Party On, Wayne!

Partyyyyyyy onnnnn says the media and market. We will highlight and discuss present risks that are empirical data points.

Highlights

• There is a defining difference between a corporate profit recession and a full economic recession. During this discussion, we will think about the labor market and the role it plays as a dam between the two outcomes.

• Headline retail sales continue to slow. The number decelerated and is near cycle lows. The Redbook index (weekly) goes negative for the first time in the cycle this month. Keep in mind, consumption is approximately 66% of GDP. 

• Industrial production goes negative for the first time during the cycle on a year-over-year basis. The Yellow Trucking company may file for bankruptcy and Knight-Swift, which is one of the largest trucking companies, reported eps down -62% y/y. Industrial production continues to slow and composes approximately 18% of the US GDP.

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Happy Friday!

Name of the game remains the same. The Fed continues tightening monetary policy into very obvious conditions of economic risk. Such has been the case throughout the past two years. Meanwhile, as showcased in multiple previous publications, certain leading economic data points have continued to get worse over the same period of time. The funny or not-so-funny part of the equation is that the fed has been reliant and is making decisions based on lagging data sets. Many of these late-cycle data points have been “resilient” or “stronger” than the market expected during 2023. This, in turn, perpetuates the tighter for longer monetary regime despite the aforementioned economic risks. It was only yesterday morning that CNBC was celebrating the “Dow’s longest win streak since 1897” (14 days in a row). Enjoy the ride.

Today I am stepping up to the plate to discuss empirical economic facts seemingly being swept under the rug and overshadowed by captivating vertical pleasantly green-colored equity prices. This dynamic reminds me of when I used to try to hide a mess that I made from my mother in the false hope that if she never saw it, then I would never face any consequences. Why does wall street nor the media not care? Because, “Party on, Wayne”!

A critical lesson that I have learned over the past couple of years is that there are defining differences between a bear market and an economic recession. One is centered around the movement of asset prices and the other is an economic reality based on reported data. Always remember that it is possible for Markets to act independently from economic data for periods of time. Often the extremes are where fundamental-price divergences emerge and that is precisely where the dance between the two becomes a dangerous game (dependent upon the investor’s positioning).

Another valuable principle is that not every single stock market move has to be fundamental, which I learned from Keith McCullough, CEO of Hedgeye Risk Management. There can be bear markets that exist without an economic recession. Often time, a bear market will coincide with an economic slowdown, growth deceleration, and profit recession. On the flip side, historically, when there is a recession there is also a bear market for equities.

The major barrier that prevents the dam from breaking is the labor market. This is true for a couple of reasons. A tight and growing labor market will continue creating new demand as workers are able to afford goods and services. In a competitive labor market, wages rise as companies seek to acquire talented workers, which also serves to increase demand when wages are rising faster than the cost of living/ inflation.

We also live in a corporate society where millions of Americans have 401k retirement plans through their employers. Each month, a piece of those paychecks flows into passively invested funds. Not going to go into all of the minutiae about “passive flows” throughout this piece because that is the expertise of

Michael W. Green

(find his Substack here). These “flows” offer key support to the market during periods of “full employment” as the passive investment vehicles are forced to deploy new capital.

Not all recessions are the same and not all bear markets are created equal. However, as the corporate profit recession continues, a natural reaction function for companies is to cut labor expenses as a means to preserve profit margins. By the time part of the “profit recession” is already realized and companies reduce their labor cost, the negative business trends have already been ongoing for months. Labor is one of the most lagging indicators for economic health.

As mentioned above, the labor market has been one of Fed Powell’s main points of focus. He has also mentioned at previous press conferences that they are comfortable with a minor lift in the unemployment rate as a means of containing inflation. The problem is that forward monetary actions are based on late reports. Adding more fuel to the fire, it can take several months for the previous monetary actions to fully affect the real economy. Meaning, how will they know if they have tightened the policy too far?

I am spending time discussing the labor market because, to date, it has kept the levee from breaking. Rising unemployment negates the positive demand dynamics that are mentioned above along with the 401k fund flows. This part of the economic cycle becomes very reflexive. There has been a corporate profit recession over the past two quarters. Either business trends start to get better from here or in the event of rising unemployment, the economic reality becomes much worse. From this point forward, the negative feedback loop of unemployment poses a meaningful challenge to an economy and market trying to recover from a corporate profit recession. Below are some of the consequences of higher levels of unemployment.

