"The show goes on" for U.S. consumers
Plus: Ways to adjust your bond portfolio that don't entail holdings lots of cash
June 30, 2023 - Bottom line up top
May consumer spending data showed a further moderation in personal outlays, particularly for durable goods. But real incomes continue to rise impressively amid further disinflation, ensuring that spending growth can continue.
Markets are pricing out recession risks, with longer-term bond yields rising and stock valuations getting a boost into quarter end.
Central bankers are noticing the stronger data. Fed Chair Powell became more rhetorically strident this week about making policy more restrictive, and futures now show roughly even odds of two more rate hikes this year, with cuts pushed out to 2024.
Good news on the U.S. housing market has almost never been easier to come by. This week offered scorching new home sales data and broad evidence that prices are continuing to rebound after declining briefly and modestly last year.
Prospective homebuyers struggling with affordability should be cheered by the fact that rents are continuing to soften around the country. The June report from Apartment List shows that rents have been flat over the past year.
Equity markets, which had until recently bristled at stronger data because of the tighter policy it invites, now seem happy to be surprised on the upside. Good news is good news, again…for now.
Cash was “king” ever so briefly in 2022 but has struggled to keep pace in 2023. Bond portfolio construction should utilize a blend of different risks and not just rely on the “risk free” rate.
Chart of the Week - Households aren’t under much financial stress
Debt service costs remain historically low despite the rise in interest rates
Despite a softer May, consumers ain’t goin’ nowhere
This morning’s May personal income and spending data showed a continued normalization of consumption habits post-pandemic. Household spending was flat in real terms, but within that figure we saw a solid increase in purchases of services offsetting a pullback in goods. With growing incomes, receding inflation and very modest financial strain (see the graph above), there’s little reason to think consumer spending growth is about to go into reverse.
Real disposable personal income remains the most important indicator for the U.S. economy, and it grew for an 11th consecutive month:
Household purchasing power has risen 4% over the past year after falling 4.8% in the prior twelve months. Progress! But real income remains below its pre-pandemic trend, a fact often obscured by the fact that household finances were boosted in 2020 and 2021 by massive government stimulus, the spikes you see on the chart above.
But what of the stall in real consumer spending? The things we would typically look for as leading indicators for weaker consumer spending — other than falling real incomes — include falling home prices (which never really materialized), falling financial asset prices (which we’re not seeing anymore) and growing job insecurity (which we’re also not seeing except in niche fields like quippy-yet-informative writing of macro/investing newsletters). So I’m keeping an eye on it, but I’m not worried yet, especially because the slowdown is still the result of a rotation in consumer preferences (from goods to services) than a broad-based pullback in spending.
The 0.3% rise in core PCE inflation keeps pressure on the Fed as it tries to cool inflation. Headline PCE price inflation is dropping because of falling energy prices, but core inflation has only slowed modestly since peaking in early 2022. That’s because the handoff from goods inflation to services inflation was virtually seamless, and services inflation has only recently peaked and begun what has so far been a gentle decline:
This morning’s report showing weaker consumer spending but persistent core inflation provides mixed signals to investors. But if we zoom out just a bit, the conditions for continued economic growth — driven by stronger investment as well as consumption — remains solidly in place while both inflation and its leading indicators are convincingly slowing. In other words, a middle way between overheating and recession continues to look like the likeliest path.
Investors can do better than “cash” with their bond portfolios
Last week, I mentioned that bond market volatility has been pretty low in 2023. I should have emphasized that this is only true at the longer end of the curve. Remarkably, the 10-year U.S. Treasury yield today is almost exactly where it was at the end of 2022. But short-term rates have been marching ever higher. This graph showing the divergence between the 3-month Treasury bill and 10-year Treasury note yields tells the story well:
The inverted Treasury yield curve triggers two thoughts in investors’ minds. First, inversions have historically signaled recessions, advising a more defensive portfolio strategy. Second, the penalty for holding cash or cash-like instruments, which was severe in the 2010s and the start of the 2020s, has turned into a reward. These two thoughts may be mutually reinforcing, leading to bond portfolios that are heavier in cash and lighter on longer duration bonds and credit risk.
But while cash was “king” in 2022, it seems less well-suited for the balance of 2023. Cash and ultra-short-term bonds currently provide respectable yields but also carry significant risks:
Reinvestment risk - There is no guarantee that the yield on a 6-month Treasury bill six months from now will be close to the 5.5% it offers today.
Inflation risk - Another flare up in inflation, while unlikely, would lower the realized real return on cash.
Market risk/Opportunity cost - This is the risk I’m most concerned about. Cash may simply not keep pace with stocks or bonds in the most likely scenarios for the economy and markets from here.
