Multiple Glide Paths
• Consumer price index data released in February showed inflation had risen by 6.4% over the prior 12 months, while January’s producer price index data posted an annual increase of 6%.
• Job markets remain tight as unemployment levels fell again in January to 3.4%.
• January retail sales also proved stronger than expected, up 6.4% on a year-over-year basis.
• Despite S&P 500 losses in 2022, the broad market index reversed course early in the year, posting +3.9% returns through February 22.
• Unfortunately, mid-February market volatility is a reminder that investors remain concerned in the backdrop of a still strong economy.
The past few weeks have only intensified investors’ nervousness about future Fed policy moves and the escalating potential of future market volatility. January led the year on an optimistic note, posting positive returns of approximately 6.2%. On February 1, when the Federal Reserve announced its eighth rate increase of the previous 11 months, investors stayed the course, given the already anticipated 0.25% increase in interest rates. Throughout the next two weeks, investors bid the S&P 500 up to a then, year-to-date return of 8%.
By Friday, February 17, however, the markets were beginning to sell off into the extended President’s Day weekend, closing the index back down to 6.2%. The index was still sitting in positive territory by February 22, but renewed inflation fears had investors bidding the markets further downward to a new year low of +3.9%.
Through early February, investors were increasingly convinced that Fed monetary policy might engineer a “soft-landing” by raising interest rates just enough to stop the economy from overheating while avoiding a significant increase in unemployment or economic disruption.
Two inflation reports quickly dispelled investor optimism, despite months of steady progress made in lowering inflation from last summer’s 40-year high of 9.1%. Unfortunately, the reports sparked investor emotions that led to volatile market swings and a 4% sell-off by mid-February.
The initial headline that led to investor reversals was the January consumer price inflation index report that pointed to a higher than expected acceleration in January’s inflation level of 6.4% annualized (compared to estimates of 6.2%). The core reading (without food and energy inflation) was up 5.6%, versus estimates of 5.3%. It was clear that even though readings were slightly lower than December’s numbers, the pace of inflation decline had slowed meaningfully.
Follow-up January producer price index data (PPI) told a similar story. This barometer of prices that ultimately make their way to the consumer had risen to an annualized 6% (versus the expected 5.5%). Again, stripping out the more volatile energy and food categories, core PPI rose by an annual 5.4%. The takeaway for investors was that the path to lower inflation was still a few more miles away, and thoughts of soft landings were likely premature.
The Labor Market Condundrum
Recession and unemployment go hand in hand: Spiking unemployment and its persistence are hallmarks of a recession, and joblessness, in turn aggravates recessions. Then again, recessions and slowdowns in economic activities, such as consumer spending, also share similar correlations. But for the first time in 70 years, after the 2020 Covid-19 recession, the job markets and consumer spending quickly recovered and continued to improve even during the monetary tightening that began last March.
Although a number of forward-looking indicators today suggest a recession may already be here—or is on the way—today’s employment indicators are still the outliers. Consider the most recent unemployment rate report of 3.4% as 517,000 new jobs were added in January. The last time unemployment levels were this low was May of 1969, and the minimum wage was $1.60. As a side note, however, in 1970, the following year, the U.S. entered a recession, and unemployment ran up to 6%! Today, minimum wage levels are obviously higher than in 1969, and so is last month’s average hourly earnings growth of 4.4%.
This year’s headlines have included several layoff reports across a number of industries. Still, in many cases, layoffs are being offset by hiring in leisure, healthcare and some manufacturing industries. In January, 83,000 workers were hired in the professional and business services category (following an average monthly growth of 63,000 jobs in 2022). Likewise, the healthcare category added 58,000 new hires (with 47,000 monthly additions last year). Construction added 25,000 jobs versus last year’s monthly average of 22,000, and despite slowdowns in manufacturing surveys, new hires last month totaled 19,000 (down, however, from 2022’s monthly average of 33,000).
Although the lagged impact of rising rates that are working through economic channels may well hit the job markets later this year, so far, markets are being supported by relatively strong corporate income statements, balance sheets and service industry help wanted signs. The questions many are asking now are, Is the job growth today just pushing the inevitable recession further down the road, or is this time different? Is our economic future a “no landing” scenario in which the economy just continues to grow but inflation is not necessarily tamed? Unfortunately, in this scenario, the Federal Reserve would likely keep hiking rates until the inevitable “harder landing” literally brought the economy down.
