VIPs

• Though Australia’s Supplier Deliveries are at record highs, they remain below the rest of the developed world; in the U.S., should there be strike threats at the ports of Long Beach and LA following the 90-day surge, regional delivery time expectations should remain elevated
• Production-related factors contributed just +0.11 to the Chicago Fed’s National Activity Indicator in August vs. +0.40 in July; though the Fed may be forced to accelerate tapering should the supply chain push up prices, tightening into a slowdown could prove devastating
• Despite low supplies, copper’s drop last week was the largest in four months, validating the fast-spreading industrial slowdown; meanwhile, bottlenecks continue to threaten earnings prospects, as only two of eleven S&P 500 sectors have seen EPS forecasts rise in October

There are two times in life when who you know makes nary a difference. Birth is the first of the two. In the case of John Batman, the firstborn child of William Batman on January 21, 1801 in New South Wales, the stain of his father’s being an ex-convict would forever haunt him. At the age of 15, John was apprenticing a local blacksmith, James Flavell. On November 4, 1816, Flavell and William Tripp, were sentenced to hanging for stealing clothes from a neighbor’s home. Set aside the irony of colonial Australia’s harshness on petty criminals; it was witness John Batman who testified to convict his employer, sending him to his death, an act emblematic of the son-of-a-convict stigma he endeavored to shed. There’s little doubt Batman left his mark on Australian commerce. On May 10, 1835, he chartered the Rebecca, a 30-ton sloop launched the year before, and sailed from Launceston, Tasmania to Port Phillip, where he landed May 29th. One week later, Batman entered a treaty with the aboriginals for use of their land to build a great city around a formidable port.

On September 18, 2016, a consortium backed by investors including China Investment Corporation, agreed to buy the Port of Melbourne, the country’s busiest, for $7.3 billion; the deal was packaged as a 50-year lease. This past May, Australian defense officials opened a review into whether a 99-year lease granted to Shandong Landbridge Group in 2015 to operate the smaller Darwin Port for $392 million posed a national security threat. Per the Wall Street Journal, “The port handles ammunition, equipment and fuel used by U.S. Marines and the Australian troops who train with them for up to six months of the year. It’s also the most suitable site in northern Australia for a major naval base and provides the country’s closest route to disputed South China Sea waters.” Did we mention the times are changing?

The globality of trade that’s induced the “bottleneck recession,” as it’s now called, has raised the study of port operations and efficiency to a new level. In the case of Melbourne, rising COVID-19 cases and striking workers have exacerbated the ongoing supply chain disruption. As you see in today’s left chart, though Australia’s delivery times are at record highs, they’re nowhere near as lengthy as those of the Euro Area, the U.K. and the United States.

Nowhere is the threat of a similar strike to the ongoing one across Australia’s ports more potentially damaging than at the U.S. West coast ports. On October 13th, Biden announced that Los Angeles and Long Beach ports will run a 24/7 “90-day sprint” while the biggest couriers and retailers will expand their hours to help alleviate congestion and presumably save the holidays. While his observation that “all of these goods won’t move by themselves” is sound, the concessions made by the International Longshore and Warehouse Union (ILWU) will likely carry a stiff price this coming summer.

According to the Journal of Commerce, the ILWU, whose “members (are) receiving the highest wages and benefits among U.S. unionized workers” and have instigated slowdowns during nearly every negotiation back to the 1990s, the lead time up to the July 1, 2022 expiration of the contract currently in place will entail more than demands for higher compensation. Per the Journal, “The union may go further, possibly seeking to roll back employers’ automation rights,” which has been expedited greatly since the pandemic hit and rightly considered an existential threat by the ILWU.

Expectations that supplier delivery times (orange line) six months out will be sustained at historic highs would intensify should headlines about the possibility of a strike proliferate after the 90-day sprint has crossed the finish line. The specter of persistently high inflation stemming from freight costs would continue crippling the industrial sector. A Bloomberg economics analysis found that if supply chain challenges force goods prices up by 5% in June 2022 compared to September 2021, the Fed would be forced to accelerate its pace of tightening.

