As the Fed started to talk about “taper,” the “bulls” sent a stern warning with a 2% “crash” they shouldn’t.

After a couple of weeks of several Fed speakers discussing the need to reduce monetary accommodation, a quick sell-off brought had Powell singing a “dovish” tone at the recent Jackson Hole summit.

  • We said that we would continue our asset purchases at the current pace until we see substantial further progress toward our maximum employment and price stability goals,measured since last December, when we first articulated this guidance. My view is that the “substantial further progress” test got met for inflation. There is also clear progress toward maximum employment. At the FOMC’s recent July meeting, I was of the view, as were most participants, that if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.
  • The timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test.

Notably, the “delta variant” gives the Fed the perfect cover to ignore their two primary mandates of “price stability” and “full employment.” As noted last week, the underlying economy is slowing following the contraction of stimulus into the economy.

Here is money supply growth versus loan growth and nominal GDP growth.

 

 

US Economy

 

  • Last month’s consumer spending was a bit below consensus, pulled down by weaker automobile purchases.
  • Spending remains above the pre-COVID trend.
  • But inflation-adjusted consumption has returned to trend.
  • Personal income topped forecasts, running slightly above trend.
  • The personal savings rate is normalizing.
  • The PCE inflation grew at a slower rate last month.
  • The updated U. Michigan consumer sentiment figures were even weaker than the earlier report.
  • The Dallas Fed’s regional manufacturing index tumbled in August, coming in well below market expectations.
  • Manufacturers have become much less upbeat about the future.

 

 

  • However, factory workers remain very busy.
  • Businesses increasingly expect to boost employee pay in the near-term.
  • Price pressures persist, although the “prices received” index appears to have peaked.
  • Pending home sales unexpectedly declined in July as rapid price gains take their toll on housing activity.
  • The number of container ships waiting to offload in West Cost ports hit a multi-year high.
  • Supply shortages and rising prices have hit US consumer buying sentiment in durable goods and autos.
  • US automobile inventory is at multi-decade lows.
  • Savings glut is having a perverse effect. A financial cushion is now the top reason for not searching for a job urgently.
  • Does the recent decline in travel point to lower airline fares? Perhaps.
  • Intentions to take a vacation by airplane ticked lower and remain well below pre-COVID levels.
  • The Conference Board’s consumer confidence report surprised to the downside. It’s the latest indication that sentiment weakened in August.
  • Gallup’s confidence indicator also declined.
  • But labor market sentiment remains robust.
  • The Chicago PMI shows a moderate slowdown in Midwest regional factory activity.
  • The Citi Economic Surprise Index continues to deteriorate.

 

  • Home price appreciation hit new highs in June, with the Case-Shiller index rising by over 19% (year over year).
  • Rising home prices are spooking potential buyers.
  • Home price appreciation takes longer to affect the owners’ equivalent rent (OER) inflation. The massive spike in housing prices (#5 above) will show up in the CPI data in the months ahead.
  • Rent inflation has been accelerating.
  • The ISM Manufacturing PMI report showed robust US factory activity in August despite shortages of supplies and labor. New orders have been holding up well.
  • However, given the recent weakness in China, we could see growth softening in the months ahead
  • Order backlogs remain elevated.
  • Supplier deliveries are still massively delayed, but the index has peaked.
  • And the “prices paid” indicator surprised to the downside.
  • Businesses are rebuilding inventories.
  • Hiring at US factories has stalled
  • By the way, the ADP payrolls index also shows a much slower pace of hiring in manufacturing.
  • The ADP private employment report was well below forecasts.
  • US auto sales tumbled further in August. Outside of the pandemic, sales haven’t been this weak in a decade.
  • The HPS-CS economic sentiment index confirmed the weakness in consumer confidence.
  • A large divergence between the U. Michigan’s and Conference Board’s sentiment indicators typically signals a cycle end (recession).

 

 

COVID Update

 

 

 

 

China

 

China is a major economic power in part for geopolitical reasons. George Friedman breaks down the factors that brought China to its present challenges, and the limited options available as Beijing seeks to maintain control. This is important background to know as you evaluate China-related investments.

