[Excerpt from The Pickett Line June 2022 Issue]
Well, this is what a US TL deflationary cycle trough feels like Ladies and Gentlemen. Only this time around, we also get the specter of a looming US economic recession to contend with at the same time. If the ride up wasn’t stomach-churning enough, the ride down is proving to be just as terrifying for many – of course all depending on what side of the market you’re on and how prepared you are. Though while there is plenty that remains uncertain regarding the road ahead, know that whatever it is won’t last forever. For in this market, what goes down must eventually go up. However, if the near-term recession outlook does indeed come to bear as the Fed continues to battle back historic inflation and we get enough demand destruction to materially slow industrial activity and dampen TL volume demand, that just means our deflationary leg may go a bit lower and last a bit longer than currently forecasted. Up to this point, we believe that this quarter’s rapid decline in Spot TL rates has been almost entirely supply-driven – the inevitable reckoning from over-expansion throughout the recent inflationary leg of the cycle. A severe drop in demand will only compound the downward pressure on TL spot market rates until enough surplus capacity is forced to exit the market and equilibrium is restored. So as we suggested last month, better make yourself comfortable because we’re gonna be down here for a while regardless.
So with that as our backdrop, let’s dive into this June 2022 installment of The Pickett Line to peer through the haze and try to get some data-driven conviction on exactly where the back half of the year will likely take us. That’s right, June marks the end of Q2 and the halfway point of yet another unusually eventful year in the US Trucking market. We would usually say something to the effect of ‘time flies when you’re having fun’ as it does seem like the first six months of 2022 have flown by, but I’m not sure how many of you would characterize recent market conditions as ‘fun’. That said, it is certainly a lot more fun and a lot less scary when you understand how and why we got here and have put your organization in a position to capitalize on the opportunities that a deflationary market presents. Now let’s take a look back at June and Q2 to see where we stand.
As we come down the Q2 home stretch, our revised US DAT Linehaul Spot Index now sits just slightly lower than last month’s -11.7% at -12.9% Y/Y ($2.09/mi) vs. our Q2 forecast of -10%. Looking back, we kicked off the quarter with a preliminary April read of -6.7% Y/Y, took a big leg down in May to close at -11.7% Y/Y, and have since only faded another 120 bps lower – so the rate of deceleration has slowed materially, at least for now. Though a huge part of the story this cycle continues to be skyrocketing diesel prices, triggered by Russia’s unprovoked invasion of Ukraine back in February. While linehaul TL rates are cratering, all-in National DAT Van rates in June currently sit dead even to a year ago at $2.68/mi. But to appreciate how challenging the current market environment is for Carriers fully exposed to the spot market, consider that diesel prices are up 74% over the same period. You may recall in last month’s note, we were just coming off CVSA International Roadcheck week and questioning whether we were likely to see any temporary inflation show up in our DAT TL Spot index. But that if we did, it would be just that – temporary. As May closed out and June kicked off, that is indeed what we observed – a minor sequential kick higher that resolved itself after a week despite rising diesel prices. As noted in the past, while expected seasonal market dislocations like Roadcheck, the annual harvest(s), or even major hurricanes may temporarily arrest the slide in US TL Spot rates, or even spike them higher for a short period of time, a more permanent floor won’t be found until enough surplus capacity is unfortunately forced to exit the market. And while the first casualties are virtually guaranteed to be those Carriers most exposed to the spot market (vs. Contract or Dedicated) with the least competitive cost structures, no Carrier will be immune to these market pressures. Really, any Carrier regardless of size that took on additional fixed costs over the last two years under the assumption that Spot and Contract rates would remain elevated in the years ahead could find themselves operating under some financial duress over the next 12-18 months.
