SEPTEMBER 2023 MARKET INSIGHTS
Every summer, we have two or three interns in the KOCAA offices to help with a number of tasks. I always tell them that I am not sure they will love the job, but by the end of their internship, they will certainly know what it means to be a securities analyst. Many people on the outside of investing think that every day is a frenetic series of people yelling “buy” and “sell.” I suppose the floor of the New York Stock Exchange was very much that way, every day, but then the computers took over! That is a story for another day. In any event, part of my admonishment to the summer interns is that one of the things investors must do, and do a lot, is read. I read voraciously every day and I enjoy reading as a hobby. Some of my off-time reading is focused on suspense and mystery novels. I suppose trying to solve those mysteries dovetails with my appreciation for trying to solve the mysteries of the markets and this is precisely where we are today. We are all trying to understand the most recent economic releases and how this mosaic of data will either lead to a recession (shallow or not) or a return to growth.
As I write this on September 1st, we are deciphering the continued level of robust household spending which rose 0.8% in July after being revised upward to 0.6% in June and a careful reading will show that this was the highest increase in household spending since January[1]. The Federal Reserve has been carefully watching economic gauges to decide whether to increase the Federal Funds Rate at their next meeting. Despite this robust spending, the Fed’s preferred gauge for inflation, Personal Consumption and Expenditures, known as the PCE Index, rose 0.2% in July from the month earlier1. Excluding food and energy, the PCE Index rose by the same amount, so over the previous three months inflation ran at an annualized rate of 2.1% and this is very close to the 2% target the Fed desires. It is important to remember that three months is a great start, but it may not be a trend. Taken on an absolute basis, one could reasonably assume that this will provide ample room for the Fed to stay on a pause of increasing rates. Ultimately, we think the direction of the employment market, wages and consumer spending will determine if this was a slight pause in the upward trajectory of inflation or a true change in trend. For the record, Federal Reserve Chair Jerome Powell has said it is premature to conclude the inflation was on track to meet the Fed’s 2% target.
I was reading some research on household income and spending given a concern of how rising rates would impact the consumer. Only 11% of household debt is floating rate and most of that consists of household mortgages. One interesting point was that despite mortgage rates hitting 7.25%, the blended rate of outstanding mortgages is 3.64%. A significant part of our consumption is tied to housing. As interest rates have risen, it has certainly lessened the propensity to trade up from the starter home to something larger. Anyone that has ever purchased a house knows that there is usually a lot of spending that follows for furnishings, housewares and items needed or wanted for the outside of the home. The more sedentary the housing market becomes, the greater the downward pressure on spending.
As regular readers will remember, we have been very focused on employment. The economy is a series of linkages, and a robust job market leads to sustained or increased spending and spending drives growth. We enjoyed a very long period of a reasonably strong job market, reasonable wage growth and very steady and low inflation. In the post-Covid environment, the excess stimulus (and I will argue that the last two rounds were holistically unneeded) drove excess savings. Once the economy reopened there was first a demand for things that then became increased demand for services.
The ability for the spending to continue is tied to the labor market. When we look at the August jobs report, we see a gain of 187,000 new jobs and this was above the consensus estimate[2]. However, beneath the headline, there were downward revisions of 110,000 jobs from the previous two months. The unemployment rate increased by 0.3% to 3.8% and this was driven by an addition of 736,000 people to the labor market2. Average Hourly earnings increased by 0.2% last month and this translates into year over year wage increase of 4.3%2.
What does this all mean? If the labor market is cooling, wage growth will certainly slow down. If wages are slowing, this may also have the effect of cooling spending. The Federal Reserve may then be able to keep the Federal Fund rate steady if labor and spending are cooling and we may continue to see inflation slow from here. If this all comes to fruition, any economic slowdown that we have may be shallow and short. The most significant countervailing issue is that the impact of higher interest rates is really now being felt by the economy and banks are tightening lending standards. In our opinion, the critical path for the economy will unfold over the next few months to see if the slowing of the labor market dampens inflation enough to allow the fed to materially slow the interest rate hiking cycle. The Fed will certainly attempt to thread the needle of cooling inflation while not completely disrupting the economy. The success of this endeavor is what will guide the economy into a recession or a return to growth.
It's never boring! Until next month.
