Consumer Durables News

Finally: Bad News Is “Bad” News!. The Markets Are Slowly Adjusting To The… | by Sagar Singh Setia | Jan, 2023

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Globalization is slowing or reversing. If this trend continues, we will lose its significant deflationary influence. (Importantly, consumer durables prices declined by 40% over 1995–2020, thanks to less-expensive imports. I estimate that this took 0.6% per year of the rate of inflation”- Howard Marks.

Zoltan Pozsar has been writing extensively about the transforming geopolitical landscape. There is no doubt that we are catapulting to a multi-polar world; in fact, those who have been reading my substack or Linkedin posts since last year know that I have repeatedly been reminding them that the pillars of deflationary forces (Globalization, Cheap Russian energy, cheap Chinese labor and labor market in the US) of the last two decades are undergoing severe decline.

One of the most powerful concepts to understand inflation is the money-price-wage concept.

According to this concept, as money growth declines in the economy, the prices of durables and commodities follow. The next domino to drop is wage growth, and as a result, core services plunge.

The Money-Price-Wage spiral perfectly justifies the current cyclical setup in the US economy.

The trends that emerged from the last week’s CPI data:

  • The goods disinflation catches pace as goods prices continue to move lower. In fact, the core goods deflation is now the biggest in 33 years.
  • The shelter inflation remains elevated; however, it lags in the CPI data by almost 6–8 months and thus will start to fall from the end of Q1 (as rents have been falling MoM for the last four months).
  • Thus, the most crucial metric that even the Fed tracks and has repeatedly emphasized remains the Core Services Ex-Shelter (excluding volatile components: Food, energy and the lagging shelter).

We can observe from the chart that the AHE (Average Hourly Earnings) has peaked and is heading lower, indicating that we have reached the “wages” part of our money-price-wage spiral.

While some people think that the Core Services Ex-Shelter is headed lower as growth tapers off and the wages cool off, others believe that it’s still resilient (and spending would accelerate) thanks to the decline in gasoline, rent and utility prices in the recent months.

We must appreciate that CPI is a lagging indicator that closely follows ISM Services PMI prices.

As the chart suggests, the CPI will likely fall to the 4% handle soon. Furthermore, an interesting development will take place from the next CPI numbers.

The CPI calculation will be revised the next month. As per UBS:

The new approach to weighting inflation will use consumer spending from 2021. US inflation will start to give more emphasis to the prices that are weakening, heightening downside risks to consumer price inflation.

The relative importance of different parts of the inflation basket changes every year. The 2023 changes could push inflation lower.

All the roads lead to a lower inflation number in the coming months. As I have advocated since last month, the growth collapse will lead to an accelerated fall in inflation more than anticipated.

Thus, the fall to 4% should be relatively swift; however, it may take time to move to 2% as the AHE will take time to descend due to the still-hot labor market.

The other significant tailwind that may lead to the resurgence of inflation remains the Chinese reopening and the ensuing surge in commodities. While the long-term inflation expectations are well anchored and stay within the Fed’s target range, the price action in Dr Copper can play the spoilsport and give JayPo sleepless nights.

The economic data released this week confirms the growth is rapidly faltering. Industrial production continued its downward trajectory (remember we discussed it in the last week’s newsletter).

The biggest surprise was the continued contraction in “real” retail sales (adjusted for inflation). Though nominal retail sales are still in positive territory (due to high inflation), the real retail sales show that the American consumer is not “as healthy” as it looks.

In fact, the contraction in real retail sales for such a long time is synonymous with the economy already in a recession.

Source: Marquee Finance By Sagar

Furthermore, the PPI data released this week confirmed that “goods” producers face a deflationary trend. The core PPI (ex- Food and energy) collapsed to 5.5% from 6.2% in Nov (YoY), an enormous decrease MoM.

The significance of PPI is vital for corporate profitability as, for the first time since December 2020; CPI has come in greater than PPI. We have already seen that margins for S&P 500 companies are higher than the long-term average.

Source: Marquee Finance By Sagar

As the bad news galore and the markets finally react to the “bad news” as really the “bad news”, what should investors do?

Let’s jump in!

As the growth data worsens, markets have started to price in an earnings recession, especially for the industrials.

Last year was marked by the stark outperformance of the Dow against the NASDAQ and the value stocks against the growth stocks. However, as the margin compression is likely in the works, the rotation from industrial to tech stocks has started.

Source: Prometheus Macro

As the bond yields seem to peak with the Fed’s tightening cycle coming to an end, the valuation compression due to elevated bond yields (higher discount rate) appears to be over for the stocks. Therefore, we can safely conclude that the valuations may/close to bottom out at 17x for S&P 500.

The Shiller CAPE (Cyclically adjusted Price to Earnings) ratio for S&P 500 is close to the mean for the last two decades. (A painful mean reversion has already happened, it seems).

Though, a hard landing can further compress the valuations.

Source: Marquee Finance By Sagar

Nevertheless, the double whammy of falling margins and slowing demand due to growth collapse doesn’t abode well for stocks.

The stocks outlook becomes gloomier if we consider the upside risk in inflation led by commodities. Higher commodity costs were passed on in the post-pandemic period, boosting margins as the consumer demand was strong.

However, the firm’s pricing power will fade as the demand wanes; thus a steep margin fall is a plausible scenario if the commodity prices surge well into H1.

High inflation coupled with earnings recession means that owning equities would lead to lower “real” earnings yield.

(Note that Earnings yield is calculated as the inverse of P/E, and as the recession kicks in, the “E” will fall).

Source: Ed Yarding

This is a compelling reason that makes bonds super attractive against owning equities. One must appreciate that real yields are now positive across the curve, as the Fed wanted. So, owning bonds will give one a secured fixed income higher than inflation, even for longer periods (say ten years).

Source: JPM

This is a fantastic chart by J.P. Morgan Asset Management. Even in the worst-case scenario, the short end of the curve will give flat returns. As I had mentioned in my global outlook, as the yield curve steepens, the shorter end will outperform the longer-end bonds. Lately, bonds have been rallying as the data deteriorates and the “hopes” of a Fed pivot rise.

Pragmatically speaking, owning bonds looks best suited for this year. Even the longer duration bonds can be bought once we are more sure about the extent of Chinese demand resumption and its subsequent effect on commodities.

Undoubtedly, a recession in the US and Europe is around the corner if they are not already in one. The CBs are most likely to overtighten this time while the BoJ and China continue to pump in liquidity in the East, resulting in a mind-boggling situation.

The bad news keeps on slamming the economy; as a result, inflation will most likely continue to soften, and the tightening cycle is likely to end. Thus, bonds look relatively more attractive than stocks.

The yield curve is undergoing extreme inversion, and the credit markets are signalling an impending recession.

Interestingly the 70s data confirm that we can be in a recession even at the time of inversion.

While the stock markets have undergone a lot of pain, the earnings recession seems to be just beginning while the analyst’ estimates remain rosy.

It’s time to position yourself according to the highly volatile macro situation.

Disclaimer

This author is not licensed investment professional. Nothing produced under Sagar Singh Setia should be construed as investment advice. Do your own research and contact your financial advisor before making investment decisions.

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