Third quarter GDP did indeed come in softer than expected this morning.
Yesterday we talked about the prospects of a negative surprise in this number, maybe even a negative number (i.e. economic contraction).
It came in at just 2% (annualized quarterly rate). That's below long-term trend growth for the economy. And it's very soft in a world that is still bouncing back from an economic shutdown, and teeming in economic stimulus.
For perspective, we started the year with estimates for growth for the full year to be better than 6% — and maybe even as high as double-digits.
In the first and second quarters, the economy was indeed running at a better than 6% rate (6.3% and 6.7%, respectively). And now we have this slowdown.
As we discussed yesterday, the drag was already showing in the consumption data. Dating back to the August consumer sentiment survey, we knew that consumers were pulling back.
Let's take a look at the BEA's report for just how much they reined in spending in the quarter.
Consumption is about 70% of U.S. economic output. And as you can see in this table, that measure (Personal Consumption Expenditures) fell off a cliff in Q3: going from +11.4% (Q1), to +12% (Q2), to +1.6% in Q3.
The big drag? Durable goods. People stopped buying big ticket items. Is it because of prices? Is it because, by the third quarter, it was clear that these items wouldn't be delivered to your doorstep anytime soon?
Remember from my note yesterday, the economist that conducted the August University of Michigan Consumer Sentiment survey explained it this way: "The reaction of consumers to rising prices has been to postpone purchases, given their fears of falling future living standards…"
How did prices look in the quarter in the face of waning demand? Still hot.
So, how are companies putting up record earnings for Q3, when the economy slowed?
It may have a lot to do with the order backlog. The widget you ordered in the first quarter, isn't officially revenue until it's delivered to you (maybe in the third quarter, in this logistics environment). So corporate America may have plenty of revenue fuel for the coming quarters, even while seeing softer demand.
As we discussed yesterday, yields (market interest rates) haven’t been going anywhere fast, despite hot inflation data and despite another strong earnings season.
Perhaps it’s because of this …
The above graphic from the Atlanta Fed, tracks the path of their Q3 GDP estimate. As you can see in the green line, this estimate started at 6% back in August, and has been in steady decline. Today’s update projects the Q3 number to be just 0.2%.
What’s driving this decline in the Atlanta Fed model?
It’s mostly, a sharp decline in consumer spending (relative to the first two quarters of 2021). Remember, back in August, we looked at the University of Michigan consumer sentiment survey. It had plunged to 10 year lows. Why? The economist that conducts the survey explained it this way: “The reaction of consumers to rising prices has been to postpone purchases, given their fears of falling future living standards…”
This “postponement of purchases” has created this major slide in economic activity, in an economy that was running at a better than 6% pace through the first two quarters of the year.
Now, with the above in mind, the 10-year yield broke down today, trading to as low as 1.52%.
That’s an 11 basis pointdecline intraday (a big move). That’s nearly a 20 basis points drop in the world’s most important interest rate barometer, in just four trading days. With that signal in markets today, key commodities that have been proxies of growth and inflation, were all knocked down today.
What’s going on?
The government’s Bureau of Economic Analysis reports the officialQ3 GDP number tomorrow morning. Based on market behavior today, this number may be negative.
If it is, expect the chatter to start about potential recession.
This would come just as the Fed is expected to take its foot off of the (stimulus) gas next week (beginning-the-end of QE).
And this would come just as the administration is clawing for leverage to push through the biggest, boldest fiscal spending plan in the history of the country.
Earnings continue to come in strong. As of Friday, 84% of the S&P 500 companies that have reported thus far have beat earnings estimates. And 75% have beat revenue estimates.
After this week, about we will have heard from about half of the S&P 500 companies.
The big question coming into this Q3 earnings season was about "costs." And so far, so good. Margins seem to be holding up, in the face of rising prices and rising wages.
That means companies are having success passing along prices to customers.
Microsoft and Google both reported record earnings today after the close. And we'll hear from Amazon and Apple on Thursday.
Despite the big earnings numbers, these "big tech" stocks should start feeling some of pain from the outlook for higher interest rates. Higher rates, for growth stocks, tends to bring about lower multiples and lower discounted cash flow valuations.
That's why value stocks should be in favor. But it's not happening yet.
While the S&P and the Dow have both returned to new record highs. The Russell 2000 (small caps) are lagging behind — still 2.7% from the March highs.
