Testing Market Resilience
• Last month, 87% of the S&P stocks were over their 50-day moving average. As of August 20th, the number of stocks still holding above their 50-day moving average slipped to 33%.
• According to Ned Davis research, interest payments on U.S. debt now represents 15% of government spending, the highest level since 2001.
• July retail sales were up 0.7% from the prior month and up 3.2% from the same period a year ago.
• In the first quarter of 2023, the U.S. economy grew GDP by an annual rate of 2%. In the second quarter, initial GDP estimates rose to 2.4%.
• July’s core consumer price inflation rate, excluding volatile items such as food and energy, dropped to 4.7%, the lowest rate since October 2021.
The Laundry List
August and September are often referred to as the dog days of summer—or the summer doldrums—given the abundance of warmer temperatures, humidity levels, and the sluggishness and stagnation they induce. So too, investors are becoming accustomed to their own doldrums these days, with each new economic release or pronouncement adding to market noise.
Despite calls for a recession that began months ago, markets have proven resilient. At July’s close, the S&P 500 was up roughly 19%. But by August 18th, returns had fallen somewhat, lowering year-to-date returns to a still positive 14.5%. This loss of 4.5% over 14 trading days was a reminder that volatility remains and is likely continuing until there is certainty on inflation’s path.
In the past few weeks, fears have also escalated over a potential fallout from the bankruptcy filings of China’s second-largest property developer, Evergrande Group. Just this past week, the company filed for bankruptcy protection (including here in the U.S.), seeking to restructure $31.7 billion in offshore debt. While the Chinese central bank is working in the background to shore up a number of its own internal economic issues, this financial fallout adds another potential global market headwind.
Also not to be forgotten is that Congress is reconvening in mid-September in time for both House and Senate negotiators to mend fences just long enough to pass a federal budget by September 30. Given recent history, expectations are low, except for the passage of another Continuing Reconciliation bill. Once again, Congress is kicking the can a bit further down the road. In the interim, the risks still exist of Washington rhetoric derailing or delaying the bill’s passage.
There are also issues that ultimately need to be addressed. According to Ned Davis research, rising interest rates and ballooning deficits have now pushed gross interest payments alone up to 15% of government spending, the highest level since 2001. Bringing these levels down will require a bit of spending restraint or resilient (and persistent) economic growth soon. A pivot back toward reversing recent rate hikes would help. Not helpful would be another unexpected U.S. debt downgrade, mirroring Fitch’s August 2nd rating agency call, which dropped government credit ratings from AAA to AA+.
Looking at the broader economic underpinnings, though, the U.S. is hitting on a number of cylinders in contrast to still lingering investor concerns. Recall that in the first quarter of 2023 the U.S. economy posted a positive GDP growth rate of 2%. Through the second quarter, initial GDP estimates are predicting a growth rate of 2.4%. This past week the Atlanta Fed’s GDPNow model issued an initial annualized third-quarter GDP growth estimate of 5.8%.
Although this is an overly optimistic signal (most certainly to be revised downward), the data represents a positive trajectory predicated on last month’s Industrial Production report, weekly jobless claims and the trending drop in inflation rates. Whether or not the Fed views the data in the same light will be the topic of discussions leading up to the next Fed meeting on September 19-20.
State of the Consumer
The constant market concern is, do consumers have the resilience to withstand the cumulative impact of the past 11 rate hikes? The job markets, a bellwether economic indicator, certainly appear to have passed the test. Layoff announcements have dropped for the third time in four months, and the four-week moving average for initial claims fell for the 12th consecutive week.
With unemployment rates now at 3.5%, we have also seen a slowdown in employee job quits back to pre-pandemic levels, implying some cooling in the labor markets. This has also been the case with a slowing in new job openings. But while the overall level of openings has come down, there are still more jobs available than people looking for a job.
And despite headline worries of more labor market pain to come, July’s report highlighted that an additional 187,000 jobs were filled across a spectrum of occupations. Health care added 63,000 jobs, wholesale trade was up 18,000 jobs, construction jobs increased by 19,000, and the combined increase in jobs filled in the leisure and services industries was up 37,000 jobs. Add one more positive: Labor productivity appears to be on the mend, with the second quarter’s productivity growth up 3.7% (comparing growth in output versus growth in hours worked).
