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Saturday, December 02, 2023

Capital markets perspective: Higher for longer

Capital markets perspective: Higher for longer

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09.25.2023

So this is what “higher for longer” looks like.

When 2023 began, confidence was running high. Sure, the domestic political scene was a mess, the war in Ukraine was slogging on, and the Fed was still firmly in tightening mode. But the job market was as strong as it had been in a generation and it looked like inflation was finally starting to peak. Consumers, itching to make up for time lost to the lock-ins (and fueled by bushel baskets of COVID-era savings), were still partying like it was 1999. And even if the Fed was still raising rates, everyone reasoned that we were closer to the end of the tightening cycle than we were to its beginning.

Investors looked across this mixed landscape and came to one conclusion: Soft landing.

That, plus a persistent view by markets that the Fed would be in a position to actually begin cutting rates as soon as early 2024 enabled a powerful rally to take hold in the equity market, particularly in mega-cap growth. When A.I. fever caught on, the rally was super-charged, and by July, the Nasdaq Composite index was more than 35% above where it started the year.

But in the background, those who were listening carefully could hear one voice, chirping in the background: “…Higher for longer, higher for longer…” It was Fed Chairman Jerome Powell, warning investors with the same quiet consistency that he had once repeated his other mantra, back before his Fed started turning the screws: “…Inflation is transitory, inflation is transitory.”

I suppose markets could be forgiven for not taking Powell immediately at his word. After all, we all know how the whole “transitory” thing turned out. (For those who are unsure, just consider 5.25% of Fed tightening since then the biggest mea culpa in Fed history.) So when Powell continually warned that the Fed was more inclined to keep rates high longer than markets seemed to expect, investors didn’t really worry too much.

Besides, as recently as June the Fed’s own “dot plot” – an estimate of where participants in the Fed’s rate-setting committee themselves think rates might end up at the end of the year and beyond – seemed to align more closely with market expectations for a small handful of rate cuts in 2024 than it did with Jerome’s warning, however consistent it might have been. But last week, in a regularly scheduled update of that same dot plot, committee members’ views tightened toward Powell’s view and away from the market’s. In fact, the median dot in last Wednesday’s dot plot now sits only an inch or so below where the Fed Funds rate would end the year assuming no more cuts are in store for 2023 (which, by the way, is itself far from a safe assumption). Said differently, the market’s view that the Fed would probably start cutting rates sometime after New Year’s Day now looks quite a bit more tenuous than it once did.

As last week’s dancing dots prove, not even the Fed’s own decision-makers can predict the path of monetary policy. And that’s okay, because the appropriate policy path depends on all sorts of other things that develop in real-time and are themselves vastly unpredictable – not the least of which is how the economy holds up in the months to come.

But that’s not the point. In fact, given some of the headwinds that seem to be building against consumers and the economic activity more generally, it’s not hard at all to imagine the economy worsening quickly and dramatically enough that the Fed might find itself needing to cut rates next year to stave off an even deeper decline, no matter what the dots say or what the market currently believes. But that’s only if the economy rolls over and finds itself mired in an ugly recession.

And that is the point: Unless something truly exceptional is going on, you probably can’t have both a soft landing and rate cuts by the Fed at the same time – but until last week, markets were priced as if they could have that cake and eat it, too. So if there was anything even mildly surprising about last week’s Fed decision to leave rates alone and the post-meeting commentary that followed it, it was that that very realization seems finally to have crept into the Fed’s psyche in a tangible way, courtesy of an updated dot plot[1]. Last week’s declines were simply the market trying to digest all that cake.

Yeah, about those headwinds …

We’ve recently written about some of the things stacked against the consumer and the economy more broadly, namely dwindling COVID-era savings, the pending restart of student loan payments, higher energy prices and an eventual cooling of the jobs market. You can now add to that list renewed weakness in the housing sector, with the National Association of Homebuilders’ monthly builder sentiment survey hooking lower after an eight-month recovery that had some asking whether the housing market might be capable of defying the gravity associated with 7% mortgage rates[2].

Disappointing housing starts[3] and flat home resales[4] sent essentially the same message last week: The nascent recovery in housing activity that seemed to be occurring earlier this year might well have been just a head fake. That matters, because housing is one of the biggest and most macro-sensitive sectors of the U.S. economy; what’s more, it’s also usually one of the first sectors to weaken in a recession and recover in an expansion. If housing is rolling over again – something that becomes even more likely if and when employment growth slows or turns negative – it’s probably not a good sign for growth more generally.

