Are Stocks Approaching a Correction? With Neil Dutta

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2:11Our stock's setting up for correction. Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Neil Dutta, head of economic research at Renaissance Macro Research. Hi, Neil. Welcome. Hi, Maggie. Thanks for having me on. Thanks for being with us and kicking off the week with us. And we had a sort of interesting dynamic here in the U.S. today. Stocks started off this week with a pretty nice-looking rally, and it seems to sort of gain strength as we headed into the close here. So everything's settling, but it looks like the Dow up over a percent. The S &P 500 now with gains of almost 1 % and the Nasdaq a little over half a percent.

2:46And at the same time, you had sort of treasury yields creeping up a little bit as I think everyone's looking ahead to the inflation data, which I know we all think is going to be very important. We had Federal Reserve Governor Michelle Bauman warning she thinks more rate increases will be needed to tame inflation. So the Fed's staying on that hawkish footing, at least verbally. You know, when you look across this, what do you see happening with the U.S. economy? Well, I think the economy continues to sort of defy all expectations. And I think that's really the main story here. There's just a lot of underlying momentum in the economy.

3:27I mean, S &P Global, this is the same institution that sort of puts out these monthly PMI data points that everyone sort of follows. But they reported that, you know, over the last three months, ending in June, real GDP in the U.S., and they run a monthly measure, that's up over 5 % at an annual rate. And over the last year, real GDP is up about 3%. This is June of this year to June of last year. So the economy is growing above potential. And I think what's important to note is that despite an aggressive rate tightening campaign that started back in March of 2022, All the Fed has to show for it is an unemployment rate that's unchanged at three and a half percent, stocks basically pressing up to fresh highs, the economy growing above trend, and more recently, both the housing market and auto markets re-accelerating.

4:26So for someone that came out and said some pain is going to be required to quell inflation, the simple fact is that we haven't had much pain. And I think the consensus is still going to be, is still flat-footed. And we're going to see continued upward revisions to GDP growth expectations between now and the end of the year. Yeah, when you say that the consensus has been flat-footed, it's been a tough one, hasn't it? because everyone's been sort of saying, well, there is a recession coming, but pushing it out. You know, there was there was sort of more stimulus that countered that Fed action, but it's coming.

5:06I mean, is a recession coming? Is it just the timeline gets putting getting pushed out or is this economy not anywhere near recession? I mean, I think, look, I mean, to me, we will have a recession. That's not really particularly useful information. The question is when. And, you know, frankly, I think there's a statute of limitations in how long people can keep up this charade of, oh, it's just six months away. I mean, to me, it's sort of ridiculous. And if you're an investor, it's better than it's not any better. It's useless information, frankly. You know, so in my view, I mean, look, I don't think by any traditional framework is the U.S.

5:41economy and recession. The time to have been worried about it, frankly, was this time last year when you had a huge food and energy shock because of the invasion of Ukraine. You had fiscal tightening. You had the housing market detonating. You had a very, very aggressive rate tightening campaign. I mean, the Fed was going 75 basis points a meeting, leaking those meetings to the journal before they were ending up doing it. So looking now, think about each of these things in turn. We have a fiscal tailwind now, right? I mean, that's the name of the game. The government's spending money on infrastructure, on decarbonizing the economy, on building semi-helping build semiconductor facilities.

6:18that's going to continue. State and local governments are stepping up to the blade. They're continuing to add jobs at a pretty rapid clip. The housing market, I mean, home builders have been doing reasonably well this year, Maggie, and that's one of the reasons why is because new home sales are up about 25 percent against last year. So the housing market is actually working in the economy's favor. And food and energy, that shock is dissipating. I mean, food and energy prices have generally been coming down, the latest movements in commodity markets notwithstanding. So as I say, I mean, and the Fed is stepping back.

6:57I mean, they're not, you know, maybe they'll go once more this year, but they're much closer to the end of something than the start of something. And so I think when you think about each of these things in turn, in my view, the risk of recession has receded dramatically. So if we look at the earnings backdrop, for instance, it's been pretty positive for stocks. Does it seem like, based on what you're just describing, those conditions are in place for this to continue? Or does it feel overextended at this point? Well, I'm not a market strategist, although I will sort of try to tie the economics call into the markets.

7:36When you think about equities, it's really three things, right? It's actual and expected earnings, it's interest rates, and it's the risk premium. And I think what you can say is that actual unexpected earnings expectations have generally been doing well. But the issue, I think, going forward is that interest rates will probably remain elevated, and that may take some of the pressure, may take some of the upward momentum out of equities, I think. Yeah, it's that conditions part that I wanted you to speak to, because I know you're not You're not going to put a number on a level. But because the economy has been strong, it looks like the corporations have been benefiting for that.

8:18So maybe let me reframe the question. What kind of health are companies in? What is their? Because it's the double, right? We've got the consumer, which based on what you're just talking about and that fiscal stimulus coming through in the jobs market sounds pretty strong. What about the corporate side of things? Well, I mean, we still remain in a very strong nominal growth environment, Maggie. I mean, we're talking about 6 % nominal growth. That's fundamentally a situation where most companies that trade on the major indices can make money. So I think the issue is the primary reason why stocks are up this year is because the consensus went into the year thinking we were going to have a recession and we didn't have one.

9:00So, and we're not going to have one this year. So that's what the stock market has been responding to, that pricing out of recession risk. Now, if you think about economic and market scenarios, I think you can sort of think it's sort of four, think about it as four factors, right? You can have a soft landing, you can have a hard landing, you can have an inflationary boom, or you can have a deflationary or sort of a, you know, a recession, right? I mean, so I think the way to think about this is, or stagflation rather, the way to think about this, we know for sure that recession risks have come down quite a bit.

9:37What I think the markets have done is kind of put a lot of the weight now towards the soft landing view. That's not the only thing that you should be increasing your probabilities of. I think the odds are higher also of a return of the inflationary boom scenario, where the economy is still growing and inflation remains sticky. And that is somewhat more challenging, I think, for stocks. It's unambiguously bad for bonds, but obviously a soft landing would be great for stocks, an inflationary boom less so. And I think the markets are kind of wrestling with that right now. Yeah, I think you're right.

10:12And my colleague, Andreas, just put out, he's been thinking about this as well, and that influence of inflation. And he just put out his latest installment of some research he does. And he's looking at some signals that have him a little bit concerned. Let's have a listen to that, and then we'll talk on the other side. So ultimately, what I'm trying to say here is that on the income side, taxes are declining. Corporate profits do not look to be on an increasing path here either. So wages need to solve the equation, so to speak, for the gross domestic income. So without a clear pickup in wages, say, over the next two, three quarters, then we will likely see a decline in the gross domestic income overall.

10:55and that leads me to say that it's too early to take that recession zero off the table and you can see that full uh installment of steno signals on our platform on the website and if you're not a member just scan the qr code and jump on a trial we have some great specials on at the moment um so neil we did get that jobs number on friday i feel like there was a lot going on on friday and so it didn't come in overly hot so people were like okay you know and kind of moved off. But Andrea's really, I think, thinking about that wage part of it. And we always think about that with inflation, because even if wages are, the labor market's really tight, if inflation's running more than that and you can't compensate, then it kind of changes the scenario.

11:39I know you did a research piece and a dive into the labor market. What are we looking at there and what is the outlook for wages? Can they keep up with inflation, especially if we see inflation swing up again? Well, right now, the main story is that real incomes are accelerating. And that's primarily because wages are solid and headline inflation is coming down, whether that's because of shelter, whether that's because of used cars, maybe to a lesser extent, food prices, grocery store prices. But real incomes are picking up and that's supporting consumer spending. um so that's the issue right now specifically with the uh with the labor market data that was released last week you know what stood out to me was the fact that goods producing or cyclical industry so this is like mining logging construction manufacturing if you look at wage growth in those industries over the last three months it's up over six and a half percent at an annual rate that is a very rapid pace of growth for average hourly earnings.

12:45And these are cyclical industries. What do we know about these cyclical industries? We were just in a freight recession. So if you had a freight recession and goods producing industries are still generating 6.5 % wage growth, what's going to happen on the other end of this? I mean, we already have started to see rail car loadings bottoming out. There's probably going to be some positive impulse to the economy from inventories. I think the primary risk that people need to be positioning for is the risk that the Fed declares victory too soon. That, in my mind, is the main risk. The Fed's patting itself on the back.

13:21We solved inflation just as it begins to turn up again. The reality is the economy is growing above trend. That means that actual resources are being taken out. And last I checked, as that happens, consumers and companies bid up wages and prices. I mean, that's how it goes. So, you know, unless you think that there's some kind of productivity miracle out there, it's really hard to see the inflation issue being resolved. Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

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14:59So it's interesting because we started to see in the market last week, bonds, we started to see yields rise as more and more people were talking about, well, I think inflation is going to swing back. Maybe there's no landing. There was this conversation about that. And then you saw it kind of roll over at the end of the week. So do you think the bond market's positioned for the idea that the Fed is going to declare victory too early? I mean, if that's the case, are bond yields vulnerable here? or the bond market vulnerable? I think it is. I think the long end is vulnerable for sure. And the reason I do is because if the Fed's going to take a step back, then the markets will do the tightening for them, right?

15:42And I think that's part of what's going on here. And, you know, look, I mean, I think the bigger story here is that the Fed seems to be anchoring to very much a post-financial crisis model of the world. And I'm not so sure that's the right thing to do. I mean, as an example, they continue to believe that neutral or longer run interest rates are two and a half percent. That's what they think is sort of the break even for the economy. They've been having that estimate in their summary of economic projections for years now. But why should that be the case? You know, if you think about the period following the financial crisis, you had a lot of people saving up for retirement.

16:21You had fiscal austerity. You had, you know, years of widening income inequality. And if you think about each of these things now, a lot of those people that were saving for retirement have since retired, and now they're dis-saving. That stimulates consumer spending. We've seen some de-globalizing of the economy. That's reducing income inequality within developed economies, and that's supporting consumption at the lower end. Remember that real wage growth for the lower income consumer has been very robust throughout the pandemic, or, you know, since 2021. And fiscal austerity, I mean, there's no such thing, right?

17:03I mean, we're decarbonizing the economy, semiconductors, infrastructure. The fact that they're drawing down all our munitions in the Ukraine, the effort to defend Ukraine, that's going to lead to more defense spending at some point. Think of that as another infrastructure package. So why should neutral interest rates be 2.5 %? My guess is that if there's a risk there, it's that it's substantially higher. And that means that however restrictive the Fed thinks it is, it's not as restrictive as they think, which means their policy needs to be policy rate needs to be higher to compensate. So I think that's really the main issue.

17:41And, you know, you saw today with an interesting piece interview with New York President John Williams in The New York Times, basically acting as if nothing's really changed. And that to me is a big risk because I think things have changed. And my sense is that neutral is higher than the Fed thinks, which means they're not as restrictive as they believe. Well, that is a massive change in psychology, if that's the case. I mean, we have been in this low interest rate environment for so long. And whatever the reason, the idea that the natural rate of unemployment, or not natural, but the new neutral rate of unemployment would be much higher, that doesn't seem to be – that has huge implications, doesn't it?

18:21Well, I mean, I'm talking about the neutral rate of interest, yes. But, yeah, the neutral rate of interest being higher means that the Fed has to keep rates higher in order to restrict growth in the economy. So, I mean, I guess that's the other thing, right? I mean, the Fed continues to talk about how financial conditions are restrictive. I mean, they almost say it like as if it's like a given. I mean, just because rates are where they are, financial conditions are restrictive. That's not how it, to me, that's not really how it works. I mean, how restrictive can things be when the Fed staff went from pricing, went from telling you there was going to be a recession in the outlook?

18:56Now they no longer believe that. So how restrictive is that? Really, how restrictive can things be if the unemployment rate is no different now than it was a year ago? How restrictive can things be with the stock market at 45, 4 ,600? I mean, to me, the proof of the pudding is in the eating. To me, there's no real sign that things are restrictive. Why would you think that they're ready to pivot, though? I mean, as you say, they say they're data dependent. They make an effort of trying to sound like they're hawkish. Jay Powell went to great pains to paint himself as the next Paul Volcker, you know, who vanquished inflation.

19:33He starts off every meeting saying inflation hurts, you know, members of the society that can least afford it. It's their job. Priceability is their mission, is one of their dual mandates. Why would they stop hiking? Why would they quit too soon? well i think the fed continues to put a lot of currency intellectual currency behind this long and variable lag i mean so this idea that they've done a lot already therefore any day now it's going to show up but again in my mind the long and variable lag argument actually works in a way that they are not thinking which is they should be continuing to keep their feet on the brakes as a result.

20:13Because if it's been nearly 18 months already, wouldn't you expect to see the most credit sensitive areas of the economy being the ones that slow down? In fact, that's not what's happening. What's happening right now is that the goods producing side of the economy is speeding up, housing and home prices are speeding up, and auto sales are speeding up. That's exactly the opposite of what you think would happen. So to me, long and variable lags, you know, frankly, as a concept might be outliving its usefulness. But the broader story is that it's not really working the way you would think. And in my, I mean, I think there's a couple of things going on here, but I do think one is just that if there are long and variable lags of monetary policy, there are long and variable lags with fiscal policy as well.

20:56And let's just be, I mean, the government did a lot of things during the pandemic, right? I mean, checks, top up the unemployment insurance, state and local government money, all sorts of paycheck protection program, all sorts of things. And in some cases, some of that money is still being spent. And so perhaps there are long and variable lags with fiscal policy as well. And that's blunting a lot of the effects of monetary policy. Yeah, that's the tricky thing, isn't it? Because as unprecedented, the Fed's trying to exit an unprecedented period where they pulled out all these new measures and they really weren't sure how to get out of them in the wake of the financial crisis.

