Spring 2023 Market & Economic Commentary
The tale of the tape for the financial markets continues to revolve around the Federal Reserve. This quarter, the debate over the pace and even direction of Fed monetary policy was joined by theories of the Federal Reserve Open Markets Committee’s impact on several regional bank failures. The first quarter of 2023 saw the collapse of a regional tech giant, Silicon Valley Bank (SVB) as well as lesser-known Signature Bank. The root cause of the collapse of these banks was thought by many to be the significant negative impact on the banks’ government bond portfolios in the face of 2022’s rapid increase in interest rates at both the short and long end of the yield curve. The Fed was responsible for lifting short-term overnight lending rates from near zero at the start of 2022, to 4.25% when the first bank failures occurred, and eventually to 4.75% – 5%, where they were at the time of this writing. Upon further investigation, it also appears that the San Francisco branch of the Federal Reserve had been lax in their oversight of SVB, which potentially should have addressed the bank’s growing solvency issues far earlier than the failure.
When news of SVB’s decaying financial condition hit the street, it caused a modern-day run on the bank, with Bay Area depositors rushing to remove uninsured deposits at SVB in a short two-day period. Several other regional banks began seeing similar depositor withdrawals, as general fears about the entire banking system spread. Ultimately, the Federal Reserve stepped in and took SVB into receivership. What shocked many was the Fed’s next step, breaking historical precedent, by insuring all customers’ deposits, many of which substantially exceeded the insurance provided by FDIC and SIPC. (SVB was the home of many tech startups and giants, as well as the deposits of their founders and insiders.) Historically, any deposits in excess of government insurance were locked up, and became creditors in a subsequent bankruptcy, often receiving 80-90 cents on the dollar, and frequently several months later. Although this and subsequent depositor bailout ladened hundreds of millions of dollars of debt on the American taxpayer, it did have the intended effect of stopping a contagion of bank-runs and subsequent failures, a stock market crash, and the related economic fallout.
Despite the Fed’s action, the collapse of SVB nonetheless spilled over into several other bank-runs, including the eventual collapse of First Republic Bank, the second-largest bank failure in U.S. history as well as the demise of one of Europe’s oldest and largest financial Institutions, Credit Suisse, which was founded during the railroad boom of the 1860s. However, the Fed’s ultimate backstop (as well as the ECB’s in Europe) turned these collapses into administrative proceedings instead of the next global financial crisis. Global stock prices remained surprisingly firm during the unfolding of these events. Interest rates for intermediate and long-term debt ironically dropped, helping shore up the prices of the same government-backed bonds whose declines started the whole problem in the first place. This left the balance sheets of the surviving banks in better shape and likely more resilient than just a few short months prior. In contrast to the 2008 collapse of Lehman Brothers, which led to some of the worst stock market crashes and credit crunches in history, the banking failures of 2023 saw stock markets rise and the cost of credit fall. In the age of endless government bailouts, why not take risks? The only people who will pay for the losses are future generations of taxpayers.
How the Markets Fared
Global equity markets managed to shake off the effects of bank failures in the U.S. and abroad. Nonetheless, value indices, which are heavily populated with banking stocks, especially in the mid and small cap indices, were not able to emerge unscathed. As such, growth stocks did far better than value stocks during the quarter. The dispersion of returns was more pronounced in the United States than it was internationally. Larger companies also outperformed smaller companies during the quarter, due to their greater access to capital and generally cleaner balance sheets. The continued rise in interest rates and tightening of credit is anticipated to hit smaller companies far harder than those of larger, more established firms. Commodities were the only area of public markets that saw declines during the quarter.
Though the Federal Reserve moderated its interest rate tightening further in Q1 by a moderate 25 basis points (0.25%) two times, once in February and again in March. (The Fed raised rates again in early May by 0.25%). All in all the Fed has increased the overnight lending rate by 5.0% since Q1 2022. The bellwether 10-year Treasury declined to 3.5% at the end of Q1 after finishing 2022 at 3.88%. This decline was largely due to expectations that the economy was nearing a recession and that the Fed would be forced to lower interest rates in response. Longer duration bonds, especially those issued by the United States, rejoiced in the lower yields, recouping some of their massive losses of 2022. Generally, most domestic fixed income vehicles regained some of their lost ground in the first quarter. The same was true of both developed and emerging market debt.
Ultimately, the Fed’s aggressive monetary policy, the recent bear market, and subsequent bank failures were all born out of the worst inflation in multiple generations. On this front, conditions are still bad, but they are improving. On a year-over-year basis, the Consumer Price Index (CPI) was up 5.0%, versus up 6.0% in February. That is the smallest 12-month increase since May 2021. Core-CPI (ex-food and energy) was up 5.6% year-over-year, versus up 5.5% in February. The food index was flat month-over-month, still up 8.5% year-over-year and the shelter index was up 0.6% month-over-month and up 8.2% year-over-year. The energy index, which was the main reason headline CPI was benign in March, was down 3.5% month-over-month and down 6.4% year-over-year.
