The Inflation Trail
• Consumer inflation levels are trending downward, as evidenced by November’s CPI 7.1% annualized inflation report.
• Job markets remain healthy, with unemployment levels of 3.7%.
• Shoppers were out in force around Thanksgiving and Cyber Monday, breaking sales records from 2021.
• Positive trends, such as recent GDP reports and forward economic estimates, are counter-recession fears, although inverted yield curves remain a concern.
• Following December’s 50 basis point rate increase, the Fed is potentially “pivoting” toward lower future rate hikes as inflation pressures appear to be waning. Fed 2023 GDP growth estimates fall to +0.5%.
The “Most Anticipated” Recession Countdown
It is no secret that 2022’s inflation accelerated quite a bit faster than the Federal Reserve expected. You might recall that in March 2021 Fed Chair Powell said that inflation was starting to show signs of life but was likely a temporary phenomenon. A month later, the inflation rate measured by the Consumer Price Index (CPI) had risen to an annualized 4.2% versus January’s reading of 1.4%. By November 2021, Chair Powell commented that he was retiring the term “transitory” in relation to inflation. A month later, the CPI posted a 7% increase. Coincidentally—and unfortunately with respect to future rate hike decisions—this reading was the largest increase in inflation since June 1982.
By the end of January 2022, inflation rose again to an annual rate of 7.5% and continued the climb until June. CPI reported for that month was up to a 40-year high of 9.1%. Then, at the end of second the quarter of 2022, the Bureau of Economic Analysis (BEA) reported that the nation’s income level (GDP) had shrunk for more than two consecutive quarters. Economic growth had fallen by an annualized -1.6% during the first quarter and in the second quarter, by -0.6%. Although there was some consensus that the U.S. had stumbled into a recession, not all the signals had aligned to make that call.
The job market, usually a casualty of an economic downturn, was a June outlier. Labor markets were performing reasonably well as nonfarm payrolls increased by 372,000 and wages increased by 5.1% over the prior year. The unemployment rate was holding at 3.6%, and the number of employed were close to pre-pandemic levels. From a market perspective, however, investors were already looking forward and had sold the S&P down a bit over -20% by June’s close. The S&P 500 had shed $8.5 trillion in market valuations in six months as the index logged its steepest first six-month decline since 1970.
Months later, we are still waiting for the most widely forecast recession in history. At this point, however, some data potentially counters this inevitable recession. Consider first that the recent third-quarter +2.9% GDP estimate from the U.S. Bureau of Economic Analysis has reversed the negative first- and second-quarter trends because of improved consumer and government spending and improving trade and nonresidential investments. Next, add in a still strong job market and a resilient consumer, adding color to the Atlanta Fed’s (GDPNow) model that is projecting an annual +3.2% growth this final quarter of 2022. Through 2023, the Federal Reserve is projecting a GDP growth rate of 0.5%. Growth, but borderline at best.
Even so, consumers and markets are still concerned that inflation pressures remain. Food prices are high, and mortgages are out of reach for many new homeowners. Last month’s 7.1% CPI report is still high, but it is the smallest 12-month increase since December 2022, potentially turning the corner toward lowering inflation concerns and/or further significant rate increases. Certainly contributing to the somewhat improved CPI report were significant price declines in headline consumer and industrial necessities, such as gasoline, lumber, used cars, grains and natural gas.
Consumers Remain Resilient, For Now
Affordability has changed significantly from this time in 2021. The Fed has aggressively raised short-term interest rates seven times and counting with the underlying goal of bringing inflation rates back into the proclaimed 2% range. The most visible impact on the broader economy is a near-plummet in home sales. According to National Association of Realtors data, existing home sales this past October fell by 28.4% over 2021. But the median home sales price is still 6.6% higher a year later, after falling by 8.4% over the previous four months. Mortgage rates that are double last year’s interest rates certainly didn’t help.
A few positive consumer readings are worth noting, however. These numbers include falling gasoline prices from the high of June 2022, with a national average of $5.10 per gallon to the national average of $3.35 per gallon today compared to the price a year ago of $3.40 per gallon. Also, consider the price of a full-size used car has dropped by more than 6%, and add last month’s improved Consumer Sentiment Index, which noted more positive trends in respondents’ personal spending, income and employment outlook. Travel is improving as well from the pandemic lows. It is now off only by -6.5%, comparing TSA passenger count from this year’s period—November 29 through December 5—versus the comparable week in 2019. Also noteworthy, hotel occupancy for the period November 27 through December 3 (2022 versus 2019) was down only by -7.7%, while revenue per available room was up +1.7%.
