August 2023 Commentary

Key Observations and Outlook

• The stock market continues to be driven by a narrow segment of companies (the magnificent 7).  This can be seen in the dramatic difference in returns of the equal weighted S&P 500 vs. the traditional cap weighted index (+7.57% vs. +18.88%).
• Increased government spending has been a significant contributor to economic growth, helping to stave off the recession thus far.
• The “U.S. Leading Economic Index” has declined for 16 consecutive months, with key manufacturing indicators continuing to demonstrate weakness.
• Consumer spending has remained higher than expected through the summer, but signs are pointed to slower spending now that pandemic stimulus has largely vanished, pent-up savings have been depleted, and credit card debt has skyrocketed.
• Inflation has continued its descent through the end of July, but we should not be surprised if there is a modest uptick in coming months with the CRB Index and Oil reflating from the lows in early June, by 10% and 25%, respectively.
• The yield curve remains inverted with the Fed unlikely to start cutting short-term rates in the near term (one more hike more likely), providing shorter-term bonds a more attractive risk-adjusted return profile.

Increased Government Spending Buoys Economy

While the Fed continues raising rates and restricting monetary policy, the government’s contribution to U.S. GDP has increased in 2023 as the federal deficit has widened. This increase in government spend along with a heretofore robust jobs market has helped to sustain positive economic growth and prevent a recession to this point. With the debt ceiling deal in place and a deadline to reach an agreement on a budget by the end of 2023, it is unlikely that government spending will increase at the same pace in future quarters given the direction of the deficit.

Government spending has grown over the last couple of quarters.

If Congress cannot reach a budget deal by the end of the year, then spending caps will be changed to reflect a 1% cut to discretionary spending from FY 2023 levels. Just a moderation in the growth of government spending will act as a headwind to economic growth in 2024. 

Leading Economic Indicators Trend Lower

The U.S. Leading Economic Index (LEI) looks at trends in the leading economic data, such as employment, manufacturing, housing, and financial conditions. The LEI provides an early indication of significant turning points in the business cycle and has historically been a potential leading indicator of recessions. “The US LEI—which tracks where the economy is heading—fell for the sixteenth consecutive month in July, signaling the <economic> outlook remains highly uncertain”, said Justyna Zabinska-La Monica, Senior Manager, Business Cycle Indicators, at The Conference Board.

While the Coincident Economic Index, which tracks where economic activity stands right now, continues to reflect that we are in a favorable, but slowing, environment, the leading index continues to suggest that economic activity is likely to decelerate and descend into mild contraction in the months ahead. Most recent data, including weak manufacturing, higher interest rates, a dip in consumer outlook for business conditions, and moderating labor trends, fueled the LEI’s latest monthly decline.

Government spending has grown over the last couple of quarters.

Note: The chart illustrates the so-called 3D’s rule which is a reliable rule of thumb to interpret the duration, depth, and diffusion – the 3D’s – of a downward movement in the LEI. Duration refers to how long-lasting a decline in the index is, and depth denotes how large the decline is. Duration and depth are measured by the rate of change of the index over the last six months. Diffusion is a measure of how widespread the decline is (i.e., the diffusion index of the LEI ranges from 0 to 100 and numbers below 50 indicate most of the components are weakening). The 3D’s rule provides signals of impending recessions 1) when the diffusion index falls below the threshold of 50 (denoted by the black dotted line in the chart), and simultaneously 2) when the decline in the index over the most recent six months falls below the threshold of -4.2 percent. The red dotted line is drawn at the threshold value (measured by the median, -4.2 percent) on the months when both criteria are met simultaneously. Thus, the red dots signal a recession.

Consumer Spending Resilience Should Wane

U.S. consumer spending trended higher through the summer, one of the key elements fueling and sustaining the stock market’s advance through July. However, there remain some stiff headwinds facing the consumer as we head into the fall. We are beginning to see early indications of a stretched consumer with pent-up pandemic savings largely depleted and early signs of softness in the labor market. In addition, the federal student loan payment pause ended in August, where interest on loans will begin accruing in September and payments will be due starting in October, for the first time since March 2020. Lastly, with depleted savings, credit card balance growth has continued to rise unabated, while the monthly delinquency rates have been accelerating to the upside in recent months. Although the magnitude of the impact of each of these factors is difficult to predict, it should present a headwind to consumer spending.  

