Authored by Simon White, Bloomberg macro strategist,
Optically flattering economic data, a still-positive real-yield curve and contracting liquidity together show that stocks remain entrenched in a bear market.
“Let no man boast that he has got through the perils of Winter until at least the 7th of May,” said the writer Anthony Trollope. Yet it is only early February and the market is seeing green shoots everywhere.
Last week’s payrolls and services ISM were taken uncritically at face value. But when so many other reliable recession indicators are sounding the alarm, it pays to apply a little more scrutiny.
ISM Services rebounded from 49.6 in December to 55.2 in January to much fanfare. But at the same time we got S&P’s Services PMI, which stayed stuck below 50 at 46.8.
The problem here is that each survey covers different industries. The ISM report used to be known as the ISM Non-Manufacturing report but was renamed ISM Services in 2020. This table from S&P Global shows the differences.
Source: S&P Global
The ISM has trended persistently higher than the PMI over the last decade, but it was the ISM that proved to be considerably more optimistic than the PMI before the pandemic hit, and had to correct rapidly.
It is probably no coincidence that last month the ISM bounced and the PMI did not due to the strong performance of commodities such as gold and copper, with mining a notable component of the ISM but not the PMI. Another extra component is retail, which has also got off to a strong start, but will face growing headwinds as credit continues to tighten.
Plenty of giddiness also greeted the +500k payrolls report. But again caution is required when there are signs we are late-cycle. The birth-death adjustment the BLS uses to take account of the creation of new businesses and the shuttering of old ones, has added 1.3 million jobs since March.
The adjustment is adding more jobs on a structurally higher basis since the pandemic. This is coming from trends in the QCEW (Quarterly Census of Employment and Wages), which revises payrolls from three quarters ago.
Net job gains have been added for 2021 and early 2022, but the QCEW’s model is beginning to factor in significantly higher gross job losses, which may cause the jobs numbers in subsequent quarters to be revised much lower (the QCEW just revised 2Q22’s net employment change 287k lower). The jobs numbers from recent quarters could soon begin to look much less robust.
Further, the disconnect between the establishment and the household survey remains considerable, with many more jobs than employees created, suggesting a rising number of people are requiring more than one job to earn a living.
And it bears repeating: jobs data are coincident-to-lagging and are often revised multiple times long after the fact, with the biggest revisions typically seen at economic turning points.
Still, stocks are staying resolute, even as money markets – now grudgingly paying more attention to hawkish Fed speakers – price in a higher peak in the Fed Funds rate.
But investors should ignore the noise and focus on the signal coming from the real-yield curve and liquidity growth.
The real-yield curve is the best single signal of the Fed’s success in reining in inflation. Specifically we need to see it invert to have confidence the Fed has done enough to permanently stamp out inflation and so allow stocks to stage a durable rally.
In the 1970s the real-yield curve continued to steepen even as the Fed tightened policy, as the market did not believe the Fed would do enough to bring inflation sustainably back down. It took the herculean rate hikes of the Volcker era to crush the real-yield curve and restore the Fed’s credibility.
The curve has been flattening recently, but remains well above zero. The Fed has not yet done enough to fully exorcise the inflation demon, leaving the equity market vulnerable to making new lows.
The curve inversion was a necessary but not sufficient sign the market would make a durable bottom in 1982, a generational buying opportunity. We also need to see a return of positive real liquidity growth.
On that, we still have some way to go.
Global real M1 growth is still negative and falling, which points to weaker stock growth in the coming months.
In the 1980s, it took the real-yield curve inverting together with positive real money growth to signal the 1982 bottom was in.
In general, when the real-yield curve is much steeper than average and real money (M2) growth is negative – as it is today – it leads to significant equity underperformance. (When these conditions are met, the S&P has an average year-on-year nominal return of 2.9% over the next three months, versus the overall average (going back to 1962) of 7.8%. Over the subsequent six months the average nominal return is also lower than 7.8%, at 4.8%).
Downside hedges remain attractive and would help protect portfolios from the worst of winter – the 7th of May is still a long way away.