The summer months are historically the weakest months in the market and this year was no exception. The S&P 500 and the Dow Jones Industrial Average both declined by over 8% from late July to early October as borrowing costs soared and rate of inflation stopped going down. The markets started the year strong as the rate of inflation dropped from 9.05% last June to only 3% this June. The markets were anticipating that inflation would be beaten by the end of 2023, and that interest rates would begin to decline, which would in turn cause the financial markets and the economy to improve. However, that has not happened. In this commentary, we will discuss how the economic headwinds facing the market are making it harder for the Fed to hit its inflation goal, and our outlook for the rest of the year.
While much progress has been made in bringing down inflation, there are still several headwinds facing the economy that are keeping inflation elevated and making the Fed’s job of bringing inflation at the current annual rate of 3.7% annually down to the Fed’s target rate of 2% difficult. These headwinds include tight labor markets, rising oil prices, and increased geopolitical tensions.
Normally ultra-low unemployment is a good thing; however, during times of inflation, economists like to see the unemployment rate rise because labor cost is a primary driver of inflation. On the contrary, the U.S. labor market remains very tight due to ongoing large government stimulus programs, an ongoing decoupling with China which is bringing some manufacturing jobs back to the U.S, and an exiting of the baby boomers from the workforce as they move to retirement. The Bureau of Labor Statistics reports that government jobs have accounted for 327,000 new jobs this year or almost 20% of the total jobs according to the Wall Street Journal. For comparison purposes, last year public sector jobs accounted for 5% of new jobs. So, it is very likely that government spending is helping in keeping the headline job numbers so strong. Regardless, with the jobless rate hovering near historic lows, and the U.S. Department of Labor’s latest job openings and labor turnover report showing a 700,000 jump in job openings to 9.6 million in August, and new claims for unemployment are also near record lows (just 207,000 in the first week of October), workers are seeing now as a good time to press for better pay, which will add to inflation. Currently, some of the largest labor strikes in decades are taking place right now. As of the first week in October, roughly 17% of the UAW (United Auto Workers) are on strike. The walkout involves two Ford factories, two at GM, and one at Stellantis (Formerly Chrysler), along with dozens of auto-parts warehouses owned by Stellantis and GM. Auto Industry analysts, as well as Rob Handfield, a leading business professor at North Carolina University, estimates the strikes and new pay packages could add 10% increases to the prices of new cars. Meanwhile, the largest healthcare strike in the country’s history is also taking place with roughly 75,000 Kaiser employees walking off the job. The coalition on strike wants a pay raise of 25% for all of its members along with better benefits, and medical benefits for retirees. So far, the two sides have agreed to a 40% increase to an education fund to better train employees and Kaiser has countered with a 12.5-16% pay increase over four years. While Kaiser is still open (non-emergency and elective services may be rescheduled), the strikers goal of hiring more workers (the union says 11% of its positions at Kaiser are unfilled) is especially challenging given the high amount of unfilled openings in the labor force (9.6 million in August).
The Federal Reserve has raised interest rates 11 times to slow down the economy in order to better match labor supply to labor demand. Moreover, they have had some success in bringing down job openings, but the current number of openings is still significantly above the long-term average implying either more time (higher interest rates for longer) or more interest rate hikes are needed.
Over the summer, the outlook for energy also changed. The price of oil is important because it is an input cost to nearly all industries. In June, oil prices had sunk to the $62 per barrel. Then, OPEC (Organization of Petroleum Exporting Countries) took action. Lead by Saudi Arabia, they announced new cuts that would slash global supplies by 1.3 million barrels starting in July. That came just as global oil demand was strengthening, driven by China’s rebound after COVID lockdowns, leading to a supply deficit. According to Rystad Energy, global crude consumption exceeded supplies by nearly 2.2 million barrels a day in the third quarter of this year and is expected to reach over three million barrels a day in the fourth quarter. This imbalance has caused oil prices to rise from $62 a barrel to over $94 (a 50% increase in oil prices) over the summer which also helped inflation to creep back up in July to 3.2% and then even higher to 3.7% in August.
Increased geopolitical tensions are also making the Federal Reserve’s job of reining in inflation more difficult. Geopolitical tensions are transmitted to the banks through the real economy. The effect of disruptions to supply chains and commodity markets have impacts on domestic growth and inflation. Since Russia’s invasion of Ukraine, agricultural prices have gone up because Ukraine is one of the world’s largest food producers. As China has become more authoritarian, especially under President Xi, and as China has failed to protect companies’ intellectual property, an increasing number of western companies have begun the long and costly process of re-designing their supply chains, adding cost which is passed on to consumers. Now with Hamas (which is backed by Iran) launching a surprise attack in southern Israel, this increases the probability of a wider Middle East conflict taking place in a globally important oil producing region, which will most likely cause oil prices to rise, adding to inflation.
