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Equities at All-Time Highs; Inflation Retreating But the Macroeconomic Backdrop is Faltering

The equity markets continued to scale new heights this past week, this time the Nasdaq hit a record high on Thursday (February 29 – leap day, how appropriate) and then again on Friday, finally eclipsing its November 2021 high after more than two years.

The Inflation Situation

It was a fairly light week for data releases. Nevertheless, the market nervously awaited the PCE (Personal Consumption Expenditure) headline and core inflation indexes, worried that, like both their CPI and PPI brethren, they would come in hotter than expected. Both, however, showed up in-line with market expectations (+0.3% for January headline, and +0.4% for the core index which was quite a large increase from December’s +0.1% advance). Because the PCE index is a more accurate gauge of inflation than is the CPI as it takes changing consumer preferences into account in its weightings, the Fed prefers this as an inflation measure. Luckily, January’s year/year rate fell to 2.4% from 2.6% in December, not because the number was so good, but because of favorable “base effects” (there was a large jump last year in the January ’23 index, which serves as the denominator in the calculation).  The all-important “Core” index (ex-food and energy), at 2.8% year/year, improved slightly from the 2.9% December reading (again “base effects”). Services prices were the bad guys, rising +0.6% in January and up 3.9% from year earlier levels. The prices of goods actually fell -0.2% in January and are down -0.5% over the year. Isolating food and energy, food costs rose +0.5% in January and are up +1.4% for the year. But energy prices moved lower in January from December (-1.4%) and are down -4.9% over the prior 12 months.

Fed Reaction

The question on Wall Street’s mind is: “Will this report cause angst among FOMC (Federal Open Market Committee) members?” Although the FOMC is an extremely conservative group when it comes to inflation, the fact that the annual growth rates of both headline and core had “2” handles should put to bed any further thoughts of rate hikes, at least not in the immediate future.

As noted, service prices advanced +0.6%, as consumers have returned to more normal consumption patterns. That is, during the pandemic, services (usually human facing) fell and goods consumption rose. The return to more normal consumption patterns that has occurred is partly responsible for the rising prices of services (more demand) and falling prices of goods (less demand).

All that said, the PCE service sector reading, excluding energy and housing, a metric which Fed Chairman Powell has alluded to several times, rose a robust +0.6% in January, raising the year/year rate to 3.5% from December’s 3.4%. While this number was north of +5% a year ago, this metric is likely to reinforce the “higher for longer” mantra.

January’s total inflation data (CPI, PPI, PCE) did show a slight acceleration. While concerning, a single month isn’t a trend. February’s data will be important in determining if January was an anomaly, and will be a critical input into the Fed’s time line for lowering rates.

More Fed Musings

The Fed has more economists on staff than any other institution in the world. Certainly, they know that rent in the CPI is lagged and subjective. According to Economist David Rosenberg, Owners’ Equivalent Rent (OER) has a 27% weighting in the CPI index. OER is calculated from one question in the survey which asks homeowners what monthly amount they think they can rent their homes for. Note: most homeowners are not real estate professionals. Two points: 1) There is no test for how accurate such data might be; and 2) In today’s marketplace, with all the hype about rising home prices, such “opinions” are likely to be biased to the upside. Conclusion: The CPI appears to be biased to the upside when it comes to inflation accuracy.

The chart below shows the close relationship between the shelter component of the CPI and the Bureau of Labor Statistics’ “New Tenant Rent Index.” If past is prescient, the shelter component of the CPI will be exerting a disinflationary, if not outright deflationary, force over the CPI for the rest of 2024, and perhaps beyond. This is one reason we are confident that inflation’s measured path will continue to be downward.

The Emerging Commercial Real Estate Issue

On Friday (March 1st), we came across a noteworthy financial issue: The Canada Pension Plan, one of Canada’s largest, having recently sold its interests in a pair of office towers in Vancouver and a business park in Southern California, sold its holdings in a Manhattan office building (360 Park Avenue) for $1!

In our blog of February 17, “Hot” Inflation Aberration Will Justify “Higher for Longer,”

we discussed our concerns over Regional and small bank loans in the Commercial Real Estate (CRE) sector. And we discussed the role that CRE played in the fall from grace at New York Community Bank (NYCB), where expected $200+ million profits turned into -$200 million due to CRE losses. The chart above shows the growth in Regional Banks’ share of CRE lending. That number, 29%, is up from 17% in 2018. There are two significant problems now emerging in this space:

  1. The volume of maturing CRE loans in 2024 is massive (see left-side of the chart below), and it comes at a time when interest rates are at levels not seen since the 1990s. That means a significant increase in interest costs for these properties – if, indeed, they have sufficient cashflow.
  • At 14% currently, office vacancy rates are at 21st century highs and are forecast to rise nearly 30% over the next 10 years according to Goldman Sachs.

