Call This Storm Leviathan—It’s Big; It’s Bad; It’s Caused by Policy

Last week HAI likened the current market and economic dynamics to a developing storm. This week, the storm continued to gather strength, and is beginning to make landfall.

The selling pressure this week was intense across the board. The degree of broad index losses scaled according to risk profile. The highest-risk small cap Russell 2000 index led declines with a weekly drop of 4.01%, while the growth heavy Nasdaq was not far behind with a 3.93% loss. Both indexes notched their lowest weekly closes since November of 2020. In fact, the Nasdaq managed an unhoped for milestone as it’s 13.26% April drubbing was its worst monthly performance since the Lehman Brothers debacle during the great Financial Crisis. The Nasdaq is now trading in a technical bear market, down more than 20% from the all-time high set late last year. The first four months of the year for the Nasdaq have been the worst stumbling from the gates to start a year in the index’s history.

As we move on to the S&P 500 and the Dow Jones, “better” is a relative term. The S&P lost 3.27% on the week and the Dow dropped by 2.47%. For its part, the S&P 500 in April capped off its worst four-month start to a year since the 1930s. Beyond the major equity indexes, volatility surged, the U.S. dollar index reached its highest level in nearly 20 years, and the bond market was characterized by a bear-flattening in the yield curve. Commodities were mixed, with most of the strength concentrated in the consumer inflation-sensitive sectors of certain agricultural commodities and the energy complex.

To cap the week off on Friday, the selling was an accelerating downside slide. All told, a stunning 97.4% of the stocks comprising the S&P 500 closed the day lower, while measures of breadth and volume were strongly negative. Like a Russian doll, Friday was an extremely bearish day within a bearish week, tucked neatly within and punctuating a brutally bearish month. Net flows for global equity funds were negative for a third consecutive week. The weekly trend of outflows from global fixed income funds continued, and bond funds have seen net outflows for 15 of the last 16 weeks. Ominously, however, according to Bank of America, the massive outflows of funds are “just getting started.”

Last week, HAI observed that the action in financial markets seemed to suggest something of a recognition moment—recognition on the part of market participants that what had previously been identified as a market “disturbance” was intensifying into a larger storm. This week, some key factors helped open market participants’ eyes even further. While the white-hot inflationary surge headlining the Covid recovery has been with us for over a year, this week officially introduced “stag” to the inflation party. The week will likely signify the recognition of a transition already complete from an inflationary recovery into a new environment of stagflation. On Thursday, the U.S. Bureau of Economic Analysis announced that the annualized pace of U.S. real GDP growth in Q1 2022 came in at a negative 1.4%. The quarterly economic growth contraction was a significant shock, and a big miss on expectations that the economy would continue to grow. It marked a significant downturn from Q4 2021’s robust 6.9% annualized growth rate.

The negative GDP print was largely due to a working-off of a buildup in inventories that was the most significant contributor to the strong economic demand growth witnessed in previous quarters. With the inventory build that enhanced economic growth in 2021 behind us, forward growth will increasingly depend on the continued strength of consumer spending and business investment.

While US consumer spending is hanging tough and underpinning the economy for now, the consumer is living on borrowed time—as HAI has detailed previously—with negative real, inflation-adjusted wages and a plunging savings rate. This week, data confirmed that not only is the savings rate below pre-Covid trend levels, its now at the lowest level since 2013. Accordingly, consumer sentiment over the past three months has remained lower than at any time in the preceding decade, and already hovers around recessionary levels. While soft landing hopes are in large part predicated on a continued Herculean spending effort on the part of consumers—in perpetuity, the current consumer dynamics are unsustainable. This week, Bank of America’s Michael Harnett observed that the recent bout of severe devaluation in Asian currencies is in large part attributable to a discounting of an expected dramatic weakening of Asian exports. According to Hartnett, much of that expected Asian export weakness ties to a discounting of a forward outlook predicated on “a much weaker US consumer.”

Meanwhile, weakening business confidence is rapidly spreading. Small business expectation measures from the NFIB report that owners expecting better business conditions over the next six months have declined to the lowest levels in the 48-year history of the survey. This deteriorating outlook for the consumer and small business confidence is reflected in professional fund manager surveys that now report that expectations for global growth are at the lowest levels recorded in data spanning multiple decades that cover several recessionary eras.

This week, a potentially critical hint that the developing storm is deepening emerged in the corporate credit markets. Seemingly endless amounts of easy to obtain, dirt-cheap funding in the debt market has been a massive source of corporate growth throughout the era of rock-bottom interest rates. In recent weeks, however, the overall volatility, price action, and clouded outlook in the high-grade corporate credit market have drained the conviction of credit investors to participate in corporate debt offerings at current levels. This week, with the gathering storm clouds, hesitation appears to be spreading from investors to the corporate issuer side of the isle. Companies selling debt now look to be growing increasingly more cautious about executing in the current funding environment. After a number of corporate issuers shelved planned bond sales, this week’s fresh debt issuance represents the second biggest miss below weekly consensus estimates of the year.

