Written by: Matt Lloyd | Advisor Asset Management
With each passing day we expect more clarity in the path of the economy and the markets…only to be given more questions than answers. We have long moved on from bullish to bearish levels of markets to reverting back to our childhoods when we put the state of the economy and markets in a level akin to Goldilocks and the three bears. The markets tend to want to classify its prospects as too hot, too cold or just right. We move between these within a timeline that is far shorter than what investors who have been around for a while would normally have.
The justification of the current markets is attempted to square the circle of longer-term metrics which only coincides with declarative statements that can be offset in the next day’s economic data or earnings announcements. As such, if you do not have a bit of consternation, you may not be trying hard enough. We have been calling this a confirmation bias market where there are plenty of metrics to justify whichever side of the investment polarity you find yourself in.
I think a more apropos metaphor is also a childhood fable, but more on the strength of the current market and economy. The three little pigs built their houses of different strength against the big bad wolf’s blows. Here we will attempt to review what type of economic strength we currently find ourselves in and whether it is made of straw, sticks or bricks.
First from a time perspective, the last true recession when leverage was flushed out goes back to 2007–2009. The Covid pandemic recession of 2020 was more synthetically induced that brought about historic stimulus and backstop measures that coincided with a very contentious Presidential election that only exacerbated the chaos of the environment at the time. A recession serves a purpose over the long run by flushing out leverage to allow for future growth to exceed the previous cycles exhaustive nature, but in varying painful measures. 2020’s shortest recession on record did not flush out the previous decade-long expansion at that point nor offered the pain metric. In fact, with the massive stimulus, one could argue it led to a further amplification of the previous cycle’s excesses.
Perhaps the most bullish component is the tightness in the labor market and one key the Federal Reserve (Fed) is watching. The one thing that history tells us though is that the labor market is more of a lagging indicator as measured by the unemployment rate. The following chart from Bianco Research shows the unemployment rate over the last seven decades. What one should note is that the period it remains at the low levels is very brief and ultimately recalibrates.
With hindsight over the 10 periods when extreme tightness occurred, wage pressure and inflation pressure caused the Federal Reserve to react with higher rates to keep the pace of inflation from getting out of control.
One area that seems to be reversing itself from an abnormal high is the amount of job openings as provided by JOLTs. The chart below reveals just what has occurred. One note that is not shown is that the last two months of declines has moved the job openings down from its 20-year trendline — a not so positive indicator when we take the considerable number of layoffs being announced by various industries from the recent quarterly earnings reports.
Source: Strategas
To add to this, a recent spike in a smaller segment of the unemployment rate for 16–24-year-olds is triggering at least a cautionary approach. While volatile, it’s important to note that it’s the third highest level since 2000 and each previous spike was associated with a recession.
Source: Strategas | M/M = month over month
This stronger trend makes the Fed on guard for increased wage pressure, which we saw in the 1970s. While that was heavily influenced by the 30+% of the workforce being unionized and cost-of-living adjustments were done on the flip of a the switch versus letting the market forces recalibrate the inflationary pressure.
The probability of recession has now risen to 61% in the next 12 months, according to the New York Fed’s Recession Probability. This is based on the Treasury spread as an indicator — which those who don’t believe in the yield curve’s predictability will, and have always, discarded even when it shows a near perfect success rate, always citing “it’s different this time.” So, while they discard the yield curve spread and inversions, they will also minimize the leading Economic Index indicator which has been negative for 19 straight months with a near perfect success rate of predicting recession. The one month when it went negative was 1996 which is the soft landing everyone points to as similar to now. The Fed only raised rates 300 bps (basis points) prior to cutting them 75 bps and tweaked them over the next few years as data came in. The current Fed does not have that luxury as inflation is averaging nearly 100 bps higher over the last few months compared to then.
A chart that has made the rounds over the last couple of years tracks the current inflation from 2019 to that of the 1972–1983 period. Is there a pattern to inflation when the wage, goods, and services all have elevated pressures?
While the headline is that inflation is coming down and the Fed and central banks around the world are beginning to see hope regarding inflation, perhaps the story does rhyme from the chart above and the measure of the supercore inflation number. With overall inflation being sticky at around 70% of all measures, monitoring some of the more basic and necessary components are telling the central banks to “hold their beer.”
Further worsening the inflationary picture is what is happening in the Suez and Panama Canal from a shipping of goods and services. Carriers now need to circumvent around Africa — because insurance for ships traveling through the Red Sea is prohibitive — increasing the length and cost of goods shipped by around 40%. The Panama Canal has had a great reduction in ships navigating the passage due to low water levels. Both not only increase the costs of goods but also greatly disrupt the leveraged shipping process with a unbalanced distribution of containers across the world.
The other bullish point is the consumer and their insatiable appetite for spending. This is the key metric in our opinion; not only where they spend, but what is the amount of dry powder they must spend — as well as wages — to offset a decline from the swollen excess savings during the pandemic.
Last week we got the Fed Flow of Funds and the household/nonprofit balance sheets are still elevated. One way we have been looking at this for nearly 15 years is the state of net worth and total cash equivalents.
So, while from the 30,000-foot view, all looks fine, the breakdown of households is a bit more problematic. Pandemic-era savings look to be depleted, and when compared to the top 20% versus the remaining 80%, a large problem for continued broad-based consumption becomes an issue for those struggling with the weight of inflation.
What is a secular compelling story is what is happening with households and nonprofits in their holdings of debt securities. As rates have risen, we have seen increased appetites for them after declining by close to 30% from 2013–2022. They now stand at all-time highs, and this may be the case for some time.
One reason for this is the accelerated returns in equities over the last 15 years compared to the historical average. This creates a more challenging market for the next decade as the assumptions and expectations take time to be realized where earnings and cash flows are concerned.
Past performance is not indicative of future results.
According to the Bank of America research piece, history shows there is potential for 3% annualized equity returns. This seems to be too low as most projections are in the 5–7% range. While this is lower than the last 15 years average, it seems to be more appropriate. This explains why many are attempting to lock-in 70–90% of potential decade-type equity returns in quality fixed income right now.
Pushing this are the many metrics that spook long-term investors and there are many charts like the one below that give off warning signs.
We would never attempt to time the market and be in a purely binary on or off position, however, there are times when one should attempt to be a bit more pragmatic. A more quality approach where cash flow and earnings predictability are at the forefront, a vigilant risk-reward-focused discipline and look at moving investments across the universe for a potentially better lower-correlated portfolio in an increasingly correlated investment environment are where we are focusing on currently.