At Beowulf’s Treasury we focus on Leading Indicators and market sentiment to help supplement our trend-following portfolio strategy, along with fundamental research.
The Labour Market is strongest right before a recession (Unemployment rate tends to be lowest/Wage growth highest). The payroll report in early August surprised to the upside with 2x jobs added versus consensus expectations. We note however, Inflation and unemployment are lagging indicators. The loosening of Financial conditions (lower interest rates, lower US dollar, low energy prices) in 2020/2021 (from 18 months before) gave rise to increased aggregate demand (goods/services), along with significant changes in consumptions patterns (goods favoured to services when we were sheltering in place/working from home during COVID-19) that created supply disruptions and in turn increased the demand for labor.
Following leading indicators such as the credit cycle/peaking in home prices may provide keys to when the unemployment rate (follows a home price top historically 12-15 mths) may start moving up. We note that Home Prices for most jurisdictions peaked around January/February 2022 and continued to decrease as Financial conditions have tightened. We have noticed that Job Openings have declined by 1.2 million roles since April 2022, though the ratio to Unemployed workers remains elevated. Wage growth has decelerated by about 50 bps since March 2022. We note its more important to follow the Rate of Change in the Job Openings-to-Unemployment ratio against Wage growth, rather than focusing on the absolute number of the ratio. Initial jobless claims have increased since March 2022 and a number of companies have recently announced layoffs which are potentially not counted in the statistics yet. Generally speaking work hours, job openings will start to decline about 6 months before we see a move in the unemployment rate and we are seeing this now.
On the Inflation front, Global supply chain pressure has eased (partially due to remix of consumption to services from goods), however, higher acceleration in labor and shelter costs, impacting core inflation, have not been considered. As we have noted before, with tightening financial conditions, world trade declines and therefore global supply chain pressure reduces.
Loosening of Financial condition from June-August 2022 (lower real rates based on lower inflation momentum) has resulted in additional risk-taking/high-beta equities up in the last couple of weeks. There has been much discussion of a Central Bank pivot now that inflation momentum has slowed in July. However, it is expected that Central Banks will remain restrictive from a policy perspective going forward until inflation momentum significantly slows (i.e. a number of months of flat or declining inflation prints before pivoting from hawkish stance) and inflation is much closer to the inflation objective of 2%.
Changes in Financial condition (i.e. tightening of rates, higher US dollar, and higher energy prices) take about 18 months to see the results and flow through the economy and impact consumer and corporate behavior. Current tightening is expected to result in a 15-20% S&P 500 EPS decline in 2023 based on historical correlations holding. This is much lower than the current consensus growth of 5% for 2023. If corporate earnings growth is lower as implied by the relationship with financial conditions, labor markets are expected to continue to weaken into 2023. Q2/2022 EPS report may mark peak cyclical earnings growth.
Recessions have followed Bear markets ~70% of the time. Bear markets along with recessions tend to be long/drawn out before new equity market highs tend to be associated with tightening of financial conditions in the preceding 18 mths (1981/82 (471 days before new high), 2000-2002 (999 days), 2008-2009 (525 days). There were numerous bear market rallies. A market trough or bottom tends to occur when evidence of loosening financial conditions and significantly lower equity market allocations in investor portfolios (lower by ~10% to 15% from original position). Bear markets with no recession, tend to be associated with loosening financial conditions (weaker dollar, lower rates, etc.) (1987/1997/1998) in the preceding 18-mths. As a rule of thumb, deviation from the 13612W3 Moving Average of -3.0 Z-Score or Lower has historically provided a margin of Safety and a higher probability of success in the next 12 months. Given the current macro setup and history, investors proceed with caution if capital is deployed into equities in current markets. Please enjoy our research in the attached pdf.