Consumer Squeeze Set To Intensify
Asset prices across the board staged a rally last week with the S&P 500 gaining 2.55%, the Nasdaq Composite ripping 3.27%, the Dow rising 1.57%, and the Russell 2000 small cap index surging 3.67%. Interest rates backed off a bit which gave a lift to bond prices and gold rose 1.57%. Marginally weaker economic data resurrected the ‘bad news is good news’ narrative where investors anticipate that the Fed can back off the most intense tightening campaign in the past four decades. I understand the thinking but advise some caution from fully embracing the ‘bad news is good news’ investment philosophy. It can work for a little while, but such a backdrop undoubtedly has a shelf life. Eventually ‘bad news’ for economic growth turns into ‘bad news’ for asset prices if the business cycle continues on a downward spiral. Not a prediction, just an observation based on basic economic principles and history.
I spent last week on the road visiting clients fielding all kinds of interesting questions, but at the end of the day you can boil them down to some permutation of; are we going to have a recession? If so, how severe do you think it will be? The easiest and safest answer is, ‘I don’t know’, but that’s about as satisfying a response as eating a salad without dressing (nourishing, but a bit gritty). Bottomline, I do think the economy will slip into a recession. Coming into the year I was in the camp that it would start sometime in Q2 or Q3, but it’s clear now that this timing was off with late-Q4 / Q1 now in my crosshairs (nice one Corey, you could be a politician yet – just keep moving those goalposts). I find myself more concerned with the duration of the downturn than I am about the severity. We know the policy response to a swift/steep recession (cut rates and fire up the printing press), but a long drawn out one likely elicits a different less impactful and more prolonged response. Time will tell, fortunately this is not a question that needs answered today.
When I look out over the next 6-12 months, I see an expanding list of incremental headwinds that when added together become rather stiff. For starters, the recent credit downgrade by Fitch while not all that material on its own, does set the table for fiscal policy restraint moving forward. The deficit hawks in the GOP are digging in even further given two of the three major credit rating agencies rate U.S. sovereign debt at less than AAA. On top of that there is the lagged impacts from the most rapid part of the Fed’s tightening cycle (+75 basis points in June, July, September, and November 2022) that are just now working their way through the system. Furthermore, even though headline CPI inflation has cratered from 9.1% to 3.0% it is still above the Fed’s 2% objective and getting from 3% to 2% is going to be very difficult over the next twelve months outside of the U.S. economy experiencing a hard landing (i.e. recession). This will cause the Fed to be purposely slow in responding to any signs of economic weakness outside of a financial calamity.
Keep in mind that the excess savings that had been built up in consumer bank accounts throughout the pandemic when the government was passing out money like it was ice cream will be depleted over the next several months (according to the work by the San Francisco Fed). What’s more is that price hikes pushed through by corporate America and the rise in general price levels over the last 28 months remain in place – they are just going up at a slower rate at this point. Not to mention that nationwide gasoline prices have shot up 30 cents a gallon over the past two months and 30-year mortgage rates have jumped roughly 50 basis points to 7.5%.
For those unaware of just how impactful this spike in mortgage rates is for a home buyer coming to market today, the Chicago Fed recently released a paper titled “Higher Home Prices and Higher Rates Mean Bigger Affordability Hurdles for the U.S. Consumer. To wit:
“Suppose that in June 2023 the typical U.S. household purchased a typical home at the median purchase price of about $349,000, financed with a 20% principal down payment and a 30-year fixed-rate mortgage at the average national borrowing rate of 6.71%. This homeowner’s monthly mortgage payment toward principal and interest would total about $1,803, a 69% increase when compared to the same metric from December 2021.”
I find it annoying when I hear pundits talk about how most American homeowners are unaffected by this rise in mortgage rates since 85% of mortgage holders are carried at less than 5%. True, but to me that is such a myopic way at looking at things because anyone willing to dig a little deeper and apply a little bit of thought to the situation will realize that its housing activity that drives growth. What this setup has created is a state of stasis in the housing market where existing homeowners can’t afford to move and want to be home buyers can’t afford to get in. Additionally, cash-out refinancing (which was a lifeline for many homeowners during previous downturns) has fallen to less than a 17% share of total mortgage loans – a 23-year low and half the historical average. This compares to 46.1% in Q1 of 2022 (when mortgage rates were around 4% - a little less than half the current rate) before the Fed commenced on the most aggressive policy tightening in four decades.
