[Excerpt from The Pickett Line August 2022 Issue]
And we’re off. The family vacations and road trips are all over (we did eventually ‘get there’) and the kids are all headed back to school. So, with summer settling into the rearview mirror as we move further into Q3, we now look forward to shorter days and autumn gloominess, a rapidly slowing US economy, and a US Truckload Market Cycle in search of its floor. Geez, when we put it that way, those dog days of summer we just experienced suddenly don’t sound so bad. While the deflationary leg of the cycle is always a depressing period for the supply side, with pessimism compounding the lower we go and the longer we stay there, we also have an economy on the verge of recession to contend with this time around, a one-two punch that we haven’t seen in over a decade – four cycles ago in 2009 to be exact. It didn’t feel good then, and it won’t feel any better now. That said, we eventually found our deflationary inflection point that led to the market recovery that launched us into the next cycle. And that is exactly what is going to happen over the next several quarters. So chins up, keep moving, and let’s get on with it. Because if we peer into the old crystal ball from just the right angle, we see that maybe things might not be so bad after all.
And with that as our backdrop, let’s dive into this August 2022 installment of The Pickett Line where we have a number of developing story lines to revisit – Recession or No Recession?, Goods vs. Services Consumption, and Contract Rates vs. Gravity to name a few. But before we do, let’s start with the US TL Spot Linehaul Rate cycle itself. Recall that after closing Q2 at -13.3% Y/Y vs. a forecast of -10.0%, we opened Q3 last month with a July read of -19.3% Y/Y ($2.01) vs. a forecast of -17.5% on our US DAT TL Spot Linehaul Rate Index. With another month now behind us, we ticked three cents lower on the quarter to -20.5% Y/Y ($1.98) – so directionally right on course but running 300 bps under our forecast line. And as with last month, the answer to ‘Are we there yet?’, with ‘there’ being the floor of the spot market and the deflationary inflection point of the current rate cycle, remains ‘No’. But we’re close. While we expect this quarter to land near current levels, we continue to project next quarter as our cycle bottom at -25.0% Y/Y ($1.95). And with national DAT Van linehaul rates hovering in the $1.90-1.93 range for the last three months, that means we believe we will see that range-bound pattern continue through the end of the year before starting to bend higher in Q1.
Now onto the battle between contract market rates and gravity. As noted last month, while we pondered the symmetry of the COVID-driven rise and fall of spot linehaul rates through the recently completed inflationary leg of the current cycle, we speculated that we might see something comparable take shape with contract rates. With our first glimpse of the Q3 Cass Linehaul Index, our proxy for the contract market, now on the board with July posting +9.3% Y/Y vs. a forecast of +5.0%, we see this correction lower beginning to form. That said, while this 360 bp move from Q2’s +12.9% Y/Y close is a good start, we would need another 530 bps to match the 890 bp move we observed in Q1 2021 when we were on the way up. Though to reach our forecast of +5.0% Y/Y, we only need another 430 bps over the next two months which we believe is entirely possible given the magnitude of the decline in the spot market in Q2 and the range-bound behavior we have observed since. But so far at least, we are declaring this match a draw though expect the scales to tip in the favor of gravity as the quarter develops. Stay tuned.
And now to the macro where the specter of economic recession looms overhead with the storm clouds only building over the last month. With revised Q2 GDP now in, we finally have an update on the battle for post-COVID Consumer wallet-share growth between Goods vs. Services. While we awarded the first round to Team Services in Q1 with a relatively lackluster takedown, the question was whether Team Goods would miraculously regain consciousness and leap off the mat Hulk Hogan-style to sneak up behind Team Services, break up the victory party, and extend the match for another round. But as we saw in the Q2 numbers, this was clearly not to be. Consumption overall slowed materially from +4.5% Y/Y in Q1 to +1.9%, now in line with pre-COVID 2019 levels. And while all three components faded lower, Services continued to hold up better with its +4.5% Y/Y read while both Durable and Nondurable Goods landed firmly deflationary at -4.9% and -1.3% Y/Y on the quarter, respectively. And while we are not likely already in a recession, economic activity is clearly slowing. But whether the National Bureau of Economic Research (NBER) makes the official call or not in the months ahead, it doesn’t really matter because if you wait until then to course correct it’s likely going to be too late. So as the Fed continues to raise interest rates in an effort to dampen demand and beat back historic levels of inflation, it would be reasonable to expect Consumption to slow still further before hitting a bottom and reversing course. The question however, just as with the US Spot TL Linehaul cycle, is how much lower and how long will it take to get there.
