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FEMALE VOICE 1:  --podcast has been prepared exclusively for institutional wholesale professional clients and qualified investors only, as defined by local laws and regulations.  Please read other important information which can be found in the link at the end of the podcast episode.

MR. MICHAEL CEMBALEST:  Good afternoon, and welcome to the Labor Day "Eye on the Market" podcast.  I haven't recorded something in awhile, so welcome back to everybody who listens to this podcast, and I hope you had a nice end to your summer. 

So, there are three sections in the market this month.  A general discussion of what's going on in equity markets, inflation, and the federal reserve, what it would take for the energy bill's projected GHG reductions to actually occur, and why I think that matters so much, and then lastly a look at what all those new IRS agents might be doing, because that was another big part of the inflation reduction act. 

To get started, let's talk about what's going on in the markets.  Earlier in the summer I wrote that while there might be a hurricane coming for the U.S. economy, a lot of the damage had already been done in the equity markets, and in May and June we showed all sorts of these charts on how the average NASDAQ stock was down 45%; a third of them were down 70%.  How in prior recessions the equities bottom way before GDP and earnings, and by the time GDP and earnings are rising again, equities have already rallied a lot.  We looked at some measure of investor capitulation that were pretty compelling. 

So, I wasn't surprised to see a bounce from the June lows, and particularly since there was a lot of hedge funds that had some short positions they had to cover.  That said, I was a little surprised at the breadth of the rally, because we really don't know where the terminal funds rate is going, and all it took was a tiny little speech from Powell after Jackson Hole to kind of usher in another little mini correction here. 

So, here's where things stand right now.  The markets are pricing in a peak fed funds rate of around 3.9% by next April, followed by a decline to 2.9% by the end of 2024.  In other words, funds are at peaks next April and then gradually start declining.  I don't know about that.  Inflation that's linked to food and energy and auto parts and used cards and certain things, they're starting to roll over. 

The less-cyclical service and housing inflation numbers are still rising, and some of the business survey suggests that the wage pressures have peaked, but the actual wage growth numbers are still really high and unrelentingly rising.  Then payrolls and jobless claims have only weakened a small amount.  As a result, what you get is the equity markets trading almost lockstep with the tenure treasury less anticipated inflation, in other words, every time you get an increase in anticipated inflation, and in increase in the real rates, equity multiples go down, and then the reverse is true as well. 

There's a chart here showing this, and the reason it's so important is those wacky forward earnings multiples of 20 to 22 that we had from the beginning of COVID until a few months ago was taking place because real 10-year yields were negative.  So, as long as you believe that real interest rates are positive now and going to stay positive, I find it hard to justify an increase in PE multiples.

Bottom line is consumer price inflation may have seen its peak but it's still elevated.  Wage inflation hasn't rolled over.  The labor force participation rate has stalled which is adding to tight labor market conditions.  So, I still think there's a one-in-two chance that we have a recession next year.  That said, I think it's a mild one.  Consumer balance sheets are much stronger than they were across the developed world, not just in the U.S., compared to prior recessions. 

When we look at a bunch of models on leading indicators for how severe a recession we might have, it doesn't look anything like 2009, and it looks like a milder version of what we had in 2020.  That said, those leading indicators are suggesting a decline in earnings, and so given those weakening leading indicators and what looks like earnings declines, I think we're going to have a rollover in equity markets sometime this fall, closer to the June lows for anybody looking for a better entry point. 

We have a whole bunch of charts in here that walk through all of this, but the bottom line is we're coming out of a decade where across the developed world you had financial repression and short rates and long rates, particularly after you adjust for all the quantitative easing that were way below, abnormally below, the returns on financial assets.  That gap is now closing which creates less incentive for leverage, less incentive for risk taking, most incentive for a resetting of portfolios to less-risk assets, and I think that process is going to be something where you don't want to be too aggressive as that's taking place. 

So, bottom line is looks like a mild recession for the United States is in the cards.  Earnings will probably decline.  Look for a rollover in the equity markets sometime this fall.  Part of that's already happening.  Then let's just see how far those leading indicators go down.  Of course, the actual wage and consumer price inflation prints over the next few months are going to be really key drivers of just how high rates have to go.