In a nutshell, with mortgage rates soaring and home prices refusing to buckle, we are left with one of the most unaffordable national housing markets in memory. Not to mention we have this tricky situation where a key release valve for the consumer, otherwise known as home-equity withdrawal, becomes inert. Fast forward to the next interest rate cutting cycle. How low will mortgage rates have to fall before they can provide some stimulative support to the economy and housing market when 85% of outstanding mortgages were locked in at the lowest levels in history? The Fed doesn’t want to go back to ZIRP (zero interest rate policy) in the next cycle, but that is what the housing market may require if its going to provide any boost to the system.
It's not just the housing market where you’re seeing a significant impact on consumer pocketbooks for items typically procured with credit. The average monthly car payment has increased by more than $150 between June 2019 and June 2023 (according to J.D. Power) with higher borrowing rates on loans accounting for only $16 of the increase. Imagine what this figure looks like over the coming 12 to 24 months if financing rates stay at these levels. This is just another classic illustration of ‘long and variable’ lags when it comes to monetary policy. The injection of fiscal stimulus from the likes of the Chips Act and the Inflation Reduction Act, not to mention the built-up excess savings (that are now almost depleted) have done a great job of offsetting the tightening impacts to this point, but all these positive offsets are at the point of diminishing from here on out. Not to mention the multi-year stimulus from the student debt payment moratorium coming to an end this month.
Which brings me to the labor market, the variable I consider to be the most important in staving off the growing squeeze on consumer pocketbooks and an economic downturn. When it comes to managing any budget it’s a lot easier to juggle with reoccurring income. Lose that cash flow and things spiral downward very quickly. Consider that a small metaphor for the overall economy. As long as the labor market holds in, even while slowing, then harmony can continue to be maintained in capital markets, the economy, and on the policy front. If/when it goes, things start to crumble.
As for Friday’s employment report, it had something for everyone depending on one’s perspective: the U.S. economy added +187k jobs, the unemployment rate shot up to 3.8% from 3.5%, average hourly earnings came in at 4.3% y/y, the workweek held steady at 34.4 hours, and the U-6 unemployment rate ratcheted up to 7.1% from 6.7%. Of all the details in the report the one that I’m paying most attention to over the last several months is the revisions to prior reports. The initial release when reported is working with incomplete data, but the BLS still issues the report and then revises the data after the fact as more complete data comes in. The data post-revisions provide you with a clearer picture of the general trends, especially at turning points where revisions typically occur in the same direction of the general trend in the economy. We are eight months into this calendar year and each and every jobs report to date has been revised down. Take the last two months for example where the June report initially showed +185k jobs created, but has since been revised down by -80k jobs to +105k (pretty big difference). July’s numbers have been cut by -30k, going from +187k to +157k. So far, total negative revisions for this year have added up to -355k.
While revisions are nothing new, I do find myself a lot less sanguine about this trend than equities seem to. And its not just the non-farm payroll report that is highlighting the weakening trend in the labor market. Earlier in the week we got the JOLTS report which showed that job openings have declined by 2.55 million over the past three months – this is the largest 3-month decline on record. To be fair this record three-month decline is coming off very elevated levels (see chart below), but don’t lose sight of the forest for the trees – a weakening trend is a weakening trend. Brings to mind something some Newton guy said about a body in motion tends to stay in motion, unless acted upon by an external force.