July retail sales were also a positive surprise, up 0.7% from the prior month and a positive 3.2% from the same period a year ago. Discounting the data for autos and gasoline, sales growth improved to 5.3% versus last year. Not surprising perhaps was that gasoline sales were down nearly 21%, given the corresponding drop in fuel prices over the past year from June’s high of +/- $5 per gallon. Also notable is that service industries are still benefitting from dining-out/take-out orders, with bar and restaurant sales growth continuing, up 1.4% from last month and 11.8% from a year ago.
One takeaway from the data is that the acceleration in retail spending last month suggests spending trends are rising faster than the pace of inflation. Policymakers would like to see this data point moderate, and it may happen if this month’s past spending levels prove to be one-off spikes from “back-to-school” sales and late summer vacations.
On the housing front, home buyers are now confronting 20-year high, 7.09% mortgage rates. Although these rates have not discouraged all potential home buyers—given the low existing housing inventory—it is causing homeowners to rethink selling their homes. According to Redfin, close to 90% of current homeowners have mortgage rates below 6%, and nearly one-quarter of them have rates below 3%. Again, there’s little incentive for existing homeowners to move. There is also a reduced risk of a feared housing meltdown, given current job market stability and the level of existing mortgages at relatively low rates.
It is not surprising that with the lack of existing housing inventory, builders are actively working to create new supply. July single-family housing permits were up 1.31% over last year, although multifamily permits fell by 30.8% from a year ago. But for prospective home buyers, rate increases have definitely impacted both affordability and availability. This factor is likely to weigh on the September Fed meeting.
Commerce (indicators and outlooks)
As mentioned, a few “green shoots” of promising data supporting the year-to-date rally exist. Not withstanding the hope that we are at (or nearly at) the end of the rate hike regimen, there are a few positive signals flashing from business surveys such as the NFIB Small Business Optimism Index. Small business respondents pushed the index up for the third consecutive month (an eight-month high), and an increasing number of firms are now planning capital expenditures over the next three to six months.
Improvement in the Industrial Production data was also noteworthy, up 1% over the prior month (versus estimates of 0.3%). Manufacturing output rose 0.5% in July as the production of motor vehicles and parts jumped 5.2%. And not surprisingly, the index for utilities climbed 5.4% as July’s higher temperatures raised demand for cooling. Also of note, capacity utilization at its current level of 79.3% is only 0.4 percentage points below its long-run (1972–2022) average. This data is often lost in inferring too much from weaker ISM Manufacturing surveys. What is positive, however, from both the Manufacturing survey and from the New York Empire Manufacturing Index is the improving outlook for new orders. In both cases, the outlook is well above inventory levels, suggesting production increases on the horizon.
The Equity Markets Pause
Investors are a fickle lot. Last month, the American Association of Individual Investors poll posted the highest percentage of bulls (51%) in almost two years. In last week’s poll, the bullish percentage dropped to 35.9%. The poll respondents’ concerns have already been noted—the uncertain Fed path, inflation concerns, overseas conflicts and an upcoming election, again. August’s market turbulence has culled some of this year’s gains, but despite a quick reversal in investor sentiment, it has still been a great year-to-date period for a few of the broader equity markets.
According to Motley Fool data, the S&P posted its best return for the first seven months of a year since 1997. Likewise, the Nasdaq posted its best seven-month period since 1975. And while August has been tough on growth stocks, through last Friday (August 18), the Nasdaq is still up nearly 27%.
On the other side of the spectrum, though, over the same timeframe, small-cap stocks (Russell 2000) and value stocks (Russell 1000 Value) posted positive but certainly less attractive returns, up 5.9% and 4.6%, respectively. I wouldn’t be surprised to see the next upturn; market breadth increases to include a number of these more attractively valued companies.
August was a difficult month for investors. The broad decline in stocks last week pushed the S&P below its 50-day moving average for the first time since April. This decline was not unique to the S&P either, as all major domestic indices broke support levels. Of particular interest, though, was a report from Bespoke Research noting that breaks in the 50-day moving average (assuming an uptrend for at least 90 days) are actually bullish for the broad equity markets over the ensuing three, six and 12 months. That is not a bad perspective looking beyond September’s Fed meeting.