That said, Carriers that currently have majority exposure to the Contract market will fare much better commercially. While our Q2 US DAT TL Linehaul Spot Index is running just slightly hotter to the downside than forecast, our Q3 Contract Linehaul Index (i.e. Cass Linehaul) continues to defy gravity after revising still higher to +13.4% Y/Y with the May print now baked in – compared to last month’s +12.9%, last quarter’s +13.2%, and our forecast of +3.0% (sure missed the mark on that one). We suspect that this can only mean that the rate of newly activated contract TL awards negotiated during the last bid season continues to exceed the rate at which those contracts are getting re-bid lower to better align with the current spot market environment. But as anxiety around a potential recession in the year ahead builds, we expect many procurement organizations to come under more and more pressure to manage costs lower. And the first page in that playbook tends to be: ‘Back out to Market to Re-bid the Freight Contracts’. While exactly the wrong thing to do for long-term supply chain stability and performance, the short-term urgency to survive a recession or earn a target bonus (let alone remain employed) often takes priority for many Shippers in times like these. Much like the extended leg higher in the TL Spot market in Q1, which ultimately revealed an air pocket below that produced a comparatively sharp correction this quarter, we foresee the same fate for our blue Cass Linehaul Index line in the quarters ahead. Enjoy it while it lasts if you’re on the receiving end but look out below.
With preliminary Q2 GDP and Consumption data not due out until next month and ‘Team Services’ already crowned the winner in the battle for post-COVID Consumer wallet-share growth with its Q1 read of +6.8% Y/Y, compared to a slide in Nondurable Goods to +3.3% and Durable Goods to -2.6% Y/Y, we don’t have nearly as many juicy macroeconomic story lines to dissect as we did last month. That said, with the tightrope that Jay Powell and the Fed are walking to bring inflation under control without plunging the US economy into recession, just about every macro data point that we track seems to have new weight as we struggle to assess the health of the US Consumer and both their appetite and means to consume enough in the months ahead to stave off another painful slowdown in industrial activity. And while our June macro read certainly indicates the possibility of economic weakness ahead, we’re not seeing anything that screams ‘imminent recession’. Sure, real wage growth remains sluggish at +0.5% Y/Y, where it has remained over the last three quarters, but it’s hasn’t deteriorated any further and labor markets remain relatively strong across most sectors – especially now that the Service industries are ramping back up in the US with COVID finally in the rearview mirror for the most part (knock on wood). And while Consumer Debt levels are growing at rates not seen since the Great Recession of 2007-09, it is our understanding that the credit quality of those loans is much healthier now than then as a result of banking and lending reforms put in place to prevent another collapse in subprime debt. We are likely to find out soon enough either way, but as it stands from where we sit, the US economy doesn’t look as terrible as much of the media narrative would imply. But let’s take a closer look, starting with Industrial Production.
We commented last month that if the slowdown in Consumption signaled by its Q1read of +4.8% Y/Y vs. +6.9% in the prior quarter (Q4 2021) implied a recession in our immediate future, Industrial Production hadn’t gotten the memo. After closing Q1 at +5.2% Y/Y, we got a preliminary Q2 read of +5.7% that was slightly higher, not lower. And now with May (which represented the 8th consecutive month of sequential improvement in the index) baked in, our Q2 read remains +5.7% Y/Y. As noted in past issues, a slowdown in both Consumption and Industrial Production has preceded just about every US economic recession over the past 70 years. And any divergence in the two, which we now have with Consumption fading lower and IP pointing higher, rarely lasts for long. So it is likely that one will reverse course to join the other in the months and quarters ahead, depending on which is more representative of the underlying strength and future direction of the economy. If Industrial Production is telling the truth, look for a softer economic landing and stable if not strong sustained growth ahead. If on the other hand it’s Consumption, then we should expect the opposite. But even in that case, consider this. In every one of the last four recessions – 2020, 2008, 2001, and 1990 – Industrial Production plunged negative Y/Y in a way that is very much reminiscent of our US Truckload Market Cycle. But with the current read way up here at +5.7% Y/Y and still trending higher, there is a lot of chart space to cover before we find negative territory. So should historical patterns persist, there is either a cataclysmic industrial collapse ahead of us on our way to recession, which doesn’t seem likely given the strength of the labor market and the amount of stimulus pumped into the economy over the last 18 months, or perhaps the state of the economy isn’t as bad as it seems depending on which media outlets one subscribes to. Until we see Industrial Production change course and turn over, we are going with the latter.