  • Economic growth is crucial to China’s internal stability, but involvements with foreign powers have to be reconciled with national unity.
  • The country must generate sufficient wealth to prevent unrest, but is unable to do so domestically.
  • China’s exports can undermine foreign economies, inviting retaliation by its own customers and suppliers.
  • With other countries now engaged in lower-wage production, China needs to compete in more advanced, higher-margin products. This puts it in competition with its main export markets.
  • China is the world’s largest importer and the US is the world’s largest importer, creating inevitable tension.

China’s primary strategic interest is to prevent the US from blocking its ocean outlets, which it needs to maintain a robust economy that pacifies the population. It must have access to US markets without giving the US equivalent access to Chinese markets. Beijing needs a way to disengage from confrontation with the US while preserving national unity. This is difficult, hence the ongoing tension.

In a recent opinion piece in the Financial Times, the 91-year-old billionaire investor George Soros took aim at the leader of the world’s largest communist state – Chinese President Xi Jinping.

Specifically, to start the essay, Soros said Xi “has collided with economic reality.”

Soros then wrote that China’s recent “crackdown on private enterprise has been a significant drag on the economy”… and that it caused Chinese stocks to plummet this year. The iShares MSCI China Fund (MCHI) fell 32% from mid-February through mid-August.

Since bottoming on August 20, MCHI is up about 9%. According to Soros, that’s because the Chinese government went out of its way to reassure foreign investors amid the six-month drop, leading to a “powerful” reversal. But as he warned in the Financial Times…

“That is a deception. Xi regards all Chinese companies as instruments of a one-party state. Investors buying into the rally are facing a rude awakening.”

 

Friday’s Jobs Report

 

Friday morning’s US jobs report covering August fell far below expectations, with the retail and leisure/hospitality sectors looking especially weak. One interpretation is that COVID fear is again keeping people home, but Peter Boockvar sees it as a labor supply issue, not a demand problem.

  • Payrolls grew just 235,000 in August but the unemployment rate fell to 5.2% – better than the 5.9% 30-year average.
  • The leisure/hospitality sector had no net job increase and retail employment fell, yet businesses in those segments are still trying to hire.
  • Similarly, construction lost jobs but we know materials shortages are causing problems.
  • Strong wage growth and rising participation are also inconsistent with weakening labor demand.
  • The labor force participation rate was unchanged at 61.7%, down from 63.3% in February 2020.

Boockvar believes the hiring shortage relative to expectations was due to a lack of available workers, not lack of consumer demand. That means the Fed shouldn’t let this data further delay its tapering schedule… but the Fed may not see it that way.

This is more than just a jobs problem. The Fed is looking for the economy to reach some mythical level of “maximum employment” before it starts normalizing policy. The expectation they will start tapering by year-end made sense two months ago. Now? Not so much. They will use the weak jobs data as an excuse. And that, in turn, leads to a variety of other challenges.

We are in an odd situation where it’s unclear if labor is scarce or abundant. Many employers can’t seem to find enough qualified workers, but the August jobs report said 8.4 million are unemployed and millions more underemployed. The unemployment rate dropped to 5.2%. Many employers are looking for workers but they only made 235,000 net new hires last month. The consensus estimate was 733,000, so a huge miss.

When the coronavirus first struck last year and many businesses had to shut down, Congress added extra unemployment benefits. It also expanded eligibility to previously uncovered workers like the self-employed. These extra benefits later expired for a few months, then were renewed, renewed again, and now expire again this month.

For many workers the added benefits were actually more than they made when working, creating a potential disincentive to work. To what extent it actually did so is exceedingly hard to measure. Certainly some workers abused the system, but many others had legitimate reasons they couldn’t work.

Nonetheless, some states decided to end the expanded benefits as early as June. Employment isn’t growing noticeably faster in those states—possibly because the worker shortages that sparked the move weren’t new. We had them before the pandemic, too.

This “labor shortage” we attribute to COVID has been brewing for many years. The virus certainly made it much worse. It created new health concerns and gave people other reasons to change careers or stay out of the labor force. But none of this is new. What we’re seeing now is better viewed as a resumption of the previous trend.

So the real question is what caused that trend? Where have the workers gone? And has COVID made the trend even worse going into the future?

You’ll notice that worker availability peaked in 2009–2010. That also happens to be when the Baby Boom generation began reaching age 65. Not all are choosing to retire—indeed, many (like me) are not—but the demographic winds changed about that point. Working age population growth slowed and, after about 2018, actually began falling.

