An Anniversary of Sorts
• Discussion of the impact of early pandemic monetary and fiscal policy changes two years ago that led to our current inflationary concerns
• Analysis of correlation of near-zero interest rate changes with inflation fears and the market concerns over the speed and size of the monetary policy tightening
• Review of the immediate and subsequent impact of jump-starting the economy and the resulting shortages in certain durable goods (autos, appliances and homes) and the inevitable breakdown in supply chains and the spike in consumer good pricing
• Discussion of today’s economic health and risk of a near-term recession
This month, we mark a two-year anniversary of sorts. On March 11, 2020, the World Health Organization declared the coronavirus a global pandemic, and by March 19th, “stay at home” orders were in place here in the U.S. and progressed across the globe. Twenty-four months later, today’s environment, inflationary concerns, and monetary policy shifts continue to be influenced by and interconnected with policy decisions made two years ago as the world’s leaders began to confront the new global COVID-19 crisis.
Beginning in the early days of the pandemic, the U.S. government and Federal Reserve worked tirelessly to keep markets afloat and provide monetary assistance to those in need. Over the next several months, the Fed provided a backstop to the financial markets by lowering fed fund rates to a range of up to 0.25 basis points; buying Treasury, agency, and mortgage-backed securities; and providing liquidity to nervous money market investors. By February 2022, the Fed balance sheet had doubled in size to $8.88 trillion held in assets acquired since March 2020. In tandem with the Fed’s monetary stabilization efforts, Congress also implemented programs (and debt) that provided relief packages and extended unemployment insurance to those most impacted by the pandemic.
Over the last two years, the labor force mostly came back to work—either at home or in the office—and consumers bought new or replacement homes, large appliances, and cars. With rates at their lowest levels, investors took advantage of bidding up “risky” assets while manufacturers attempted to reopen their locked-down businesses and restart supply chains.
But problems quickly multiplied as housing and used car prices spiked, financial markets broke new records, supply chains broke down, and companies scrambled to find help. With the addition of a new war overseas between Russia and Ukraine, putting the economic pieces back together had become more complicated.
Now, the situation is beginning to turn around as the Federal Reserve has commenced what will be at least a year-plus process of reversing monetary policies that began in March 2020. Whether or not inflation continues to perpetuate the problems being reflected in financial market volatility remains to be seen. Even so, over time we should see some earlier complicating issues reverse and provide an inflationary release valve. With COVID cases falling (moving from pandemic to endemic), labor shortages should ease. Consumer goods spending will normalize as inventories are replenished because of improving shipping backlogs. Consumer spending will continue but will be more directed away from a “working at home” focus. Although the ensuing rate hikes may get a bit more aggressive, Fed Chair Powell’s parting comments last week were a reminder that the American economy remains strong and well positioned to manage tighter monetary policies.
Fed Hikes, Inflation and Outlook
Inflation and the Fed
The Fed began policy tightening with a 25-basis point (¼%) hike last week, although earlier expectations, including in the equity markets, were for a 50-basis point increase. Still, expectations are for six more increases after last week’s meeting, with more to come next year. As for balance sheet reductions, we should expect the Fed to begin reducing its Treasury securities, agency debt, and mortgage-backed securities by its next meeting.
This change in monetary policy has been well communicated for several months. Inflation is on the rise, and several factors, such as rental costs, auto purchases, food prices, wages, consumer goods, and commodities were contributors. The recent February spike in CPI inflation, jumping to an annualized 40-year high of 7.9% in tandem with last month’s Producer Price Index increase of 10% (80% given jumps in energy and food costs), provided confirmation of what consumers were already witnessing.
Inflationary fears aren’t new. Over the past few quarters, companies have highlighted rising commodity prices and supply chain shortages and their impact on prices and earnings. Likewise, market watchers have expressed concerns about whether investors, anticipating a recession and Fed policy changes, were buying longer term Treasury securities as a “safety trade” instead of equities and shorter-term maturities. This safety trade often results in longer-term yields falling below shorter-term maturity yields and is referred to as an inverted yield curve.
