A Stealth Goldilocks Market
• The FOMC (Federal Open Market Committee) hit a pause on a June rate hike, but the odds-on favorite prediction for next month is a 25 basis point hike.
• Following ten consecutive rate increases, Fed funds rates are now above the U.S. inflation rate level (CPI). With few exceptions, since 2010, Fed funds rate levels have generally fallen below inflation levels.
• At 3.7%, unemployment levels ticked upward slightly from May’s 3.4%, but the numbers still reflect near-historical low unemployment levels and a more selective hiring market.
• Housing starts are up 21.7%, representing the largest monthly increase since 1990. Lower housing prices and improving sales are among the mindset of the construction industry.
• The top seven stocks for the S&P 500 and QQQ are identical but carry different weights in the benchmark holdings. These stocks account for approximately 23% of the S&P 500 and approximately 51% of the QQQ.
A Market’s Reprieve
Earlier this year, recession risks were an increasingly worrisome issue for investors. Despite a still “hawkish” Fed, the economy has continued to sidestep recession concerns—largely because of a relatively resilient consumer and job market.
Nearly a year and a half into a tightening cycle, we are still experiencing historically low unemployment rates and “relatively” stable financial markets. Even so, a few close calls, including the recent congressional debt-limit “game of chicken,” jeopardized the prevailing economic environment. Fortunately, calmer heads—and votes—prevailed as another government funding uncertainty was pushed further down the road.
We should also not forget that a few months earlier, a few regional bank failures made headlines, threatening a more widespread run on smaller regional bank deposits. In short, the Fed—with some help from J.P. Morgan—rolled up (or out) problem banks, infused new capital into the financial system and circumvented the risk of more banking spillover fears.
Although 10 Fed rate hikes and counting have threatened the prospect of a recession, so far, the domestic economy has continued to grind upward. The exception, of course, occurred during the first half of 2022. Although last year’s first two quarterly GDP reports posted negative growth rates of -1.6% and -0.6%, the “recession call” was not made by the official “recession caller,” the National Bureau of Economic Research (NBER). From that point forward, however, quarterly GDP growth rates rebounded, posting positive growth rates of 3.2% (Q3), 2.6% (Q4) and 1.3% (Q1, 2023). Now, for the second quarter of 2023, GDPNow estimates from both the Atlanta and St. Louis Fed offices are projecting growth rates of 1.9%.
The Fed Tug-of-War
One week ago (June 14), the Fed paused, the first rate hike lapse since monetary tightening began in March 2022. After the FOMC meeting and throughout this week (June 19-24), Fed Chair Powell has spoken to the press and before the House Financial Services Committee, sharing voting policy committee member thoughts from their earlier June meeting. There appears to be an agreement among the committee members that as long as the U.S. banking system remains sound and resilient, tighter credit conditions for households and businesses are likely to weigh on future economic activity, hiring and inflation.
Powell has also commented that policy members still believe that “there is a long way to go” to return to price stability and that they expect two more rate hikes this year, depending on the data, of course. The tabling of further hikes would require three necessary economic conditions: slower than modest economic growth, further easing in supply chain bottlenecks and a more balanced labor market (higher unemployment).
Although the threat of additional rate hikes remains, relatively good evidence exists to show that a few components of the post-pandemic inflation spiral are reversing course. One inflation metric, producer price inflation (PPI), is a compelling example. PPI is a measure of industry-wide inflation at the wholesale level. In January 2021, the PPI annualized inflation level was 1.6%. Fourteen months later (March 2022), the inflation level peaked at 11.7%. And today, an additional 14 months later, the PPI inflation level has settled back to 1.1%.
A similar story is evident in the Consumer Price Index reading. In May 2020, year-over-year CPI was a reported 0.1%, and by June 2022, the inflation gauge had risen to 9.1%, the highest reading since November 1981. This May’s CPI gauge, 11 months later, sat at 4%. Unfortunately, one reading, Core CPI (CPI less food and energy), was higher than expected, up an annualized 5.3%. But in September 2022, this inflation indicator was up 6.6%, well above the post-pandemic low of 1.3% in February 2021.
These “core” costs exemplify the inflationary concerns that the Fed’s voting members are watching most closely. Although food and energy costs have been two of the more volatile price concerns for consumers throughout the past 12-18 months, these expenses have abated somewhat. Annualized inflation growth in categories such as dining out (up 8.3%), transportation services (up 10.2%) and shelter expenses (up 8%) have been relatively sticky, despite tightening monetary policy efforts.
