• Inflation remains persistent, although much can be attributed to the post-pandemic recovery and Ukraine war (energy, food and housing prices).
• Today’s strong dollar has provided an advantage for consumers. Because of the dollar’s stronger relative value, buying goods overseas is relatively cheaper.
• Home prices have slipped over the last two months, a consecutive timeframe not seen since early 2012.
• Current unemployment lows are providing a floor to support wage stability, while the widespread need for workers has not yet forced any wholesale corporate layoffs.
• The key to market sustainability is the Fed’s signaling that rate hikes will be slowing, and until Chair Powell signals otherwise, markets will be volatile.
Investors gained a bit of ground last week as the markets began hoping that negative news to date would be enough for the Fed to pivot toward lower rate hikes in its upcoming Federal Open Market Committee (FOMC) meeting. But with the exception of this past week’s close (October 28), market rebounds have been sporadic throughout the year with interim rallies falling short of expectations. Rising interest rates and the Fear of More Coming (FOMC)—versus the old Fear of Missing Out (FOMO)—have punished and teased investors through a handful of bear market rallies.
Although there has been some recovery from September’s new low, the S&P 500 is still off 18% year-to-date, paling in comparison to the tech-heavy Nasdaq losses. Market gains from the stay-at-home shopping/working bubble have disintegrated, deflating consumer, retailer and home builder outlooks. Port traffic congestion is now an outdated issue as are supply chain snarls and new order backlogs and pricing. Consumers are shopping less for durable goods, spending more time on the road, and for many, getting back to the office routine. In short, some of the inflation effects from the early recovery days are beginning to work themselves out through the pipeline.
Looking at inflation by the numbers, last week’s data wasn’t as bad as two weeks ago, but it wasn’t exactly good, either; what it did show was that inflation remains sticky. The Consumer Price Index for September dropped slightly to 8.2%, annualized from 8.3% the month before. Backing out food and energy brought the core percentage down to 6.6%. It was noteworthy though that the inflationary pressures most impacting consumers were housing, food and energy.
Excluding the latter two items, housing/shelter index accounted for 40% of the total increase. Looking more closely at food inflation, the subcomponents for meats, dairy and related products were up nearly 16% from last year. Energy prices were even more of a revelation with the electricity index up 15.5%, gasoline up 18.2% and natural gas up 33.1%. These inflationary expenses were further exacerbated by the jump-start recovery from Covid and most recently from the shortages, expenditures and embargos related to the ongoing war in Ukraine.
The Consumer Backdrop
Consumers are the other “wild card” in Fed efforts to wrangle inflation back into its target range. Thanks to a low unemployment environment coupled with Covid-era excess savings, consumers are balancing their income and expenditures with spending now roughly 8% above pre-pandemic levels (exceptions are furnishings and appliances). And despite any downturn in Consumer Sentiment surveys to the contrary, consumers are still comfortable with their spending trends as they redirect dollars towards more discretionary consumables, including travel.
Also helping consumers balance their budgets is a relative strong currency and a still healthy personal savings balance. Although today’s strong dollar is not the boon for most multinational companies, it has provided an advantage for those consumers buying goods at relatively cheaper prices overseas.
Also interesting, consumers are apparently looking beyond the next few years in terms of inflation impact, viewing it more as a transitory nuisance. Recent consumer surveys show a continuing decline in the respondent’s inflation outlook, both next year and through the following five years. The latter outlook indicates expectations of an inflation level of 2.35% five years down the road
The Covid-era housing market run-up quickly became the homebuyers plight earlier this year, coinciding with the Fed’s initial monetary tightening. As mortgage rates hit 20-year highs, the ripple impact became more visible throughout the homebuilding industry. Although recent Case-Shiller data still points to 13% housing price gains over the past 12-months, valuations are likely to slip further with waning housing sales and mortgage affordability.
In October, mortgage applications were off -21.1% over the prior 13-week timeframe while September’s new home sales dropped almost -11% on a month-over-month basis. Now, new applications have fallen to a 25-year low, and refinancing loan applications have fallen to a new 22-year low. Because of higher prices and mortgage rates, new home inventories increased to 462,000 units for September, up 29% from last year.
