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As The Recession Asserts Itself, The Fed Takes a Hard Line

Sinks Stocks

Equity markets were in a holding pattern all week waiting for some tidbits from the Federal Reserve’s (Fed) annual Jackson Hole Symposium; especially waiting for Chair Powell’s Friday eloquence. Through Thursday, only the DJIA was off more than -1%, the Russell 2000 was almost flat, while the S&P 500 and Nasdaq were down marginally. Turns out that Powell wasn’t so eloquent after all, and, on Friday, the DJIA was down a staggering -1008 points (-3.0%) while the Nasdaq was down -4.0%, the S&P 500 -3.4%, and the Russell 2000 -3.8%. The table shows the weekly change for the major indexes, all falling significantly. Bonds were more muted with the short end up much more than the long end – the yield curve becoming even more inverted (2s/10s now inverted by 35 basis points). Yield curve inversion of this magnitude is always associated with a recession.

The headline on page A-1 of the Weekend Wall Street Journal said it all: “Fed Chief’s Hard Line Sinks Stocks.” Seems that, after Powell’s eight-minute speech, stock traders have finally seen what the bondies have known for some time, i.e., the Fed is hell-bent on bringing down Y/Y inflation and now appears willing to tolerate a Recession of some significance. The result is that the equity markets are now playing “catch-down.”

Here are some key remarks from Powell’s presentation:

While higher interest rates, slower growth and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses.  (emphasis ours)

Our responsibility to deliver price stability is unconditional…we will keep at it until we are confident the job is done.

And this quote is key:

Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy. (emphasis ours)

From these remarks, it appears that this Fed Chair is willing to keep raising rates even as economic activity craters (see below), at least until the backward-looking Y/Y inflation metrics (CPI and PCE) come nearer to their 2% goal.

The “Premature Loosening” Issue

It is interesting that he, Powell, would talk about the historical record, i.e., “prematurely loosening policy.” He was clearly referring to the Arthur Burns era of the 1970s when the Fed kept monetary policy too easy even while inflation and inflation expectations were high and rising. But that remark is short-sighted and really represents the exception, not the rule. The history of the post-Volcker Fed is that, because they do not know how long the lags are between policy implementation and the impact on the economy, they are always late in loosening policy, long after the Recession is well established and ingrained. Most monetary economists know that the Fed is often the responsible party when it comes to Recession blame. In today’s case, the Recession is already staring them in the face as they resolve to raise rates higher and for longer. And that’s because they have tied their wagon to lagging, backward-looking, indicators. (Perhaps, we think, this may be due to the political atmosphere where the current Administration is being blamed for the highest inflation in more than 40 years.)

The equity markets’ nasty reaction appears to have hinged on the realization that there isn’t even a glimmer of hope for a Fed “pivot” or the much wished-for “soft landing.” The bond market reached that conclusion several weeks ago (thus the inverted yield curve). As a result, it appears that the equity market rally of the past seven weeks was just the typical rally that occurs in all major “Bear Markets.” i.e., a “Bear Market” rally, meaning that the June lows are likely to be retested, and soon, as the incoming economic data continues to be dramatic to the downside with many indicators now showing up at levels worse than what occurred a decade-and-a-half ago, i.e., during the Great Recession.

What Q2 Earnings and Supply Chains Are Telling Us

During the recent earnings season, the major retailers were all disappointed. Besides Walmart, Target, and Kohl’s, Nordstrom, a retailer catering to the affluent, cut their profit and sales forecast, remarking that “demand and traffic are slowing markedly.” Macy’s reduced earnings guidance by -30%, while Ross and BJ’s Wholesale announced inventory clearance sales. Nvidia (semiconductors) warned on revenue (too much inventory); Peloton had another quarterly loss (couldn’t make money even during the Covid era), and Dell Computers cut its outlook citing slow personal computer sales. To show the extent of the inventory issue, on a Y/Y basis, Walmart’s inventories are +25% higher, Target’s +36%, and Kohl’s +48%.

Backlogs and vendor delivery delays have eased significantly as have production bottlenecks. This implies further supply easing and lower inflation numbers in the months ahead, even without further Fed action. As shown below, even the Fed’s own regional bank indexes are seeing significant easing in supply chains.

