Light at the end of the tunnel?

In this post, we cover the recent data regarding the state of the global economy focusing on recent employment and inflation reports (lagging indicators) and trying to glean if we can see the light at the end of the tunnel of the rate hiking cycle/reduction of liquidity.

We have noted in the past the importance of including liquidity trends and market risk appetite and have included this in our global risk indicator to determine when to take additional equity market risk.

The following are the key themes we are tracking:

1)Global Liquidity Trends: Liquidity growth is still well below trend growth, but may have bottomed in September, as in October China’s Liquidity increased, US Liquidity Index continues to tighten overall. Lagging indicators (Employment and Inflation) continue to be at late-cycle levels. Liquidity trends are expected to drive equity markets going forward, so we are going to continue to pay attention to shifts in momentum. As liquidity increases, we expect the $US dollar to continue to weaken, potentially increasing future US corporate profits.

2)Employment growth in November remained positive, though growth trend starting to follow interest rates on a lagged basis (~18-mths historically). There are long variable lags of monetary policy which take time to flow through economy and have only been in the rate hiking cycle for last 9 months. We are seeing deterioration across rate-sensitive industries in which layoffs have tracked the uplift in rates and tend to lead over all employment trends. Most leading indicators of employment have declined and high frequency data such as increasing initial jobless claims/ layoffs, and daily tax withholdings, and contractors have slowed/declined year-over-year pointing to future wage growth slowing.

3)Transportation, Supply Chain and Consumer: Transportation/freight trends have recently weakened and supply chain pressures have subsided. Consumer has remained strong, though credit availability tightens at the same time as interest rates flow through the economy putting pressure on future retail sales and continues to increase inventory levels relative to sales.

4)Inflation remains elevated but has peaked and momentum is slowing given that demand for goods appears to be declining. Momentum across most inflation-leading indicators has continued to decline throughout 2022…The implied shadow Fed Funds rate appeared to peak in October/November and remains above inflation. We are watching the yield curve slope to see if the yield curve starts to steepen (i.e. 2-year rate declines more than the 10-year rate) as central banks start to consider cutting overnight rates, given that the yield curve first inverts, then steepens right before the recession. Based on our research, we note that equity markets tend to bottom when the yield curve troughs and steepens and continues to steepen.

5)US Equities – Valuation/Earnings:

Valuation multiples have recently expanded slightly potentially due to higher net central bank liquidity month-over-month in November – we continue to track this trend. If the Fed sticks to Quantitative Tightening plan of ~$90B per month, we could see S&P 500, re-test October 2022 lows of 3500 if prior correlation holds.

We do not believe a recession has been considered in consensus earnings as consensus EPS of 2% compares with earnings recession of average (23%) from prior recession since 1949 and (25%) estimate from tightening financial conditions from 18-mths before.

6)China Update: China’s growth has been slower when US Dollar has been strong. Industrial Profits declined 2% in October. Credit and money growth in 2022 has been below trend and appears to have bottomed.  Appears that China may gradually turn back on the liquidity taps to support economic growth which could partially offset recession conditions in the rest of the world. Generally, recent global slowdowns when liquidity was tightening, have been offset by liquidity growth in China (2008-2009, 2016-2018). Though given the debt levels/real estate market and potential for higher inflation of imported goods and services, the liquidity provision is expected to be less than prior liquidity injections, so may not offset the potential global recession. Emerging from COVID lockdowns may increase liquidity and commodities prices as well, driving inflation higher.

7)OECD Composite Leading Indicators (CLI): Most countries’ OECD CLI point to slowing economic growth in coming months, however, there appears to be a turn in trend change in OECD CLI momentum as 43% of countries have increased month-over-month….Is there light at end of the tunnel? Could China’s reopening and economic support via liquidity avert the global recession?