Something’s Got to Give

There is an extraordinary dichotomy in market outlooks
Bull Case:
- The growth slow-down has been priced in
- The consumer remains strong
- Labor market is still tight
- Inflation will recede
- Recession will be mild at worst, avoided at best
- Rates will decline soon, buy risk (stocks, bonds, RE, etc.)
Bear Case:
- Valuations have only corrected the extremes of the past 2 years
- The consumer is spending but borrowing to do it
- Labor is strong, but at the margin is fading
- Inflation is coming down, but will be difficult to fully correct
- The Fed will stay restrictive until inflation is addressed, implying a deeper recession
- Rates won’t decline soon, risk assets are too risky
We remain more sympathetic to the bear case.

Our inbox this week reached extremes with advice ranging from the ‘All Clear’ has sounded and it’s time to buy the dips again, all the way to Armageddon type scenarios. There doesn’t appear to be much middle ground. The extremes have diverged so violently, you’d think we were talking about politics, not economics and markets. Like a stretched rubber band, at some point, something snaps. The question is precisely what is going to snap? Inflation? The Economy? Europe? Taiwan? Housing? Take your pick or come up with your own suggestion, but the plain fact is that much of the data is conflicting. Here are some examples:

Employment:

Weekly initial unemployment claims continue to rise (red bars), albeit from very low levels. But at the same time, monthly payrolls (blue bars) continue to rise, with July data leaping by 528,000, more than double the expected 250,000.

Purchasing Manger’s Surveys:

The S&P Global US Services PMI (left) came in at 47.3 in July of 2022 and that reading dragged the Composite PMI down to 47.7, suggesting the first contraction in private sector business activity since June 2020. (Readings below 50 signal contraction.) However, the similar ISM (Institute for Supply Management) Non-Manufacturing survey showed just the opposite, increasing to 56.7 in July from 55.3 in June and beating market forecasts of 53.5.

Gasoline demand (4-week average): The weekly data is heading lower and is now almost 1 million bbls/d below last year, which is huge. If this were true, one would expect inventories to be increasing sharply, but they have declined by almost 3 million bbls over the last 2 weeks.

For crude oil, there is a disconnect between futures markets, where prices are falling, and physical markets, where supply remains tight.

Anyway, you look at it, deciding whether to be bullish or bearish is particularly difficult at the moment.

Our problem is to remain balanced and open to change. Although we have been consistent in our recession call, we are constantly questioning that position. Where could we be wrong? What do we need to watch to stay on course? Thus far, we remain fundamentally bearish. Here’s why:

Nothing about the last two years was normal. We had a supply shock due to the pandemic and a demand shock largely due to our response to the pandemic. In a globalized world of just-in-time manufacturing, and single/few sources, that combination presents a large problem. The scramble to adjust to these rapid changes starts the bullwhip effect. When you are desperate for parts, you double, or even triple order, just to make sure and the economy explodes higher. When demand is suddenly satisfied, the cancelations begin; the economy can quickly sink. In an economic sense, we have not yet returned to normal and at the moment, we see the cancellations beginning, in a figurative sense.
The pendulum swings back and forth. The globalized world didn’t work especially well the last two years and now political tensions are exacerbating the problem. We believe it is now very clear that the pendulum had reversed and we are headed into a more nationalistic world. That is inherently inflationary and will make taming inflation a bit more difficult. We may be very good at making things here is the U.S., but we can’t make them cheaper than other parts of the world. The implication is that the deflationary impact of globalization is now behind us.
Over the past 25+ years the Fed has reacted with greater and greater speed and authority to address economic turmoil. At the moment, Wall Street clearly envisions a re-run of the same plan from the Fed. The difference this time is inflation, which is something that should (and, in our view, will) prevent the Fed from acting quickly. If the Fed reacts too quickly, it risks a failure to tame inflation. They have clearly and repeatedly stated they do not intend to do that. We believe them.