Pro Perspectives 7/18/22

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July 18, 2022

On Friday we talked about earnings from three of the big four banks. 
 
All produced soaring net interest income, thanks to rising interest rates. 
 
All had solid overall earnings performances, before adding to an already massive war chest of loan loss reserves (although loan losses continue to be low). 
 
And all had positive things to say about the strength of the consumer. 
 
We heard much of the same today from Bank of America, the second biggest bank in the country. 
 
So, the banks continue to be profit printing machines.  When times are unstable over the past fourteen years, they’ve been backstopped by the Fed (de-risked), and incentivized to fuel credit creation to help the economy — from which they make money in loan origination, investment banking and trading. 
 
When times are more stable, their customer account balances balloon (as they have now), from which they get to earn what is becoming a very healthy interest rate spread from the rising interest rate environment. 
 
Heads, they win.  Tails, they win.  And the systemically important feature of being one of the biggest banks in the largest economy in the world, means that (as we’ve observed) risk is absorbed/transferred/backstopped by the Fed and government. 
 
With the above in mind, as we discussed on Friday, the banks are dirt cheap at lower than 10 times next year’s earnings (a straight average of the big four banks).   That’s less than 0.6x the P/E of the S&P 500.
 
This relative valuation is near historic lows, not only for the big four banks, but for financials on whole, relative to the broader stock market.
 
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Pro Perspectives 7/15/22

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July 15, 2022

Second quarter earnings season is just getting underway.  We've heard from three of the big banks this week.
 
JP Morgan, the biggest bank in the country, "missed."
 
That was the big news yesterday.  But don't let the headlines fool you.
 
They had growth in almost every category.  The exceptions: investment banking, and assets under management (due to the decline in the stock market).
 
The earnings miss was a management decision.  They chose to take charge offs and move almost half a billion dollars to "loan loss reserves."
 
That's the corporate America playbook for a down stock market.  Put all of the bad news you can muster on the table.   That sets up for positive surprises in the quarters ahead.     
 
If we add the allocation to loan-losses, back to earnings, JP Morgan would have beat estimates by 2 cents.  Meanwhile, they grew year-over-year revenue by $200 million.
 
This, rather than the headlines, is more in line with the way Jamie Dimon (CEO of JP Morgan) described the health of the economy.  He said, "the U.S. economy continues to grow and both the job market and consumer spending, and their ability to spend, remain healthy."
 
Now, add to this, we heard from Citibank and Wells Fargo today.  
 
Citi beat on earnings and revenues.  They, too, took a big write off for bad debt, and set aside $375 million for (additional) loan losses.  They still beat.   
 
Wells Fargo missed.  This is the "put all the bad news on the table" posterchild.  They took big write downs on private equity and venture capital investments.  Meanwhile net interest income jumped 16%.   
 
Keep in mind, these three banks still have a combined $10 billion more in "loan loss reserves" than they did prior to the pandemic.  This is a war chest of capital that was set aside early in the pandemic, that will be moved to the bottom line (i.e. turned into earnings) at their discretion.
 
Bottom line:  The big four banks are in good shape, and are cheap, with forward P/Es under 10. 
 
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Pro Perspectives 7/14/22

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July 14, 2022

Over the past two days, we've seen the June inflation rate on consumer and producer prices.  Both were hot, running at double-digit annualized rates. 
 
Consequently, interest rate markets have quickly adjusted, pricing in a coin-flips chance of a 100 basis point hike at the July 27th Fed meeting.
 
Stocks reacted this morning, going deeply in the red. 
 
But most of the losses were recovered by the end of the day.  The Nasdaq (the most interest rate sensitive stock index) finished UP on the day. 
 
What's the story?
 
The markets have just set up for a positive surprise (i.e. they are not going 100 bps).
 
As we've discussed here in my daily notes, the Fed doesn't have the appetite for big rate hikes.  If they did, they would have acted bigger, and more aggressively already. 
 
Remember, high inflation environments, historically, have only been resolved when short term rates (the rates the Fed sets) are raised above the rate of inflation.  The Fed is currently almost eight percentage points behind.  We can only assume, at this point, that it's intentional.  
 