And it's because of this chart …
With the 10-year yield at just 1.61%, rateshave notbeen moving up fast — thanks to a Fed that is still in control of the Treasury market.
As we've discussed in past notes, coming out of recession, small caps historically track rates higher, and go on to outperform large cap growth over the following decade (post-recession).
With the above in mind, small cap value stocks continue to be the spot of relative opportunity in the stock market.
As we approach the big Fed meeting next week, let's look at a couple of charts.
First, we'll take a look at stocks, which have quickly returned to new record highs.
As you can see the chart, in addition to its QE formula of the post-financial crisis era, the Fed had to go nuclear (outright buying ETFs) to get control of the stock and bond market last year. That explicit "Fed put" has led to this doubling of the broad market in nineteen months.
With that in mind, in eight days the Fed will begin the end of emergency policies.
As we know, also contributing to this chart of stocks, was about $5 trillion dollars of fiscal stimulus. While the "Fed put" has given people the confidence to invest. The fiscal response, which protected the balance sheets of consumers and businesses, has given people the confidence to spend.
And they have. With that, we have inflation running at levels we haven't seen in four decades.
Yet the bond market is behaving as it did in the post-financial crisis environment, when we had no inflation.
We had no inflation in the post-financial crisis era because we were emerging from a debt crisis. In debt crises, you can incentivize people to borrow and spend, through monetary policy, but those people buried in debt tend to want less debt, not more — they save and they pay down debt.
In the case of the pandemic, we've had a supply and demand shock. And it's clearly resolving itself in inflation. Of course, whether or not that inflation is short-lived or a total reset of prices, depends on how much economic output was lost in the shock, relative to how much stimulus they poured into the economy to plug the gap.
We already know the answer to that. The economy contracted by $2.2 trillion in 2020, from Q1 through Q2. If we just look at the increase in money supply ($5 trillion), we can see that the response has been far greater than the damage.
So the reset of prices (too much money chasing too few goods) is clearly at work. The question is, when the Fed stops suppressing interest rates, how far will rates run (to levels of 80s era inflation?)? That will determine how heavy the headwinds will be for stocks (particularly growth stocks).
Yesterday we talked about the sentiment among the big influential investors about the path for interest rates.
Most are seeing hot inflation persisting. But most are not seeing a response of dramatically higher interest rates.
That suggests that the Fed will remain passive on inflation, and ultimately let higher prices solve higher prices. That may be the case, or it may not.
On that note, in prepared remarks, the Fed Chair, Jerome Powell, may have set expectations for this scenario this morning. After telling us all year that inflation would be short-lived, he admitted that supply chain constraints have gotten worse, and that higher prices from the supply chain disruption will last longer than they expected. And he said that the Fed's "tools don't do much for supply constraints."
So, the political talking point has tied higher prices to the supply chain. And Powell seems now to be using that as cover.
That said, it's clear to everyone paying attention, that inflation is being driven by factors other than bottlenecks at the ports. Wages. Shelter costs. Transportation costs. Food. Energy. Many of these are sticky. When they go up, they don't come back down. This includes energy, in the current case. An agenda-forced underinvestment in fossil fuels, has created a structural supply shortage. And there's also this issue: a 30% growth in money supply over the past eighteen months (inflationary).
As we've discussed in the past, this Fed response, which seems disconnected from reality, is all part of their "guidance" strategy.
"Guidance" is code of perception manipulation. What the Fed fears more than inflation itself, is consumer (and business) inflation expectations. If you expect higher prices, you might behave in ways that lead to higher prices (and potentially runaway prices). If the Fed can convince you that prices are stable, you may behave more normally in your consumption. Moreover, if they can convince investors of the same, they can manufacture stable markets.
As an example, back in July, after the Fed repeated this idea for months that inflation was "transitory," a survey of fund managers showed that 70% thought inflation was temporary. The Fed's messaging worked. And, as such, three big inflation indicators in the markets were behaving in a way that confirmed the fund manager viewpoint: stocks were trading to new record highs, the 10-year yield was stagnant around 1.3% and gold was 13% off of the all-time highs.
Here we are three months later, and the inflation picture is clearly hotter – and not abating anytime soon. And the Fed has changed its tune, but its strategy seems to be working, still. Stocks are on record highs. The 10-year is at just 1.6%. And gold remains 13% off of record highs.