That said, what we haven’t observed just yet is a comparable break down in either Industrial Production or the underlying demand for truckload capacity that tends to track with it. After closing Q2 with a final read of +4.6% Y/Y, our first glimpse at Q3 Industrial Production with July came in at a relatively stable +4.1%. Sure, it was sequentially weaker than the quarter before, but not by much and still sits at a relatively healthy level. The question of course is how closely it will follow Consumption in the months and quarters ahead as historically speaking, Industrial Production and Consumption tend not to diverge for very long. But at this moment in time, Industrial Production continues to be one of the bright spots in the macro read and a reason for optimism in the path of the economy and the US truckload market from here.
Now on to inventory levels and imports. As noted last month, the Q2 Inventory to Sales ratio had finally begun to break out of its 2021 range of 1.25-1.26 with a revised May print of 1.30. With June now baked in, we see that read confirmed and steady at 1.30. But as relative inventory levels finally begin to come in higher, the pace has been slow – especially as compared to what we see and hear in the mainstream media from the likes of Wal Mart, Target, and other retailers suffering the sting of the bullwhip effect. And certainly, while a rising Inventory-to-Sales Ratio tends to be a negative signal for future economic activity and the freight market overall, there may be a silver lining this time around for as retailers slash prices to move surplus goods, that could help alleviate some of the inflationary pressures that got us here in the first place.
In the meantime, Q2’s revised read on Imports provides us with another bright spot in the macro outlook. After surging all the way up to +30.6% Y/Y during the Q2 2021 COVID peak, Imports have settled into a range of +9.6% and +12.0% over the past three quarters – with Q2 posting at a historically robust +10.8% Y/Y. While Industrial Production acts as the primary catalyst for US Truckload demand, Import activity plays a secondary role but a meaningful one nonetheless. So, despite the relatively negative read on US Consumption in Q2, both of our leading indicators for Truckload Demand remain strong. Again, perhaps market conditions may not be as depressing as many seem to think right now – at least the ones that are out there speaking and writing publicly on the topic.
So now on to US Truckload Demand itself, as interpreted through the relative behavior our two TL demand indicators – ATA TL Volume & Cass Shipments. As you may recall, they crossed over each other in Q1, with ATA climbing higher Y/Y and Cass Shipments bending lower, thus signaling a change in TL market direction from a state of relative supply scarcity to one of relative supply surplus. At least, that was our hypothesis. In Q1, the divergence between the two measured only 70 bps with ATA TL Volume at +1.02% Y/Y and Cass Shipments at +0.5% Y/Y. Then, with Q2 Cass Shipments closing with a final read of -1.8% Y/Y and ATA up to +4.0%, that divergence grew to 5.8 percentage points or 580 bps. And a growing divergence implies that TL capacity is indeed exiting market at a faster rate than TL demand may be slowing. But while TL demand as measured by the Cass Shipments Index may indeed be slowing as compared to the last two years of nosebleed Y/Y inflation, at -1.8% Y/Y in Q2 and now with a preliminary Q3 read on the board at -1.4% Y/Y, we are basically treading water at a more neutral level. So to repeat last month’s observation, despite the headlines claiming otherwise, demand for truckload capacity has not shown any signs of falling off a cliff – at least not yet. We may get there if Industrial Production makes a material move lower in the months ahead to track deteriorating Consumption levels, we’re just not there yet.
With the demand side of the market covered, let’s now move on to the first of our primary Supply indicators, US Net Class 8 Tractor Orders. We have remarked repeatedly 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. And the same goes for the other direction. At least until Q4 2021 and Q1 2022 that is, where Net Tractor Orders broke Y/Y deflationary while TL Spot rates remained stubbornly Y/Y inflationary. That break in historical relationship was however resolved in Q2 2022 when TL Spot rates collapsed Y/Y deflationary as well. Now with our initial Q3 2022 read on Class 8 Net Tractor Orders on the board with July’s -65.7% Y/Y and the lowest deflationary read yet for this leg the cycle, we remain back in line with historic patterns. So expect at least another few quarters of Y/Y deflationary activity before recovering along with TL Spot rates in the back half of 2023.
Finally, on to retail diesel costs which have finally started to correct lower after exploding steadily higher for much of the year up to this point – from $3.727/gal in January to $5.754/gal in June before retreating slightly to $5.624 for July as reported last month. And now most of the way through August, we see that the retreat has continued in earnest – with the national average now below $5 for the first time since February and sitting at $4.988/gal. This takes the revised the Q3 read down to +56.0% Y/Y and now well off of the Q2 peak of +70.7% Y/Y. As noted last month, the last time we saw anything like this was in 2008 where diesel climbed to +66.6% Y/Y that June – in the throes of The Great Recession. During that TL Market Cycle, unlike this one, diesel spiked higher several quarters ahead of Spot and Contract rates. As a result, we saw an unprecedented wave of motor carrier bankruptcies as profitability was wiped out – especially for those most exposed to the spot market. The key difference this time around is that Spot and Contract rates led diesel by several quarters, which allowed the market to absorb the diesel shock without forcing Carriers out of the market in material numbers. That is only now just starting to play out in the current market as rates fade lower. So as the battle rages on, the role that diesel costs play from here will be in helping to set the ultimate market bottom where our Y/Y US DAT TL Linehaul Spot Index line finally inflects higher as sufficient surplus capacity has been forced to exit as their operating margins compress towards zero, or worse. And at this point, we continue to expect that to happen next quarter. However, if diesel continues to move materially lower in the months ahead, we could see that inflection point come in at a lower level as cheaper diesel allows the supply side to endure an even weaker spot rate environment than currently projected before setting a market floor.
