Hell or higher interest rates
Plus: Stocks don't look likely to break out even as the U.S. avoids recession
“Looks like I picked the wrong week to stop sniffing glue.” - McCroskey, Airplane!, 1980
May 26, 2023 - Bottom line up top
U.S. Treasury default risks are still swirling and Fed rate hikes are back on the table for this summer. Prospects for the latter hinge on a smooth resolution of the former. In other words, rate hikes are preferable to the alternative.
American consumers continue to spend a lot of money each month, and American businesses continue to place a lot of new orders for durable and capital goods. It’s almost like the economy is humming along.
New home sales in the U.S. are up nearly 12% in the past year, and construction hasn’t even begun on a growing percentage of them. That’s a nice leading indicator for residential investment and overall GDP.
Investors have gone from pricing in Fed rate cuts this summer to Fed rate hikes thanks to a run of strong economic data and some hawkish rhetoric and minutes from the Fed itself. But a pause in June still seems the likeliest outcome.
Despite more good news on earnings, the stock market remains hostage to the bond market. Higher rates threaten stock prices, but plummeting bond yields — and the elevated recession risks they would represent — would be worse.
U.S. high yield bonds offer attractive value yielding nearly 9%, but spreads have been squeezed as rates have risen in May. Lower-rated securities offer less recession protection than usual, and the 10-year Treasury offering more than 3.8% is compelling.
Chart of the Week - A debt ceiling-driven inversion at the short end of the curve
Very short term Treasury bills are being whipsawed by the debt ceiling negotiations
Do you not want more Fed hikes or do you not want a Treasury default?
Even by recent standards, this was an extremely strange week in financial markets. A combination of hawkish Fedspeak and strong data pulled up interest rates while the specter of an imminent default caused equity and credit markets to wobble and the 2-week Treasury bill yield to surge before it retreated on news of an imminent deal.
A further rise in interest rates and a Treasury default are mutually exclusive risks, but neither is particularly appetizing. I’m reminded me of Hell or High Water, Taylor’s Sheridan’s pre-Yellowstone instant classic, specifically the exchange (one of the most memorable in any recent film) in a diner between a pair of Texas Rangers and a salty waitress played by the late Margaret Bowman:
T-Bone Waitress: What don't you want?
Marcus Hamilton: Oh, well, uh. I think I'll just, uh...
T-Bone Waitress: You know. I've been working here for 44 years. Ain't nobody ever ordered nothing but T-Bone steak and a baked potato. Except this one asshole from New York tried to order trout back in 1987. We don't sell no goddamned trout. T-bone steaks. So either you don't want the corn on the cob, or you don't want the green beans. So what don't you want?
Marcus Hamilton: I don't want green beans.
Alberto Parker: I don't want green beans, either.
So, either you don’t want default or you don’t want interest rates to stay high. Default would be hell, but more rate hikes would be higher water for investors who have struggled to keep their noses above the surface for the past year (more on the equity market below). I’d like the Fed to pause and see where inflation falls to this summer, and I think that’s what they’ll do. But I’d much prefer another 25 basis points to rolling the dice with a debt ceiling breach. Assuming policymakers manage to avoid the latter, we’ll be back to the familiar pattern of the last few years: bracing for every inflation print, hoping it will be a little bit softer than the last one. In fact, we just got an inflation report this morning. But to cover it, I’ll need a new section.
U.S. consumers spent lots of money in April after lying to survey takers
I wrote a lot about the facts and myths behind the U.S. consumer story in last week’s newsletter, so I won’t repeat that here. This morning’s personal income and spending data provided our first comprehensive look at household cash flows to start the second quarter, and it was encouraging. Let’s start with the spending side. Personal consumption comprises the vast majority of U.S. economic growth, and households delivered a significant upside surprise in April, growing their spending 0.8%. Half of this was inflation and half was higher real consumption.
Rising spending eventually requires rising incomes. Longtime readers know that real disposable personal income is my North Star for the current economic cycle. That measure was negative every month for over a year following the final inflationary blast of federal stimulus in early 2021, but it’s now been positive for nearly as long, tallying 3.4% over the past year. When income growth exceeds inflation, as it has, spending can rise without exorbitant borrowing or a large drop in the saving rate. In short, inflation is no longer a binding constraint on most households’ purchasing power.
Last, but not least, we have the inflation data. April PCE inflation came in a tick hotter than expected, with both the core and headline price indexes rising 0.4% last month. That’s obviously not compatible with a 2% annual rate of inflation — there are twelve months in a year, after all — which strengthens the case for the Fed to hike rates again sometime this summer. But there is more disinflation in the pipeline through at least June and potentially beyond it if we start to see rents declining as I expect.
As a reminder, the Fed targets a 2% rate of inflation on the core PCE price index, which excludes noisy food and energy prices. Having just exited a period in which headline inflation was tracking far ahead of core (because food and energy prices had outpaced everything else), we are entering a phase in which core will be stickier even as headline plummets due to the sharp energy deflation and the coming drop in food prices. The PCE price index helpfully breaks down into durable goods, nondurable goods (i.e., food, gas and clothing) and services. Here is the ride we’ve been on since 2021:
Core inflation won’t be down to 2% by year-end, but inflation will no longer be tracking at a historically high rate heading into 2024.