All of this said, as we've discussed over the past year, we should pay attention to what they do, not what they say. With that, they will begin reversing emerging monetary policies next month.
We've heard from some of the most influential investors in the world over the past few days, as they gathered at Michael Milken's conference in California.
On the topic of rising interest rates, many of them see inflation as persistent and problematic. But few of them thought we would see dramatically higher interest rates.
In the words of one of the great macro hedge fund traders of our time, Paul Tudor Jones, "the Fed has become inflation creators, not inflation fighters." That suggests that they have been conditioned to one-sided policy making, which explains why they are already well behind the curve on responding to what has been an obvious formula for inflation.
But the CIO of Blackrock, the world's largest asset manager, said he "doesn't see rates going up much from here."
Why? Billionaire Nelson Peltz doesn't see enough incentives for the Fed to aggressively chase down and kill inflation. He says "very few people in the world, very few groups, need higher interest rates. Home buyers don't need it. Governments don't need it. And the dollar doesn't need it."
How do we interpret this view?
First, what's key in this statement is "governments." It's plural. Ballooning government debt isn't a U.S. centric thing, it's global. Much like the financial crisis, the great health crisis was/is global and the recovery is globally coordinated. And global governments, especially now, don't need capital moving out of their countries and into the U.S./the dollar in search of higher yield. Not only would it damage fragile emerging market economies, but it would threaten the global economic recovery.
And don't forget, a key tenet in the global economic recovery, is the global coordination of the clean energy transformation. They're all on the same team/in the same boat.
What about his comment on the dollar?
This looks like the easy mark. The purchasing power of U.S. consumers has already eroded. Next will likely be global purchasing power through a weaker dollar. So, in the end, the broad viewpoint from some of the most influential investors in the world seems to be consistent with: higher prices will be the solution for higher prices (i.e. at some point higher prices will curb demand, slow the U.S. economic growth, and ultimately resolve inflation). This means the pain is put on the consumer through lower quality of life.
Stocks have gone on a five-day run, to revisit record highs. Yields are on the move, trading as high as 1.67% today. And commodities continue to climb.
Is it the strong start to third quarter earnings season that's driving this "risk on" surge in markets?
Doubtful. We knew the bank earnings would be huge. The interventionist policies, combined with their war chest of loan loss reserves at the banks, have made them profit printing machines.
We are just now getting to hear from companies that are talking about "costs." So this buzz surrounding Q3 earnings should begin to wane.
Is the recent surge in markets due to the likelihood that a deal on "The Big Spend" is in the offing? Maybe quite the opposite.
As the days pass, it's becoming more believable that the two Democrat Senators opposing the $3.5 trillion plan are genuinely digging in. The headline number ($3.5 trillion) to "Build Back Better" has already been cut down. And some key pieces are being carved up. The Wall Street Journal reported this afternoon that Sinema is opposing tax increases.
At this point, with the hot inflation picture forcing the Fed to, already, telegraph a faster path to its first rate hike, the potential for this "big spend" to become less transformational, or even completely obliterated in the negotiation process, would be a positive for the economic outlook, and for market and price stability (i.e. get out of the way and let the $5 trillion already injected into the economy, combine with a returning workforce to drive growth). Perhaps some are beginning to price that scenario into markets.
We talked about the SEC approval of the new bitcoin ETF on Friday. It started trading today under the ticker BITO.
As we discussed, whether you believe bitcoin will ultimately survive government regulation or not, the introduction of an ETF that tracks bitcoin futures, creates access for a new audience. For institutional investors, now they can allocate to bitcoin, within their mandate. And it allows individual investors who may have never participated in bitcoin, to buy it in their normal brokerage account.
With that, we talked about the similarities to the 2004 launch of the first gold ETF (GLD). GLD offered a new and easy way for traditional long-only institutional investors, as well as individuals, to allocate to gold. And with that, gold prices took off. Gold was low $400s at the time, and never looked back. The price of spot gold rose almost five-fold over the following seven years.
So, this bitcoin ETF should benefit similarly from these new flows. But there may be more to this GLD comparison. Many view bitcoin as the new gold — as a store of value and hedge against inflation. With that, in the face of the hottest inflation we’ve seen in decades, we will see if money moves out of GLD, to fund new investments in BITO.
It’s early, but so far we can see some divergence in the charts that suggest that, at least, speculators are taking bets that this “swap” (GLD for BITO) may happen.