Also, when asked about the inflationary risks of QE, back in 2010, the former Fed Chair (Ben Bernanke) said dealing with inflation is no problem.  "We could raise rates in 15 minutes."  They haven't. 
 
Add to this:  The current Fed Chair has told us that they were going to aggressively attack inflation, by "expeditiously" raising interest rates, and "significantly" reducing the Fed's balance sheet.  They have done neither.
 
So they have the tools.  They understand the formula for resolving inflation.  But they aren't acting. 
 
Why?  Even if the U.S. economy (including our government's ability to service its debt) could withstand the pain of nearly double-digit interest rates, the rest of the world can't.  That's it.  End of story. 
 
Capital is already flying out of all parts of the world, and into the dollar.  Is it because U.S. bonds are finally paying interest?  Partly.  Mostly, it's because the U.S. is pulling global interest rates higher, which makes sovereign debt more expensive (more likely, unsustainable), particularly in the more economically fragile emerging market countries.  Rising U.S. rates accelerate global sovereign bond markets toward default/ sovereign bankruptcy. 
 
And historically, sovereign debt crises tend to be contagious (i.e. you get a cascading effect around the world).  So far, we've seen defaults by Sri Lanka and Russia. 
 
This is why the Fed is talking a big game, but doing very little with rates. 
 

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Pro Perspectives 7/13/22

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July 13, 2022

The June inflation report this morning came in hotter than market expectations.  The year-over-year headline CPI is now nearing double-digits.  And the monthly inflation number is now reflecting prices rising at a mid-teens annualized rate.
 
This is what happens when you grow the money supply by $6 trillion in two years (a one-third increase).
 
Still, of the legislative handouts that have been approved over the past two years, three-quarters of a trillion dollars remains unspent. 
 
That’s more gas yet to be poured onto the inflation fire. 
 
But just in case you thought that wasn’t enough, the democrats are resurrecting “Build Back Better.” 
 
Why?
 
This is the cornerstone of the global (G7) agenda, of which, the U.S. administration is in full, explicit cooperation to execute.
 
It’s rooted in energy and social transformational policies, and it doesn’t get done in the most important constituent country (the U.S.), if the democrats lose control of Congress in November.
 
What will they do?  Whatever it takes.  At the moment, this renewed effort to push through over a trillion-dollars of new spending, is being framed as a solution to inflation.  This sounds like the California playbook.  The carrot:  Gas checks for everyone!
 
Thankfully, Manchin would hold the line against complete insanity.
 
But this brings us back to my June note, after NATO announced accession plans for Finland and Sweden, following a number of other provocative actions. 
 
Excerpt from June 29, Pro Perspectives:  “We know that Western leaders are all coordinating to execute on an economic, social and political agenda.  And we know that the current economic environment (high inflation, record high debt and deficits, and record low interest rates) is a conundrum, which threatens the execution of the agenda.  Still, we also know that they have the appetite to keep spending, to keep executing.  
 
What better way to excuse more fiscal spending (to get the agenda done) than to enter a global war.  And I suspect, if the current proxy war, turned into a global war, it would be a war of posturing. It would be as ambiguous as the current war.“
 
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Pro Perspectives 7/12/22

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July 12, 2022

Tomorrow morning, we get the June inflation number.
 
As we discussed yesterday, rising gas prices in June will be a big contributor to upward pressure on CPI. The consensus view is for a hot headline number – a new 40-year high.   
 
But as we also discussed yesterday, given some weakness in other inflation inputs, as well as weakness in broad economic data, don’t be surprised if the Fed and the media try to turn focus to the “core” inflation rate (in effort to manage confidence). 
 
The core number excludes the effects of food and energy.  It has been ticking down the past two months, and is expected to continue that trend in tomorrow’s report.
 
On cue, we had an article from Reuters this afternoon that drew attention to the core number.  And the head economics guy at the White House tweeted this, this afternoon…
So, the White House is trying to get in front of the number tomorrow.  The White House also included in today’s sentiment manipulation campaign, that economic data in Q1 and Q2 was not consistent with “recession.”
 
