A September to remember.

[Excerpt from The Pickett Line September 2022 Issue]

Well, that was unexpected. September is typically one of the quieter months of the year with regard to the US TL Spot Linehaul Rate Cycle and the macroeconomic data that we track as leading, lagging, and coincident indicators. There are no market-moving seasonal shifts to really account for, though major storms can be a factor as we get deeper into the Atlantic hurricane season. As the third month of a quarter, the Q3 averages are already mostly baked so we tend not to see any material changes to the forecast. And we won’t have the next Consumption, GDP, or Import numbers to dissect until the end of next month. So pretty dull, all things considered. Not so much this year. We got a September to remember as we narrowly dodged what would have been an incredibly disruptive strike by the railroad unions while the US Fed’s aggressive tightening of monetary policy sent tremors across virtually every segment of the economy. So far at least, no market is safe as interest rates are accelerated higher to combat record high US consumer and producer inflation. And while all of this volatility didn’t have much of an observable impact on the trucking market over the last few weeks, it hasn’t made the old crystal ball any easier to interrogate. But that’s never stopped us before, so let’s get on with it.

As we close out this third quarter of 2022 and prepare for a Q4 that for now remains cloaked in economic uncertainty, this September 2022 installment of The Pickett Line revisits many of our dramatic freight market storylines in progress: ‘Recession or No Recession?’, ‘Contract Rates vs. Gravity’, and everyone’s favorite ‘Are we there yet?’. So perhaps it’s best to start there, with the crowd favorite. After closing Q2 at -13.3% Y/Y vs. a forecast of -10.0%, the Q3 read on our US DAT TL Spot Linehaul Rate Index through August sat at -20.5% Y/Y ($1.98) vs. a forecast of -17.5%, as reported last month. Now with another month of data accounted for and the quarter just about wrapped up, our revised Q3 read has ticked another three cents lower to -21.7% Y/Y ($1.95). As with last month, we remain directionally on course but are now running 420 bps under our forecast line.

So, are we there yet? Have we reached the floor that the collective market has been racing towards over recent months? Our answer remains the same as it was last month. Not yet, but we are getting close. One can almost feel the supply side grinding slowly and painfully, 3 cents at time, towards the operational breakeven point where cost/mile exceeds rate/mile for enough motor carriers that the market finally finds its floor and we see a deflationary inflection point form. Interestingly enough, our current Q3 TL Spot Linehaul Index read of $1.95/mi is exactly the level where we have that floor projected at in Q4. While we will no doubt open Q4 somewhat below that based on current trend, call it $1.85-1.90, we expect to revise slowly higher as the quarter develops and we see at least some version of peak retail demand conditions come to pass. So we continue to believe that $1.95 is a perfectly reasonable expectation as to where we ultimately land to close out the quarter and the year – plus or minus 5%. From there, we then get our typical three-quarter journey back to inflation land to repeat the cycle all over again. Good times.

So now onto our next dramatic narrative: the battle between contract market linehaul rates and gravity. Or rather Wile E. Coyote vs. Gravity as we colorfully described the face-off back in the July issue. Our hypothesis was that while peak contract linehaul rate levels got artificially extended by a quarter or two, courtesy of the Q1 2022 COVID-19 Omicron surge, they would likely be breaking materially lower this quarter to follow spot rates as market gravity finally took over. So much like Wile E. Coyote out over the cliff furiously sprinting in place, we would soon find ourselves tumbling to the valley floor. Or in our case, deflationary Y/Y market rate levels. And the first leg of that journey would have our Q3 Cass Linehaul Index, our proxy from the contract TL market, decelerating all the way from Q2’s +12.9% Y/Y to land at a projected +5.0% – an incredibly sharp move lower in historical terms. With July’s preliminary read of +9.3%Y/Y, we got 360 bps of the way there. And now with the August Q3 revision on the board at +8.3%, we only have another 330 bps lower to go from here in September, which publishes mid-October, to close the gap to forecast. While we had declared this match a draw through last month, we are now seeing gravity starting to pull ahead in the count as the inevitability of the market cycle once again reveals itself. Will we get our +5.0% Y/Y by quarter close, or will we come up short? You won’t want to miss the October issue to find out. Get the popcorn ready freight nerds!

