The Big Conversation
Episode 140: Are recessions defined by unemployment?
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Rog [00:00:00] Last week. FedEx, which is often considered a bellwether for the economy, released a statement outlining the lack of visibility in earnings due to a slowdown in global growth. The stock dropped 20% intraday. Equity market bulls, however, highlight many contrarian indicators that are currently flashing a buy signal for the broad market. The swing factor will probably be the outlook for employment, but is that going to be more of a story for 2023 than for the rest of the year? That's the Big Conversation. Investors are generally impatient to see their thesis play out almost immediately. The bears want to see equities make new lows now before the end of the year, whilst the bulls are pointing to a number of contrarian technical factors that have been associated with some of the major market lows of recent history. Which of these outlooks transpires will be down to the evolution of inflation and the reaction of the Fed to that.
Rog [00:00:58] Now, two weeks ago, we looked at how the Fed was caught between a rock and a hard place. If the Fed does too little, inflation could remain elevated. That would prevent growth from reaching a sustainable footing because the market would reprice rates even higher until inflation was under control. The Fed would still have to raise rates a lot further, and if the Fed does too much, well, that could create a nasty recession. And historically, prices have meaningfully fallen through the midst of a decent recession, because the recession has curtailed growth and demand. Since the 1970s, CPI has peaked either before or during a recession and then fallen thereafter. If we are in the midst of a US recession today, then this one is relatively mild by historical standards. We have had two quarters of negative GDP growth, but these could be prone to future revisions both up and down. The Atlanta Fed outlook for the third quarter has also been falling, but is not yet gone negative. And the economic drag has so far mainly been confined to households and small businesses. The headline ISM numbers have been relatively robust, indicating an expanding economy. That is still some way from recessionary territory, which is typically considered to be around 45 for this indicator. The ISM, however, focuses on large-cap companies with many overseas operations, and they have greater capability of offsetting or passing on the higher prices. When we compare the S&P Global US services PMI versus the ISM Services Index, we can see that the S&P Global version, which includes smaller businesses, is much weaker and has dropped into recession territory. And U.S. consumer sentiment remains close to the record lows and has been impacted by the unaffordability of many large ticket items. Inflation remains high and real wages are still negative, and this has been a drag on the household sector in the US, and in fact indeed many other parts of the world as well. High prices therefore remain an impediment to sustainable growth. Prices may have peaked in the US at 9.1%, but have not come down to levels that are acceptable to policymakers. At the same time, sentiment towards the US equity market is very poor. Active investors remain very bearish in most surveys. The Bank of America fund manager survey also shows investors have cash levels that are similar to cash levels seen during the steepest declines of the dotcom crash 20 years ago. The US market has also seen a significant amount of put buying in recent weeks and this is often considered to be a contrarian indicator. Many of these, however, have coincided with major expiries like December 2018 and March 2020, and this may have been a greater influence on the ratio than the actual sentiments of the market at the time. ISM manufacturing prices paid has also seen a significant five month decline, and this may well be a prelude to a decline in CPI. Jason Gopfert's Sentiment Trader, has calculated that since 1949 the S&P has been 10% higher after 12 months on 100% of the occasions that it has had a similar drop on the prices paid. Now that doesn't mean we won't see new lows, we did in 2009, but the lows may be close at hand according to this indicator. So should we expect more of a sell-off first? Well, as mentioned earlier, this may be dependent on the outlook for employment. And the key point here is that a U.S. recession usually occurs when there is a significant increase in unemployment. Now, these may be coincident, but one is never far from the other. If we look at initial jobless claims, we can see that recessions usually occur as the pace of initial jobless claims picks up. So far, claims have only just started to tick higher. Either we are not going to see a meaningful pickup in unemployment, or the main part of the recession is still ahead of us. But how far ahead? Well, employment is generally a slow moving beast at first, though, we do have a recency bias because of the speed with which things happened during March 2020. But that was a one off. A reversal in employment generally takes place at a much slower pace before accelerating through the recession. Again, the unemployment data suggests that we're either not going to get a proper recession or the big one is still squarely ahead of us. It may well be that the couple of quarters of slowdown that we've had this year is just the precursor to the main event. And this is where it gets interesting for the