Fall 2023 Market and Economic Commentary
Reality finally sank in for the markets. Higher interest rates may be here for longer than many had hoped. For over a year, we have been discussing the interrelationship between the tight labor market, the economy, and the Federal Reserve’s fight against inflation (specifically wage inflation). The markets wishfully thought that the economy would slump and that the Fed would moderate and even reverse their torrid pace of lifting short-term interest rates. Initially, the markets were predicting that the Fed would stop at 4% to 4.5%. Now the hope is that they are nearly done at 5.5%. We have urged that the risk of continued rising rates has been higher than expected from the beginning, and we are still cautioning that there may be more to come. A lot more.
With over 9.5 million unfilled jobs in America (according to the latest JOLTS report), the U.S.’s 3.9% unemployment rate is unlikely to move anytime soon. That shortage of workers is still driving wages to grow at 4.1% and the Fed doesn’t like it. As early as March of 2022, Fed Chairman Jerome Powell cautioned that wages were “moving up in ways that are not consistent with 2% inflation over time.” He foreshadowed, “We need to use our tools to guide inflation down to 2%. That will be in the context of an extraordinarily strong labor market.” And use those tools they did. After lifting rates just 0.25% in the month preceding that statement, the Fed raised rates a staggering 5% over the coming 18 months. Still, wage inflation has only moderated slightly in that time, from near 5% in March of 2022 to the 4.3% it is presently.
But worker shortages and increasing wages aren’t the only headwinds that American businesses face. Throughout the first three quarters of this year, AP reported that according to Cornell University’s Labor Action Tracker, “at least 453,000 workers have participated in 312 strikes in the U.S. this year.” Industry behemoths UPS in transportation, the UAW in automotive, SAG and WGA in entertainment, and Kaiser Permanente in healthcare – all have seen massive disruptions in their industries with high-profile worker strikes this year. And it’s not a coincidence. After decades of subordination, labor once again has the upper hand. Not only are wages on the rise but also benefits and improvements in conditions. This all comes at the cost of American businesses, and eventually can spill over to the consumer.
How the Markets Fared
The Federal Reserve only raised rates by a quarter of a percent during the quarter, but it was their comments that disappointed the market. With the Fed indicating that short-term interest rates are likely to stay at current or even higher levels for longer than the markets had hoped, interest rates across the yield curve continued to climb during the quarter. The bellwether 10-year Treasury soared from 3.81% to 4.57%. The two-year rose from 4.87% to 5.03%, indicating a higher chance of sustained 5% rates. This caused additional losses in the intermediate and longer-term investment-grade fixed-income markets to such an extent that the aggregate index was negative for the year. Long bonds, which are used in many defined benefit plans to hedge against their liability costs, lost double digits. This is on top of last year’s nearly 30% decline in long-term government bonds. Besides cash instruments, which are returning upwards of 5% annualized.
Presently, the only other bright spot in the credit markets was in high yield. Sub-investment-grade bonds were bolstered by higher coupon payments and managed to post slightly positive returns for the quarter. International markets were mixed due to similar dynamics. Higher quality developed market bonds saw declines akin to those in the U.S. Higher yielding emerging markets generally managed to avoid losses for the same reason the high yield bonds performed well during the quarter.
On the equity front, the news wasn’t much better. Generally, global equities saw declines across the board. In large cap U.S. equities, there was little discernment between declines in cyclical/value-oriented and growth sectors, with the exception of some strength in energy stocks. In the small cap area, losses were far more focused in the growth end of the spectrum as discounts for future growth expectations widened as interest rates continued to increase. Further challenging this end of the marketplace is the expectation that funding future growth through debt and other means will become increasingly more expensive for these small cap stocks in the near future.
