Every METAR knows by now that the markets rejoiced on Friday because CPI inflation was ONLY 7.7%, a level that would have caused disbelief and horror in 2021. But it was a couple of tenths of a percent below the market’s expectation, so – Party Hearty!
The Fear & Greed Index popped into Greed. The trade was risk-on as stocks and junk bonds popped while the USD dropped. The entire Treasury yield curve fell except the shortest duration, controlled by the Fed.
Oil prices rose while natgas stabilized.
The entire market reacted as if one month of falling inflation will be enough for the Fed to abandon its monetary tightening. The market ignored the Fed’s clear message that they will not loosen until inflation is reliably down to their target of 2%. Even if the Fed only raises the fed funds rate 0.5% in December (as the markets expect) instead of 0.75%, the real fed funds rate is still negative. They have a long way to tighten to achieve a restrictive positive real fed funds rate.
And it is likely that the slowing economy that the Fed wants is coming.
Even as markets delight in the prospect of smaller rate increases from the Federal Reserve, earnings are becoming more of a threat
By James Mackintosh, The Wall Street Journal, Nov. 13, 2022
Wall Street analysts have been slashing profit forecasts at a pace rarely seen outside recessions — and still seem optimistic. While recession is increasingly the consensus among economists, risky assets such as shares aren’t yet pricing in significant risk to earnings.
The 12-month forward prediction for S&P 500 earnings per share is down more than 3% since June, with next year’s forecast down 8%. The only significantly bigger drop outside a recession was in 2015, when the Fed was moving toward its first rate rise in nine years.
Reality is only just beginning to set in, though. Earnings are still forecast to hit a new high next year, up more than 4% from this year even after the pullback…
So what are the risks of recession? High, according to economists. The most interest-rate-sensitive sectors are already showing weakness, led by housing; the U.K. and Europe are on the brink of recession; and even after slight relaxation of the rules, Covid lockdowns are still stunting China’s growth. … [end quote]
The U.S. hasn’t had a good, old-fashioned business cycle recession in a while. Those were driven by orders falling while production stayed high, leading to high inventories. Then the company would slow production and lay off workers as they gradually sold off excess inventory.
The inventory-to-sales ratio is climbing. The Covid shipping bottlenecks eased in mid-2022, bringing in goods from 2021 when normally manufacturers would have been working on the holiday goods for 2022. Even though new orders are still strong the level isn’t growing.
The October 2022 Manufacturing ISM® Report On Business® shows New Orders Contracting; Production Growing; Backlogs Contracting. The October Manufacturing PMI® registered 50.2 percent, 0.7 percentage point lower than the 50.9 percent recorded in September.
The ISM Services PMI fell to 54.4 in October of 2022 from 56.7 in September, and below market forecasts of 55.5, pointing to the slowest growth in the services sector since a contraction in May of 2020. There is a clear downtrend. TradingEconomics.com forecasts a recession in 2023.
High inflation, rising interest rates and a slowing economy = stagflation. All METARs “of a certain age” will remember this from the 1970s. The Fed loosened when the economy slowed and inflation came roaring back. (Driven by rising energy prices.) The stock market suffered a series of wild swings but the overall trend was down. The stock market bottomed in 1982 after the terrible recession of 1980-82.
Investors need to think short, medium and long term.
Captaincs played Friday’s “Bull Trap” brilliantly with options. If the markets follow the 1970s example of alternating highs and lows this could be a good (though risky) play.
The METAR for next week is sunny, since the momentum will probably carry through from Friday. The darker forecasts will probably take a while to manifest. Medium term, recession. Long-term, recovery.