Policy Mistakes?

Risk measures have spiked back up to pre-March levels, driven entirely by disappointing earnings and guidance in the quarter, which includes some mega cap tech stocks. We are monitoring the ratio of reported earnings to revenue and comparing that to the ratio of operating earnings to revenue. Normally the two ratios are similar, but as the economy slows, companies are less confident in their ability to beat earnings expectations. This leads to write-offs and one-time items creeping in below the line and reported earnings drop while operating earnings are propped up by their financial engineering. This reflects a more pessimistic view among corporate CFOs and usually coincides with a one to two-quarter market selloff and is a good indicator to reduce equity exposure.

Is the Fed Too Patient?

The Fed has a problem. It has gone from a situation of a solid labor market, which allowed them just to worry about inflation, to the current environment of falling inflation with a weakening labor market. The trimmed mean Personal Consumption Expenditures Inflation rate fell from a 42-year high of 5% in Q4 2022 to 2.8% this June, thanks to the Fed’s rate hikes aimed at cooling demand. At the time, they could afford to hike rates sharply and keep them high due to the resilience of labor demand. While the fixed-income market is forecasting with almost 100% certainty the Fed will not cut rates again at their upcoming meeting, former Federal Open Market Committee (FOMC) members and prominent economists are screaming about the risks of a policy mistake. The concern is that the Fed sticking to a policy of high real interest rates that exceed 2.5% (5.375% Fed Funds less 2.8% inflation) is driving employment, consumption, and housing construction down and risking a recession.

However, the Fed is considering the likelihood of the current 2.8% inflation not falling further, which would mean living with an uncomfortably high inflation rate that the economy has not seen since the early 1990s. We believe that the economy could weaken to the point where the Fed is forced to ease to deliver on its goal of maximum employment at the expense of its stable prices mandate. If inflation does stick at a 2.8% rate, then it will be a painful decision for the FOMC. Their fear would be that cutting interest rates will push inflation back above 3%, risking stagflation. Equity markets do not like painful decisions, so the scenario where the Fed is pushed off its patience pedestal due to rising unemployment is going to cause many equity investors to become defensive.

Yellen Drowning in Bills?

Despite this week containing both a Federal Open Market Committee meeting and the July nonfarm payroll report, the most anticipated market event for professionals is the Treasury announcement on Wednesday of their Quarterly Refunding Announcement (QRA). The QRA outlines the amount of Treasury securities by maturity that will be auctioned in the upcoming quarter. Secretary Yellen has been overweighting the quarterly refundings with Treasury Bills and shying away from coupon securities (maturities between 2 and 30 years). A year ago, in August 2023, the QRA surprised market participants by scheduling heavier-than-expected  coupon auctions and sparked a sustained equity market selloff. Bills currently represent about  22.5% of the total debt outstanding. That figure is above the recommended 15-20% level, and the Treasury has had to defend itself against allegations of manipulating the auctions to keep long rates from rising to help support the stock market.

The Treasury Department is arguing they try to borrow at the lowest cost over time, and they are hoping to borrow longer term only if rates fall next year. They point out that the reduction in the long end amounted to only a one-percent decrease in issuance. Furthermore, the 15-20% range suggested by the Treasury Borrowing Advisory Committee (TBAC) is just that—a guideline.  Even the TBAC has mentioned it is comfortable with migrating up to 22.5% at times. Given that the Treasury has taken extraordinary steps to discuss their reasoning for auctioning more Bills, we expect no material changes in the auction composition. That should keep the markets comfortable upon the QRA release at noon E.S.T. Wednesday, just two hours before the release of the FOMC statement. 

NFP Could Slap the Fed with a Ruler

Friday’s nonfarm payroll report could trigger the Sahm rule, which has been a good recession predictor historically. It is calculated by averaging the three most recent unemployment rates and comparing that number to the lowest three-month average over the past year. The percentage difference is currently at 0.43%, and if it rises to 0.5%, the signal triggers and will cause stocks to sell off on the release of the employment report, absent other positive news. Many are not concerned about the rule because the unemployment rate is rising thanks to the fast-growing labor force. We disagree for two reasons. First, the 1973 recession (also accurately forecasted by the Sahm Rule) had an analogous situation of strong labor force growth. Second, there is evidence of job losses. Initial Claims have been rising along with continuing claims for unemployment insurance. Additionally, we have discussed the discrepancy between the household survey, which is reporting that employment has peaked, and the establishment survey, which reflects expanding payrolls. To predict a recession, the household survey is the better indicator, even though it is based on a smaller sample.   

Looking at the data, when the Sahm rule is triggered, the unemployment rate rises at least another 1.5%, which means a fully valued equity market will have to contend with the potential of 5.6% to 6% unemployment rates. Those rates are comparable to what was seen during the height of the 2001 recession when the NASDAQ had fallen precipitously following the tech bubble.

What will it take for the Sahm rule to trigger? Fortunately, the low 3.4% April reading falls out of the calculation, so the July 2023 3-month average is 3.6%. Therefore, if the unemployment rate for July rises from 4.1% to 4.2%, a recession countdown begins.

What to Look for This Week 

1. After the market close this week, we receive the earnings results for some of the world’s biggest companies. Microsoft is on Tuesday, META Wednesday, and AAPL and AMZN on Thursday. 

2. The Bank of Japan holds its highly anticipated July meeting on June 31. Their Monetary Policy Statement is released at 10:30 p.m. E.S.T., and the rate decision is announced at 11:00 p.m. on June 30. They are likely to discuss plans to taper their government bond purchases. Similar to the Fed, they should not raise rates, postponing that decision until September.

3. Wednesday July 31 at 8:30 a.m. E.S.T. the Employment Cost Index for Q2 is released. It has been trending down for two years but spiked up in Q1 and if it continues higher it will raise concerns about wage inflation given the proximity to the Average Hourly Earnings data contained in Friday’s employment report.