It appears that the period of depressed CRE prices, especially office buildings, is just beginning. This will have large, negative impacts on the portfolios of most of America’s small and mid-sized (Regional) banks. In addition, Commercial Mortgage Backed Securities (CMBS) which comprise a goodly proportion of bank investments, saw delinquencies tripling to 6.3% over the past year. This will only get worse as long as rates stay high.

The Kansas City Fed produces a Commercial Real Estate Index. Its latest version is shown in this chart.

What is of equal interest is the chart of factors contributing to the falloff in the index. Of the 13 factors in the index, only three were positive (two barely so) (see chart below).

The upshot here is that we expect that we are only at the beginning of a CRE valuation issue, one that has significant implications for the health of the Regional and small bank system. Already we are seeing significantly rising CRE loan delinquencies (see chart below). When asked about delinquencies on a recent 60 Minutes show, Chairman Powell indicated that such were “under control.” From our viewpoint, by years’ end, this won’t be the case.

Macroeconomic Environment

We have continued to see weakness emerge in the macroeconomic variables as Q1/’24 has so far unfolded. The latest is pending home sales. These are contracts signed but not yet closed. This continues the negative housing streak (lower Existing Home Sales, lower Housing Starts, lower permits). As noted from the chart below, Pending Sales have been at a low level for over a year (right-hand side of chart), and are now approaching the low level that occurred briefly in the pandemic when the economy was in shut-down mode. A look far enough back also shows these sales contracts are now at a level lower than they were during the Great Recession.

Besides housing, there are other concerning macroeconomic issues, ones that, strangely, the media tends to ignore. Unemployment claims is one of these. Granted, no one is going to get too excited as long as the U3 unemployment rate is below 4%. But the trends are not favorable. Continuing Unemployment Claims, those folks collecting unemployment compensation for more than one week, shot up 45,000 the week of February 17, from 1.860 million to 1.905 million. We haven’t seen numbers this high since November ’21, during the pandemic.

In addition, Economist David Rosenberg recently reported that the U3 unemployment rate is up +0.5 percentage points in 60% of the states. When the U3 rate, on a national level, rises that +0.5 percentage points, a Recession has been a certainty. Rosenberg asks: “Does this mean that a Recession has already started in those states?”

The fact that Macy’s (symbol: M) is closing 30% of its stores (150 of them) over the next three years (50 in 2024) says something about the plight of the Retail sector. Most Q4 retailer reports had soft guidance for 2024. Lowe’s, (LOW) for example, saw same store sales fall -6.2% in Q4 versus a year earlier. And their guidance for 2024 sales was -2.5%! Even Walmart (WMT), which normally benefits when tough times come around as higher income families trade down, said its average purchase ticket fell -0.3% year/year.

The Dallas Fed Manufacturing Index came in negative again in February (-11.3) and has been negative each month since May ’22. That’s 21 months in a row! The Richmond Fed Manufacturing Index has also been negative in 20 of the past 22 months (-5 in February). Even the Chicago Fed’s Manufacturing Survey, at 44 (<50 is contraction) registered an eight month low. For sure, manufacturing has already entered a Recession.

Final Thoughts

  • While January’s inflation numbers were somewhat disappointing, we attribute some of this to seasonality (beginning of a new year, time to raise prices!). The good news is that on a year/year basis, most of the important inflation indexes either have a “2” handle or are close. Our view is that unless the Fed begins the easing process sooner (unlikely) rather than later, we could actually see deflation, i.e., overall price declines, before the year is over. Many would say “Hallelujah” to that, but normally, deflation and Recession go hand-in-hand. So, let’s be careful what we wish for.
  • Commercial Real Estate is going to become a major problem for lenders as the year progresses. Already, prices of office buildings are down about a third from year ago levels. For banks, delinquencies are rising, and that could prove to be a nasty wake-up call. Perhaps we will see a re-run of the March ’23 Regional Banking affair.
  • The Nasdaq hit a record high on Thursday, like the S&P 500 and the DJIA earlier in February. For the Nasdaq, it took more than two years to eclipse its November 2021 high. And the Japanese stock market also made new highs – but in that case, it took more than 30 years. Nevertheless, despite the behavior of the equity market, we continue to see many contradictions:
  • The housing sector is plumbing new lows;
    • Retail sales were negative in January, and retailers are downbeat. Then there is the announced closure of 150 Macy’s stores!
    • Sales guidance, even among tech companies is tepid (Mobileye, Texas Instruments, Intel, Qualcomm, and AMD).
    • Aggregate hours worked are falling. This leads to lower real (inflation adjusted) take home pay. How does that positively impact economic growth?
    • Full-time jobs are contracting; the reason for the “growth” in employment is entirely from part-time jobs. How healthy is that?
  • So, despite the stock market exuberance, the data portend an economic slowdown, coming soon!

Robert Barone, Ph.D.

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


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