Market Perspectives- May 2023

Expectations Reset

•  The FOMC (Federal Open Market Committee) raised rates, potentially for the last time, to a Fed Funds range of 5-5.25%, the highest since September 2007.

• Inflation levels are falling, with April’s Headline CPI dropping to 4.9% from the June 2022 high of 9.1%. The PPI (Producer Price Index) fell to 2.3% from a June 2022 high of 11.2%.

• Today, Consumer debt stands at $17.05 trillion, or $2.9 trillion more than at the close of 2019.

• Investors are now concerned with the impact of initial unemployment claims, up roughly 30% from the first of the year, and job openings, now down 14% over the same time frame.

• On a year-to-date basis, a number of the markets have already found traction as investors discount potential recessionary risks and the likelihood of future sell-offs rivaling last year’s October lows.

Another month of economic news

With April’s CPI and PPI inflation reports indicating the abatement of inflation pressures, the FOMC raised the federal funds rate above 5% for the first time in 15 years (possibly the last time) following its May 3rd meeting. The long-awaited message from Fed Chair Powell following the rate hike was more “dovish” than expected as the Fed essentially hit the pause button on future hikes. Messaging added “to the extent to which additional policy firming may be appropriate” was Fed-speak for “we’re done—for now anyway.” What was missing, of course, was the long-awaited timing announcement for rate cuts as Powell disavowed any thoughts of rate cutting. Not surprisingly, however, the markets have already factored in that likelihood.

This month’s economic data supported the possibility of a rate hike pause as disinflation signals continued to trickle through segments of the economy. One of Chair Powell’s talking points focused on recent banking struggles and corresponding market upheavals in March and included the message that these events provided one of the FOMC’s “learning lessons.” It was also likely to be one of the most significant factors in the May FOMC decision to increase rates by 25 basis points.

On an absolute basis, however, inflation is still too high, at least when measured against the Fed’s 2% target. Whether or not that is an achievable target before rates pivot downward is a waiting game. A few of us don’t agree that the age-old 2% Fed rate target is still viable with the U.S. push toward developing more “grown-at-home” industries and employment opportunities. As companies and jobs return to the U.S., onshoring from lower-cost markets comes with a higher price tag. Perhaps inflation at 2.5 to 3.0% should be the new normal.

For now, though, inflation is fading from last year’s high. Headline inflation dropped below 5% (to 4.9%) for the first time since 2021, while core inflation (which excludes food and energy) eased only slightly to 5.5% (versus 5.6%). More interesting, perhaps, is the drop in the Producer Price Index (PPI), which reflects the price for goods and services sold by the producer to retailers or distributors and then on to the consumer. April’s PPI price inflation dropped to 2.3% from a high of 11.2% last June. Because PPI is a rough leading indicator of CPI, the trend is certainly positive.

Fed conversations, Treasury markets and finding the path ahead

The Treasury markets are working hard to reflect the economic market risks exacerbated by accelerated rate hikes, the not-so-surprising regional banking crisis last month, the quickly approaching debt issue standoff and, of course, the flight to quality by safe haven income seekers. With rates improving across bond maturities deciding to buy fixed-income investments has become quite a bit easier compared to last year.

Even so, the volatility we’ve seen in the markets has contributed to concerns about “inverted yield curves,” meaning short-term bonds are yielding more than longer-term maturities. This year’s “yield-inversion” is a phenomenon also exacerbated by the rapid increase in short interest rates by both Fed actions and investor cash flow volatility.

Given this environment and the historically predictive nature of yield inversions, two notable inverted spreads demonstrating investor recession concerns are the 10-year/2-year Treasury with inverted yields (-0.55%) since July 2022 and the 10-year /3-month Treasury with inverted yields (-1.69%) since October 2022. The issue is that recessions usually follow on the heels of inverted yield curves within six to 24 months. The most important for investors to remember is that the inverted yield data is an indicator, not a forecast.