Consumer’s Inflation Impact Still Muted—Somewhat
One stalwart component of this economy since the beginning of last year’s monetary tightening efforts has been the consumer. Last month, consumer sentiment ticked up, generally rising in tandem with falling food and fuel prices. Meanwhile, consumer spending has continued to hold up, despite rising price levels. May consensus estimates were expecting a decline in sales growth, but surprisingly, sales were up +0.3%. On a year-over-year basis, sales grew by 1.6%, net of inflation, though sales were slightly off, down 2.4%.
Although retail sales reports weren’t especially strong, the data is not pointing toward any near-term hard landing. A few bright spots are worth noting: sales were up in a number of categories versus last year as the bars & restaurants sector took the lead, up 7.99%. The health & personal care sector was up 7.78%, online shopping was up 6.53%, and the autos sector was up 4.38%. But detractors also garnered attention:
• The gas stations sector was down 20.46% (lower fuel prices).
• The furniture sector was down 6.39%.
• The electronics sales sector was down 4.99%.
Looking at retail trend sales over the past months, sales are off a nominal -0.34%. Again, no worrisome signals appear here.
The jobs report is running somewhat parallel with the retail data. At 3.7% unemployment levels, the number of unemployed ticked upward slightly from May’s 3.4%, but the numbers still reflect near-historical low unemployment levels and a more selective hiring market. In addition, May’s job markets added 339,000 new employees, a number that is in line with the average monthly gain of 341,000 over the prior 12 months.
A number of industries were hiring last month, and growth trends were evident in several core job skills such as professional and business services (up 64,000), government (up 56,000), healthcare (up 52,000), leisure & hospitality (up 48,000), and construction and transportation (up 49,000). The job markets are tightening and will likely continue to do so, but the number of job openings still remains greater than the number of those looking for jobs. This is as employers continue to recalibrate their labor needs.
The real estate industry is especially paradoxical at this stage of the economic cycle. Mortgage rates are sitting at 6.67%, off their recent highs of 7.1% and nearly 250% over the 2.7% lows set in January 2021. But despite higher mortgage rates and rising unaffordability levels, the home-building industry is rather optimistic as housing inventories remain near historically low levels (two months).
Consequently, home builders appear to be seeing some light at the end of the tunnel based on a recent jump in the industry’s National Association of Home Builders Index, which posted its sixth consecutive higher index reading. Correlated to shifting builder confidence was this May 23 data from Redfin, highlighting that today’s homebuyers are experiencing a shrinking inventory of houses, off 5.2% from last year, coupled with a slight -3.4% decrease in the median home sales price. Home builders are looking beyond today’s higher mortgage rates and are now selectively building inventory. The result this past month was a jump in housing starts, up 21.7%, representing the largest monthly increase since 1990. Lower housing prices and improving sales are among the mindset of the construction industry.
How fast mortgage rates fall (and when) will set the foundation for the next potential resurgence in home buying trends, housing turnover and inventory rebuilds. At this point, three sticking points are still major factors: current housing prices, potentially now at the cusp of softness trends in pricing and rents; mortgage rates, a function of Fed tightening efforts, their lending impact costs, and of course, demand; and finally, low inventory levels, dependent on new construction (possibly being remedied) and new listings of existing homes. The latter component is made more difficult because most existing homeowners have financed their homes using more favorable rates than those available in the current market. Data from Redfin highlighted this (positive) homeowner conundrum of staying in place:
• 91.8% of U.S. mortgaged homeowners have a rate below 6%.
• 82.4% have a rate below 5%.
• 62% have a rate below 4%.
• 23.5% have an interest rate below 3%.
Bull Market Recovery or a Bear Market Rally?
The equity markets have forged ahead despite recessionary calls, rising interest rates, an averted regional banking crisis, and a debt ceiling standoff. At the close of this week (June 23) and with five more trading days left in the month and the quarter, the broad market index, S&P 500 managed to push back into bull market territory. From an October 12 low last year, the S&P 500 has rebounded more than 20% and “appears” to have technical support, holding above its 50- and 200-day moving average. Other broad markets, including the tech-heavy Nasdaq (QQQ proxy), also share in this recovery.