Concerns are that every recession has been presaged by an inverted yield curve, although not every inverted yield curve is followed by a recession. Looking at the spread (difference) between the 10-year and 2-year Treasury, the yield differential is only 0.17%, but in comparison to the 10-year and 3-month yield securities, the yield differential is 1.72%. As with both examples, there has been quite a bit of volatility lately, echoing investor concerns and trades, and continuing to watch these spreads does provide some insight into investor perspectives. Still, given the early stage of rate hikes countered by a strong jobs, housing, and manufacturing base, a recession is not at the top of my worry list. At the point where there is a sustained negative difference signaling an inverted curve, the recession worry might move up on the list.
A number of concerns weigh on the fixed-income markets and the broader economy, including the global impact of the war in Ukraine. The aftermath is still unknown, including the impact of millions of displaced people, damages, lives lost, and the costs to rebuild and reconnect. There is a point, however, where higher energy costs resulting from the war will ease, as will supply chain issues and labor shortages. These factors will not necessarily bring down recent wage hikes, but they will slow their growth.
As supply chains further open, we will experience quicker delivery of goods and decreasing cost and pricing pressures through the system. Price decreases for food, however, will not likely be as accommodative given the sourcing of many of our main staples. Ukraine, for instance, is the fourth largest exporter of both maize and barley and the fifth largest exporter of wheat. Replanting, growing, harvesting, and distribution will not happen overnight.
We can also expect monetary policy changes to lead to slower money growth, a smaller Fed balance sheet, and a slowdown in nominal GDP growth. As supply chains continue to work themselves through, raw materials, supplies, and finished goods will become more quickly available. The demand for retail goods will fall, however, as consumers transition away from appliances to more service-related industries, including business and vacation travel. Over time, a more normal business cycle prevails.
Consumers Hanging Tough
The Jobs Picture
Despite all the recent factors described above, the consumer financial position has continued to strengthen. The collapsing jobs picture two years ago has completely reversed course. According to most recent March data, initial unemployment claims are still trending downward, and continuing claims have fallen to new lows (1.419 million). The nonfarm payroll data for February was better than expected with a gain of 678,000 new jobs, versus an expected 400,000 jobs, which in turn has brought the unemployment rate down to 3.8%. More good news for a broadening economy was the widespread nature of employment increases. New construction jobs increased by 60,000, and on the other end of the spectrum, leisure and hospitality industries added 178,000 new positions. Although the job picture has certainly been tightening, job openings still posted near-record highs of approximately 11.2 million jobs. If there’s any doubt, just look at the “help-wanted” signs on storefront windows.
Housing Demand and Rates
As we have also seen in past market cycles, the health of the housing markets is dependent on several factors, including a healthy labor market, financially qualified buyers, housing affordability, and accommodating mortgage rates. With the job market outlook and recent housing data in a strong position, qualified buyers are still looking. Although it is still too early to gauge the impact of future rate hikes, mortgages are already pricing up higher rates, as evidenced by today’s 30-year average of 4.072% in contrast to 3.369% just two months ago on January 3. Even though mortgages are becoming a bit more elevated, baby boomers in the crowd still view current rate changes competitive compared to the past few decades.
Home prices, however, are beginning to challenge affordability. Just before the last recession and pre-pandemic, the median sales price of houses sold in the U.S. was $329,000. According to the Federal Reserve Bank of St. Louis, the median price has risen to $408,000 as of December 2021. For those looking for rental property instead, Realtor.com posted a note that in July 2021, first-time homebuying was more affordable than renting, and this trend would likely hold through 2022. With declining new home and existing home inventories, limited supplies will support these past price increases as buyers and renters reach a bit further into their savings.
Despite the recent and prospective rate increases, mortgage purchase applications through last month have not let up, rising to a four-week high as housing starts increased by 6.8%. Still, the continuing demand, decreasing inventory levels already mentioned, and an improving jobs picture mean little or no concern for overbuilding today and new opportunities for expanding home construction efforts.
Despite the still relatively stronger financial position consumers find themselves in today, higher fuel prices and concerning global headlines are impacting their outlook and recent spending habits. These worries were enough to push March’s University of Michigan Consumer Sentiment Index to its lowest level since 2011. Meanwhile, retail sales posted for February were positive but muted (up 0.3%), with the category changes more reflective of the sentiment captured by the University of Michigan Index. Positive sales growth categories were gas stations, up 5.34% (higher fuel prices), and bars & restaurants, up 2.49% (reopening of after-work activities). Sales declines included online shopping, down 3.66%, and health and personal care, down 1.78% (goodbye treadmills).