Internationally, cyclically oriented companies largely avoided declines, performing far better than growth stocks. Rounding out international market performance, emerging markets generally saw modest declines in both the Asian and Latin regions. North Pier has noted in the past that Latin American emerging market equities have had a tendency to outperform when commodity prices are rising or shortly thereafter. It deserves note that commodities did see in modest rebound in Q3 and, as such, one might expect to see Latin American emerging market equities finish the year on a stronger foot as long as commodity prices hold firm.
Be-Laboring the Point
Just as inflation and the Fed’s corresponding unprecedented actions in catapulting short-term rates were the fulcrum off which all markets levered in 2022, the unwavering strength in the labor force is at the center of nearly everything in the economy. As mentioned in my introduction, workers are enjoying some of their best leverage in modern history. They’re taking up a tad recently, the unemployment rate at 3.9% is well into its second year of full if not outright over-employment. Though markets rejoiced with the recent November employment data, North Pier believes that this slight easing was largely attributed to the unprecedented United Auto Workers strike against all three major U.S. automakers. With two of the three major U.S. car companies (ex-Tesla) reaching agreements with the union (agreements in which many concessions were made) it is highly likely that this slack in the labor market will prove temporary in the next one or two monthly job reports. By North Pier’s estimate, the unfilled jobs in America will need to decline by 3 to 4 million from the present 9.6 million openings, currently reported in the JOLTS report, for significant wage growth to finally abate and for the unemployment rate to return to a healthier 4.5% to 5%. With a strong holiday season looming on the horizon, seasonal retail and transportation workers will likely add to near-term re-tightening.
Americans spent at a healthy clip in the third quarter with monthly increases from 0.6% to 0.8% in retail sales. With wages on the rise and confidence in the jobs market, this behavior makes sense. However, it contradicts recent malaise in the consumer confidence data. The Consumer Confidence Index dropped to 102.6 in October from an upwardly revised 104.3 in September. This confirmed the lackluster results from The University of Michigan Consumer Sentiment Index for October, which posted a reading of 63.8, reversing recent gains and September 67.9 results. Both reports show improvements over the same time last year but are far from showing a consumer that is as confident as recent spending would indicate. One likely weight on consumers’ moods has been the recent pullback in U.S. equity prices. After such a rough 2022, any retreat could trigger PTSD for investors, including American workers overseeing declines in their 401(k) plans yet again. With the recent market rebound, this negative impact on sentiment may be short lived. We have regularly remarked, however, that the consumer confidence readings have been showing a far more pessimistic consumer than reality has borne out for well over a year now. We believe that the labor market and its continued strength is a far more meaningful contributor to consumer behavior than sentiment surveys might reveal.
Inflation data has been showing some mixed signals. On the one hand, headline consumer price index (CPI) data has been declining, albeit not yet to the Fed’s target of 2%. Total CPI growth in September once again grew at an annual rate of 3.7% while core CPI (excluding food and energy) decelerated to an increase of 4.1% compared to 4.3% for the 12 months ending in August. The good news is that most areas of inflation measurement in both goods and services have come down to sub-3% year-over-year growth. However, in addition to the aforementioned 4.1% wage growth, the shelter index continues to exhibit 7.2% annual increase in the cost of keeping a roof over one’s head. This is likely a key driver for why the University of Michigan consumer sentiment survey revealed that respondents’ expectations for inflation for the year ahead increased to 4.2% versus their initial estimates of just 3.2% in September.
The coming few months will be crucial for prices. If the recent rebound in inflation at the wholesale level is a directional indicator, further declines in inflation may prove to be evasive. The Producer Price Index (PPI) for September was up 0.5% month-over-month following a 0.7% increase in August. PPI, excluding food and energy (Core PPI), rose 0.3% since August, climbing back up to 2.7%, versus the 2.2% annual rate in August. Headline PPI inclusive of food and energy was up 2.2% annually, versus 1.6% in August.
