Pro Perspectives 7/22/22

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July 22, 2022

Standard and Poor’s published its Purchasing Managers’ Index report this morning.  This is a “flash report” projecting the way July private sector output is tracking.
 
It wasn’t good.  The index fell from 52 to 47 (weighed down by services, not manufacturing).  
 
Below 50 is considered to be contraction in activity, which tends to be consistent with a contraction in the economy. 
 
This has people taking about “possible” recession.
 
But as we’ve discussed here in my daily notes, the economy has very likely already been in recession — for the first half of the year. It’s old news.  
 
Remember, the official GDP contracted in Q1 by 1.6%.  And a model the Atlanta Fed uses, to track all of the inputs used by the BEA to calculate the official GDP number, has been projecting a negative number for Q2 since late June. 
 
That projection now stands at -1.6%, and we only have a few data points for the month of June yet to be incorporated.  That data will come next week.   
 
With that, by Thursday of next week, we will get the first look at Q2 GDP.  It will very likely be negative.  Two consecutive quarters of negative GDP is by definition, a recession.
 
This is technical recession, driven by high inflation (which is driven by both policy and pandemic driven supply deficits). 
 
But what does this technical recession really say about the health of demand? 
 
If we look at the nominal rate of economic growth it’s running hot — better than seven percent annualized based on the Atlanta Fed model.
 
For perspective, take a look at the past seventy years of nominal GDP growth.  This nominal growth rate is “rare air” for the U.S. economy, only seen in times of high inflation (which we are experiencing).   

Of course, when we subtract a 9.1% year-over-year inflation rate, we get negative “real” GDP (i.e. after the effects of inflation).
 
But that’s all in the rear-view mirror, and aligns with a stock market that quickly discounted such a first half. 
 
More importantly, what’s in store for the second half of the year?
 
Heading into the first half of the year, the Fed was clearly going to embark on a new tightening cycle.  A rising rates environment is a recipe for lower P/Es (lower valuation on stocks).  The P/E on the broad market has indeed fallen, from well north of 30 (ttm) to around 20.   
 
Heading into the second half, there is a fair case to be made that this tightening cycle is near the end — perhaps as early as next week (with one more hike).
 
Add to this, the job market remains strong.  And consumers and business balance sheets remain strong (as just confirmed in bank earnings reports).
 
This sets up for a good second half. 
 
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Pro Perspectives 7/21/22

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July 21, 2022

The European Central Bank raised rates this morning for the first time in eleven years.  They surprised markets with a 50 basis point hike (market was expecting a quarter point). 
 
This takes the benchmark short-term lending rate in Europe to a whopping zero percent. 
 
Yes, after watching print after print of record high eurozone inflation (eight consecutive months of new, higher record inflation – resulting the chart below), the ECB is so interested in becoming inflation fighters that they have just now decided to exit negative interest rate policy.
If you somehow believed the lip service the Fed has been giving us, about alleged intentions to "expeditiously" raise interest rates, this view of Europe should set you straight.
 
The Fed has done a lot of talking, and yet has set (deliberately) the effective Fed Funds rate at 750 basis points UNDER the rate of inflation. 
 
In Europe, the ECB is 860 basis points UNDER the rate of inflation.
 
What tools do the central banks have to kill inflation?  Rates.  What does it take, historically, to kill inflation.  It takes moving the short-term rate ABOVE the rate of inflation.
 
Neither have done it.  And though they've done a lot of talking, they haven't even taken a "shot across the bow" with a big and bold rate move.  Remember, as Bernanke said, after launching QE to respond to the Great Financial Crisis, "we could raise rates in 15 minutes" to combat any concerning inflationary consequence.  
 
Bottom line:  As we've discussed often in these daily notes, even if the U.S. economy could withstand the pain of higher interest rates (which includes our government's ability to service its debt), the rest of the world can't.
 
Sticking with Europe, what would happen if the ECB were to really take on the inflation fight with higher rates?  The fiscally fragile countries of Europe would quickly become insolvent, unable to sustain on higher borrowing costs.  And the dominoes in Europe would begin to fall, which would lead to sovereign debt dominoes falling around the world.   
 
