Hopes are high. Are investors?
Plus: Can a construction boom carry the economy forward as consumers normalize?
“Let me tell you something my friend. Hope is a dangerous thing. Hope can drive a man insane.”
Red, The Shawshank Redemption, 1994
but also…
“Remember. Hope is a good thing, maybe the best of things, and no good thing ever dies.”
Andy, The Shawshank Redemption, 1994
(I had to do dueling quotes for Barbieheimer weekend)
July 21st, 2023 - Bottom line up top
U.S. equity investors have latched onto the “soft landing” narrative. Even amid mixed economic and earnings news this week, stocks rallied on a macro backdrop that appears disinflationary without being recessionary.
Consumer strength doesn’t seem to be waning. Core U.S. retail sales came in stronger than expected for June and were revised up for May. But industrial output contracted for the second straight month, which could mean less of a boost from inventory restocking in next week’s GDP report.
China’s economy appears to have finished the second quarter stronger than it started it, but overall GDP growth came in below expectations. Because much of the shortfall has come from weak demand in the services sector, the impact on global growth has been limited.
Housing starts data shows a growing divergence between multi-family construction (which has peaked) and single-family home building (which has only just started to recover from last year’s swoon).
It’s still early, but corporate earnings season has started with a mostly upbeat tone, especially for airlines, homebuilders and most of the big banks.
Chart of the Week: Uh oh! Investors are stoked about stocks again!
Individual investors are more bullish on the S&P 500 than they’ve been since April 2021
Equity investors are high on “Hopium” as earnings season starts
Stocks continued their climb this week as second quarter earnings season got underway. While early reports — especially those in travel, construction, and banking — have generally been better than expected, the melt-up in stocks over the past few weeks has been mainly the result of the pricing in of an economic soft landing. A crash would decimate profits and lead to general risk aversion, crushing stocks. But a continuation of the high inflation/rising rate environment we’ve been in since late 2021 would also be challenging for equity investors. But if reality gives us something in between the two? Say…soft landing? That’s about the best scenario one can imagine for stocks from here.
One thing is for sure. The vibes from coming from economists and market observers on my social media feeds are getting better as the financial community begins to accept a happy ending to this economic cycle (or whatever you call 2020-2023) is possible. Consensus earnings projections — which are admittedly slow to change at inflection points — still show no profits growth in 2023, but equity valuations have shot up to levels well above anything we’d seen for twenty years before the pandemic:
They’ve done so in part because of the upside risk to earnings growth and in part because investor risk appetite is increasing, as I showed above in my chart of the week. If you think it’s just a Tech anomaly or a stock market thing, just take a look at what speculative-grade corporate bond spreads have done:
Both equity and fixed income markets have priced out recession risks over the past three months. This means financial conditions have eased despite the Fed’s interest rate increases and balance sheet shrinkage.
I’ve been skeptical for months that stocks can hold these valuations for long, let alone increase further, with interest rates at multi-year highs. That’s one reason I’ve favored bonds over stocks on a valuation basis. But in the short-term, an equity rally can swamp whatever returns fixed income may provide, and that’s just what’s happened this summer. Further evidence of falling inflation coupled with solid hiring seems like the most likely source of upside risk to equity prices from here. The next few months should deliver more good news than bad news for stocks, but returns cannot continue to annualize at a 30% rate. How’s that for hope?
The U.S. housing market has landed…softly
A year ago, people would look at you like you were crazy if you dared to utter the term “soft landing” in connection with the U.S. housing market . At the time, the Fed was not even halfway into its “Summer of 75” hiking cycle. Oh, and the housing market looked like it might collapse, with mortgage rates having just hit 6% for the first time in a generation and prices in steady decline.
