Weekly Market Insights 05.15.23

A Well Deserved State of Confusion

Financial Markets

United States equity markets closed mixed on Friday, with both the Dow and the S&P 500 falling for the second straight week.  The Dow fell 1.11%, the S&P 500 fell 0.29% and the NASDAQ rose 0.40%.  This is the 6th week in a row where the S&P 500 has moved less than 1%.  Investors appear to be waiting for the next shoe to drop.

Of course, the most current concern is the debt ceiling, but clearly there are many other concerns—the posture of the Fed, interest rates, the path of inflation, recession, and the ongoing banking crisis just to name a few.  More about these issues in the economics section.

There are plenty of contradictory signals that seem to be confusing investors.  We wrote last week about the abundance of mixed economic and market signals this cycle and why we expect that to continue.  Investors have allocated an unusually low percentage of their portfolios to equities.  This can be interpreted as a positive or a negative.  On the positive side, there will be plenty of buying if things turn decisively positive.  On the other hand, it signals investors’ negative view of the future.

Economics

There are a lot of interesting and conflicting signals for both investors and analysts to ponder, but the dominant and most immediate concern is the debt ceiling.  In reality, when writing about this topic, a more fitting title would be “Politics.”  The debate really has very little to do about economics.  Instead, it is more about posturing between political parties.  The debt is owed and will have to be paid.  This fight has become a tradition.  In the past, they have been able to settle on a compromise at the last minute.

What are the possible ramifications of a default?  The first and most obvious is that the U.S. dollar would fall.  Interest rates would rise as sellers dump the dollar along with many dollar denominated securities.  One of the most damaging ramifications would occur if money market funds had to sell Treasuries.  This would both accentuate and accelerate the decline of the dollar.  Globally, it would impair the prestige of the United States and the confidence in the U.S. as a world leader.  A U.S. default would also give a big boost to the China-Russia powers and their goal to knock the United States out of its privileged position of global hegemony.  It is an interesting and very disconcerting thought.  Although we think this a very unlikely event, it will keep investors on edge for a while longer.

We continue to point out that this cycle is different, and we encourage investors to continue to follow economic releases.  Although sometimes contradictory, they are certainly not useless.  Many people are concerned that the current banking crisis will morph into a rerun of 2008.  Our view is a strong no.  The scope, reasons, size, and breadth of those affected are very different.  Readers will remember the bailout of Bear Sterns and the Lehman Brothers bankruptcy and will connect it to the bank failures we are seeing today.  However, the major difference between today and 2008 goes back to the causation.  The present problem is a foolish mismatch of assets and liabilities, which is far different than failed loans and borrowers walking away from their debts.  Readers can get an excellent comparison by reading Josh Zumbrun’s piece in the Wall Street Journal titled, “Stop Equating the Latest Bank Failures to the 2008 Crisis.”

As we suggested earlier, economic indicators are giving off mixed signals.  Last week’s University of Michigan Consumer Sentiment Index fell to a six month low, and longer-term inflation expectations jumped higher.  For some time now, the Consumer Price Index (CPI) has been showing a steady decline in the rate of inflation.  Similarly, the Producer Price Index (PPI) hit its lowest level since 2021.  Interestingly, when the year-over-year CPI has declined by at least five percentage points over the previous year, the S&P 500’s median return has been 14.9% over the following 12 months.[1]

Conclusion

It continues to be difficult to come to a definitive conclusion about the economy or the financial markets.  Mixed signals are everywhere.  Our view has not changed from last week.  We do not think the government will allow a default, although they may go to the very edge.  If they do, the country does have enough funds to pay bills for a bit longer, but the humiliation will last a long time.

Economic Indicator Update

Economic indicators seldom move in unison, and when considered together, often provide conflicting conclusions.  Given the multitude of indicator types, frequencies, and methodologies, along with the complexity of the economic issues at hand, that is certainly the case today.  That being said, economic data over recent weeks has reinforced our belief that inflation has peaked and is trending lower as economic growth continues to weaken.  The pace of disinflation and the extent of economic weakening remain the most important and largely unanswerable questions we face today.

Inflation Indicators

Despite continued signs of disinflation from the latest Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) Index reports, wage-related data suggest services-oriented prices may prove to be stickier than hoped.  The more prolonged this period of elevated inflation becomes, the more important inflation expectations and the anchoring of those expectations becomes.  As we’ve explained before, expectations of future inflation can be self-fulfilling.