The only catch is that the Fed cannot tighten into a slowing economy. This morning’s Chicago Fed National Activity Index (CFNAI) for September may flag an emerging industrial recession. In August, production-related indicators contributed +0.11 to the index, down from +0.40 in July which clearly pressured the headline which fell +0.29 vs. +0.75. We will also wake to today’s IFO release for October, due out at 4 am EST. The expectations series is the most closely watched gauge of German business confidence and hit a five-month low in September.

Despite low supplies, perhaps copper’s slide by the most in four months last week validated the fast-spreading industrial slowdown. As headlines about rising COVID-19 cases in China hit, copper and the industrials metals complex continued to weaken in Asian trading overnight.

The ramifications of these severe bottlenecks directly effect profits’ prospects. According to Citi’s Lorraine Schmitt, a longtime friend of QI, only two of the 11 S&P 500 sectors have seen their earnings per share forecasts raised in October. In the meantime, the Levkovich Index, which we’ve known as the “Panic/Euphoria” index all our careers, rose last week and remains in euphoric territory even as the Cyclical Expectations Index fell. The one tentative flash of positivity was freight rates per 40-foot container between Shanghai and Los Angeles ticking down from September 16^th’s high of $12,424 to $10,898.

VIPs

• Since peaking in July 2020 at a 11.5 million SAAR, U.S. Light Vehicle Production has fallen to a 7.5 million pace, the worst since March 2020; meanwhile, October is set to mark a 6th consecutive month of falling Light Vehicle Sales, not seen since the height of the GFC
• At 0.96, the Inventories-to-Shipments Ratio for Autos is at its highest since May 2020, while the same ratio for Non-Autos has slipped from 2.4 in April to 2.0; the latest prints of the Empire State and Philly Fed Mfg. surveys confirm a rise in inventories and urge to stockpile
• Though Deloitte projects a 5% rise in holiday spending vs. 2020, the higher-income cohort plans to spend 15% more vs. 22% less by the lower-income cohort; absent a further stimulus injection, the threat of continued weakness remains due to demand being pulled forward

Tails don’t hold a candle to outliers, defined as observations that lie an abnormal distance from other values in a random sample. The key to identifying abnormality is defining normality, which involves the bell curve. In business school Statistics, outliers were living, breathing human beings – those engineering undergraduates from the Midwest who played rugby by day, partied all night, slept through their classes and could only be bothered with waking to take exams. Once the test results were announced, these outwardly seeming slouches inevitably ‘blew the curve’ and promptly fell back asleep to store energy for the long night of beer-bonging that awaited. While there was little in the way of controversy surrounding these irritants cum curve blowers, historical statisticians have long debated the deeper question of whether we’re living an outlier existence borne of no world wars since 1945. Statistically speaking, despite the uber-violent century that preceded World War II, peace would have to persist for another hundred years before our mutual existence could be classified as a historical outlier.

Conversely, weather, economic data and financial market valuations haven’t escaped outlier territory for years, which is oxymoronic. Be that as it may, Texas has frozen solid three times in the last decade tossing the notion of 100-year storms on its arse. Real yields on junk bonds out to the furthest tenor on the maturity spectrum are negative. And fiscal and monetary policy generated a flash recession that practically ended before it began inducing the biggest demand pull-forward in the history of U.S. consumption. Yesterday, QI’s Dr. Gates identified yet another outlier, illustrated in today’s charts.

To presage his finding, if you will, on October 12th, Cox Automotive Chief Economist Jonathan Smoke opined that, “It could be that October is the bottom for the sales pace, and we start to see gradual improvement – emphasis gradual – in inventory and new-vehicle sales to come.” Hurricane Ida alone should suffice in the “gradual” manifestation department. At the peril of demoting the supply chain disruption, which has undeniably harmed the U.S. auto sector more than any other within industrials, Light Vehicle Production (red line) peaked in July 2020 at an 11.5 million seasonally adjusted annualized (SAAR) rate; it has since slumped to a 7.5-million-unit pace, the lowest since March 2020’s smackdown month.

At the risk of blaspheming, there’s more to see here than a semiconductor shortage.

This is where the reality of outliers steps in. After peaking at an 18.3-million-unit SAAR this past April, the pace of sales has fallen to 12.2 million units (blue line). According to Cox’s estimates, October will mark a sixth consecutive month of declining sales, a 99.4th percentile event. We’ve only the precedents of March and April 2008 and February 2009, three months engulfed by the Great Financial Crisis (GFC).

