The myriad gears of the global economy and markets are turning, clunking and skipping. Some appear in need of oil and others outright repair. Here are the components I see as critical to success for the markets and the economy this autumn:
First is Russia and the European energy crisis. European energy prices are extremely problematic. They are hitting consumers. They are hurting manufacturers. They are disrupting every element of society. With Gazprom announcing ongoing "issues" with Nord Stream 1, we have to assume that Russia will "toy" with Europe this winter -- as a cat "toys" with a mouse. Sanctions, in my view, have backfired. Prices remain high. Russia has developed new and larger buyers in China, India, Brazil, etc. At the same time Europe continues to pay up for resources when available. I think the market has not yet prepared for how bad this could get.
Another problem? Inventories and new orders. My single biggest fear for the U.S. economy is clear evidence that inventories are too high and that orders and shipments are slowing dramatically in response.
On a simple straight line extrapolation, inventories are easily 7% or more above where they should be. We've seen inventories build 14 months in a row. Many of those months have seen relatively high increases and we are at 23 out of 24 months of building inventories. Yes, a post Covid recovery was needed, but this seems absurd. In the past few months we are seeing new orders roll over. The Institute for Supply Management's Manufacturing Purchasing Managers' Index has been 49.2, 48, and 51.3 for the past three months. That's not conducive for the pace of inventory build we are seeing. According to the U.S. Census Bureau, new orders dropped 1% in July, the largest monthly decline since Covid hit.
Baltic dry shipping costs have dropped dramatically. That is clearly linked to fewer exports from China. The economic bulls will argue that the decline in Chinese exports is a function of lockdowns, but the bears (of which I am one) will argue that is more likely a response to already having over-ordered. China is stimulating their economy, because it is seeing weakness domestically -- and globally. I've seen a number of pieces recently highlighting rapidly declining costs for freight, which indicates that the problem with inventory overbuild is widespread and is starting to be addressed.
Higher yields, the housing and real estate markets, as well as the market for automobiles together make up an additional problem. Let's look at each of those, starting with the 10-year yield.
The 10-year yield gets a lot of attention -- deservedly so. But I'm more concerned about shorter rates and mortgage rates. Lots of companies fund themselves on a relatively short-term basis (many did a great job locking in low yields for long maturities, but there is still sensitivity to short rates, especially as inventories build).
The housing market is dependent on mortgage rates to a large extent. The housing data has been ranging from bad to abysmal for months. I'm told that "home prices won't go down, because there won't be forced selling." Against that, I would argue that forced selling comes in over time, but more importantly, people aren't stupid and they understand that their house is worth less than it was a few months ago and that the outlook for at least the next few months isn't positive. With over 60% of U.S. households owning their homes, that is a big deal.
On the auto front, my inbox went from being clogged with messages about people wanting to buy my used car, to some interesting offers. Just like mortgages, auto loan costs are going up, which has to have some impact. Finally, consumers responded to shortages and potential shortages by buying more cars (also, a surge in demand related to the work from home and work local trends. That surge may be over. Commercial real estate remains very "local" and many companies, especially those with big exposure to commercial real estate, are pushing return to the office, but if that push fails and rates remain stubbornly high, there could be more pressure on that space.
We also have the wealth effect. Add in crypto and disruptive stocks to the losses in more traditional stock indexes and the housing market and we have a recipe for less spending. While the jobs data remains decent, Friday's jobs numbers had a revision of -105,000 jobs to the June report. June jobs went from 398,000 to 293,000. That's not a bad number but off by 26% of the original estimate. Call me skeptical, but I suspect when they get done revising July and even August, the numbers won't look so great.
We could discuss the possibility of China being more aggressive against Taiwan (see link to Around the World) or how quantitative tightening is a risk to asset values, Europe's quagmire of no growth but high inflation, or any number of topics, I'll stick to the big 4 for now.
My Take
Given my outlook on the economy I'm looking for lower yields and steeper (or at least less inverted) curves. As for credit, here's my take:
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Prefer investment grade to non-investment grade.
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Prefer high yield bonds to leveraged loans.
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If you have access to private credit funds, they can be interesting.
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I like municipals (through closed end funds) and am eyeing collateralized loan obligations (like the Janus Henderson AAA CLO ETF (JAAA) and Janus Henderson B-BBB CLO ETF (JBBB) ) thought that is a touch early.
As for equities, they're following the same pattern we've seen year to date: Weakness. And that weakness is being led by the companies with least obvious path to positive strong cash flow.
With cryptocurrencies, I see new lows, if not a crash.
Finally, commodities will go lower and it will not be a good thing for stocks as I'm convinced the inflation fears are overblown and recession fears are what is coming next and that will be evidenced by commodities.
