The Consumer Price Index, the key inflation gauge that measures price changes for a basket of goods and services, increased 4% for the year ending in May. This represents a sharp slowdown from April’s 4.9% and the peak rate of 9.06% in June 2022 (see chart below). But it is still double the Federal Reserve’s target rate of 2%. The stock market has rebounded this year in part due to the declining inflation rates, but the market gains have been concentrated to a very few stocks primarily in the technology sector. In this commentary, we will discuss the trends that we think will continue to bring inflation down, the slowing economy, and our market outlook for the rest of the year.
There are several trends bringing down the rate of growth of inflation including the labor market, housing, a slowing economy and a weakening consumer. Jerome Powell, the Chairman of the Federal Reserve Bank, has mentioned that the tight labor market is a leading reason why the Fed has not reduced interest rates in light of the slowing economy. Labor is one of business’s biggest cost, and labor shortages have fueled price spikes over the past year and a half. However, there are signs that the labor market is beginning to slow. The Commerce Department reported in May that the length of the average workweek declined to 34.4 hours, down from 34.6 hours the year before, which is equivalent to several hundred thousand jobs. Even though the workweek is shrinking, employers are not letting go of their workers because many firms have found themselves understaffed in the recent past and are reluctant to let workers go.
Wage growth has also slowed from its peak of last year. In May, the Labor Department reported wage growth of 4.3%, which was down from 6% last year, and 9.3% in January 2022. As a reminder the market is looking for real wage growth. For example, wage growth of 3% and inflation of 2% is 1% real positive wage growth. Unfortunately, the current wage growth, although a traditionally high number, is lagging inflation so real incomes have dropped over the last year. The Federal Reserve Bank is trying to bring down wage growth as a means to destroy the inflationary cycle that started last year. If wage growth continues to decline, it is hard for prices to keep going up.
Moreover, the closely watched Job Openings and Labor Turnover Survey put out by the Labor Department showed that new job listings fell to 9.82 million in May, down 496,000 from April and below the over 10 million job openings that have existed for much of the last year and a half. Job openings outnumbered the available labor pool by 1.6 to 1 for the month, a level that had been closer to 2 to 1 just a few months ago. Again, a sign that the labor market while still 3 strong, is cooling and reducing inflationary pressures. The May decline would have been even more had there not been an increase of some 61,000 government-related job opening positions. The Federal Reserve has stated it believes job openings to available labor ratio of 1.2 to be consistent with its goal of balancing growth and keeping inflation low.
In our last commentary, we mentioned that housing cost is currently the largest contributor to the Consumer Price Index at about 33% of the index. We also mentioned that due to The Bureau of Labor Statistics collecting data on rent for 50,000 residences through personal visits or phone calls on a rotating 6 month basis that their information was delayed and still showing rental prices for apartments going higher year over year when national online databases like Rent.com, Redfin and Zillow are showing declines. We think this data will show up in the CPI numbers later this year, and we also believe the high number of new multifamily construction units taking place nationally will also limit rent growth this year. Construction starts of multifamily housing units in buildings with five or more units (such as in large condo and apartment buildings) spiked in May to 58,500 the highest since 1986, up by 42% from May last year, and up by 49% from May 2019, according to the Census Bureau. More importantly, the 12 month average, which irons out the huge seasonal and month-to-month fluctuations and shows the longer-term trends, rose to 45,100 units, also the highest since 1986 (green line). All of this new apartment construction coming at a time of a slowing economy should depress rent growth in the near term.
Slowing consumer spending is also a leading reason why inflation growth rate is slowing. In the chart below from the Federal Reserve Economic Data the red line shows consumer savings rate which spiked with each of the three stimulus packages, and is now below the level in which COVID started, while the blue line represents credit card debt, which has picked up dramatically over the last year as consumers borrow more to maintain their standard of living. This chart is a sign of a strained consumer.
Rail traffic also suggest the same reality as rail shipments have declined 3.2% year over year as of June 24th, 2023 according to the Association of American Railroads. The Wall Street Journal also reports that the import prices from goods from Hong Kong, Singapore, Taiwan and South Korea are down 6.3% in May and 2% from China according to the Labor Department1 . This is a sign that consumers are pulling back and manufacturers are reducing prices to keep sales up.
Starting in August consumers will take another hit as the “debt ceiling deal paves the way for student loan payments to resume as early as August 29, 2023. For most, this will be the first time making payments since the early days of the pandemic in March 2020.”2 According to a New York Fed study, the average student loan payment is $393 monthly, and up to 40 million people could be affected. For consumers taking advantage of the program, they have deferred 39 months’ worth of payments, resulting in more than $15,327 in additional discretionary income during the period, much larger than the amount most consumers received from other COVID stimulus programs. As a side note, since the Supreme Court has ruled student loan forgiveness is unconstitutional, it is still possible the current administration could lower the interest rate on the current loans to make the loans easier to repay and not run into unconstitutionality questions. Consumer strain can also be seen in that 37% percent of workers have taken a loan, early withdrawal, and/or hardship withdrawal from their 401(k) or similar plan or IRA, according to a survey released by the nonprofit Transamerica Center for Retirement Studies (TCRS) in collaboration with the Transamerica Institute. This is an all-time high.