The economic growth number in China for the third quarter came in at 4.9%. That sounds like a good number. It's not for China. It's recession territory.
If we exclude the ugly numbers from the depths of the crisis last year, this is the slowest economic growth in China since 1990.
Of course, the world continues to emerge from the disruptive pandemic, but the China data is something to keep an eye on.
We can see some similarities to 2009. Early on in the Global Financial Crisis, China weathered the storm better than the developed world. The economy quickly bounced back to double-digit growth by late 2009. And with $3 trillion of foreign currency reserves in the coffers, and beaten down global commodities market, they took advantage and started stockpiling valuable natural resources on the cheap.
China's buying in the commodity market was a huge contributor to the recovery in commodity-centric emerging markets. Brazil went from recession to growing at close to 8%.
As you might remember, many were saying that emerging markets had survived the recession better than advanced markets, and they were driving the global economic recovery. And Wall Street was claiming/cheerleading a torch passing from the developed world to the emerging world as the future of growth and leadership.
It didn't last long. It soon became clear that China and emerging markets couldn't do well, without healthy consumers in the advanced economies (namely the U.S.).
Fast forward to today, and China's economy is thought to have withstood the pandemic better than the advanced world. And again, China has taken the opportunity, with cheap commodity prices to stockpile key commodities. They had record volumes of crude oil, copper, iron ore and coal in 2020. They also imported a record amount of corn, wheat and soybeans. So they've definitely contributed to driving commodity prices higher, in a fragile recovering global economy – which creates a headwind for global economic recovery.
And now, China's economy is sucking wind.
With the above in mind, let's take a look at some of the key economic data in China overnight.
First, here's a look at GDP. You can see here, excluding the decline of last year, China hasn't had an economy running this slow since 1990 (the economy was 2% of its current size, back then).
If you don't like the year-over-year comparison with the big bounceback numbers of last year, the growth in the third quarter, compared to last quarter was just 0.2%. That would be a annual run rate of less than 1% growth.
This next chart is Industrial Output in China. Again, excluding last year, it's at the worse levels since 2002.
And here's a look at China retail sales growth …. it's hovering around worst levels of the past 30 years (ex-last year).
We should remember, prior to the pandemic, China's economy was in trouble. The trade tariffs had taken a toll, and most of these key economic measures were running at levels worse than the depths of 2009.
We end the week with a broad "risk-on" mood for markets.
This follows very strong earnings for the big banks this week.
We are in the very early stages, but thus far, Q3 earnings are looking like Q2: a lot of positive earnings surprises. Positive earnings surprises are fuel for stocks.
That said, we came into the week knowing that the big banks were going to have blowout numbers. Next week, we should start seeing a more realistic picture on how "costs" are effecting businesses across industries.
The winning sector of this week was energy.
Crude oil closed on a higher high for the eighth consecutive week. The price of oil finishes the week above $82. That means those producers that have survived the attack on the U.S. shale industry, can now sell oil for about double the price it costs them to produce it.
As we've discussed for the better part of the past year, the vow to kill fossil fuels in the name of climate action, only builds a moat around the existing producers.
Let's talk about bitcoin …
Bitcoin was up 7% today, ending the day above $62,000. This was driven by news that the SEC would approve a bitcoin futures ETF.
Now, back in 2017 Chinese citizens circumvented government capital controls using bitcoin as a way to get money out of China. And China responded with a total ban on crypto trading activities (in China). The price of bitcoin initially plunged, and then proceeded to rip seven-fold higher. Three months later, bitcoinfutures launched, which gave hedge funds a liquid way to short the madness. Bitcoin topped the day the futures contract launched. A few months later, it was worth 1/6th of its value at the top.
Fast forward to today. China has, as of September, declared bitcoin trading, or mining, illegal. The initial move on the news was down, to below $40k. But now its up over 50% from the lows of three weeks ago. And now we have the announcement that the first bitcoin futures ETF was approved by the SEC and will begin trading on Tuesday. Is this another catalyst for a bitcoin crash?
Not likely.
The ETF structure will enable a large institutional audience to allocate to bitcoin. This looks like it may be another GLD like moment (spot gold chart below). When the gold ETF, GLD, launched in 2004, institutions piled in. It offered a unique way to allocate to gold, within the mandate of the long-only equity crowd. We will see if this plays out in a similar way.
