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The Economy is Softening; the Fed is Already Behind the Curve

As seen from the table, the equity markets were flat for the week. Perhaps markets have begun to pay attention to incoming economic data.

Looking beyond the weekly data, it is quite clear from the year-to-date numbers that small cap stocks (Russell 2000) and industrials (DJIA) have not participated much in the market run-up. The Nasdaq and S&P500 have performed much better, but that’s simply due to their large technology components. The S&P500, for example, is a market capitalization weighted index, i.e., the larger companies have more weight. On the chart, it is shown as the black line.

The red line is the equal weighted S&P500 (each company has the same weight). Note the difference in the year to date returns. In fact, if we eliminate the Magnificent 7 (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla), the other 493 stocks are flat on the year. Clearly the stock run up is very narrowly based, and that is a worry.

Housing

The housing market has always been an accurate predictor of the economy as a whole. Existing Home Sales (contracts signed and closed) have slowed (-0.7% in May from April, and -2.8% from a year ago). We can place some of the blame on mortgage rates. They are near 7% while many homeowners have mortgage rates in the 3% to 4% range, having refinanced prior to the Fed beginning its tightening cycle. Thus, for the majority of homeowners, even a lateral move would cause the monthly mortgage payment to rise 50%-60%. Who is going to go for that? As a result, supply is constrained. So is demand at 7% mortgage rates. In fact, the Homeowner Affordability Index is at a four decade low and qualifying income for a median priced home is now more than $100K/year.

One would think that such a slowdown would negatively impact prices. Not so! While unsold inventory rose to a 3.7 months’ supply (from 2.9 months’ in February), prices still rose! (Note: we believe that the median home price will soon be falling due to a weakening economy.)

Pending Home Sales, which are contracts signed but not yet closed, fell -2.1% in May (vs. April). And April fell -7.7% from March. These sales are down -6.6% from year ago levels.

If the inventories of Existing Home Sales are down, one would think that, in a healthy economy, new home sales would be up. But this is not the case. New Home Sales fell -11.3% in May from April and are down -16.5% over the year. Homebuilders now have a 9.3 months’ supply of homes to sell at current sales rates (it was 8.1 months’ supply in April). This is the largest months’ supply since October ’22 when the pandemic was still a concern. And, unlike the existing home market, median new home prices are falling (-0.1% in May, -4.4% in April, -0.9% year over year). Given these trends, we think we will soon see falling prices in the existing home market.

According to the latest housing data, the economy should be weakening; and it is.

Inflation

There was a sigh of relief on Friday morning (June 28th) as the Personal Consumption Expenditure (PCE) Deflator, the one the Fed prefers over CPI, came in benign. The monthly change in the headline index (see left side of chart below) was flat (0.0%) moving the year over year change in the headline index to 2.6% in May from April’s 2.7%. The Core rate (excludes food and energy) also landed at 2.6%, down from its 2.8% April rate. These are now within striking distance of the Fed’s 2% goal.

Speaking of the Fed, their forecast for the end of the year for the PCE Core rate is 2.8%. So we are actually 20 basis points (0.2 pct. points) below that. As a result of this inflation report, the market’s odds for a September rate cut have now risen to 62.3%, and to 91.4% for December.

The next chart shows the CPI with and without the shelter (rent) component. Note that without the shelter component, the Core CPI Index, at +1.9%, is already below the Fed’s 2% target (see bottom left-hand side of the chart below).

As discussed in past blogs, the CPI’s shelter component is significantly lagged and has biased the CPI to the upside over the past three quarters. This is clear in the next chart which shows the shelter component of the CPI (still above 5% year over year) versus the real time New Tenant Rent Index (which is approaching 0%).

With a large weighting in the indexes, shelter is one reason we are confident in our call that inflation will be at or below the Fed’s 2% bogey soon because we already know where the shelter component of the CPI (the blue line) is going (i.e., highly correlated with the red line with a 10-month lag)!

Retail

As we discussed in our last blog, retail sales are stagnant (-0.2% year over year). In May, the Johnson Redbook Same Store Sales Index was off -2.6% from April, showing how rapidly the consumer is tightening the purse strings. General Mills, the breakfast cereal purveyor, showed up with Q1 revenues off -6% from a year earlier. It is clear that consumers are either eating less breakfast cereal or, more likely, trading down to a cheaper store brand. In addition, Southwest and American Airlines have guided lower for sales. Clearly the consumer is vacationing closer to home this year (i.e., withing driving distance), thus saving on airfare. Another sure sign of a soft consumer is when the fast-food industry has a price war – MacDonalds (MCD), Burger King (BK), and Wendy’s (WEN) all have lower priced specials.

