Navigating the Varying Economic Currents

Navigating the Varying Economic Currents

The Fitch downgrade of U.S. debt, its warning of possible credit downgrades of some large U.S. banks, and the economic weakness in China (the bankruptcy of China’s largest property company, Evergrande) have weighted upon the financial markets.  Long-term rates have moved higher, with the 10-year treasury near 4.3%.  The upward bias was certainly influenced by the large volume of treasuries that are being issued to finance the federal deficit.

In response to these factors, the equity market has been under pressure for the last several weeks.  Given the strong performance in the first seven months of the year, it would be natural for a period of consolidation to follow.

However, in a short period of time, sentiment has become decidedly negative (contrary indicator), and the technical indicators have moved swiftly from an overbought to an oversold condition.  This would suggest that the worst of the downturn might be behind us.  It is interesting to note that the August and September time frame is a difficult period seasonally, and these are the months when consolidations often occur.  Historically, such corrections often set the stage for a seasonably strong fourth quarter.

Against this market backdrop, the US economy is performing surprisingly well, with consensus estimates of 2 to 3% real GDP growth in Q3, and the Atlanta Fed having an outlier estimate of over 5%.  Such growth would provide impetus for higher than anticipated corporate profits in the third quarter and at least a partial offset to the impact on valuations due to higher interest rates.

This level of growth could become a problem for the Fed, thereby feeding the notion that the credit restraints it has imposed have yet to produce the results that have been forecast.  However, part of the success of the U.S. economy can be attributed to declining inflation, which has produced a gain in real income (inflation lower than the gain in nominal income).  At the same time, declining inflation is raising real interest rates (nominal rate minus inflation), thus increasing monetary restraint.  This phenomenon is getting increased attention from some members of the FOMC and may become a source of discussion.  Considering all these factors, it seems very likely that a pause will occur at the September meeting.  In addition, maintaining rates at the current high level for longer will probably permeate the dialogue and imply a relatively high real rate.

The forces and counterforces at work in the economy will do little to promote clarity in the future outlook.  Fiscal stimulus provided by the infrastructure bill, the CHIPS Act, and the IRA (Inflation Reduction Act) will clash with the monetary restraint that the Fed has imposed with eleven rate increases, no monetary growth, and quantitative tightening, through reducing the balance sheet.

However, some things in the economy have changed little.

First, consumer debt continues to rise, now exceeding $1 trillion.  Default rates are beginning to increase, and additional burdens will fall upon a portion of the population with the return of student loan debt.

Second, bank lending standards have been raised, which has slowed lending.  Further, regulatory restraints are increasing, placing even more pressure on mid-sized banks.

Third, the commercial real estate market is entering a major restructuring phase, with significant refinancing needs of existing properties and the burden of overbuilding in the multifamily sector.  Given the long lead time on these projects, it will take several years for the market to come back into balance.

Fourth, the job market is a critical component to sustaining consumer spending and the economy, and it has held up well.  The service sector continues to be the resilient component, while the goods sector is still under pressure.  The question remains how long the consumer will be able to sustain its spending level, and will the goods sector suffer even more.  As we discussed in an earlier commentary, the consumer’s psychology appears to have been altered by the COVID experience, but eventually increasing financial burdens will weigh upon spending decisions.

In July, airfares have fallen 9% month/month and 19% over the last year.  Some further signs are showing up among durables, as used car prices are falling, and the higher cost of new autos places a greater burden on the buyers.  The home builders are now reintroducing incentives. The strong supply/demand imbalance remains, with new homes being the only real supply that is coming on the market.  The dilemma of the existing home buyer remains.  The extremely low mortgage rates of a few years ago (under 3%), created by the Fed’s 0% interest rate policy, provide no incentive to sell when facing 7% mortgage rates for a replacement home.

Against the confusing domestic environment, international monetary policy will take center stage at the Jackson Hole economic symposium starting August 24th.  “Structural Shifts in the Global Economy” is the title.  Many papers will be presented with a great deal of empirical research on this topic.

Most certainly the international economy has gone through significant change over the last several years as COVID and the policy responses changed behavioral patterns.  The supply chains were severely disrupted, and technology surged, altering historical relationships.  The papers that will be presented hopefully will shed light on these complex relationships.

Another element entering the global equation is geopolitical realignment.  NATO has expanded and coalesced.  Russia is becoming more isolated, while China’s power is weakening.  Moreover, the war with Ukraine is depleting Russian resources, and China’s failed economic policy is becoming more apparent as cracks emerge with the failure of the property company Evergrande.  A lower 5% growth target that has been announced is unlikely to be achieved, as has been the case for some time.  The combative nature of China’s policy does nothing to stimulate trade and points to the weakness in Xi’s strategy.

The pressure that has been developing internationally has provided strong support for the dollar.  The ruble has fallen, and Russia raised interest rates, while the Chinese yuan has broken its ban.  Moreover, the political turmoil in South America and the devaluation of the Argentinian peso creates a run to stronger currencies and economies.  In a world with major unrest, the U.S. economy stands out and its financial markets remain very attractive.  High interest rates, declining inflation, and the best and most creative companies in the world make investing in the U.S. hard to resist.