But as we know, official Q1 GDP was negative.  And Q2 is tracking a contraction of 1.2%.  That would be two consecutive quarters of negative GDP, which is technically defined as recession. 
 
The White House is clearly trying to assuage a recent small business optimism index report, which plunged to nine-year lows, and consumer sentiment which is on record lows. 
 
All of that said, if we look at nominal growth, the economy is indeed growing at a better than average clip of over 6%.  It’s inflation that is crushing “real” growth.  It’s an inflation-driven recession.   
 
If we look back to the inflation spikes of the early early 80s, nominal GDP grew by an annual rate of 9% during those periods. 
 
Stocks did this … 
Notice the impact inflation had on the real (after adjusted for inflation) rate of return in stocks (the third column). 

 
And through a four-year period, where inflation averaged nearly 10% per year, you can see, in the far two columns, what it looked like for those that remained invested in stocks, relative to those that went to cash. 
 
The takeaway:  Being long stocks not only gave you a hedge, but increased your buying power by 30% over the period.  Going to cash, destroyed your buying power by 33% over the period.
 
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Pro Perspectives 7/11/22

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July 11, 2022

We get the big inflation data on Wednesday, and then the banks will kick off Q2 earnings to end the week.
 
Let’s talk about three factors, that have already been revealed, that will influence the June inflation number.  
 
First, gas prices:
 
This carries almost a 1/5th weighting in the CPI calculation.
 
As you can see in this 10-year period between 2002 and 2012, gas prices and the consumer price index track very closely. 
So what did gas prices do in June?  The Energy Information Admistration (EIA) does a weekly survey of gas stations across the country.  Those survey results show a rise in gas prices by about 11% from May to June.
 
That doesn’t bode well for the inflation number. 
As you can see in this above table, these sharp rises in gas prices have resulted in big monthly change in CPI.  These monthly changes in CPI around 1% are representing an annualized inflation rate of double-digits (well above what has been the high year-over-year rate recorded thus far). 
 
So, as far as Wednesday's number goes, this gas price input is bad news.
 
But there is some hope that the inflation report could come in a softer, and therefore, take some pressure off of the Fed to act more aggressively.
 
We looked at the wage data on Friday. 
 
The Fed is worried about the wage pressure influence on prices (or worse, a wage spiral). 
 
On that note, the June jobs report showed average hourly earnings grew by 0.3%.  If we annualize that, we get 3.7% wage growth.  That's significantly lower than the year-over-year change of 5%+. 
 
That's good news (i.e. less pressure on prices). 
 
Finally, let's take a look at what's happening in China, where the products are made that we will be buying in the many months ahead…
Notice on the far right of this chart, producer prices in China were screaming higher late last year (at 13.5% year-over-year rate).  It was the hottest reading in 26 years.  Meanwhile, the Fed was still playing the inflation denial game.  This data was clearly telling us what was happening, and what was coming.  And we have seen it.  
 
But, this number has since been falling like a stone, for eight consecutive months (now at 6.1%).
 
Again, this all relates to how aggressive the Fed will (at least threaten) to put the brakes on the economy. 
 
With the above in mind, with clear softening in the economy and in some of these inflation inputs, expect the Fed to start focusing the media and Wall Street on the core inflation number (chart below).  This number excludes the effects of food and energy — which they like to justify by calling these inputs too "volatile."  This has always been the number, with which they have positioned their policymaking.  
 
If we see this core number continue to roll over, the Fed could be, in the coming months, in a position to claim victory (with the excuse to pause on tightening) — though the true cost of living pain, from food and energy, will continue. 
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Pro Perspectives 7/8/22

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July 8, 2022

As we discussed yesterday, the Fed's primary objective is to reduce leverage of the job seeker, and current work force, in commanding higher wages. 
 
Wage growth has fueled inflation.  And what the Fed fears is a wage (upward) spiral.  
 
That said, after adding $6 trillion to the money supply in two years (ten years worth of money supply growth in two), we should expect higher prices.  It's excess money, chasing a relative stable quantity of assets.
 
That's a formula for higher prices. 
 
And as we've discussed, while the rate of change in prices (i.e. inflation) will come down, the level of prices will not — unless much of that $6 trillion is sucked out of the economy.  That's not going to happen.
 
