A Deep Recession Is Rapidly Approaching
Volatility remains the major feature of financial markets. You are correct if you interpret the word “volatility” to include a downtrend in equity prices. This is the kind of action one normally sees in a “Bear” market. The table below shows the changes in the major U.S. indexes from their year-end peak values to the end of April, May and to the close of business on Friday, June 10. It wasn’t a pretty week with the major indexes down between 3.0% and 5.4%. Both the Nasdaq and the Russell 2000 are well into “Bear” market territory while the S&P 500 may well be there next week. It appears that, contrary to the narrative on Wall Street that the approaching recession will be “mild” and won’t occur until next year, investors are recognizing that the recession will be ugly and will likely come sooner than later.
Part of the issue for the markets is the inflation scenario. We deal with it in detail later in this blog. The 8.6% Y/Y CPI print on Friday was the catalyst for Friday’s sell-off. As shown in the table, while markets took a breather in May (“Bear” market rally), the downtrend reignited this past week.
|Peak Val||Value 4/30/22||4/30 Chg fr Peak||Value 5/31||5/31 Chg fr Peak||Value 6/10||6/10 Chg fr Peak|
The chart at the top of this blog shows a comparison of the top-10 equity market sell-offs during the first five months of the year. Note that, despite the rhetoric coming out of Wall Street and the May “Bear” Market rally, as of the end of May, over the 122-year period, the severity of the equity sell-off is tied for third.
Employment – What the Data Says
In today’s world, the media, including the financial media, appear to report with a point of view. Without digging deeper, one would never get the whole story. We reported in our May 9th Blog that the +428k net new jobs number reported in the Payroll Survey for April was closer to +148k once all the nuances were considered. While the headline was lower than April’s, May’s Payroll Report (+390k) was actually somewhat better. But again, after considering that about +100k was added from the assumed growth of small businesses (the Birth/Death imputed add-on), the counted number of +290k falls to under +200k if ADP’s count of small business jobs (-92k) is used. Hence, this number was on the weaker side. Nowhere did we see any mention that the Retail Sector laid off -61k, or that the factory workweek and overtime hours declined. In fact, overtime hours are down three months in a row; the first time this has happened in seven years. In addition, those working part-time for economic reasons (they can’t find full time because business is slow) rose by +349k and has now risen in three of the last four months.
ADP is the largest payroll purveyor in the U.S. They are able to count the number of employees who get paid from their internal records, and they can divide them by the size of the businesses they serve. The ADP data is trending lower, much lower as seen from their monthly total employment estimates: Dec: +780k; Jan: +512k; Mar: +249k; May: +128k. For small businesses, which are much more sensitive to changes in the economic environment than are large businesses, ADP’s numbers show May: -92k and April: -123k. Year to date, the number for small business employment is -278k. In addition, the weekly data on Initial Jobless Claims, while still fairly low, have started to increase, and layoff announcements (Challenger) are on the rise. Thus, we think that the employment data will continue to deteriorate as the year progresses.
The New “Narrative”
In the face of deteriorating employment data and, worse, poor Q1 results from major retailers (see below), the Wall Street narrative has changed from a “strong” economy to that of a “mild” recession that won’t arrive until next year. The incoming data say something much much different.
Let’s start with Q1 corporate reports. In mid-May, Walmart (WMT) and Target (TGT) reported sales, earnings and guidance that disappointed Wall Street analysts. Both said that consumers purchased fewer “discretionary” items. WMT said consumers spent more on food and less on discretionary items. Home Depot (HD) and Kohls (KSS) offered much of the same, so it appears that the Retail Sector is reeling (per the -61k layoffs in May in this sector noted above). But the weakness is not confined to Retail. Both Microsoft (MSFT) and Tesla (TSLA) disappointed with TSLA announcing a 10% workforce reduction! Note also that, of the four major indexes shown in the table above, it is the Nasdaq (tech heavy) and the Russell 2000 (small businesses) that are down the most. The fall in the Russell doesn’t surprise us because small businesses are much more sensitive to the economic environment than are large ones. But the fact that investors have run from tech should be of concern. MSFT’s miss may be prescient.
