Fall 2022 Market & Economic Commentary
Markets like clarity, even when the view may not be as rosy. As North Pier conducts our routine research calls with those that allocate capital these days, we note a general unwillingness to make economic and market forecasts, and certainly a lack of conviction from those who are willing to express their thoughts. Many Wall Street pundits fear stagflation, akin to what the U.S. experienced in the 1970s and early 1980s. Some of those comparisons may be true. We may experience an extended time of growth that can’t keep up with the rapid pace of inflation, leading to a benign economy when measured in real terms (e.g., adjusted for inflation). However, one large factor in the equation weighs just as heavily today as it did 45 years ago, but in the opposite direction – Boomers.
In the late 1970s, Baby Boomers were ascending into America’s consumer society and labor markets with force in numbers. Remarkably to this day, there are more boomers in the United States than any other generation before or since. As they began to buy cars, houses, have children, and save for college and then retirement, they were a positive force in saving and spending; something the country had never seen. Today, they are retiring in the millions, draining the workforce, and spending down instead of saving into their 401(k)s. Eventually, many will downsize or outright sell their big homes and deplete their savings. But for now, they are getting more conservative with their investments, reigning in their appetite for the volatility of stocks, and starting to buy bonds (which for the first time in nearly a decade, actually have a competitive yield). To ignore this headwind is to miss the economic elephant in the room. This one factor means that we have no playbook to reference while confronting the modern-day problems of high inflation, choking national debt, spiraling healthcare costs, and an under-resourced retirement class.
How the Markets Fared
- The 10-Year Treasury yield skyrocketed from 2.9% on June 30 to 3.8% at the close of Q3.
- The Federal Reserve raised short-term rates twice at an accelerated pace of 0.75% each time to end the third quarter at a Fed Funds Rate of 3.00% to 3.25%. They then raised it again by another 0.75% during the first week of November.
- Credit-spreads are predicting that default rates are going to worsen in 2023-2024, but not near the levels seen in 2009-2010.
- Growth indices in the U.S. reversed course and marginally lead value sectors. Losses in value indices are still less than half of those for growth for the year.
- Small Cap began to rebound. The Russell 2000 Growth index was the only index up domestically during the quarter and small caps in general outpaced large cap stocks.
- International Stocks continue to lag due to continued strength in the U.S. dollar.
The October ISM® Report on Business® (ROB) Manufacturing Index dropped to 50.2% from 50.9% in September. There may be some good news beneath the headline numbers, though. Orders did rise to 49.2% from 47.1% and prices fell. This could mean that the decline in manufacturing activity is leveling out, albeit at tepid levels.
The ISM ROB® Services Index decreased to 54.4% in October from 56.7% in September. New Orders declined to 56.5% from 60.6% for the month prior. The newest report indicates that the services side of the economy may be beginning to take a pause as well.
Both surveys indicate that the U.S. economy is not rolling over into recession, but if the recent trends continue, one could very well be looming.
Working Through It
With business-to-business activity ebbing, the labor markets began to ease ever so slightly. The October unemployment rate rose modestly to 3.7%. Further, the labor force shrunk a bit, resulting in a net increase of just over 300,000 unemployed people. Unemployment readings under 4% still indicate an incredibly tight labor market, but this is the first sign of movement in the ‘right’ direction (from Fed Chairman Powell’s perspective) since the Federal Reserve started lifting interest rates aggressively to stem upward pressure on wages. However, continuing claims for unemployment benefits continue to hover at 1.5 million, which is still below the COVID lows of 2019. Though slightly off their peak of just under 12 million job openings, September’s JOLTS Jobs Report showed that job openings were up nearly 50% from the previous 2019 highs, with 10.7 million jobs unfilled. The Fed will have to do a lot more if they want to unwind this imbalance. This tightness in the labor markets gives employees significant negotiating leverage. This has helped average hourly earnings climb 4.7% over the last 12 months. The Fed sees this increase as a key contributor to inflation.
