After North Pier warned of the pending likelihood of a delay in expected cuts in interest rates from the Federal Reserve (the Fed), inflation data almost immediately began to disappoint market participants. The Fed has made good on prior admonitions that cuts would only follow a further ebb in inflation. However, to date, inflation has proven resilient at well above the Fed target (~2% annually). Initially, market participants shrugged off the news that CPI had ceased its descent, stabilizing in the mid-3% range. But after a third consecutively higher inflation print in a row, the Fed was forced to admit, “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards 2%.” This sent interest rates back to levels not seen since October. What’s shocking is that unlike 2022, when rising interest rates led to a severe correction in global equities, stocks seemed largely detached, if not in denial, when faced with interest rates that once again appeared to be staying ”higher for longer.”
How the Markets Faired
Generally, equity investors seemed immune to the disappointing news about the Fed’s pacing and potential direction of monetary policy. Large U.S. companies rose strongly in Q1, with broader participation among both cyclically sensitive value stocks as well as those in the tech-heavy growth indices. Growth indexes did manage to edge out value-oriented ones, but only by a few percentage points. Smaller companies in both the United States and abroad were positive but not as much as larger cap names. The same was generally true of emerging market equities, except in Latin America, which lagged most other global markets in Q1.
With the Federal Reserve failing to deliver the rate cut many bond investors were hoping for, interest rates rose across most of the yield curve. The 10-year Treasury rose nearly a half percent from the end of 2023 to 4.33% on April 1st. And they kept rising to start Q2. This caused bond values, especially those of longer-dated maturities to decline for the quarter. Similar to last year, the bright spots of the fixed-income markets were cash and ultra-short vehicles (90-day maturities or less) and high-yield bonds. Interest rates in most developed markets were also on the rise during the quarter in sympathy with the U.S. bond markets. This may have been an overreaction as the ECB and Bank of England may have a different hand to play, since their inflation data (except for France) is moderating quicker than that of the U.S., giving those central banks more room to ease monetary policy. Emerging markets bonds also saw gains during the quarter. Some of that may be due to their generally higher yields supporting prices, just as we saw in the high-yield markets.
Growing Weaker
Maybe investors were right to shrug off the delay in monetary easing. The initial report for Q1 GDP disappointed, showing that growth decelerated to just a 1.6% annualized pace versus a strong 3.4% in the fourth quarter. Despite some indicators to the contrary that we will discuss below, the initial GDP print was reportedly dampened by a drop in personal consumption expenditure growth to just 2.5%. At the same time, the GDP Price Deflator, a key measure of inflation at the household level, unfortunately, moved in the other direction, rising to 3.1% versus 1.6% for Q4.
Is It the Best of Times Or the Worst of Times?
Though the GDP data would indicate that consumption is reining in, the other data may be telling us a different story, or perhaps two different stories. Recent conflicting consumer confidence data show a tale of two consumers. The Conference Board’s Consumer Confidence Index dropped to 97.0 in April from a downwardly revised 103.1 in March. Though still relatively confident about present conditions in the U.S., respondents to that survey showed meaningful concern about the upcoming economic environment. The April University of Michigan Index of Consumer Sentiment, however, was relatively stable at 77.2, down only slightly from March’s 77.9. That’s a marked improvement from last year’s April reading of 63.7, indicating a calm and reasonably confident attitude from households from that survey.
The drop in consumption reported in the initial Q1 GDP report was somewhat contradicted by decent Retail Sales growth, which showed general strength in March, most noted in the online store arena (up 2.7%) as well as an uptick in food services (up 0.4) month-over-month. Also encouraging was the continued strength in the home improvement sector, which jumped 0.7% in March and 2.3% in February. So American households, which have been driving the strength of the economy in recent years, may not be shrinking in that role quite yet. But will they be in the coming months? The recent report on consumer credit showed that it increased by just $6.3 billion in March, down from $15.0 billion in February. Revolving credit (mostly credit card usage) was virtually flat, which means that net new credit usage actually shrunk, replaced by interest that was accumulating at high rates.
Is This Thing Working?
According to the Bureau of Labor Statistics’ (BLS) latest report in April, the unemployment rate ticked up to a higher-than-expected 3.9%. This was driven by an increase of 175,00 in the nonfarm payroll numbers. The average workweek was down slightly to 34.3 hours and average hourly earnings were up just 0.2%, both smaller than expected. However, average hourly earnings have risen 3.9% over the last 12 months, versus 4.1% for the year ending in March – still double the desired target of the Fed.
