Signals to watch as crucial fall season approaches

My view for the last several weeks is that September and October is where the rubber hits the road for the US economy. By that time, the second spike in coronavirus cases will have diminished and we will get a more realistic forward-looking view on a ‘steady state’ US economy, just as investors come back from the summer lull.

Here are the economic and market signals I am watching.

1. Inflation: there are incipient inflationary signs in the US economy. I am watching them to see if they last. But I don’t see them as pronounced enough yet to be more than fleeting at this point. Mostly, it is on the cost input side of things. And the question is whether that raw material inflation can be passed on to consumers in this economic environment. Also, remember that wage pressure is muted given the high levels of underemployment. And at the same time, remember that rents are plummeting in some areas. And owners’ equivalent rent is large percentage of the CPI. Deflationary pressures here will feed through in the next several months.
2. Interest rates: Closely related to inflation is interest rates. I see the currency as the release valve for US Treasury market issuance overload. But to the degree inflation expectations rise, they can become embedded in the yield curve via bear steepening, with long-dated Treasuries selling off as the short end of the curve remains anchored by Fed policy. The question is how long this steepening can occur without creating havoc in equity markets – via discount rates and equity premia – and in credit markets via increased credit spreads. I see curve steepening as limited in scope but potentially a negative catalyst for a risk-off re-assessment.
3. Multiple expansion: Related to interest rates via the discount rate and equity risk premia are the price earnings multiples for stocks (and the spreads to Treasuries for high yield bonds). All of the kick up in shares since the March lows are built on the back of multiple expansion, not earnings growth or forward earnings outlooks. I think a large part of this is the lack of forward visibility on the economy and earnings. And I am looking for September and October to be the time when visibility improves and risk premia react accordingly.
4. Bifurcation: While the median share or bond in markets is up, cyclical stocks and low-quality credits are getting killed as technology and stay-at-home companies are flying high. Amazon is up 71%, Apple 57% and Microsoft 34%. Meanwhile bank stocks are down over 30%, energy stocks 40%, and airline stocks almost 50%. It is a massive differential. And I think it’s unsustainable. How the ‘mean reversion’ breaks will decide whether this rally has legs past October. But, it is built on Fed policy. The Fed has signalled it will backstop US government and investment grade credits, meaning there is a floor for these companies. Companies with poor credit and in fear of bankruptcy have no such backstop. That’s why AA bond yields are almost 1% lower this year while B-rated bond yields are over 50 basis points higher. This feeds through to equities in the exact same bifurcated way, even more so, as shares in moribund companies can go to zero.
5. Fiscal policy: My operating assumption has been that President Trump has less incentive to compromise with Democrats because he is already being blamed for the poor economy. His goal is to get Democrats to share that blame. And, without a compromise fiscal deal, Democrats will increasingly share blame. That means we are likely to see concessions from them in September. Will it be enough to get a deal? I don’t know. The political environment in Washington is toxic. But, if no deal is reached and the economy crumbles, Trump won’t be the only person getting blamed.
6. Initial jobless claims: In terms of real-time data, initial jobless claims are where the rubber hits the road. They are declining but elevated. A steady-state post-recessionary economy is associated with maybe 400,000 initial claims, about half today’s levels. If we don’t get down to that level quickly, expect expectations on consumption, capital investment and GDP growth to crumble for Q3 and especially Q4. If the downward trend in claims stops and reverses, the economic implications would be even worse. I wouldn’t rule out a negative print for Q4 GDP.

Overall, I would say that the US economy is in a mildly disinflationary environment, with massive spare capacity utilization, tamping down on any upward pressure on wages and prices. Fiscal and monetary stimulus has been enough to weather the initial storm. But, given the loss of jobs and income, any pullback in fiscal spending could be catastrophic to consumption and investment. So I see the fiscal cliff(s) as the most important variable in the coming month.

September and October are crucial months because they are times when traders come back from the summer holiday to reset outlooks. That reset is particularly important this year because of the previous lack of earnings visibility, the second spike in coronavirus, the coming indoor and colder flu season, fiscal brinkmanship, and the monumental US election. I believe that all of things will combine to either reinforce market momentum or wreak havoc on financial markets as outlooks adjust to a new reality.

One thing to keep in mind is that equity market funds have seen outflows and bond funds have seen inflows as markets have rallied off of March lows. To me, this points to fragile underpinnings for equity markets in particular, meaning a (negative) reset of outlooks will have a more meaningful impact than usual.

One last thought: the political economy has become a dominant force in shaping economic and market outcomes. That requires one have a view about potential political outcomes. For example, Apple earnings could be materially affected by whether China decides to retaliate against it because of US actions against Chinese companies. I also think that the ongoing pandemic and upcoming government shutdown fiscal negotiations are of major economic significance.

I am not fully comfortable with this. For example, I have to speculate regarding what the likely outcomes are from fiscal cliff negotiations because we are at a fragile moment in the US economy. But, this is the reality of the day. I try to embrace the political economy with as much ‘will likely happen’ language as possible, because I am not making policy. And I don’t have any influence on policy.

What I think ‘should happen’ isn’t useful to you. Politicians have (political) reasons for their strategies. And I am not going to second guess any of that. Please keep all this in mind when you read anything I write on political outcomes. Who is to ‘blame’ is not relevant, though thinking about who could be blamed politically is relevant to negotiating strategies.

Finally, I have been on holiday since Saturday. So, apologies for the light posting schedule