Now before moving on, let’s pause briefly to take a little bit of inventory prior to diving into the next dramatic storyline we have swirling this month. So, in the case of ‘Are we there yet?’, the judge ruled ‘No, but we’re close’. And in the heavyweight fight pitting Contract TL Rates vs. Gravity, we’ve got Gravity ahead in points with one more round to go. So that leaves us with ‘Recession or No Recession?’, perhaps the most depressing of the bunch as conditions deteriorated further this month on the back of another 75 bps increase to benchmark interest rates and Fed Chair Powell delivering increasingly resolute guidance that we’ll keep going until inflation is brought under control, regardless of whether that sends the US into economic recession. So, are we in a recession? At this point in time, we don’t think so. But it sure doesn’t look good. That said, while continuing its march lower from the Q2 2021 post-COVID peak of +16.9% Y/Y, Q2 2022 Consumption remains inflationary at a weak but still positive +1.9% Y/Y – and still higher than pre-COVID levels from 2018-19. We have also remarked in the past that in three of the last four NBER-designated recessions, Consumption ran Y/Y deflationary for at least some portion of it. The only one where it didn’t was the 2001 dot com recession where Consumption bottomed out at…yes, the same +1.9% Y/Y level we’re at today. Signal of some sort or just a weird coincidence? Probably the latter.

Though while we’re not there yet, given the trajectory we’re on and considering all of the bad things that are supposed to happen to consumer spending during a Fed tightening cycle, it would be irrationally optimistic not to expect our green Consumption line to see Y/Y deflationary territory by mid-2023 at the latest – and perhaps as early as next quarter. In any case, the preliminary Q3 read that publishes at the end of next month should help us build some conviction one way or the other – which then makes the November issue where we will get the chance to unpack this one ‘must see-TV’ as well. If there any non-subscribers out there reading this, see what you could be missing out on? It’s not too late to hop aboard.

So, will Consumption and the broader US economy continue to break lower in the months and quarters ahead, eventually going Y/Y deflationary and signaling at least some version of a recession?  Or is Industrial Production the better directional indicator here, which continues to show some hopeful resilience. We noted above that Y/Y deflationary Consumption has a 3-1 record over the last four recessions, breaking below the x-axis in all but one. Not to be outdone, Y/Y deflationary Industrial Production (IP) has a perfect record, breaking lower in all four. With the August revision to its Q3 read, we find IP holding at a relatively stable +3.9% Y/Y where it has been somewhat range-bound from +5.5% over the last year. So yes, bending slightly lower, but it has hardly fallen off a cliff the way that Consumption has over that same period. We observe that IP tracks Consumption pretty consistently throughout history, with Consumption generally leading. And during times of recession, IP has overshot it to the downside in every one of the last four. For those historical patterns to persist, and for IP to keep its perfect record intact, one of two things now has to happen. Either we are indeed headed for a painful economic recession within the next year where we will see a dramatic collapse in Industrial Production and therefore TL capacity demand. Or the current trajectory for Consumption is more a reflection of extraordinary Y/Y COVID-driven comps, not the true health of the US Consumer, and the numbers will surprise to the upside in the next release as the Consumption line goes higher not lower to trend back into alignment with Industrial Production. So, is the glass half empty or half full? Maybe there’s still a chance for a soft landing after all. We’ll all find out soon enough.

