MAGGIE LAKE: Hi, everyone. Welcome to the Real Vision Daily Briefing. It's Wednesday, July 6th, 2022. I'm Maggie Lake and here with me today is Darius Dale, founder of 42Macro. Hi, Darius.
DARIUS DALE: Hey, what's up, Maggie? How are you?
MAGGIE LAKE: I'm doing okay. It was a really interesting session today. And I'm plugging back in for having been unplugged and away for a week. So, we see stocks advancing, bond yields moving higher, energy lower, and investors really sifting through it seems like the Fed minutes and some data coming in. And all I heard about all day long splashed all over the place was recession. So, let's start with those Fed minutes. Anything jump out at you as different or interesting that would have caused any market reaction?
DARIUS DALE: Yeah, two things in particular, although I'm not sure the market reaction today reflected those two things. But I'd say the number one thing that really caught my attention was just how concerned the Fed was about inflation relative to growth. There's 90 mentions of the word inflation in the Fed minutes, zero mention of the word recession. This goes back to something we've been talking about in the program in terms of the Fed only having a singular mandate or a dual mandate within the context of one of the sleeves, which is getting inflation back to target, and more importantly, restoring credibility of the institution after last year's botched transitory call.
And then secondarily, I'd say the one thing I think that was shocking to me is how open and honest they were at least in the discussion about the concept of a Fed put, and I'll read the quote specifically because I think it sums it up better than I could with my own words, which is, many participants judge that a significant risk now facing the committee was that elevated inflation could become entrenched if the public began to question the resolve of the committee to adjust the stance of policy is warranted.
Translation. You guys all think there's a Fed put, there is no Fed put, we need to get inflation back under control. And so, that, to me, those are the two most important takeaways from the Fed FOMC minutes.
MAGGIE LAKE: Yeah, great flag, Darius, because when you're listening to the Fed, it can seem very wonky, and no one heard-- you don't exactly not going to say, hey, you think we're going to come bail you out if we see a downturn, we're not, but that is what they were saying. And you've been really consistent saying, listen, I think people are underestimating their resolve. They think they're behind the curve. They think they're going to waver. They're not, this is a Fed who's singularly focused on inflation.
And we are certainly seeing that increasingly now and hearing that from them. But it's interesting that the economy, I still think there are people out there, maybe they don't think they care about asset markets and saving the stock market. But a lot of people are saying, hey, it's hard to think the Fed's going to continue to raise rates into a recession. Maybe we are already in one.
We did get some data out today. We had services ISM. It dipped to a two-year low, new orders down, unemployment component down, but it's still sitting at 55, which would suggest expansion. So, how should we be looking at some of this? Where are you in-- are we in a recession? How do we need to think about growth?
DARIUS DALE: No, we talked about this last week, it's very unlikely that we are in recession currently, although the probability for that outcome continues to rise, particularly when you look at on a next 12-month time horizon perspective. I think as we get into the summer months, at least, our model has been projecting all along all year, which is when the pace of deceleration really starts to pick up to the downside, that's when you will start to really see recession fears get incrementally priced into markets. I think Q2 earnings season could be a commencement of that process. But certainly, it's something we expect to last into the fall.
So, just on the ISM services datapoint, just from a levels perspective, much more healthy than what we saw out of ISM manufacturing, which is pretty much a report last Friday. But just in terms of the employment components to me, I think the employment component in both of these reports, ISM and employment lowest since August 20, ISM services and employment lowest since July 20. That's exactly where the Fed wants to see, the dissipation, the air being let out of the balloon that is the US economy.
The labor market itself, just in terms of like signaling recession, continues to run very, very hot, it continues to overheat. Brian, if you pull up a chart, I have a chart for you. The labor market is cooling rapidly and up rapidly enough. And that's the key takeaway. There's a couple of statistics I want you to focus on in that chart, which is the second cluster of bars, which is average hourly earnings at 5.6%. This is data through the May jobs report, we're going to get the June jobs report on Friday. So, this will be updated as of Friday.
But with the data that we have in hand, we have average hourly earnings accelerating on a three-month annualized basis up at 5.6%. That compares to a 2015 and 2019 trend of 2.8%. So, we're running at a double in terms of wage inflation relative to the pre-COVID trend. And then the last cluster bars, which is probably more relevant, when you think about identify where we are in the business cycle, which is aggregate income growth from the private sector, which is running at 8% on a three-month annualized basis, that's basically a double relative to where it was in the 2015 to 2019 trends.
So, the Fed is going to continue to take a chainsaw, weed whacker, or aluminum bat, whatever metaphor you want to use to this economy, because they're looking at lagging statistics like that, and like inflation, and that doing the forward-looking work that we investors are doing to understand where the economy is likely to end up let's call it six, nine, 12 months from now.
MAGGIE LAKE: Yeah, so Darius, the wage, we do talk about the labor market all the time, we have these wages, but if you're getting eaten away by inflation, will it fuel that demand that's going to make the economy run hot or is the Fed, again, not really just focused on the danger of the inflation, and not making that connection? Real earnings are not high enough to overcompensate for inflation and fuel runaway demand, or are they?
