The case for recession & why retail spending is now more important than inflation.

Submitted by acneadjr t3_10of7z0 in wallstreetbets

The BEA recently announced its US GDP findings for Q4 of 2022. On Page 18, a clear pattern can be seen when evaluating nominal change to consumer spending and business investments.

Exhibit 1 (*1)

https://preview.redd.it/h5xqy2mg31fa1.png?width=2264&format=png&auto=webp&v=enabled&s=4e177d0bc7dfde513ecc6be636fa5506baf8b25f

Personal Consumption expenditures (green) are all the goods and services consumers purchase. Exhibit 1 shows that consumer spending has been slowing dramatically since a high in Q2 of 2021.

Gross Private Domestic Investment (blue) is the amount of capital US business invest to create growth. Exhibit 1 shows over the last 4 quarters US businesses have dramatically decreased the capital they are spending as consumer spending has declined.

It is estimated that 70% of GDP comes from personal consumption and 18% comes from business investments. We can clearly see that US companies have dramatically decreased investments as consumer spending has declined. A combined 88% of US GDP is showing signs of slowing or decline.

With 29% of the S&P reporting earnings as of January 27, FactSet reports that earnings are continuing to fall. Currently, earnings are tracking to -5.0% with 69% of companies reporting a beat with a margin of 1.5%. These rates are both well below the 5 year historical averages of 77% and 8.6% (*2).

Based on current earnings and investments, it is clear US growth is stalling. As US companies try to hit declining EPS targets, they will continue to pull back on investments and may shift to larger rounds of layoffs. If US companies shift to larger rounds of layoffs, consumer spending will decline further.

We can further evaluate the health of US companies and the future of the US economy by looking at US inflation from the January 27 PCE report in Exhibit 2.

Exhibit 2 (*3)

https://preview.redd.it/13pnj0mi31fa1.png?width=2298&format=png&auto=webp&v=enabled&s=99a7fb982549a874d3cc4b09d7346d73bd7c1e53

Exhibit 2 shows goods price inflation (red) has been falling for the last 6 months. However, during the last 8 months services inflation remains sticky and sideways. Annualizing a 4-month period in two segments over the last 8 months (green: May – Aug, blue: Sep – Dec) we find that services inflation has remained constant at 5.4% annualized (sum of 4 months = 1.8% * 3 = 5.4%).

With a sideways inflation of 5.4% for services, we can expect the Federal Reserve to keep monetary policy tight. Sideways services is an indication that if the Fed were to take its foot off the interest rate brake, inflation could become elevated again.

Furthermore, caution should be emphasized when evaluating the decreasing goods inflation rate as energy has been largely responsible for a top line decrease (purple). The top line decrease in energy inflation is hiding services inflation. If energy inflation were to increase again, the economy and equities markets will incur a sharp decline. Chinese oil demand and aviation fuel demand will be important factors in the future of energy prices.

With goods inflation continuing to decrease (for now?) and Fed policy likely to stay tight due to sideways services inflation – US companies will face increased margin pressure due to a decreased ability for consumers to pay higher prices for goods. Consumers will need to balance paying for goods and paying for necessary services like health care which remain inflated. Consumer spending may further shift downward as US households begin to save for a recession, increasing the likelihood of a recession.

To evaluate the US economy and its trajectory, we should begin to focus on Retail Spending to evaluate cash flows for US companies. In Exhibit 3, we can see that consumer spending declined -1.0% in November and -1.1% in December.

Exhibit 3 (*4)

https://preview.redd.it/97e1h5hj31fa1.png?width=612&format=png&auto=webp&v=enabled&s=77eadc24a8634adb478fcaed278e52be6391941f

If sales continue to decline, US retail companies will be squeezed as revenue drops and labor costs stay high. To cut costs, US retail companies will increase layoffs and those layoffs will infect other industries.

If we do not see layoffs from US companies, US equity earnings will fall faster due to increased margin pressure that brings forward an “Earnings recession”.

In summary, Retail Sales will show if consumer spending will continue to decline. Inflation as the leading driver of equity values becomes less important as 1) an increase in inflation only further causes more tightness in Fed monetary policy and further reduces consumer spending or 2) a decrease in Goods Inflation causes greater margin pressure for US companies and consumer spending declines. Any rally in equities will be transitory as an earnings recession becomes increasingly more obvious.

A note for future consideration

When evaluating unemployment, we should consider if the metric we are using is counting correctly. Due to the way the US Department of Labor counts U3, portions of U6 may be “Real unemployment” that are not being counted in U3 due to “technical” counting reasons. More research will be done to understand unemployment.

Lastly, a reason we may not have seen the layoffs typically associated with a recession is that companies have chosen to cut Cap Ex before Op Ex due to difficulties hiring in 2021/2022. This can be inferred from the nominal GDP decrease we see in Private Business Investments.