 

Pillars of economic support

The U.S. economy is primarily consumer driven, meaning the health of the economy is dependent on the well-being of consumers, their outlook and their pocketbooks. So far, consumers remain relatively optimistic—perhaps not as obvious in monthly sentiment measures, but certainly reflected in their economic activities. According to the latest travel data from U.S Travel Association, spending this year was 4% above March 2019 levels. Air travel was almost on par with 2019 flight levels, and that was also the case with hotel room demand. Although fuel prices are still up around 23% from the past five year’s $2.94/gallon average, St. Louis Fed data is a confirmation that today’s highway congestion remains on par with pre-pandemic levels.

Not surprisingly, perhaps, as the economy rebooted post-pandemic and consumers spent less time web-browsing, their spending—and debt levels—increased. According to the New York Fed’s Quarterly Report on Household Debt and Credit, today, consumer debt stands at $17.05 trillion, or $2.9 trillion more than at the close of 2019. Also not surprising with the pandemic-era housing environment, mortgage loans accounted for the largest share of debt growth. Under the prior lower rate environment, credit card usage escalated, with card balances increasing post-pandemic at an annualized 17% growth rate.

For now, there is good news: borrowers are still relatively current with their debt payments. The New York Fed report noted that home foreclosures today remain low and in line with Q4 2022 levels. The state of student loans, a headline topic in years past ($1.6 trillion), has also improved dramatically as a result of the Government’s Fresh Start program, making defaulted loans current. Although it is just a moment in time, today’s student loan delinquency is less than 1%. And at least for now, current consumption and debt levels are being supported by a still reasonably strong jobs market in the backdrop of now fading inflation pressures.

Looking more closely at the jobs market, a recent surge in initial jobless claims is now raising the specter of an unwinding labor market. With initial claims up 35,000 over the past two weeks, the month-end total of 264,000 was the highest level since October 2022. Recall that these numbers are within the context of continuing historic lows in unemployment rates and a still rather robust labor market. Nevertheless, investors are now concerned with the economic impact of initial claims, up roughly 30% from the first of the year and job openings, now down 14% over the same time frame (now 9.6 million but down from a high of 12 million openings in March, 2022).

Despite fluid job market concerns, however, employment levels for both service and manufacturing industries have remained at relatively stable levels. Whether manufacturing jobs can withstand any further downturn remains to be seen, but what has not diminished is the number of “help wanted” signs in stores and restaurants. The continuing need for employees in stores and restaurants is not surprising based on May’s report from the National Restaurant Association, noting that April represented the 14th time in the last 15 months that restaurant sales growth outpaced gains in the overall retail industry.

Both the housing markets and retail sales have remained stalwarts of economic stability since the early days of the pandemic, and not much has changed this past month or year. The existing homes market today remains tight, with roughly 2.6 months of inventory. This data boosted builder confidence regarding future activities to a 10-month high, as did the increase in permits for single-family homes to a seven-month high. Meanwhile, Realtor.com reported that median home prices were up 2.5% versus last year, and homes sold spent 49 days on the market (17 days longer than last year but a shorter period than before the pandemic).

In retail sales, revenues in April were up by 0.40% versus the prior month. Over the past 12 months, retail sales were up 1.6%. Stripping out inflation, however, growth rates were actually off -3.2%. A deeper dive reveals a number of positive data “twists.” First, March sales were revised upwards by 0.30%. A big detractor to retail sales was gas station sales (off 0.80% for the month and -14.55% for the year), the result of lower fuel prices (deflation). And online sales proved again to be one of the brighter categories in the report (up 1.2% for the month and 8% for the year).

