Proxy War of Economic Indicators

The Fed will win the fight against inflation, but the battle of proxy indicators forecasting economic gloom has just begun. According to the Conference Board, Consumers still feel ebullient about their present condition, but their expectations of tough times ahead is the worst it has been in a decade. Many proxies that have perfect track records predicting economic turmoil would seem to validate their dour expectations. One of the prominent harbingers of troubled times is when short term interest rates, controlled by the Fed, rise above long-term rates, creating an inverted yield curve. Stock market Bears always salivate in a pavlovian unison to this inversion, assured that stocks and the economy will collapse at some unknown point over the next 12 to 33+ months – that’s helpful?  Inverted yield curves arise when central banks seek to smother the fire of high inflation. The only other time the curve has been this deeply inverted was during the record high double-digit inflation of 1979 to 1981 that led to one of the most severe economic downturns since the Great Depression. This sounds ominous indeed, but what’s different today are demographics and hyper stimulus. In a capacity constrained world of aging populations combined with fiscal and monetary stimulus far beyond any in history, consumption has far outstripped supply. This allows a significant degree of credit tightening by the Fed and demand destruction before economic pain manifests. The demand surplus has kept national employment hitting new record highs for 10 straight months with a near record number of unfilled job openings. The inverted yield curve, if correct, does a poor job of forecasting when the economic storm may arrive. However, in downturns, labor is a coincident indicator. Watching for employment growth to roll over closer to the dark side will be a clue that the over anticipated recession and new Bear market in stocks are upon us.

You don’t hear stock market Bears talk about housing like they did last year when they viewed it as a house of cards in a hurricane. Many pessimists still claim housing is in recession. After a massive run up during Covid with cheap interest rates, home builders had a deep, but normal, correction in 2022. Stocks merely returned to healthy pre-Covid records as Mortgage rates moved from the 2’s to over 6.5%. However, with such high rates, few chose to sell their homes, keeping inventories lean. Home builders this quarter are optimistic with 400,000 job openings.  Investors are bidding their stocks back up to all-time highs. The economy will slow, and it may not be a great time for house hunting, but this doesn’t look like the sky is falling for the impending recession that is consensus this year.

The ISM survey of manufacturing purchasing managers is another historically accurate warning of a general economic recession. Purchasing manager surveys measure the direction of jobs, new orders, shipments and more. Under 50 means contraction and since 1968, a number below 45 has always confirmed an ongoing recession. We are not there yet, but job openings in the harder hit non-durable goods sector (groceries, soap …) are falling toward normal levels as supply chains improve. 

Recently, some regional Federal Reserve Banking districts have shown positive traction since the manufacturing deceleration through most of 2022. It would be odd to have multiple returns into growth mode, as we are witnessing in the April report, if we are in recession. The 1.1% GDP growth report today revealed that consumption component accelerated to 3.7% growth, which created a contraction in inventories. Final sales spending has now expanded for the last 4 quarters in a row. Factories may need to build inventory and boost production if this continues. 

What may be unique about this cycle is the extent of monetary and fiscal stimulus applied to a supply constrained population in demographic decline. In the past, the US and Western allies could keep adding capacity with a rapidly growing labor force as consumption rose. Inflation and mass shortages were the inevitable result this cycle of a rapidly retiring population, a rapacious level of Government handouts ($5 trillion) and a Fed that opened the money printing flood gates ($5 trillion). This allowed the 2022 Bear market in stocks to reprice future earnings for the reduction of ever-increasing stimulus expectations, while causing no pain to jobs or the economy. With Industrial production near record highs and Durable Goods consumption still pushing to record peaks this year, it counters the claim that the manufacturing sector is in recession. When Durable Goods spending falls sharply for a few months, then a more worrisome slowdown could start. Autos, homes, planes and military hardware are among some major essentials that remain in short supply. Not what one expects during a “slowdown”.  

One more chart showing the Citi Economic Surprise Index and ADS Business Conditions Index should also ameliorate the dire assessments of the economy and earnings. As long as these indices are positive, a recession would be hard to conceive.  

The alarming bank panic in March brought to light the concern that small businesses and consumers would struggle to get loans. The very sharp rise in bank lending standards is certainly a yellow flag that credit and therefore spending will slow this year.  While 1997 witnessed tighter credit conditions (see chart) than today, it did not deter loan growth. We would be concerned if more than 50% of banks increased credit card standards. Thus far, loan volumes remain elevated, but possibly rolling over.

The popular Bear crowd also points to distressed corporate balance sheets. It’s true that business debt has been rising, although at a normal 6% rate YoY. The deeper concern is that a record amount of bond debt will mature and be renewed at double the cost of just over a year ago. This sounds daunting, but long-term rates are falling again and debt burdens as a percentage of business equity values remain very low. It may be too early to see a trend, but the last 2 quarters (including Q1 2023) will show a debt burden reduction. Falling debt/equity ratios are very Bullish for stocks.

Corporate Bond Distress Index levels echo our earlier comments that the bond markets do not appear alarmed. There was a very minor spike in High Yield Junk Bonds in March when a couple large banks failed, but that fear is currently in the safe zone.

We will conclude our wide-ranging review of economic conditions by illustrating a simple view of the consumer at all income levels. Esteemed Bank of America CEO Brian Moynihan has a good bead on the economy. Brian notes that consumer spending is up 9%, year over year, as of March 2023. Consumer credit quality and balance sheets are still excellent among Bank of America customers. Customer borrowing capacity is strong and BofA is planning to hire over 10,000 more workers this year. As the chart below reveals, individuals have not even come close to their healthy pre-Covid level of credit card capacity usage. This view is shared by hotels and airlines that have locked in bookings far above pre-Covid and expect record revenues this year. Inflation has been held up by the strong service sector this year, but if it keeps falling gradually without any of our warning flags occurring, then the consumer may just charge ahead even faster.

The economic backdrop discussed above raises some doubt about the most anticipated economic and earnings recession we can recall. The surprisingly buoyant economic data combined with negative investor and money manager sentiment supports the recent 7-month rebound in stocks. While a flight to high yielding short term Treasuries is understandable with guaranteed 5% risk free returns, the aversion to stocks compared to bonds is typical of major market bottoms. Treasuries are rapidly becoming the new savings account with daily money market account yielding 4.7% today. The banks had better start competing before every account has a minimum balance. BofA is set up well with their Merrill Lynch Edge arm that provides a 4.5% return on idle cash that one can move freely back and forth into the checking account. Investors of course are naturally lazy, so there is more room for cash to rise like the Tower of Bable and provide pent-up demand for stocks when rates eventually move lower.

While some of our indicators have remained stubbornly neutral during the forecasted rally into April, the composite indicator below (FG, red line) has been warning of a short-term overbought condition in the broad stock market. FG pulled back a notch on this week’s minor correction, but the wedge formation since February and Seasonality allow for a surprise spurt higher into the Fed rate decision May 3rd. While small cap indices are impaired by the move to mega cap banks, the major large cap indices could continue higher into June after a couple week pullback in May. The current 2023 highs could hold back the near-term rally or have a quick surge over 4300, but over the summer even higher highs could be the surprise. We don’t view this as an all-clear for a Bull market, but the outlook is favorable. Any break of key uptrend support at 3810 on the SP 500 Index should confirm a serious breakdown that the Bears have been over anticipating for months. For now, the trend remains positive and pullbacks in May will be an opportunity to increase equity exposure. 



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