Chronic

“The absence of evidence is not evidence of absence.”?

?????????????????--Donald Rumsfeld, W.

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Waiting longer for the inevitable doesn’t invalidate it.

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Key Takeaways:

·????????The Leading Economic Index (LEI) lives up to its name. It is a very reliable indicator of economic cycles. It has been sounding the recession alarm for a while. Although some may view that as reducing its accuracy, I argue that the signal is rising in strength. The deeper the LEI goes without a recession creates the appearance that the economy is bullet proof. This sense of complacency often occurs right before the rug gets pulled out from under them.

·????????If tax collections are weaker than expected the X-date (the time the government runs out of revenue) arrives faster. The earlier the X-date, the greater the possibility of a stopgap measure. That would postpone any chance of a government shutdown, resulting in an equity relief rally. After that rally comes the realization that the Treasury General Account (TGA) will no longer be adding liquidity and supporting equity prices.

·????????We will gain insight into how fractured House Republicans have become when they vote on Speaker McCarthy’s debt ceiling bill this week.

·????????More negative divergences are forming in the equity markets as the Bear Stearns analog looks to conform to the typical seasonal pattern ending April with a rally, and then the risk tradeoff turns negative heading into the Federal Open Market Committee (FOMC) May 2-3 meeting. We lean bullish unless 4070 support in the S&P 500 cash is broken.

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Noteworthy:

o??The fixed income market is reacting to the upcoming budget crisis before equities. Investors have been piling into 1-month treasury bills relative to 3-month bills, a strong statement they believe they will be paid back next month, but they are less certain of a full return of their investment in July.

o??The consensus narrowed the X-date to early June (assuming tax receipts are 35% lower than last year) through late July (assuming tax payments are 30% lower y/y). Treasury Secretary Yellen will be updating her forecast this week with official tax data, which could surprise the market as she will opt for an early X-date to avoid a technical default.

o??Wells Fargo earnings revealed that nonperforming commercial real estate loans increased by 50% in the first quarter this year. Looking at the Federal Reserve H.8 report released Friday, commercial real estate loans have been steady for the first two weeks of April as worried borrowers probably drew down available lines of credit.

o??The fact that UK inflation remains over 10% will have implications for British consumers and the Bank of England. CPI should fall sharply because high energy prices from a year ago are dropping out of the CPI calculation; in addition, continuing declines in food prices should also dampen inflation. However, if price increases remain stubbornly high, inflation expectations and the central bank’s rate hiking path will be impacted.

o??Single-family housing permits fell a worrisome 8.8%. The homebuilding industry and DR Horton have outperformed the S&P this year. Even though DR Horton spiked this week after earnings, its order backlog was almost half that of last year’s peak level. This is a warning sign because it exceeded the drop from 2006 that started the slide into the financial crisis.

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Display of D’s Dept: There is already an accelerated discussion about the debt ceiling D-Day, but the D’s I am fully focused on are the depth, duration, and diffusion of the LEI series.

March LEI was down 7.8% over 12 consecutive lower readings, so that confirms the depth and duration. Speaking of duration, when was the last time LEI fell for 12 straight months? That was when the March 2008 report was released 15 years ago in April 2008, yet another correspondence to the Bear Stearns analog.

Diffusion was seen in the eight components out of ten that were down, and only the S&P index and consumer goods orders improved (both were barely above zero).

The following chart is the Conference Board’s calculation that illustrates their recession signal. When the LEI’s 6-month rate of change (the blue line) falls below -4.2%, a recession signal is triggered as illustrated by the red horizontal line. A recession signal forecasts a recession within the next 12 months.

Two observations stand out from the above chart. First, the signals have been excellent indicators of an impending recession, and the record going back before 2000 is as accurate. Second, the current signal triggered last year, and is still in effect.

In a commentary written last year, I first showed this LEI chart when the red dot first appeared. This recession has been so highly anticipated that we must ask if we missed it. Did it come and go without us noticing?

This indecisiveness over the potential of a recession is the exact dynamic I have been writing about. Investors found themselves in the same situation during late April 2008. The longer we go without entering a recession, the chances of it occurring increase; it does not diminish its likelihood.

Chronic bears on the equity market and the economy have been suffering since the October 2022 lows. However, it is the economic situation that is chronic:

·????????Bank credit had already become scarce before Silicon Valley and Signature Bank, and lending is only going to become less available. We are already witnessing its negative impact on hiring demand and wage growth.

·????????Real incomes will fall because wage growth is falling unusually early, even before we have entered a recession. Wages tend to peak at the start of a recession. Real wages will also fall with any inflation uptick, therefore expect dampened consumer demand either way.

·????????Earnings have not collapsed as had been widely expected, and the bar has been increasingly lowered. However, unless banks suddenly ease their lending standards and loan demand reverses, earnings should continue to contract.

·????????The forecast that China is growing again and will help the rest of the world return to normal remains to be seen. Chinese unemployment among the youth just reached its second-highest level ever at 19.6%.

The Conference Board says that we will not have to feel impatient much longer. The LEI suggests we will be in a recession by mid-2023.