October’s Consumer Price Index (CPI) was up 7.7% versus the same month last year. This was lower than expected and down from 8.2% in September. Excluding food and energy, CPI rose 6.3% year-over-year. Though this number eased inflation fears somewhat, the prior four monthly reports, which occurred during the third quarter, gave the markets fits. October’s deceleration was the first time since the Ukraine invasion in February that inflation rose less than 8%. The Producer Price Index (PPI), a key factor in the cost of producing goods and services, showed less moderation, advancing 8.0% for the 12 months ending October. Core PPI (PPI less foods, energy, and trade services) increased 5.4% for the trailing year.
Mortgaged to the Wilt
The rapid increase in interest rates at both the long and short end of the yield curve drove all mortgage rates, both fixed and adjustable, to well over 5%, with 30-year fixed rates rising above 6% for the first time since the Great Financial Crisis (GFC). A combination of interest-rate sticker shock and diminished affordability has definitively taken the proverbial bloom off the housing market’s rose. Reports from The National Association of Realtors show that existing-home sales continue to decline, now pacing well below the normalized levels of 2014-2019 (the period after the recovery from the GFC, yet before the impact of COVID). Median prices were still 8.4% ahead of the same time last year, but on a month-over-month basis, the cracks are beginning to show, with median prices now down 8% from the July peaks.
If there is any bright news, it’s that inventory of unsold existing homes is at a 3.2 months’ supply, even at this reduced sales volume. Supply under 5-6 months is considered to be tight, so even with mortgage rates as high as they are, there is still a lack of supply. We are watching this indicator closely, as continued shortages should cushion further declines. However, a spike in supply would accelerate the correction, adding a new fracture in the economy.
Some initial cracks may be showing. New home sales (which are typically geared towards newer buyers and buyers at the more modest end of the economic spectrum) declined 10.9% month-over-month in September, down 17.6% since this time last year. In this end of the market, supply has risen to 9.2 months, up from 8.1 months in August. (Again, 6 months is approximately equilibrium.) It’s important to note that affordability is much more sensitive at this end of the housing market, so mortgage rates and rising household costs in general may have a larger impact here then they do on the much larger and more mature end of the housing market. Nonetheless, this may be an early indicator of further declines on the horizon for the broader housing market in general and should not be ignored. Either way, this slowdown has caused a recent decline in housing starts, which has an impact on the broader economy due to a slowdown in construction spending.
The Conference Board’s October Consumer Confidence Index fell to 102.5 from a revised 107.8 in September. Declines were mostly due to a drop in the Current Situation Index, which dropped to 138.9 from 150.2, led by continued inflation concerns, especially due to rising food and energy costs. It deserves note that consumers expect inflation to climb at a pace of 7% next year. The preliminary report from the University of Michigan Consumer Sentiment Index confirmed the Conference Board data by falling to 54.7 in November. Consumers are now as pessimistic as they were at the depths of the Great Financial Crisis in 2009.
With the mid-term elections behind us and a likely split of power between the two houses of Congress, it is probable that policymakers will be forced to take a more measured and perhaps even collaborative approach for the coming two years. Given the magnitude of policy response since COVID (well exceeding $10 trillion in aggregate), we view that as a good thing.
North Pier’s biggest concern at the moment is the policy coming out of the Federal Reserve. We are not alone. The U.S. stock market rallied nearly 5% in the days following a CPI report that came in slightly lower than expected at 7.7%. The general feeling was that the hint of a retreat in the rate of inflation would compel the Fed to take a less aggressive approach at the upcoming December FOMC meeting (and subsequent policy meetings). We believe this is wishful thinking. The Fed has pledged to break the trend of rising wages. The only way to do that is to reverse demand from employers who are starved for workers in almost every industry. There are still nearly two job openings for every unfilled job in America right now, a modern-day record. Wage growth is not an issue at the margins; taming it would require a complete reversal of the current economic reality – a reality based on a decreased supply of workers from Baby Boomers retiring, not just excess demand from employers. The Fed is using a 40-year-old playbook to confront an entirely new dynamic. If they won’t stop raising rates until wage growth abates, it will require bringing about a meaningful recession and resulting job losses. Exactly what problem are they trying to solve? I fear the cartoon below may tell the tale.