Cloudy days for the cloud?

Stocks had a mixed close after a mélange of economic numbers indicated that inflation is softening but the industrial economy is also softening. Manufacturing contracted for the first time since 2020.

One down, more to go. If you are an equity investor, you have learned over the past year, to become a student of interest rates. My intrepid colleagues could once be heard bellowing on about this stock or that stock, the cloud, blah, blah, blah, energy this, energy that, meat substitute, streaming subscriptions, and so on. Now it’s all about interest rates, bond yields, the Fed, and inflation. That fascination is somewhat justified as rising yields, driven by the Fed have caused stock prices to fall not only since it began raising rates but, in some cases, even since it first hinted that it may tighten monetary policy. Another justification is that bond yields are actually attractive for the first time in many years. Of course, nobody likes inflation, and everyone wants to see inflation get back to normal, and we are told that rising interest rates is the way to get there. Ok, all justified. But we know that the real reason stock investors are so focused on interest rates is because they know that once the Fed pivots to first halt the hiking and ultimately cutting rates, that stocks will once again be able to rally like they had in the golden years… after the 2008/2009 recession… when great fortunes were made by buying the dip… with the exception of 2015 and 2018, of course. With Powell’s earlier in the week admission that the pace of rate hikes may start to slow, stocks reacted with a rally. So, are we out of the woods, and will the gentleman who once occupied the office next to mine be able to get back to his carrying on about only stocks?

Sorry, it’s not that simple. In yesterday’s note, filled with bursting bombs, a dark-grey battlefield, and dirt-smudged faces, I dropped some little hints about the importance of things like Manufacturing PMIs and trying to minimize layoffs. I specifically referenced the ISM Manufacturing number which came in at 49.0. That was not a good print. Not only did it come in below economists’ estimates, but also below 50, which indicates a contraction in manufacturing, the first since the onset of the pandemic. I referred to that as collateral damage in the Fed’s fight against inflation. You see, it is part of the bigger picture and hints at the next big challenge… the potential for recession. Manufacturing may be boring to most stock investors who would rather focus on sleek technology or disease-fighting drugs, but manufacturing is still very much a part of the US economy. Shall I go further? You know I will, and I am going to start with a chart, because you know I love a good chart.

It is a busy chart with lots to see, but don’t worry, I will simplify. First, please note that this chart goes back to 1947 when some of you were still in short pants if you were even around yet. You will note the 12 recessions the US has endured since 1947, as demarked by red-shaded areas. You will also note that each one of those recessions included a dip in the ISM Manufacturing PMI below 50.0. In fact, there was only 1 incident in which the gauge dipped without a recession, in the mid-90s. So, we have a pullback in manufacturing which could lead to a recession, is that it? Unfortunately, it is not. This last earnings season presented us with some interesting clues. There was a clear pattern in which companies missed revenue targets but managed to beat EPS targets. There was also a clear trend of companies issuing cost-cutting measures. When sales begin to slow due to decreased demand, companies’ first responses are always to cut costs to maintain margins. At some point, decreasing sales can no longer be offset with small cost cuts. What typically follows are larger layoffs and EPS losses… yes, losses. Now, whether or not those layoffs and losses lead to a recession is unknown, but they are generally not positive for stocks.

That scenario would be the ultimate collateral damage from the Fed’s month’s long campaign against inflation, and one which the Fed would very much hope to avoid. It is clear that interest rates will continue to rise through the first half of 2023, but perhaps at a less hasty clip. For some, that may be the light at the end of the tunnel, but for others, students of the economy, that just means that another tunnel is rapidly approaching. Now that my neighbor moved his office, I have not been able to hear his take on interest rates or stocks. I will have to ask him out to lunch. He is a smart fellow… and a good friend.

YESTERDAY’S MARKETS

Stocks had a mixed close yesterday after inflation figures came in with a good print and manufacturing PMIs with an ugly one. The S&P500 slipped by -0.09%, the Dow Jones Industrial Average fell by -0.56%, the Nasdaq Composite Index gained +0.13%, and the Russell 2000 Index declined by -0.26%. Bonds gained and 10-year Treasury Note yields slipped by -10 basis points to 3.50%. Cryptos fell by -1.02% and Bitcoin fell by -1.02%.

NEXT UP

• Change in Nonfarm Payrolls (November) is expected to come in with a +200k gain, down slightly from last month’s +261k increase.
• Unemployment Rate (November) is expected to have remained constant at 3.7%.
• Next week: more PMIs, Durable Goods Orders, Producer Price Index / PPI, and University of Michigan Sentiment. All this in a run up to the following week’s big inflation number and the FOMC meeting. In other words, you need to pay close attention next week