On that note, what did the ECB incorporate into today's decision?  A newly branded asset purchase plan.  On the one hand, they are telling the world they are "tightening" policy to curtail inflation, and on the other hand, they are restarting QE (reopening the liquidity spigot they just closed on July 1st). 
 
This new iteration of ECB QE, called the Transmission Protection Instrument (TPI), is a plan/threat to be the buyer of last resort of the sovereign debt of these weak eurozone countries, to keep a lid on their borrowing rates. 
 
What does it all mean? 
 
We can look to the interest rate market behavior today for the answer. 
 
After the first rate hike in Europe in eleven years, at a market surprising 50 basis points, key global interest rates moved lower on the day (that includes German and U.S. rates).
 
What will stocks do when the realization finally sets in that the Fed (and major global central banks) can't and won't do anything meaningful with interest rates?  Answer:  Stocks will soar.  
 
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Pro Perspectives 7/20/22

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July 20, 2022

We've talked in recent days about the opportunity in bank stocks, and in commodities stocks.
 
The stock in these sectors have been dragged down, with the broad market, for non-fundamental reasons.  If we step back, for some perspective, we came into the year knowing that a rising interest rate environment would not be friendly to the high valuation tech sector.  
 
And it has been the ugly unwinding of irresponsible over-concentration in these big tech investments that has led to selling of even the most fundamentally sound stocks.
 
As such, we've been given an opportunity to buy good stocks at a discount.  As we've discussed, for the banks, rising interest rates are fueling explosive net interest income growth.  For commodities, the "clean" energy agenda and pandemic-driven supply disruptions have combined to leave us with structural deficits.  That has led to higher selling prices, and widening profit margins.
 
With this in mind, according to a Bank of America survey this week, global profit optimism is at record lows.  That sets up for positive surprises (which is good for stocks).  So, how is Q2 earnings season shaping up?  As of yesterday's close, 81% of companies that have reported have beat earnings estimates.   
 
Add to this, if we look at the chart of the S&P 500, coming off of the worst first half in more than 50 years, you can see we've retraced about a third of the gains from the pandemic lows.  
If these lows hold, this would be considered a shallow retracement of the trend.  Shallow retracements tend to happen in strong trending markets. 
 
Wait, a strong bull trend?
 
For perspective, if we extrapolate out the long-term average annualized gain of the S&P 500 (of 8%) from the 2007 pre-Global Financial Crisis highs, the S&P 500 should be north of 5,000.  It closed today just south of 4,000.
 
So, there are reasons to believe the Fed is near the end of this rate hiking cycle (at least, nearing a pause).  There are reasons to believe we've had a technical recession in the first half, from which a rebound in economic growth in the second half of the year looks promising (historically, growth tends to bounce back strong out of recession).  And there are reasons to to believe that there are deeply undervalued stocks in this environment.
 
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Pro Perspectives 7/19/22

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July 18, 2022

We've talked about the big banks the past couple of days.  If you look just a bit past the headlines, you find that the performance of the biggest banks in the country have been good — despite enduring what increasingly looks like a technical recession in the first half of the year (technical recession = two consecutive quarters of negative growth).
 
But as we've discussed here in my daily notes, this is negative growth AFTER the effects of 40+ year high inflation.  For perspective, nominal growth is still running hot (6%+).  That means economy is still moving.  Demand is still there. 
 
With that, the biggest takeaway from bank earnings:  the consumer is strong, and balance sheets and credit worthiness (for both business and consumers) remain strong.
 
So, we've talked about the opportunity in bank stocks.  Today, they led the way, in a day of broad stock market strength.   JP Morgan was up 2.5%.  Bank of America was up 3.6%.  Citi was up 4.2%.  Wells Fargo was up 4%.   And Goldman Sachs was up 5.6% on the day.
 
We heard from Haliburton before the bell today.  This is the biggest provider of products and services to the energy industry.  They beat on earnings, and beat on revenue estimates.  They put up huge growth numbers, just compared to the past quarter!
 
That should wake up the investment community to energy and commodity stocks, both of which are benefiting from structural supply shortages, and high prices — a recipe for expanding margins.  
 
Yet both (the stocks) of which have been pummeled in the past five weeks. 
 