As for markets, let me start with the bond market/interest rates and say that irrespective of the selloff in bonds following last Friday’s jobs report and that action trickling into today – I see that report as constructive for the Treasury market. No matter which way you look at the labor market it is undoubtedly cooling, and I am of the opinion that Treasury yields across the curve are putting in a top in yields. Sure, maybe the yield on the 10-year T-note can pop up to 4.6% from current levels of 4.25%, but ultimately, I think it dips into the low 3’s within the next twelve months. I could be wrong, and I’ve been wrong since starting to buy Treasuries with yields in the low 3’s, but it’s hard to sneer at a secure 4 – 5% yield across the Treasury curve with little to no credit risk. Especially when you consider that we have a Fed at the end of an aggressive tightening campaign, economic growth showing cracks, equity valuations stretched to the upside, and inflation rolling over. I’m not saying Treasuries should be the only investment you hold in a portfolio, but as I’ve said before – it’s been more than fifteen years since investors could choose to forgo putting capital at risk and still garner a secure mid-single digit return.
Let me make this point and make it emphatically. Inflation is in the rear-view mirror. I see that in the leading inflation indicators, such as the New York Fed’s Underlying Inflation Gauge. I see it in the St. Louis Fed price-pressure index. I see it in the PPI pipeline measures. The Fed is doing what it does best, which is to fight yesterday’s war at exactly the wrong time. The shame of missing the 2021 and 2022 inflation bulge to 9% has created this policy of “take no prisoners.” It’s my contention that we are on the doorstep of the ‘high for longer’ strategy starting to break stuff. It took longer and rates had to go higher than I expected they would, but we are here, nevertheless. The Fed is starting to get the results its policies were intended to achieve – unfortunately I don’t think we are going to like those results in the fullness of time.
As for the stock market, it, like the economy remains resilient - led by the mega-cap tech contingent that appears destined to conquer us all. The remaining 493 companies in the S&P 500 outside of the magnificent seven are collectively up less than 5% ytd. That to me is a better representation of where the overall stock market and economy are. That being said, you must play the game that’s in front of you and there remain areas of the market that look intriguing. Energy and certain commodities remain near the top of the list of what I want to own. Over the past three months the Energy sector is up +17.5% while the industrial and material sectors are up +11.4% and +10.8%, respectively. This is a strong showing compared to the Tech sector up +6.8% and Communication Services +7.5%. I’ve spilled plenty of ink on these pages over the years with my bullish stance on a Nuclear Energy Renaissance and how that would buoy the prospects for uranium miners. Well, like most fine wines, that thesis gets better with age. Over the weekend, Cameco, the second largest uranium miner in the world provided a company update to announce they will not be able to meet their production goals for this year (a reduction of about 1.7 million pounds from their original estimate). On the surface that doesn’t seem like much when you’re talking about an annual global uranium supply of about 150 million pounds. But when you have a market as tight as is the case with the uranium supply/demand dynamics, (annual demand is north of 185 million pounds) even the slightest of production disruptions can have significant impacts for the market. Second and third-tier players are rallying strongly today as they stand to benefit from the contracts the big producers will not be able to fill.
Most commodity markets are in similar positions as we are seeing play out in the uranium space. Not nearly as unbalanced or opportunistic as was the case in uranium 24 – 36 months ago, but be it oil, copper, rare earth metals…the global economy has underinvested in energy and commodities over the past decade. I’m not saying there is a shortage of resources around the world because there isn’t (most are plentiful), but there is a shortage based upon economics - the price is too low or cost too high to incentivize extracting it. That is the situation we’re in for many commodities. This isn’t an endorsement to go out and load up on any and all but do some leg work on the space. Commodities/energy is one area that continues to come up as a constructive secular investment backdrop for investors with a time horizon of 3 -10 years. This should be a part of all investors’ portfolios and a prudent complement to stocks, bonds, and cash.
One final thought as I close this week’s missive. There is not much in the capital markets that I have a lot of conviction or am really excited about at the present time. Consider me indifferent and patiently waiting. If we end up in a situation where we get a soft landing in the economy, then I suspect almost everything will do okay from current levels – stocks, bonds, commodities, and cash. This is the outcome most priced in at the moment. However, if we get a hard landing then equities will get hit hard, commodities will experience some pain as well, but Treasuries will rally, and cash will remain stable. A well balanced and diversified portfolio should serve investors well for whatever lies ahead – no need to be a hero or make highly concentrated bets right here, right now. Sure, it could pay off, but that’s what the casinos are for if you need to scratch that itch. Don’t do it with your life savings.
The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.
Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.