​

Sources:

*1. https://www.bea.gov/sites/default/files/2023-01/gdp4q22_adv.pdf

*2. https://insight.factset.com/sp-500-earnings-season-update-january-27-2023

*3. https://www.bea.gov/sites/default/files/2023-01/pi1222.pdf

*4. https://www.census.gov/retail/marts/www/marts_current.pdf

59

Comments

You must log in or register to comment.

n1ck90z t1_j6ebhpk wrote

A good read. Thanks

12

MamasBrewThug t1_j6epzu1 wrote

"a reason we may not have seen the layoffs"

How many people have been laid off from tech companies already before it even starts?

Totally agree that retail is a strong indicator since the job market is still robust. Those two should not inverse.

8

acneadjr OP t1_j6etkb0 wrote

Bloomberg had reported ~120K big tech layoffs over 2022. Some estimates expect the economy to start losing ~240K jobs / month.

The reason I think Tech went first in layoffs is because Tech doesn't have the other Cap Ex buckets to shed first. Tech's employees (Product, Engineers, Design) are usually included in Cap Ex calculations in comparison hourly / GA workers are not. In other industry's they can cut back on new store openings, inventory purchases, etc.. Tech just doesn't have these expenses so they are left cutting employees first.

4

garbageacct123456789 t1_j6h05yt wrote

Mostly accurate. I have observed something close to this at my company but instead of cutting employees they cut 90% of the contract workforce. Those numbers don’t actually count as a layoff until the consulting firm needs to clear the bench and lays them off. If one were interested they could try and get the data for layoffs at consulting firms such as Accenture, etc. Most times the contract worker actually costs us more than a full time employee. Sure the worker gets paid less by their firm but their firm bills 2-2.5x their salary.

3

GoodGuyDrew t1_j6ejya0 wrote

Ok, so how do I know when it’s time to buy puts?

5

acneadjr OP t1_j6eniwc wrote

I am watching for two things:

  1. Fed raises rates and Apple / Amazon report negative forward guidance, this could be 1 catalyst for a large downward move.

  2. From Dec -> Jan we have seen about a 10-12% MoM raise in gasoline prices . Assuming this has a similar affect on inflation that Octobers increase had, the second scenario I am looking at is an increase in MoM CPI followed by a decrease in Retail spending for January. I think this is the more likely catalyst for breaking the upward movement.

9

GoodGuyDrew t1_j6fmxqt wrote

I think scenario 1 is less likely to be a killshot, given what happened with MSFT after earnings.

Scenario 2 is an interesting prospect and is exactly what the inflation doomers have been shouting - that every previous period of inflation has had periods of cooling followed by even more rapid inflation. The gas prices might signal a resurgence here, but my personal experience (and the data) suggest that inflation in the price of goods is just about done.

My sense is that the probability of us experiencing extreme chop is the same as us experiencing aggressive flatness. Hence, I’m feeling a bit paralyzed here…

5

acneadjr OP t1_j6fs61w wrote

I agree with you on scenario 1. The one difference maker may be the cumulative earnings of the S&P at the end of next week. If it continues to decline optimism may start to fade. I am watching but not diving in to this scenario.

On Scenario 2 I think inflation is sideways to down. However as long as services continue to stay sticky we see the Fed increase or hold rates in '23. I am sort of past inflation, I see this as last year's story.

The story in '23 will start to switch to consumption as it is 70% of the US economy and business investments 18%. As we see these numbers decline GDP falls fast. This is why I am more interested in Retail Sales now. I think it's all about when more hard data starts to show this decline.

3

GoodGuyDrew t1_j6fzvzi wrote

The hard data will definitely tell us plebeians when the tides have turned. But by then, big money will already be on the other side of the trade.

I’ll keep focused on the data for long-term prospects, but I think Fed “tone” and market whim will dictate movements day to day and week to week for the rest of 2023. So as per usual, I’ll just be hoping to get lucky 🍀

3

Moist_Lunch_5075 t1_j6gydog wrote

>big money will already be on the other side of the trade

If 2020 taught us anything, it's that capital flows matter and the economy basically doesn't.

1

Moist_Lunch_5075 t1_j6gxy79 wrote

>Scenario 2 is an interesting prospect and is exactly what the inflation doomers have been shouting - that every previous period of inflation has had periods of cooling followed by even more rapid inflation. The gas prices might signal a resurgence here, but my personal experience (and the data) suggest that inflation in the price of goods is just about done.

This is called the "Whipsaw Effect." It's an expected part of the inflationary prediction. The periods of inflation are also getting shorter and less relatively impactful. It just feels like it hurts more because years of inflation are compounding and we have headlines like the price of eggs to look at... but as the order and contract system catch up and cycles emerge, it'll get easier to ride the inflation waves for companies and that means better margins.

Edit: I do agree that in the nearterm, there's a risk of an earnings recession, mostly agreeing with the dynamics u/acneadjr has laid out... but I would only say that the market may surprise us if things aren't as much of a downward spiral as they're suggesting.

