The Big Conversation
Episode 150: Is bad data now good news for stocks?
In this episode Jamie McDonald examines the possible reasons for the pullback in commodity prices and asks whether an impending recession is the main driver. If that is the case, then why do we see such resilience in 2023 corporate earnings especially when other data, particularly housing data, is pointing to estimates being far lower?
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Jamie [00:00:00] Since the summer, copper has fallen by over 15%. Oil, after its own 35% tumble, is now negative on a year-over-year basis.
Jamie [00:00:08] Lumber, iron ore, global shipping rates - one by one the factors that contributed to the surging price pressures throughout 2022 are quickly receding, and that spells good news for a peak in inflation.
Jamie [00:00:08] But does this imply a bullish outcome for equities? Well, to frame it another way, If inflationary pressures are easing due to the potential onset of a recession, should investors now be looking at bad data as good news?
Jamie [00:00:08] And that's this week's Big Conversation...
Jamie [00:00:08] Over the past decade plus, following the global financial crisis, investors have become accustomed to one rule of thumb as economic data deteriorates, the market places increased odds and a more accommodative Federal Reserve.
Jamie [00:00:08] In other words, bad news was interpreted as good news for asset prices.
Jamie [00:00:08] But could that all be about to change?
Jamie [00:01:09] The risk of that old playbook is that it operated within the backdrop of an extremely low levels of inflation. Any slowdown in the data allowed the Fed to pivot and stimulate economic activity - the Fed was basically fighting a single mandate growth.
Jamie [00:01:26] Today, we're faced with a very different scenario. As I brought up at the outset, the correction in commodities and specifically industrial commodities is likely a sign that the Fed's tightening campaign is starting to impact economic demand.
Jamie [00:01:40] That price action seems to corroborate some of the data we've seen from leading indicators such as the US manufacturing PMI. Those headline PMIs confirm other economic indicators like the NAHB traffic of prospective buyers, which has now fallen to its lowest level since 2020 COVID lockdowns and the onset of the 2008 Global Financial Crisis. And that one is extremely important because there are several important linkages from the housing market, which is estimated to contribute about 16% of US GDP to overall demand.
Jamie [00:02:21] So take for instance, the relationship between home buyer traffic and new homes under construction. If the Fed's aggressive rate hike campaign has caused homebuying activity to grind to a halt, well, that will likely weigh on construction activity. And a severe slowdown in construction activity, tends to coincide with not only a decline in raw industrial commodity prices, but also a rapid rise in the unemployment rate.
Jamie [00:02:48] So while we can talk about easing price pressures, those are only at the margin. In fact, the Fed's own projections show inflation to remain well above their stated 2% target throughout all of 2023.
Jamie [00:03:01] The point being with all of this, is that even with the economy creeping closer to a recession, the Fed still plans to forge ahead with rate hikes to contain inflation.
Jamie [00:03:12] In fact, you can read commentary from some of the main players telling people not to expect cuts anytime soon.
Jamie [00:03:18] So is bad news good news? Well, if we consider that recessions tend to coincide with a fall in corporate profits, then easing price pressures due to a recession might not be all that bullish for equities. And if corporate profits begin to contract, then the argument that the repricing of equity valuations has rendered them attractive, well, that might be a tad misleading as well.
Jamie [00:03:43] Because remember, if valuations are lower based on estimates for future profits that have not moved that much, then we need to ask ourselves how accurate are those projections? To this point, estimates for next year's earnings per share still reflect more than 12% growth from the trailing 12-month period - a far cry from the traditional year-over-year contraction experienced in a typical recession. Somebody is wrong somewhere.
Jamie [00:04:05] If corporate profits tend to contract during a recession, and many indicators are trending towards a recession, then how reliable are those rising profit estimates?
Jamie [00:04:06] And then there's the wildcard in this entire equation. And yes, I'm talking about China and their ongoing zero-Covid policy. So over the weekend, there were multiple news reports of social unrest over these exact measures. Now, granted, no one knows whether this could signify a major turning point, but that should be something we all have on our radar.
Jamie [00:04:06] As far as we can see, the current policies remain in place and those lockdown measures have undoubtedly contributed to lower commodity prices. But again, if prices are falling due to a significant slowdown in demand, whether that's from China or the potential onset of a recession here in the United States, it's hard to argue as a bullish development for risk assets.