increase global recession risks and keep inflation rates elevated. We believe that many financial markets have priced in at least partially the increased probabilities of potential stagflation or recession. The economic data examined this week show weakening U.S. economic trends. We also believe that there is a high likelihood that the U.S. labor market is less tight than most people assume. The rapidity of changes in circumstances cannot be overstated. We will remain “data dependent” in our investment approach and will try to maintain an “open mind.” We will not hesitate to change our views if incoming data warrant any changes. Some companies are beginning to announce negative forward guidance on lowered earnings or revenue projections, as well as reduced margin expectations. We have been anticipating such negative revisions for quite some time.

Our fundamental investment approach for long-term investors remains the same as expressed in our recent commentaries. We maintain our preference for large-cap, high-quality stocks in a diversified portfolio with at least some commodity exposure.



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.

Basis Points (bps) – A basis point is one hundredth of one percent, used chiefly in expressing differences of interest rates.

Nasdaq – The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange. As a broad index heavily weighted toward the

Dow Jones Industrial Average (DJIA) – The DJIA is a stock market index that tracks 30 large, publicly owned blue-chip companies trading on the New York Stock Exchange and Nasdaq.

Seasonally Adjusted Annual Rate (SAAR) – A rate adjustment used in business to account for changes in data due to seasonal variations. By adjusting data that is affected by seasons, more accurate comparisons can be made between different time periods.

Non-Seasonally Adjusted (NSA) – Rates that do not take into account seasonal ebbs and flows. Concerning a set of information, NSA data corresponds to the information’s annual rate.

Nord Stream 1 pipeline – One of two major Russian gas pipelines that transports Russian natural gas through the Baltic Sea to Germany.

Leading economic indicators – A leading indicator is any measurable or observable variable of interest that predicts a change or movement in another data series, process, trend, or other phenomenon of interest before it occurs. Leading economic indicators are used to forecast changes before the rest of the economy begins to move in a particular direction and help market observers and policymakers predict significant changes in the economy.

Household employment survey – A survey of households reflecting the entire noninstitutional population of the United States, and provides information about the labor force, employment, and unemployment. The household survey is conducted by the Census Bureau as part of its Current Population Survey.

European Commission – The European Commission is the EU’s politically independent executive arm. It is alone responsible for drawing up proposals for new European legislation, and it implements the decisions of the European Parliament and the Council of the EU.


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