The halftime show | Financial Times
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Good morning. Memory chip maker Micron placed an exclamation point at the end of the first half when it reported gains yesterday afternoon. Guidance was, as always, the most important. Wall Street analysts expected Micron to have sales of about $9 billion in the August quarter. The midpoint of the company’s forecast was $7.2 billion. Big miss – fitting with the concerns about inventory and demand for goods we’re talking about here.
Interestingly, though, the stock (already down 40 percent this year) fell just 3 percent in late trading. Perhaps, unlike the analysts, investors have already priced in a slowdown. Good news, if so.
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We are halfway through the year. Let’s take a step back and assess where we are. The Scoreboard:
In risky assets, we had nowhere to hide but commodities. The reason (at least in the beginning) was that inflation drove interest rates. Here’s what happened to the yield curve in the first half:
Note that the 3-month/10-year curve (historically the most accurate recession indicator) doesn’t even come close to inversion. The 2-year/10-year (less accurate, but not useless) is within a hair’s breadth. That might be the difference between the rough market we have now and a pretty panicky market we’ve managed to avoid so far.
In terms of internal stock market performance, the most discussed topics this year were the poor performance of technology (which had clearly crossed this cycle) and the great performance of energy. But there is a broader theme with more explanatory power: investors playing defensively. The S&P is down 20 percent. Loss of energy returns, as a result of an exogenous shock, the sector performance falls into three groups. Defensive stocks (utilities, commodities, health care) outperformed. Risky/speculative stocks (technology, discretionary) underperformed. The rest has moved with the index:
However, the first six months of the year were all a stretch. There has been a shift over the past two months, moving from mainly inflation concerns to mainly recession concerns. One way to look at this is through the relative performance of growth and value:
It was half the value as expensive technology stocks sold and cheap energy stocks rose. But about a month ago, value’s outperformance stopped. This corresponds to the fear of a recession. Value – i.e. cheap – stocks tend to be cyclical, highly leveraged, in highly competitive sectors, or are all three. Historically, stocks like this have done poorly on the road to recession and good at securing recovery. They will look less attractive now than they did a month or so ago, when the Fed looked less fierce and indicators or economic momentum looked better.
As usual, the bond market got the memo before the stock market. The yield on the 10-year bond has risen sideways since early May, with some peaks and troughs, suggesting that the high inflation years were too pessimistic. Two-year break-even inflation expectations have fallen since late March and have fallen particularly sharply recently, suggesting that the Fed will cool inflation fairly quickly:
The futures market confirms the picture. It now prices rate cuts that begin (slowly) in the middle of next year:
To sum up. First the fear of inflation and then the fear of a recession, risked assets snapped in the first half. The market now seems confident that the economy will slow down soon, and in a year’s time inflation will be a secondary concern. Investors are beaten up and increasingly defensively positioned, but don’t panic.
What happens in the second half? Several points we have made before are worth repeating. Global central banks are withdrawing liquidity from the financial system. Appraisals (although there are attractive boxes) are still not particularly cheap. In stocks, if not bonds, there are few signs of capitulation or bottoming. And the leading indicators of economic activity are deteriorating. All of this lends itself to volatility.
Yes, the Fed has gone a long way in convincing the markets that it will soon get inflation under control. But we still expect the second half of the markets to be as turbulent as the first, and probably more so.
More delay data
The Fed is getting the demand slowdown it wants, little by little. This was evident from Thursday’s personal consumption expenditure. Real consumption fell by 0.4 percent in May, thanks to a sharp drop of 3.5 (!) percent in spending on real durables. No surprise, but still nice to see. The chart below smooths out the three-month data and focuses on the amount of durable goods purchased each month, ignoring prices:
Between rising inventories and declining demand for goods, production also slows down. Omair Sharif of Inflation Insights has compiled regional Fed indicators for factory activity. Averaged over the five measured regions, new orders rose in June. Chances are, the nationwide ISM manufacturing index, released today, will also fall:
However, consumption remains strong. Real spending on services rose by 0.3 percent in May, only a small slowdown from April. May’s core PCE inflation rate came in at 4 percent year-on-year – the same as in February, March and April. Don’t spin higher, but don’t come down easily either.
Following yesterday’s PCE report, the Atlanta Fed’s GDPNow forecast plunged into the red:
As a general rule of thumb, negative real GDP growth for the second quarter in a row puts us in recession territory. Fixing on this misses the point. Ultimately, what matters is whether slower growth will lower inflation (as the market expects).
To make sure of that, we need compelling evidence that services inflation is falling. But the labor market remains stubbornly hot. The number of applications for unemployment has increased slightly, but the current level is comparable to the booming labor market of 2019. Falling goods consumption helps, but not enough. †Ethan Wue†
a good question
A few readers pointed out that Tuesday’s letter on durable goods surpluses did not adjust for inflation, suggesting that new orders for durable goods could fall in real terms (as domestic consumption of those goods already is; see above). Are they? A good question, but difficult to answer. The data I used, from a Census Bureau survey of manufacturers, doesn’t have an exact price deflator to convert face values to real ones.
I looked anyway, with the closest deflator I could find, the producer price index for consumer durables. Adjusted for inflation, new durable goods orders are still growing, albeit modestly:
The June data is likely to change this picture (see previous section). But so far, US manufacturing has held up better than dismal research data suggests. †Wu†
A good read
Sure, there’s a near-perfect inflation hedge. Good luck with buying†