There's a couple of pages of exhibits here.  Some of the exhibits that are worth looking at are exhibits on the collapse of new orders versus production, how inventories are extremely elevated, the leading indicator model that we use to look at what earnings are up to, that kind of thing. 

Then there's also a table in here, every time the fed has hiked rates since 1965 you've had a recession sometimes, and not other times.  When you haven't had a recession, the common factor or at least one of the common factors have been food and energy inflation in single digits of 4-5%.  So again, when you haven't had a recession after fed hikes it's happened in those times when food and energy inflation was very low.  That's not the case this time around, and that's why I think you've got a one in two chance for recession next year. 

Okay, so let's talk a little bit more about the energy bill and why it's so important to try to understand what's going on with it.  When there's a bill that affects taxes and spending, the CBO comes out with projections of what they think happens to the deficit, growth, inflation, things like that.  There's no government agency to make GHG or climate projections. 

When Manchin and Schumer were working on their energy bill they consulted with three outside energy modeling firms to ask them, hey, if we put these policies in place, what are the GHG reductions going to be.  I find in all the breathless support for the bill, and I think it's a good bill, I would have voted for it, but for all the articles talking about a 40-45% decline in GHG emissions resulting from this bill, there's not a single article I've seen to talk about the actual assumptions made to get there. 

I took a look at the detailed assumptions by one of those modeling teams.  These people are very smart, they're very well informed on energy transition dynamics, but the models they build assume perfectly optimal behavior by every business and every individual based on economic incentives. 

So, in other words, if it makes sense for somebody to buy an electric car economically, everyone will do it.  They ignore the frictional issues related to supply chains for battery and critical minerals.  There's limited acknowledgement of the actual interconnection delays of wind and solar power, and the difficulty in siding new transmission to support that wind and solar power. 

Notice that House Democrats, by the way, may already block passage of the infrastructure projects siding bill that Manchin was trying to get them to agree to in exchange for his support.

I looked at a long list of our assumptions versus this modeling group's assumptions, and there were some kind of remarkable differences in there.  They've got a pace of solar and wind additions that would represent the fastest pace of any kind of electricity generation capacity added in history, and by a wide margin.  They have a seven-times increase in the pace of solar installations, 100% EV penetration of sales in 2030 for passenger cars and light trucks. 

What's kind of more amazing is a 90% EV share assumed for medium-duty and heavy trucks, even though those don't exist today.  They've got a 30% expansion in the transmission grid over the next few years, even though over the last 10 years it's been closer to 5-10%.  Anyway, we walk through all the assumptions.  Some of the assumptions that we made are similar to theirs.  The reason this is so important is, forget about the GHG issue for a minute, if you accept their presumptions, right now natural gas represents about a third of all primary energy consumption in the United States.  Under their assumptions it drops to 20% in just eight years, and falls rapidly after 2030. 

So, if you believe those assumptions you would already be taking steps today to curtail the viability and profitability of the natural gas industry because you don't need it in the future, so you might as well start putting it in wind-down mode, similar to what's being done with coal and parts of nuclear.  Under our assumptions, the primary share for natural gas is only down a couple of percent in 2030, and so you would not take those steps to constrain the growth and viability of the natural gas industry.

So, even more than the GHG emissions, these policy assumptions of how these bills work is really important, because they drive decisions that are going to be made as it relates to a lot of things about which industries are supported and which aren't.  If you take a look at what's going on in Europe right now there's and abject lesson in if you get that wrong it's extremely expensive.  I'm sure you've seen this, but we have chart in here on what's happening with the energy prices in Europe and how Germany could actually run out of gas this winter depending upon what Russia does with supplies. 

Anyway, take a look.  I think it's important for all of us to be fluent as possible in the widgets of what drive these GHG assumptions so that we can identify Panglossian articles when they appear on energy.

