It has been a relatively tame week, with indices basically flat, but a few things could start to add volatility back into markets. Today is options expiration, with ~$2 trillion in derivatives set to expire, and $1 trillion of that in S&P 500-linked contracts alone. That, along with low volume on exchanges during a heavy vacation month, could cause some added whipsaws in stocks. Overnight, Germany released another astonishing set of inflation prints with their Producer Prices Paid Index jumping a whopping 37%. This helped bring futures down about 1% across the board.
Next week, all eyes will be on Jackson Hole where Fed Chairman Powell will speak Friday morning. Bulls hope he aligns with the notion that we are already near the end of this tightening cycle. Following that we will have August data on unemployment and inflation measures.
One day does not reverse the strength since June, but there are indications of at least a pause with so many headwinds still present.
Retailers closed out second quarter earnings with mostly better than expected results. Most of the larger brethren (Walmart, Target, Lowe’s#, Home Depot#) showed positive revenue growth, but minimal or even negative earnings per share tallies relative to this point last year. During inflationary times, it is easier to grow the revenue metric since pricing is going up. When inflation is 9%, growth of 5% basically means companies are seeing 4% less volume. Further down the income statement, costs are going up even more than sales, resulting in lower earnings per share. Case in point was Walmart. Sales were up 8.2% relative to last year, however earnings per share were down double digits. Consumers are feeling the pinch. Stock reactions were quite impressive following this subpar result with Target the only one of those four not up strongly this week.
Consumer balance sheets are still in great shape outside of the lower income class, but credit card debt is rising. Savings account balances are dropping. The free money from the past two years is being spent. Discretionary spending slowness is the first step to a much broader slowdown.
The rest of the market did quite well during earnings season. Reported sales growth jumped 13.9%, well above just being due to inflation. Earnings, however, did not keep pace. They advanced 6.4%. Margins are clearly contracting off their record peaks. Forward earnings estimates have also dropped, pointing towards $235 in S&P earnings for 2023 and an 18 P/E. We would be surprised if that metric does not come down even more in the coming months.
Interesting graphic below from The Daily Shot and Oxford Economics. Consensus estimates are above even the most optimistic of soft-landing scenarios. Buyer beware of forward earnings projections:
Chairman Powell’s testimony after the last Fed meeting was quite dovish when compared to previous announcements. For the first time, he hinted at an end to the rate hiking cycle and noted the risks in going too far. Since then, stocks have bounced…substantially so. Following that, committee members have tried to jawbone the euphoria back in line with their dot plots, inferring at least another 100bps in rate hikes and a laser focus on beating inflation first and foremost. Judging by the nearly 20% rise in the S&P since June, the market does not believe them.
Meeting notes released on Wednesday delved further into their recent discussions. Nick Timiraos, the Fed’s new Wall Street Journal mouthpiece, highlighted a few things:
• He has quoted a specific line from the minutes, “Declines in the price of oil and some other commodities could not be relied upon as providing a basis for sustained lower inflation as these prices could quickly rebound.” In fact, oil is rebounding again and many commodities have held up over the past few months. Stopping a tightening schedule today could add fuel to the commodity market which is not needed right now.
• He also noted the Fed’s first risk is “significant” in not hiking enough. A secondary risk in “hiking too much” does not have a modifier. Clearly, the Fed does not want to go down the 70’s path of beating inflation for a few months, cutting rates and going back to spiking prices. Lessons were learned, to beat inflation first and pick up the pieces later.
Even taking all that into account, the chance of 75bps dropped this week, making 50bps the new base case for September. Markets still expect another 25bps at the following two meetings. If that holds up, 3-month Treasuries will yield ~3.5%, while the 10-year Treasury is at 2.88% today. Recall, a 10-year / 3-month inversion has a 100% track record of predicting recessions (look at what happens to earnings in the graph above for a recession scenario). That is not even mentioning quantitative tightening which will pull almost $100B from bond holdings on a monthly basis.
INFLATION AND JOBS REPORTS
This is where things get dicey, on both ends. We have a chicken or the egg scenario here. Does higher consumer price inflation force employees to demand fairer wages? Or, do higher wages due to a tight labor force create more inflation? Or, do higher wages allow households to have one parent stay at home, lowering the available workforce even further? Is higher unemployment a good or bad thing?
Whatever the case, it remains clear that inflation will not be beaten with wage increases over 5%, more job openings than people searching, and millions more out of the labor force compared to pre-pandemic. America needs more workers or growth must come to a halt, forcing employers to stop hiring. The Fed can force recessionary ingredients, but cannot increase the labor force on its own.
Yesterday, jobless claims data turned around, with less people filing for unemployment. Less people were laid off than expected. Employment remains strong, which is great for workers but bad for a Fed focused on lowering inflation. Something must give here over the coming months, or the Fed will have more latitude to increase rates over and above projections.
With earnings season behind us and not much on the data calendar until September, all eyes are geared towards The Federal Reserve Bank of Kansas City’s annual Jackson Hole Economic Policy Symposium. Participants include central bankers, finance ministers, market participants and field generals from across the world. This year’s version is titled “Reassessing Constraints on the Economy and Policy.” All we really care about will be Fed speeches, highlighted by Chairman Powell. Last year, he made his “inflation is transitory” case, which obviously was a massive blunder. We expect him to be clear on the Fed’s intent to beat inflation and get it back to the 2% target…over time. Dropping from 9.5% to 8.5% is a great start, but very, very early in the game back to normalcy. Last year’s blunder must be self-corrected. I would not be surprised at increased volatility, with his every word being scrutinized later next week. Stock reactions would not be kind to a renewed emphasis on aggressive tightening after this massive rally.
Bill Clinton is 76 today. Actors John Stamos and Matthew Perry turn 59 and 53, respectively. You may not recognize the name, but Arthur Fry, inventor of the Post-It Note, is 91 today.
James Vogt, 610-260-2214