But now, we’re in the summer of soft landings, and this week I want to focus the one we’re seeing in the U.S. housing market. Mike Simonsen runs Altos Research, a fantastic research shop for anyone interested in seeing around corners in the U.S. residential real estate market. His weekly updates provide data on sales, inventories, and prices in a very digestible way. This week, his post was all about the soft landing in the housing market. Here are the main points to know:
Home prices are rising again in most parts of the country after dropping in the second half of 2022 and the opening months of 2023.
The number of homes for sale remain historically low, even lower than they were at the start of the year. In a typical year, they’d be peaking right now, and in a weak year they’d be spiking with sellers outnumbering buyers.
While home sales, especially existing home sales, remain low due to a lack of sellers, we’ll likely see more home sales in the second half of 2023 than we did in the second half 2022. Buyers are still showing up despite high mortgage rates, and new construction is creating at least some new supply.
To get a soft landing, we needed price increases to slow from their torrid 2021 pace without crashing completely. It looks like we got there. Higher mortgage rates appear to have succeeded in slowing price increases, but buyers are still showing up and the legacy of a decade of ultra-low fixed-rate mortgages and subdued home construction is keeping inventories extremely tight.
Why is this important for the overall economy? First, home sales tend to lead consumer spending. Second, we need residential investment (i.e., construction) to contribute to GDP growth in the next few quarters after dragging it down since early 2021. This week’s housing starts and permits data showed that the recent divergence in single-family construction (weak but about to pick up a lot) and multi-unit construction (strong but likely to soften from here) endures. While a record number of multi-family units are currently under construction, the pipeline for new projects has begun to dry up. At the same time, permits for single-family homes — a leading indicator for construction — continue to increase. These two graphs, which I’ve shown before but have updated with June’s numbers, tell the story very well:
The other important macro story related to housing is rent disinflation, which the Zillow and Apartment List reports tell us is well underway but which we have not yet seen the official inflation data. The 2022 boom of new rental construction has put downward pressure on new leases, as has the overall cooling in consumer demand. Homebuilder confidence is strengthening, however. The construction industry is undergoing a large internal shift, but hiring is robust and more public money is on the way. I expect to see a small but positive contribution to GDP from residential investment in next week’s Q2 U.S. GDP report, with larger bumps in Q3 and Q4.
What to watch for over the next week (and beyond)
Bah gawd that’s Q2 GDP’s music! It’s a stale measure, but given all the recession talk this year, a strong report could further help market confidence. U.S. GDP probably grew at a little better than a 2% rate, an improvement on the previous quarter thanks to more support from construction, inventory restocking, and public investment.
Real disposable personal income almost certainly rose again in June, which would make it the eleventh positive month out of the past twelve. While this is a welcome respite for consumers, it could contribute to slower hiring and compressed profit margins.
June PCE inflation will show a big annual deceleration similar to last week’s CPI report. Because PCE is less weighted toward shelter than core CPI, it never peaked as high and does not have to fall as far to get back to normal. Another inflation-related measure, the quarterly Employment Cost Index, should show a gradual cooling of wage pressures based on what we’re seeing in other data.
What else I learned last week
I learned that when there’s a 50% chance of a thunderstorm every hour of every day, it makes it hard to plan anything. And I don’t even live in Florida.
I learned that I really want to see Oppenheimer on 70mm IMAX, but finding the six-hour window to get into the city, watch the 3-hour movie and get home isn’t as easy as it sounds.
I learned that when you warn your boys “only one fast food lunch this week” and you’ve already gotten them McDonalds on Monday, you’re playing defense the rest of the week.
I learned that The Bear’s Christmas Eve dinner was slightly more chaotic than my family’s annual gatherings (to say the least!), but like the Berzattos we do make “gravy” for the 60% or so of attendees who don’t eat any fish.
I learned that getting three 8-year olds to disengage from their playdate and get ready for soccer practice is incredibly fun and rewarding, even more so when their coach doesn’t show up.
I learned that we now have two Korean hot pot dinners under our belt as a family with only a minimum of scalding.
Cheers,
Brian