Employment & the Fed

Both Initial Jobless Claims and Continuing Claims have been rising.

Let’s not forget that the Fed has a dual mandate, an inflation mandate (which has been their emphasis for the past couple of years) and an employment mandate. The Fed’s end of year forecast for the U3 unemployment rate is 4.0%, where it currently sits. The peak in that rate in the Fed’s forecast is 4.2%. So, theoretically, the unemployment rate rise to 4.2% this year, then falls back to 4.0% by year’s end.

Given the current high degree of restrictiveness in monetary policy, the Fed’s own “higher for longer” mantra, and the long lags from the time policy is changed until it impacts the economy, it does appear that the U3 unemployment rate will be rising for the remainder of the year; we think to 4.5% or more. How it falls back to 4.0% (the Fed’s year end forecast) by year’s end is truly a mystery, especially given the weakness emerging in the jobs market where we see rising jobless claims, falling voluntary quits, and, especially apparent in the ADP payroll report, rising layoffs at small businesses.

Manufacturing

The chart below shows June Purchasing Managers’ Indexes for the world’s major economies. Note that in June only the U.S. was marginally positive. This also tells us why exports are falling (which will negatively impact Q2 GDP).

Commercial Real Estate (CRE)

CRE values continue to implode. In last week’s blog, we reported that there are 63 banks on the FDIC’s “Watchlist.” Every week this quarter, we have seen large CRE foreclosures. Four such significant foreclosures occurred this week.

  • 1407 Broadway, a midtown Manhattan office tower, lost $400 million in value in five years. It appraised for $510 million in 2019, and recently appraised for $136 million. Barclays made a $350 million loan on it in 2019.
  • The office tower shown below is in San Francisco’s Mid-Market area which was acquired for $62 million in 2018 (90K sq. ft.). It just sold for a 90% discount.
  • Another San Francisco property (see picture below), its largest apartment complex, was transferred to a special servicer (meaning payments have ceased). According to @aryal1994, “$1.8 billion in loans (about $558K per unit) have been moved to special servicing due to the … upcoming loan maturity.”
  • Still another California property, this one Hollywood’s largest retail center, a 463K square foot retail site with 77% occupancy, was sent to special servicing. This one has a $211 million loan on it.

Final Thoughts

Equity markets are being buoyed by the large tech companies and those thought to most benefit from the coming AI “revolution.” The Magnificent 7 come to mind. The table at the top of this blog shows that small cap stocks have lagged this year and are barely positive while market hype would have one believe that all equities have participated in the run-up. It is a similar story for the industrials (DJIA). For the Nasdaq and S&P500, all of the action has been in the large tech stocks. Absent that, market prices are flat.

The economy is softening. Retail sales have been sluggish and major companies are guiding lower. Both new and existing home sales are significantly off their highs, and while prices of existing homes are still rising (marginally), they are now falling in the new home market. We expect existing home prices will be falling by year’s end.

The U3 Unemployment Rate has risen to 4.0% (its most recent low was 3.4%).  Initial and Continuing Unemployment Claims are on the upswing. We expect the U3 to rise, perhaps to as much as 4.5% by year’s end.

The Fed has a dual mandate: inflation and employment. Even if they start to lower rates in September (by 25 basis points (0.25 pct. points)), the lags in the transmission of monetary policy to the economy are long and likely won’t impact for six to nine months or more. Don’t forget, even lower by 25 basis points in September and again in December still leaves monetary policy deep in the restrictive zone (Fed Funds at 4.75%-5.00%). The Fed itself believes that a “neutral” Fed Funds rate (neither accommodative nor restrictive) is 2.75%. That’s 250 basis points (2.50 pct. points) lower than today’s rate. There’s very little chance that such moves will have anything other than a marginal impact on the economy by year’s end.

We continue to worry about the health of the financial system, especially Regional and Community Banks because that’s where the CRE loans reside. (In addition, most banks are significantly underwater in their bond portfolios.) To us, the odds appear high that we will see several “problem” banks pop up over the next 12-18 months.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog.)

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