You may recall the specter of permanent unemployment was a thing back then. We would argue that the same may be occurring right before our eyes today, obfuscated by the sound and fury of reopening and the vestiges of fiscal stimulus spending gone wild. As hinted, we will continue to work on the idea of accelerated automation rendering redundant unknown millions of U.S. jobs since COVID-19 washed ashore as companies fight to mitigate margin damage.

Broadening out, with a hat tip to Simplify’s Michael Green, the number of homes under construction is the highest since 1974. Today’s release of the latest episode of Down the Middle features a deep demographic dive with Zelman Associates’ co-founder Dennis McGill. His exhaustive work, based on years of research married to the most recent Census decennial data, has found that the National Association of Realtors’ estimate of a deficit of 6.8 million homes is too high by a factor of five.

To once again harken the Lacy Hunt rule of cycles, housing and autos lead economies in and out of recession. With more homes under construction than any time in nearly the past half-century, we may be staring down the double barrel of oversupply in both housing and autos at a time of waning demand, to put it politely.

At 0.96, the Inventories-to-Shipment Ratio of Autos within the latest reads on manufacturing we’ve got on hand (yellow line) is the highest since May 2020, when the nation’s automakers were in a whittle-down Defcon 1 mode. That same ratio for non-auto durables (green line) has drifted down to 2.0 from April 2020’s recent high mark of 2.4-times. We add that inventories have been on the rise in the latest prints out of the Empire State and Philly Fed readings.

The urge to stockpile is palpable, and understandably so. “Just in time” is synonymous with “twice burned” in a post-trade-war and post-pandemic world. The risks of being caught off guard with too much inventory on hand have not, however, been diminished if demand destruction as payback for demand pull forward is what we’re witnessing.

Today’s flash Markit PMIs on U.S. manufacturing and services will provide more clues as to where we are in the cycle. We know from Deloitte’s latest survey that holiday spending is anticipated to be up 5% over 2020 this season. This average conceals the fact that higher income earners will do more than their fair share, upping what they shell out by 15%, while those in the lower-income cohort plan to spend 22% less. Absent a big stimulus injection, much of the demand going forward is in the rearview mirror.

VIPs

• The top four concerns in August & September’s BofA’s Global Fund Manager survey were Inflation, Tantrum, Bubble and COVID-19 – none of which got more than 25% of responses; clarity on risks emerged in October, with Inflation the clear winner at 48% and China at 23%
• At 31%, investors view inflation and the Fed as the primary drivers of 2022 asset markets; with China at a distant fifth place with 8% of responses, deflation is an underpriced risk reflected in the yuan’s appreciation to 6.3930, which defies the deflation narrative
• Per BofA, the net percent of investors expecting a steeper yield curve fell to 23% in October, the lowest since June 2019 and well below September’s 48%; though deflation is not the consensus view, opportunities exist should China tail risk probability grow in importance

Know any Rock and Roll Hall of Famers who are Nobel Prize in Literature winners? Bob Dylan is revered as one of the greatest songwriters of all time. One of his works spoke to us today. Recorded in October 1963, “The Times They Are a-Changin’” became an anthem for the era’s frustrated youth, a call to action to the anti-establishment that would earn the moniker of “hippies.” Of the song, Dylan wrote, “I wanted to write a big song, some kind of theme song, with short, concise verses that piled up on each other in a hypnotic way. This is definitely a song with purpose.” Fate being the wild card it is, less than a month after Dylan recorded the song, President Kennedy was assassinated. The night that followed that dark day, Dylan opened his set with the tune. He said that he had to sing it: “Something had just gone haywire in the country and they were applauding the song,” he recalled, and he couldn’t understand why, “it was just insane.”

The same cannot be said of the financial markets. Over the 18 months ended September 2021, the S&P 500 posted monthly gains in 14. The first two-thirds of October indicate the streak is set to extend to 15 of 19 months. It helps that investors have central banks at their backs. The Fed’s balance sheet expanded $3.2 trillion to almost $8.5 trillion from March 2020 to September 2021. A broader measure incorporating the European Central Bank, Bank of Japan, Bank of England, Swiss National Bank and the People’s Bank of China with the Fed rose $9.6 trillion to $33.0 trillion. That’s insane.