It is implied that the Fed's quantitative tightening program will accomplish that, but if we look back at the 2017-2019 period, when the Fed was shrinking it's balance sheet, the money supply (M2) kept growing!
 
Back to the jobs report today…
 
Again, the most important data point in the report this morning wasn't jobs, but it was wage growth.
 
Is there more evidence that the wage spiral threat is abating?
 
The answer is, yes.
 
Average hourly earnings grew by 0.3%.  If we annualize that, we get 3.7% wage growth.  That's significantly lower than the year-over-year change, which is better than 5% growth (but trending lower), as you can see in the chart below… 
 
Wage growth in the 3s would get us back to pre-pandemic levels.  That would take some of the steam out of inflation, and take pressure off of the Fed to raise rates.
 
To be clear, with inflation running 8%+ and wage growth running quite a bit less, we have negative real wage growth.  Life is just more expensive — which begins to slow economic activity.   
 
Given all of the available options to deal with inflation, that seems to be the Fed’s favored option:  Let inflation solve inflation.   
 
On that note, the market is pricing in another 75 basis point hike from the Fed later this month.  If the CPI number on Wednesday comes in lower, my bet is for another 50 basis points (to return the Fed Funds rate to 2%), and the Fed will be done.
 
We will see.  They already gave us a clear signal last week — by executing only 15% of their June plan to shrink the balance sheet — that they are not serious about doing any meaningful tightening.  
 
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Pro Perspectives 7/7/22

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July 7, 2022

We get the June jobs report tomorrow.  Remember, the Fed has explicitly targeted employment, as a tool to bring down inflation.
 
The last jobs report (measuring May employment) wasn’t weak, but it wasn’t strong.  And the wage component was relatively soft.  
 
Stocks moved lower following that report. And we haven’t seen that pre-jobs number level since.
The consensus estimate for tomorrow's number is for 268k new jobs added.  That would be the weakest job growth since April of last year. The six month moving average is over 500,000 monthly jobs added.
 
So this number tomorrow in the 200s would indicate a less healthy job market (still good, relative to pre-pandemic times). 
 
This less healthy jobs report would reflect an economy that is likely in recession.  So, is bad news good news?  Will it curtail the Fed's interest rate threats? 
 
Probably. 
 
That said, the Fed has been focused on getting people back into the job market, and reducing the massive number of job openings – shaking out the excesses of an exuberant economy.
 
On that front, as you can see in the chart below, the report yesterday on openings showed things rolling over (albeit very gradually)…
Now, let’s look at the labor participation rate.  As you can see, we haven’t recovered to pre-Covid levels — and well under the levels of past decades …
Still, if we look at the math on how that gap between job seekers and job openings will close, it doesn’t look possible. 
 
It’s a big gap (over four million people). 
 
That said, the Fed’s primary objective is to reduce the leverage of the job seeker, and current workers, to command high wages. 
 
Why?  Higher wages are fueling inflation. 
 
If we look at the record low levels of consumer confidence, they’ve probably already accomplished that goal.  
 
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Pro Perspectives 7/6/22

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July 5, 2022

This past Friday was a relatively quiet day for markets, heading into a long holiday weekend.  Yet, the 10-year yield traded from over 3% to a low of 2.79%.
We've since had lower lows this week.  And mortgage rates have dropped nearly half a point.
 
What's going on? 
 
Is there safe-haven buying of Treasuries, on the prospects of recession and war?  Probably.
 
But in addition to that, there was a very important release from the Fed after the close last Thursday (the last day of the month of June).  It was the Fed's report of domestic security holdings. 
 
Remember, June 1 was the official start of the Fed's quantitative tightening (QT) program.  This was the onset of a plan to extract $1 trillion of liquidity from the financial system over the course of the next year. 
 
And also remember, heading into that June 1 date, financial conditions had already tightened.  Stocks were already in bear market territory.  Mortgage rates had spiked (the fastest near doubling on record).
 
We questioned, in these daily notes, if the Fed would even be able to begin the process of shrinking the balance sheet (QT).  
 
