Financial Markets
& Economic Update - Fourth Quarter 2023
Summer Update
On this warm October day, I am staring at my Bloomberg screen, still
heartbroken over the Phillies Phailure. Now,
all of our hopes ride with the Eagles. Interest
rates are all elevated, with the 2-year Treasury yield at 5.01% and the 10-year
at 4.85%, which is up by over 100 basis points since June 30, 2023. Most of the inversion between these two
yields is gone. The 3-month T-Bill is at
5.45%, so there remains some inversion to the 10-year yield. Stocks are down again today and have been
down all week. Gold has reclaimed $2,000
per ounce and its status as a safe haven, with all that is going on with war in
the Middle East. Too bad Treasuries are
not as much of a safe haven. Markets
sent Treasury yields higher in reaction to huge deficit spending and a Federal
Reserve intent on pushing rates higher, keeping them “higher for longer” with
large price risk as everyone has learned for the past three years.
Some argue that, because we saw real GDP rise by +4.9% in 3Q23, that the
economy is robust and strong.” Yes, it
was for that quarter, but, if you read my last newsletter, the summer of fun
meant that quarter would be stronger, as the last stages of pandemic pent-up
demand saw excess savings spent with abandon.
YOLO- You Only Live Once! People
traveled on vacations with their newly renewed passports, enjoyed entertainment
(can you say Taylor Swift and Barbie?), and ate out at their favorite
restaurants. Now the harsh reality will
sink in and El Nino is sure to give us a cold winter. Inflation is still elevated, even while it
slowly declines from 2022’s peaks. We
will continue to fall toward the Fed target of 2.0% but it takes time and
patience.
Index of Leading Economic Indicators
I just finished studying a chart of the year-over-year changes in the
index of leading economic indicators, or “LEI,” going back to 1960. For every period of sustained y-o-y
declines in LEI, recession has either begun or followed quickly. The LEI fell again in September, 2023 by -.7%
and is down y-o-y by -7.8%. The index began
to decline in March, 2022 (no surprise that the Fed started tightening that
month), and has been down for 18 months in a row; the LEI is down -11.1% since
March, 2022 to 104.6. In July, 2022, the
LEI began to decline y-o-y, yet we have not been in recession or see one
imminently.
The chart showed eerily similar patterns of declines in 1990 and
2000-2001. Unsurprisingly, the largest
declines occurred starting monthly in March, 2006 and on a y-o-y basis in
September, 2006 and continued to November, 2009. The largest monthly decline took place in
May, 2009 at -27.2% y-o-y with the index reaching a low of 75.7. We all remember the Great Recession, which
began in 2007, but the LEI knew it as early as March, 2006. This time will be no different and patience
is required.
By the way, there are sister indices to the LEI, the coincident for
current conditions and the lagging index for 6 to 9 months ago. Both are relatively stable, indicating the
economy has been and currently is okay.
Are Rates Restrictive?
Do you remember what it means for Fed policy to be “restrictive?” It means getting the Fed Funds rate above
inflation so that a positive number, or real rate, would result after
subtracting inflation from the Fed Funds rate.
Every inflation measure that I track closely is below current Fed Funds
of 5.50%, resulting in restrictive rates of varying degrees.
Fed Funds is 1.40% over September’s annual core CPI of 4.1% and 1.80%
over annual headline CPI of 3.7%. Fed
Funds is 3.10% over 3Q23 core PCE of 2.40% and 2.60% over the PCE deflator of
2.9%. Fed Funds is 1.10% over the
annualized 3Q23 employment cost index of 1.1% and is 1.30% over the most recent
data for wage growth of 4.2%. So, yes,
rates are restrictive. And the FIBER
leading inflation index and M2 money supply are both falling year-over-year, by
-1.2% and -3.6% respectively, so inflation will continue to trend downward. Fed Chairman Powell stated “You know
restrictive only when you see it.” Well,
you be the judge… I believe that the Fed is done raising rates; they just don’t
know it yet. And looking ahead to the
2024 Presidential Election, they clearly would want to be on the sidelines.
Risks to the Economy
We were growing real GDP 2.1% to 2.7% for the four quarters ended 2Q23
and then experienced an outlier of +4.9% in 3Q23. Yeah, the summer of fun. Consumer spending accounted for one-half of
GDP. Businesses built inventories adding
1.30% to GDP. Housing made a small
positive contribution after a string of negative quarters. Much of the data was weak, so it’s doubtful
that we can keep repeating this pace.