Either way, market narratives over the last year and a half have pivoted from Coronavirus topping the Wall of Worry in 2020 to this year in which Inflation and Bond Tantrum jockeying for the top spot. Observe the left chart. Number one Inflation and number two Tantrum both peaked in March and have faded through the summer months. Asset bubble, now number four, has been relatively constant, but a lesser concern. COVID-19 rose recently due to the Delta variant but stepped back in September.

Wavering conviction signals new narratives brewing. In August and September, the Bank of America (BofA) Global Fund Manager Survey revealed low conviction about the largest tail risks. Of the top four choices – Inflation (light blue line), Tantrum (green line), Bubble (purple line) and COVID-19 (orange line) – not one garnered at least a 25% share of fund manager responses. Fans of the game show Who Wants to Be a Millionaire would be familiar with this concept. When contestants use a lifeline to ask the audience and there’s no clear cut “winner” of the four choices, it’s like the masses answering, “I don’t know.”

Then October happened, and fund managers downed a tall swig of clarity.  At 48%, Inflation was a clear and decisive top tail risk. The other three – Tantrum (0%), Bubble (9%) and COVID-19 (3%, lowest since the pandemic hit) – faded. Not illustrated in the left chart was the second biggest tail risk — China, at 23%. To emphasize a point, both Inflation and China were well ahead of all the remaining choices the survey record 430 panelists had to choose from. Write this down: China is a Deflationary tail risk. Evergrande surfaced, and the pace of economic growth slowed. Investors are in a classic tug-of-war set up between Inflation in the right tail and, to a lesser extent, Deflation in the left tail.

As you see on the right, Inflation is also top-of-mind for fund managers as the biggest factor for asset markets next year. Trading the dominant Inflation narrative will dictate investor positioning. In that same vein, the Fed being tethered to Inflation is synonymous with the higher short rate volatility we flagged Tuesday.

Looking down the list, China was a distant fifth. Investors believe (1) deflation will not be a significant influence next year and (2) deflation is an underpriced risk right now. The Chinese yuan’s continued appreciation through yesterday’s close of 6.3930 does not back the deflation narrative. For perspective, a greater inflationary pressure would build should the Chinese currency break below the May 28th post-pandemic low of 6.3685.

The narratives they are a-changin.’ A critical mass of investors has put Inflation at center stage. They also see inflation prescribing financial market positioning into next year. With the Fed also a main driver, it reinforces the notion of a bear flattening in the yield curve, that is, with rising short rates doing more of the work. It’s no wonder that BofA also indicated that the net percent of investors now expecting a steeper yield curve collapsed to 23% in October, the lowest since June 2019, and well south of the 48% surveyed in September.

At the highest level, to lean on a term that’s held throughout today’s missive, broad positioning is insane. “We’ll let our friend David Rosenberg’s tweet from yesterday bottom-line it “Cognitive dissonance? BofA survey shows global PMs with weakest economic outlook since April 2020 and yet they have retained a huge net overweight in the equity market — and record underweight in bonds.”

Deflation risk expressed through the China narrative that would bull flatten the yield curve is not front and center. But since deflation is not a consensus-like view, it presents “lottery ticket” opportunities for those with capacity and nimble portfolios should China tail risk probability grow in importance.

VIPs

• The median price of a single-family new home rose to a record $390,900 in August, an unprecedented 26% jump from April 2020; as a result of affordability challenges, UMich’s consumer home buying conditions index has held at record levels of negativity since May
• Since 1993, the National Association of Home Builders’ sentiment index has had a 0.92 correlation with UMich home selling conditions vs. 0.08 with buying conditions; in the last 12 months, that correlation has flipped to -0.77 and 0.81 for selling and buying conditions
• Historically, the MBA’s average home purchase loan size has tracked with single family building permits; loan size appears to have stalled around $400,000, while single family permits fell back in September to July 2020 levels in the face of retracting demand

“I assume that Congress fully understands that the fur industry cannot, and would not if it could, pay this tax, wherever it is placed. If conditions improve enough to create a seller’s market, the tax will be passed on, with costs to the consumer, in the retail price. If conditions remain as they are, namely, getting worse by the day, the tax will come out of the farmer’s pocket.” – David C. Mills, Director of the American Raw Fur Institute (Revenue Act of 1932 hearings before the U.S. Senate Finance Committee). As defined, a “seller’s market” is a market in which goods are scarce, buyers have a limited range of choice and prices are high. As Mr. Mills argued to the Committee, the tax was aimed at the “well-to-do” but would fly “straight as an arrow at the poorest people in the country,” the fur farmer. And so it was.