Unfilled jobs in the U.S. declined to their lowest level in two years according to the most recent JOLTS report from the BLS. However, as one will note from the chart on the right, at 8.5 million open positions, we are still far above the pre-COVID highs. Wage growth may be slowing a tad, and unemployment may be rising off of historic lows, but the labor market is still tight as a drum from a historical perspective. Labor markets were tight back in 2019 when the JOLTS numbers peaked at 7.5 million. Until we shrink well below that mark, upward pressure on wages is likely to persist at a level far higher than the Fed needs to feel comfortable to ease.
Hi-Home, Hi-Home…
The labor market isn’t the only place we see tightness in the economy. Housing shortages continue to drive the price of shelter higher despite (and in some cases because) of the high cost of borrowing.
The median existing home price for all housing types increased 4.8% year-over-year to $393,500, the ninth consecutive month of year-over-year price increases and the highest ever for March. Unsold inventory sits at 3.2-month supply at the current sales pace, up from 2.9 months in February, yet still far below the typical 6 months mark that signals a more balanced marketplace. New home sales were up 8.3% as homebuilders continued to adjust prices and add incentives to attract buyers. Lack of inventory continues to create upward pressure on housing prices, with the Case Shiller report showing housing prices hitting an all-time high again in their latest report.
There is little hope that the tight market dynamic will change anytime soon. Housing starts in March declined 14.7% month-over-month to a seasonally adjusted annual rate of 1.321 million units, well below estimates, and the forward indicator of building activity, building permits, shrunk by 4.3%. Though housing builders continue to try to meet the demand of this shortage-driven housing market, high lending costs at the corporate level have constrained that growth. I recently led a CRE debt panel at the ALTS-LA conference where two homebuilding financers reported that borrowing costs for the land required to build communities are running between 15% and 18%… for the largest developers in the country!
Too Hot To Touch
The tightness in housing markets has regularly been one of the largest contributors to the recent stickiness in inflation. The Shelter component of the Consumer Price Index (CPI), though moderating a bit, is still showing an annual inflation rate of 5.4%. Total CPI year-over-year, increased 3.5% in March, accelerating from 3.2% in February. Core CPI, which excludes food and energy, was up 3.8% for the second consecutive month. Interesting notables from this recent report were a surge in both electricity costs and transportation costs. If rent, utilities, and transportation are the biggest expenses many American households face, these are troubling trends.
There are additional signs that inflation may persist at these levels or even accelerate. Inflation at the producer price level has been easing over the last year. This led many to hope that more moderate prices at the wholesale level would eventually trickle down to consumers. Here too, we are starting to see an increase in the pace of inflation. The March Producer Price Index (PPI) rose 2.1% in March versus 1.6% in February and virtually zero in Q4. Core PPI ex-food and energy was up 2.4%, an increase from 2.1% in March.
Of late, the Fed has been focusing more and more on the Personal Consumption Expenditure Price Index (PCE) from the Bureau of Economic Analysis as their indicator of inflationary trends. The latest PCE was up 2.7% versus 2.5% in February, and the core-PCE Price Index was up 2.8%. Again, this is well ahead of the 2% Fed target for inflation. Though the PCE Price Index for Goods was up just 0.1% year-over-year, the PCE Price Index for Services was up 4.0%. In this economy that is increasingly dominated by services, especially consumer services like food delivery and food eaten out of the home (which saw costs rise 4.2% in the latest CPI report), this increase in the cost of services is troubling for those looking for a Fed easing in monetary policy.
Slip and Fall
American businesses continue to struggle to gain any upward momentum. The April Institute of Supply Management Report on Business® (ROB) Manufacturing Index slipped back below the key 50% line which signifies contraction, coming in at 49.2%. New orders shrank to 49.1% from 51.4% in the latest monthly reading. The services ROB also fell below the 50% mark, declining to 49.4% in April from 51.4% in March. New orders on the services side of the survey also declined by about two percentage points.
The slowdown in expected business activity would be troubling enough. Additionally worrying is that both surveys showed prices jumping. The manufacturing price data came in at 60.9%, up from 55.8% last month and the services side soared to 59.2% from 53.4%. Contraction in the face of rising prices is a bad combination for the months ahead in the business side of the economy.
Piering Ahead
Weaker growth coupled with higher Inflation spells stagflation. This is the catch-22 that no one wants to see materialize. Unfortunately, that’s the scenario that has become a distinct possibility. And nobody is talking about it yet. If growth continues to decelerate and inflation stays hot, that’s where the pundits will shift their focus. If the financial press picks up that theme, pressure on stocks and other risk assets will likely mount and a risk-off correction (or worse) will likely ensue. And let’s not forget that it’s an election year. You can rest assured that the challenger won’t be quiet with this theory. He and the rest of the GOP will be yelling it from the rooftops.