Inflationary pressures are also seen easing by commodity prices. Global commodities have seen a more than 25% slump over the last 12 months as reflected by the S&P GSCI Commodities index3 . A large percentage of this decline has been a decline in energy prices, but is reflective of a slowing economy and slowing demand which should continue to ease inflationary pressures. High interest rates are also starting to affect the banking industry as savers are taking money out of the banks to invest in higher yielding assets like bonds and money market funds. This has caused bank deposits to fall 5.57% from their peak, please see chart below.
In turn the falling bank deposits have caused the largest decline in lending since the Financial Crises as banks hold on to cash to maintain their own capital ratios. The overall decline in lending is still small, but is indicative of a slowing economy as banks are unwilling to make new loans as depositors leave (see chart on next page).
As we have mentioned in the past, the slowdown in the economy is being caused by higher interest rates as the Federal Reserve tries to bring inflation under control. The Federal Reserve’s reasoning is that they would rather have a slowing economy than high inflation. In fact, inflation running at close to 10%, which is what it was last June will evaporate half of the nation’s wealth in five years, while many of the consumers and economic problems will be fixed with lower interest rates. Indeed, the market has been rallying this year in the anticipation of lower interest rates, as the market has been focused on many of the points mentioned in this newsletter and concluding that the Federal Reserve is likely nearing the end of its rate hiking cycle (the future’s market is pricing in one more rate hike on July 26th). Once the Federal Reserve does start to lower interest rates and increase money supply a new business cycle has traditionally begun and investors have been putting money to work to take advantage of a perceived new growth cycle. So, our outlook for the second half of the year is for more volatility against an upward bias in the equity markets as a slowing economy and reduced earnings negatively affect stocks, but hopes of lower interest rates attracts new money into the market in hopes of a stock and economic rebound.
One area which we have not mentioned, but could also negatively affect stocks is geopolitics. The market is carefully watching the Ukraine/Russian war and its potentially subsequent inflationary pressures as large quantities of natural resources are withdrawn from world markets. Moreover, global supply chains are already starting to relocate some production out of China in part due to fears over a China/Taiwan clash. China’s President Xi Jinping, who is increasingly looking like an authoritarian dictator, has said he wants China’s military to be ready to annex Taiwan by force by 2027.
While the situations in Ukraine/Russia and China/Taiwan has received a lot of attention, relatively little attention is being paid to a potential Israel/ Iran clash as Iran gears up to make nuclear weapons. Iran has stated they want to destroy the state of Israel and Israel has publicly stated they will not allow Iran to acquire nuclear weapons. The United States has strong defense treaties and relationships with Israel, and in May of this year, Mark Milley, the Chairman of the U.S. Joint Chiefs of Staff, stated that they estimate Iran may have nuclear weapons deliverable by rockets as early as within one year. Meanwhile, Israel has conducted some of its largest military training exercises ever over the last six months. In January, the U.S. State Department reported an exercise called Juniper Oak 2023, conducted with Israel, which included 140 aircraft and 12 naval vessels, practicing bombing simulated Iranian nuclear sites. Next, on June 3rd, the Israeli Defense Forces (IDF) completed its “Chariots of Fire” military exercises, the largest the IDF has held in decades, designed to simulate simultaneous fighting on multiple fronts, mainly Hezbollah and Iran. From an economic perspective, an Iranian/ Israel conflict would be harmful to the global economy, and has the potential to directly draw the U.S. into the conflict, and potentially cause Iran to shut the Straits of Hormuz which runs off its coast. The Strait of Hormuz is only 21 miles wide and the U.S. Energy Administration estimates that about 20% of the world’s oil flows through the strait.
Moreover, Russia has also been rearming Serbia with weapons which could open old wounds in Kosovo. The Kosovo war was fought between February of 1998 to June of 1999 between the Federal Republic of Yugoslavia (i.e. Serbia and Montenegro) and the Kosovo Liberation Army (KLA) ethnic Albanians. The fighting ended when NATO (mainly America) intervened by large scale airstrikes. In 2008, Kosovo declared independence from Serbia, a move Serbia rejects. This month, NATO has increased the number of peacekeepers on the ground in Kosovo which is the primary reason fighting has not flared back up.
In conclusion, we believe that inflation is slowly getting better and the financial markets have rebounded from last year’s lows due to the declining inflation rates. The market is anticipating that the lower inflation rates will cause the Federal Reserve to lower interest rates and cause a new growth cycle. However, we remain more conservative for the second half of the year after the recent market rally. The leading economic indicators and savings rates point to a slower economy ahead and the Fed will most likely hike rates at least once and maybe two more times (the Fed has had ten rate hikes over the last fourteen months) before they finish. Moreover, the geo-political landscape and the potential for new conflicts to arise look troublesome while the U.S. ability to deal with new problems has been weakened due to the country’s ever expanding debt load. Lastly, the current stock rally can be mainly attributed to just seven of the largest companies which are now trading at lofty valuations and make up the largest percentage of the overall market in decades (see chart below).
Thus, investors buying the S&P 500 (the 500 largest companies in the country) are not nearly diversified as they think. In fact, year to date, as of July 10th, the Invesco S&P 500 Equal Weight (all stocks in the S&P 500 having the same weight) stock index (RSP) is up +5.96%, while the iShares Core U.S. Aggregate Bond Index (AGG) is down -0.18% and Vanguard REIT (VNQ) index is up +1.77%, which means the rally so far this year has been contained to very few companies. This is after large drops last year. As a result, we continue to favor investing in large capitalization, brand name companies with strong balance sheets who provide goods and services that consumers and businesses need to use on a daily basis as the best risk versus reward investments in the current markets.
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Sincerely,
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