A discipline learned many moons ago is to simply describe the existing state of the economy and investment markets, and project forward from there. Here are the important elements, with projections in the commentary and statements sections.
Monetary Policy
The Federal Reserve has increased the price of borrowing by 5% in just over a year, to now a real (inflation-adjusted) cost of borrowing money. There is likely at least one more increase. All this after over a decade of low- to no- cost money.
Their expresses target is a real rate (cost) of borrowing across the entire yield curve. Some pundits are saying higher for longer, the actual is real rates are now policy.
The Fed’s management of the money supply, as measured by M2, has been lousy in the last two years. It spiked because the “stimmy” checks were essentially monetized (re: printed money). Now, M2 levels have begun to reduce but have a lot further to go to get back to the steady pre-covid trend.
The policy known as Quantitative Easing (QE) or Quantitative Tightening (QT) is back in QT mode, withdrawing about $100 billion of “liquidity” from the economy each month. It had reverted to QE mode in March to offset the three major bank failures (approx. $300 Billion). That has completely reversed.
Fiscal Policy
The US Government budget is projected to incur a deficit of $1.5 trillion this year and next. For reference, our economy is about $26.5 trillion per year.
In addition to the deficit spending, three major legislations add to the deficit that need to be funded: The Infrastructure Act of 2021, the Inflation Reduction Act of 2022, and the CHIPs and Science Act of 2022. Together, these add another $2.3 trillion to be financed. The combined total is over 13% of our economy. That is huge.
Political Influence
Please ignore the posturing for the 2024 elections. That is essentially irrelevant to investment decisions until much later this year, at the earliest.
Geopolitical Influence
China deserves a close look. They are clearly going in their philosophical direction (“Chinese” socialism) and they also clearly have major economic impediments. Their likely growth descends to 2-3% pace in the next few years. At issue is what effect that has on the economies of the region and does it prompt more outward belligerence.
Japan is also experiencing a significant transition, likely to end their massive monetary policy experiment that supported and /or maintained levels in their stock and bond markets. Yen strengthening certainly puts a pause on its role as funding currency.
Ukraine War – the motivation for a negotiated end is rising on both sides. Er, both the US and Russia.
Europe is…Europe. Try as I might, finding issues there that would meaningfully affect our economy is hard. True, their stocks are much cheaper than ours. They have earned that.
Domestic Economy
Inflation – well off its peak, but inflation declining to the 2% Fed target is a multiyear process in the Fed’s own words. Of the two “parts” to inflation, goods inflation has come way down, even negative in some products or raw materials. Goods inflation has not been an issue going back to before 2000 – it has been less than 1% most of that time frame. During that same time period though, services inflation tended to be near 3%. And this in a time period noted for its “stubbornly” low inflation. We are through the “easy” phase of reducing inflation.
Student loans – repayment moratorium ending, which will put a dent in the spending of 37 million people. It’s a big number and starts in the fourth quarter.
Looking into the possibility of a strike at UPS (July 31), the elements seem an interesting sketch of our current economy. Half of the 340,000 UPS workforce is part time. What UPS delivers is so ubiquitous, if a strike is called, parts of the US economy will start stopping real fast. What is demanded? More full time from the part time force. Ultimately the end of lower pay for part time, but absent that, more pay for seasoned veterans (so +15%) who don’t like what recent hires are getting compared to them (so only +10%). Bonuses for those that “had to work” during Covid lock downs. Less management harassment of workers. Plus, a host of safety and health issues. Not helping UPS is that their primary US competitors FedEx and DHL have very few unionized employees. As a final note: union leader Sean O’Brian has asked the Biden administration not to intercede in the negotiations. Keep this issue on your radar…
Companies are in the process of reporting quarterly earnings and market participants will learn a great deal about current conditions and what managements see going forward.
Commentary
Current monetary and fiscal policies are enormous in scale and…contradictory. What may give it a tilt is that additional legislations mentioned are “industrial policy”, so subsidizing or steering the economy toward a desired design. Debate it either way, but they do add a “safety net” under the economy.
We have been watching our economy exhibit strength so now “soft landing” is the narrative. Part is due to fortuitous weather; part is due to the underrated ability of US corporate management teams to keep moving forward. At issue is can corporations keep raising prices more that the increased cost of labor and financing? Unit growth is already fading in some industries.
The 5%+ increase in the cost of money is embedding itself in the economy. That will either stop projects due to financing costs or increase the cost to businesses, both of which reduce future earnings. Monetary policy works with a lag; companies will be talking about these effects for the next two quarters. To quote Hemmingway: “gradually, then suddenly”.
As that process pertains to banks and lending, it remains closely guarded whether some will have great difficulty with their clients, especially in the office building sector. There is a huge amount of capital waiting to buy distressed assets to be sure. The problem is, if those sellers negatively involve their banks, bank issues always create stock market stress.
The Fed has a dual mandate: price stability (i.e., control inflation) and maximize employment. An election year is coming. Which way do you tilt policy if you are Chair Powell?
The recent bank failures sent the message to the markets that there continues to be a Fed “put”.
Current market sentiment is squarely in the FOMO zone. And, as market strategists have learned, there’s no predicting when a turn happens: markets go until they stop.
Statements
At current S&P 500 index levels and earnings estimates, the forward P/E ratio has risen to over 20x. That’s expensive.
Forward earnings estimates continue to decline, though they remain above (+9%) last year’s depressed earnings.
At the end of all the economic adjustments to come, the pace of GDP growth will still be only 2%- ish.
Interest rates are now at “real” levels and will remain so in the foreseeable future.
We are through the “easy” phase of reducing inflation.
China is simply non-investable. Tradeable maybe.
The summer and into the fall will be a time to reposition portfolios and lower prices will certainly help. Market sentiment is very high right now and as mentioned, the market P/E is expensive. The thematic growth sectors of the economy and those targeted by our industrial policy legislations have multi-year support.
Bonds ought to be a good investment from these levels, though expected returns remain higher in equities. Caution though: that’s relative. The expected return for the S&P 500 has dropped to 5.5% by a common measure. The market is expensive right now.