United States – Delinquency Rate on Credit Card Loans, Banks Ranked 1st to 100th Largest in Size by Assets

Source: tradingeconomics.com

Inflationary Pressures Subside with Some Mixed Signals

The headline inflation rate has continued to ease through June to 3.0% but saw a modest tick higher in July to 3.2%. The Fed is still locked in on achieving a 2.0% inflation rate, so continued progress will be necessary to reduce the probability that the Fed will feel the need to hike rates again. Shelter is the largest component of CPI, making up 43% of the index and had been the stickiest; however, over the last 3 months, we have seen a steep deceleration in real-time apartment rent indices, helping to push inflation lower. The counter to moderating shelter costs has been the rapid increase in the price of oil and other commodities, which had been strong contributors to the decline in inflation over the past several months. However, since the beginning of June, the price of oil and the Core Commodity CRB Index have increased by 30% and 12%, respectively. These components will place upward pressure on the inflation rate over the next couple of months. 

Yield Curve Remains Inverted as Fed Maintains Higher Rates

Short-term rates, reflected by the 2-year treasury yield, remain well above the 10-year treasury yield, 4.87% versus 4.11% as of the end of August, as the Fed has maintained its restrictive monetary policy. When short rates are priced above longer rates, the yield curve is considered to be “inverted”.  In the past, inverted yield curves have been a reliable indicator of an economic slowdown, as higher short-term rates choke off economic growth. At the Fed’s most recent meeting, Chairman Jerome Powell reiterated yet again the Fed’s resolve and vigilance to slow the economy and contain inflation.  This means that short-term rates will remain higher for longer, a fact that the market’s had not previously priced in.  Fed funds rate futures show that the market is now pricing in higher fed funds rate expectations into early 2024.

10 Year yields have been trading below 2 year yields for over a year now.

While Powell acknowledged that progress has been made against inflation, inflation is still above where the Fed feels comfortable. He gave little indication that the Fed is ready to start easing up anytime soon, reiterating once again that although inflation has moved down from its peak, it remains too high. He said the Fed is prepared to raise rates further if appropriate and intends to hold policy at a restrictive level until they are confident that inflation is moving sustainably down toward the target rate of 2.0%.

10 Year yields have been trading below 2 year yields for over a year now.

The Bottom Line

Until recent weeks, the stock market has moved higher in 2023, defying  historical recession indicators as government and consumer spending have enabled economic growth to remain positive. However, the slowing leading economic data coupled with tighter lending standards indicate an elevated risk of an economic slowdown over the next several quarters.

S&P 500 corporate earnings growth has been negative for the first half of the year, down approximately 3% – 4%. With the S&P 500 price return up over 17% year-to-date, the S&P 500 earnings multiple or valuation has expanded by approximately 20%. Furthermore, Wall Street consensus estimates for corporate earnings growth of 12% for 2024 do not seem to appropriately account for the indicators signaling the potential for moderating economic growth into 2024. The high probability of an economic slowdown lead us to believe that future earnings estimates may require downward revisions.

The Federal Reserve is likely to continue with its aggressive monetary policy for longer than markets currently project unless the CPI inflation rate continues to decline back to the 2% target. While we seem to be headed in that very direction with headline inflation down to 3.2, we will be keeping an eye on all components of inflation, including energy and commodities, which seem to be moving in the upward direction.

At Bison, rather than trying to predict the market, we always build our client portfolios based upon our client’s goals and objectives, focused on the long-term and preparing for any market environment. While we currently maintain a cautious approach towards the equity and fixed-income markets, we do not shy away from those exposures. Rather, we seek to implement strategies within our client portfolios that can mitigate the typical volatility of the financial markets and maximize risk-adjusted returns over the long term. This approach has helped us to navigate changing market environments while still meeting the ultimate financial objectives of our clients.