July Investment Comments
A Tale of Two Economies
The U.S. economy is still feeling the after-effects of the Covid emergency more than three years after it began. In the early going, consumers hoarded items they feared would be in short supply like toilet paper and cleaning products. Demand for many types of services like travel and dining collapsed. In the next phase, component shortages caused prices of many goods to surge. Then, as Covid restrictions eased and demand returned, labor shortages led to further price increases. The war in Ukraine exacerbated growth and price challenges.
The government played a role as spending levels and easy monetary conditions were left in place for too long even as the worst of the crisis had clearly passed. The Federal Reserve was caught flat-footed, assuming the nascent surge in inflation two years ago to be “transitory.” It has spent the last year and a half making up for its initial failure, raising short-term interest rates from around zero to 5.00%.
While headlines imply that the economy is strong, cracks have begun to appear in the U.S. and globally. The Purchasing Managers Index for Manufacturing fell in May for the seventh consecutive month and is well into contractionary territory. The Services index has also been on a downtrend but remains positive. The same trends are in place in Europe and China – weakening manufacturing with services holding up better. The global manufacturing sector is already in a recession.
To some degree, these trends could simply be a correction of imbalances that occurred early in the Covid period when consumers and businesses hoarded products to avoid running out while shunning services. However, manufactured products are more sensitive to interest rates as these items are frequently bought with borrowed money that went from “free” to very costly.
Over the past year, retail sales have risen 1.6%, well below the 4.9% increase in inflation. Retail sales are not adjusted for inflation and therefore reflect lower unit purchases. Retail sales include restaurants and stores but exclude travel and entertainment which surged as the pandemic waned.
Commodities prices have been weak with prices for energy, metals, and grains broadly lower year to date. Some of this may reflect a fading of initial price shocks in the early stages of Russia’s war in Ukraine. However, falling prices for industrial commodities confirm softness in global manufacturing.
U.S. employment has remained strong, but cracks may have emerged in that indicator. A strange anomaly occurred in May when one component of the employment report showed a gain of 339,000 jobs while the other component showed a loss of 310,000 jobs and a sharp increase in the unemployment rate. One survey in the report asks businesses about employment while the other survey asks households about their employment situation. It is unusual to see such a pronounced divergence between those two views.
Inflation pressures are gradually easing. Year-over-year price increases peaked in September at 8.2% and have receded to 4.0% for the year ended May 31st. “Core inflation,” excluding food and energy, rose 5.3%, suggesting broad inflation.
However, much of the increase in core inflation can be explained by the shelter component of the Consumer Price Index which makes up over one-third of the CPI. The Bureau of Labor Statistics, which publishes the CPI, says housing costs are up 8% year-over-year. Consumer prices excluding food, energy, and shelter, the so-called "supercore” inflation indicator, rose 3.4% over the past year, half the increase of the 12 month period ended September, 2022 and far below “core” inflation.
We have been cautioning for some time about mismeasurement risk in housing costs. Much of housing costs are “owner equivalent rent,” as if you were renting your house instead of owning it. The vast majority of homeowners have either fixed-rate mortgages or own their home outright. Their housing costs have changed very little. Those with adjustable-rate mortgages or who rent have a different inflation experience. Even still, the national rental cost index peaked last September and has declined significantly since then. The reported impact of housing on overall inflation may be overstated, and supercore inflation may better reflect the experience of most consumers.
The global manufacturing recession and ebbing underlying inflationary pressures suggest it is time for the Federal Reserve to pause its rate-hike program to allow a few months for past rate hikes to work their way through the economy. We are heartened the Fed agreed to pause rate hikes in its mid-June meeting, although almost all Fed governors signaled that they expect to raise rates again at some point this year. It seems like we could face this drama before every Fed meeting, which generally occurs every six weeks. It could also be a case of “jawboning” designed to get investors and markets to do the Fed’s work for it. After all, if Fed governors expect inflationary conditions to persist, why wait another six weeks?
Stock investors have remained surprisingly calm this year despite the challenges of interest rate hikes, the now-concluded debt-ceiling drama, and uncertain economic growth. This suggests they may be looking past any economic weakness. However, in recent months they’ve shown a strong preference for the largest companies, generally shunning small- and mid-cap stocks. With the S&P 500 returning 13.8% so far in 2023, the 100 largest have gained 19.4% with the S&P 400 mid cap index and S&P 600 small caps each rising about 5%. Small- and mid-cap companies are perceived to be more exposed to the domestic economy than their large-cap brethren, and a migration to big stocks might be investors’ way of remaining invested while hedging the risk of a recession. We believe it is appropriate for growth and diversification purposes to be invested in companies across the spectrum rather than chasing short-term trends.
Scott D. Horsburgh, CFA