This blog serves as a follow up to our previously released Q3 Investment Themes, as well as an update on what we are seeing and our current outlook.
Here are the top three things we are covering in this month’s blog:
- Our inflation estimate is above consensus for the first quarter of 2023. And it will remain more than double the Fed’s target through at least the third quarter of next year. Any recent drops in prices (rent and gas for instance) have come from historically high levels and have not been significant enough to ease the crushing burden on households all over the world. The overall Consumer Price Index (CPI) YoY has only dropped slightly from late Summer.[1] Despite all the headlines and central bank talking points, when the rubber meets the pavement, the Fed will not pivot. This will keep pressure on interest rates through the rest of 2022 and into 2023.
- The Wealth Effect Dissipation is accelerating, led by an absolute implosion in the real-estate market[2]. The mother of all bubbles is popping at the same time inflation is ravaging consumers. The crypto market has already lost $2 trillion in market cap[3], and the U.S. equity market has lost $9 trillion in market cap[4]. Consumers are shifting away from higher price items at stores like Target and bargain hunting at stores like Walmart. Black Friday and Cyber Monday hit record sales in 2023, but only because of record discounts[5], and a massive jump in “buy now pay later” purchases.[6]
- Corporate earnings are decelerating and headed towards recession. Plunging profit margins from deep discounting (in order to make sales and clear inventory) is only exacerbating the problem. If not for the performance of the energy sector earnings (due to excessively high oil prices), the aggregate S&P 500 earnings growth number would have been negative in the third quarter of 2023. Based on the wave of companies guiding down forward estimates in October and November, it’s likely we are headed for a second straight quarter of negative aggregate earnings growth in the fourth quarter of 2023 (barring the energy sector).
Market
The S&P 500 (SPX) reacquired it’s bear market rally thanks to a November 30th statement by Jerome Powell. The Fed Chair issued a statement that hinted at rate-hike-pace moderation in December, which was somewhat expected. But he also expressed, for the first time, some concern that the Fed must not overtighten rates too quickly ahead of the inflation numbers actually coming down (to the Fed’s target)[7]. At the end of the day, Powell did not really say anything that will change the trajectory of Fed policy – and Powell knows this. But that didn’t stop him from trying to prop the markets a bit in hopes of “engineering a soft landing”, which the Fed is unlikely to accomplish.
The SPX finished up 5.81% for the month. The Nasdaq underperformed the SPX in November as tech companies continue to slog their way through worse-than-expected earnings. The Nasdaq finished up 5.30% for the month. The Dow Jones performed better than the SPX in November. Energy and Healthcare companies helped prop up the Dow. The Dow finished up 6.77% for the month. Small Caps (the Russell 2000 or RUT) underperformed the SPX. Most of the short-squeezing in the current bear market rally is done, which has left the index without a clear catalyst in the near-term. The RUT finished up 1.90% for the month.[8]
The World Index (MSCI) outperformed the SPX in October. The inevitable consolidation of the dollar in November, after the huge 9-month rally earlier in the year, gave a boost to foreign equities. The MSCI finished up 12.07% for the month.[9]
The commodity index (BC) rose again in November. It wasn’t much, but that’s not the issue. The issue is that prices did not come down significantly, which will keep pressure on the Fed despite Jerome Powell’s comments on the last day of the month. The BC finished up 2.58% for the month.[10]
Gold was up for the month of November as real rates subsided slightly and the market began to price in some recession concerns. In addition, many global central banks were buying gold to hedge against their own currencies, and to protect against rising uncertainty.[11] Gold is still considered a “safe haven” asset, and the market is finally beginning to exhibit some of that buying behavior as the world moves deeper into recession. Gold finished up 6.68% for the month.[12]
Longer term interest rates (as measured by the Ten-year Treasury or TNX) decreased in November as the market began to contemplate the possibility of a recession (while still “hoping” for a “soft landing”). However, shorter term interest rates held near their highs for the year. Remember, the short end of the interest rate spectrum (or curve) usually prices in Fed policy. The long end of the curve usually prices in economic outlook. For now, the yield curve remains inverted at historic levels (short-term rates higher than long-term rates). Note that an inverted yield curve has correctly predicted every recession for the past 50 years. The Ten-year yield (TNX) finished the month of November at 3.68%, down from 4.10% at the end of October.[13]