Home builders are no fur farmers. They construct the largest financial commitment the average U.S. household makes. The median price of a single-family new home rose from a post-COVID 19 low of $310,100 in April 2020 to a record high $390,900 this past August. Historically speaking, the 26% advance over the 16-month stretch was an extreme; the sole precedents are episodes in 1973 and 2013. Even the outsized 14% gain in personal income, excluding transfer payments over the same period, didn’t match the home price spike.

This discrepancy highlights the specter of housing affordability. While not directly comparable to the new home market, the National Association of Realtors (NAR) Housing Affordability Index, which gauges homebuyers’ wherewithal to finance median-priced homes fell more than 17% in that same April 2020 to August 2021 span. Moreover, demand challenges presented by higher home prices drove the University of Michigan’s (UMich) consumer home buying conditions index to a net atrocious time to buy setting in May of this year. Most remarkably, it’s sustained this intense negativity for the six months through October (red line).

Usually, home builders don’t blink at variations in home buying conditions. Since the inception of the UMich home selling conditions index in November 1992, the correlation to the National Association of Home Builders (NAHB) home builder sentiment index has been a stout .92. Alternatively, the same calculation against home buying conditions was .08.

There’s nothing like a global pandemic to further snarl a supply chain that was already a mess thanks to that first Trump tweet that ignited a trade war, which so few can recall sent world trade into contraction for the full year 2019. The supply chain being turned upside down in 2021 has altered the dynamic on the homebuilding front. Not only did confidence hit an all-time high last November; in the subsequent 12 months through October, the historical correlation has flipped — buying conditions scored 0.81 (previously .08), and selling conditions nosedived to a -.77 (from that ‘stout’ +0.92).

Though buying conditions have mattered more than selling conditions of late, this hasn’t staunched home builders’ optimism. They are sellers. Sellers love to sell in a rising market, especially one where supply constraints are not easily rectified and are likely to persist — it makes for more profitable transactions even if you are selling fewer units…up to a point, which few homebuilding cowboys remember from past cycles.

NAHB Chairman Chuck Fowke characterized conditions as such: “Although demand and home sales remain strong, builders continue to grapple with ongoing supply chain disruptions and labor shortages that are delaying completion times and putting upward pressure on building material and home prices.” Read between the lines — home builders are passing higher costs along to buyers.

No doubt, the Fed’s keeping emergency settings for $40 billion per month in mortgage-backed securities of quantitative easing (QE) has overheated the housing market. Home prices are the smoking gun. Homebuilders’ perspective is, however, as such: falling joblessness equates to household creditworthiness becoming more worthy with every one-tenth decline in the official unemployment rate. It’s a classic right-tail problem of higher inflation, not a textbook left-tail problem of higher unemployment.

You know we’re incapable of presenting one side of the story. A fresh body of work we’re undertaking at QI is accelerated automation eradicating untold millions of U.S. jobs from the workforce. Topping that premise is an exhaustive analysis undertaken by QI guru Dennis McGill of Zelman Associates on demographics that runs the gamut from who we’ve lost in terms of would-be buyers to an epidemic of young deaths to the extraordinary, and growing, ranks of adults living with and multi-generationally bunking up with their parents, to the nearly 750,000 Americans whose lives have been taken by COVID-19.

With this as backdrop, the Mortgage Bankers Association (MBA) average home purchase loan size (light blue line) first breached the $400,000 threshold in 2021. While this series has consistently predicted single-family building permits (purple line) and the average home purchase loan size has leveled off, it’s yet to signal a down cycle. Getting to that point would require crimped demand, increased supply or some combination thereof (welcome to where we are today).

Join the masses — assign the pull-back in September single family permits to a July 2020 low to idiosyncratic and unforgiving Hurricane Ida. You’d be joined by builders, especially of the publicly traded nature, who won’t retract their shovels despite macroeconomic headwinds, even in the face of supply chain and labor challenges.