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Wednesday, July 17, 2024

Capital markets perspective: Wait-and-see in waffling economy

Capital markets perspective: Wait-and-see in waffling economy


Didn’t any of these people see the Terminator movies?

Setting aside the possibility that an A.I. apocalypse could be approaching faster than Arnold Schwarzenegger in a stolen cop car, investors seem to have decided that artificial intelligence is ultimately a force for good, not evil. How do we know? Because optimistic comments made last week by chipmaker NVIDIA related to an A.I.-generated surge in demand for its chips powered technology stocks to a strong(ish) gain last week that in turn allowed the entire S&P 500 to eke out a small gain, even as ratings agency Fitch placed the U.S. – that’s right, the government of the whole freaking United States! – on ratings watch negative.1 Apparently, investors’ sudden obsession with artificial intelligence is a more powerful force for markets than the potential tarnishing of the world’s only truly “risk-free” asset, and market returns have remained durable as a result.

Debt ratings agencies place debt issuers on watch for potential downgrade about as often as the National Weather Service issues tornado warnings in Kansas, so in some ways its perhaps not too hard to look the other way when a group of analysts like those at Fitch do something as audacious as pointing out that political dysfunction in the Capitol could dent America’s longer-term ability to borrow forever and ever without bound. But it’s less common to see actions like this taken against the debt-issuing capacity of an entire fully-developed sovereign nation, let alone the world’s reigning hegemon. So color me least a little surprised when equity markets barely seemed to notice when Fitch’s analysts boldly started calling it like they see it with regard to the debt drama in Washington.

But it’s also not unprecedented. The last time the debt ceiling debate got as close to the brink as the current episode – during the spring of 2011 – it was the ratings analysts at Standard & Poor’s who stood up and cried foul, ultimately downgrading U.S. debt rather than simply threatening to, like last week’s announcement from Fitch did. But at least one similarity is worth note: Fitch’s analysts, like those at S&P last time around, cited “governance challenges” that are “a weakness relative to ‘AAA’ peers.” That’s not quite the same as downgrading a corporate borrower because the CEO has a bigger appetite for sport cars, expensive booze and all-night raves than his peers at other firms, but its close enough that it should have raised a few eyebrows. At a minimum, it suggests that the U.S. is partying harder – and in a less-responsible way – than, say, the Aussies, the Swiss, or the entire European Union. Either way, not a good look.

But it’s also wise to remember that tech and other high-growth stocks – those that rallied hardest last week despite the debt drama – aren’t the entire market. Sure, it may feel that way when the Nasdaq Composite is beating the greasier, dirtier and decidedly less-sexy Dow Jones Industrial Average by more than 3% per week or more than 24 percentage points year-to-date, but when the market’s gains are so concentrated in a single area, questions about the market’s durability are inevitable. At a minimum, it may reflect an implicit understanding by investors that all is not well with the economy – at least not outside of a few fast-growing (or suddenly fashionable) segments.

The point about diverging fortunes inside an uncertain economy was made perhaps even more clearly than that by last week’s flash purchasing managers indices2 (or “PMIs”), in which the sleeker, sexier services sector continued to expand at an accelerating pace while the big, dirty manufacturing economy seems to have slipped back into contraction – a downward slip that was also suggested by regional manufacturing surveys released last week by the Richmond3 and Kansas City4 branches of the Federal Reserve. Interesting, too, that each of these reports independently verified a few things that further supported the idea of an us-versus-them economy: inflation – both at the loading dock and at the factory gate – has clearly begun to ease for manufacturers, but is still very much a problem for services providers, where demand continues to expand.

But one area where there still seems to be general agreement across economic segments is hiring. Even in manufacturing, where demand is clearly contracting, job growth has remained positive and was recently aided by “a better availability of candidates,” which both the PMIs and regional Fed reports seemed to corroborate last week. It was reflected, too, in weekly jobless numbers: after a brief run higher – which was at least partially blamed on a suspicious and potentially fraudulent increase in jobless claims in Massachusetts – unemployment claims have settled back down into a trough that leaves the number of first-time filers still tens of thousands below a level that could even remotely be called recessionary. 

Adding workers to your payroll despite slowing demand simply because there are more good candidates hanging around waiting to be hired is as good a definition of “panic hiring” as you’re likely to find, and unless that changes, it will be hard to confidently call an end to inflation. So said the Fed itself, when it released the minutes from its May meeting last week: “some participants remarked that a further easing in labor market conditions would be needed to help bring down inflation,”5 suggesting that all this talk of a pause in June might eventually come to nothing unless there are renewed signs that the labor market is loosening up.