The last topic for this month's "Eye on the Market" is the other component of the Inflation Reduction Act is $45 billion dedicated for tens of thousands of new IRS enforcement agents.  The CBO did score that part of the bill, and they assume a 4:1 return.  In other words, 45 billion invested in new agents and they're going to generated around 200 billion of additional revenues over a 10-year period.  Not so fast. 

Audit rates have come down over the last 10 years, but are still highly skewed towards people with incomes of a million or more.  So, let's assume that the audit rate for those earning more than--let's even it out at 400,000.  Let's assume that the audit rate goes back up to seven times what it is now and goes all the way back to what it was in 2010.  Based on some information from the general accounting office on how much additional revenue you raise from those kind of audits, that would raise about $8-10 billion a year in 2031, which is way below the $35-40 billion estimated by the CBO. 

This all sounds like boring IRS math until you think about the implications here, because Treasury Secretary Yellen and the IRS Commissioner are saying don't worry, we're only going to direct these new agents to focus on wealthier taxpayers, but if focusing on wealthier taxpayers only raises, let's say, 20-30% of the projected revenues they're going to have to look much more broadly at a broader group of taxpayers to raise the money that was assumed here by the CBO and the House Ways and Means Committee.

We have some data in here on audit rates by income and how much money you make by auditing people and things like that.  I think part of what's driving this initiative is that the Treasury has published a document suggesting hundreds of billions of dollars of a tax gap every year, which is the difference between what should be paid and what is actually paid.  I think a lot of those numbers are vastly overestimated and we walk through some of the computational issues as to why that estimate is way overstated. 

But look, that's how we're looking at it.  Other people look at it differently.  The bottom line is whatever the theoretical tax gap is, it looks like these new IRS agents are going to be focusing intently on a broader group of taxpayers involved with partnerships, sole proprietorships, and owners of commercial and residential property.  The clue there is there was a chart from the Treasury that they published this year that showed the percentage of income not reported, in other words, underreporting of income. 

For people and entities that are subject to information reporting and withholding, they assume almost a zero percent noncompliance rate, and even when there's no withholding and partial reporting, the noncompliance rate is 15%.  But where they're really going to be looking is they assume a 55% noncompliance rate for certain kinds of partnerships, proprietorships, and owners of commercial and residential rents and royalties and things like that.  So, that really is where it looks like they're going to be focusing here. 

We have a couple of pages explaining all of this, and then just to round things out, the IRS also believes that there's a very large degree of noncompliance and nonreporting by crypto holders.  There's been a whole bunch of new executive orders focused on that. 

There was a widely publicized on Twitter enforcement announcement of someone you will have heard of for tax evasion related to crypto that took place last week, and so that's what we think is going to come next.  A lot of comprehensive field exams of digital asset funds, principals, and investors, and some economic and other kinds of penalties that are going to be very well publicized to raise the bar for people that are noncompliant.  

If you didn't get a chance to see it, in July in the last "Eye on the Market" we had a great chart on Bitcoin according to Shakespeare, so if you haven't seen that, please take a look.  It's a chart with different Shakespeare quotes depending on what the price of bitcoin was actually doing. 

So, thank you very much for listening.  We are having a Zoom webcast of some kind with Henry Kissinger in September that a lot of you will receive invitations to, to talk about what's going on.  Henry's almost 100, so it'll be interesting to hear what he has to say.  Thank you for listening.  Bye.

FEMALE VOICE 1:  Michael Cembalest's "Eye on the Market" offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of JP Morgan Asset and Wealth Management.  Michael Cembalest is the Chairman of Market and Investment Strategy for JP Morgan Asset Management and is one of our most renowned and provocative speakers.  For more information, please subscribe to the "Eye on the Market" by contacting your JP Morgan representative.  If you'd like to hear more, please explore episodes on iTunes or on our website. 

This podcast is intended for informational purposes only and is a communication on behalf of JP Morgan Institutional Investments Incorporated.  Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation.  Outlooks and past performance are never guarantees of future results.  This is not investment research.  Please read other important information which can be found at https://privatebank.jpmorgan.com/gl/en/disclosures/legal-disclaimer.

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