Off Target

manufacturers the Fed inflation off target Jay Powell

Last week was brutal for retailers as major earnings announcements showed how they have been hit very hard by huge cost increases. Wal-Mart started the week off shocking the market with its very weak earnings outlook and then there was Target.

Target shares sink 25% after company says high costs, inventory woes hit profits

Its stock price got absolutely crushed in the wake of its results being released.

XLP (Consumer Staples, Walmart Target April 19 May 18 April 20 - May 19

The stock market has been suffering mightily in 2022 as this drawdown is one of the larger ones since 2010.

S&P 500 % Drawdown 2011 - 2022

It seems pretty clear that the Fed has no problem inflicting pain on investors in order to tighten financial conditions to curtail demand in the economy so that inflation can be tamed. The following are excerpts from an interview done by Kansas City Fed President Esther George.

Ester George President of the Federal Reserve Bank of Kansas City

Ester George President of the Federal Reserve Bank of Kansas City

The Fed clearly has its eye on the stock market.

“What we’re looking for is the transmission of our policy through markets understanding and that tightening should be expected. It is not aimed at the equity markets in particular but I think it is one of the avenues through which tighter financial conditions will emerge”

George then added that,

“right now, inflation is too high and we will need to make a series of rate adjustments to bring that down,”

she said.

“We do see financial conditions beginning to tighten so I think that’s something we’ll have to watch carefully. It’s hard to know how much will be needed.”

There’s an interesting argument that inflation affects everyone while unemployment only impacts a small percentage. As a result, if it takes a recession to bring inflation down then so be it as that will be for the greater good. One can see that unemployment is not the primary concern of the Fed anymore.

US Initial Jobless Claims (NSA '000) US Continuing Jobless Claims

And if a Fed is ok with inducing a recession, then it looks like the stock market is in for more pain if history is any guide.Click To Tweet

Exhibit 4_ S&P 500 has contracted 24% from peak to trough around the median recession since WWII 1948 -2020

Collateralized Loan Obligations (CLOs) have been a very hot area for firms to access money. Much of the acquisition capital in the apartment industry over the last year has come from lenders who make loans to apartment owners and then package them up to be sold as securities to investors. There is no question that this capital has fueled an explosion in apartment acquisitions, as well as other non-real estate company purchases over the last year or two. This chart shows how annual CLO issuance in the U.S. has been really strong over the past couple of years.

Annual US CLO Issuance 2013 - 2022 May 19, 2022 The Daily Shot

And this one shows how apartment acquisition activity, particularly portfolio purchases which are overwhelmingly financed using CLO debt, has exploded over the past year or so.

Apartment Sales, Trailing 12-Month Total Witten Advisors and Real Capital 2002 - 2022

With the Fed on a very aggressive tightening path and wanting to inflict financial pain by making credit more costly and difficult to access, CLO spreads are widening. We are seeing this in the apartment industry as the cost of debt has gone way up and lenders are pulling back which is impacting pricing for apartment assets.

Palmer Square CLO AAA Spread (bps) July 2020 - April 2022

Another area of the economy that is impacted by higher rates is housing. Mortgage rates have gone up at a very rapid rate.

US 30yr Mortgage Rate Yearly Changes 1975 - 2020

Refinance activity has plummeted, which isn’t surprising given that most homeowners with mortgages have rates that are lower than what’s now available in the marketplace.

MBA Refinance Index NSA 2013 - 2022

Housing has become much less affordable given the very strong appreciation of home values and higher rates.

US Housing Affordability Index 1990 - 2020

Demand appears to be cooling off a bit.

Redfin Homebuyer Demand Index - 7% Year Over Year

Listings are starting to finally get to the point where they should be growing year over year.

US Weekly Active Home Listings % YoY

Shipping and transportation costs were the main culprits for Target and Wal-Mart’s earnings misses. Unfortunately, without significant demand destruction, it looks like gas and diesel costs will remain elevated as the following charts show.

US gasoline stocks Jun 2020 - June 2022

US crude oil stocks

US distillate stocks June 2020 - June 2022

US Big 4 Storage (Crude with SPR + Gasoline + Distillate + Jet Fuel) 2010 - 2022

Demand for energy remains strong.

Power Burn (in Bcf_d)

The United States is exporting a tremendous amount of refined product.

Net Product Imports 2011 - 2022

The combination of higher demand and more supply being exported has led to very high natural gas prices, along with oil, and gasoline.

PJM Western Hub day ahead LMP on-peak average 2018 - 2022

All of this is weighing on the outlook of manufacturers who clearly are expecting a slow down if the recent manufacturing outlook from the Philadelphia Fed is any indication.

Philadelphia Fed Manufacturing_ Outlook 2005 - 2022

Manufacturers expect that most of their unfilled orders will be taken care of in the coming months.

Philadelphia Fed Manufacturing Expected Unfilled Orders

Given the subdued future outlook, manufacturers are not very excited about spending money on capital expenditures.

Philadelphia Fed Manufacturing Expected CapEx 2005 - 2022

Bond investors are now sensing a slowing economy that the Fed is not inclined to stop. This has pushed inflation expectations down.

FRED 5-Year, 5-Year Forward Inflation Expectation Rate 2021 - 2022

The shift in inflation expectations has brought 10-year Treasury yields down as well.

Yield 2.799%

The Fed argued last year that inflation was transitory but had to admit that it was wrong as inflation only got worse and became more pervasive. And now it is on an aggressive path to tighten credit and raise short-term interest rates. It’s very possible that long-term bond investors are coming around to inflation actually being transitory now that the Fed is showing firm resolve to fight it. This is leading to company earnings on the path to being very off target which will most likely lead to cost-cutting, a less robust labor market, and consumers being more restrained in their spending at the same time that the cost of credit is going up for businesses and individuals. 

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