Fed. At the moment we're seeing CPI dropping a bit because of a pullback in prices that were initially influenced by higher commodities and the excesses of the pandemic response. But commodity prices are not the main concern of the Fed at the moment. They're going to be concerned with wages. Real wages have so far been negative. Workers are worse off, hence the recession in the median household that's taking place in many regions. But workers are now demanding better wages and ones that beat inflation. In the US, the National Carrier's Conference Committee for Freight Rail Workers have been putting together a 24% pay deal over a five year period. With over 14% of that in the first year and the rest spread out over the next four years. Now it's still early days, but if these types of deals become commonplace, then higher wages could lead to much stickier inflation. So far, the absence of inflation busting pay deals has meant that many large corporations have been able to hang on to decent margins. But if these deals start to come through, companies will either see margins fall or they'll have to cut workers. And that's when unemployment starts to pick up and that's when we generally see the main part of the recession. So far as we've seen, unemployment has remained very tight, partly due to the legacy impact of COVID still working its way through the system, and partly because many corporates have not yet felt the pinch. And this might be how we get the real low in the equity market. At the moment, we've seen active fund managers getting bearish and raising cash to near record levels. But so far, the redemptions have not yet arrived. According to the Bank of America survey, the rolling two years sum of household equity flows remains positive. There have not been any major outflows yet, and according to the Twitter site Macro Charts, the three month flow of major stock ETFs in the U.S. is still in the 'fear of missing out' stage of inflows. There's not yet been a major capitulation event. And although the tweet I'm referencing here is from three weeks ago, it's unlikely that much has changed since then. And this makes sense if the jobs market remains strong. It's commonplace for the final quarter of the bear market to be the most aggressive, and this usually takes place through the middle of a recession. Equities are sold for liquidity to offset jobs that have been lost or on fears of greater job insecurity. Again, if the recession is ahead of us, the relationship between recession and equities suggests that the major market lows are also ahead of us. The question is, have we had our real recession yet? Therefore, it looks like it will require a pickup in unemployment to trigger the type of correlation event that sees all assets sold into the low of the equity market. Now, obviously, it may be the Fed communication that causes the recession that leads to lower lows in stocks. But so far this market has been very well behaved because there's been no panic selling or redemptions of note. The VIX has been high, but it's not been excessively so and has largely been tracking the actual volatility of the underlying market rather than registering real fear. Furthermore, active managers have been hedging their portfolios which have fallen in value due to the decline in the market, but have not yet seen significant assets withdrawn by end clients. If the cost of using options to hedge portfolios is at fair value and the asset managers still have significant assets to hedge, then this may explain the increase in put options premiums that we've seen this year. It may not be the contrarian indicator this time around.
Rog [00:09:25] But maybe employment will remain robust and not deteriorate in a meaningful way. And that's one of the key arguments behind the soft landing scenario. But that's also the rock and the hard place for the Fed. If employment stays robust, then demand will keep prices and wages elevated, creating a drag on growth that will eventually require the Fed to be even more aggressive. The Fed may need to engineer a recession in order to drag prices back down to sustainable levels. So will the Fed be pre-emptively aggressive now and take interest rates to stifling levels that generates a swift recession this year? Or will this be a story for next year when inflation-beating wage increases start to become embedded in the system? But it may be prudent to have a few upside hedges in place here via index calls in case employment either doesn't deteriorate or takes a few months to do so. Large cap corporates may be surprisingly resilient in the meantime. The FedEx statement last week on lack of visibility suggests the slowdown may be on the near horizon, but employment appears to be that key variable. No change and the Fed may have to go even harder on the rate hikes. But if employment starts to pick up, then history suggests that the bulk of the recession is still ahead of us. And if that's the case, then the redemption activity that usually accompanies a major low in the equity market is still the most probable outcome that we may have to keep our powder dry into 2023 for that to play out. Being patient is hard in a world where information is so immediate, but bear markets used to play out over many months rather than a few weeks. We've been used to the Fed reversing course over the last 20 years to support equities, but right now they are still gunning for prices. And that means the reversal from them is unlikely until unemployment has genuinely picked up.