“Hints of stagflation are anything but fatal”
However, initial hints of stagflation are anything but fatal. Although still quite tight, the labor markets are starting to see signs of initial easing. One doesn’t need a full-blown recession to see wage growth slow and consumer confidence and spending wane. As we’ve said for well over two years now, “It’s the wage growth – stupid.” If the job market continues to cool off and we get more healthy unemployment levels (in the mid to upper 4% range), then that lack of demand (and affordability) may give the Fed the sub 3% CPI they need to start cutting interest rates, which will stimulate both the consumer and the business ends of the economy. That’s the Goldilocks scenario that markets were initially hoping for if not outright expecting. We may eventually get there from here. But even if we do, I suspect we will have one more gut check with a stagflation scare en route.
Spring 2024 Market and Economic Commentary
After North Pier warned of the pending likelihood of a delay in expected cuts in interest rates from the Federal Reserve (the Fed), inflation data almost immediately began to disappoint market participants. The Fed has made good on prior admonitions that cuts would only follow a further ebb in inflation. However, to date, inflation has proven resilient at well above the Fed target (~2% annually). Initially, market participants shrugged off the news that CPI had ceased its descent, stabilizing in the mid-3% range. But after a third consecutively higher inflation print in a row, the Fed was forced to admit, “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably towards 2%.” This sent interest rates back to levels not seen since October. What’s shocking is that unlike 2022, when rising interest rates led to a severe correction in global equities, stocks seemed largely detached, if not in denial, when faced with interest rates that once again appeared to be staying ”higher for longer.”
How the Markets Faired
Growing Weaker
Maybe investors were right to shrug off the delay in monetary easing. The initial report for Q1 GDP disappointed, showing that growth decelerated to just a 1.6% annualized pace versus a strong 3.4% in the fourth quarter. Despite some indicators to the contrary that we will discuss below, the initial GDP print was reportedly dampened by a drop in personal consumption expenditure growth to just 2.5%. At the same time, the GDP Price Deflator, a key measure of inflation at the household level, unfortunately, moved in the other direction, rising to 3.1% versus 1.6% for Q4.
Is It the Best of Times Or the Worst of Times?
Though the GDP data would indicate that consumption is reining in, the other data may be telling us a different story, or perhaps two different stories. Recent conflicting consumer confidence data show a tale of two consumers. The Conference Board’s Consumer Confidence Index dropped to 97.0 in April from a downwardly revised 103.1 in March. Though still relatively confident about present conditions in the U.S., respondents to that survey showed meaningful concern about the upcoming economic environment. The April University of Michigan Index of Consumer Sentiment, however, was relatively stable at 77.2, down only slightly from March’s 77.9. That’s a marked improvement from last year’s April reading of 63.7, indicating a calm and reasonably confident attitude from households from that survey.
The drop in consumption reported in the initial Q1 GDP report was somewhat contradicted by decent Retail Sales growth, which showed general strength in March, most noted in the online store arena (up 2.7%) as well as an uptick in food services (up 0.4) month-over-month. Also encouraging was the continued strength in the home improvement sector, which jumped 0.7% in March and 2.3% in February. So American households, which have been driving the strength of the economy in recent years, may not be shrinking in that role quite yet. But will they be in the coming months? The recent report on consumer credit showed that it increased by just $6.3 billion in March, down from $15.0 billion in February. Revolving credit (mostly credit card usage) was virtually flat, which means that net new credit usage actually shrunk, replaced by interest that was accumulating at high rates.
Is This Thing Working?
According to the Bureau of Labor Statistics’ (BLS) latest report in April, the unemployment rate ticked up to a higher-than-expected 3.9%. This was driven by an increase of 175,00 in the nonfarm payroll numbers. The average workweek was down slightly to 34.3 hours and average hourly earnings were up just 0.2%, both smaller than expected. However, average hourly earnings have risen 3.9% over the last 12 months, versus 4.1% for the year ending in March – still double the desired target of the Fed.
Hi-Home, Hi-Home…
The labor market isn’t the only place we see tightness in the economy. Housing shortages continue to drive the price of shelter higher despite (and in some cases because) of the high cost of borrowing.