And then there was this: Remember the debt ceiling deal back in June that renewed the U.S. Treasury’s ability to issue new debt and thereby keep the U.S. in the chips through the end of 2024? Well, it turns out that it wasn’t quite that simple: In order for the deal to work, Congress must first pass a package of a dozen or so spending bills. If those bills fail, a government shut-down becomes likely[5]. Based on last week’s tumultuous session, it’s looking less and less likely that the House of Representatives will pass those bills before the September 30 deadline. While it’s not entirely clear to me exactly how impactful another government shutdown would be in the medium- to longer-term, it comes at a time when market and consumer sentiment are already fragile. 

Adding all this up, it’s becoming harder and harder to see how the U.S. avoids at least a mild recession in the near-term. That point was underscored – expectedly, perhaps – by the good folks at the Conference Board last week when they issued the latest version of their Index of Leading Economic Indicators, or LEI. The commentary inside that release wasn’t as in-your-face-negative as other recent reports, but the group’s economists nonetheless said they still expect that “…economic activity will probably decelerate and experience a brief but mild contraction” in the months ahead.[6]

Except maybe for the “brief but mild” part, I (for one) have a hard time disagreeing with that conclusion.

What to watch this week

Economic Events, September 25–29

Monday: Dallas Fed, CFNAI

Tuesday: Home prices (x2), consumer confidence, Richmond Fed, new home sales

Wednesday: Durable goods orders

Thursday: 2Q GDP (final update), weekly jobless claims, pending home sales, KC Fed

Friday: Income and Outlays, UofM consumer sentiment

Saturday: Deadline for federal government shut-down

This week’s economic releases are kind of scattered all over the map, so the most impactful things on the horizon this week will occur outside our regularly-scheduled programming. First, the UAW’s ongoing strike against Detroit’s Big Three enters its second week. So far, only Ford has been able to make much progress toward a contract, and as of last Friday, the union added another 6,000 or so employees to the picket line, ratcheting up the pressure to reach a deal. Regardless, expect the UAW-Versus-the-Big-Three to continue to dominate news flow this week.

Ditto for the government shut-down conversation, which comes to a head on Saturday. Without a significant change-of-heart, it looks like the necessary appropriations bills will likely fail to forestall a shutdown before October 1. Efforts toward reaching a compromise could result in a modest relief rally, while continued lack of progress might have the opposite effect.

In terms of scheduled data, we get a few more opportunities to see whether or not the housing head-fake was real or imagined when new home sales are reported on Tuesday and pending transactions data are released on Thursday. Anything other than “subdued” would be a surprise. Home prices will also be on display Tuesday (it’s probably reasonable to expect home prices to have remained durable given extremely tight inventories).

We’ll also have more PMI-type data to chew on, including three more regional Fed manufacturing reports (Dallas on Monday, Richmond on Tuesday and Kansas City on Thursday). That, together with durable goods orders on Wednesday, will probably show continued softness in manufacturing. Again, the manufacturing sector’s weakness has been in evidence for a year; the real controversy lies on the services side – will services activity hover near neutral, or will it continue its long, slow grind into outright contraction? If so, the recession call becomes easier. If not, maybe the soft-landing crowd has a point. Unfortunately, we have to wait until next week’s services PMI to find out.

Of more importance will be two reads on consumer attitudes, the Conference Board’s consumer confidence report on Tuesday and the University of Michigan’s final September sentiment report on Friday. Like housing, consumer sentiment appears to be weakening again after trying hard to break out of its deep funk for most of the last year. Those looking for a more nuanced view beyond just the headline numbers might look for the “jobs easy/hard to get” data inside the Conference Board’s report on Tuesday (which provides a good, forward-looking view into whether the labor market is really softening or not). Similarly, UofM’s survey usually does a great job of breaking down consumer sentiment by income. Weakening sentiment among lower- and middle-income consumers probably reflects a waning of COVID-era savings (where stimulus efforts had a bigger impact), whereas a weakening of sentiment among higher-income consumers would most likely correspond to September’s weakness in financial markets. (But all income cohorts are impacted by rising gas prices and political dysfunction, so the numbers could be weaker regardless.)

Sticking with the consumer for a moment, Friday’s income and outlays report could be the single most interesting release on this week’s calendar. The U.S. consumer’s willingness and ability to spend in the face of so many headwinds is beginning to feel almost heroic. Because it details not only how much consumers are spending, but also how much (and where) they’re generating income, Friday’s report could be the centerpiece of this week’s econ data buffet.

 

[2] https://www.nahb.org/news-and-economics/housing-economics/indices/housing-market-index

[5] https://www.brookings.edu/articles/what-is-a-government-shutdown-and-why-are-we-likely-to-have-another-one/

[6] https://www.conference-board.org/topics/us-leading-indicators

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Tom Nun

Tom Nun, CFA

Contributor

Tom Nun, CFA, is the Portfolio Strategist at Empower.

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