October Investment Comments
As we head into the fall, 2023 has left egg on the face of most forecasters. The seemingly inevitable recession on the heels of a turbulent 2022 hasn’t materialized. The economy continues to grow, inflation is abating, and the stock market has had a remarkable year. Interest rate increases haven’t torpedoed the employment market. Government, consumers, and the market have coalesced around a “soft landing” narrative. However, as always, there are risks.
Since March 2022, the Federal Reserve has executed eleven separate increases to the Federal Funds rate, bringing it to a range of 5.25% to 5.5%. This rapid pace of increases is having the desired impact on inflation and a red-hot labor market.
The consumer price index rose 0.6% in August, a sizable jump versus the 0.2% increase in July. However, gasoline shot up a dramatic 10.6%, accounting for more than half of the increase. Energy and food tend to be volatile categories and when excluded from overall CPI, “core” inflation rose 0.3%, a slight increase from 0.2% in July. On a year-over-year basis, inflation rose 3.7%, a larger increase than the 3.2% for the 12 months ending in July, but core inflation rose 4.3%, continuing its downward trend since peaking in September 2022. The progress on core inflation is impressive considering that shelter costs are up 5.9% compared to last year and are set to fall over the next few months.
U.S. employers added 187,000 jobs during the month of August, but June and July were revised down a combined 110,000. Over the past three months job gains averaged 150,000 per month, cooling from the 238,000 average gain of March through May. The unemployment rate ticked up to 3.8% in August, reflecting an increase in the labor force as more Americans seek jobs. Job openings confirm the cooling of the labor market, with 8.8 million openings in July, down sharply from 11.2 million to start the year.
Falling inflation and a cooler labor market has not stopped economic growth. After a 2.1% increase during the second quarter, the Atlanta Fed estimates third quarter GDP will grow 5.6%. We have observed the Atlanta Fed often overstates the actual GDP reading, but directionally it seems safe to say that growth has picked up.
Fueling this growth is household spending, which increased 0.8% in July. In addition, the Commerce Department revised June’s growth to an increase of 0.6%. These increases represent the fastest pace of spending since January. Consumers are opening their wallets as inflation falls and wage gains remain solid, with inflation-adjusted wages rising 3% in July. Recessions typically don’t occur when consumers are seeing real wage gains.
Markets have begun to price in a “soft landing” scenario on the belief that the Federal Reserve may be very close to ending interest rate increases and may even be in a position in early 2024 to reduce rates if inflation continues its downward path.
Analysts are now estimating third quarter earnings for S&P 500 companies will grow 0.5%, the first quarter of year-over-year growth since the third quarter of 2022. The forward P/E ratio of 18.6 is only slightly below the 18.7 average for the previous 5 years and above the 10-year average of 17.5. The strengthening economy is broadening earnings growth participation as eight of eleven industry sectors are expected to post increases.
Now, let’s look at those risks I mentioned earlier.
Inflation has received an outsized benefit from dramatically lower energy costs since the middle of 2022. These tailwinds are reversing, as seen in July’s numbers, as the price of crude surpasses $90 per barrel. Higher energy costs feed into future price increases for goods and services as companies strive to maintain their profit margins by raising prices.
While declining shelter costs will aid future CPI measures, the median price of a U.S. home increased 1.9% in July, to $406,700, the first increase posted in five months. The reason for the increase is lack of supply, as active listings have declined 7.9% from a year ago and 46% from August 2019. There simply aren’t enough homes on the market as homeowners choose to stay put rather than give up their 4% or lower mortgage. To illustrate how financially difficult it is to move, according to Black Knight the average principal and interest payment for homeowners with a mortgage was $1,355 in June. In contrast, the median payment for those buying a home with a 30-year fixed-rate mortgage in July was $2,306. It may take quite some time before housing demand and supply balance, keeping home costs elevated and, with it, inflation.
Government spending might also derail inflation progress. Passage of the CHIPS and Inflation Reduction Acts have increased government spending while tax collections have lagged, largely due to the lack of capital gains from 2022. The result is an expected budget deficit of $1.7 trillion in fiscal year 2023, about 6.3% of GDP. In a normally growing economy, the deficit tends to run around 3% of GDP. This represents a significant amount of fiscal stimulus that elevates demand.
Federal Reserve policy is the largest risk. If progress on inflation reverses, like it did in July, the Fed may be inclined to raise interest rates further. There has been much debate in academic circles about the lagged impact of interest rate increases. Historically it takes about a year or so for interest rate increases to fully impact the economy, but some economists believe that today’s more globally integrated economy has shortened the lag adjustment period. Certain large factors point in the other direction: the shortage of housing that keeps prices high gives more pricing power to landlords, and we haven’t yet seen much in the way of commercial property foreclosures due to lower demand for office space. With so much conflicting data the Fed can easily make policy mistakes.
Investing always entails risk. However, the U.S. economy is headed in the right direction with rising incomes and falling inflation. Those that stay fully invested do well over time and we see no reason to act any differently now.
Daniel J. Boyle, CFA