The COVID era changed consumer preferences and disrupted US retail inventory management, with wide-ranging effects throughout the economy. Gavekal’s Tan Kai Xian explains how it is now raising the odds of a US recession.

Key Points:

  • Businesses replenished inventories this year as supply chain bottlenecks eased, but also because sales have been deteriorating.
  • Adjusted for inflation, the US inventory-sales ratio has regained its pre-COVID level.
  • Fewer businesses are complaining of shortages, and some appear to have excess inventory.
  • A housing downturn will weigh on durable goods consumption, adding more upward inventory pressure.
  • Less inventory-building will weigh on overall price levels, but doesn’t mean inflation will collapse.
  • Manufacturing activity typically declines as inventory levels grow.
  • A manufacturing contraction at the same time as other growth drivers falter increases recession probability.

A potential offset to this scenario is that many businesses are softening their just-in-time inventory models due to supply chain uncertainty, trade barriers and geopolitical concerns. They would rather have extra product on the shelves than risk running out again. Finding the optimal level may take a lot of trial and error, though. Meanwhile recession is still possible, if not likely.

 

US Economy

 

The U. Michigan consumer sentiment index topped expectations, boosted by lower gasoline prices. The current conditions indicator declined (2nd panel), but the expectations index was higher (3rd panel).

 

 

  • Here is the buying conditions index for household durables.

 

 

  • Import prices declined more than expected last month
  • Short-term market-based inflation expectations have been declining.
  • How will the Fed respond to moderating inflation? Could inflation re-accelerate after we see the “all-clear” signal – as we did in the 1970s?
  • Inflation has been driven more by supply constraints.
  • The NY Fed’s manufacturing report, the first regional indicator released in August, was shockingly weak.

 

 

  • It suggests that the manufacturing sector at the national level is in a recession
  • New orders plummeted.

 

 

  • Factories have been cutting employee hours.
  • CapEx expectations are slowing.
  • Supply bottlenecks are no longer a problem as demand crashes.
  • Unfilled orders:

 

 

  • Price pressures are starting to ease.
  • At the national level, the inventory-to-sales ratio also signals a manufacturing contraction.

 

 

  • Homebuilders are under pressure

 

 

  • signaling a sharp slowdown in residential construction

 

 

  • Homebuilder cancellations jumped last month.

 

 

  • Housing affordability has deteriorated further.

 

 

  • New listings of homes are down almost 12% relative to last year as sellers pull back
  • Tighter liquidity tends to precede recessions.

 

 

  • July manufacturing output surprised to the upside, diverging from much weaker survey-based data.
  • Vehicle production jumped.
  • Capacity utilization improved.
  • Survey-based indicators continue to point to manufacturing weakness ahead.
  • The GDPNow model’s Q3 GDP growth forecast is back below 2%.

 

 

  • Goldman’s estimate has the current quarter’s growth at 0.9%.
  • Retail sales surprised to the upside
  • While new residential construction slumped in recent months, there is a massive backlog that will drive construction activity for some time to come.
  • The reduction in supply chain bottlenecks points to lower CPI.

 

 

  • Auto dealer inventories are starting to improve as supply chain pressures ease.
  • Initial jobless claims are holding above pre-COVID levels
  • Continuing claims remain at multi-year lows for this time of the year.
  • The Philly Fed’s regional manufacturing index unexpectedly jumped this month, diverging from the NY Fed’s dreadful report.
  • Price pressures continue to moderate.
  • Forward-looking components of the Philly Fed’s report remain depressed

 

 

  • which doesn’t bode well for corporate earnings.

 

 

  • The Conference Board’s index of leading economic indicators was down for the 5th month in a row in July.
  • Existing home sales slumped in July, and are now down 22% vs. last year

 

The Fed

 

The FOMC minutes show that the US central bank is fully committed to getting inflation under control.

FOMC: – Participants concurred that, in expeditiously raising the policy rate, the Committee was acting with resolve to lower inflation to 2 percent and anchor inflation expectations at levels consistent with that longer-run goal.

And there is little indication of the so-called “pivot” in the Fed’s policy.

Participants agreed that there was little evidence to date that inflation pressures were subsiding.

The market interpreted the minutes as being a bit on the dovish side because of this language.

Participants judged that, as the stance of monetary policy tightened further, it likely would become appropriate at some point to slow the pace of policy rate increases while assessing the effects of cumulative policy adjustments on economic activity and inflation. Some participants indicated that, once the policy rate had reached a sufficiently restrictive level, it likely would be appropriate to maintain that level for some time to ensure that inflation was firmly on a path back to 2 percent.

The probability of a 75 bps rate hike in September, which was climbing on Wednesday morning, dropped below 50% after the FOMC minutes.

 

 

Short-term Treasury yields declined as well (but are rising this morning). Equities jumped but retreated shortly after. The market expects the Fed to hike rates by an additional 120 bps before the end of the year, with the fed funds rate peaking at 3.7% early next year. The market no longer expects rate cuts in the first half of next year.

 

Market Data

 

Technical indicators show the S&P 500 and the Russell 2000 as overbought as the indices test resistance at the 200-day moving average.

 

 

  • The Nasdaq 100 held long-term support.

 

 

  • Summer rallies are typical before a September pullback.

 

 

  • Over 90% of S&P 500 members trade above their 50-day moving average.

 

 

  • Risk appetite is back.

 

 

  • Second-quarter S&P 500 earnings have been better than expected. But analysts have been downgrading earnings forecasts for Q3 and Q4 (as well as next year).

 

Quote of the Week

 

“I heard the word ‘icy’ is easy to spell.  Looking at it now, I see why.” – Indian Hills Community Center

 

Picture of the Week

 

 

 

 

All content is the opinion of Brian J. Decker