The Fed’s lingering discomfort with inflation was evident elsewhere in the minutes as well, and participants in the early May meeting provided markets with a handy-dandy laundry list of items that the committee itself is watching. In addition to labor markets, Federal Open Market Committee participants are paying attention to the “cumulative effect of policy tightening” and its impact on economic activity, tighter credit conditions wrought by the regional bank crisis, and the pace at which economic growth is slowing as part of its calculation about when to stop. I’ll leave it to you to tally your own scorecard, but there were enough tick marks on the market’s own version to convince traders that the hoped-for pause in the Fed’s rate-rising campaign had perhaps not yet arrived: as of this morning, another quarter-point increase at the June 14th meeting had become the consensus view.6

So where is the consumer in all this? Just like the labor market, the U.S. consumer has continued to show surprising strength throughout all this uncertainty. Last week’s income and outlays report gave hints as to why: continued wage growth supported continued gains in consumer spending, but also kept inflation at the forefront of the discussion: so-called Personal Consumption Expenditures (PCE) prices – which matter more to the Fed than more pedestrian measures of inflation like the Consumer Price Index and Producer Price Index – remained elevated, with core PCE inflation still running at an annual pace of 4.7%.7 (Incidentally, that’s might provide further evidence that the once hoped-for pause in rates may not happen next month after all.)

Still, all is not necessarily well for the U.S. consumer. Last Friday’s update of the University of Michigan’s consumer sentiment index showed a slight improvement from the mid-month update two weeks ago but was still notably lower than April’s final reading.8 So far, the index has given back about half of the gain realized since mid-2022, when U.S. consumers suddenly started feeling a little better. And then there were retailers themselves, who probably have a better view into U.S. consumer trends than university surveys or big, cumbersome government reports ever could. Without diving too deeply into the gory details, several high-profile retailers released earnings last week, joining a consistent chorus of complaints over the last several weeks from retailers who noticed that sales began tipping over in March and have only seemed to weaken since.

So the macro picture remains mixed. Markets remain mostly ambivalent to the ongoing debt ceiling drama, either because investors are confident a solution will be reached at the 11th hour as has been the case in the past, or because they view it simply as political theater. Investors also seem to have mostly forgotten that the U.S. economy recently suffered its own little banking crisis that may not be over yet and could restrain future lending activity even if it is. The Fed and its reaction to inflation, too, seems far less important to markets than in the recent past, with hints that the hoped-for pause might itself be on pause failing to generate much in the way of reaction.

So if none of this matters much right now, what does the market care about? Increasingly, it looks like the economy – which remains split between areas of weakness (like manufacturing) and strength (like jobs and the services sector), with a whole bunch of “undecideds” in the middle (consumer spending and sentiment.) Eventually, things will break one way or the other, and all the indicators will begin pointing in the same direction, which should shake markets from their long stupor in the process. But for now, it’s just a matter of wait-and-see.

What to watch this week

Economic Events, May 30th – June 2nd          

Monday: Memorial Day holiday

Tuesday: Home prices (x2), consumer confidence, Dallas Fed

Wednesday: JOLTS, Fed’s Beige Book

Thursday: ADP payrolls, ISM manufacturing, weekly jobless claims, Challenger layoffs

Friday: Non-farm Payrolls

Welcome again to payrolls week, that time of the month when we get loads of data for all things labor-related. Wednesday will bring the Job Openings and Labor Turnover (JOLTs) report and its accounting of how many job openings are currently available across the U.S. economy, together with other lesser-known indicators such as the “quits rate,” which has become a proxy for how confident Americans are in their ability to find a new job if they leave their current one. Then on Thursday we’ll get both Challenger Gray and Christmas’ list of who’s laying off workers, together with ADP’s estimate of how many jobs were added to payrolls last month and deeper insight into how much people are being paid. That’s all a big build-up to Friday, when we get the non-farm payrolls release and all that comes with it, including the unemployment rate, labor force participation and about a dozen other bits of data designed to measure the health of the US jobs market. As discussed above, persistent labor market strength remains as much a liability in this Alice in Wonderland world of the post-pandemic economy as it is an asset.

Beyond payrolls, this week will also feature another look at consumer attitudes and two more reads on manufacturing activity including the Institute of Supply Management’s manufacturing PMI as well as the Dallas Fed’s regional manufacturing survey, both of which could serve as a cross-check against other data suggesting that a contraction in the manufacturing sector is gaining momentum.

Finally, Tuesday’s twin reads on home prices will probably provide more insight into things like consumer confidence and willingness to spend than into the arguably more important question of whether the housing market is nearing a trough that could mark a turning point for the economy. Last week’s new home sales data was a slight upside surprise, something that recent strengthening of the National Association of Home Builders sentiment survey had foreshadowed well.9 Less upbeat, though, was the National Association of Realtors’ pending home sales data, which was essentially flat.10 But in both cases, an extremely lean inventory situation was cited as one reason that transaction volumes remain depressed. That makes prices a less-than-perfect indicator of future trends because it distorts the impact of true demand, making it possible for prices to remain elevated even if the number of homes sold remains depressed. For those hoping to see signs of a sustainable turnaround in housing, you probably won’t get it there.










Tom Nun, CFA


Tom Nun, CFA, Portfolio Strategist at Empower, works alongside teams overseeing portfolio construction, advice solutions, portfolio management, and investment products and consulting.

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