Another related crucial narrative that further developed this week is that while this latest corporate earnings season was still net positive, cracks in corporate America are beginning to emerge beyond small business sentiment. Most notably, those cracks are now moving up the food chain and reaching into the previously solid foundations of the tech economy. The historical backward-looking results this reporting season are significantly better than forward guidance, and now, in a notable development, some of the recent bull market-leading tech behemoths are coming up short and showing vulnerabilities. As senior investment strategist for Allianz Charlie Ripley put it, “Rising cost pressures and uncertain outlooks from the largest technology names have investors agitated…” Given the now glaring escalating combined risks of slowing growth, continued high inflation, a weakening consumer, rising interest rates, and tighter financial conditions, corporate results are likely peaking for this cycle.

Significantly, huge tech sector spending has been a major boon to the economy. Now, in a far more hostile environment where tech sector largesse is being severely punished, massive corporate spending with dwindling profits or even losses to show for it no longer flies. If significant cost cutting in the tech sector ensues, something that a cooling off of corporate credit markets would point toward, it will add another major headwind to broad economic growth going forward.

An additional development this week emanated from the labor market. Data released Friday morning accentuated hawkish expectations for economic demand, dampening rate hikes from the Fed beginning with next week’s crucial FOMC meeting. The data revealed that the inflationary wage-price spiral is heating up as first quarter corporate employment costs surged by the most ever seen in data extending back to the early 2000s. At the same time, the surging corporate cost of employment is being met, in response, with NFIB small business survey data that captures pervasive plans on the part of businesses to raise their prices. The latest NFIB data found that, to cover surging costs, the percent of owners raising their average selling prices increased to the highest reading in the survey’s 48-year history. A shockingly large portion of the planned price increases were non-trivial. Alarmingly, the NFIB survey found that 40% of respondents intend to raise their selling prices in the next 3-months by a whopping 10% or more.

Fighting an ultimately doomed battle, wedged firmly within the center of this vicious wage-price spiral, is the consumer. This week, University of Michigan Surveys of Consumers chief economist Richard Curtin outlined the precarious nature of the current interplay between the consumer, labor market dynamics, and the Fed. Curtain points out that hopes for the consumer to maintain the hamster wheel experiment “increasingly depend on prospects for a strong labor market and continued wage gains.” Curtain also finds that, at this point, “consumers have lost confidence in economic policies…” Nevertheless, despite a consumer dependance on the labor market and the wage side of the price spiral, and their vote of no confidence on policy, “monetary policy now aims at tempering the strong labor market and trimming wage gains, the only factors that now support optimism.” This likely ends badly. If the consumer responsible for 70% of the economy breaks, everything breaks.

Following the employment cost data release and ahead of next week’s FOMC meeting, Mohamad El-Erian spoke with Bloomberg. After acknowledging that we are entering the “most challenging period for policymaking” in the modern central bank era, El-Erian voiced the two primary problems he heard expressed from corporate America this earnings season. The first was that supply side constraints continue. The combination of shortages, supply chains, and employment costs “remain an issue.” He phrased the second issue thusly: “I was also hearing something new, corporations starting to worry about the demand side. They’re starting to worry about demand coming down.” He added, “when you translate that for the economy, it means stagflation.”

If corporations are now at the point of significant cost and growth concerns, that doesn’t bode well for employment or wages. As a result, it especially doesn’t bode well for the consumer dependent on strength in both. Anything but Fed policy perfection beginning with this week’s FOMC could risk fast-tracking our newfound stagflation right into recession. This storm is rapidly intensifying, and the market is beginning to respond accordingly. All eyes will be intently attuned to Mr. Powell and company on Wednesday.

Weekly performance: The S&P 500 was down 3.27%. Gold was off by 1.17%, silver was down 4.86%, platinum was up 1.32%, and palladium lost 2.92%. The HUI gold miners index lost 5.91%. The IFRA iShares US Infrastructure ETF was down 4.33% on the week. Energy commodities were up. WTI crude oil rallied 2.57%, while natural gas surged 8.66% on the week. The CRB Commodity Index was up 1.33%, while copper was off 3.75%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 5.28% on the week, while the Vanguard Utilities ETF (VPU) was off 4.07%. The US Dollar Index was higher by 1.73% to close the week at 102.96. The yield on the 10-year Treasury inched lower by 1 bp to end the week at 2.89%.

Have a wonderful weekend!

Best Regards,

Morgan Lewis
Equity Analyst & Investment Strategist
MWM LLC