Retail sales data did point out, however, that since the early days of the pandemic (April 2020), retail sales are up more than 60%. What is worrisome, though, is that while sales are up more than 17% since February last year, more than half can be attributed to inflation, including gas prices, autos, home furnishings, and most noticeably of late, food prices.
Forward looking, today’s data is already noting a transition towards the leisure and travel industries. Latest TSA checkpoint travel data as of March 19th reported an average five-day pass-through of 2.096 million passengers. While not back to the pre-pandemic 2019 levels (five-day average of 2.359 million passengers), we are 89% of the way there. Hotel visits, over the same timeframe through the week ending March 5th, were similarly encouraging. While occupancy was still off 8.2%, average daily rates were up 4.7%, with the revenue generated per available room off only 3.8%.
State of Business
Following pandemic lows, the business and manufacturing environment has experienced a significant rebound, but risks and supply constraints continue to dampen a full recovery. Given issues in the domestic markets, we continue to buy from overseas markets as the trade deficit continues to widen with imported cars, industrial commodities, machinery, and food supplies. Of note, the NFIB Small Business Optimism Index slipped for the second consecutive month as business owners now worry about inflation—a worry exacerbated by rising interest rates, oil prices, labor shortages, rising wages, and oil prices. The service industry was also weaker than expected, with the ISM Services Index dropping to a 56.5 reading versus the prior month’s 59.5 reading. The biggest culprit was employment, with the component reading falling to an August 2020 low.
Manufacturing data also provided mixed messages this past month, reflecting the same concerns of smaller businesses. A slight uptick in February’s ISM Manufacturing index to a reading of 58.6—versus the prior month’s 57.6—was the result of a slight improvement in orders, manufacturing, and supply availability. This improvement was also reflected in February’s Industrial Production report, which notched a 1.2% rebound in manufacturing output. A surprising and welcome positive, though, was that Capacity Utilization (manufacturing capacity) rose to 78%, just shy of its prior peak in 2018 of 78.4%.
The Markets and Outlook
2022 started with one of the worst routs in the financial markets. Although the major global benchmarks were in correction territory early in the first quarter, there has been some recovery from the lows. The question that remains, however, is whether this was a recovery or a relief rally with more down days ahead. Investors fearful of the rate hikes announced last Wednesday were initially vindicated as the markets sold off on initial FOMC hawkish news, but they were quickly left on the sidelines as the markets rallied through this past Friday’s close. At this writing though, the markets still remain in negative territory, with the Russell 2000 still firmly in correction territory (down from a recent high greater than 10%), and the emerging markets still on the cusp of a bear market (down 20% from a recent high).
One of many market indicators we have been watching is the VIX index, a real-time measure of the market’s expectations for S&P 500 price changes that is based on S&P Index options. Last week (March 14-18), the VIX broke an 11-day streak with an index reading above 30. As noted by Bespoke Research, since the volatility index was launched in 1990, the VIX has remained above 30 for seven-plus days in only 17 instances. Particularly noteworthy, at the end of these “streak” instances where the VIX fell below 30, the S&P was in positive territory 81% to 94% of the time over the ensuing one- to 12-month period. This occurrence is generally the result of the options market becoming less stressed over near-term expectations.
Aside from the VIX Index reading, the days ahead are still cloudy in terms of forecasting the potential for another downturn or another volatility spike. The Fed has assured us of more rate hikes ahead, and we know that inflationary pressures are still working through the pipeline. We also know that turmoil continues overseas. In addition, we know that company management is focused on the same issues concerning investors and that corporate earnings are still expected to grow through 2022.
While still early in the year, analysts are expecting S&P 500 earnings growth for 2022 of 9.3% and revenue growth of 9.0%. Although these estimates are certainly fluid this early in the year, they provide a guidepost for continuing profitability despite inflationary headwinds. We’re also reminded that some companies will benefit from the inflationary impact that has concerned investors. In our view, the challenges ahead are more easily accomplished through an active management lens.
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.