By Ben Norris, CFA, Senior Investment Strategist, Vice President
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I’m confused. And I may not be the only one. I would bet that the members of the Federal Open Market Committee (FOMC) and other U.S. Federal Reserve (Fed) policymakers are a little confused as well. Last week featured a particularly confounding set of economic data releases spanning housing, consumer confidence, economic growth, and inflation. Depending on your point of view, things are either going well for the American economy, or we’re already in a “rolling” recession that has the potential to expand into a full-on recession as new areas of the economy begin to decline. Policymakers at the Fed have made it clear that they are firmly in the “things are going well” camp. In the FOMC’s last policy statement, they unanimously saw the need for two more quarter-point interest rate hikes in 2023—indicating their belief that high inflation remains a threat and that economic conditions are strong enough to handle even tighter monetary policy.
While certain economic indicators support the Fed’s view, others are very much contradictory. To be fair to the Fed, inflation measures have come down broadly, albeit, not at the pace or magnitude they likely hoped for. Friday featured the release of the Fed’s favored inflation measure, the Personal Consumption Expenditures (PCE) price index. Year-over-year, PCE shows that the pace of price increases continues to move lower, falling to a 3.8% increase versus a nearly 7.0% rate at this time last year. In fact, this is the first time that headline PCE has been below 4.0% since April of 2021. Unfortunately, nothing is that simple and the “core” reading of PCE, which strips out the impact of typically volatile food and energy prices, remains elevated at 4.6%. This is an indication that the major categories that go in the PCE calculation, notably housing, are still seeing large increases compared to a year ago. The Consumer Price Index (CPI) tells a similar story, recently declining to just over 4.0% while its core counterpart remains elevated at 5.3%.
The latest reading of U.S. Gross Domestic Product (GDP) has also created some good will for the Fed, with the final Q1 number showing an improvement to a 2.0% annual growth rate, up notably from the 1.3% prior reading. Consumer spending, exporting activity, and homebuilding were all better than previously thought and contributed to the revision higher. Investment by businesses, government spending, and inventory levels were revised lower, and corporate profit levels have fallen compared to last year’s level. Consensus expectations are that corporate profits will continue to decline for the next two to three quarters before seeing a strong rebound late this year or early next year. This remains my biggest concern for equities for the rest of the year—profits won’t come in high enough to support already-stretched stock valuations.
While we can count progress on inflation and better-than-expected economic growth as wins for the Fed, the recent results of bank stress tests are more of a mixed bag, in my opinion. The Fed was eager to announce that all 23 banks subject to enhanced stress testing passed, which now opens the door for relaxed restrictions on return of capital to bank shareholders. Still, many are wondering just how valuable these stress tests are when several major banks have collapsed already in 2023, and Credit Suisse, which has already had to take on outside investment to stay afloat, passed its test without issue. At the same time, American banks continue to borrow from the Fed’s various lending programs, which suggests that certain banks are still facing liquidity issues. Banks continue to access the Fed’s discount window, a practice that was previously viewed as a last resort. The Fed’s Bank Term Funding Program (BTFP), which was created to allow banks to exchange high-quality assets for short-term loans at face value, increased once again and remains above $100 billion. It doesn’t take a math genius to figure out that banks are tightening their lending standards as a result. In fact, a recently released paper from the Fed indicated that financial conditions are the tightest they’ve been in more than a decade.
“Tight financial conditions” is a fancy way of saying that businesses, and especially consumers, are having a harder time getting access to credit from lenders—this is exactly what the Fed wants. However, concerns around financial conditions getting too tight continue to linger. Much of the savings that consumers built up during the pandemic is being spent down and is on pace to run out later this year. Total U.S. consumer credit card debt actually fell during the pandemic but has quickly returned to record levels and is approaching $1 trillion. Another factor that will soon start working against consumers is the resumption of federal student loan payments in October. Last week the Supreme Court ruled that the Biden administration did not have the authority to forgive a portion of loans for most borrowers. The net effect is that consumers will have less money for discretionary purchases—and in an economy that is heavily reliant on consumer activity, this will be a headwind.
The U.S. housing market has slowed since the Fed began increasing interest rates, as the cost of borrowing and surging home prices meant that average mortgage payments were out of reach for many consumers. The impact of higher housing costs is far-reaching and a primary factor in high inflation numbers as noted above. Last week we saw a reversal in that trend. New home sales came in much higher than expectations, as it appears consumers have finally accepted the new higher mortgage-rate environment. At the same time, prices have finally started to come down from their elevated levels seen during the pandemic, according to the Case-Shiller Home Price Index. The final two pieces of the economic puzzle from last week are employment and consumer confidence. Employment data remains choppy, but it appears the general trend is that the job market is slowly weakening while still at historically low levels of unemployment. Consumer confidence is where much of my confusion stems from this week. Not only did consumer confidence come in much higher than expectations, but it also reached its highest level in nearly 18 months, as consumers breathed a sigh of relief now that the U.S. debt ceiling issue is solved, and inflation is working its way lower. Gas prices falling to surprisingly low levels for summer (they’re down roughly $1.30 per gallon compared to last year) certainly helps as well. Despite these positive trends, consumers still have a fair amount to be worried about—tighter financial conditions, a weakening job market, student loan payments, etc.
Despite mixed economic data, stocks have managed to start 2023 with a bang. The NASDAQ Composite (COMP) is off to its best start in more than 40 years, and a few mega-cap stocks have seen massive gains as they power indices higher. Apple (AAPL), the largest publicly traded company, is up nearly 50% this year, and its market cap has exceeded $3 trillion for the first time. For some perspective, AAPL’s market cap is now larger than the entire small-cap focused Russell 2000 Index. Six other mega-cap stocks have accounted for the majority of gains seen in the major indices, and 50% of the constituents of the Russell 3000 are still negative for the year. In simple terms, the U.S. stock market has been remarkably narrow this year, and narrow markets tend not to be healthy markets. As investors go hunting for more gains in the second half of 2023, there is little doubt in my mind that smaller stocks will have to start contributing. Without their participation, markets will likely trend sideways for the remainder of the year as investors wait for future earnings to support extended valuations.
The coming week will feature a relatively light slate of data given the Independence Day holiday. Investors will dissect the latest FOMC minutes on Wednesday before getting updates on the job market to round out the week.
Thanks for reading and we hope you all have a great Fourth of July.
|Monday 7/3/2023||ISM Manufacturing Index||46.9%||47.3%|
|U.S. Markets Close Early|
|Tuesday 7/4/2023||Independence Day – U.S. Markets Closed|
|Wednesday 7/5/2023||ADP Employment Report (June)||278,000||220,000|
|FOMC Minutes (June)|
|Thursday 7/6/2023||Initial Jobless Claims||239,000||246,000|
|U.S. Trade Deficit (May)||-$74.6B||-$69.4B|
|ISM Services Index (June)||50.3%||51.1%|
|Friday 7/7/2023||U.S. Employment Report (June)||339,000||240,000|
|U.S. Unemployment Rate (June)||3.7%||3.6%|
|Hourly Wage Growth||4.3%||4.2%|
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Weekly Market Commentary/Market