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Despite Deteriorating Economics, Equity Markets at All-Time Highs

There were several important news events this week including the Fed’s January minutes. But this took a back seat to Nvidia’s blowout top and bottom-line numbers and its forward guidance which occurred after Wednesday’s (February 21st) market close. The equity market, which had been relatively flat on Tuesday and Wednesday, advanced more than 2% on Thursday and held those numbers on Friday.

Year to date, through Friday (February 23rd), the S&P 500 has advanced 6.69%. Most of that gain was the result of the performance of the phenomenon known as “The Magnificent 7” (MSFT, GOOG, APPL, AMZN, META, NVDA, TSLA). Year to date, their weighted average prices (weighted by market cap) have advanced 14.48%, led by Nvidia and Meta (formerly known as Facebook). The S&P 500 Index is weighted by the market capitalization of the companies in the index. That is, the larger the equity market value of the company, the more influence it has on the index’s value. The Mag 7 have a combined 30.7% weight in the index. The other 493 account for the other 69.3%. Doing some math, the “Mag 7” were responsible for 4.44 percentage points of the 6.69 percent total advance, or 66%. That’s pretty top heavy! The other 493 stocks, on average, advanced 2.24% (compared to the 14.48% of the Mag 7). We note here that 2.24% as of late February, is not that shabby; if kept up for the entire year would result in a return of approximately 15%. (On the other hand, if the Mag 7 continued their pace, that annualizes to 98%! – how likely is that?)

There have been several well-known market commentators out with cautionary advice for equity market participants, as traditional market measuring metrics, like the Price/Earnings ratio, are well above their historical averages.

The Fed

As noted, the other important news release was the Fed’s January meeting minutes. While not a market mover, it appears that those minutes sealed the market’s view that a March rate cut is off the table (market odds now under 3%). At the after-meeting press conference, Chairman Powell reiterated what his FOMC was thinking. In the minutes, we find the following:

…participants noted that the economic outlook was uncertain and they remained highly attentive to inflation risks…

Risks around the inflation forecast were seen as tilted slight to the upside…

From our perch, it would appear that the odds of a May rate reduction are also low (market odds now 8% from over 20% as a result of “hawkish” jawboning from FOMC members). Even June is getting iffy (71%). We note here that record highs in the popular equity indexes (S&P 500, Nasdaq, DJIA) are yet another reason rate cuts may be held up, as the Fed doesn’t want to encourage even more risk taking. Nonetheless, even the Fed thinks there will be three rate cuts this year, now likely in June or later.

One positive thing going in the Fed’s favor is the low level of inflation expectations, a closely watched indicator by the FOMC. The chart shows the NY Fed’s index of one year ahead inflation expectations (currently 3.0%) and the CPI. Note the strong relationship between the two. In addition, the University of Michigan’s most recent Consumer Sentiment Survey (February) pegged five to 10 year inflation expectations at a lowly 2.9%. So as long as inflation continues to wane, as we expect, then inflation expectations are likely to be well behaved. Again, this is a positive for the Fed.

Housing

For a change, Existing Home Sales showed up with a “+” sign in January, rising +3.1% month/month. Still, sales for the month were lower by -1.7% from January ’23. These are closings of contracts signed in November and December when mortgage rates briefly dipped down to 6.6% (they have since rebounded to near 7.3%). So it is highly likely that January’s positive month/month number won’t be repeated in February. As can be seen from the chart, despite the slight January uptick, Existing Home Sales are back at Great Recession levels.

New Home Sales, however, appear to be back to their pre-pandemic levels (see chart above). They have recently been bolstered by the slowdown in Existing Home Sales as low mortgage rates from a few years ago have kept Existing Home Inventories low, thus pushing potential home buyers towards the “New Home” market.

Housing Starts and Building Permits, both keys to future New Home Sales, both fell in January. Starts were off -14.8% from December levels and new permits were down -1.5%. The big story here is in the Multi-Family sector. In past blogs, we’ve discussed the record number of Multi-Family Units under construction (right-hand side of chart) that are now coming online.

This is not a one-off situation as new units under construction continue to come online in record numbers (left side of chart). There are still nearly one million units under construction, up 5% over the year.

According to Rosenberg Research, rental completions rose 6.3% in January, the third month in a row of large increases, and are up 54% from year earlier levels. Needless to say, this will continue to put downward pressure on rents, with its attendant (but lagged) impact on the CPI.

