Nearly all the equity market gains from the two-day rally on Monday and Tuesday were wiped out by Friday. The table shows the peak value of the indexes at the turn of the year, the index lows (three of the four indexes had new lows on September 30), the percentage change from the peak, and where the closing prices stood on Friday (October 7) relative to their lows. Note that three of the four major indexes are close to their September 30 lows, and, as the week ended on a sour note, are likely to test those lows as the new week begins.
|Peak||Cycle Lows||Cycle Low chg fr Peak||Date of Cycle Low||10/7/22||10/7 chg fr Peak||10/7 chg fr Low|
Things aren’t much better in bond land. The 2-Yr. Treasury closed the October 7 week at 4.31%, slightly above its close of 4.27% the prior week. (Only the baby boomers remember those kinds of yields!) And while four basis points doesn’t appear to be out of the ordinary, that yield was as low as 4.10% on Monday (October 3). The 10-Yr. Treasury displayed similar volatility: 3.83% on September 30, 3.62% on October 3, and closing the week (October 7) at 3.88%. The important 2s/10s spread inversion was -44 basis points (bps) at the quarter’s end and -43 bps at last week’s close.
Why so much volatility in the financial markets? For equities, September 30 was the quarter’s end, and part of the sell-off was due to window dressing on the part of fund managers not wanting to show high levels of equity holdings for the quarter-end reporting period. The Monday/Tuesday rally was at least partly due to extremely oversold conditions, but there was the new sentiment in the market questioning the Fed’s ability to raise rates with a developing Recession at home not to mention the struggles Europe, Japan, and other allies are having with the values of their currencies, the impacts on their financial markets, and the specter of a developing default cycle, all due to an over-zealous Fed.
“Surely the Fed would have to pay attention to such developments” was the market sentiment during the Monday/Tuesday rallies. There was even a rumor on the October 1-2 weekend that the Fed had called an emergency meeting to deal with such concerns. Indeed, a Fed meeting had been called, but this Fed’s Open Market Committee meets every month via Zoom. When a meeting is not listed and published on the public agenda, the Fed is required to use its “emergency” powers to call such a meeting. (It has done so every month this year outside of its regular schedule.) So, the rumor turned out to be just a rumor.
Besides the market being oversold, much of the Monday/Tuesday price spike was based on that “hope,” i.e., that this Fed had come to its senses and would not carry out its stated rate agenda. On Wednesday, the Australian central bank raised rates by 25 basis points; the market had anticipated 50. So, there was still some “hope” that the Fed might only raise 50 bps at its November meeting instead of the anticipated 75. Unfortunately, those hopes were dashed as FOMC members Bostic, Daly, and Williams put the kybosh on the notion that this Fed would soon “pause” or deviate from its plan, much less “pivot” anytime soon. Markets began slipping on Wednesday and by Friday, those slips and slides turned into a rout (the DJIA: fell -630).
The Good News
On Friday, the market plunge intensified because of the “solid” labor market report (i.e., good economic news has now become bad news for financial markets, as good economic numbers give the Fed even more reason to be hawkish). The payroll report number was +263K, right around the expected level. But what was unexpected was the fall in the unemployment rate from 3.7% to 3.5%. Remember, the Fed, itself, forecast a 4.4% unemployment rate by December. Thus, the employment report put another nail in the “hope” coffin, and on Friday market participants threw in the towel.
How We Know It’s a “Recession”
Sometimes history repeats itself; most of the time it rhymes.
- The Conference Board’s Leading Economic Indicator Index (LEI) for August fell -0.3%, down six months in a row and in seven of the last eight (chart). Historically, when the LEI is negative for six straight months, a Recession occurs 100% of the time.
- The rule of thumb definition of a Recession is two consecutive quarters of negative GDP growth. The reason for the rule of thumb is that when two such consecutive negative GDP quarters occur, a Recession results 100% of the time.
- When a 40+ basis point yield curve inversion between 2 Yr. (4.31%) and 10 Yr. (3.88%) Treasuries occurs, a Recession follows 100% of the time.
- When the equity market falls more than -30% (Nasdaq and Russell 2000 so far), history tells us that a Recession occurs 100% of the time.
When Bear Markets End
Because the incoming data continues to point to Recession, even some of the sell-side analysts (Goldman, BAC…) are now using the “r” word (not capitalized) because it is qualified by the “m” word (“mild”). They are now talking about when the “Bear Market” might end.
History tells us that “bad stuff” continues to happen in the economy after the Fed’s first rate cut. That’s because monetary policy acts with long lags. Over the last seven Recessions, the S&P 500 low occurred, on average, 11.6 months (median 10 months) after that first rate cut (the data ranges from two months (1980 Recession) to 21 months (2001 Recession)). According to this Fed, we are many many months away from that first rate cut. “Bad stuff” is likely to continue.
- From the labor market report, we see that the workweek was stagnant at 34.5 hours. It’s been flat or down every month since March. YTD, hours worked are down at a -1.2% annual rate. First hours worked fall, then layoffs occur. That’s why hours worked are a leading indicator and payrolls are a coincident one.
- Real (inflation-adjusted) average weekly earnings have been flat or negative in nine of the last 11 months. They are -3.4% Y/Y.