Oil prices finished down slightly in November. The White House continues to furiously drain the Strategic Petroleum Reserves in hopes of manipulating prices down. In addition, the White House has turned to oil producing nations like Venezuela [14]to try and import more oil into the United States. These tactics will have a short to intermediate-term effect on prices, but eventually prices will go back up unless the world plunges deeper into recession. A rock and a hard place. Oil finished down at a price of $77.10 per barrel for the month.[15]
Economy
The second GDP number (2nd of 3 updates) for the third quarter (Q3) of 2022 printed at 2.9%.[16] It broke the string of two straight quarters of negative GDP prints (a recession). Once again, this is not because the economy has moved back into expansion. Much of the gain in the GDP print was due to exports of weapons, oil and gas to Europe.[17] Projecting forward, our analysis is that GDP will hold in the same area for the fourth quarter of 2022, then recede back down to another two quarters of negative prints on a QoQ basis. In addition, we forecast GDP to continue to decelerate on a year over year (YoY) basis.[18] We continue to repeat our theme from the past two months: 2/3rds of GDP is personal consumption, and our projection is that consumer spending is dropping off a cliff because of higher prices, higher debt, and a collapsing Wealth Effect. In economics, the Wealth Effect suggests that people spend more as the value of their assets rise. The inverse is true as well, so with prices falling in real estate, stocks and bonds (while prices go up in gas, food, and many other consumer items), the United States middle class is feeling much less financially secure. This is showing up in the overall trend of consumer sentiment.[19] The crypto market has already lost $2 trillion in market cap, and the U.S. equity market has lost $9 trillion in market cap. The same central banks and governments that blew the biggest bubble in world history are being forced to unwind the 13-year risk-on trade that cost roughly $25 trillion in aggregate global central bank balance sheet expansion (i.e. money printing).[20] For the first time in modern history, the global yield curve has inverted. The key catalyst for the shift from the loosest monetary policy in history to the fastest tightening of monetary policy in history? Runaway and record inflation brought about by the combination of digitizing all that new currency, shutting down the world’s supply chains over covid, and restrictive energy policies in the United States and Europe. As noted earlier, corporate earnings are decelerating, and could fall off a cliff by the first or second quarter of 2023. All this adds up to a Quad 4 outlook for the next four quarters. As a reminder, Quad 4 means a period of decelerating growth along with decelerating inflation.
The moves in the market this month were tired to a couple indicators and the fed speech. One of those indicators was inflation, which came in lower than expected at the beginning of the month. The lower than anticipated inflation created a notion that fed to pivot or even lower rates.[21] However, not much has changed with inflation. Current political and central bank policy is to focus on demand in order to reduce prices with little thought being given to increasing production and supply. Historically high prices have been hammering on consumers all year and will continue to hammer on consumers through the rest of the year and into 2023. The Fed and global central banks have no control over supply. Until we see real structural fixes in the global supply chain, more effective and production-friendly political policies, and some type of resolution to the Russia-Ukraine war, the higher absolute readings on inflation will persist. The net result will be an ongoing drag on the global economy. Europe is the most afflicted region currently due to terrible energy policies, and European consumers are dealing with record-high natural gas prices.
At the end of the month, we did see a positive job report come out which impacted the market. However, these reports do contain a large amount of noise, and as that data is picked through, it may not seem as positive as it might have appeared. This means that it may not be as indicative of the challenges we are seeing in the economy right now.[22]
Finally, on the 30th, Fed Chair Jerome Powell gave a speech in which he said mostly the same thing as in the speech he gave earlier in the month. What was different, was that many interrupted the tone of the speech differently. It was interpreted that they are going to slow the speed of rate incases which could potentially mean a pivot ahead. This created a significant rally in the markets compared to the selloff that occurred earlier in the month. Based of the data they use; we don’t see any meaningful change that would lead to a positive change in the market.[23]
Although we project CPI to decelerate as we plunge deeper into recession, the real numbers will still be double and triple the historical average.[24] The impact of stubbornly high real inflation numbers, along with a slowing economy, will keep the Fed and other central banks stuck between a rock and a hard place, which is tightening into a deepening global recession.