Inflation, Fed Intentions and Closing Thoughts
Inflation is a sticking point for investors, the markets, and more importantly, the Fed. Last month in its July 25-26 meeting, most Fed officials still viewed high inflation as an ongoing threat. Despite signs of progress, price level growth was still well above the Fed’s 2% target. And at that last meeting, the Fed raised rates for the 11th time in 17 months with little guidance about what the next move would be.
Investors had different takeaway ideas based on the limited commentary from Fed Chair Powell following July’s meeting. From the investor perspective, the signal was fairly clear: the Fed was “at or nearing” the end of the rate hikes. But shortly afterward the meeting, a few Fed officials expressed contrary views, apparently wanting to keep options open for another hike.
There have been a few “sticky-inflation” data points since the Fed’s July meeting, including the recent retail sales data suggesting that last month consumers were spending at a higher pace than expected. But there have been countering data points as well. The housing industry is a prime example. Housing remains expensive, primarily the result of scarcity of inventory. New home construction has slowed dramatically, which will not alleviate the scarcity for months ahead. More rate hikes will not be the solution.
Recent economic data points still point to slowing inflation levels, albeit with still “sticky” components. The consumer price index (CPI) was up 0.2% over the prior month and up 3.2% from a year ago. Almost all of the monthly inflation increase came from shelter costs, up 0.4% for the month and up 7.7% from a year ago. By contrast, real wage adjusted for inflation was up 0.3% for the month and 1.1% over the prior 12-months. The more “watched” core consumer price inflation rate, which excludes volatile items such as food and energy, dropped to 4.7% in July, down from the prior month’s 4.8%, the lowest since October 2021.
One last inflation reading was the Producer Price Index (PPI), which posted a 12-month growth rate of 0.8% and a one-month increase of 0.3%. As a reminder, PPI gauges the changes in prices that domestic producers pay. This data is interesting because the biggest increase this past month was in the services industry. In this instance, 40% of the increase in July was due to a 7.6% increase in the price for portfolio management.
Looking Beyond the September Meeting
A few weeks back, my thoughts were that the markets were predicting no more rate hikes, but investors became a bit nervous with the better-than-expected sales report. A bit of market volatility began to echo worries of more rate hikes ahead. This might be the outcome, but the data has not changed significantly enough to expect a hike, at least not in September’s meeting. In the last Fed meeting, some voting members were not interested in hiking at that moment, while others worried that risks were rather balanced between hiking rates or leaving them alone. The Fed is still data-dependent, and I suspect that the housing industry will be the key factor in Fed members’ thinking in September. Home prices remain extremely sticky; homeowners today are loath to sell as long as housing inventory is limited and they are being held captive by their current mortgage rates.
While there may still be a rate hike ahead later this year, investors are still counting down to the first rate cut, which is not likely to happen this year. This much anticipated pivot will probably be pushed back further into 2024, and that is contributing to the upward pressure on yields and to the stock headwinds. The issue investors may need to consider is not when the next rate hike will be made, but rather how long it will be until the first rate cut. Unfortunately, the longer rates stay at this level, the more economic and market headwinds ahead.
In the meantime, the parting thought this month is that there are a number of strong underpinnings to the market and economy:
• Labor markets remain robust. Unemployment is low, broad job openings exist, layoff worries are still limited and productivity is improving. Demand for service and leisure employees remains high.
• Consumer travel continues. TSA headcounts continue to grow, exceeding the air passenger count pre-pandemic. Hotels are at or near 2019 levels.
• The U.S. economy is growing above trend. We were in a recessionary environment in the first half of 2022, with GDP contracting into negative territory. This year the economy is growing above trend and expectations.
• Despite the past year of rate hikes, the overall drag on the economy (outside of investor worries) has been rather nominal. Rising rates are certainly chipping away at household savings, but this is a factor that should be on the Fed’s radar.
• More financial institutions are beginning to expect the U.S. will avoid a recession despite the regimen of rate hikes. Bank of America, JP Morgan and Goldman Sachs are top of the list.
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