There must be a reason why Retail is behaving so poorly (remember consumption is 70% of GDP!). The chart below says it all. Despite the fact that wages have risen at a faster pace over the past year and a half than they had for many years, inflation has risen even faster, so real (inflation adjusted) earnings are falling behind. Note in the chart below that falling real earnings are often associated with recessions. It isn’t really rocket science!
The Inventory Overhang
Inventories are too high. One could have gleaned that from the TGT and WMT reports that consumers purchased fewer discretionary items. Over the past year wholesale inventories are up 24% and retail inventories 15% and stand at a 38-year high. We also note that the CA ports are reporting near record unloadings. That indicates that supply chains are becoming unclogged and that inventories will rise further.
Much of this appears to have been a function of the “shortage” narrative that was a major theme in 2021. That narrative caused businesses to order early as they worried about not having goods on their shelves. Now they have the goods, but consumers aren’t buying them. We expect this excess inventory will go “on sale.” (That should help the inflation issue!) In fact, on Tuesday (June 7) the following headline appeared on CNBC: Target expects squeezed profits from aggressive plan to get rid of unwanted inventory. The sub-headline was: Target said it will take a short-term hit to profits as it cancels orders and marks down unwanted merchandise. Walmart, which saw inventories grow 33% Y/Y, and Kohl’s (40%) are in the same boat. Many others, too. We expect discretionary merchandise to be “on sale,” if not now, then soon.
The Consumer Strength Myth
Part of the narrative has been that consumer balance sheets are strong and they have significant savings, so consumption will remain elevated. Again, that is ancient history. The savings rate, which was over 30% when Washington D.C. was giving money away, has now fallen to a 14-year low of 4.4% (see chart). Not much there to spur consumption!
In addition, over the last four months, consumers, in an attempt to maintain their living standards in the face of rising food and fuel prices, have gone on a borrowing binge. There has been a record run-up in credit card debt to the tune of $38 billion in April alone and $120 billion over the last four months (11.2% growth and a 22% annual growth rate). As one would expect, delinquencies are also on the rise: 60-day delinquencies for sub-prime credit card holders are up six months in a row; 11% of credit card holders with credit scores below 620 are delinquent, and 8.5% of car loans/leases are also delinquent.
Cracks in the Housing Market
The New Home sector is a major contributor to GDP. We have seen new housing inventory go from a couple of months supply to nine months. Mortgage applications to purchase have been falling on a week-to week basis over the last several months and are -21% lower than a year ago. This is no doubt a function of rising mortgage rates which have gone from the 3% area to more than 5.5%. Which means that the monthly mortgage cost for a median priced home a year ago is now 50% higher. April’s Existing home sales are down nearly -6% Y/Y, pending sales -9% and new home sales -12%.
Worse, the rise in interest rates have caused a -75% Y/Y falloff in mortgage refinances. Often, consumers borrow against the appreciated value of their homes for big ticket items, like home improvements, to finance an expensive vacation, or even to purchase a car. The fact that such applications have fallen so far, so fast implies a dramatic slowdown in such purchases. In fact, the data say that overall refi-mortgage applications are at a 22-year low.
Big-Ticket Items Tank
It’s not just housing. For the last several months, The University of Michigan’s Consumer Sentiment Survey has indicated that consumers were not in any mood to purchase homes, cars, or other big-ticket items as seen from the chart showing consumer intentions to buy cars.
Lo and behold, we now see new car sales (passenger cars and light trucks) were down -30% Y/Y in May.
The U of M’s sentiment gauges continue to point lower. The chart below shows that the overall Consumer Sentiment Index for June has fallen to the lowest level in its history.
Because U of M’s sentiment gauges continue to point lower, we can expect that major purchase statistics will continue to deteriorate for the foreseeable future.