Housing is Sinking

We just mentioned retail’s inventory issues, but we also see excess inventories in new housing with skyrocketing months’ supply as there are fewer prospective buyers (see charts) and cancellations are the highest since the Covid lockdowns.

Toll Brothers, America’s largest luxury home builder, says its order books contracted by 60%! New home sales in July fell by 12.7% M/M on top of June’s -7.1% result. On a Y/Y basis, new home sales are down -30% and are falling at nearly a -60% annual rate on a year-to-date basis. At a 511K annual rate in July (consensus was wildly off, i.e. 575K), the level is less than the 582K Covid low of April 2020.

Existing Home Sales fell -5.9% M/M in July, are down six months in a row, and -20.2% Y/Y. Marketing times are now rising and prices have begun to soften. July’s Pending Home Sales (new contract signed) fell -1.0% in July (down in eight of the last nine months) on top of a -8.9% fall in June. That means pending sales are -9.9% lower than May! On a Y/Y basis, pending sales are down nearly -20%.

For housing, the worst appears to still be on the horizon as mortgage applications for purchase fell another -2% the week of August 19, are down -21% Y/Y and, except for the Covid lockdown, now sit at a 22-year low. Refi apps? They are down -83% Y/Y (see chart at top).

Other Financial Indicators

  • We’ve already seen the first bankruptcy in the mortgage lending business – First Guaranty, co-owned by PIMCO, couldn’t generate enough volume to bundle and sell and was forced to file.
  • The Census Bureau reported that 40% of Americans are now experiencing difficulty in meeting their monthly obligations.
  • The S&P Global PMI (Purchasing Managers Index) for the U.S. for August showed up at 45.0 (50 is the demarcation between expansion and contraction), down further from July’s 47.7. The services sub-index was 44.1 (47.3 in July) while the Manufacturing sub-index was still positive at 51.3, but down from July’s 52.0.
  • The Richmond Fed’s Manufacturing Index for August was -8, down significantly from 0 in July. Shipments, Orders, Backlogs, and Capacity Utilization were all in contraction, and Vendor Lead Times, a measure of supply chain tightness, at -14, was the lowest since March ’09. This particular metric was 0 in July and as high as 45 last March and shows what is happening on the supply side (a positive sign for lower future inflation).
  • The Kansas City Fed’s Manufacturing Index was 3 in August, down from 13 in July. It was 37 in March, and the fall over the past five months is unprecedented, even faster than during the Great Recession. Like in Richmond, Production, Shipments, and Orders were all in negative territory.
  • The Chicago Fed’s National Activity Index (over 80 variables) showed up negative for the second month in a row with its Sales/Orders/Inventories, Personal Consumption/Housing, and Production/Income sub-indexes all contracting.
  • The NY Fed’s Manufacturing Index was -31 in August.

So it appears that both services and now manufacturing have hit a wall.

In the rest of the world, the Eurozone continues to fall into an energy-induced Recession, although it appears that the natural gas situation for the upcoming winter won’t be as dire as initially thought. China’s central bank has eased, but that economy continues to be plagued by its real estate issues, lockdowns, and now drought, and there is no longer any mention of its 5.5% 2022 growth target. It appears that growth there will be the slowest in 40 years.

Final Thoughts

The economic indicators continue to move lower with the all-important housing sector leading the way, and both manufacturing and the service sector either showing outright contraction or weakening substantially.

In this environment, the Federal Reserve is intent on moving interest rate policy into restrictive territory and keeping it there, apparently until its backward-looking inflation indicators approach its 2% target. That may not occur until sometime late in 2023. In addition, no one, not even Powell himself, is discussing the impacts of Quantitative Tightening (QT) which will begin in earnest in September with the sell down of $95 billion/month of Treasuries and Mortgage Backed Securities and continue for many months thereafter. That will put even more upward pressure on interest rates and downward pressure on the economy. So, it’s no wonder that the equity markets reacted badly on Friday when Powell came out as hawkish as ever.

In looking at post-WWII economic history, we find that there are three conditions necessary for the equity market to find a bottom:

  1. The yield curve must be positively sloped, not inverted as it is today;
  2. The Fed is easing (not tightening into an inverted yield curve);
  3. The economic data are getting better, not worse.

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog)