The Federal Reserve Recession: Tax Data Flashes Huge Red Flag; What It Means For S&P 500

The S&P 500 has rallied on hope that the Federal Reserve will pivot in time for the US economy to avoid recession. But new tax data suggests recession may already be here.

The Federal Reserve Recession: Tax Data Flashes Huge Red Flag; What It Means For S&P 500

Federal Reserve has slammed on the brakes in order to curb inflation. A further 75 basis-point rate increase is expected tomorrow, even though the U.S. economic system is struggling. It now appears highly likely that the Fed will cause a recession.

The debate is largely focused on when a recession will begin, whether it's this year or in 2023. The most recent indicators are increasingly pointing to a possible recession, if it hasn't already begun. Daily Treasury Statements through Monday reveal that the growth in federal income and employment tax withheld from employee paychecks has suddenly cooled since May.

Even a shallow recession can cost more than a million jobs. However, a relapse in growth near term may not be as bad. This would ease the worst inflation in decades and allow Fed rate increases to end sooner. This could prevent a worsening recession, which would slash corporate profits and cause a sharper drop in the S&P 500.

Regardless of the economic situation, inflation worries will not subside unless the Fed increases its pain. Unemployment is going to increase. This could happen abruptly or continue into 2024, as projected by the Fed in its low-probability projections. Stock market investors need to be realistic when it comes to the prospects of a sustained near-term rally.

Irene Tunkel, BCA Research's chief equity strategist, told clients of the firm in a webinar on Monday that as long as inflation is a concern for policymakers, they are unlikely to grant an exemption from stock market volatility.

She said, "Someone must pay the price." The Fed wants to reduce the "regressive taxes" that inflation imposes on lower-income households by cooling demand through a reverse wealth impact, which will shift the burden to those who are wealthy and have money in the stock market.

Recent economic data is awash with red flags. Initial claims for unemployment rose to 251,000 during the week ending July 16. While historically low claims have increased by about 50% since March's lows. Liz Ann Sonders, chief investment strategist at Charles Schwab, says that some previous recessions began after a mere 20% increase in claims.

Housing starts also fell 14% in the last two months due to a rise in mortgage rates. Consumer spending, adjusted for inflation, fell by 0.4% in may. This is more than canceling out a 0.3% increase in April. In June, the Institute for Supply Management manufacturing survey revealed that new orders had suddenly turned negative.

Many economists have increased the chances of a recession. If the job and income growth is still strong, then it's unlikely that the economy will falter quickly.

A closer look at the situation is necessary. Remember that the Labor Department’s household survey revealed that the number of employed people fell by 315,000 during June. The survey shows that 347,000 people are working less than they did in March.

Economists tend to take household readings that are discordant with a grain or two of salt because the sample size is smaller, and the margin of error is greater than in the employer survey. Sonders writes that the "household survey leads (employers) payrolls at economic inflections."

It could be that time. IBD's analysis of Treasury flows shows that the growth of federal income taxes and employment tax withheld by workers has been declining sharply. The growth in tax receipts for the 10 weeks ending July 22 was just 7.6% compared to a year earlier. This is down from about 14% through mid-May.

Tax data suggest that aggregate labor income - reflecting increases in wages, hiring, and incentive pay throughout the economy - has reached an inflection. Real terms, labor income has shrunk.

Matt Trivisonno tracks tax withholdings of investors on in order to identify such inflections. He told IBD he is also seeing a "nasty reversal," which contradicts the supposedly robust job market.

Trivisonno stated that he "expects the 372,000 new jobs created in June to be revised in the future."

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What about all these job openings? Jerome Powell, Fed chief in May, said: "I don't recall a time where we had two jobs for every unemployed individual."

Since then, job listings have fallen by 600,000. That's a 5% drop. The picture has changed only marginally. According to the latest Labor Department figures, there are 11.3 million job openings and 5.9 million unemployed.

Fed officials want to cool down the economy to dampen wage increases and reduce job openings, but without creating significant layoffs.

A new paper by the Peterson Institute for International Economics, co-authored with former Treasury Secretary Larry Summers, paints these job openings in an entirely different light. The number of job openings is only a part of the economic activity. The high rate of job-switching has also played a part. The paper also argues that the economy is less efficient at matching workers with jobs. If this is true, then the labor market could be even tighter that the 3.6% rate of unemployment, which is near a 50-year low.

This finding leads to two undesirable conclusions: the natural rate of unemployment, or noninflationary rate, may be higher than what the Federal Reserve believes. The ratio of unemployed workers to job openings will likely not fall "without a substantial rise in unemployment."

Some Wall Streeters still believe that Powell & Co., despite all the Federal Reserve talk about recession and policymakers' aggressive efforts to slay the inflation, can achieve a soft landing.

Oil and other commodities have already dropped sharply. This could transform modest drops in real spending to modest gains. The Fed could pause or slow rate increases later this year if inflation falls enough and if the job market is weak enough. Stock market gains have been sparked by expectations of a Fed shift.

Even in the event of a soft landing, the outlook for the stock markets near-term may not be very bullish.