So back to the theme of last month’s note: are we there yet? Our answer remains the same – Yes and No. While we likely have one more quarter to go before inflecting back towards Y/Y positive territory, we don’t believe we are too far from that eventual bottom linehaul rate-wise. This means that the market will slowly grind its way towards a temporarily equilibrium point through the end of the year, then look to make an inflationary recovery to kick off the next US TL Spot Market Cycle in mid to late 2023. Though the ultimate pace at which this occurs will continue to be driven by the two market forces identified last month as our primary wild cards for the month ahead: TL-intensive Consumer Spending (i.e. Durable and Nondurable Goods) and Diesel costs.
1. TL-Intensive US Consumer Spending: The headwinds that remain in play for the US Consumer today are numerous and only getting tougher – despite early evidence that inflation has possibly peaked with July CPI coming in at +8.5% Y/Y, slightly lower than June’s +9.1%. But while rising interest rates and high inflation continue to erode discretionary income, Consumers continue to consume. So it’s not all doom and gloom out there. Unemployment remains historically low and retail sales are generally holding up. We’re just seeing the typical shifts in consumption patterns that unfold when the economy slows and people are forced to compromise and substitute. And while we have seen this compounding effect of less discretionary income and the allocation of that income to other things take Goods Consumption negative Y/Y in Q1 and keep it there through Q2, the jury remains out as to where we go from here. As noted above, TL volume indicators remain stable and Industrial Production continues to hold up. But again, how much gas is left in the tank as the Fed continues to tighten, the economy slows further, and conditions likely get more difficult for the average US Consumer before they improve? With revised Q2 2022 Consumption now on the board, we clearly did not get the constructive signal that we were hoping for. So we’ll have to until the Q3 release for any evidence of a potential recovery, but in the meantime we’ll be looking for signal across the other indicators that we track on a monthly basis.
2. Diesel Prices: As with last month, we’ll use that ‘gas left in the tank’ metaphor as a convenient segue to our second wild card, the rapid spike higher in diesel prices that peaked in June and has cooled 13% since. Perhaps more than any other market force, diesel costs in the months again will determine our bottom in TL Spot Linehaul rates – both the ultimate destination and how long it takes us to get there. Should this period of relief prove only temporary in nature and should diesel somehow surge higher again from here, the breakeven point for motor carriers rises and we likely see our deflationary inflection point sooner. But should they fade lower, perhaps in conjunction with a slowing US economy, we get the opposite effect and Spot Linehaul rates get more room to run lower for longer. We continue to believe that with diesel at current levels, the market has already reached the point where spot market dependent motor carriers will begin to exit in large numbers – either temporarily or permanently. So, it becomes only a question of the pace at which this continues in the months ahead, and that depends very much on what diesel costs do going forward.
And that’s where we stand at the moment Ladies and Gentlemen. Now most of the way through Q3, we find ourselves navigating both an economy sliding towards potential recession and a Y/Y deflationary US TL Spot Linehaul cycle in search of its floor. But while the path ahead for the economy is exceedingly difficult to assess from here, the road ahead for the US trucking market is much clearer. We expect our DAT US TL Linehaul Index to fade another 5-10 cents lower before finding our market floor and deflationary cycle inflection point, which we expect to occur next quarter. From there, Spot linehaul rates will rise incrementally until they break Y/Y inflationary again by the back half of 2023 and kick off the next rate cycle. Contract rates will continue to break lower until they reach Y/Y deflationary territory by early 2023 where they then spend most of the year. So if you are on the Demand side, that is all good news for transportation budgets, service levels, and network performance in 2022, but don’t expect the good times to last through 2023 as the market flips yet again. And if you’re on the Supply side, plan to diversify your truckload fleet assets accordingly over the balance of the year and into 2023 based on relative opportunity and the markets in which you operate – Spot, Contract, or Dedicated. But regardless of your role in the marketplace, know that current market conditions won’t last forever. They never do. This is a recurring cycle after all. What goes up must go down…then up again…then down again after that. So as was the case during last year’s inflationary spikes, operational flexibility and nimbleness remain king. Navigate this deflationary leg of the TL Spot Linehaul Rate cycle the best you can, confident in the knowledge that this too shall pass. Good luck out there. Now on to September.