Over the past several weeks, consumers’ moods appear to have become a bit more resilient and confident while holiday spending appears to have improved as well. Between Thanksgiving and Cyber Monday, consumers spent $35.27 billion online, which according to Adobe Analytics, amounted to a 4% increase from last year. In addition, millions of in-person shoppers braved cold weather and jammed parking lots. According to the National Retail Federation, these 122.7 million shoppers spent 17% more than last year’s pre-rate hike holiday sales. With the gift-giving season just around the corner, holiday shoppers expect to spend more than any other time in the past 20 years (not adjusted for inflation). Statista Research forecasts the average shopper will spend $932, up from $886 in 2021.
Unfortunately, the downside to the merriment is that consumers have continued to draw down savings while ramping up credit card use. Over the past 12 months, through September 2022, credit card balances have increased by $121 billion. According to the New York Fed, this 15% increase stands out as the largest seen in the history of Fed data since 2004. Compounding the credit card debt and more expensive mortgages, absolute debt growth is up 8.3% for the year. Meanwhile, savings rates which were 11.9% in 2021, have fallen to 2.3% in November, the lowest level since 2005.
The question yet unanswered is whether consumers are spending down their savings and increasing their credit card debt because they have an improving outlook for the future or just because they are trying to make ends meet On the positive side, consumers have been buoyed so far by falling gas prices, wage growth (+5.1% annual increase in average hourly wage) and a rather robust job market. However, headwinds remain, including the prospect of potentially two more rate hikes (perhaps more); a still “hawkish” Fed; continuing economic fallout from military escalations in Ukraine; and the still-to-be-felt lagging effects of past rate hikes. All of these factors will likely weigh on consumer sentiment and business outlooks as this year’s rapid rate tightening worked its way through pocketbooks and profit margins.
With employers adding 263,000 jobs in November, monthly jobs gains are still near record levels despite the Fed’s best efforts to stall labor growth. Unemployment levels of 3.7% remain near historic lows, while the current level of initial jobless claims is on par with 2019 pre-pandemic employment levels. And what are we to make of a growing number of layoffs? Although situations may change with rate hikes still working their way through the economy, for now, many of the laid-off workers are quickly landing new jobs. The Fed prefers a slightly higher level of unemployment to dampen the persistent “inflationary” wage growth this year.
A case in point today: Peeling back November’s employment data, two industries had visible net job losses—transportation and warehousing: and retail. Retail is likely to be revised upward for holiday shopping part-time employees. In terms of industry job gains, however, additions were across a broad spectrum of industries year-to-date through November. Monthly job gain averages for government services (local) were 25,000. Construction added 19,000 jobs. Professional and business services averaged 58,000 new monthly job positions. Financial services increased by 12,000 jobs. Manufacturing up an average of 34,000 jobs.
Business Growth Plateau?
Recession expectations and outlooks are increasingly divergent across industries and regions. A broad range of business surveys, such as the Manufacturing Purchasing Managers Index (PMI) and the Conference Board’s Leading Economic Indicators, indicates that the economy has already slid into contraction territory. According to the Conference Board’s chief economist, the worsening outlook amid high inflation will likely push the U.S. into a recession by this year-end (2022) and will continue until mid-2023 (clock is ticking).
There is also little doubt that the global economy is, broadly speaking, already in recession territory. The Global PMI report posted its fourth straight month of contraction. On a global basis, no hiding room was to be found as the downturn was evident across a wide spectrum of emerging and developed country economies. Europe was especially vulnerable, just posting its fifth straight month of contraction in view of spiking commodity prices related to the warring conflicts on the European continent.
On the domestic front, the ISM Manufacturing PMI data fell into contraction territory in November after 29 months of growth. The index fell to 49 from its prior reading of 50.2. (A reading below 50 is contracting.) In addition, a few glaring negatives in the Manufacturing report included the fifth monthly contraction in new orders and the second contraction in the labor markets. Interestingly, the ISM data on the employment landscape was contrary or possibly premature, compared to the government jobs report highlighting steady hiring growth in the manufacturing industries.
Still, positives existed in the manufacturing outlook as actual production to date continues to grow because of the auto industry; motor vehicles and parts production rose 5.3% in November, the biggest monthly increase since a 31% surge in July. Also of note were October’s order increases driven by a 2.2% rise in transportation equipment bookings, following a 2.3% increase in bookings in September. Also supportive for future growth were increasing machinery orders, up 1.5%, alongside solid orders for computers, electronic goods, appliances and electrical equipment.