What’s next after a lost two years for U.S. stocks?
The S&P 500 hit its all-time high just shy of 4800 on January 3rd, 2022 from which it dropped sharply as investors realized interest rates were going to rise and rise quickly. Nearly eighteen months later, the index has not come close to returning to its apex. Even if you bought U.S. large cap stocks all the way back in the spring of 2021, all you have to show for it is the dividend checks. The index itself is down 1%.
Of course, over time U.S. stocks have provided fantastic rates of return for the risk, including during the 10-year, 5-year and 3-year periods ending in May 2023. This is true whether we measure in absolute terms or relative to bonds and cash. But most investors base their financial satisfaction on how their portfolios have performed recently. And we need to go back a pretty long way to find a period in which stocks were this far off their all-time high for this long. Every financial advisor in the country has had a string of painful quarterly reviews with clients wanting to know when their account balances will finally recover. To provide a reasonable answer, we need to dive into the two things that drive the stock market: earnings and valuations.
Let’s start with earnings, which are down modestly over the past year despite solid sales growth, because profit margins have narrowed. Sales are still growing in most industries, though not exploding as they were in 2021 and 2022. Labor cost inflation remains elevated, as well, but consumers (and businesses like Walmart!) have begun to rebel a bit against price hikes. With rising costs and static prices, profits get squeezed. But following the better-than-expected Q1 reporting season, earnings estimates for the next twelve months, which is the most common way for the stock market to be valued, seem to have at least stabilized:
Can the stock market rally without earnings growth? Sure! But for that to happen valuations need to rise. This requires investors to be in a hopeful mood, as they might be, for example, coming out of a recession. Stocks bottomed in March 2009 while the Great Recession was ongoing and well before earnings returned to their pre-crisis peaks. By the time they did so in 2011, the S&P 500 index had already doubled. Are investors in the same kind of mood today? It appears not. Many believe a recession lies ahead, and the Fed is still talking about hiking rates more to bring down inflation. Further disinflation would come in large part as a result of further depressing profits growth.
Without a burst of earnings growth or a good reason for investors to suddenly value stocks more highly (say, via a benign drop in interest rates, which seems unlikely for now), it’s hard to see the S&P 500 making a steep climb back to 4800 anytime soon. Investors can get respectable yields on assets like cash and highly-rated bonds, which had provided little to no returns for well over a decade before this year. In fact, the equity risk premium — the expected return on stocks vs. bonds for the next 5-10 years — is below its long-term average:
If you’re in equities today, there’s no reason to be alarmed. Valuations do not suggest we’re in a 1999-like bubble. But the past year’s rise in interest rates has rightly put an end to TINA — “There is no alternative” to U.S. equities — in the minds of investors. The balance of the 2020s will be a more difficult environment for investors expecting large gains from plain vanilla investments. I’ll have more thoughts on this in the coming weeks.
What to watch for over the next week (and beyond)
Friday brings the May U.S. employment report, which, if it’s anything like the last dozen will show stronger-than-expected job creation and low and stable unemployment. The sweet spot is around 175K new jobs and a stable jobless rate, with only modest average hourly earnings growth. Markets may call me a liar, but I’d rather be on the hot side of all of those.
JOLTS data is a little sketchy, as I’ve mentioned in the past, but the Fed wants to see a further decline in job openings, which means we all should, too. Also look for a small decline in the quits rate and a small increase in the layoffs rate as the labor market inches toward the pre-pandemic normal.
Home price data from March is already a little stale, but it will tell us whether the shocking February rise in prices was a blip or, perhaps, the start of a trend. Historically low inventories in most areas continue to support home values.
Loads of survey data — PMIs, consumer confidence, Dallas Fed activity — for you to ignore. You should also ignore this week’s S&P Global PMI showing stronger-than-expected U.S. services activity, even though it confirmed my priors.
What else I learned last week
I learned from my experience last weekend hosting an 8th birthday party for my son and 19 of his friends that for his 9th birthday we’ll just let him loose with 19 wild ferrets instead, just so things are calmer.
I learned that if you make a large batch of martinis for your 8-year old’s James Bond-theme birthday party and no one in your family drinks them, it’s perfectly fine to polish them off on your own. That night.
I learned that the 10-year old’s kickline team tries every year to get me to buy a uniform for her that just fits, so they can sell me a larger size next year. But I cracked the code! Her new one for this fall fits like a bathrobe. It was either this or feed her less and hope she doesn’t grow.
I learned that the strange transition from HBO Max to “Max” gave me the opportunity to assign avatars to the entire Nick family. So, say hello to Jamie Lannister1, Shiv Roy, Luna Lovegood and a cartoon pickle from Rick and Morty.
I learned that Max’s first original animated show is, to my delight and the delight of my boys, Secrets of the Mogwai, a very cool Gremlins prequel set in China in the 1920s. It’s not too scary for little kids as of the second episode, but the gremlins just hatched, so…
Cheers,
Brian
All right, he has a few character flaws, but overall a very compelling character. “There are no men like me. There is only me.” Come on, that’s great!