The risks are many. We have an
aggressive Fed threatening more rate hikes.
Long-term interest rates just increased by 100 basis points in the past
few months, in a time when inflation is falling. Government spending and huge budget deficits
are upsetting investors. Mortgage rates
are now close to 8.00%; affordability is at its lowest point since 1989,
according to the National Association of Realtors. Low inventories of homes has hurt sales. No one will give up their 3.00% mortgage for
an 8.00% one. Usually high interest
rates would put a damper on home price increases and we might expect prices to
outright decline. But not in this
market. Prices are stubbornly high and
rising, with August y-o-y increases of +2.2% for the Case Shiller 20, +2.6% for
Core Logic, and +5.6% for the FHFA.
China is having its own economic troubles and supply chains could suffer
again. And what a time for the UAW to go
on strike- demanding outsized pay raises and slowing production at the Big
Three automakers and hurting their suppliers.
Thankfully, they appear to be close to agreement. According to Cox, one-half of Americans
cannot afford a new car. Sales will be
affected by both the strike and affordability.
Some banks have tightened credit and there is also weakening demand for
bank credit as small businesses are hurting from higher costs and higher
interest rates. Huge amounts of
government debt and business debt, including commercial real estate, are
repricing over the next two years at higher rates. Real bank credit (excluding inflation) has
been falling for the past 12 to 24 months.
Generally, GDP would be falling in this situation.
Finally, one more thought about the Fed.
They have raised interest rates by 5.25% since March, 2022, let almost
$1 trillion of their bond portfolio mature without replacement and allowed M2
money supply to decline y-o-y starting in December, 2022 for the first time
since the 1940s and at the fastest pace since the 1930s. September was -3.6% and July and August were
both -3.9%. Leads and lags for M2
changes are thought to be 12 to 18 months.
The Fed has been pushing inflation lower, but, if they really believed
in policy lags and looked at the LEI and M2 y-o-y declines, they would ease
right now. I wonder what Maestro would
do.
Where is Recession?
Be patient. It will come. High interest rates- both short-term and
long-term- an aggressive Fed, the LEI, and an inverted yield curve are all
precursors of a recession. The yield
curve is less inverted than it was earlier this year, due to large increases in
longer-term rates. This actually plays
into the recession forecasts. The
inverted curve is the precursor of recession, but it is the re-steepening of
the yield curve that is the sign of imminent recession.
I mentioned the LEI earlier. It
has been falling on a monthly and y-o-y pace that is always associated with
recessions- big ones and small ones. Do
not ignore this and other indicators as they always teach us something.
M2 is falling. Inflation is
responding by falling. It was the
massive increase in M2 in 2020 and 2021 (and beyond!) along with
pandemic-related supply chain disasters that led to inflation. It will be the decline in M2 that reduces
it. The FIBER leading inflation index is
still falling on a y-o-y basis, and is currently -9.2% from its high in March, 2022.
The major surveys, including ISM, S&P, and the local Philly Fed,
continue to show weakness in terms of current conditions and outlook. Inflation has tamed down in most of
them. Stock markets have been very
volatile and are mostly down since the summer months. Are they all sensing that the summer of fun
is over? Profits have been mostly
positive for the 3Q23, but probably not enough to make the past 12 months
positive. We shall see.
I was in Switzerland in July and I regret that I did not have the time
to visit CERN, the home of the Large Hadron Collider. The LHC has been running heavy ions through
the system for the past five weeks, ending on October 30th. What will we learn from this? Maybe the LHC really is changing our world,
turning economics upside down, and leading to outcomes that are unexpected
given our knowledge of the past. As
always, thanks for reading!
D. Jaworski 10/28/23
Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.