The Tight Labor Market
The champions of the “mild recession” narrative say the economy is still vibrant and point to the labor market. They say the Unemployment Rate is still 3.6% and “Now Hiring” signs are everywhere you look. The answer is that the tight labor market preceded the pandemic. Part of this issue is demographic in nature, because as baby boomers are retiring, replacements aren’t 100% there. But much of the problem has been caused by the narrative itself. That is, the view that there aren’t enough workers has caused both over-hiring and labor hoarding. We see this in the productivity statistics. In Q1, productivity eroded at an annual rate of -7.5%. That number is huge, and we haven’t seen such a number since 1947! Over the last three quarters, productivity has fallen at a -1.9% annual rate. That’s a harbinger for recession as poor business results will cause right-sizing.
While the Initial Jobless Claims are still fairly low, they have recently started to rise. We also note that layoff announcements (from Challenge) are on the rise.
Inflation and the “Transient” Issue
The May CPI number was quite ugly on Friday (June 10) with the Y/Y inflation rate rising to 8.6%. The main culprits, once again, were food which was up +1.2% M/M (+10.1% Y/Y) and energy (+3.9% M/M; +34.6% Y/Y). These are taxes on the real spending power of households, especially lower/middle income ones. As a result of the energy spike, airline fares rose double digits and are now 38% higher than a year ago, and the energy costs also spilled over into delivery services and freight costs. The “core” inflation rate (ex-food and energy) rose an ugly 0.6% and only fell on a Y/Y basis (6.0% from 6.2%) because of “base effects,” i.e., the denominator (moving from April 2021 to May 2021) spiked higher.
Nonetheless, we still maintain the view that this bout of inflation is “transient.” We know that this is a discredited word. The problem with that word is that it was never defined as to time frame, so imputed to it was a short period, like 2 or 3 months. The term actually means “not permanent.” And that remains our view. As to time frame, likely another 12-18 months barring any non-economic events (like Russian aggression). At this stage, we see significant downward pressure on inflation for the following reasons:
- Demographics – the demographics in the U.S. and in major developed markets (older populations) are such that disinflation/deflation results. We saw this in the U.S. economy between the Great Recession and the pandemic;
- Fiscal policy has turned from giving away money to one of a significantly shrinking deficit;
- The money supply is now contracting and the velocity of money is still near record lows;
- The Fed has not only caused interest rates to rise, but they have now begun Quantitative Tightening (QT); liquidity is drying up and that will impact financial markets (likely already has);
- Vendor delivery delays are easing – the ISM measure is at a 14 month low;
- The supply chain logistics appear to have eased – the near-record unloadings at the CA ports support this view;
- Multi-family units will come to market at a record level in the 2nd half of 2022; that will stop the rise in rents;
- The U.S. dollar is strong which reduces the cost of foreign goods;
- Commodity prices appear to have peaked:
- Lumber: -43% over the last 3 months;
- Steel rebar: -22% from its peak;
- Iron Ore: -35% from its peak;
- Baltic Dry Index: -20% since mid-May;
- Major retailers will be reducing inventories (reduced prices); TGT already announced its major inventory reduction;
- Wage growth has slowed to about half of its 2021 rate; it will further moderate as the unemployment rate rises.
The indicators are all saying that the recession will come sooner and be deeper than currently expected:
- The Citigroup Economic Surprise Index is deeply negative;
- The Atlanta Fed’s GDP forecast for Q2 is now 0.9% (June 8), down from 1.9% on May 27 and 2.5% on May 17;
- U of M’s overall Consumer Sentiment Index dove to 58.4 (prelim) in May from 65.2 in April – that’s a big move for that index, and, as we discussed earlier, it has proven to be a leading indicator for car and home sales.
- Lower/middle income earners are suffering from a large inflation tax – that is impacting consumption;
- Upper income earners are suffering from a “Bear” Market in equities, and that has a psychological impact on their spending;
- The implications for the economy:
- Inventory reductions (things “on sale” should help reduce inflation);
- Cost cutting as profit margins erode;
- That means layoffs and rising unemployment.
Robert Barone, Ph.D.
(Joshua Barone contributed to this blog.)