Since June 8th, the energy sector ETF (XLE) declined 27%.  This is an industry that put up record numbers in Q1, and we will very likely find that they set new records in Q2. 
Is it because oil prices are in the political crosshairs? 
 
It’s not just energy stocks that have been battered in the past month, it’s broad commodities stocks, as you can see in this chart below …
What are these commodities primarily priced in?  U.S. dollars.
 
What has been screaming higher since June?  The dollar.
 
So, with a soaring dollar, weaker commodities prices are buffering the pain for global consumers.  
 
But the dollar is rolling over now. 
 
This should align well with the timing of Q2 earnings in commodities stocks (i.e. a buying opportunity).  Even after some weakness in commodity prices late in the quarter, I suspect we will find these commodity producing companies continued to produce a ton of cash, with which they have been  paying down debt and returning large amounts to shareholders (share value creating).  Commodity stocks are a gift to buy on this sharp correction. 
 
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Pro Perspectives 7/18/22

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July 18, 2022

On Friday we talked about earnings from three of the big four banks. 
 
All produced soaring net interest income, thanks to rising interest rates. 
 
All had solid overall earnings performances, before adding to an already massive war chest of loan loss reserves (although loan losses continue to be low). 
 
And all had positive things to say about the strength of the consumer. 
 
We heard much of the same today from Bank of America, the second biggest bank in the country. 
 
So, the banks continue to be profit printing machines.  When times are unstable over the past fourteen years, they’ve been backstopped by the Fed (de-risked), and incentivized to fuel credit creation to help the economy — from which they make money in loan origination, investment banking and trading. 
 
When times are more stable, their customer account balances balloon (as they have now), from which they get to earn what is becoming a very healthy interest rate spread from the rising interest rate environment. 
 
Heads, they win.  Tails, they win.  And the systemically important feature of being one of the biggest banks in the largest economy in the world, means that (as we’ve observed) risk is absorbed/transferred/backstopped by the Fed and government. 
 
With the above in mind, as we discussed on Friday, the banks are dirt cheap at lower than 10 times next year’s earnings (a straight average of the big four banks).   That’s less than 0.6x the P/E of the S&P 500.
 
This relative valuation is near historic lows, not only for the big four banks, but for financials on whole, relative to the broader stock market.
 
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Pro Perspectives 7/15/22

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July 15, 2022

Second quarter earnings season is just getting underway.  We've heard from three of the big banks this week.
 
JP Morgan, the biggest bank in the country, "missed."
 
That was the big news yesterday.  But don't let the headlines fool you.
 
They had growth in almost every category.  The exceptions: investment banking, and assets under management (due to the decline in the stock market).
 
The earnings miss was a management decision.  They chose to take charge offs and move almost half a billion dollars to "loan loss reserves."
 
That's the corporate America playbook for a down stock market.  Put all of the bad news you can muster on the table.   That sets up for positive surprises in the quarters ahead.     
 
If we add the allocation to loan-losses, back to earnings, JP Morgan would have beat estimates by 2 cents.  Meanwhile, they grew year-over-year revenue by $200 million.
 
This, rather than the headlines, is more in line with the way Jamie Dimon (CEO of JP Morgan) described the health of the economy.  He said, "the U.S. economy continues to grow and both the job market and consumer spending, and their ability to spend, remain healthy."
 
Now, add to this, we heard from Citibank and Wells Fargo today.  
 
Citi beat on earnings and revenues.  They, too, took a big write off for bad debt, and set aside $375 million for (additional) loan losses.  They still beat.   
 
Wells Fargo missed.  This is the "put all the bad news on the table" posterchild.  They took big write downs on private equity and venture capital investments.  Meanwhile net interest income jumped 16%.   
 
Keep in mind, these three banks still have a combined $10 billion more in "loan loss reserves" than they did prior to the pandemic.  This is a war chest of capital that was set aside early in the pandemic, that will be moved to the bottom line (i.e. turned into earnings) at their discretion.
 
Bottom line:  The big four banks are in good shape, and are cheap, with forward P/Es under 10. 
 
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Pro Perspectives 7/14/22

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July 14, 2022

Over the past two days, we've seen the June inflation rate on consumer and producer prices.  Both were hot, running at double-digit annualized rates. 
 