The state of the manufacturing and services industries

As has been the case for multiple months, the manufacturing and services data are sending mixed signals. Much of the confusion is the result of the unique way our economy evolved into this situation, namely the stop-start impact of Covid on business, consumer and life activities. Retail sales, housing and the labor markets all evolved within this new post-pandemic environment. The same is true with the manufacturing industry, impacted by labor shortages, hiring sprees, supply-chain shutdowns, reopenings and transportation snafus. As the Fed has already noted, no available economic models exist to understand this confluence of disruption impacts and their fixes.

Today, however, there is weakness across a spectrum of industries and businesses, mostly related to rising interest rates, squeezed margins, labor shortages and the war in Ukraine. In a number of industries, though, the consumer has yet to feel inflation’s impact. Service industries are one example of companies that have mostly weathered rising inflation rates. The latest service index reading remains in expansion territory (index 51.9), posting its fourth consecutive month of growth. April’s data highlighted improving domestic orders, export orders and supply chain improvements, setting the stage for potentially improving business conditions.

Manufacturing lines of businesses, however, posted a fifth monthly contraction, following 30 months of expansion that began shortly after the spring 2020 Covid-19 contraction. With ISM’s Purchasing Manager Index posting an index reading of 47.1, few positive “forward-looking” highlights were to be found. This April downturn was particularly noted in the New York Fed Empire State New Orders Index, which fell an astounding 53 index points to -28.0—a decline rivaling the pandemic contraction time frame.

The one positive news item was industrial production—which includes manufacturing, mining, and utility output. According to Fed data, this category rose 0.5% in April (and 0.24% over the prior 12 months), notching the first increase since January. One of the key drivers of the April report was autos, with total vehicle assembly up 13.68% for the month, the largest one month increase since October 2021.

Market’s support

The pressures and fears of a potential hard economic landing (recession) are the most likely explanations for investor flight from the equity markets this past year. According to S&P Global Market Intelligence, since last May, institutional investors have withdrawn approximately $340 billion from the stock market. Fortunately for investors, there were few missed equity opportunities over the ensuing 12-month period as both the S&P 500 and NASDAQ Indexes remained essentially flat after recovering from a volatile selling spree through mid-October. In fact, the S&P 500 is now only a few points away from where it closed three months earlier.

But on a year-to-date basis, a number of markets have already found traction as investors now discount potential recessionary risks and the likelihood of future sell-offs rivaling last year’s October lows. The NASDAQ has traded up to support levels that generally indicate a market recovery. And the S&P 500 isn’t too far behind. Seven months ago, every sector, aside from energy was below its 50 day moving average. Today, the situation has reversed somewhat, with energy now trading near the bottom of the pack. At the same time, more growth-centric sectors such as technology, consumer discretionary and communication services have rallied as investors begin forecasting an earnings recovery early into next year. Markets written off by investors last year have also found traction, including cryptocurrencies and the non-U.S. markets, including our next door neighbor, Mexico.

Companies have delivered in terms of revenue growth (or cost cutting efforts), with 92% of the earnings reports (through May 12), 78% of the companies have reported earnings above estimates with the highest number of surprises since the last quarter of 2021. Companies with stronger than expected earnings have also represented a broad spectrum of industries, highlighting that despite tighter credit conditions, banking system stress and debt ceiling worries, fundamentally sound companies have been able to navigate troubled economic headwinds (or at least convince investors that to be the case).

Whether or not companies will continue to post positive earnings growth will be tested over the next few quarters, but at this point, the markets have already moved beyond the lows set last October. The question though, is whether the momentum is maintained with the remaining economic uncertainties. As already noted, efforts to cut inflation have brought CPI levels down considerably quicker than it took to set the highs posted last June. The labor markets still remain rather robust despite the recent increases in first-time unemployment filings. Retail spending levels have yet to reflect the economic unease felt by consumers, and the housing market, while still expensive, is holding up exceptionally well.

At this point, the outstanding issue is the glide path for the economy going forward. If a soft landing is ahead (avoids recession), the market is still cheap. A hard landing (recession) will mean the recent monetary tightening was too aggressive and fast, and a market sell-off is still on the table.

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.