The National Association of Realtors® latest report on existing home sales (coving September) showed continued tightness in the housing market. Inventory of 1.3 million homes is up over recent months and has rebounded off of the early 2022 lows of just 850,000, but is still far from the pre-pandemic levels of 1.9 million in the summer of 2019. Even at a slower pace of sales, the existing inventory represents just a 3.4-month supply of homes on the market. Supply below 6 months is considered tightness. As long as that pace and supply stay in this range, home prices will continue to stay firm. This same report showed a 2.8% increase in median sales prices over the same time last year and just 4% off of their all-time high over the summer. (The fall/winter typically sees a season dip, despite broader market conditions.)
The S&P Case Shiller data, which lags the reporting period of the NAR but is considered to be more accurate, broke a record in the latest reporting period (July). Craig J. Lazzara, Managing Director at S&P DJI stated that, “Our National Composite rose by 0.6% in July, and now stands 1.0% above its year-ago level… July represents a new all-time high for the National Composite. Moreover, this recovery in home prices is broadly based.” Lack of supply has continued to bolster the building of new homes. After being hindered by 2022’s spike in mortgage rates, that new home market is rebounding strongly. New home sales increased 12.3% month-over-month in September, the strongest rate of sales since February 2022 (before mortgage rates spiked.) On a year-over-year basis, new home sales were up 33.9%. Builders have adjusted to higher mortgage rates with concessions of subsidized mortgage rates and lower, more affordable prices (the median sales price declined 12.3% year-over-year to $418,800) to stimulate demand. Managed inventory and spurred sales have helped winnow supply down close to equilibrium at 6.9 months, versus 7.7 last month and 9.7 months in September 2022.
Generally, the news in housing is good for homebuilders (as volumes are increasing), good for new home purchasers (due to incentives), and good for homeowners (due to firm values). For those folks, the economic impact is positive. However, the current market is still challenging for those who own homes that they want to move from. Many homeowners are resistant to the idea of selling a home where they have a 3% mortgage, to buy a home paying 8% interest. For the median home purchase price of around $400,000, with a $300,000 mortgage, that’s $15,000 more a year in interest payments. This ‘delta’ is causing many to stay put, or to move and rent out their old home instead of selling it.
The gains that American workers are enjoying mentioned earlier in our observations aren’t materializing out of thin air. Though a strong economy benefits all, underneath that variable there is a tug-of-war going on between labor and businesses, and lately, businesses are losing ground. That may be part of the reason that businesses in America are growing less optimistic according to recent purchasing manager surveys. The November Institute of Supply Management® Report on Business® released during the first week of November shows that the recent improvement in the manufacturing side of the economy is fizzling once again. The recent survey results for the ISM ROB Manufacturing Index disappointed with a reading of 46.7% after rebounding to 49.0% last month. (As a reminder, readings under 50% indicate contraction.) The ISM Services ROB also decreased to 51.8% in October from 53.6% in September, not quite showing contraction but not instilling confidence either. There was a bright piece of the Services Index data – New Orders rose to 55.5% from 51.8%, which bodes well for December’s reading. Since the Business Activity/Production portion of the index was the largest detractor from this month’s reading, having dropped to 54.1% from 58.8% in October, one could speculate that attention to geopolitical events may have been the driver and that the dip will be temporary.
The U.S. economy is still driven over two-thirds by consumption. At the end of the day, people’s willingness and ability to spend drive our near-term economic condition. Though businesses may be facing substantial headwinds from higher borrowing costs, increased cost and scarcity of workers, and higher energy and materials costs, American households are generally keeping up with rising costs due to their increased earnings and healthy personal balance sheets. The resultant consumer spending is driving the U.S. economy forward at a shockingly firm pace. The first report of third quarter GDP was up 4.9% in real terms and an outstanding 8.5% in current dollar-term (unadjusted for the 3.5% inflation deflator). The net result is a year-over-year real increase of 2.7%. That’s impressive given the economic headwinds that higher borrowing costs have created.
