Resilient Economy Showing Some Cracks

Stocks opened lower this morning, but quickly turned around. At the moment, the Dow is down only 110 points and the S&P 500 is down .6%. The energy sector is bucking the trend, up 1.3%, on higher oil prices (see below). Bonds are selling off across the board, allowing yields to float higher.

WTI crude oil surged over $120/barrel in the aftermath of Russia’s invasion of Ukraine. Most investors cited increased geopolitical uncertainty as the primary reason. Some still cite Russian oil sanctions as a factor, though I think India and China are sopping up much of that. But surely the fact that oil production hadn’t yet fully recovered from Covid had something to do with that. Global production, somewhere around 81-82 million barrels per day (bpd) back in 2019, is now hovering around 78 million bpd. But despite desperate calls from politicians to drill, drill, drill, slowing global economic growth is showing production discipline to be wisdom. Crude has fallen back into the mid-$80s, and OPEC is clearly worried about it falling further. The cartel just agreed to cut production quotas by 2 million bpd. In a Bloomberg interview this morning, JP Morgan analyst Christyan Malek said US producers aren’t willing to invest in new projects to boost production at current prices. The result is that gasoline prices may remain elevated for a while.

Mortgage applications tanked again last month, presumably because mortgage rates just hit a 16-year high. The Mortgage Bankers Association’s index of loan applications fell to its lowest level since 2015. Economists and real estate analysts tell us a structural shortage in housing supply will keep the market from crashing, but clearly there will be some “pain,” as Fed Chair Powell puts it. A year ago the median price of existing home sale transactions was rising at an unsustainable 14% y/y clip. Since then it has slowed to 7.7% and is likely headed lower. We could probably benefit (in the long-run) from a period of stagnant home prices.

US service-sector business activity grew at a very healthy rate in September. ISM’s monthly Services Index edged down to 56.7 vs. 56.9 in the prior month, but economists expected the survey to fall toward 56.0. As with any other PMI survey, 50.0 is the dividing line between growth and contraction. ISM said current production and new business orders remain “elevated,” and even hiring activity accelerated. By contrast, manufacturing activity is clearly stagnating, as we learned earlier this week. But of course, services are far more important to the US economy than is manufacturing. Setting that aside, investors are more focused on the fact that both reports confirmed falling inflation. The services inflation gauge remains on the high side, but has fallen to the lowest level since January 2021. This is very encouraging news.

It’s hard to escape the conclusion that capital markets are in the process of pricing-in an economic recession, whether or not it comes. Bloomberg news says the “recent drumbeat of negative economic news” suggests that the “Fed’s hikes are starting to bite…” The economy has shown remarkable resilience, as evidenced by Citi’s Economic Surprise Index still in positive territory. But clearly cracks are showing. I’ll point out again that stock and bond markets are always looking forward, not at yesterday or even today. So as we commence earnings season, what CEOs say about 2023 will have more weight than how their companies performed during the most recent quarter. These announcements should provide clues as to the recession question.