But while IP continues to tell a constructive story, we can’t say the same thing about relative inventory levels. Since late Q3 and early Q4 2021, as many importers surged orders to mitigate inventory availability risk during what was expected to be a record holiday retail season, we have suggested that this policy would lead to surplus inventory levels at some point as a result of increasingly inaccurate demand forecasts due to longer and longer order lead times and shifting post-COVID consumer demand patterns. It seemed logical, if not inevitable, that we would get some version of this in 2022. But through Q4 and into Q1, the Inventory-to-Sales ratio remained stubbornly range-bound at 1.25-1.26. However, now with our first glimpse of Q2 on the board with April’s print of 1.29, we’ve finally got the break higher that we have been expecting. And with more manufactures and retailers pointing to ballooning inventories as a drag on results on recent earnings calls, it is reasonable to expect this number to rise in the months ahead. And a rising Inventory-to-Sales Ratio, if it goes high enough, can certainly put a ceiling on Industrial Production and help trigger a recession. Though a silver lining could be that surplus inventory levels should be a deflationary force as retailers mark down prices to burn through the excess, which could help the Fed in its tightrope act and keep the risk of a hard landing for the economy at bay.
Now onto our perhaps more relevant trucking demand and supply indictors. The big news last month was that we confirmed the convergence and now divergence of our two TL demand indicators – ATA TL Volume & Cass Shipments – as they crossed over each other. We see this as a signal that TL capacity or supply has transitioned from scarcity to surplus, with ATA running higher while Cass Shipments fades lower. The divergence continues this month with Q2’s preliminary ATA read coming in at an accelerated +3.5% Y/Y compared to Q1’s +1.2%. And while the revised Q2 Cass Shipments Index improved to -1.8% Y/Y vs. last month’s -4.4%, it remains deflationary and the gap between the two continues to expand. That said, TL demand as measured by the Cass Shipments Index is hardly off a cliff. After surging with the explosion in goods consumption during COVID lockdowns, we have simply returned to flattish Y/Y conditions. As more capacity continues to exit the market, we expect the ATA index to run higher in the quarters ahead. The degree to which the Cass Shipments Index runs lower should serve as one indicator that we can use to assess the strength and durability of the industrial economy. As just like with Consumption and Industrial Production, we don’t expect to see Industrial Production and the Cass Shipments Index to diverge, as they do now, for very long.
Now moving along to the first of our primary Supply indicators, US Net Class 8 Tractor Orders which up until recently was the greatest head scratcher of them all in this current cycle. We have remarked consistently in past issues that net tractor orders had proven to be perhaps the most consistent signal over past US TL cycles. Across the last four complete cycles observed since 2007, both the US TL Spot Index and Class 8 Net Tractor Orders have flipped Y/Y deflationary in the same period (plus or minus a quarter) as the cycle transitioned from its inflationary leg. Just like clockwork, as went Y/Y net orders so went US TL Spot linehaul rates. But this time around, we observed two quarters where that relationship diverged for the first time, with Y/Y Net Tractor Orders plunging deflationary in Q4 2021 and Q1 2022 while TL Spot rates remained stubbornly Y/Y inflationary. However, that divergence was resolved this quarter with Net Tractor Orders remaining deflationary with May’s revised Q2 read showing -48.8% Y/Y (vs. -45.0% last month and -49.4% in Q1) while TL Spot Linehaul rates finally joined them with its own deflationary revised Q2 read of -12.9% Y/Y. Going forward, we expect net orders to remain Y/Y deflationary for at least the next few quarters. From there, it will be interesting to see if they return to historic patterns relative to US TL Spot Linehaul Rates or if they shift to instead lead Spot Rates into the inflationary leg of the next freight cycle after leading them into this current deflationary leg by a couple of quarters.
Finally, on to retail diesel costs where after holding relatively flat M/M in April at ~$5.10-$5.12/gal we moved yet another material leg higher this month to reach $5.71/gal MTD – with many parts of the country continuing to register well north of $6. Now at +73.7% Y/Y for June, we remain in record territory as we take out the prior mark of +66.6% Y/Y from June 2008. Our revised Q2 2022 now sits at +70.3% Y/Y, also another record…by a mile. So here we sit, with diesel inflation levels not seen since The Great Recession of December 2007 to June 2009, which resulted in an unprecedented wave of carrier bankruptcies. But as noted last month, the key difference this time around is that US TL Spot rates had already risen to record levels, allowing the market to absorb the diesel shock without forcing Carriers out of the market in material numbers – at least not yet. Which is how diesel can rise +74% Y/Y this month, yet all-in DAT National Spot Van rates remain flat to last year. That only happens if there are enough carriers out there with enough room in their Operating Income line to continue to run profitably even after absorbing that kind of gut punch at the gas pump. As this battle rages on, the only role that diesel costs will likely play from here will be in helping to set the market bottom where our Y/Y US DAT TL Linehaul Spot Index line will ultimately inflect higher as sufficient surplus capacity has been forced to exit as their operating margins compress towards zero, or worse. If diesel finds a way to run still higher from here, we likely reach a shallower bottom sooner. And should it finally correct lower, then the market bottoms at a lower level than currently projected and it takes us an additional quarter or two to get there.