If the economy is growing well despite these challenges, and American workers are finally seeing some personal gains net of inflation after a generation of stagnation and backsliding, maybe the Fed shouldn’t be trying to kill wage growth with their tight monetary policies. This provokes the question, what exactly is it that the Fed trying to do? To answer that question, one might look to what the Fed is, and ultimately who it serves. The Fed declares that its two primary objectives are to enact monetary policies that encourage stable and full employment and stability in prices. However, in their urgency to tamp down multi-generationally high inflation by raising short-term lending rates from near zero to 5.5% in less than two years, they appear to be attempting the antithesis.
Raising interest rates has created price instability in one of the most meaningful areas, the cost of capital and major purchases. The cost of a mortgage has nearly doubled in two years. Not the interest rate, which has tripled… the actual monthly payment on the same size loan. Commercial real estate owners and developers can’t affordably refinance their debt. This is contributing to rent which is still growing at over 7% per year nationally. Car leases and loans have skyrocketed in cost. This price “instability” is not due to the value of a building or car, just the cost of acquiring one for most people. Further, the Fed has openly stated that it is trying to unseat labor’s leverage by killing jobs. In September 2022, Chairman Jerome Powell clearly explained their objective for raising rates as aggressively as they have.
“What we hope to achieve is a period of growth below trend, which will cause the labor market to get back into better balance, and then that will bring wages back down to levels that are more consistent with 2% inflation over time.” –Jerome Powell
That doesn’t sound like the objective of an organization that wants full employment. As a reminder, the Fed isn’t a government branch, agency, or in any way an entity of the Federal Government. It’s a private institution in which banks are the shareholders. Fed member banks must pledge 6% of their capital to those shares. However, unlike typical companies, the price of these shares always stays the same and the U.S. Government ultimately guarantees that stability. In turn, these same banks make a 6% dividend from their required capital. It’s essentially a 6% guaranteed return on risk-free capital for the banks. That rate looks pretty darn good in 2021 when banks were paying depositors 0.0001% on their savings accounts (a 6% spread). It doesn’t look so great in 2023 when a fully liquid 3-month Treasury pays 5.5%. There’s one motive for wrecking the economy to get rates down.
However, a far bigger motivator is the interest of the depositors and investors that these member banks cater to as clients. Most Fed member banks make a significant portion of their profit from corporate clients. Earnings can come from interest from real estate and commercial loans, cash management, transaction fees, and spreads from deposits. Many larger member banks also have investment banking arms. These divisions add significant revenue from investment banking activities, such as mergers and acquisitions, bond and equity underwriting, and ancillary services like managing retirement plans. So what do these important corporate clients of the Fed member banks all have in common? Employees. The very same employees that are exerting leverage in wage negotiations one by one or through wholesale contract negotiations with unions. If the Fed can engineer a short-term slowdown in the economy, their constituents stand to benefit in the long term with lower borrowing costs and more modest wage growth.
Although this concept may have the sniff of conspiracy emanating from it, one need only ask, why else would the Fed be enacting policy that flies in the face of their two primary policy objectives? Regardless of whether serving a corporate master is the true motivation for recent Fed policy or not, the end is the same. The Fed has failed to break the back of wage growth, despite their draconian 5.25% increase in short-term rates. If they fail to reverse course on their designs of a softer labor market, they will begin raising interest rates once again. It is possible that they will pause at or near these levels for the time being. They may even cut rates by a token 0.25% once or twice before the election (if you believe such decisions can be politically motivated or influenced). However, with nearly 10 million unfilled jobs in America (enduring in part due to the wave of retiring baby boomers leaving the workforce), wage growth and other demands from American workers won’t abate soon. Those increased wages will make their way into Amazon carts, driveways, and vacation plans, all of which will continue to propel the consumer-driven two-thirds of the U.S. economy further ahead.
If this strength persists, it will force the Fed to continue or increase their tight economic policies, in their goal to bring about a “period of growth below trend.” They have told us plainly to expect interest rates to stay higher for longer. It’s my PIERspective that corporate America should brace for the same in workers’ wages and benefits.