DARIUS DALE: No, they're not. So, you're looking at a disposable personal income basis, we're still tracking negative on both a year-over-year and three-month annualized basis for earnings with the trauma of moving average per chance and on something like disposable incomes down over 4% year-over-year. So, that's a pretty telling statistic in terms of the level of demand in the economy.
What I think is also incrementally telling, and we got this data last Thursday, it's a little bit lagged because the PCE data comes out on the full month lag, but the May PCE data confirm that the US economy has ground to a halt with respect to consumer spending. It was 0.2% on a three-month annualized basis for headline consumer spending, goods PCE, real goods consumption at minus 1.4% three-month annualized, and then you have real services consumption which is we're supposed to technically be in the middle of the services sector boom, is actually slowed from a growth rate of 4.7% on a year-over-year basis to 1% on a three-month annualized basis, so we know those numbers are going to have lower in the coming months.
So, this goes back to something we've been talking about for a while now going back to the Q1 of this year, which is, Brian, if you put up another chart I sent you, forward guidance accelerates the monetary policy transmission. And this is something I think-- I'm not sure that every investor really understands this. But what's very new about this tightening cycle, and yes, this time is different is the aggression with which the Fed is using its forward guidance function.
Forward guidance in and of itself is really something that's only been around for, let's call it the prior decade or so. And they're really stepping on that lever or pulling that lever in this particular tightening cycle. So, what this chart shows, in the upper panel, the blue line just shows the real 10Y Treasury yield, nominal Treasury yield deflated by the Cleveland Fed's 10-year forward inflation expectations index that gives you a long time series.
And what you can see, what those black dotted lines, those horizontal lines denote is anytime we see something that looks like a two-sigma shock on a trailing three-year basis and in this statistic, and there have been seven over the past since the 1980s, you get a significant slowdown in economic growth. I'm just showing using the main ISM manufacturing PMI as a as a proxy, but those things are highly correlated.
So, we're going to have a significant slowdown in economic growth. It is starting in the month of June, it's likely to materially accelerate to the downside as we get throughout Q3 and throughout Q4.
MAGGIE LAKE: So, why do we see stocks rallying today, especially tech stocks? That would seem counterintuitive to people, I think.
DARIUS DALE: Yeah. So, that's a fantastic question. So, we saw tech stocks rally today. We saw stocks reverse yesterday on this significant decline. This washout we're seeing in crude oil prices, which we can touch on why I think that's happening right now. But the consensus narrative is that, hey, the recession is really breaking down commodity prices. We've talked about this in our research for a while now. And we've seen industrial metals bearish from the perspective of volatility adjusted momentum signal.
Agriculture broke down to bearish recently as well, crude oil may very well be on its way to bearish [?] as well. And the consensus narrative out there is that, hey, the US economy is nearing recession, it's destroying energy demand, so the Fed is going to have to do less. We're seeing that reflected in money markets, if you think about Terminal Fed Funds Rate pricing, but more importantly, the pivot the Fed is likely to make on the other side of the Terminal Fed Funds Rate, and you're seeing a significant decline in Eurodollar rate expectations.
I think that's the wrong view. What's actually happening in our opinion in the commodities market is the China's zero COVID policy and Xi's renewed commitment to maintaining that view or to maintaining that policy regime, and ultimately, the proliferation of rising case counts again and testing in Shanghai. You're getting into Beijing, Omicron's now in western China. And so, the market is looking ahead and removing whatever the China reopening premium was across many physical commodity markets and just taking that premium to zero effectively, because ultimately, the market realizes that China is going to be doing fits and starts from an economic perspective for the foreseeable future.
MAGGIE LAKE: Yeah, that's a great point. And that's a huge issue that we're going to have to grapple with. And I think it's something that comes in and out of focus just because of everything else that's going on. But that is a major, that's another major setback for a big engine of growth for the global economy. I'm curious, we go back to stocks, Darius, you have a chart, earnings estimates remain out to lunch, can we pull that up?
There has been this strange phenomenon that people are sticking to their estimates, despite the fact that we are seeing expectations for slowing growth. And based on what you just said, like substantially slower growth as we head into the latter part of the year. Do these estimates need to come down? And what does that mean to start? Are they looking through something that we need to understand?
DARIUS DALE: Yeah, they need to, and they will come down, particularly as we get into the second half of this year. I think they'll start to come down in the second quarter, depending on what company based on whatever transpired in their P&L into Q2 is going to be forced to start issuing negative guidance. As most companies, most IR departments are not incentivized to snitch on themselves. So, we're going to see whatever company has that significant degradation that we're seeing on a three-month annualized basis, across most of those economic statistics, those companies will have to raise their hand and say, guidance is good, we got to cut down guidance.