Speaking of reasons to be more ‘glass half full’ optimistic despite all the lousy economic news swirling around us at the moment, we got our first glimpse at Q3 Inventory to Sales with our July read of 1.31. While this number by itself doesn’t mean much, compared to prior quarters it signals a potential flattening in the inventory correction we saw in Q2 where the index surged from 1.26, where it sat for the previous five quarters of COVID-driven inventory scarcity, all the way up to 1.30. If July’s read holds, that would imply that perhaps the reports of system-wide inventory gluts may be somewhat exaggerated or perhaps contained mostly within the retail sector. And at 1.31, that leaves us on the low end of the historical scale, looking back over 30+ years. Perhaps this is just a pause in an otherwise inflationary pattern and the quarter closes much higher once August and September are accounted for. But if not, and surplus inventory conditions are not as dire as the headlines suggest, that would create additional support for Industrial Production in the months ahead as the two lines tend to run inverse to each other. We’ll be watching this one closely as the quarter develops.

So if our Industrial Production and Inventory to Sales Ratio reads are telling constructive stories, we should expect to see the same this month in our two TL demand indicators – ATA TL Volume & Cass Shipments. And as we unpack the most recent revisions, we find that indeed we do. After closing Q2 at +4.0% Y/Y, our first glimpse at Q3 with the July read has us flat sequentially at the same +4.0%. If we hold at this level in the coming months, this could imply that we are reaching max capacity flight where the rate of carriers exiting the market has peaked relative to available TL capacity demand. Based on past cycles, we would expect this to occur at the trough of the Spot TL Linehaul rate curve, so to the implication is that over the next quarter or two we will observe our deflationary inflection point in US TL Spot Linehaul rates while the ATA TL Volume Index holds in the current range of +4.0% Y/Y temporarily before turning lower. Looking back at the last deflationary leg of the rate cycle in 2019, that is exactly what happened. We held at 3.7-4.1% for three quarters before breaking materially lower as the cycle flipped inflationary. So will history repeat itself? Only time will tell.

But perhaps the more interesting signal is coming from our Q3 Cass Shipments Indicator, which revised from an uninspiring -1.4% Y/Y last month all the way up to +3.4% Y/Y with the August read. Unless this proves to be an anomaly or a reporting error, this suggests a pretty material change in direction. We noted in the past that Cass Shipments tends not to deviate very far from Industrial Production for very long, so going into the back half of this year we should expect to see either a breakdown in IP to align with Cass Shipments or a recovery in Cass Shipments to align with IP. We just got signal for the latter, which again if it holds, would be very constructive to Industrial Production, TL volume demand, and the US economy overall. And if this trajectory continues, with Cass Shipments running higher while the ATL TL Volume indicator flattens out, we could see another inflationary crossover take shape, which would signal an impending change in TL market conditions from a state of net surplus to net scarcity. This would be much earlier than expected and would no doubt accelerate the recovery in TL Spot Linehaul rates over the next year. One data point hardly makes a trend, but this one was a surprise to the upside for sure. We’ll have to wait another few weeks before we get the September number to find out more. In the meantime, stay tuned and know that it’s not all doom and gloom out there.

With the demand side of the market now accounted for, let’s turn our attention to the supply side – starting with 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 norms was however resolved in Q2 2022 when TL Spot rates collapsed Y/Y deflationary as well. Now with our revised Q3 2022 read on Class 8 Net Tractor Orders on the board at -48.2%, we remain back in line. You may notice that this was a significant move higher from last month’s preliminary Q3 read of -65.7% where net orders came in at their lowest level of the year. The August read came in at double that, which at this point we don’t attribute to anything other than noise in the monthly order books. We will need to see a few more months before we interpret as anything more meaningful. Until then, it’s steady as she goes so expect at least another few quarters of Y/Y deflationary activity before recovering along with TL Spot rates by the back half of 2023.