 

 

Worse, the percentage of this already-shrinking population who are available for work is also shrinking. The “Labor Force Participation Rate” measures the percentage of adults who either have a job or want a job. Some don’t because they are retired, full-time students, etc. So with Boomers retiring it has been on the decline, but even so, tried to stabilize in the 2016–2020 period. The pandemic ended that trend.

 

 

The especially disturbing part here is that participation plunged quickly when COVID hit, then bounced back about halfway to where it had been, and has since been stable near that level. It’s starting to look like a “new normal.”

But one thing has changed. Prior to COVID, more older Americans (those 65 and older) were staying in the labor force. That trend has clearly changed. Let’s look at the chart:

 

 

That’s the labor force participation rate, but what does that mean in raw numbers? Almost 1 million Americans aged 65+ dropped out of the labor force between February 2020 and July 2021.

 

 

By raw numbers, looking at the total participation rate, we find that something like 3.5 million Americans of all ages who were in the labor force pre-COVID decided to leave it and haven’t come back. We know many decided to change careers and are now reeducating themselves. They will likely be back. The “working retirees” who are concerned about COVID risks may be back, too. But that still leaves the previous downtrend in the labor supply. What was going on?

An economy that has too few workers to grow at a robust pace isn’t just slower-growing. It is an economy forever teetering on the edge of recession. It limits access to credit. It is an economy that fails to engender the optimism to invest in training and productivity enhancements to build social wealth—and as we are seeing globally, slow-growing economies undermine confidence in capitalism, trade and free societies.

Adjusting the statistics for the age and sex of the US population only explains about half of the pre-pandemic decline in the labor force participation rate. I realized that we have to understand the reasons for this loss of American economic vitality if we are to have any chance of restoring our labor markets to their historic strength.

I know economies tend to move in cycles. They rhyme, if not repeat. But the data shows that the magnitude and the dispersion of the interrelated social problems now suppressing our labor force and sapping our economic vitality are unprecedented—making today wholly unlike past economic cycles, in kind, not just in degree.

 

Market Data

 

 

  • Consumer discretionary shares have been underperforming this year

 

 

…pressured by Amazon.

 

 

  • Should investors be concerned about a peak in margin debt?

 

 

  • When you buy a stock you are really buying what you think will be the stock’s future earnings. Success depends heavily on how much you pay for those earnings. The Cyclically Adjusted Earnings Yield is an attempt to measure this, adjusting for cyclical effects and inflation. As you can see in this chart, market tops coincide with low yields. Buying at that point means you paid more for each dollar of earnings. Conversely, buying at market bottoms helps deliver higher “yield” for your investment.

 

 

That’s simple enough. Where are we now? The earnings yield is as low or lower than it was at historic market tops like 1929 and 2000. Of course, no one knows what the next 5–10 years will bring. Conceivably buying today could work out well. But history says it might not.

  • This chart is an interesting way to compare stock valuations in different countries. It compares 5-year average P/E ratio with annual earnings growth. Ideally, you would like to own markets in the lower right, where you get the most earnings growth for the lowest price. You would avoid the upper left, where you are paying a premium price for less earnings growth

 

 

By this measure, the optimal stock markets are those of Canada, Germany, Japan, and Italy. You might want to stay away from Australia, Norway, and France. The US is somewhere in between, with moderately high earnings growth but the highest valuations on the chart. These are measures of broad indexes representing entire countries. So there are likely good companies in the otherwise low-ranked countries, and bad companies in the otherwise optimal countries. As always, you want to find the right balance.

  • EPS growth is peaking, with tougher comps ahead.

 

 

Sectors with the highest buyback activity tend to outperform.

 

 

  • As the S&P 500 soared to new highs over the past couple of months, defensive sectors like Utilities and Health Care have outpaced the index. That has led to an unsupported view that it’s a negative for the broader market.

 

Thought of the Week

 

“Two waves in the ocean are talking to each other. The front wave tells the second that it’s frightened because it is about to crash into the shore and cease to exist. But the second wave shows no fear. It explains to the first: “You are frightened because you think you are a wave; I am not frightened because I know I am part of the ocean.”

– Daniel Gottlieb,

Letters to Sam: A Grandfather’s Lessons on Love, Loss, and the Gifts of Life

 

Pictures of the Week

 

Apple AirPods revenue in perspective:

 

 

 

 

 

All content is the opinion of Brian J. Decker.