Consequently, interest rate markets have quickly adjusted, pricing in a coin-flips chance of a 100 basis point hike at the July 27th Fed meeting.
 
Stocks reacted this morning, going deeply in the red. 
 
But most of the losses were recovered by the end of the day.  The Nasdaq (the most interest rate sensitive stock index) finished UP on the day. 
 
What's the story?
 
The markets have just set up for a positive surprise (i.e. they are not going 100 bps).
 
As we've discussed here in my daily notes, the Fed doesn't have the appetite for big rate hikes.  If they did, they would have acted bigger, and more aggressively already. 
 
Remember, high inflation environments, historically, have only been resolved when short term rates (the rates the Fed sets) are raised above the rate of inflation.  The Fed is currently almost eight percentage points behind.  We can only assume, at this point, that it's intentional.  
 
Also, when asked about the inflationary risks of QE, back in 2010, the former Fed Chair (Ben Bernanke) said dealing with inflation is no problem.  "We could raise rates in 15 minutes."  They haven't. 
 
Add to this:  The current Fed Chair has told us that they were going to aggressively attack inflation, by "expeditiously" raising interest rates, and "significantly" reducing the Fed's balance sheet.  They have done neither.
 
So they have the tools.  They understand the formula for resolving inflation.  But they aren't acting. 
 
Why?  Even if the U.S. economy (including our government's ability to service its debt) could withstand the pain of nearly double-digit interest rates, the rest of the world can't.  That's it.  End of story. 
 
Capital is already flying out of all parts of the world, and into the dollar.  Is it because U.S. bonds are finally paying interest?  Partly.  Mostly, it's because the U.S. is pulling global interest rates higher, which makes sovereign debt more expensive (more likely, unsustainable), particularly in the more economically fragile emerging market countries.  Rising U.S. rates accelerate global sovereign bond markets toward default/ sovereign bankruptcy. 
 
And historically, sovereign debt crises tend to be contagious (i.e. you get a cascading effect around the world).  So far, we've seen defaults by Sri Lanka and Russia. 
 
This is why the Fed is talking a big game, but doing very little with rates. 
 

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Pro Perspectives 7/13/22

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July 13, 2022

The June inflation report this morning came in hotter than market expectations.  The year-over-year headline CPI is now nearing double-digits.  And the monthly inflation number is now reflecting prices rising at a mid-teens annualized rate.
 
This is what happens when you grow the money supply by $6 trillion in two years (a one-third increase).
 
Still, of the legislative handouts that have been approved over the past two years, three-quarters of a trillion dollars remains unspent. 
 
That’s more gas yet to be poured onto the inflation fire. 
 
But just in case you thought that wasn’t enough, the democrats are resurrecting “Build Back Better.” 
 
Why?
 
This is the cornerstone of the global (G7) agenda, of which, the U.S. administration is in full, explicit cooperation to execute.
 
It’s rooted in energy and social transformational policies, and it doesn’t get done in the most important constituent country (the U.S.), if the democrats lose control of Congress in November.
 
What will they do?  Whatever it takes.  At the moment, this renewed effort to push through over a trillion-dollars of new spending, is being framed as a solution to inflation.  This sounds like the California playbook.  The carrot:  Gas checks for everyone!
 
Thankfully, Manchin would hold the line against complete insanity.
 
But this brings us back to my June note, after NATO announced accession plans for Finland and Sweden, following a number of other provocative actions. 
 
Excerpt from June 29, Pro Perspectives:  “We know that Western leaders are all coordinating to execute on an economic, social and political agenda.  And we know that the current economic environment (high inflation, record high debt and deficits, and record low interest rates) is a conundrum, which threatens the execution of the agenda.  Still, we also know that they have the appetite to keep spending, to keep executing.  
 
What better way to excuse more fiscal spending (to get the agenda done) than to enter a global war.  And I suspect, if the current proxy war, turned into a global war, it would be a war of posturing. It would be as ambiguous as the current war.“
 
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Pro Perspectives 7/12/22

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July 12, 2022

Tomorrow morning, we get the June inflation number.
 
As we discussed yesterday, rising gas prices in June will be a big contributor to upward pressure on CPI. The consensus view is for a hot headline number – a new 40-year high.   
 