Global Manufacturing Update
Following the Covid-19 shutdown, recovery in the manufacturing sector was far from uniform across industry sectors and national borders. Much of the world opened unevenly; the results were massive supply chain, transportation and inventory snafus. Although there is considerable improvement, certain markets such as China are only now beginning to reopen. Staggered manufacturing rebounds and relapses remain a reasonably consistent issue across global markets and are further exacerbated by disruptive situations, such as the now yearlong war in Ukraine.
As might be expected from economies confronting the scale of historical health, human, geopolitical, market and business cycles disruptions we’ve witnessed in the past three years, bringing global economies back on line in some synchronized fashion is not easily accomplished in a quarter or two. This problem is common among global industries, and the most recent manufacturing reports once again highlight the difficulty in managing economic growth against a backdrop of volatile swings in the labor markets and business cycles with global backgrounds of changing monetary policies, inflation-fighting and recession fears.
Here in the U.S., a number of issued reports speak to the dispersion among business and labor outlooks. Last month’s Manufacturing Purchasing Manager Index (PMI) reported a second economic contraction in manufacturing following a 30-month period of expansion. The new index reading of 47.4 is the lowest since May 2020 and is a level that is considered to be in contraction. Of interest, one subcomponent of the index, the “new orders index,” had a reading of 42.5; since 1948, a reading this low has always led to a recession, with only one exception.
Other concerning data through January was chronicled in the Conference Board’s Leading Economic Index (LEI), which reported a contraction for 10 consecutive months in factory new orders, consumer outlooks and credit conditions. One positive gleaned from the report, that the broader readings were consistent with a 40% probability of either a mild recession or an economic soft landing.
Among few positive reports, NFIB, the small business industry group, noted a slight improvement in business optimism. Also noteworthy was the sharp uptick in the ISM Services PMI report, which bounced back into expansion territory. The index jumped by 6 index points to 55.2. In addition, a flash reading for the U.S. Composite Output Index noted an unexpected uptick in February’s business activity. The index tracked the combined manufacturing and service sectors rebounding to their highest levels in eight months. Reasons stated for the uptick were significant improvements in delivery times, peaking inflation levels and fading recession risks. Unfortunately, the Fed may view this data point a bit differently.
One other noteworthy point relating to the foreign manufacturing outlook should be considered. As is the case in the U.S., the service sector PMI appears to be driving improving outlooks. This month’s overseas report posted an improvement in several developed market surveys. Highlights include solid and improving data points from the UK (improving demand for business services), France and Japan (which reported higher increases in new business activities). Two factors often quoted in reports were declines in European energy costs and growing optimism over the potential Chinese economic growth.
As we’ve already noted, job markets have managed to sidestep the Fed’s efforts to use rate hikes as a means to slow labor growth. Through January, at least, consumer perspectives on an easing inflation picture coupled with strong labor markets and easing fuel prices helped push the University of Michigan consumer sentiment index to its highest level (66.4) since January 2021.
Last month’s retail sales were also unexpected surprises for the markets, increasing a full percentage point more than anticipated, up 3% (6.4% on a year-over-year basis). Ignoring auto sales (up nearly 6%), along with fuel and building materials, overall retail sales were up +2.3%. The story becomes a little more interesting when we break retail sales out by category. Aside from robust auto sales (which help explain steady, select manufacturing labor markets), categories that have continued to do well include bars and restaurants, up 7.19% for the month and 25.24% since last year (explains help wanted signs); furniture, up 4.41% for the month and 3.8% through last year; and clothing, up 2.52% for the month and 6.28% for the year. Surprisingly, two noteworthy slowdowns were gasoline sales (up 0.04% for the month) and online sales which appear to have peaked a bit, up only 1.3% for January (possibly given last month’s near record online holiday sales). Housing is one sector that rising interest rates have impacted, just as Fed policymakers had hoped. Rising mortgage rates coupled with expensive housing prices have slashed home buying activities. Even so, rising interest rates have not been successful in significantly lowering housing prices. The question now plaguing both the Fed and the markets is how to deflate housing prices when there is a persistent shortage of homes available for sale.
Looking back to a few recent recession-era timeframes, in July of 2007, the peak in housing inventories was about 4 million homes. In April 2009, the inventory was close to 3.3 million. Today, the inventory available for sale is 980,000 homes. Tracking new housing permits, the peak in June 2005 (before the Great Recession) was 166,000 construction permits filed. By comparison, in February 2023, there were 52,000 permits filed. Despite the best efforts of the Fed to cool down housing prices, these shrinking inventories of existing and to-be-constructed homes have kept prices at today’s elevated levels. This is one example of “sticky” inflation.