1. Credit card balances at all-time highs→ Higher delinquency and bad debt

2. Credit card interest rates at decade highs→ Large amounts of interest accruing on unpaid balances

3. Un-affordable housing and mortgages→ Defaults and foreclosures

4. Record rent prices→ Rising bad debt/ delinquent rent, evictions, higher vacancy, and lower profits for real estate owners

5. Vacancy too high as a commercial real estate loan matures→ Unable to refinance and forced to give the keys back to the bank (foreclosure)

6. Auto loans→ Higher delinquency and default

7. Poor credit quality→ Gets worse

8. No job→ Tough to make ends meet and certainly no demand for excess spending

9. Higher unemployment→ Lower volume passive 401k flows

10. Wage growth gone→ Lower levels of consumer demand and a lower standard of living

Now, please do not take this out of context. All I am saying is that these are some of the potential consequences of higher levels of unemployment from here. Many of which, are highly disruptive to already struggling businesses. Everything is interconnected and “some unemployment” can quickly grow into higher levels as underlying business trends are affected by the first wave of unemployment causing other businesses to lay off more of their workers. From there, the negative credit cycle feeds on this loop. Large labor losses are one of the defining differences between what is just a corporate profit recession and a full economic recession.

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Macro

Admittedly, I am surprised by the positive GDP prints to date in 2023. Starting in Q4 2022, year-over-year growth was +0.9% (cycle low to date). Q1 2023 GDP was +1.8% y/y and preliminary Q2 2023 GDP yesterday was +2.6% y/y. My view over the first half of the year was slowing economic growth based on various macro data points such as the industrial and retail sectors, which will be discussed today.

Many of the other data points that I am referencing continue to get worse each week and month. So far, my view on growth has wrong in relation to the overall GDP numbers to date, however, I will not be changing my viewpoint from here given many of the pieces of the overall puzzle are withering away beneath the surface. Globally, European Manufacturing PMIs are hitting new cycle lows, and some countries’ Services PMIs are below 50 (contractionary territory). Below are some highlights of the recent US GDP print year over year.

• Personal Consumption Expenditures (PCE) +2.3% y/y (Q2 2023) vs. +2.4% y/y (Q1 2023)

• Services +2.6% y/y (Q2 2023) vs. +3.3% y/y (Q1 2023)

• Gross Private Domestic Investment -3.1% y/y (Q2 2023) vs. -8.1% y/y (Q1 2023)

• Government Spending +3.8% y/y (Q2 2023) vs. +2.7% y/y (Q1 2023)

The report demonstrates weakening consumers in PCE and services slowing above. Although, only marginally for PCE. Overall GDP print number was supported by increased government spending and domestic investment. “So, you are telling me there’s a chance”. Not going to speculate until I have real data, but I wonder how much of the domestic investment acceleration came from “AI CapEx”, which according to Microsoft, will have a gradual impact on business trends based on commentary from the Q2 2023 earnings call guidance.

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Retail Data

Why is focusing on retail data important? Consumption makes up approximately 66% of GDP. Headline US retail sales continue to slow. See the chart below from last week’s report for the month of June.

*Tradingeconomics.com

*Tradingeconomics.com

Another important data point to follow is the weekly Redbook Index updates. These are higher frequency (reported weekly) but still hold relevance. What is the Redbook Index? According to tradingeconomics.com, “The Johnson Redbook Index is a sales-weighted of year-over-year same-store sales growth in a sample of large US general merchandise retailers representing about 9,000 stores. Same-store sales are sales in stores continuously open for 12 months or longer. By dollar value, the Index represents over 80% of the equivalent 'official' retail sales series collected and published by the US Department of Commerce. Redbook compiles the Index by collecting and interpreting performance estimates from retailers. The Index and its sub-groups are sales-weighted aggregates of these estimates. Weeks are retail weeks (Sunday to Saturday), and equally weighted within the month”.

*Tradingeconomics.com

*Tradingeconomics.com

Recently, the Redbook index has gone negative for the first time this cycle during the month of July (-0.4% year over year for the reported week of July 22).