Now on to retail diesel costs which have finally started to correct lower after exploding steadily higher for much of the year – from $3.727/gal in January to $5.754/gal in June before retreating slightly to $5.013 to close out August. And while September MTD’s $5.027 implies that the correction has stalled for now, the weekly trends signal that prices are still coming down with the most recent week’s $4.964 breaking below $5/gal for the first time since February. Overall, this takes the revised the Q3 read down to +49.7% Y/Y and now well off 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 particular US TL Spot Linehaul Rate 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 has allowed the market to absorb the diesel shock without forcing Carriers out of the market in material numbers at the same rate. So far, it has been a much more gradual exit this time around. And 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 as noted above, we think we’re just about there. 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. If not, then we expect to see our deflationary inflection point take shape next quarter.

So to summarize: we’re not there yet, gravity has taken the lead over the forward trajectory of contract linehaul rates, we’re not in a recession but it doesn’t look good, and we see a few optimistic signals in the industrial production, inventory, and TL demand data. With all of that in mind as we look to next month, and with the risk of a national railroad union strike apparently now off the table, we find ourselves focused on the same two market force wild cards that we were dialed in on last month and the month before: TL-intensive Consumer Spending (i.e. Durable and Nondurable Goods) and Diesel costs.

1. TL-Intensive US Consumer Spending: Conditions remain tough for the average US Consumer, despite signal that peak Consumer Price Inflation (CPI) may be behind us after two months of sequential decline – from June’s +9.1% Y/Y to July’s +8.5% to August’s +8.3%. But while the Fed’s tightening monetary policy looks to be achieving its end, Powell and the gang don’t appear to be taking any chances and will continue taking interest rates up to a suggested terminal level of 4.6% before they consider taking the foot off the brake.

So if the current trends hold, while Consumers should start to get some welcome inflationary relief, the cost of debt will continue to rise materially with interest rates making it more expensive to consume more. And as both the housing and global financial markets turn over, the reverse wealth effect may begin to set in, acting as an additional headwind. That brings us to the last line of defense, wage growth and the labor market – both of which remain strong. So far, mass layoffs seem to be contained to the tech and financial services sectors. Should that remain the case and should the core economy continue to hum along without the broader labor market taking a dive as interest rates rise, then there is every reason to remain optimistic –with regard to both US industrial activity and the demand for TL freight capacity. Up to this point, retail sales signal no impending collapse as Consumers continue to consume. Sure, the patterns of that consumption will continue to shift like they do any time the economy slows down or speeds up. But much of that spending will continue to be on Durable and Nondurable Goods that require Class 8 tractor and trailer capacity to move. If consumption levels remain stable, we should expect a quicker recovery in US TL Spot Linehaul rates going into next year. If not, then it likely takes us an extra quarter to break Y/Y inflationary.

2. Diesel Prices: As noted in recent issues, 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, i.e. this quarter. 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 – even more so than what happens in the broader economy.

So it was a September to remember indeed. While we all could have probably used a little less excitement, things certainly could have been worse. We could have found out just how disruptive a national railroad union strike would be for the US supply chain and the trucking market specifically. And we could have seen a major storm or two make landfall to shake things up given the season. Unfortunately, Canada’s Atlantic coast wasn’t so lucky with Tropical Storm Fiona wreaking havoc on its way north as we write this. And with Tropical Storm Ian currently on track to make landfall in Florida as a Category 4 hurricane in the coming week, our luck in the US may be running out as well. But given the slack in the current trucking marking as we make our way through the deflationary trough and the expected storm track, we don’t expect Ian to be a market moving event. That said, as we get further into the Atlantic hurricane season and as the US TL Spot Linehaul Rate Cycle finds its floor, the risk for storm disruptions through the end of the year will rise. And if things start to get wild in the coming weeks (since we just jinxed us), we may even get an addition to our wild card list in next month’s issue. Until then, we maintain both our Spot and Contract rate guidance through 2023. The spot market likely finds its floor next quarter, reverses course, and breaks inflationary once again in the back half of 2023. Contract rates bend lower from here before breaking deflationary by Q1 next year at the latest. Now on to October and Q4, which we expect to be every bit as memorable as September. Good luck out there. And keep those glasses half full.