Well they did, but not much.  They planned to sell $30 billion of Treasuries last month.  They sold less than $10 billion.  And they planned to sell $17.5 billion of mortgage backed securities.  They bought nearly $3 billion. 
 
So, the Fed told us they were going to aggressively attack inflation, by "expeditiously" raising interest rates, and "significantly" reducing the Fed's balance sheet.  They have done neither.  
 
After watching inflation rise to 8.6%, they raised the Fed Funds rate to just 1.5%.  And after promising to extract $47.5 billion worth of liquidity from the global financial system, they did only about $7.5 billion. 
 
As we've discussed along the way, this continues to look like a Fed that's trying to bluff it's way to curtailing inflation.  And they've done a pretty good job.  They have curbed exuberance and manufactured a technical recession with mostly words.
 
But the monetary policy tailwinds are still here.  Perhaps this is why the Nasdaq (higher growth, higher valuation stocks) have led the way the past two days (after this "QT" data has been circulating).  
 
For perspective, even while we may be in technical recession (two negative quarters of "real gdp"), nominal GDP is running north of 6%. 
 
After inflation, it may not be a feel good economy, but it's still a liquidity-fueled strong economy. 
 
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Pro Perspectives 7/5/22

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July 5, 2022

We had some big swings across global markets today.
 
It was the “rising likelihood of recession” that received the blame.
 
For example, we had a steep plunge in crude oil prices today.  That makes sense if you think recession is on the brink (i.e. less demand for oil).  
 
But as we discussed last week, we’ve likely seen the recession already. 
 
The Fed has already successfully killed animal spirits through it’s threats of aggressive interest rate hikes. 
 
It has already been reflected in the data.  Official GDP for Q1 was negative.  And the Atlanta Fed’s GDP model, which mimics the methods used by the BEA to estimate the government’s GDP measure, is projecting a negative second quarter.  Two negative quarters, is an official recession. 
 
That said, the big June data from Q2 has yet to be incorporated into the Atlanta Fed model.  The June jobs report will come this Friday.  And then we have June inflation data next week, and housing data the following week.
 
But we’ve already seen clues on jobs, inflation and housing, via other June economic reports, to safely assume a softening in these forthcoming data points. 
 
With that, by the end of July, when we see the BEA’s advance GDP number for Q2, we will likely get confirmation that have already seen the recession.
 
So, why the big swings in markets today?
 
As we also discussed last week, the drums of war are beating.
 
Remember, last week G7 leaders met, which rolled into a NATO meetings later in the week. 
 
And it was an eventful week.
 
>G7 allies banned imports of gold from Russia.  
>That was soon followed by a Russian debt default (a missed debt payment) — the first default to foreign creditors since 1918.
>Next, NATO announced plans to increase “troops on high-readiness” from 40,000 to 300,000.
>Then the the G7 included in its communique that they would phase out Russian oil, and in the meantime, threatened price caps on Russian oil imports (which would only further limit global supply, and increase prices).
>Finally, Finland and Sweden signed an agreement paving the way to join NATO.
 
Importantly:  Putin has already said that he will respond (in kind) if NATO were to deploy military and infrastructure in these bordering countries (Finnish land border, and Swedish maritime border). 
 
Was it a war flashpoint that kicked off the market turmoil today?
 
It just so happens, that the opening of European markets on Tuesday coincided with the signing of accession protocols by NATO allies, to add Finland and Sweden to NATO.
 
As it was happening, the euro began to plunge. That set the tone for markets.
 
Let’s take a look at the euro. 
Above, you can see the collapse of the euro this morning.
 
And when we think about this flashpoint of war, the longer-term euro chart tells a story that gives credence to this view of escalation toward WW3.  
The euro traded to a 20-year low today.  While the common currency in Europe launched in 1999, this chart engineers a history based on the member state currencies from the adoption of the euro.  As you can see, the big long-term trendline has broken.
 
Europe would clearly, continue, to suffer the brunt of the impact of a full blown world war.  And there would be a massive (global) fiscal spending response, which Europe is maybe the least equipped to absorb. 
 
Is this a message the euro is sending?  Perhaps. 
 
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