• The Consumer Price Index increased 0.4% month-over-month, in line with consensus estimates but higher than the prior month’s 0.1% rise. The year-over-year rate fell to 5.9%.
• Core CPI also increased 0.4% in April, consistent with consensus and the prior month’s reading. The year-over-year rate edged up to 5.6%.
• The shelter component of CPI decelerated 0.2 percentage points to 0.4% month-over-month. April’s deceleration provides some optimism that we are beginning to see declines in more real-time rental data show up in the lagged CPI measure.
• The Employment Cost Index (ECI) increased 1.2% quarter-over-quarter, higher than consensus estimates calling for a 1.1% advance and the prior quarter’s 1.1% rise. At a nearly 5% annualized rate, there has been limited progress on sufficiently cooling wages thus far.
• Average Hourly Earnings also turned higher, increasing 0.5% month-over-month and 4.4% year-over-year.
• A measure of long-run inflation expectations from the Michigan Consumer Sentiment survey came in at 3.2%, higher than the 2.9-3.1% range it has been in for 20 of the last 22 months.

Labor Market Indicators

It is apparent from recent employment data, particularly from leading indicators, that the labor market is normalizing.  However, with record low unemployment and consistently robust job growth, there is a long way to go until labor market balance is achieved.  A normalization from overly-tight labor market conditions is undoubtedly a positive; however, the pace and degree of normalization will have broader implications for consumer health and the severity of a potential recession.

• Nonfarm payrolls grew by 253,000, well-ahead of consensus estimates calling for a 179,000 increase and March’s reading of 165,000.
• April’s job growth is still below the 290,000 average seen over the prior 6 months, and there were sizeable downward revisions to prior months—150,000 combined.
• Temporary employment declined by 23,000, following an 11,000 decline in March and a 10,000 decline in February. Temporary employment is viewed as a leading indicator, as temporary employees are the easiest to cut when business conditions begin to deteriorate.
• The unemployment rate fell to 3.4% the—the lowest reading since 1969.
• The Labor Force Participation rate held steady at 62.6% after increasing gradually in recent months.
• JOLTS job openings declined to 9.6 million from 10 million in the prior month and 12 million in March of 2022. Decreased openings are consistent with the Fed’s goal of cooling the demand for labor and achieving looser labor market conditions.
• Initial unemployment claims rose by 22,000 to 264,000 this past week—the highest reading since October 2021. Unemployment claims are a leading indicator for the labor market, with increased claims suggesting higher unemployment may be on the horizon.

Consumer-Related Indicators

Supported by a strong labor market, consumers have shown unexpected resilience throughout this elevated inflation environment.  However, fears of recession and the associated prospect for reduced employment opportunities ahead are materializing in consumer spending and confidence declines.

• The Michigan Consumer Sentiment Index took a sharp move lower, falling 9.1% from the prior month. The decline was driven by renewed concerns over the trajectory of the economy and the continued debt ceiling standoff.  Year-ahead expectations for the economy fell 23% month-over-month and longer-term expectations fell 16%—a signal that consumers do not expect the feared economic downturn to be brief.
• Retail Sales fell 1.0% month-over-month, steeper than consensus estimates calling for a 0.4% decline and the prior month’s 0.2% drop. Retail sales have fallen in 4 of the last 5 months, making January’s 3.0% increase look more like an aberration than a trend change higher.
• Personal Consumption Expenditures came in flat month-over-month. Better than consensus calling for a 0.1% contraction, but a deceleration from the prior month’s 0.1% increase.  Adjusted for inflation, expenditures declined from the prior month.
• Another sign of weakening consumer spending came from Bank of America’s measure of total card spending per household. The metric was down 1.2% in April, marking the first year-over-year decline since February 2021.[2]

Economic Growth Indicators

While economic growth data does not look recessionary quite yet, a growing number of indicators have shown signs of weakness.  Given the importance of consumer spending to U.S. GDP, future economic growth will be heavily tied to labor market health and consumer strength.  Should more significant unemployment come to fruition, we should expect this to materialize in lower or even negative GDP growth.

• 1st quarter GDP rose at a 1.1% seasonally adjusted annualized rate, weaker than consensus calling for a 1.9% increase and marks a step down from the 4th quarter’s 2.6% pace.
• The Conference Board Leading Economic Index (LEI) fell 1.2% in March, reaching its lowest level since November 2020. March marked the 12th consecutive month with a negative LEI reading, and the current level signals a potential recession over the next 12 months.[3]
• Industrial Production improved 0.4% month-over-month, higher than consensus calling for a 0.2% rise and the prior month’s reading of 0.2%. Despite the higher than expected monthly growth, the year-over-year rate of 0.5% marks the slowest pace since March 2021.
• Durable Goods Orders increased 3.2%, well ahead of estimates calling for a 0.7% gain and the prior month’s 1.2% contraction. However, it is worth noting that Core Capital Goods Orders (non-defense and ex-aircraft) declined 0.4% month-over-month, showing that the headline number benefitted from a big jump in aircraft orders.
• The Atlanta Fed’s GDPNow real-time estimate of 2nd quarter GDP growth is pointing to 2.7% annualized growth.

Given the mass of economic data at our disposal, it can be difficult to distill the takeaways from each data point and combine them into a sensible conclusion.  While it is difficult to believe a recession is imminent with record low unemployment and GDP growth tracking positive, broader weaknesses in economic indicators are materializing.

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