More Good News on Economy is Bad News for Investors

Business cycles can be viewed simplistically. When demand increases faster than supply, there is an economic expansion phase until surplus production outstrips consumption creating a contraction to bring supply and demand back into balance. Before a contraction or recession can begin, excess inventory occurs. This slows production and triggers increasing worker layoffs and unemployment. While the markets have already priced in a modest recession, today, we still have rising production and mass shortages of products and workers as a nation. A private manufacturing and commercial real estate operation we partner with are both experiencing excess demand and a lack of supply, typical of an overheating economy. This tide will recede over the next year, but currently, the economic expansion needs to cool off until supply expands or demand contracts enough to reach an equilibrium. What this is not, is a recession – yet. For investors, good news for the economy this year will continue to be bad news for stocks as it prolongs the Fed rate hikes and compresses valuation multiples to price stocks.

The unemployment rate reported last week fell back to record lows at 3.5%, reinforcing Fed members that keep telling hard of hearing investors that an end to rate hikes is nowhere in sight. This great news for jobs today was terrible news for stock market investors as it implies a bad economy tomorrow due to interest rates hikes and tighter credit. Stock market pundits see every rate hike or decline in economic indicators as confirmation of impending doom, despite the lack of evidence in the present. Some esteemed money managers claim inflation is crushing consumers and if the Fed doesn’t pause or reverse its course, then unemployment will soar. Perhaps the willful ignorance of the jobs data is the most telling. We hear that the 10 million job openings are fictitious (for the first time in history) and that unemployment has enormous lags to the economy. These assertions have already been proven false. Unfilled jobs and unemployment have never been this good 9 months after the economy began contracting its GDP, as it has today. As we have persistently asserted, this cycle is different, and demographics ensure that we are in the middle of a 30+ year phase of general labor scarcity. Today’s report of 3.5% US unemployment and record low layoffs support the large body of evidence that financial stress of individuals remains near record lows, despite the legitimate concern over inflation eroding their purchasing power. According to the data, there is still a lack of motivation for the stay-at-home crowd to find a job due to Government stimulus. Potential workers on the sidelines can still wait for the perfect premium pay, remote work employment opportunity. The quit rate for those already employed is high, which speaks to the power of workers to dictate to employers how they will choose to do their job. While the tight jobs market has finally begun to loosen modestly, we may need another 4 to 6 months of recent trends to reach a healthy labor supply and demand balance before we should worry about a potential recessionary unemployment spike. The worker shortage is still far too high, supporting higher wage inflation and rents, but the new downtrend in demand for new hires is one of many signs that future inflation will keep falling. When the Quit rate falls under 2.5 and unfilled job openings have a 7 million handle, then we would expect normal supply chains and much lower inflation to become evident. Our milestones appear attainable by the end of 2022’s first quarter, barring an exogenous, yet realistic nuclear action by Russia.

The IMF estimates that headline inflation may stay above 6% throughout most of 2023 despite a slower economy. So, for those screaming that the Fed has already raised rates too much, their alarm and clarion calls should ring hallow with inflation projected to stay at multi-decade highs until 2024. We have highlighted the many signs of slowing inflation out there from purchasing managers, small businesses, transportation, but until the Fed’s core Personal Consumption Expenditures Index (PCE) and headline CPI fall under 4% and 7% respectively, it would be premature to tell the Fed to pause rate hikes. Inflation always falls when consumers contract spending and the inventories to sales ratio rises above its long-term average. That is when employers no longer need more workers to increase production, as they still do today. We are moving in that direction, but it’s a bit early to assume the mass shortages of labor and paucity of products today will shift to a recessionary surplus tomorrow.  Inventories relative to sales demand for the US economy are moderately low, but the shortage of cars and trucks is still extremely tight. With tight inventories, and 39-year high inflation rates, the Fed will continue with quantitative tightening (QT), draining loanable funds from the monetary system and shrinking the nation’s money supply. Maybe something will break as many fear, but inflation must be defeated before it becomes entrenched in an automatic long term price spiral that would require a deep recession.

For investors, the aggressive Central Bank actions to reduce demand with higher interest rates have kept the Dollar at 20-year highs. US stocks perform poorly when the US Dollar and interest rates are appreciating this fast, hurting the debt heavy technology sector, multinational companies, emerging markets and housing in particular. With the official inflation numbers about to start falling more persistently, the stock market decline should be on the verge of a temporary floor from which to stage a relief rally. Our bottoming window from late September into the October 13th inflation report is about to expire. The assumption had been that the CPI inflation report would begin to outline a downtrend in inflation was reaccelerating. However, after the Producer Price Inflation (PPI) report today of 8.5% with upticks in Service sector prices, there is risk of  a slight miss in the CPI on the 13th. Our cash levels remain very high unless the indices can sustain a very sharp rally over SP 3800 beginning on October 13th to avoid new lows during the seasonal bottom due in the final week of October. A relief rally from deep oversold conditions today is due to begin in October and peak in November before risk levels rise once again. Until the Dollar falls and the forecast for lower inflation improves, earnings and stocks will be under pressure for new lows. Defense, healthcare and cybersecurity stocks remain interesting sectors to have invested exposure.

 

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