Summer 2023 Market & Economic Commentary

Sure, inflation is still with us, albeit at more modest levels (by most measures). Yet, that’s not the inflation I’m speaking of. It’s the re- inflation of the valuation bubble in large cap growth stocks, the bubble that burst just a year and a half ago. The Russell 1000 Growth Index is now trading at 26.6 times next year’s expected earnings. This is verses 18.8 times for the 20-year average, over a 40% premium. This is better than the 60% premium over its long-term average that we saw as the market was peaking at the end of 2021, but we can see it from here. This index is up a whopping 30% year-to-date. But these gains and valuations fly in the face of the realities of the fundamentals of the underlying stocks, heavily weighted by technology companies. FactSet expects these companies to grow earnings by an average of 12.5% over the next five years. That growth is quite normal and does not justify the premium. Unless…

Unless A.I. (artificial intelligence) is the paradigm shift that many speculate it is. If that is the case, then perhaps this year’s run-up in growth stock prices is justified. The inevitability of A.I.’s progression was not a surprise, though. It has been discussed for years and has been gradually incorporated into everything from customer service (bots) to email predictive language. What changed was the public release of ChatGPT and some other graphic programs that began to demonstrate the power of the tool. But have they established the value? What is known is that every earnings report over the last few quarters is laced with the terms “machine learning,” “A.I.” and the like. This phenomenon has the feeling of hype but may also contain a heavy dose of hyperbole. Any way you slice it, the markets have shaken off an abdominal year in 2022, and quickly embraced the promise and risk of a new era.

A.I. didn’t completely dominate the markets over the last quarter. Our friends at the Federal Reserve continued to grab the spotlight by first pausing their rampant rate hiking cycle at the June meeting (giving hope that we may have reached the end of the most aggressive rate hiking cycle in modern history) and then by resuming their trend of raising interest rates. Despite headline inflation moderating to more tolerable rates over the last four months, the Fed continued to focus on wage growth, which continues to increase at nearly four and a half percent annually. As such, they have resumed increasing the cost of short-term borrowing rates and have indicated that more hikes may be required in the future.

With the Fed dimming the market’s hopes that we had peaked in interest rates, bond yields rose throughout the quarter (rising further during July). This led to modest losses in higher-quality U.S. fixed income. The bellwether 10-year Treasury yield jumped from 3.5% to 3.8% during Q2 and has since broken well above 4% thus far in Q3. High yield bonds, supported by larger coupons and improving credit spreads, broke the trend, adding to their already attractive gains for the year. The same was true for emerging market debt. Developed market international bonds saw slight declines, similarly to those of U.S. fixed income instruments.

On the equity front, stock prices advanced broadly across most of the globe. Unlike Q1, which saw most of the gains concentrated in a handful of mega-cap tech stocks like Microsoft and Apple, Q2 saw more participation, both in value indices as well as smaller cap stocks. Large cap growth names still led the way, with the Russell 1000 Growth index up nearly 30% for the first half of the year. Internationally, gains were more even between value and growth. This is likely due to developed market economies generally being more influenced by cyclical companies. Emerging market equities were more muted in Q2 with the exception of Latin American stocks which soared due in part to some surprising strength in the Brazilian economy. Further gains for Latin currencies versus the dollar also aided in their strong performance. Of note, this move was a bit counter cyclical, as Latin equities typically move in line with commodity prices, since many of those economies are heavily reliant on exports of natural resources. That was not the case this quarter, as commodity prices continued to sag a bit, continuing to retreat off of their highs reached during the peak of inflation last year.

Back to the Other Inflation

Despite the stock market’s run up, which heavily favored AI-focused companies, the day-to-day tape still has been heavily influenced by a focus on inflation and its ultimate direction. The second quarter saw a generally favorable deceleration in the growth rate of both consumer and producer price increases, with CPI growing at a 4.8 percent annualized rate (not factoring in volatile food and energy prices). This was an improvement from the 5.3% rate reported in May and nearly half of the peak inflation seen a little over a year ago. As food and energy prices do make up a significant portion of non-fixed spending for consumers, more encouraging news was seen in the headline CPI number which grew at a 3% year-over-year rate in June compared to 4% growth in May from the same time in 2022.

That said, there is still a very concerning amount of inflation that impacts Americans, especially younger and more marginalized participants in the economy, and that is the cost of housing. The CPI Shelter Index for June was persistently still up 7.8% year over year. As many workers and retirees on fixed incomes are subject to the variability of rent costs and do not own homes with steady mortgage expenses, this stubborn area of inflation will continue to press on the wallets of a significant portion of society. Offsetting these challenges has been a significant moderation in inflation at the services level, which impacts consumers from all walks of life.