Look at facts and estimates, we're talking about 10% year-over-year earnings growth throughout the back half of this year. We'd be lucky to grow at all in earnings. We could very easily have an earnings recession in the back half of this year if you factor in 42Macro's scope projections. But anyway, just getting back to this chart, the blue line just shows consensus next 12 months earnings per share estimates for the S&P 500. Obviously up into the right making new highs, have seen no degradation like [?] the S&P.
What the red line shows is the implied net profit margin estimate as if you look at consensus earnings divided by consensus sales, and what you're seeing is in and around recession, you're talking about at least a 20% to 25% reduction in forward profit margin estimates. 25% in the 2001 recession, which was by far the smallest recession in US history, only down 30 basis points peak to trough, you saw that decline 38% in expectations terms in the GFC and then minus 21% in the let's call it six-week recession we had in COVID.
We've seen no degradation in that red line off the cycle high. And so, in our opinion, just purely from a profit cycle perspective, it's very unlikely we've seen an earnings reset, or an actual outright recession priced in, let alone an earnings recession. I know the buy side is a lot lower than the sell side at this particular juncture on earnings, but there's no way in hell of the buy side is low enough if we go into an actual recession, because we have not seen a recession priced in the financial markets and we have a dozen indicators that are confirming that.
MAGGIE LAKE: So, that would suggest a lot more downside or significant downside risk to to equities and maybe risk assets.
DARIUS DALE: Yeah, absolutely. So, Brian, if you can pull up this one more chart, financial conditions remain uncomfortably loose. This is a chart I've shown on the program before. And what the chart shows is the blue line is the Goldman Sachs financial conditions index, we need to unpack that for those of you who just look it up. Those who don't know to look it up, please. The red line just shows the S&P 500's next 12 months earnings yield. So, taking that earnings number, that earnings estimate and dividing it by price.
And then the blue line just shows the average corporate credit yield spread. So, the average credit spread for the broader US credit market. And what you can see what those dotted lines denote are where we are today just relative to prior cycles. And the solid lines denote is where we were at the close of the 2000 and 2002 market cycle. And the reason I highlight that is because, again, that was the shallowest recession in US history, minus 30 basis point decline in peak to trough GDP.
And so, if you're thinking about that, that's being sort of, okay, if we go into the softest of soft landings ever, we still have a long way to go in terms of tightening financial conditions, in terms of getting the market to a cheap enough valuation and make it broadly supportive, to buy and ultimately for credit spread to blow out to make credit probably supportive to allocate to. So, just again, we have another set of indicators that we'll unveil to our subscribers at 42Mmacro on Friday, but just looking at this particular statistic, stock market, credit market, broader financial conditions, nowhere near pricing in an even soft landing, soft-ish landing.
MAGGIE LAKE: That's really concerning. And Tim from Long Island brings up this point from the RV site, would you agree that investors are not understanding how fast this market can drop given the environment, 6% to 10% drop in a matter of days or weeks? Love to get your thoughts if you agree on that. I'll just switch it a little bit and say, is the market still vulnerable to that really quick downside move or because there's so much talk about inflation, and maybe an awareness that these earnings estimates haven't caught up, will it feel like more of a grind lower?
DARIUS DALE: Yeah, the market is actually less vulnerable now to an expeditious decline than it had been in the most recent couple of months. And part of the reason for that is if you look at our volatility analysis, look at deviations and skew relative to the trend and deviations in the volatility risk premia, we've seen as a lot of risk assets, in particular US equities, go from what we call the regression probable quadrant, where you have a significantly depressed skew, significantly discounted implied volatility discount to something that's much more middling and tolerable from the perspective of immediate term risks.
So, we would disagree that the market is increasingly set up to have an expeditious decline. But that doesn't mean it's not going to go where it's going to go with the course of the cycle. If you look at our base case scenario, and this has been our base case scenario since March, our scribes will confirm that, which is 3200 to 3400 in the S&P. If you look at 3200, that's down roughly about let's call it 17% from here, 3400's down about another 12% from here.
And if you look at our fair value math in terms of the net liquidity analysis that we do, the actual fair value for the market by the end of the year is somewhere close to 2900. I don't think we're going to get to 2900 before the Fed pivots, ultimately, but I do believe down 12% to 17% over the course of the next couple of quarters is very reasonable for this [?].
MAGGIE LAKE: Yeah, that's really important for people to get their head around, and also tests against what their trading perspective is. And we'll talk about that because short term, there may be some opportunities or some way to think about this, but longer term, and if you need that money in a shorter-term point of view, you don't have anything to lose, that's going to really change your perspective to always got to plug in that time horizon.
But interestingly, Darius, that scenario, I think, is going to continue to put pressure on risk assets. And that is something that's going to have reverberations in the crypto markets as well. We know that the risk-off environment that we've seen, there's been a lot of pain in crypto because of that. Raoul just sat down with Sam Bankman-Fried, the head of FTX. Many of you may know him. If you don't, he's really emerged as a white knight these last few weeks providing capital to some firms who are really struggling