The needed shift in perspective … financial fragility increasing … the problem with “lag time” … stock market pain with and without a recession

Over the last few weeks in the Digest, we’ve suggested that investors need to shift their perspective…

From inflation to the health of the U.S. consumer and corporate earnings.

Behind this suggestion is a simple assumption:

Yes, inflation is still incredibly important. After all, that’s what the Fed is watching.

But if we take the Fed at its word, even after we see a meaningful decline in inflation (which isn’t defined by the Fed), it’s going to hold rates at an elevated level for some length of time (also not defined by the Fed) in order to make sure inflation is conquered.

But that period of lingering elevated rates is going to continue to erode the health of the U.S. consumer and corporate earnings.

And at the end of the day, stock prices reflect the condition of earnings (and earnings reflect the condition of the U.S. consumer).

It’s also critical to factor in how the impact of rate hikes takes weeks if not months to manifest for many parts of the economy. So, there’s a lag-time before we’ll really feel the full brunt of the pain.

It’s like bumping into an old college buddy who forces you to drink lots of celebratory beers with him as you reminisce about the old days.

Even after you reach your “uncle” point and stop drinking, the alcohol you’ve consumed is still working its way through your system. There’s a lag time before you know just how impaired you’ve become.

Right now, Federal Reserve Chairman Jerome Powell is your old college buddy, forcing you to shotgun beers

Meanwhile, Wall Street is breathlessly waiting to celebrate the moment that Powell finally says “eh, we’ve been drinking pretty hard. Let’s just nurse this latest beer for a while.”

But even when that pivot comes, instant sobriety and a refreshing morning won’t be the result. After all, the alcohol is still in your body. Plus, you’re still drinking – just slower.

Doesn’t that mean a hangover should be expected?

Seems logical. The unknown is how bad will it be.

So, while Wall Street focuses on when Powell will slow down ordering beers, we think monitoring your blood alcohol level is a better way to gauge the coming hangover.

How do we measure this?

One way is to check out the latest reading of S&P Global Ratings’ Financial Fragility Indicator.

When we do, it points toward the need for a tall glass of water and a handful of Advil.

U.S. households and businesses are watching their financial cushions “rapidly deteriorate”

From MarketWatch:

After socking away savings during the aftermath of the COVID-19 crisis, American households and businesses are watching their financial cushions rapidly deteriorate as prices have soared and the Federal Reserve has substantially raised the cost of borrowing money.

That’s the takeaway from the latest reading of S&P Global Ratings’ Financial Fragility Indicator, which rose rapidly during the second quarter this year, marking the fastest pace of deterioration since the great financial crisis in 2008, and the dot-com crash back in 2001.

It turns out that the indicator has returned to its long-term average of zero. But what’s noteworthy is the speed at which it’s gotten there.

From Beth Ann Bovino, who is the chief U.S. economist at S&P Global Ratings and the author of the report:

What I find alarming is how quickly they sped through their savings. That doesn’t bode well for 2023, as the cumulative rate hikes take hold.

The story is one you already know…

During the pandemic, the U.S. consumer built up a sizeable financial cushion thanks to stimulus dollars and reduced spending due to lockdowns.

But when the world reopened and all that freshly-printed money resulted in the worst inflation in 40 years, those financial cushions began deteriorating rapidly.

It’s now getting worse.

Back to MarketWatch:

…As borrowing costs continue to rise and prices remain stubbornly high, Bovino expects these signs of stress to worsen heading into 2023…

It’s quite possible that the indicator could reach levels associated with severe economic stress as soon as next year, Bovino said.

Yes, stocks have gotten nailed this year. But they’ve gotten nailed with an earnings performance that hasn’t yet reached its worst condition.

What’s going to happen to earnings – and by extension, stock prices – if “severe economic stress” manifests next year?

One of the major problems in all of this is the dynamic of “lag time”

It would be wonderful if the entire economy responded to the Fed’s rate hikes in the same way the mortgage market does – instantaneous. If that was the case, the Fed could turn on and off the rate-hike spigot with laser-like precision.

Unfortunately, it doesn’t work that way. Instead, we have “lag-time.” And that creates conditions ripe for mistakes.

It’s not widely referenced, but the Federal Reserve Board of Governors published a study in July that looked at the depression of 1920, which is sometimes called The Forgotten Depression. During this time, stocks fell by nearly 50%, and corporate profits declined by over 90%.

In the Board of Governors’ findings, high among the factors that contributed to that depression’s beginnings was “lag time.”

From the report:

The Federal Reserve miscalculated the lag times inherent in monetary policy changes, leading the central bank to raise interest rates during the early stages of a recession.

While it is important for the Federal Reserve to tighten monetary policy and manage inflation, it is also important to adjust policy rates at an appropriate pace.

According to the old definition of a recession (two consecutive quarters of a decline in GDP), we’re already in one. Meanwhile, we’re currently experiencing the fastest pace of rate hikes in four decades, lag time be damned.

Meanwhile, yesterday – after all the recent speculation about a Fed Pivot – Minneapolis Fed President Neel Kashkari said:

We have more work to do.

Until I see some evidence that underlying inflation has solidly peaked and is hopefully headed back down, I’m not ready to declare a pause.

I think we’re quite a ways away from a pause.

This morning’s jobs report data only strengthens this perspective. Job growth numbers came in hotter than Wall Street wanted, giving the Fed reason to keep the pedal to the metal on rate hikes next month.

Translation: Powell just ordered us a fresh round of beers.

What does all of this mean for stocks?

Well, remember, Wall Street and Main Street are different beasts that operate on different timeframes.

Wall Street can be partying hard while Main Street is in the gutter.

However, over the long-term, Wall Street can’t get too far away from Main Street. That’s because, as we noted earlier, stock prices ultimately reflect earnings.

Sure, there are periods of wild excess and deep despair when stock prices soar and plummet in ways that don’t accurately reflect earnings. But at the end of the day, earnings are what matter. Prices return to their primary driver.

As we stand today, Main Street hasn’t yet reached the worst of its pain. By extension, in all likelihood, earnings haven’t reached their ultimate lows.

The extent of this pain and those lows will reveal themselves only after sufficient “lag time” passes.

So, the big question is: Do 2022’s market declines accurately reflect the coming pain of the U.S. consumer and the related impact on earnings?

A parallel question is: Will our current bear market be limited to a “regular bear market” or will it be a “bear market with a recession”?

Well, what’s the difference?

Here’s Reuters:

If the U.S. does turn out to be in a recession, however, history shows the rough ride stock investors have endured this year may get even bumpier.

Bear markets accompanied by a recession tend to be steeper than those without an economic downturn, according to the Wells Fargo Investment Institute.

Among bear markets since 1946, the average decline with a recession was 35.8% versus 27.9% on average without a recession, their data showed.

The lowest that the S&P has fallen all year is about 23%. That’s not even on par with the average bear market decline, let alone a bear market with a recession.

But doesn’t Wall Street always look ahead?

And if so, won’t a Fed Pivot mean Wall Street will look further out in time, pricing in the conditions that will be here after the hangover subsides? And if that’s the case, can’t Wall Street begin its rebound even though Main Street might still be in pain?

Yes, that’s certainly possible.

But for such a stock market rebound to last, it requires Wall Street to accurately forecast how severe the hangover will be – and how long it will stick around the next day. And that’s a tough call given the issue of lag time.

It’s a bit like trying to get up early for a jog the morning after. You can plan to do it all you want the night before, but your body might have a different idea when daylight comes.

So, we’ll see.

In the meantime, drink up. The waitress is headed our way with that new round.

Have a good evening,

Jeff Remsburg