The median existing home price for all housing types increased 4.8% year-over-year to $393,500, the ninth consecutive month of year-over-year price increases and the highest ever for March. Unsold inventory sits at 3.2-month supply at the current sales pace, up from 2.9 months in February, yet still far below the typical 6 months mark that signals a more balanced marketplace. New home sales were up 8.3% as homebuilders continued to adjust prices and add incentives to attract buyers. Lack of inventory continues to create upward pressure on housing prices, with the Case Shiller report showing housing prices hitting an all-time high again in their latest report.
There is little hope that the tight market dynamic will change anytime soon. Housing starts in March declined 14.7% month-over-month to a seasonally adjusted annual rate of 1.321 million units, well below estimates, and the forward indicator of building activity, building permits, shrunk by 4.3%. Though housing builders continue to try to meet the demand of this shortage-driven housing market, high lending costs at the corporate level have constrained that growth. I recently led a CRE debt panel at the ALTS-LA conference where two homebuilding financers reported that borrowing costs for the land required to build communities are running between 15% and 18%… for the largest developers in the country!
Too Hot To Touch
The tightness in housing markets has regularly been one of the largest contributors to the recent stickiness in inflation. The Shelter component of the Consumer Price Index (CPI), though moderating a bit, is still showing an annual inflation rate of 5.4%. Total CPI year-over-year, increased 3.5% in March, accelerating from 3.2% in February. Core CPI, which excludes food and energy, was up 3.8% for the second consecutive month. Interesting notables from this recent report were a surge in both electricity costs and transportation costs. If rent, utilities, and transportation are the biggest expenses many American households face, these are troubling trends.
There are additional signs that inflation may persist at these levels or even accelerate. Inflation at the producer price level has been easing over the last year. This led many to hope that more moderate prices at the wholesale level would eventually trickle down to consumers. Here too, we are starting to see an increase in the pace of inflation. The March Producer Price Index (PPI) rose 2.1% in March versus 1.6% in February and virtually zero in Q4. Core PPI ex-food and energy was up 2.4%, an increase from 2.1% in March.
Of late, the Fed has been focusing more and more on the Personal Consumption Expenditure Price Index (PCE) from the Bureau of Economic Analysis as their indicator of inflationary trends. The latest PCE was up 2.7% versus 2.5% in February, and the core-PCE Price Index was up 2.8%. Again, this is well ahead of the 2% Fed target for inflation. Though the PCE Price Index for Goods was up just 0.1% year-over-year, the PCE Price Index for Services was up 4.0%. In this economy that is increasingly dominated by services, especially consumer services like food delivery and food eaten out of the home (which saw costs rise 4.2% in the latest CPI report), this increase in the cost of services is troubling for those looking for a Fed easing in monetary policy.
Slip and Fall
American businesses continue to struggle to gain any upward momentum. The April Institute of Supply Management Report on Business® (ROB) Manufacturing Index slipped back below the key 50% line which signifies contraction, coming in at 49.2%. New orders shrank to 49.1% from 51.4% in the latest monthly reading. The services ROB also fell below the 50% mark, declining to 49.4% in April from 51.4% in March. New orders on the services side of the survey also declined by about two percentage points.
The slowdown in expected business activity would be troubling enough. Additionally worrying is that both surveys showed prices jumping. The manufacturing price data came in at 60.9%, up from 55.8% last month and the services side soared to 59.2% from 53.4%. Contraction in the face of rising prices is a bad combination for the months ahead in the business side of the economy.
Piering Ahead
Weaker growth coupled with higher Inflation spells stagflation. This is the catch-22 that no one wants to see materialize. Unfortunately, that’s the scenario that has become a distinct possibility. And nobody is talking about it yet. If growth continues to decelerate and inflation stays hot, that’s where the pundits will shift their focus. If the financial press picks up that theme, pressure on stocks and other risk assets will likely mount and a risk-off correction (or worse) will likely ensue. And let’s not forget that it’s an election year. You can rest assured that the challenger won’t be quiet with this theory. He and the rest of the GOP will be yelling it from the rooftops.
“Hints of stagflation are anything but fatal”
However, initial hints of stagflation are anything but fatal. Although still quite tight, the labor markets are starting to see signs of initial easing. One doesn’t need a full-blown recession to see wage growth slow and consumer confidence and spending wane. As we’ve said for well over two years now, “It’s the wage growth – stupid.” If the job market continues to cool off and we get more healthy unemployment levels (in the mid to upper 4% range), then that lack of demand (and affordability) may give the Fed the sub 3% CPI they need to start cutting interest rates, which will stimulate both the consumer and the business ends of the economy. That’s the Goldilocks scenario that markets were initially hoping for if not outright expecting. We may eventually get there from here. But even if we do, I suspect we will have one more gut check with a stagflation scare en route.
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