So as we prepare to tie a bow on Q2 and with another month of market data accounted for, we find that the TL Spot Market is behaving pretty much as we expect it to at this stage in the cycle – the only exception being perhaps some unexpected strength in Contract rates as measured by the Cass Linehaul Index, as temporary as that may prove to be. And as the risk of a US economic recession looms, our short list of wild cards to focus on in the month ahead has narrowed even further. At this point, the impact of rolling COVID lockdowns in China and the potential impact on freight flows into and within the US has proven immaterial – so off the list it goes. And Russia’s invasion of Ukraine, while it remains top of mind from a humanitarian and global security standpoint, the impact on the US TL Spot Linehaul Rate cycle has become almost entirely to do with the price at the pump of diesel fuel. So that leaves us with these two:
1. TL-Intensive US Consumer Spending: The headwinds in play for the US Consumer today are numerous – May’s +8.6% Y/Y print on the CPI shows no sign of an inflationary peak yet, rising household debt and rising interest rates are beginning to eat into discretionary income, and the risk of recession is threatening job security and perhaps the appetite to consume. That said, there are plenty of good things happening out there too. Unemployment remains historically low and as the Service sector emerges from its long slumber while COVID mitigation policies expire, experiences like air travel, sporting events, and concerts are finally back on the table as life slowly returns to some form of normalcy for many. And while we have seen this compounding effect of less discretionary income and more things other than goods to spend it on take Goods Consumption negative Y/Y in Q1, the jury remains out as to where it goes from here. Truckload volume indicators remain mostly stable and Industrial Product continues to trend higher. But what is increasingly clear is that this market force more than any other (even diesel prices), as it sets the direction of TL volume demand, likely determines the shape of the deflationary leg of this cycle.
2. Diesel Prices: And with that as our segue to our second wild card, the rapid and ongoing spike higher in diesel prices has come to represent the primary supply-side catalyst in play at this point – not the supply of drivers and not component shortages capping the OEM production of Class 8 tractors. As noted earlier, should diesel somehow surge still higher from here, the breakeven point for motor carriers rises and we likely see our deflationary inflection point sooner. And should they correct lower, we get the opposite effect and Spot Linehaul rates ultimately run lower for longer. In in any case, we don’t expect it to get any easier out there anytime soon for motor carriers – especially those that are dependent on the spot market to get loaded.
So as we gear up for July and Q3, let’s summarize our current position and outlook for the balance of the year. After guiding for a steep drop in Y/Y US TL Spot Linehaul rates to break Y/Y deflationary by Q2 of this year for the last couple of quarters, here we sit at -12.9% Y/Y with just a few days left to go. As we move further into this deflationary leg of the cycle, it is important to keep in mind that these cycles are slow. The market doesn’t just bounce back. It takes time for supply and demand to rebalance, at it can be quite painful for everyone involved depending on where they sit and what actions they have taken to prepare. From here, we are maintaining our guidance that we reach our deflationary inflection point somewhere in the neighborhood of -25.0% Y/Y by Q4 before turning higher to break Y/Y inflationary once again by Q3 2023. Again, once we’re down here we tend to be down here for a while – 5 to 6 quarters in total should the current forecast hold up. And while -25.0% Y/Y sounds like a long way from the current -12.9% Y/Y, it is really only another -6% sequentially lower assuming current diesel prices as the Y/Y comps change. So in all likelihood, this first quarter of this deflationary leg will prove to have been the scariest part of the ride where we swung from +17.9% to -12.9% Y/Y. Compared to that, another 6% of downside should feel like a relative non-event. Instead, it will be the grinding wait we will have to endure before we make our turn and prepare for the other side and the inflationary leg of the next rate cycle. And like the late great Tom Petty said, “the waiting is the hardest part.” Good luck out there. This too shall pass.