I think looking at consumer patterns is the right place to look overall... I just don't know that it necessarily correlates with a market decline or that it necessarily cyclically builds to the extent it appears it could.

2

-Johnny- t1_j6fq4ov wrote

I'm thinking the next 2 GDP announcements we will see a huge sell off. So buy puts about 7 months out and add to it if the market goes up at any point between.

2

ErectoPeentrounus t1_j6ebp6q wrote

as long as ER estimates are lower than reality it’s bullish. The average idiot doesn’t realize estimates were giga low to begin with

4

MamasBrewThug t1_j6eqa07 wrote

Actually most of the major investment advisors are saying the PE ratios are far too high and not discounting the earnings recession that just started and has another quarter or two to go.

8

Moist_Lunch_5075 t1_j6gvb18 wrote

The issue I have with that is that the PE ratio metrics they're largely using are against traditional average ratios.

The asterisk on that metric is that as capital available to lending institutions increases, which comes from the expansion of M2 combined with bank lending appetite and cost of money, the "price" component expands, which since the 1990s has been slowly pushing the average P/E ratio up.

We're currently sitting around the mid-2019 level for the S&P 500's combined P/E ratio.

The thing is... the Fed's not going to suck all of the expansion of M2 out... in fact, probably about 25%, mostly to investment houses, has escaped already and won't be called back. Some of it's in longer term bonds, so that's not coming back right away. There's a lot of uncertainty around how much the Fed will draw down on the balance sheet, with some people guessing a full reset down to 2019 levels, but I would say the pain to get there relative to the gain is not going to allow for that to happen... and current Fed projects indicate that there's no appetite to restrict to reduce the money supply to that extent, reducing the pull-forward from like 10 years to a couple of years is probably enough...

...which still leaves the banks cash-flush and with lots of money to re-enter the market that institutions began pulling out in 2021.

Once stock return projections get higher than the risk-free rate of return again, that should float the P/E ratios up higher than the expected 2019 baseline. Of course individual equities will have their own dynamics, but the flow of the market will also dictate to some extent whether they have strength or not.

In other words, current market pricing could be based in an overly pessimistic view relative to the amount of capital that will be looking for a home in a market reversal... it's safe for them now to take a risk-averse approach, and not wrong to do so given the unknowns... but the reasoning behind their argument regarding P/E ratios has a blindspot.

Edit to add: Prior to the 1990s, the range on the P/E ratio is tighter, in part, because money expansion was generally tighter and because Glass-Steagall meant that more of that M2 expansion made it into the real economy, meaning the 'E' part of 'P/E' was more likely to scale with stock pricing.

What happened in the 1990s other than an explosion in investment speculation and a bit of a change in monetary policy and a tech bubble? GLBA and Glass-Steagall were repealed, which opened the doors to more intermingling of S&L and investment house funding. That drives the 'P' part farther than the 'E' part of the ratio can run.

2

n1ck90z t1_j6ectku wrote

In "sane" times an ER beat with lower guidance would make the stock still fall

4

ErectoPeentrounus t1_j6ed73c wrote

should’ve seen them lower tesla guidance before ER

0

acneadjr OP t1_j6ef582 wrote

I don't really care about individual earnings and this is not a thread about Tesla bears vs. bulls (I don't care). My argument was about the direction of the economy and not the current most pain / hopium phase the market is experiencing.

5

likenoteven t1_j6fmbwy wrote

How are you playing hawkpow? Or just waiting til after this week.

1

acneadjr OP t1_j6foh8f wrote

I am not specifically playing to the Fed decision on Wednesday, I sometimes trade during the day when strong signals indicate an upward or downward movement.

I am looking at some positions against electronics and department store retailers given the large decline recent data has shown in these categories.

My strategy is focused on 6+ month option expirations that return 1-5 or 1-6 by buying out of the money spreads slightly above the bottom of the previous lows (~3660). I am about 25% in with 75% waiting to be deployed when I am more certain of momentum switching.

3

BugTotal6212 t1_j6fo8wh wrote

The tech layoffs would have decent severance. So wouldn't that be a lagging indicator for jobless claims and unemployment rate which would lag more?

1

acneadjr OP t1_j6fpe70 wrote

Without a question, unemployment is a lagging indicator. I need to study how the data is collected, when unemployment is counted, and what other sources there are to check against the department of labor.

I also believe companies have shied away from layoffs in favor of cutting Cap Ex to meet earnings estimates. In Tech most labor is Cap Ex. When non-Tech starts to cut Op Ex we will see larger waves of layoffs.

If I am right about Cap Ex being the cost savings measure for companies in this Quarter, then it may make it harder for those companies to switch on growth again.

3

BarberExpert9114 t1_j6g83kz wrote

Seems like your not forward looking based on facts but instead based on if and maybe.

−1