As a result, the financial markets are no longer expecting any interest rate cuts this year, and the probability of an additional hike is rising. On the other hand, historically the Federal Reserve has not known when to stop hiking interest rates until it is obvious they have gone too far. Moreover, there is a growing consensus that Federal Reserve is near the tail end of this rate tightening cycle. This has been the fastest interest rate tightening cycle on record, and cracks in the economy are starting to show in real estate, the banking sector, the consumer and in the sustainability of the U.S. debt.
Since the Fed’s new monetary policy took effect, the average 30-year mortgage rate has topped 7% for the first time in twenty years. According to the National Association of Realtors, the average monthly (30-year mortgage rate) rose 85% over the past twenty months, from $1,212 in January of 2022 to $2,243 in August 2023. This has slowed home sales, an important driver for the U.S. economy. An important note is that there is still strong demand for homes, but many buyers are now waiting on the sidelines for better interest rates. Furthermore, commercial real estate has also been affected. Most commercial mortgage loans are fixed for 5, 7, or 10 years. As these loans roll over to the new higher interest rates, many of these loans will not be profitable to the borrower and they may walk away from the buildings. This is especially true in the office market where hybrid work has deceased the demand for office space.
As these loans roll back to the banks, these losses will affect the banks’ ability to make new loans in the future. Furthermore, the steep rise in interest rates has already given the banks paper losses on their existing assets (see chart above). Fortunately, the banks are still in a much better financial condition, and much better regulated than they were before the financial crisis (2008-2009), but the current conditions will most likely lead to less loan growth which will lower overall economic growth.
The U.S. consumer has also been effected by sharp rise in interest rates. Research by Hamza Abdelrahman and Luiz Oliveira of the Federal Reserve Bank of San Francisco suggests that Americans have burned through more than 90% of the "excess savings" they amassed in 2020 and 2021. What little remains, according The Economists magazine, is likely to be gone by the end of the year.
Moreover, credit card debt just hit $1 trillion, a record, and the interest rates on credit card debt is now near an all-time high, pressuring consumers with expensive debt after they had paid a lot of credit debt down during 2020-2021. July's credit card delinquencies climbed to pre-pandemic levels, with the average delinquency rate for the eight largest lenders tracked by Seeking Alpha (a financial website) rose 14 basis points to 2.67% and exceeds the July 2019 average of 2.64%. This all suggests that consumer spending rate of growth will be slowing in the months ahead as savings and credit cards are being slowly tapped out.
The current trajectory of interest rates is also putting tremendous pressure on the U.S. debt. With the exception of President Clinton, deficit spending has been a bi-partisan problem that has only been getting worse. Currently, the budget deficit is 6.5% of gross domestic product, which is at the highest levels since World War II. In the year 1982 the government ran a deficit of 5.9% GDP, but the country was also facing 10.1% unemployment rate at that time. Today we are enjoying record low unemployment of 3.8% and are still running record budget deficits (Brian Wesbury Chief Economist- First Trust Research).
Total federal government revenue is $3.97 trillion dollars according to USTreasury.gov, while nationalpriorites.org estimates that 75% of the current federal budget spending is already spent on mandatory expenses primarily made up of social security, defense, and Medicare. Since the nation’s total debt is now over $33 trillion, and the short term interest rates are over 5%, once this debt resets at the new interest rates, the interest cost alone will exceed $1.65 trillion dollars. Since we already spend $2.978 trillion just on defense, social security, and Medicare, this new spending will take total spending up to $4.628 trillion dollars even if the government cancels all other programs. Thus, we expect large pressure on the Federal Reserve by Congress to reduce interest rates to fund these very high debt levels as soon as they are able to do so.
In conclusion, tight labor markets, rising oil prices, and increased geo-political tensions have kept inflation higher than expected and have pushed back the date on when the Federal Reserve can reverse the current monetary policy. However, the pressure in the real estate market, consumer savings, and bank balance sheets are at levels historically where the Federal Reserve have reversed course on interest rates. Moreover, we believe Congress will also put pressure on the Fed to lower interest rates in order to keep the national debt more manageable. Once interest rates do begin to fall, many economic problems will begin to look better. The budget deficit will be easier to finance, the economy will improve as cars and homes become easier to afford, and business investments will begin to pick up as projects that were not feasible with high rates, become more feasible with low rates. Likewise, the stock market will improve as interest rates fall and the dividends of large corporations begin to look more attractive. In the meantime, we continue to like large capitalization companies with strong balance sheets, who provide goods and services that consumers and businesses need to use on a daily basis, and who are returning cash back to investors for the best risk adjusted returns in an increasingly volatile world.
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