On the other hand, the PPI (Producer Price Index) index for final demand was up 2.7% versus 4.9% in February versus the same time last year. Excluding food and energy, the index for final demand was up 3.4% versus 4.8% in February. This deceleration in PPI growth suggests that there may be a decrease in inflationary pressures at the consumer level in the coming months/quarters. However, it’s important to note that there may be a lag before consumers see any relief in prices, as corporations will likely take some time to moderate their prices. This could be due to a need to recover from the massive price and supply chain shocks of 2021 and 2022, or simply because of profiteering.
That said, an abatement of large-scale inflation is anything but certain. The final University of Michigan Consumer Sentiment Index for April reported that inflation expectations for the year ahead held steady at 4.6%. The reading from the Conference Board’s Consumer Confidence survey was even more concerning, reporting that consumers’ 12-month inflation expectations remained at 6.2%. If consumers are correct about this and inflation persists, the Fed is less likely to ease interest rates any time soon, and may, in fact, continue to raise rates as its fight against inflation wages on. Normally consumers might not be the best sources of insight on such issues. However, as one will read ahead, strength in the labor market, and in subsequent wage growth may be the cause of continued inflationary pressures. If that’s so, then workers, not policymakers, would have a better view of inflation looming on the horizon
Working in the Heat
If the Fed is trying to dowse the flames of wage inflation with higher interest rates, then the fire is still raging. The US labor market showed signs of continued strength in April with nonfarm payrolls increasing by 253,000 (which was stronger than expected), although the gains were partially offset by downward revisions of nearly 150,000 for the previous two months. April continued job growth led the unemployment rate to decline to 3.4% versus 3.5% in March. The U6 unemployment rate, which accounts for unemployed and underemployed workers, was a mere 6.6% versus 6.7% in March. (Also at a record low.) Despite the positive news for workers, there was an uptick in the number of long-term unemployed, indicating that some isolated workers are still struggling (or unwilling) to find jobs. Record tightness in the labor markets helped propel average hourly earnings for April up an additional 0.5%, an increase of 4.5% year-over-year. Though down from the nearly 6% annual gains at the peak, there is clearly still upward pressure on wages, which supports the Fed’s hesitancy to reverse its policy of lifting interest rates.
As we have stated in previous economic commentaries, the tightness in the labor market is greatly impacted by the retiring of millions of baby boomers each year. The Fed is using an old monetary policy playbook, as if the jobs market was in some sort of normalized equilibrium. We haven’t been and we are still not even close to typical conditions. Presently, there are nearly two open positions for every unemployed worker in the U. S. and higher interest rates have had little effect in bringing those numbers back in line with historical norms. If there is any good news to be had, it’s that the JOLTS Job Openings report March declined to 9.6 million openings, down from 10 million last month and a peak above 11 million last year. That is still far ahead of the pre-pandemic record high of 7.5 million. However, it is a move in the right direction that may give the Fed some hope that wage inflation may be on its way to being tamed.
House it going?
The housing market continues to fluctuate with the National Association of Realtors® reporting that existing home sales declined 2.4% month-over-month in March, down 22.0% from the same period in 2022. Despite the slowdown, home prices have remained relatively stable nationally, with only a slight decrease in price since the same time last year – except in the Western region which experienced a 7.5% drop year-over-year. The inventory of homes for sale has increased slightly from a year ago, but the inventory of unsold homes for sale remains very low with a 2.6-month supply. This indicates that the housing market is still very tight and unlikely to see substantial additional pricing declines any time soon, despite significantly higher borrowing costs for potential buyers. Although counterintuitive, the same higher interest rates that are driving up mortgage costs and keeping potential buyers at bay may also be keeping existing homeowners looking to relocate, upgrade, or downsize from wanting to list their homes out of fear of losing their low-interest mortgages acquired over the last decade.
Despite the challenges for both sellers and buyers alike in the existing home market, new home sales appear to be a recent bright spot. The sale of new homes increased 9.6% month-over-month in March, down just 3.4% from this time last year, and median sales prices actually increased 3.2% year-over-year to $449,800. The current sales pace shows a supply of new homes for sale at 7.6 months, down from the 9.4 months of supply last November (approaching equilibrium). As these homes tend to be in faster-growing markets and regions, this may be an indicator that suggests demographics in transition, and not a broader comment on the national real estate market as a whole.