Unfortunately, the accelerated increase in interest rates (and the promise of more to come) is taking a toll on the current housing market. According to the most recent Case-Shiller Price Index, home prices have slipped over the last two months, a consecutive time period not seen since early 2012. Existing home sales are also off 29% since the post-Covid peak while housing starts are down 8.1%. Also noteworthy was the National Association of Home Builders (NAHB) index which fell to a level of 38; outside of a brief period during Covid, the reading was the lowest since 2012.
As time goes by and rates continue to rise, expect more slippage in building permits, home sales and homebuilder sentiment. Whether or not this rapid downturn in the housing industry factors in the next FOMC rate decisions remains to be seen, but the rapid housing price inflation that concerned so many is quickly deflating. Although they are unsettling today, these trends will help “normalize” future housing markets without completely unraveling the housing industry. Keep in mind that homebuyers over the last two years locked in mortgage rates approximately one-half of today’s market rates of 7%.
Jobs, the Fed Outlier
Labor markets are among the other anomalies countering the Fed’s effort to bring down inflation. The current state of the job market, wage growth and consumption levels are offsetting other Fed efforts to push price levels back to their target range and inflation outlook. The September jobs report is a reminder of the job market’s strength, as unemployment held steady at 3.5% and initial jobless claims fell to their lowest level since April 23.
How the labor markets work through this contradiction will be interesting. The Fed is counting on a downturn in both job and wage growth as higher inventory costs, interest rates and slowing demand pressure corporate margins. Fed Chair Powell has already acknowledged that wage growth because of strong labor demand is one of the biggest Fed concerns. But in this environment, current unemployment lows are providing a floor to support wage stability, while the widespread need for workers has not yet forced any wholesale corporate layoffs.
The holiday season is now approaching, and the next two months is a prime period for companies to hire additional part-time staff. The Fed’s efforts to also push the labor markets back into its target range will be evaluated (as will the efforts to navigate a soft landing).
Manufacturer Surveys down,Industrial Production up
It is quite the conundrum. The employment markets are steady; September’s Industrial Production reported a rebound. Yet the manufacturing outlook is weakening. The outlook from the Fed regional manufacturing surveys is firmly in contraction as shipments and new orders are bottoming out and expectations for new orders are at record lows. In addition, the Conference Board’s Index of Leading Economic Indicators posted its steepest decline since Covid (-1.45%). Meanwhile, the six-month outlook for capital spending has fallen to July’s low, and a recession is in the making.
Surprisingly, though, industrial production held its own. Although current readings are most likely lagging the impact of higher rates and a strengthened dollar (by-product of relatively higher rates), September’s Industrial Production posted its highest level in recent history. As might be expected with the spike in production was the increase in capacity utilization readings of 80, a level generally synonymous with a fully engaged economy. I would also expect capacity utilization to fall as recession headwinds catch up and match the decline in new orders that have been reported across the nation’s manufacturing industry.
It comes as no surprise that the slowdown in manufacturing and business in general is not just a domestic issue. Reports across the globe are moving in lockstep, although many countries are in earlier or, in many cases, deeper throes of inflation or a recession. Uncertain food and fuel prices and supplies are impairing economic viability in numerous countries. In addition, a number of geopolitical issues, continuing hostilities, trade difficulties and more are impacting a number of our trading partners. It is little surprise that the Eurozone manufacturing industries PMI Index has posted its lowest reading since the beginning of the pandemic.
One positive to the current situation though is this year’s situation reversal: last year the global economy was accelerating, but today, the impact of the global recession is putting downward pressure on inflation.
Looking for Direction
Investors were undoubtedly relieved at Friday’s market close and the returns booked last week. With only one trading day left in October, performances for the month have recouped September’s losses. Although the S&P closed Friday up a positive month-to-date 8.8% return, the Dow Jones Industrial Average flew by the S&P, pacing itself for its best return for October in history. Although not bad for a bear market rally, it’s an important reminder for investors to put these returns in perspective because bear markets are often characterized by sharp rallies followed by reversals.
Key to market sustainability is the Fed’s signaling that rate hikes will be slowing. Although some changing inflation perspective from the voting FOMC members might be in the offing over the next few months, while Chair Powell is in charge, markets will be volatile.