Summary
- Our inflation estimate is above consensus for the first quarter of 2023. And it will remain more than double the Fed’s target through at least the third quarter of next year. Any recent drops in prices (rent and gas for instance) have come from historically high levels and have not been significant enough to ease the crushing burden on households all over the world. The overall Consumer Price Index (CPI) has only dropped slightly from late Summer. Despite all the headlines and central bank talking points, when the rubber meets the pavement, the Fed will not pivot. This will keep pressure on short-term interest into the first quarter of 2023.
- The Wealth Effect Dissipation is accelerating led by an absolute implosion in the real-estate market. The mother of all bubbles is popping at the same time inflation is ravaging consumers. The crypto market has already lost $2 trillion in market cap, and the U.S. equity market has lost $9 trillion in market cap. Consumers are shifting away from higher price goods and bargain hunting and discount shopping. If they do spend, the trend continues to be loading up credit cards and going further into debt.
- Corporate earnings are decelerating and headed towards recession. Only the energy sector is keeping aggregate S&P 500 earnings growth from being negative. Based on the wave of companies guiding down forward estimates in October and November, it’s likely we are headed for a second straight quarter of negative aggregate earnings growth in the fourth quarter 2023 (barring the energy sector).
- Having a hedged and cross-asset class approach to investing can help you navigate the multiple storms blowing through the global economy and financial markets. This type of strategy will increase in importance as we go deeper into a global recession, and as volatility and uncertainty increase across financial markets, the global economy and major governments and political organizations.
We hope you have enjoyed getting a deeper look into our investment research and look forward to providing this to you each quarter going forward. Thank you from the entire Konvergent Team!
[1] https://ycharts.com/indicators/us_consumer_price_index_yoy
[2] https://quoththeraven.substack.com/p/housing-demand-vaporized-after-rates
[3] https://www.cnbc.com/2022/11/11/crypto-peaked-in-nov-2021-investors-lost-more-than-2-trillion-since.html
[4] https://www.cnbc.com/2022/09/27/stock9-market-losses-wipe-out-9-trillion-from-americans-wealth-.html
[5] https://www.zerohedge.com/economics/cyber-monday-sales-hit-record-113b-fuelled-deep-discounts
[6] https://www.cnbc.com/2022/11/26/black-friday-online-sales-top-9-billion-in-new-record.html & https://www.cnbc.com/2022/11/30/buy-now-pay-later-for-holiday-gifts-is-horrible-harvard-fellow.html
[7] https://www.zerohedge.com/markets/wall-street-reacts-powells-dovish-speech-markets-explode-higher
[8] Slide – Major Indexes
[9] Slide – Global vs Emerging Market Equities
[10] Slide – Commodities
[11] https://oilprice.com/Energy/Energy-General/Central-Banks-Are-Buying-Gold-At-The-Fastest-Pace-In-55-Years.html)
[12] Slide – Precious Metals
[13] Slide – 10 Year & 2 Year Treasury Rate
[14] https://www.forbes.com/sites/brianbushard/2022/11/26/biden-administration-allows-chevron-to-pump-oil-in-venezuela-heres-why-its-so-controversial/?sh=64ea509ae5fe
[15] Slide – WTI Oil Price Change
[16] https://www.bea.gov/data/gdp/gross-domestic-product
[17] https://www.zerohedge.com/markets/q3-gdp-revised-higher-pce-comes-hotter-expected
[18] Slide – GDP YoY Projections
[19] Slide – Consumer Sentiment
[20] https://goldswitzerland.com/in-the-end-the-goes-to-zero-and-the-us-defaults/
[21] Slide – CPI Actual vs Forecast
[22] Slide – US Nonfarm Payroll
[23] Slide – Fed Speech 11/30
[24] Slide – Consumer Price Index