With the jobs market still robust, and home prices holding stable, one would expect that American families would be feeling more comfortable than they do. The Conference Board’s Consumer Confidence Index for April fell to 101.3 from 108.6 for the same period a year ago. The Present Situation Index increased to 151.1 from 148.9, which is quite rosy. However, the Expectations Index dropped to 68.1 from 74.0. As we’ve commented on before, the disconnect between present conditions and expectations for the future is perplexing. Consumers have been feeling this way for well over a year now, yet the sky has not fallen. The chief cause for this pessimism was a weaker outlook for business conditions and the labor market. One might ask how much these views are shaped by the media and social echo-chambers than the personal observations of the population. But that kind of fatalistic thinking can lead to the economic contraction that many fear. The surprising January increase in retail sales of 3.1% was not an indicator of phantom strength at the consumer level, as we had hoped. It appears to have been an anomaly. Instead, retail sales declined 0.2% in February and another 1.0% month-over-month in March. Consumers may be tightening their belts, which would not bode well for the coming quarters. However, consumer credit usage increased by $26.5 billion in March (up 5% year-over-year) which was led by an increase of $17.6 billion in revolving credit. Non-revolving credit increased by $8.9 billion (installment loans). The ultimate question is, are consumers taking on this additional credit (mostly on credit cards) out of necessity to get by, or out of confidence in their ability to pay it back in the future?
With credit usage and interest rates on the rise, it is logical to ask if Americans are overextended. The simple answer is no, in the aggregate. Though household debt service costs have risen meaningfully over the last year or so, it deserves to note that it has risen from a record low due to the easy money of the last decade. Despite the additional costs, debt servicing still costs Americans less than or equal to any point during the 40 years prior to COVID-19. Even defaults are at historically extremely low levels. Even if things get worse from here, households in the U.S. are generally well-positioned to weather an economic shower, if not an outright storm.
With the U.S. stock market valuations reinflating to 18.2 times next year’s earnings (for the S&P 500), stocks have gone from slightly cheap to a bit overvalued again. Long-term norms of approximately 16.5 times earnings may be more reasonable, especially in the face of what some see as a looming recession. Globally, pricing looks much more reasonable. Japanese and European equities are trading at a considerable discount to their long-term norms, as is China (although geopolitics may justify China’s discount). Emerging markets are on par with their historical averages. Only the U.S. still trades at a premium to its median valuation, despite declining 15% from recent market highs. Presently, Non-U.S. stocks are nearly two standard deviations less expensive relative to U.S. stocks. These stocks are starting to outperform those of the U.S. Further the dollar seems to have peaked, which could continue to aid this outperformance. After over 15 years of U.S. dominance, is this the beginning of the long-overdue international trend?
Globally, value-oriented sectors are still far cheaper than those of growth stocks, albeit not nearly at the dispersion we saw in 2021. Even bond values have become attractive. Yields on almost every domestic and international fixed income vehicle are at or near their highest levels since the great financial crisis. With fixed income and other yield-oriented vehicles finally paying 5%, 6%, 7% or more, and international equities representing bargains compared to those in the U.S. One must wonder if the FANGs (Facebook, Amazon, Netflix, and Google) have been de-toothed.
Taking Care of Business
The U.S. Economy is still bifurcated. The April Institute of Supply Management (ISM®) Manufacturing Index increased to 47.1% from 46.3% last month. (Readings above 50% represent expansion, below 50% suggests contraction.) This marks the sixth straight month of contraction for domestic manufacturing. The ISM Non-Manufacturing Index for April representing conditions for the service side of the economy increased to 51.9% from 51.2% in March. New Orders for services increased to 56.1% from 52.2% in March, which is very promising for continued expansion. Since the services side of the economy represents more than three-quarters of business input on the economy, sustained growth in services may predict that we a heading towards a soft landing, and not a severe recession (if any at all). The same phenomenon was also observed globally, with The JPMorgan Global Services Business Activity Index posting an expansion inspiring 55.4 in April. Job growth was reported virtually across the globe, confirming the strength in labor seen in the United States.
With domestic and international labor markets strong, workers can demand better wages. This leads to increased spending and investing power that is likely to propel global economies forward. One need look no further than the increase in personal consumption expenditures which accounted for nearly 2.5% in the first estimate of Q1’s GDP. Despite all the doom and gloom predictions of a looming recession over the last year, one has still yet to materialize. Initial reports show that real GDP (adjusted for inflation) increased at an annualized rate of 1.1% in the first quarter, after increasing by 2.6% in the fourth quarter; this was up and above the impact of inflation. These gains are taking place despite the Fed aggressively raising the cost of capital to both businesses and consumers alike. We are certainly not saying that the economy is likely to avoid a slowdown, but we are challenging prevailing assumptions about when it will hit and how severe it will be. We even challenge the ‘where.’ Our PIERspective is that the U.S. will likely see an economic contraction in regions like the San Francisco Bay Area and industries like technology and select manufacturing. But other service-focused industries such as hospitality and healthcare are likely to see continued strength, as will the regions and cities that are the beneficiaries of demographic shifts out of states like New York, California, and Illinois. This isn’t likely to be a falling tide lowers all ships kind of slow down… if one even hits at all. But then again, if Main Street America manages to avoid a recession, will the Federal Reserve step in and make sure that we have one anyway?