THE DATA SAYS RECESSION — EQUITIES CONTINUE TO CLIMB
Something Has to Give!
The S&P closed on Friday (June 9) at the highest level since May 2022; this is despite clear evidence that the economy is entering, if not already in, Recession. Q1 corporate earnings have fallen particularly in the all-important Retail sector, which is a proxy for consumer strength. Don’t forget, consumption represents nearly 70% of GDP. Economists are all over the lot on their view of the Recession with many Wall Street firms canceling their Recession call even as incoming data continue to deteriorate. (Of course, the Recession isn’t consistent with a rising equity market!) We haven’t seen any positive economic data in months, and even the seemingly strong May employment report falls apart upon closer scrutiny.
Payrolls
Despite April’s +339K nonfarm payroll number, there continue to be significant contradictions when one looks at the details. So, it makes sense to be skeptical.?First, the +339K was juiced by +85K, a number added (not counted) by the Birth/Death model. Because BLS does not survey small businesses, they add a number to the monthly payroll report based on a long-term growth trend for America’s small businesses. No doubt, small business employment grows over time, but not every month, and not when the economy is fading. Eliminating the Birth/Death model add-on leaves the counted jobs at +254K – still a relatively strong number.
Let’s look at some of the contradictions: First, the ADP monthly survey said large businesses cut -106K jobs in May. ADP processes payrolls – there is a good chance that their numbers are an accurate reading of the employment scene.
The sister survey to the Payroll report, the Household Survey, taken simultaneously (a telephone survey of households), showed a fall in employment of -310K. (Same month but a polar opposite result!) Strange that the media has ignored this. It is the Household Survey that is used to calculate the unemployment rate. Not only was there -310K in the count, but the labor force itself grew by +130K and the combination of the two raised the unemployment rate from 3.4% to 3.7%. The broader unemployment measure, called U6, includes people working part-time but wanting full-time jobs and those not currently actively looking but would take a job if offered. That rate rose to 6.7% from 6.6%.
Layoffs
Challenger, Gray & Christmas, the company that is the leader in providing layoff data, said they counted more than 80,000 layoffs in May, that’s up +287% from May 2022. Outside of the pandemic, this was the highest layoff number for any May since 2007. The table shows layoff announcements in selected sectors for May.
In addition, in May, the workweek fell from 30.4 hours to 30.3. The workweek has been flat or down for four months in a row, a sign of economic weakness. According to Economist David Rosenberg, if we used hours worked as our primary measure of employment, this would be equivalent to the loss of -140K jobs.
While layoffs are high and rising, job openings still appear to be positive. Let’s look at this from the point of view of someone who heads an HR department. Since the pandemic began, keeping employees has been challenging, and finding them even more demanding. So, companies have kept looking. Now that some slack in business has appeared, the first reaction is not to let go of the people who have been so hard to find but to cut back on overtime and hours worked.
Then, on Thursday (June 8), we finally saw a pop of +28K in Initial Unemployment Claims for the week ended June 3 (see chart at the top of this blog), perhaps the first sign that businesses have begun to realize that the soft economic data wasn’t just a passing fad. This is very likely the beginning of some significant deterioration in the labor market, and we are just at the beginning of the up-cycle in the unemployment rate.
So while the equity market was enamored with the non-farm payroll data, investors don’t appear to be looking at the detail. If they did, it would become apparent that the employment report wasn’t compatible with the view of a burgeoning economy.
Foreclosures
Rising foreclosures are always an ominous sign. The most visible signs of economic stress are in the Commercial Real Estate (CRE) market. This is particularly true for office buildings which continue to suffer low occupancy because of the work-from-home phenomenon. An article in Tuesday’s WSJ (June 6) said, “35% of pooled securitized commercial mortgages coming due between April and December 2023 won’t be able to refinance based on current interest rates and the properties’ incomes and values.” The article said that, by one estimate, “as much as 83% of outstanding securitized office loans won’t be able to refinance if interest rates stay at current levels.” Note the implications of the Fed’s “higher for longer” stance here.
May’s data show that the Commercial Mortgage default rate has risen to 4.02% from 2.77% in April. This past week saw the owners of the Hilton Hotel on Union Square in San Francisco and the nearby Parc55 Hotel walk away from their mortgages. Those are the second and third this year in San Francisco (The Huntington Hotel was foreclosed earlier this year.). And as we write, we saw a post that said that seven more San Francisco hotel properties are in danger of mortgage default. While San Francisco may have its own idiosyncratic issues, we reported in an earlier blog that office buildings in Los Angeles and New York had entered the foreclosure process. We believe the foreclosure phenomenon isn’t going to be limited to any particular geography.
The economic takeaway is that regional and community banks are heavily exposed to the CRE sector. As commercial property values fall and foreclosures mount, even those CRE loans that don’t default must be written down and monies set aside to cover expected loan losses. Owning bank stocks looks much more risky today than just a few months ago.
The banks, of course, are well aware of this, and we are currently seeing a pullback in commercial lending (see chart). Over the five weeks ending June 5, commercial bank lending has contracted by -$67 billion (at a -5% annual rate). This is a sign of economic stagnation.
More Signs of Deterioration
In past blogs, we’ve discussed the negative trends in retail sales and commented on the downbeat outlooks from some of the major retailers. The latest surprise came from Campbell Soup, where sales fell -11% in Q1 from year-earlier levels. (One must wonder what happens when soup sales stagnate!) The chart shows that same-store retail sales have continued on their downward path.
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In the labor market, we see that productivity (output/hour) has fallen for four quarters in a row (right side of the chart) while unit labor costs (left side) have peaked and are now falling. These are classic signs that corporate America is overstaffed, and rising layoffs appear to be a foregone conclusion.
Finally, the chart below on corporate profits would lead one to believe that the stock market should be struggling, as investors are interested in profits, cash flows, and dividends. Shrinking profits indicate future economic issues.
Inflation
There is a plethora of evidence that supports our view that inflation is on the wane.
Final Thoughts
The Fed meets on June 13-14. On June 13th, the CPI for May will be released. Unless that CPI report is quite “hot,” a Fed “pause” in their rate hiking cycle is very likely. The official word will be that the “pause” is not a sign that the next move will be a move down (i.e., called a “pivot”). But, they have to say this, or else the financial markets would begin to move market rates lower in anticipation.
The Fed views interest rates as its primary inflation-fighting tool. As we have pointed out in prior blogs, the inflation rate in this cycle is closely tied to the growth/contraction of the money supply with a 16-month lag (see chart). Their Quantitative Tightening (QT) tool has been quite effective in the fight against inflation. (Note: When the Fed sells bonds from its portfolio, it reduces demand deposits in the banking system which shrinks the money supply (M2). The chart shows how the money supply (M2) influences CPI inflation with a 16-month lag.
The preponderance of the incoming economic data is moving to the downside, yet the equity market (S&P500) closed on Friday (June 9) at its highest level since May 2022. This is puzzling, especially considering falling retail sales, corporate profits, and likely even GDP itself. Moreover, in the near future, there will be a liquidity squeeze as the Treasury seeks to rebuild its cash ($1 trillion) in the wake of the debt ceiling resolution. We may see interest rates temporarily spike, especially in the maturity time frames of the Treasury’s issuance. This will sap the economy of liquidity; the financial markets are sure to take note since they are liquidity dependent. A liquidity squeeze always has negative economic consequences. Stay tuned!