Looking a bit further out, there are a few promising housing signs. January’s data reported an increase in new purchase applications of 5.9% (and 14% over the previous three months), which coincides with improving outlooks from the National Association of Home Builders (NAHB). This industry association reported its second consecutive month in improving sentiment while also projecting that the housing markets have passed peak mortgage rates for this cycle and that home builders expect to see a rebound in home construction later this year and into 2024. One signal that housing affordability will be the headline next year IF inventories do get back on track.
Another takeaway for current data, however, is that given today’s state of the housing markets, the industry has minimized some recession risks, given the historically low housing inventories, low levels of new construction and the low mortgage rates for most homeowners who purchased before rates doubled last year.
The Market’s Economic Read
You may recall that among the takeaways from last month’s perspective was an observation that bond yields (and short-term cash instruments) were attractive again and made sense now from both an asset allocation and investment perspective. Given current fixed income yields, including the 1-month Treasury now yielding 4.6%, 1-year Treasury yields at 5%, a 2-year Treasury is at 4.6% and a 10-year Treasury is at 3.9%, they’re still attractive.
In looking at equity markets, I noted that reasons to be optimistic existed there as well. That included the fact that inflation had likely peaked, and valuations on mid-cap and small-cap companies were more attractive (as is also the case for many of the overseas companies).
A month later, the takeaway is investors did bid up equities over a very short timeframe; both small cap (Russell 2000 up 7.82%) and international equities (MSCI EAFE up 6.44%) outperformed the S&P 500 (up 3.95%). What was surprising though was relative outperformance of the technology sector, up 9.4% also on a year-to-date basis through February 22. This, of course, is now history, and the future of the equity markets is again the question.
It has certainly helped that market internals had already started to turn positive in the latter part of last year’s final quarter, which helped January rank as one of the strongest first-month returns in market history. Unfortunately the rally, as of this writing, has lost a bit of steam and has turned February into what is now beginning to look more like a consolidation month. One seemingly slight positive tracking forward is mending investor sentiment. The American Association of Individual Investors (AAII) notes that there now appear to be more market bulls than market bears—at least according to the association’s bull-bear spread. Of note, this is the first time that optimism has exceeded pessimism on a consecutive weekly timeframe since November 2021. Of course that didn’t work out too well a few months later. Tracking a few market technicals, the percentage of stocks trading today above their 50-day moving average (47%), their 100-day moving average (64%) and the 200-day moving average (60%) is well above respective lows set back in June and September of last year. Today the S&P 500 price line is sitting on support above the 200-day moving average, and the 50-day moving average has recently broken through the 200-day line.
While all technical in nature, these key data points are what a few market-watchers specifically track. At this point, they are bullish signals but still tentative at best. To see further improvement, investors will need to see a continued dampening of monthly inflation, corporate optimism and convinced voting committee members at the Federal Reserve. This particular quarter’s earnings season will be extremely telling about how corporate earnings are being impacted in the tightening environment.
“Soft,” “Hard” or “No Landings” Ahead
As I’m writing this, I am reminded again that we are living in a world of rolling historical events. Whether pandemic, economic, geopolitical, housing, recession, inflation, Y2K or government-related, these outliers all share at least one common denominator—they impact financial markets.
From the Fed’s perspective, inflation still remains uncomfortably high. The fear exists that elevated inflation might become embedded into components of the economy; Federal Reserve policymakers have emphasized their determination to keep rates high enough to curb inflation.
While economic and market reports this month (labor and retail sales growth, along with still high PPI inflation) continue to point to a robust economy, investors remain concerned that still high inflation may require more rate increases than many had assumed. From an investor perspective, this scenario would likely lead to a “hard landing” where the Fed tightens so much that it creates a recession. Unemployment goes up; people lose their jobs and consumption drops. Despite all the daily headline news (noise), the question of what we are heading toward—a “hard landing,” a “soft landing,” or “no economic landing” won’t be answered until more time has passed. We do believe economic growth is slowing, despite monthly outlier reports indicating otherwise. To date, we have seen eight rate increases in less than a year, and it takes time for the full impact of those rising rates to be felt throughout the economic channels.
With employment levels still strong, time is needed to gauge the impact of higher rates and slowing growth on corporate earnings and market multiples. We are also guessing about how many rate hikes are ahead and what the magnitude of those hikes will be. In addition, we are also conjecturing about when we believe the Fed will pivot and begin to lower rates. As of today, I am presuming that will not happen this year. The Fed has told us many times that its decisions are data-dependent. Until then, though, we should see the housing industry become less of an economic headwind and global economic conditions gradually improve.
And as we have suggested for several months now, great investment opportunities will exist throughout this phase of economic recycling for patient investors.
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