Solita Marcelli is the chief investment officer Americas for UBS Global Wealth Management. She wrote: "In our base-case scenario, we believe stocks will remain largely range bound with increased volatility as investors assess whether economic and corporate profits growth can be sustained in the face aggressive Fed rate increases and declining real consumer earnings." Equity bear markets usually end when either the Fed begins to reduce interest rates, or the market anticipates a return to business growth and increased corporate profits. These two potential catalysts for an upside are unlikely to occur in the near-term.

What will it mean for the pricing power of corporations and their profits if inflation and the job market soften to a point where Fed rate hikes are stopped early? Morgan Stanley's Chief Investment Officer Mike Wilson believes that the S&P will fall to 3,400 in a scenario of a soft landing. He believes that the inflation rate will fall much more than anticipated due to a lackluster economy. This suggests that earnings will be downgraded by a lot.

"Profits were inflated because of inflation." "Now they will deflate because we are going to see deflation in many different areas," he said to CNBC on 12 July.

Wilson believes that the argument that S&P profits will remain stable implies that "inflation will stay hot and pricing strength is going to be robust." Wilson believes that this is unlikely in an environment "where we're already witnessing demand destruction and consumer trust is tanking."

BCA's Tunkel said analysts have not yet reduced their estimates of S&P 500 earnings rising about 10% in the next year. According to her, stocks may fall by another 10% if the EPS growth rate is reduced to zero.

Desh Peramunetilleke, a Jefferies strategist, wrote in this month that "earnings may be the next casualty." He pointed out that EPS fell an average of 17% in the last 10 recessions.

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No coincidence, the S&P 500 reached a temporary low in mid-June just as the 10-year Treasury rate was surging close to 3.5% – a level not seen since 2011. The S&P 500's decline of 24.5% from peak to trough was largely due to investors discounting future earnings to the present using a higher rate (the yield on the 10-year Treasury).

S&P 500 losses have been reduced to 17.3% since its peak on Jan. 3. The major indexes regained their 50-day lines as we head into the Federal Reserve Meeting and a number of earnings reports.

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Stock valuations have improved a little as the yield on 10-year Treasury notes has been easing to below 3% in recent weeks, as investors prepare for a possible slowdown or worse. Treasury yields could remain at current levels in the event of a soft landing, which avoids recession or a major hit to employment. This means that there could be little additional relief in terms of valuation, despite a weaker earnings outlook.

Arend Kapteyn told reporters on a call held Tuesday that even a moderate economic recession could prompt the Federal Reserve's key interest rate to be cut to zero. This would "reverse the recent liquidity shock" and help reinflate stock prices, says Arend Kapteyn.

The key question is, what will it take for the Fed's policy to be tightened to stop and reverse?

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The Fed's last hike with both hands was in late 2018 -- through rate increases and shrinking the balance sheet. All it took was for the S&P 500 to drop 20% before the Fed reversed course. In fall 2019, the Fed cut rates and began buying bonds.

Robert Dent, Nomura's senior economist, told IBD that the market believes weak growth figures will get the Fed to ease up. But "inflation really has tied their hands."

Dent, along with Aichi Amiemiya of the Aichi Amiemiya Economics Group, made a call for a recession in Q4. They expect the "one-mandate Fed", which has effectively abandoned its mandate to maximize job creation so that it can combat inflation, to tighten financial terms until consumer and employment markets roll over.

Nomura's economists expect Fed rate increases at every meeting in the next five, including a 75 basis-point hike on Wednesday. The Nomura economists expect a 50 basis-point increase in September. This will be followed by quarter-point increases in November,December and February.

The inflation will determine when a pause occurs. Dent points out that Federal Reserve Governor. Christopher Waller (a hawkish economist) has stated that a rate cut could be implemented once inflation falls to 2.5%-3% on an annualized basis. This equates monthly inflation readings between 0.2% and 0.25 percent.

Dent believes that the Fed is going to continue its quantitative tightening and let bonds mature off of the balance sheet until October 2023, when policymakers will start cutting interest rates in order to avoid a worse recession.

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Finally, it's clear that the inflation rate has reached its peak and is on its way down. This is certainly a good reason for a stock market rally in the short term. There's no reason for assuming that a CPI peak necessarily indicates a bottom in the S&P.

The U.S. economic situation is like a tunnel with no light at the other end. The Chicago Fed and Goldman Sachs are among the many financial indexes that show the equity and bond market conditions as being only near neutral after years of easy cash.

This is partly due to the time delays before Fed policies impact the economy, and partly because, despite the Fed's fast-rising policy rate, it has not yet reached a level economists consider restrictive. The Fed has only recently begun to shrink its balance sheet. It's currently down by about 36 billion dollars, or 0.4%, of the total $8,9 trillion. In August, the pace of spending will increase to $95 billion per calendar month.

Goldman Sachs CEO David Solomon stated on the earnings call of July 18, "We are seeing inflation deeply embedded in the economy."

Gas prices are down from their peak, and the prices of goods have also fallen. However, inflation in non-energy services accelerated to its highest level in 30 years at 5.5%. This includes 57% of the consumer budget, which includes categories such as rent and medical care that are tied to wage growth.

The Fed may need more time to dampen the price pressures. If we are really on the verge of a Fed led recession, it may happen sooner than expected. The economy and the job market will be hit hard in either case. Investors in the stock market are not likely to be entirely spared.

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The Federal Reserve recession: Tax data flashes huge red flag; What it means for S&P 500 first appeared on Investor's Business Daily.