December 2022

Employment and service sector show strength again while manufacturing sector contracts

The November employment report saw job growth and wage growth exceed expectations.  Employers added 263,000 new jobs to the U.S. economy, well ahead of the 200,000 estimate. The unemployment rate held steady at 3.7% and the broader U6 unemployment rate fell slightly to 6.7%. The real problem was the surge higher in wages, which rose 0.6% month-over-month (M/M) or 5.1% year-over-year (Y/Y). Both figures were well ahead of estimates. The “hotter” than expected jobs report will potentially bring more hawkish Fed policy back into play after markets began pricing in an end to the current policy tightening cycle. After raising rates by another 50 basis points at its December meeting, the Fed now expects the terminal rate to be around 5.1%.

U.S. manufacturing fell back into contractionary territory in November after expanding for 29 straight months. The ISM Manufacturing Index fell from 50.2 in October to 49.0 in November. The main sources of weakness were new orders, employment, and prices.  Demand eased, and the manufacturing sector hit its lowest level since the COVID pandemic began. The pace of activity in the service sector accelerated in November, as the ISM Services PMI increased from 54.4 in October to 56.5.  Production surged higher and employment moved back into expansion territory. Survey respondents cited continued improvement in supply chains heading into the holiday season.

CPI inflation declines while retail sales & durable goods orders show resilience

Headline CPI came in below expectations at a gain of 0.1% M/M and 7.1% Y/Y. Core CPI rose 0.2% M/M and 6% Y/Y, also below expectations. Inflation is clearly starting to cool, but there is still concern over rising shelter costs and high/sticky wage growth. Markets initially rallied on the news but reversed course as investors grew more cautious over the increase in services inflation. Goods inflation has fallen over the past few months, but services inflation continues to remain high, including shelter costs that admittedly are reported with a lag.

Source: Bureau of Labor Statistics, CNBC

Retail sales surged by 1.3% in October as consumers continue to spend despite inflation.  Consumer spending increased on items such as gas, groceries, furniture, and cars, but shoppers pulled back on spending at electronics and appliance stores, sporting goods retailers, and department stores. Consumer spending has remained resilient despite 40-year high inflation. However, at some point, the $1.5T in aggregate excess savings will either run out or consumers will reduce discretionary spending. Durable goods orders in the U.S. jumped 1% M/M in October, following a downwardly revised 0.3% increase in September. Excluding the volatile transportation sector, durable goods orders rose 0.5% and the core component that relates to GDP business spending increased 0.7%. The Atlanta Fed’s GDPNow model is forecasting 3.4% growth in Q4 while the consensus amongst economists sits in the 2.0-2.5% range.

Slowing growth creates vulnerability for earnings and valuations; housing affordability is a problem

U.S. corporate earnings continue to show some level of resilience with Q3 growth coming in at +2.5% for the S&P 500. Energy has been the big story this year and if it were removed, the Q3 EPS figure would drop to       –5%. Right now, analysts expect a 2.4% decline in earnings for Q4 and growth of 5.6% in 2023. Depending on how markets perform in December, S&P 500 earnings should end in the $220-225 range. U.S. economic growth is forecast to slow in 2023, perhaps creating some vulnerability for current earnings estimates. EPS could fall 20-30% during a recession but also could remain flat if the economy holds up better than expected.  In either scenario, it is difficult to say that valuations are cheap, and a decline in earnings makes valuations look more expensive.

Source: FactSet

The combination of supply/demand imbalances and surging mortgage rates have made housing affordability difficult for most Americans. According to Goldman Sachs, servicing the costs of owning a home in today’s market have surged 71% Y/Y. Although housing prices have begun to decline in certain hot markets, a lack of supply continues to support prices in most cities/regions. The doubling of mortgage rates over the past year also decreases affordability. The end result is prices that remain near peak levels and an estimated annual income of $112,528 required to purchase the median priced U.S. home.

Source: Goldman Sachs, Freddie Mac, U.S. Census Bureau

Are weak PMIs signaling a looming eurozone recession? Japan’s economy unexpectedly contracts in Q3

The eurozone economy grew 0.2% Q/Q in Q3 or 2.1% Y/Y. Major countries eked out slight growth, but the forecast looks bleak moving forward. November saw business activity fall across the eurozone for a fifth consecutive month, according to flash PMI data. Business sentiment remained gloomy by historical standards, and demand continued to fall at a steep rate, leading to a pull-back in employment growth during the month. A further fall in business activity in November adds to the chances of the eurozone economy slipping into recession. So far, the Q4 data are consistent with GDP contracting at a 0.2% quarterly rate.

Japan’s economy unexpectedly shrank for the first time in a year in Q3, stoking further uncertainty about the outlook as global recession risks, a weak yen, and higher import costs took a toll on household consumption and businesses. Q3 GDP fell at annualized rate of 1.2% with private consumption growing 0.3% and corporate investment rising 1.5%. External factors were the driving factor behind the negative growth. While exports expanded 1.9% from the previous three months, imports grew by 5.2% as higher energy costs and the weak yen pushed up the prices of products coming to Japan. The steeper import bill led to a decline in net exports, dragging GDP lower.

COVID & regulatory uncertainty make other EMs more attractive than China

The inevitable economic cost of Chinese cities being forced to impose restrictions amid a surge in coronavirus cases has already started to appear. The official manufacturing PMI fell to 48 in November, down from 49.2 in the prior month.  November marked the second consecutive month of contraction and the lowest reading since April. The official non-manufacturing PMI, which measures business sentiment in the services and construction sectors, also fell to its lowest point since April after slowing to 46.7 in November from 48.7 in October. Weakness in PMIs, retail sales, property markets, and industrial production point to a bleak economic picture across China. The government has attempted to stimulate the economy through interest/lending rate cuts and more traditional means such as infrastructure investment, but results remain bleak.  Consumers are clearly reigning in spending and the government has limited options to support the troubled real estate market.

With all the uncertainty impacting China, other emerging market countries such as India, Indonesia, Mexico, Brazil, and South Africa perhaps present better opportunities. Economic growth looks more compelling in most of these emerging market countries with cheaper valuations and better earnings growth. As investors consider shifting allocations away from unpredictable China, these countries could be beneficiaries.  India trades at a forward P/E of 22x, but the other countries cited trade at multiples generally between 8-10x. Earnings are forecast to grow 9% in emerging markets in 2023, but  the forecasted growth rate increases to 13% when excluding China.

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