Through this year there have been few financial market safe havens, as exemplified by both the technology and communication sector, each respectively losing -25.47% and -36.88% through Friday, October 28. The 20-year Treasury hasn’t fared any better, off -34.68%. Neither has inflation protection bonds with the IShare Tips bond ETF down -17.54%.
Not surprising to consumers either, the one positive outlier was the energy sector, +60.81% (courtesy of rising fuel oil and natural gas prices). One other market segment that performed respectably was dividend yielding stocks with the proxy IShare Dividend ETF down slightly, -3.04%.
From a market fundamental perspective, the third quarter has provided a mixed bag of data. Despite a few positives (energy), there’s now a marked downtrend in forward earnings estimates. Earnings are still trending positive though, albeit at a much slower growth rate. Projections for the fourth quarter are for earnings growth of 2.7% with next year’s growth estimates rising to 6.4%. Investor sentiment (as measured by the “bear” responses in the American Association of Individual Investors) is at, or near, historic lows.
Looking at market drivers over the next few months, we see several hurdles and tailwinds ahead. The most obvious obstacle is the FOMC’s continuing efforts to bring inflation back in line to its targeted range. With five rate hikes behind us, the Fed funds rate is now set at a 3% floor. This week the floor will be raised most likely by another 75 basis points. If the current economic data shows sufficient weakening, perhaps the Fed will pivot to a lower rate earlier than most expect. But given the tone of the Fed board members recently, I wouldn’t count on any significant language change this month.
Meanwhile, the S&P is finding support and bouncing off its 200-day moving average, a leading indicator of market-bottoming support. Add a forward P/E multiple of approximately 16.3 versus the five and 10-year averages of 18.5- and 17.1-times earnings estimates, and the markets have certainly shed some of their prior year’s excess valuations. Last, we have the seasonality factor which is generally equity-market bullish the last quarter of the year, even during midterm election years. In a matter of days, we should get a clearer sense of how the markets will react to both the midterm election outcomes and the Fed policy transitions.
All Eyes on the Fed
While financial markets have teased investors with relatively short-lived rallies this year, we’ve not lost sight of the central bank’s determination to bring still-stubborn inflation gauges under control. Over the remainder of this quarter, we will again face the prospect of potentially two more rate hikes, one in November and one in December. Both increases possibly in the 50 to 75 basis point range. For many market watchers, the question isn’t “when will we see a recession” but rather “when did the recession begin.”
One interesting detractor from the recession watch, however, was the initial third quarter GDP data reporting a turnaround (+2.6% annual growth) from the prior two negative quarters. While investors might view this report as a reversal of fortunes, it remains one of those anomalies where exports growth for the quarter (+2.77% annualized), was one of the few noteworthy components. Although monthly trade suggested an improvement in net exports, the next revision to third quarter GDP will probably diminish the impact because of the weakening global economy. Today’s dollar strength will likely result in higher net imports over the near future.
Aside from the GDP report, several signals today still point towards an imminent recession, including the state of today’s housing market and the slowdown in manufacturing. Another stalwart signal investors generally scan for is the inversion of the three-month and 10-year Treasury. This recently occurred with the shorter-term three-year maturity crossing over the longer-term note (meaning the three-month yield of 4.13% has a higher yield than the 10-year note’s 4.02%). The reaction by the Fed in its upcoming meeting will be telling as well. Any acceleration in the timing or the magnitude of the remaining rate hikes will probably intensify further risks toward the rate yield stability and certainly any prospective recession.
Until there is further news from the Fed, however, keep in mind we are further along the tightening cycle than we were earlier in the year. In the past several weeks, other global central banks have begun to loosen up on their timing or magnitude of rate hikes. Recently, both Bank of Canada and the Bank of Australia cut back on the level of rate hikes while the European Central Bank has commented on lowering future hikes. This trend is undoubtedly being watched here as well.
Investors will be considering several variables throughout the next few months, including midterm elections, market seasonality, continuing strength in the job markets and relatively attractive valuations in the equity markets—and once again, bond yields that can provide an attractive cashflow for savers and investors.
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.