Putting the S&P 500 and the QQQ into perspective, however, the top seven stocks for each index proxy are identical but carry different weights in the benchmark holdings. These stocks account for approximately 23% of the S&P 500 and approximately 51% of the QQQ. Although both have done quite well since their respective lows last year, to date, most of the higher-weighted securities have performed exceptionally better and have been the momentum drivers of the cap-weighted benchmark.
An ongoing debate questions whether the recent market activity is more likely a bear market rally in “sheep’s clothing” than a bull market recovery. Certainly, not all stocks or sectors shared equally in the rally. At this week’s end (June 23), the small-cap universe (Russell 2000/IWM) has yet to climb into a bull market recovery (+7.9%). That is also the case for the Dow Jones Industrial Average (+15.5%), the Consumer Staples sector XLP (+5.7%), Health Care Sector XLV (+8.3%), the Energy sector XLE (-3.4%) and the S&P 500 Equal Weight RSP (+13%).
Following the lows of last October, the overseas markets have also had rather interesting recent performances, as a number of the regional markets outperformed the S&P 500 here at home. Examples include some of the European markets, such as France’s ETF, EWQ (+37%), Germany’s EWG (+41%) and Italy’s EWI (+43%). On our southern border, Mexico’s EWW is up +35%. Meanwhile, in Asia, Japan’s EWJ is up +25%, in contrast to China’s ASHR, up a nominal +0.30%. For inflation-sensitive investors, inflation protection securities, such as TIPS, are up a nominal +2%, while the broad commodity index DBC is off -9.5%. These performances are perhaps somewhat indicative of expectations about future inflation.
Data Dependent Yet Again
According to Investment Company Institute (ICI) data, over the past five weeks (May 10 through June 14), investors—mostly U.S. investors—transferred almost $63 billion in assets from global equity funds into money markets. Over that distribution period, the S&P 500 rose by 5.9%, while Nasdaq’s QQQ rose by 13.5%. Many factors account for the outlays, including profit-taking, asset allocation or fears of some future sell-off. These equity outflows have been mostly allocated to bond funds and money markets.
For most investors seeking yield today, the attractive alternative has generally proved to be money markets, which are currently yielding +/-4.7%. Treasury notes, on the other hand, have been a mixed bag, with a three-month Treasury yielding 5.23%, a five-year Treasury yielding 3.97% and a 10-year Treasury yielding 3.72%. Although the Treasury markets now offer a safe harbor in a volatile market, the longer-term securities remain subject to rising rate risks.
And what can be said about the current economy? The data has not proven to be as negative and problematic as some predicted. Although some signs indicate that consumers are seeing a material spending slowdown, a recent research report from Kinsale Trading noted that retail spending over the past three months has remained relatively unchanged. This resiliency has also been documented in the employment markets. Initial unemployment claims have been volatile, with an upward spike this past month, but job creation continues across a broad spectrum of key core positions.
Meanwhile, the Fed has made it clear that the FOMC voting members are biased toward further rate hikes, potentially two more hikes before year-end. Again, rate hikes would be predicated on continued stubbornness in Core CPI inflation rates. A key component in this category is housing inflation, and based on recent data, that might be slowly unwinding. Upcoming housing, employment, and core inflation trends over the next four weeks will be critical to the decisions made at the Fed’s next meeting, July 25-26. In the meantime, the economy is beginning to feel the burden of the already 500 basis point increase in interest rates. Although rate increases have not forced a recession yet, the verdict is still out about whether or not the economy weathers rate hurdles that could be coming in the next 12 months.
Looking at the equity markets in particular, the S&P 500 today is currently trading at forward multiples of approximately 18.8 times the next 12 months’ earnings. According to Factset data, this P/E ratio is slightly above the five-year average of 18.6 and a bit more over the 10-years expectations of 17.4 times earnings estimates. With respect to future earnings, estimates for S&P 500 companies for all of 2023 is a growth rate of +1.1% with revenue growth of 2.4%. Next year’s expectations, however, increase to 11.7% growth over the ensuing 12 months and revenue growth of 4.9%.
Will the market stumble over that period? The answer remains to be seen, but at these levels, the broad indexes are anticipating continued growth and at worst, a managed economic soft landing. Questions still remain about whether or not the handful of growth stocks can support the market’s momentum or, potentially, we begin to see a rotation into the more cyclical companies that have been left out in this year’s market rally.
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.