Other positive economic news included rapidly declining shipping (domestic and overseas) rates and disappearing issues in port congestion, all mostly former effects of the post-pandemic shopping frenzy. Furthermore, because of the recent partial reversal of this year’s sky-rocketing dollar strength, the prospect for U.S. exporting looks even more attractive. The weakening dollar will also help earnings from the vast number of U.S. companies generating revenues in overseas markets.
Finally, November’s ISM Services Index reading of 56.5 (an index increase of 2.1) provided more supportive economic news. Although it is an outlier positive survey, the data highlights some resilience within non-manufacturing businesses, perhaps still reflecting the underlying strength of the consumer. This strength was especially visible within the travel and leisure industries and, to some extent, in the retail and dining-out industries.
Flashing Market Signals
The S&P 500 began its decline in early January 2022, falling into correction territory (loss greater than 10%) on February 23 and then into official bear market territory on June 13 (loss greater than 20%). Although not every index followed the identical timeline, all followed the same downward trajectory. Through this writing (December 14), very few markets or sectors have remained or recovered back into positive territory. The few exceptions include sectors, such as energy and utilities. Commodities performed well, especially natural gas and oil, but the performance of both are more attributable to overseas conflicts and energy embargos.
In the foreign markets, Mexico was the significant outlier with positive year-to-date returns (+4.44%, MSCI Mexico EWW). Unfortunately for investors looking for safer waters during these inflationary times, neither gold nor TIPS provided the needed security. Fast forward to late September, though, when a sell-off in the U.S. dollar sparked a reversal of fortune for a number of overseas equity markets, including Europe and Asia, and besting returns in our domestic markets at least on a quarter-to-date period.
For reasons already mentioned, investors are still understandably wary of the markets. According to data from Refinitiv Lipper, U.S. equity funds recorded withdrawals of $26.66 billion over a week’s period ending December 7, the largest weekly outflow since April 2021. These investor withdrawals impacted growth funds the most, causing them to lose $9.91 billion as investors fretted over increasing recession conversations and the next potential round of rate hikes. The American Association of Individual Investors (AAII) survey also measured this changing gauge of investor concerns, which found that index levels are holding steady in the “concerned” category, as 41.8% of the respondents were still bearish. With investor pessimism back to a four-week high, the contraindicator continues to remain above its historical bearish average of 31% for 52 out of the past 55 weeks.
Fixed income markets were certainly not immune to the rising rate environment either. Bond returns bore the brunt of monetary tightening along with equity securities as Treasury bonds posted negative returns. Longer maturity bond security losses (20-plus years) rivaled the losses of most technology stocks.
As investors are most likely aware, this year’s dismal bond returns will go down in the history books as a reminder of the perils of non-managed market risk. A case in point: The Bloomberg Aggregate Bonds Index, one of the more widely recognized benchmarks for the diversified investment grade bond markets, was down 11.23% as of this writing. Looking back to 1980, over the past 42 years the index has only recorded declines in value five times. So far this year has been the most difficult. The highest return over that time period was 32.65% in 1982, and the worst until this year was -2.92% in 1994.
A Crystal Ball Preview (to be continued next month)
The U.S. will continue to face a number of risks in 2023. Despite the best efforts of Fed policies to break an inflation growth cycle, companies have continued to hire and consumers have continued to spend.
• This week’s November CPI report showed a continued drop in inflation pressures as both headline and core PPI eased more than expected and further confirmed that price declines were becoming more widespread. Despite noted weaknesses in rent inflation, housing, energy prices, transportation and used car prices, momentum should help this “disinflation” continue, especially once housing price declines show up in future CPI data.
• With the prospect of declining inflationary pressures, relief from the stronger dollar earlier this year should continue, a boon to profit margins for corporations operating overseas.
• Supply chains continue to ease as freight charges also decline from pandemic highs. China has recently opened its economy from continuing zero-Covid policies. Over time, this change will help ease inflationary pressures with more competitively priced goods from trading partners.
• Despite the inflationary impact that has led to market and recession concerns this year, we are not at risk of a systematic financial collapse. The banking system remains structurally sound and well-capitalized. Corporations, in general, have strong balance sheets. Consumers are not in financial distress, and delinquency rates on commercial loans were well below pre-pandemic highs through third-quarter 2022.
• Financial markets will continue to challenge investors until there’s more rate-hike clarity from the Federal Reserve. Visibility on the targeted Fed fund rates of +/-5.1% does eliminate one market negative.
• Equity markets continue to provide opportunities, but as mentioned before, diversification, risk management and a 3-5 year horizon is key.
• Fixed income is now providing opportunities for more conservative investors seeking yield. While performances to date have not provided investors with yield, total return or risk management, current yields are making this asset class more attractive.
Not Investment Advice or an Offer -This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.