A period of steady growth and falling inflation (i.e., a soft landing) would be consistent with rallies in both stocks and bonds, while a mild recession (not my base case) could lead to very good returns on longer-duration bonds relative to cash while not necessarily seeing stocks descend back into bear market territory, at least not for long, as rates were cut to stimulate growth.
So what would I do instead of owning a bunch of cash? I sympathize with those who are loathe to extend duration at the moment, especially with the term premium (the “extra” yield investors usually receive to hold longer-maturity bonds) still negative and the yield curve as steeply inverted as its ever been. But in honor of Harry Markowitz, the godfather of Modern Portfolio Theory who passed away this week at the age of 95, I feel obligated to stick up for taking interest rate risk. Including duration risk in portfolios is likely to pay off in the event of either a soft landing or a recession as yields fall. That makes it useful as a ballast against blowouts in credit spreads and drops in stock prices. But I also would not want to be too defensive given my generally bullish economic outlook and the possibility that rates move higher from here. So I would hold:
A larger-than-normal bond portfolio (versus stocks), that was…
Overweight credit risk compared to its benchmark, and…
Slightly underweight duration compared to its strategic target
That positioning would have gotten you absolutely smoked in 2022, and it would have underperformed thus far in 2023 because of how well the equity market has done. But with recession risks falling and the belly of the yield curve selling off, now seems like a good time to build a 4-7 year average maturity bond portfolio in either investment grade municipals or diversified taxable bonds (depending on the tax status of the account).
I also favor a tactical overweight to U.S. high yield credit at the expense of U.S. large cap equities. High yield credit has really been more of a tactical than a strategic asset class over the past decade:
You wanted to own some high yield bonds in 2012 and 2016, but most of the time you would have been far better off with a volatility-matched basket of U.S. stocks and Treasuries, which happens to be around 50-50. But the Bloomberg HY index has been offering a yield in the 8-9% range for a year, far higher than any time since the GFC save for a few acute crisis periods. Income-sensitive investors may want to start looking at high yield as more of a strategic asset class, particularly if held in tax-deferred accounts like IRAs.
Those wanting to get a little more granular in the lower-rated fixed income space can look at senior loans, preferreds and/or private credit as ways of implementing the high yield overweight. All have advantages and disadvantages ranging from less downside protection (loans) to less liquidity (private credit) to more concentrated financial exposure (preferreds). The right balance is up to the individual investor, but all of these exposures will ultimately be pretty closely correlated.
Timing markets is a loser’s game. Take it from someone who used to try it for a living. But buying assets that a) have recently underperformed; b) offer attractive value; and c) can perform well in multiple likely scenarios can improve performance at a relatively low cost. If nothing else, relatively minor adjustments can help investors sleep better at night.
What to watch for over the next week (and beyond)
Next week’s edition may be a short one. But I’ll be recapping the second quarter market performance and covering the Friday morning jobs report along with some of the other labor market data coming at us earlier in the week.
It’s been really, really dumb to take the under versus consensus for employment data over the past year. The expectation for next Friday’s June release is for — stop me if you’ve heard this before — hiring to slow from its recent torrid pace. The consensus estimate of 213,000 jobs would be the fewest number in any month since December 2020 but still nothing to sneeze at.
A further increase in the unemployment rate after last month’s jump to 3.7% would raise some eyebrows. The household survey has become too volatile to interpret on a month-to-month basis, but a longer pattern of divergence from the establishment survey would be concerning.
Lots of business survey data is on its way. It will be analyzed, just not by me. (Notice I did not mention the unexpected strong consumer sentiment report out this week! Well, until now.)
June U.S. consumer price inflation data will arrive on July 12 and should show another large decline in YoY inflation. Headline CPI probably rose just over 3%, but core inflation has been closer to 5% with shelter costs leading the way. Much more on this when we get the data.
What else I learned last week
I learned that the Broadway revival of Sweeney Todd is one of the best musicals I’ve ever seen, and it was only slightly too scary for my 8-year old, who appeared to be the youngest person in attendance.
I learned that my 10-year old is apparently going to be donning pointe shoes in her ballet class this fall for the first time, and I can’t wait to see whether takes a worse toll on her feet or my wallet.
On that topic, I learned that this is apparently what my daughter and I looked like when going through her dance schedule for the 2023-2024 season (my worried and slightly horrified wife is the blurry visage of General Hux in the background):
I learned that both the 8-year old and 5-year old liked Elemental, which surprised me because it’s basically an on-the-nose allegory about immigration and social classes wrapped in a romcom.
I learned that I am all in on Hulu’s The Bear, a show about a James Beard award winning chef trying to turn around his late brother’s sandwich shop in Chicago. Nothing could make me hungrier at 10:15pm.
I learned that my 5-year old’s reaction when I swap the names of the girls from his class into bedtime songs to get a rise out of him reminds me of this:
Amusing but pointless! If only I’d thought of that name for this newsletter earlier!
Oh, well!
Cheers,
Brian