As we commented on last quarter, inflation that is measured at a more wholesale level, the producer price index, seems to be moving into truly benign levels. Again, not factoring food and energy costs, the PPI decelerated to a modest 2.4% year-over-year growth versus 2.6% in May. However factoring food and energy, which can have a very large impact on manufacturing and delivery of goods, PPI fell 2 nearly zero compared to the same time last year. In the short term, this can help bolster profits for U.S. companies in the face of a slowing economy. The GDP Deflator, which is more a broad measure of real costs in the United States, fell to just 2.2% in Q2 based on initial estimates from the Bureau of Economic Analysis (BEA).

Shifting Gears

With broad-based inflation decelerating, we are starting to see more normalized calculations for the growth of the economy. Real GPD for the second quarter, adjusted for inflation, grew at 2.4% (according to the advanced report from the BEA). This top-line number appeared strong but was impacted by a much-reduced GDP Deflator. In current dollar terms, not adjusted for inflation, GDP increased by an annualized rate of 4.7% which was down from 6.1% in Q1. Current data is still suggesting a domestic economy that is growing, albeit at a muted pace.

Waging War

If the Fed has been at war with wage inflation, the news from the front isn’t great. Continued tightness in the jobs market, which is far more due to a lack of available workers than booming demand, is driving continued hourly earnings growth of 4.4% annualized. The Fed would like to see that number cut in half or more.

July nonfarm payrolls increased by 187,000, for a three-month average of 218,000. Though the last two months may have added less than the key 200,000 level that many look at to ease pressure, at the same time the July unemployment rate declined to a 50-year low of 3.5%. Further, the U6 unemployment rate, which includes those unemployed and those underemployed, dropped to a very low 6.7% versus 6.9% in June. Part of this may be due to a distortion in the way both numbers are reported. Non-farm Payrolls come from what’s known as the Establishment Survey, meaning that the data comes from known and established businesses. The unemployment rate, however, comes from the Household Survey, which is a poll of American households to see if they are working and at what rate (full or part-time). In the new world of gig-workers and sole proprietors, this second datapoint may be far more indicative of the current labor market than the former. If that is the case, the Fed hasn’t moved the needle one bit.

Another reliable indicator of the labor market is the BEA’s JOLTS report, which showed 9.6 million current job openings vs. just under 11 million this time last year. As we reported last quarter, coming off the peak is a small step in the right direction, but leaves far too many openings to restore equilibrium in the labor markets. To level-set this statistic, the prior high was set at 7.5 million in 2019, when the unemployment rate was 3.5% prior to COVID.

House You Doin’?

Housing prices are climbing again, after a brief and slight pullback after mortgage interest rates better than doubled after bottoming in late 2021. The National Realtor Association reported that median existing-home sale prices for June grew to $410,200, less than one percent off of last year’s all-time high of $413,800. Higher borrowing costs have not been enough of a dampener on the market to offset bone-dry supply in the market. Even at this year’s significantly slower pace of sales, there are still only just 3.1 months of supply of homes on the market, about half the amount required for equilibrium. The Cases Shiller index for May 2023 (which lags the NAR® report) showed that “all 20 major [U.S.] metro markets reported month-over-month price increases for third straight month.” Here too, declines year-over-year were a modest 1.7% loss.

For those who were hoping the housing market would correct after their torrid rally leading up to and through COVID, there is no relief in sight. Housing starts have declined nearly 20% from a year ago. The higher cost of capital due to higher interest rates is impeding much-needed new supply in both single-family homes as well as multifamily condos and apartments. This is good for homeowners, suggesting that supply will remain low; but it is concerning for those who rent and have seen nearly double-digit percentage increases for nearly three years now (the most stubborn of the inflation factors).

Mood Enhancers

Americans are growing more and more optimistic, or should I say less and less pessimistic. We’ve been commenting about the fact that consumer confidence readings over the last year or so were equal to the despair at the depths of the Great Financial Crisis fifteen years ago. (Remember the 10% unemployment and 40% declines in home values?) Maybe it’s the abatement of runaway inflation, the recovery in the stock market, or continued faith in the employment situation – whatever it is, moods seem to be improving.

The final July University of Michigan Consumer Sentiment Index came in at 71.6 versus 64.4 for June and up from just 51.5 one year ago. These readings have continuously been dampened by Americans’ expectations for the future, not based as much on their current situation. This is where we find the most meaningful improvement. The future expectation component of the Michigan survey rose to 68.3 from a catatonic 47.3 this time last year. Though numbers near 70 are far from ecstatic, they are getting close to the average point between both good and bad times, and the trend is heading in the right direction.

Other measures of the mindset of the average American confirm that views are getting rosier as well. Consumer Confidence as reported by the Conference Board also showed a jump this last month and over the last quarter. The July reading came in at 117.0 improving from 110.1 in June and soaring from the lows this time last year of 95.3.

