Leading economic indicators have been declining for over a year, and the peak-to-trough decline is the steepest for any non-recession period this century. Money supply, year-over-year, is falling at a rate approaching 4% and it could fall at least 3% more over the next 12 months unless the Fed decides to stop reducing its balance sheet at the present pace. New highs for mortgage rates are starting to impact demand for new homes. Housing starts dropped over 11% in August. They had already impacted the existing home market. While the Fed Funds rate remains just north of 5%, credit card borrowers are paying over 20% while used car loans are often 15% or higher. Yet despite all this, we are not in recession yet. American consumers are still spending.
A principal key is the job market. For the past three months, net new jobs have averaged 150,000. That is well below recent gains, but it is still an increase. Government worker increases account for an outsized 20% of recent gains. Most of that is at the state and local level as efforts are made to hire to replace police, teachers and others who resigned post-pandemic. Growth in employment also continues in the strong hospitality sector, although there are signs of weakening demand there that might bring an end to job growth soon. So far, layoffs have been modest. Companies are fearful that they might lose skilled workers. Elevated strike activity is also likely to have an impact, particularly if the auto workers stay out for any serious length of time. There is also the threat of a partial U.S. government shutdown at the end of September. While furloughed workers usually get makeup pay once government reopens, they will have to live off savings over the short-term. Finally, student loan repayments start again in October. While President Biden is trying everything to limit those that must start to repay, it is likely that about $100 billion will be drained from consumer spending in order to repay the loans.
The good news is that slower activity is accelerating the decline in inflation. Rents are now down year-over-year and could fall further as a huge inventory of new apartments comes to market over the next 12 months. It is hard to forecast the rent and imputed rent portions of CPI and PCE, but should that number morph from inflation rates of high single digits earlier this year toward zero, it is quite possible that the Fed could reach its 2% targeted rate early in 2025, maybe even sooner.
Thus, we see the dilemma the Fed faces. Looking backwards, as is always the case when you rely on data, inflation, excluding food and energy, is still twice or more the Fed’s goal of 2%. While declining, it has been moving lower slowly. The recent spike in oil prices will seep into the costs of many companies’ products, putting further upward pressure on inflation. GDP growth on the other hand has been solid, in some segments robust. Americans are still spending the excesses accumulated during the pandemic when they were unable to spend. While the Fed is unlikely to adjust rates today, they could move at the next meeting. But the slowdown in both economic growth and inflation suggests, at least at the moment, that further increases any time soon would be unnecessary. One should note that if rates stay constant and inflation declines, the real cost of borrowing increases without the necessity for the Fed to increase rates further.
While the course of the Fed, at least in the short-term, appears set, the course of the financial markets is less clear. Technical factors like money flows are starting to decay. But volatility readings remain muted and a few successful IPO offerings within the past week give some optimism. With that said, we remain cautious. 10-year Treasury yields are back to their October 2022 highs. They are higher than at any time since prior to the Great Recession more than 15 years ago, and are higher than the current pace of core inflation. You can see the impact directly in the decline in housing starts for August which were reported yesterday.
Tech leaders, the so-called “Magnificent Seven” are off their highs. No new set of stocks are assuming leadership. Just look below at what investors and the economy face.
• Elevated borrowing costs
• The auto strike, which threatens to get wider and more impactful
• A possible U.S. government shutdown within two weeks
• The resumption of student loan repayments starting October 1
• Equity market money flows turning negative
• A slowdown in housing starts and a pending slowdown in new car sales should the strikes last for several weeks or more
• An expensive stock market selling near 19 times next year’s expected earnings.
On the bright side, a solid reception to the ARM Holdings and Instacart IPOs suggests speculative fever hasn’t gone away. But the negative clouds are building and the bright spots are fading.
We still don’t know if a recession looms. That won’t be known until GDP turns negative, if it happens at all. As long as the economy adds jobs and layoffs remain muted, it is still quite possible that a recession can be averted. Employment figures for September and October will be distorted to the downside by strike activity.
If the market wasn’t expensive, one could live with the brewing storm clouds. Equity markets climbed steadily from last October into August. A breather seems logical. That doesn’t mean a big bear market. It simply means some price adjustments until the positive and negative news are more balanced. I don’t want to be alarmist and cry wolf. But to me, a correction of a few percentage points is insufficient to create the bargains that entice me to step in now with any vigor. As Jim Cramer likes to say, “there is always a bull market somewhere”. There are parts of the economy that will be relatively unimpacted by all the problems I noted above. The pandemic created a lot of valleys and spikes in business activity for many corporations. Just as some pockets of strength are starting to weaken (e.g., domestic air travel), there are signs other sectors are bottoming (e.g., PC demand). Markets are not monolithic except at extreme moments of euphoria and despair. But, with that said, I will wait for a better entry point when the good and bad news are better balanced.
Today, former Goldman Sachs CEO Lloyd Blankfein is 69. Glass artist Dale Chihuly is 82. And, Charley, today one of your movie sirens of yesterday, Sophia Loren, turns 89.
James M. Meyer, CFA 610-260-2220