Commercial Real Estate

Housing isn’t the only real estate sector in disarray. Commercial Real Estate (CRE) is in even worse shape. The ability to work from home for many jobs, as discovered during the pandemic, and the desire on the part of a large segment of the labor force to do so, has substantially raised the vacancy rates in office buildings, some of which can no longer meet their monthly mortgage payments from the buildings’ meager cash flows. In our last blog, we noted that the Q4 losses at New York Community Bank (NYCB) were from two CRE loans. This, we think, is going to become a banking nightmare over the next couple of quarters, and Chairman Powell won’t be able to say, as he recently did on “60 Minutes,” that the CRE issue is “under control.” The chart shows the rapidly rising CRE Loan Delinquencies.

Debt

In today’s world, debt is ubiquitous in every aspect of life, from households to businesses to government. The first chart shows a comparison of debt and income in the 1970s and today. Note that in the ‘70s, the growth of income (yellow line) kept up with the growth of debt – but not so today.

Consumers: In past blogs we have noted the record levels of credit card debt and the rising level of consumer delinquencies (credit cards and auto loans). And just when consumers have little credit left on their credit card lines, retail figures out a new strategy – called “Buy Now Pay Later,” and it turned out to be a godsend for the holiday shopping period. Nevertheless, in January we saw a fall in Retail Sales (-0.8% from December’s level). Given a consumer choking on debt, January may be the first of many months of Retail Sales either in decline or stagnation. One other thing to consider: credit card debt and “Buy Now Pay Later” come with interest rates approaching 30%!

Business: Consumers are not the only segment gouging themselves on debt. The chart below shows the oncoming wall of maturities in the corporate world. The problem here is that most of this debt was originated when interest rates were significantly lower than they are today. Refinancing them means higher interest costs and lower profit margins.

Government: While all levels of government borrow, the federal government is the most egregious offender when it comes to debt, especially in this century.

Note the general uptrend in the federal deficit as a percentage of GDP on the right-hand side of the chart. Grated the bulges in 2008 and 2020 were due to emergencies (Financial Crisis and Pandemic) as were the WWI and WWII protrusions. But in fiscal 2023, a year of no fiscal emergencies and a strong economy, the federal deficit was 5.7% of GDP. Economics 101 teaches that deficits should be run in Recessions, with surpluses when the economy is strong. (How long has it been since that happened?)

Worse, the Congressional Budget Office (CBO) estimates the deficit in fiscal 2024 will be 6.8% of GDP. The right-hand side of the chart below shows the CBO’s debt/GDP estimates out to the 2050s.  Note that in 1980 this ratio was 34.5% and it was 59.0% in 2000. Also note that we have now breached the 120% level (currently 123%) and projections are that the debt will be at or above 175% of GDP by 2050. We think that estimate is significantly low if current deficit trends prevail.

Today, interest on the federal debt is 20% of federal revenues. With higher interest rates and a growing debt level, that percentage will only get larger (see chart above) unless taxes rise.

In order to have a vibrant economy, interest on debt, a non-productive use of cash, can’t be so high as to squelch economic growth. That is, as debt costs rise, less is left of the income pie for consumption, investment and government spending (i.e. GDP). As debt as a percentage of GDP grows, low interest rates become more and more important, i.e., a “must have.” Much of the economic growth the economy experienced from 2012 to 2022 was due to the low interest rate environment.

Monetary Policy’s main tool is the ability to set interest rates. When economic growth grinds to a halt (Recession), the Fed lowers interest rates; conversely, it raises them when growth is too fast and promotes inflation. Thus, high debt levels relative to income (GDP), as we have today, stifles economic growth as households, businesses, and government devote a significant portion of their monetary intake to debt service, especially during high interest rate episodes. Since recent trends in key economic sectors (Retail Sales, Industrial Production, Manufacturing, Housing) suggests that a stalling out of economic growth is in process, lower interest rates are needed.

Final Thoughts

  • The “Magnificent 7” have accounted for most of the equity market’s gains over the past few months. Worried? Legendary Wall Street veteran, Bob Farrell crafted 10 Rules for Wall Street. Here are a couple apropos to today’s environment:
  • Markets are strongest when they are broad based and weakest when they narrow to a handful of blue-chip names.
  • Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.
  • We continue to see layoff announcements (Nike, Cisco, UPS, Alphabet, Amazon…), concerning economic data (falling Retail Sales, Manufacturing Output, Housing), growing debt levels, and rising delinquencies.
  • If the Fed is waiting for a break in the equity market to lower rates, it may well be that they’ve already waited too long to engineer a “soft landing.”

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog)

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