Another indicator of consumer sentiment isn’t just how they respond in surveys but how they behave. With retail sales growing 0.4%, 0.5%, and 0.2% in April, May, and June respectively, it appears that consumers are putting their money where their mouths are. This isn’t frivolous spending with money they don’t have. American households are generally still having an easy time servicing their debt and are far from overextended. (See chart – right. Source: J.P. Morgan)

A Tale of Two Sectors

If consumer sentiment surveys give a glimpse into the future spending behavior for consumption in the U.S., then the ISM® Report[s] On Business® (ROB®) let us look into the crystal ball for the approaching growth rates in the Manufacturing and Services sectors of the economy. As we reported last quarter, the news here is quite mixed. Manufacturing in the U.S. arguably entered a recession last summer. The ROB Manufacturing report rose a tad over last month to 46.4%. That’s quite anemic given that readings below 50% suggest contraction. Although new orders rose a bit to 47.3% in July, what is concerning is that the employment sub-index showed a large contraction. This means that manufacturers are hesitant to hire and are trimming headcounts in advance of the coming cycle.

On the other side of the equation, The ROB® Non-Manufacturing (i.e., Services) report posted a July reading of 52.7%, down from 53.9% in June, but up from our last commentary in April. Though certainly not indicating boom times ahead for services, it still indicates moderate growth equal to about 1% real GDP growth for the coming year. Add that to the Manufacturing ISM ROB® prediction for a contraction of 0.8% and it appears that we are heading towards at least a stagnation in the U.S. economy in the coming quarters.

That may actually be good news, at least to the Fed’s ear. Similar to the contracting employment data for Manufacturing, the services side of the PMI survey showed employment declining to 50.7% from 53.1% in June. With both sides of the economy growing more hesitant about their labor forces, perhaps the Fed will finally see some results from their draconian interest rate increases over the last 18 months.

PIERing Ahead – We Think Not

We still think the Fed is wrong and they will stay that way far longer than they should. A slowdown in manufacturing and a moderated robust services side of the economy won’t be enough to sop up the massive backlog of demand for workers any time soon. Looking back at the JOTS data, we need to either destroy demand for, or fill, about 4 million of the 9.6 million currently open jobs to get back to equilibrium in the labor markets. A mild recession, even if we were to enter into one, won’t come close to accomplishing that. Perhaps the Fed’s interests aren’t truly tied to price stability, as they are chartered to be. Maybe it’s big banking and their large corporate constituents’ interests that have been motivating their nearly myopic obsession with killing the slight gains in real wages that workers in America have finally been enjoying. The writing is and has been on the wall regarding the slowing economy and easing inflation Yet at the July Federal Reserve Open Markets meeting, the governors once again voted to lift interest rates. Further, Chairman Powel stated in his post-meeting comments, “The process of getting inflation down to 2 percent has a long way to go.”

Again, we think the Fed is wrong. In fact, they are ironically creating more inflation in areas of the economy with their failure to end their cycle of increases. The still persistent 8% inflation in housing costs (Shelter Index) can’t come down without more supply. More supply is constrained by increased borrowing costs. Increased borrowing costs are a result of Fed hike action. Further, new building needs financing in general. Credit is not only expensive, but it’s also getting harder to come by. This is because the banks (generally regionals) are suffering from losses to their bond portfolios from 2022’s bond market collapse (al la SVB, Signature, and First Republic banks) Further, these banks are stressed by the commercial real estate loans on their books that are having difficulty requalifying as their cost of new mortgages has soared precisely at the time office buildings sit vacant and values of those buildings start to plumet. I wrote extensively on this phenomenon last month in my first article as a contributor, “Don’t Look Up – Why A Commercial Real Estate Crash Might Be Streaking Toward Us.”

Markets, media, and even most analysts have a very short-term perspective on the interest rate cycle. They think rates will go up and then down just like they have for the last several decades. A look back at history prompts another possibility. The economy, deficit spending, inflation, and interest rates over the last few years are not all that dissimilar to conditions that presided during the late sixties, moving into the high inflation era of the early 1970s. The Fed raised interest rates aggressively in 1969 to fight inflation. Those increases weighed on the economy bringing about a recession in 1970. Though inflation had begun to come down, the Fed cut interest rates to stimulate the economy in advance of the 1972 election and inflation reignited shortly thereafter. This paved the way for waves of double-digit inflation, which persisted until the early 1980s.

Far too few people have offered the possibility that inflation may only be taking a pause (as if 4.5% inflation represents a pause). There are so many variables in today’s economy that it is naive to think that we are beyond this problem and that “normal” is right around the corner. What if it’s not? What if the title of our Summer 2024 commentary is Re-Re-Inflation? What would happen to those ballooning stock valuations then? It’s not that we are confident that this is the direction we are heading. It’s simply that our Pierspective at the moment is – it’s a very real possibility, especially if the Fed disappoints dovish moderation hopefuls and it continues on its (war)path.

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