Lots to cover today, so let’s dive in. The American jobs machine cranked out 263,000 new hires to close out Q3. The official unemployment rate fell to 3.5% with wages ticking up 0.3% MoM. U6 also declined from last month’s reading of 7.0% to 6.7%. The major story here is that the labor force actually shrank in September, which is not what the Fed or President Biden want to see at this stage of the fight against inflation. The hope has been that more Americans would enter the workforce as Covid fears gave way to the need for paychecks (and significantly larger ones at that), but today’s report is the latest in a series of data that seems to confirm a different reality taking hold. Meanwhile, the White House has been heralding the resilience of the labor market as a testimony to the strength of the economy. However, the fact that labor force participation has been stuck in neutral for roughly nine months with the economy emerging from the Covid-19 pandemic suggests something else could be afoot in Laborland (more on that below). On the positive side, the appetite for workers among employers is abating as evidenced by the most recent job openings figures or JOLT’s. Nevertheless, weekly jobless claims data continue to indicate that overall demand is still strong, though there are also signs that fewer Americans are quitting for new opportunities. This could mean that the wind is starting to come out of the sails of what has been one of the strongest job markets on record. It just needs to happen at a measured pace, so the economy does not find itself dead in the water.
Central banks the world over are on the move. The Federal Reserve hiked short-term rates by 75 bps at its 3rd consecutive FOMC meeting. The European Central Bank (ECB) jumped on the bandwagon, boosting rates in the Eurozone by a similar amount. Meanwhile, the Bank of Japan (BOJ) was forced to intervene in currency markets as the yen has fallen off the proverbial cliff. To date in 2022, the BOJ has been relatively inactive. Japan finds itself in a unique position insofar as it has yet to encounter any meaningful inflationary pressures this cycle. Thus, as other central banks around the world have embarked on the most ambitious rate hiking cycle in roughly four decades, the Japanese currency has weakened in rather dramatic fashion. Of course, the yen is not alone in this regard. As a matter of fact, every developed market currency has declined in value relative to the US dollar year to date. A weakening currency tends to stoke inflation in its local economy. So, most developed nations have been forced to play the same game as the Fed (at least to some extent). Then, there is the cautionary tale of Liz Truss, the UK’s newly appointed prime minister. During her first days in office, Ms. Truss unleashed an economic program that simultaneously crushed the pound and sent gilts (the UK’s form of treasuries) screaming higher. The market reaction was so severe that it necessitated intervention by the Bank of England (BOE) to stem the crisis and a reversal of her tax plan. As an aside, it is always good for politico’s to remember that things don’t happen in a vacuum in the financial universe-- where we are in the cycle is critically important. Meanwhile, the Royal Bank of Australia (RBA) diverged notably from its global peer group with a dovish 25 bp increase during its most recent meeting. The rationale was simple: the bank doesn’t know exactly how tight policy needs to be in order to rein in price pressures (sound familiar?), but it does know that monetary policy acts with “long and variable lags.” So, the time to take stock economically is likely sooner rather than later (at least in the RBA’s view); we tend to agree.
It remains to be seen where Jay Powell stands on this issue. Of course, the Fed’s own summary of economic projections or SEP rapidly deteriorated in September. The new median estimate for Fed Funds is now 4.4% by yearend with domestic economic growth projected to essentially flatline year over year. This is not a rosy picture, folks. Naturally, stocks and bonds sold off on the news last month as valuations compressed further given the prospect of higher rates (for longer) and stagnating growth. Operating earnings are on the rise, however, with growth expected to be in the mid to high single digits YoY and over the next 12 months. Fundamentally, the picture hasn’t changed much, but the price investors are willing to pay certainly has. This leads us to the disappointing but increasingly likely conclusion: without some meaningful circumspection the Fed will “overdo it” this time around. Given that there is still ample cash in the system and American businesses continue to churn out record profits, the use of short-term rates (i.e. borrowing costs) as a means to manage near-term demand is basically nullified. In short, the Fed appears to be pushing on a string. Unfortunately, hiking until something breaks with inflation on the rise is just as much a part of the Fed’s DNA as overaccommodating exogenous and endogenous financial risks when inflationary pressures are subdued. The bright side is that in today’s world jobs are likely to hold up fairly well absent a full-blown financial crisis, and a strong labor market should in turn fuel domestic consumption, which is the bedrock of the US economy.
Consumers vs Producers… Zooming out, we would note that the world is composed of two competing economic models: those that are driven primarily by consumption and those that are driven by production. The most prominent production-based economies are those that derive their economic viability from manufacturing or some sort of resource extraction. China, Russia, and OPEC+ are increasingly becoming “hostile” producers in today’s fraught economic landscape. The West for its part has been trying to manage its consumption and reliance upon “producer states” for some time. Regardless, the tools these producer states have at their disposal are different, but the results they achieve are much the same… Russia has used its military to engage in a land war in Europe. China has stymied supply chains the world over with its notorious Covid lockdowns, and OPEC+ just announced it will cut production by 2MM barrels of oil/ day. Russia claims the war in Ukraine is a “special military operation” designed to liberate its people from the “corrupt” government in Kyiv. Most recently Putin has gone so far as to openly declare Russia’s moral superiority over Ukraine and its allies, labeling them “satanic.” Chairman Xi’s domestic Covid Zero policy has meaningful ramifications for the world’s manufacturers of all stripes, as the once constant supply of various components and products comes and goes with the wipe of a nose. It also allows China to play the role of “responsible global citizen” in today’s pandemic ridden world. By slashing oil production, OPEC+ effectively created what is likely to be a significant supply imbalance in energy markets through 2023. Of course, the rationale given by the cartel’s membership was billed as a means to achieve more “stability” in energy markets given that “current pricing” is not reflective of supply and demand in the physical market. The real goal here for MBS and his cohorts at OPEC+ is more transparency (#SARCASM)! Hope everyone is familiar with the term, “gaslighting.” With this backdrop will Powell and Co make a policy error? The odds are rising along with the duress from various hostile producers, and there appears to be little if any supply-side help on the horizon coming from Capitol Hill. My, my, my… It doesn’t help that the American Petroleum Institute (API) is on record as saying Team Biden is the most restrictive administration in terms of domestic oil and gas leasing and permitting since World War II! Intransigence isn’t a strategy.
The case for patience seems to get stronger by the day. After all, the only cost associated with cash is opportunity cost. With the range of economic outcomes widening and various rate scenarios growing more precarious a la a policy mistake, investors across the spectrum have sought cash as a haven. At TWP, we can say, “Been there, done that.” Bonds have trouble with inflation, equities struggle with recession risk, and real assets ebb and flow with broader economic trends that underpin their supply and demand characteristics. The market dynamics in place today will certainly change simply because they are not sustainable, but these cross currents are also unlikely to change as long as the variance around future economic outcomes is as wide as it is currently. Given the elevated level of risk across asset classes and recalibrating our models for an even more hawkish Federal Reserve, we are adjusting our fair value estimate for the S&P 500 to 4200. To be sure, this is more a function of rates rather than the health of corporate balance sheets and/ or earnings expectations. Patience is a discipline that investing rewards; we will continue to be patient and vigilant as the end of 2022 approaches.
Market Outlook: Neutral USD, Neutral Duration, Neutral Equities
News Release: Bureau of Labor Statistics (The Employment Situation- September 2022)