D-Day of the Debt Ceiling

The U.S. Treasury General Account has been drawing down to pay the bills ever since hitting the debt ceiling. It just dropped to a low of $86 billion on April 12 from $450 billion one year earlier. The liquidity that the TGA has added to the economy has been stimulative and equity friendly. Once the debt ceiling issue is resolved (sorry, postponed), its removal will have the reverse effect.

Three factors are leading to a postponement of the debt ceiling debate:

1.??????Thanks to recent tax receipts, the TGA has increased to $265 billion. As mentioned earlier, if the tax receipts are worse than expected, the X-date moves forward to early June, and if better than expected, the X-date is postponed to late July. Secretary Yellen will refine the forecast with updated tax information, and her inclination is to be more conservative; thus expect an X-date consensus that is sooner rather than later. This should create a sense of urgency that will probably result in a stopgap measure.

2.??????The degree of dissent among House Republicans could lead to delays in passing the bill and that would shorten the amount of time that Speaker McCarthy and President Biden have to negotiate, thus increasing the potential of a logjam, and lead to choosing McCarthy’s second proposal of postponing the discussion until March 31, 2024.

3.??????McCarthy’s proposal contains rollbacks of several key Biden programs including clean energy tax credits and student loan forgiveness. The plan is barely even a starting point for the negotiation process with the administration. The negotiation process with President Biden would be too polarized to realistically expect a reconciled bill. Even the 64-member bipartisan Problem Solvers Caucus has recommended suspending the debt limit through the end of this year.

This is the path of least resistance from my perspective, although this path will appear rocky. The market will only experience a temporary sigh of relief because as soon as the stopgap measures are implemented, the TGA will stop adding liquidity and the equity market will lose an important pillar of support.

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We are waiting for two delayed events: waiting for recession’s arrival, and waiting for the official delay to resolving the budget. No wonder we are in one of the tightest trading ranges of the past 80 years.

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Regarding the markets, the Bear Stearns analog has become remarkably accurate, and the similarity of price and indicator patterns points to a top near the FOMC meeting. ?The short-term market tone is positive if the S&P 500 Index continues to close above 4100 S&P 500, with the first reversal sign on a break below 4070. From a buy and hold perspective, 3800 is key support.

Weak Breadth

The percentage of stocks trading above their 20-day moving average has been trending lower this week as the general indices trended higher, which is a sign of weakening overall demand, equivalent to the December and February market tops. ?Another closely followed breadth indicator fell below zero on Friday, and the last two times that occurred were also early December 2022 and the first week of February 2023, both before selloffs to 3800.

Regional Banks Lagging

KRE/SPY improved slightly last week supported by the following:

·????????Bank Term Funding Program borrowings fell slightly and borrowings at the Fed’s Discount Window were steady.

·????????Deposits fell 5% at large commercial banks for the April 12 reporting week whereas small banks saw a relatively low 1% drop in their deposit base.

·????????Lending to the bridge banks that the FDIC created for Silicon Valley and Signature banks has reduced by about 1%.

The Semiconductor Capex Pendulum Has Swung Too Far to the Other Side

Semiconductor capacity has increased since 2021, and the industry has reported an enormous jump in inventories toward the 2000-2001 highs when technology stocks cratered . The 2020 rush to buy semiconductors has created a surplus. The SMH semiconductor ETF has underperformed the S&P by 10% over the past month, and Taiwan Semiconductor has underperformed the SMH for the past three months.

Taiwan’s entire economy is suffering, as exports fell over 25%, its worst result since the global financial crisis.?

Meanwhile, technology stocks in general are slated to see a 1.4% rise in profit margins to an all-time high. The sector is already vulnerable to higher rates if inflation persists, but given our recessionary outlook, record margin forecasts are ambitious, to say the least.

Recently, the Shanghai Composite and crude oil have similar price patterns, and both need to hold last week’s lows, or else there will be a sharp increase in selling. Hopes for global growth would be damaged if crude moves below the March 31 $75.80 high set just before OPEC+ made its surprise production cut. It closed Friday at $77.80.

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Bond Note

Ten-year yields were capped at 3.60% last week. Most of the attention was on the very short end of the curve as the market begins to react to the approaching budget debate. Three-month bills yielded 5.32%, a level not seen since 2002. There was discussion about the number of bonds falling out of the investment grade (IG) classification into junk ratings, but the $80 billion amount was roughly 2% of the total BBB corporate bond market, with the average since 2000 being 3 times that level. Furthermore, $70 billion is expected to rise out of junk into investment grade, for a minimal net impact. The real problem for corporate bonds is that they look unattractive through the lens of a bank’s higher cost of funding. If banks demand for corporate bonds shrinks, yields on IG corporates need to rise to become more competitive.

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Dollar Note

The dollar index traded in a very small range last week, similar to stocks, and remained above key 100 support. This week the focus moves to the Bank of Japan (BoJ), where newly installed BoJ Governor Ueda holds his first meeting, which should result in no action. The currency market will move based on Japan’s quarterly outlook report, their version of the Statement of Economic Projections. Japanese core inflation of 3.8% is at a four-decade high, up from just over 0.5% a year ago. How dramatically the Ueda BoJ shifts its inflation forecasts through fiscal year 2025 will suggest how quickly the central bank can remove monetary stimulus. Any drop below 132.50 in USDJPY could help bolster commodities.

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Peter Corey

PavePro Team

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