- Corporate default rates are on the rise; they’ve doubled since July. According to Moody’s, corporate “distress” is now at 2011 levels. Moody’s says defaults may occur in up to 6% of corporate America.
- The dollar’s surge in value has caused the world’s major central banks to run down their foreign exchange reserves by over $1 trillion (that’s -8% of their total reserves) to defend their currencies’ values from the uber-hawkish Fed. The British pound fell to as low as $1.03 (was $1.30 not long ago), and the euro to $0.95 (was $1.15). [Our view is that if this continues, there will be a groundswell to get rid of the dollar as the world’s reserve currency.]
- U.S. imports fell -0.5% in August (down six months in a row). Demand is falling. Also, this means lower foreign exports and lower foreign production (the world’s economy is slowing).
- In August, German factory orders fell by 2.4% M/M and Swedish Industrial Orders were down by 4.2% M/M. Eurozone Retail Sales were off -0.3% (vs. -0.4% in July) and are down more than -2% Y/Y. In the Eurozone, the Construction PMI was 45.3 (50 being the divide between expansion and contraction).
- Taiwan’s exports fell -5.3% Y/Y in September. This was the first such decrease since June 2020. (Note: the consensus was for a rise of +2.4%! So this was quite a shock.) And tech-related orders in Taiwan are down -13% from their peak.
- In the U.S., YTD through August, total energy consumption is off at a -9% annual rate. (Perhaps OPEC’s oil production reduction of -2 million BPD may not get them to their desired $100/bbl. price!)
- Vendor delays in all the Fed Regional Bank surveys are back to pre-COVID levels as are prices paid and received.
- Commodity prices are in a Bear Market. From their recent peaks: Lumber: -70%; Aluminum -40%; Iron Ore: -35%; Copper: -30%; Energy: -23%; Ag Products: -20%; Textiles: -16%.
- Trans-Pacific shipping rates are now $2,265/container. In September 2021, they were $20,586/container. That’s an -89% fall!
- Recent WSJ headlines:
- Costco Waits on Price Cuts Even as Freight Rates Slide
- Conagra Predicts Relief on Food Costs
- Housing is the most interest-sensitive sector. Every metric there says Recession (chart). Prices have started to fall (Redfin, FHFA, and Case-Shiller surveys) as mortgage rates breach the 7% level. During the Great Recession, home prices contracted by 25%. Some similar scenario is likely in this cycle.
The Labor Market
Prior to layoffs, hours fall, full-time positions become part-time, and real take-home pay falls as do job openings.
- Challenger Data: Layoff announcements are up +68% Y/Y in October; in September, they were up +30% Y/Y. The reasons: 1) Demand downturn; 2) Cost cutting; 3) Financial loss; 4) Business closings. Hiring announcements were off by 60% Y/Y in September.
- The latest data, and a favorite of Chairman Powell, is the JOLTS (Job Openings and Labor Turnover Survey) (chart). Job openings fell in August by 1.1 million (-10%), from 11.2 million in July to 10.1 million in August. That’s the second fastest fall on record (only beaten by the first month of the pandemic lockdowns (April 2020). It is now October; we imagine that September’s JOLTS will show continued deterioration.
- Of the 3.8 million jobs the payroll survey says were created YTD (on a seasonally-adjusted basis), 928K were added via the Birth/Death small business automatic add-on (i.e., BLS doesn’t survey small business – they just add a number based on a time trend). When the economy is sputtering, small business formation is unlikely; in fact, contraction is highly likely. In our view, the payroll data is deceiving.
We are in a Bear Market in equities, and, for the first time, in a simultaneous Bear Market in fixed income. That’s because the Fed normally raises interest rates when the economy is expanding, not when it is contracting. The normal relationship between fixed-income prices and equity prices is that when one is rising the other is falling, and this has spawned the idea that investor portfolios should have both asset classes for balance. This Fed, however, is tightening into the teeth of a Recession and the result has been Bear Markets in both asset classes. Given that the Fed employs 300-400 economists, they have to know what we have written here.
- Perhaps they are motivated by hurt pride; they were criticized for their “transitory” inflation call and are now out to slay the inflation dragon. Unfortunately, they are gazing through the rear-view mirror using past inflation as their guide instead of looking at what’s ahead. And it turns out that much of the inflation was, indeed, “transitory,” but with a 16-month time frame.
- Perhaps they see the equity and housing price bubbles and are out to prick those. (Ouch!)
- And it is highly likely that there is a political agenda, as the Biden Administration is on the hot seat for much of the inflation and the mid-term elections are rapidly approaching. (Note: The Fed itself had a lot to do with the inflation as the money supply grew at double-digit rates (via Quantitative Easing) for much of 2020 and 2021. Now we have Quantitative Tightening with negative money growth – another worry as far as the Recession is concerned.)
Much of the inflation is now in the rear-view mirror. Considering falling commodity prices and shipping rates, slowing demand, falling real take-home pay, and 0% CPI for July and August combined, the best word to describe current Fed policy is “overkill.” While most of the inflation is behind us, most of the Recession lies ahead. By the time this Fed recognizes reality, the economy and financial markets will be in deep trouble. As indicated above, this Fed is also having a huge impact worldwide. The consequences of that could ultimately be significant for the dollar’s reserve currency status, the loss of which would have dire implications for the U.S. economy.
Robert Barone, Ph.D.
(Joshua Barone contributed to this blog)