21:39But right now, because of the pandemic, we're coming out of unprecedented fiscal measures, the amount of money that was thrown at that problem. And it doesn't seem like anybody really understands these lags. So how on earth can the Fed navigate that and try to figure out the best case scenario, they want them to offset each other in a gradual, gentle way, right? Yeah, but again, I mean, to me, it's, I mean, part of it just starts with observing the data, right? I mean, if, so if you, I mean, these are interest rate sensitive sectors that are the ones that are doing the best so far this year. What does that tell you about long?

22:16And I mean, part of this is that they communicate so often with the markets that these, these, I mean, monetary policy works through expectations management, right? I mean, that's, and that's how it works in my view, right? So that's why the effects, I think, are a lot shorter than people think. And you see it now. I mean, for a company, they had been preparing for a recession since the spring of 2022. Okay? It never came. So now a lot of these companies are probably throwing their hands up in the air and thinking, well, I mean, there's no time like the present. I might as well go about that project I was planning on doing because this recession hasn't happened.

22:53and so you know to me one of the ways you get recession is through some kind of element of surprise right companies think things will be okay and then they're not okay and that forces some kind of clearing out of inventory your capex plans your hiring plan but what if companies have been planning for that for eight months and it never happened now the risks build in the other direction where they have to play catch up and and that could become a very problematic thing for the fed in fact i think that's what is happening because if you look at measures of business confidence, they're going up. If you look at how people are thinking about the risk of recession, it's going down.

23:28What do you think is going to happen with precautionary savings rate if people are less concerned about recession? Presumably, they'd go down, which means consumer spending presumably will go up. So again, I mean, the consensus thinks that GDP is going to be like maybe less than 1 % in Q3, potentially negative in Q4. There is just zero evidence that that's going to happen. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

24:04So it seems to me that if the Fed's watching this all, what better place to try to reset expectations than Jackson Hole, right? Yeah, I mean, you would think so. I mean, the Jackson Hole, I mean, that's sort of, sometimes it's very significant, sometimes it's not. Yeah, exactly. Sometimes it's kind of back and forth. I mean, what I would say is that in his latest public commentary, I would just say that, you know, it sounded to me like Powell was more dovish at his last press conference. And the way I'm thinking about that is just sort of trying to gauge their reaction function. What's clear to me is that a downside inflation surprise will push the Fed away from hiking more than an upside employment surprise will push them towards hiking.

24:53So there's a bit of an asymmetry there. I mean, they're data dependent, but they care a lot more about the inflation numbers right now than anything else. So that's going to make this week's data very important then. Well, yeah, I mean, but it's also important to remember that there's a lot of disinflation in the pipeline right now, at least through the fall, right, because you have used car prices coming down, you have shelter inflation coming down. um so there's a lot of reason to think that inflation will will be weaker for the next few months um the issue is how sustainable is that in an environment where the unemployment rate is so low and wages are growing we're there because ultimately all that means is that you're just shifting things around maybe people spend less on used cars but then they have more money to go spend somewhere else and over time that drives up the prices for those those other goods and services.

25:41So I think that's kind of the thing that the Fed needs to be cognizant of is that, you know, really, it comes down to something a lot more basic, I think, for the Fed is that they started off this tightening campaign by basically viewing inflation through the prism of the labor markets. And now they seem to be stepping a little bit away from that, which may be one reason why the markets are so happy. But, you know, ultimately, I think you either believe the labor markets are a conduit for inflationary pressure or not. And I think at some level, labor markets matter. I mean, whether it's the Teamsters making a deal with UPS or UAW making a deal with the auto manufacturers.

26:24I mean, the reason these companies are agreeing to these deals with the unions is probably because they think they can push those prices onto their end consumer. Absolutely. I was just thinking about that when you were talking before about the small revival. I mean, to be clear, unionization is nothing like it was at its peak in this country. But you have seen these contracts coming back and you have seen areas unionized that were not unionized before. And I'm sure the companies think they can pass it along. They're also afraid of not having workers because we have labor shortages in some areas.

26:58It's a completely dynamic, Maggie. I mean, if you think about what we had in the 2010s was basically structural, you could say structural labor surpluses. Companies can get workers whenever they want them. We don't have that now. It's a completely new dynamic in the careers for most of us. And so that is something that we have to contend with. And ultimately, I think it's more inflationary than not. G. Blackburn asking a really good question. Isn't AI the productivity and inflation miracle? How are you thinking about that? You know, Robert Solo once talked about how productivity is everywhere except for in the economic data.