But as we also discussed yesterday, given some weakness in other inflation inputs, as well as weakness in broad economic data, don’t be surprised if the Fed and the media try to turn focus to the “core” inflation rate (in effort to manage confidence). 
 
The core number excludes the effects of food and energy.  It has been ticking down the past two months, and is expected to continue that trend in tomorrow’s report.
 
On cue, we had an article from Reuters this afternoon that drew attention to the core number.  And the head economics guy at the White House tweeted this, this afternoon…
So, the White House is trying to get in front of the number tomorrow.  The White House also included in today’s sentiment manipulation campaign, that economic data in Q1 and Q2 was not consistent with “recession.”
 
But as we know, official Q1 GDP was negative.  And Q2 is tracking a contraction of 1.2%.  That would be two consecutive quarters of negative GDP, which is technically defined as recession. 
 
The White House is clearly trying to assuage a recent small business optimism index report, which plunged to nine-year lows, and consumer sentiment which is on record lows. 
 
All of that said, if we look at nominal growth, the economy is indeed growing at a better than average clip of over 6%.  It’s inflation that is crushing “real” growth.  It’s an inflation-driven recession.   
 
If we look back to the inflation spikes of the early early 80s, nominal GDP grew by an annual rate of 9% during those periods. 
 
Stocks did this … 
Notice the impact inflation had on the real (after adjusted for inflation) rate of return in stocks (the third column). 

 
And through a four-year period, where inflation averaged nearly 10% per year, you can see, in the far two columns, what it looked like for those that remained invested in stocks, relative to those that went to cash. 
 
The takeaway:  Being long stocks not only gave you a hedge, but increased your buying power by 30% over the period.  Going to cash, destroyed your buying power by 33% over the period.
 
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Pro Perspectives 7/11/22

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July 11, 2022

We get the big inflation data on Wednesday, and then the banks will kick off Q2 earnings to end the week.
 
Let’s talk about three factors, that have already been revealed, that will influence the June inflation number.  
 
First, gas prices:
 
This carries almost a 1/5th weighting in the CPI calculation.
 
As you can see in this 10-year period between 2002 and 2012, gas prices and the consumer price index track very closely. 
So what did gas prices do in June?  The Energy Information Admistration (EIA) does a weekly survey of gas stations across the country.  Those survey results show a rise in gas prices by about 11% from May to June.
 
That doesn’t bode well for the inflation number. 
As you can see in this above table, these sharp rises in gas prices have resulted in big monthly change in CPI.  These monthly changes in CPI around 1% are representing an annualized inflation rate of double-digits (well above what has been the high year-over-year rate recorded thus far). 
 
So, as far as Wednesday's number goes, this gas price input is bad news.
 
But there is some hope that the inflation report could come in a softer, and therefore, take some pressure off of the Fed to act more aggressively.
 
We looked at the wage data on Friday. 
 
The Fed is worried about the wage pressure influence on prices (or worse, a wage spiral). 
 
On that note, the June jobs report showed average hourly earnings grew by 0.3%.  If we annualize that, we get 3.7% wage growth.  That's significantly lower than the year-over-year change of 5%+. 
 
That's good news (i.e. less pressure on prices). 
 
Finally, let's take a look at what's happening in China, where the products are made that we will be buying in the many months ahead…
Notice on the far right of this chart, producer prices in China were screaming higher late last year (at 13.5% year-over-year rate).  It was the hottest reading in 26 years.  Meanwhile, the Fed was still playing the inflation denial game.  This data was clearly telling us what was happening, and what was coming.  And we have seen it.  
 
But, this number has since been falling like a stone, for eight consecutive months (now at 6.1%).
 
Again, this all relates to how aggressive the Fed will (at least threaten) to put the brakes on the economy. 
 
With the above in mind, with clear softening in the economy and in some of these inflation inputs, expect the Fed to start focusing the media and Wall Street on the core inflation number (chart below).  This number excludes the effects of food and energy — which they like to justify by calling these inputs too "volatile."  This has always been the number, with which they have positioned their policymaking.  
 
If we see this core number continue to roll over, the Fed could be, in the coming months, in a position to claim victory (with the excuse to pause on tightening) — though the true cost of living pain, from food and energy, will continue. 
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