The deterioration of credit and demand begins with lower-quality consumers. Wealth inequality continues to crescendo with risk-free money dynamics at decade high-interest rates. For example, someone with $10,000,000 in a money market or high-yield savings fund earning 5% interest can be paid out approximately $500,000 a year in interest (assuming non-compounding). Meanwhile, at the lower end of the spectrum, someone with $10,000 in the same type of account would only earn the interest of $500 at the end of the year. This has a very disproportionate impact on the wealth inequality of the lower class. The rich get richer while the smaller account is able to buy 1-month’s worth of groceries for their family at the end of the year.

That being said, recent data from Louis Vuitton and Moncler post declining year-over-year sales in the US in their Q2 2023 reports. Is this showcasing cracks for the higher-end consumer as well? Are the beneficiaries of the higher risk-free interest starting to see spending beginning to slow? Both of the below are very strong companies with desirable luxury products.

• LVMH US sales -1% y/y Q2 2023 vs. +8% Q2 2022

• Moncler US sales -5% y/y Q2 2023

• These data points were first called out to me by Hedgeye retail analysts Brian McGough and Jeremy McLean

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Industrial Data

Industrial production makes up approximately 18%-20% of US GDP. For this reason, we have followed ISM and S&P flash manufacturing numbers for the US and around the globe since the inception of this publication. Below are charts up to date with June industrial production numbers where the print was negative year over year for the first time during this economic cycle. -0.43% (June) vs. +0.026% (May).

*Tradingeconomics.com

*Tradingeconomics.com

As shown above, the data continues to slow and get worse. Below I will cite some of the carnage within the transport sector. This will be specific to individual trucking companies (transports). None of this is financial advice and I am just using it for data.

• Yellow Trucking may have to file for bankruptcy (FreightWaves)

• KNX Earnings (cited previously in my publication “Trukin”), which got worse.

  • EPS Q1 2023 of $0.73 vs. EPS Q1 2022 of $1.35 (-45.9% y/y)

  • EPS Q2 2023 of $0.49 vs. EPS Q2 2022 of $1.41 (-65.2% y/y)

  • Guidance for 2023 to start the year was $4.05 to $4.25 for full-year EPS

  • Revised guidance for year-end 2023 after the Q2 report is $2.10 to $2.30 for full-year EPS.

Important to remember that one company does not speak for an entire industry or sector, but the trend speaks for itself. The trends for KNX continue to get worse, and their initial forecast for the year 2023 was about -50% off the reality of where they expect the year to end following the first two quarters during 2023.

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Conclusion

The prevailing dynamics have been difficult to navigate because there is a disconnect between certain sets of data that are being reported and the overall movement over the last couple of months. It is easy to ride the wave for whatever is working. I think it is fair to ask the question, what happens if everyone tries to exit at the same time? If many people are aware of these negative sets of conditions but are choosing to ignore them because they believe that they will be able to get out before everyone else, what are the consequences if the trends continue to get worse?

There is a defining difference between a corporate profit recession and a full economic recession. The labor market acts as a dam between the two outcomes.

Headline retail sales continue to slow. The number decelerated and is near cycle lows. The Redbook index (weekly) goes negative for the first time in the cycle this month. Keep in mind, consumption is approximately 66% of GDP. 

Industrial production goes negative for the first time during the cycle on a year-over-year basis. The Yellow Trucking company may file for bankruptcy and Knight-Swift, which is one of the largest trucking companies, reported eps down -62% y/y. Industrial production continues to slow and composes approximately 18% of the US GDP.

The stock market is not the economy. Economic data is what it is. The market can be influenced by short-term fund flows and human behavior. This is not investment advice, but it is my view that trading a high-yield credit short position continues to be a viable method to hedge the long book. As realized over the last two years, this continues to be a very slow process in motion, and it is important to exercise patience. Do not fade the data-driven process at one of the hardest tested points of cycle time.

Happy Friday,

Aaron David Garfinkel

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Resources

Waynes World Cover Photo (*Source*)

Preliminary Q2 2023 GDP Report (link here)

Retail Sales Data (link here)

Redbook Retail (link here)

Industrial Production Data (link here)

Yellow Trucking Article (FreightWaves link)

Truckin

KNX Earnings (link)

LVMH Earnings (link)

Moncler Earnings (link)

Keith McCullough, CEO, Hedgeye Risk Management (Twitter)

Brian McGough, Retail Analyst, Hedgeye Risk Management (Twitter)

Jeremy McLean, Retail Analyst, Hedgeye Risk Management (Twitter)