Early in 2024, I wrote that while many pundits felt we were entering a 1970s style stagflation, I wrote it felt more like 1999. In the first half of the year, it has played out much that way. That being said 6 months does not make a decade. There is still plenty of time left for stagflation to play out. We’ll leave that for another time.
It has been well documented that we have been underweight stocks and neutral on bonds for much of this year. I also mentioned that returns would lag a bit if a 1999 style market showed up. We have year-to-date. I also forecasted a recession in 2023 that too never materialized, at least not yet.
To be candid, I underestimated the power of the massive COVID stimulation and liquidity injected into the system beginning in early 2020 and continuing up until mid-2022. The Fed had to finally admit inflation wasn’t transitory ( I got that one right) and began a series of interest rate hikes beginning in 2022 and stopping in late 2023. This is where the market began rallying.
Two things that bother me the most. First, interest rates take on average about 18 months to impact the economy. The timing of that would be about now. To use an analogy. If you put a glass of water in the freezer, over time it turns into ice. This is the transition phase for a liquid to turn to a solid. Now substitute water for interest rates and all you have to do is leave rates alone and the economy transitions from expanding to contracting. This leads me to point number two. The broader measure of money supply (M2) has been declining since early 2022. Partly due to the Fed unwinding a bloated balance and the rest coming from declining savings and demand deposits from COVID stimulus.
My fixed income calls were pretty good. We have a lot of bonds coming due this year and next that will get invested at higher rates. The flip side to this is that a lot of loans are coming due and the average interest rates that consumers and businesses will pay are creeping up. This is a systemic issue. Going back to Economics 101, if the marginal rate is higher than the average rate, then the average rate will rise even if the marginal rate declines. To sum up people are going to pay more going forward.
Since 2008 the federal debt has been up almost 400%! The current trajectory is unsustainable and here comes the pain! All that liquidity at low to zero interest rates has fueled earnings, stock prices, house prices and consumer spending. I am not going to touch on the debt issues in detail here. I’ll save that for another time. The pain I am speaking about is a retrenchment in consumer spending and earnings.
In summary, I am downgrading equites further and increasing high quality long duration debt.
Where to go from here after that?
Two reasons why we avoided a recession – massive stimulus and labor demand exceeding labor supply. Both of those are the result of COVID. Money as well as people not working or in other words leaving the workforce. Both have now rectified themselves. The only way for the Fed to slow inflation is to put people out of work – slow demand. To keep this short I am going sum up both those points with a small narrative and a few charts.
Let us look at money and consumer health.
The next three charts show that Pandemic-style stimulus has all but been eroded. Personal savings rate has normalized and is actually below the average of around 6% sitting at shade under 4%.
Chart: Cumulative aggregate pandemic-era excess savings
Source: Bureau of Economic Analysis
As savings have diminished, the consumer has kept going by adding to credit card debt…
But the interest rate has jumped dramatically…
Pushing the consumer further behind as shown next.
Let’s talk about jobs.
This has all been fine and good while inflation was low and jobs plentiful but that has changed. Job openings are declining, and labor participation is back up. Early on, people could move from job to job increasing their wages. Without overloading you with charts, the ‘jobs quit rate” has shrunk and real wage growth is on the way down. I believe in my last report it was moving down but wage growth was still about 4%. It needs to go lower before the Fed will loosen. They are behind the curve but that is their mindset.
I am going to provide three charts that show that the excess labor demand has been filled. Job openings are declining and in conjunction more people are working filling that excess demand gap.
As consumer health declines and unemployment begins rising the savings rate will climb further curtailing spending. I am leaving out here Federal and business spending that make up the other 30% of the economy. The short answer is there is no room for the government to significantly add to growth and businesses for all their profits and discussion of on shoring, the capital expenditure numbers just are not there. AI is not showing up currently in business capex. The infrastructure bill is also not pushing capex higher. In fact, commercial investment is on a downward trajectory.
Conclusion
I am leaving out a lot here but let me just skip to the end. Valuations have not gotten any better since my last report. I put the S & P 500 at about 150% of fair value. There are more than few indicators that go into that but some are:
- Forward earnings projections
- Shiller CAPE 10
- Price to Sales
- Price to Book
- Monetary and Financial Conditions
- Sentiment and Momentum
Earnings are and always will be the major source of value. Beyond that, investors push values to height and depths based on sentiment. Currently AI is the new theme. Analysts are completely on board.
The average increase in corporate profits is just a shade north of 5.4% since 1980. (They track GDP growth close give or take 1% or so.) The last 15 years it has been about 7.4%. Now here is the kicker as analysts’ long term annual earnings growth are at a stunning 17% provided by IBES.
Do you see anything that suggest that profits margins should grow indefinitely and at any rate close to that?
By the way, I just cannot help myself. Unemployment is ticking up slowly.
My last thoughts are that as the economy slows and turns into a recession, the Fed will loosen and the flight from risk assets will flow to government bonds. That is why we have been pushing up our exposure to Treasuries. What about AI? Stay tuned, I hope to have a report out by the end of August.
See my last report on stock and bond levels if we fall into recession. Those numbers have not changed. What about who is president? It does not matter regarding the next 12 months’ economic picture. The next administration will have to deal with a recession early on in 2025. The stage has already been set by the Fed and previous three administrations as debt has risen almost 400% by Obama, Trump, and Biden.
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