Last week we suggested that US markets were priced for the optimal combination of disinflation, aggressive Fed easing, growth near trend, acceleration in earnings and benign credit conditions. While any one of those outcomes might happen, it is unlikely that all of them will happen together. The macro news flow over the coming week, especially on labour market conditions will likely determine the near-term direction for the path of short-term interest rates and risk assets.
Overnight, the ISM manufacturing index poured cold water on the benign growth outlook. The leading new orders sub index and orders relative to inventory ratio was particularly soft. While manufacturing is no longer a major component of US GDP, it is important for the cyclical element due to the inventory cycle and the global supply chain. For that reason, it is also correlated to the industrial profit cycle and S&P500 earnings. There is a notable bearish divergence between ISM new orders and the S&P500 performance over the past 12 months (Chart 1).
Chart 1
US employment in July was weak and amplified fears that the labour market might be slowing faster than anticipated, but the unemployment insurance and state-level data confirm a sizable hurricane effect. This might contribute to an upside surprise (unwind) in the August data released on Friday. Nevertheless, the 0.9% rise in unemployment from the 3.4% trough and deterioration in leading indicators (temporary hires, job openings, ISM employment and consumer confidence) suggest that labour market has deteriorated to the point where a Fed easing cycle is warranted. The time series below highlights net jobs plentiful with the unemployment rate (inverted on the right-hand scale). The big picture point is that a substantially weaker labour market would imply larger rate cuts.
Chart 2
Although equities have responded enthusiastically to the dovish rate outlook, historically once rate cuts commence investors will pivot to the implication for growth and profits. Growth has remained resilient so far in this cycle supported by irresponsibly loose fiscal policy. However, a range of key leading indicators suggest that macro conditions appear likely to deteriorate more sharply looking forward. In that context, the S&P500 valuation multiple, equity and credit premium offer insufficient compensation for risk at current levels. This suggests having moderate aggregate risk exposure and a focus on quality (balance sheet strength and cash on cash returns) in portfolios. We fear another drawdown phase over the coming weeks into October (that drawdown phase might have commenced on Tuesday).
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