We are in an election year, our economy is comprised of an unusual mix, and the stock market has risen to expensive levels. Let me help you put it all into perspective. For those TL; DR inclined, the investment conclusions are contained in the last paragraphs.
Monetary Policy – A number of changes have occurred since my last Outlook except one: the cost of money is still at 5.25%- 5.50%. The key changes are 1) The Fed has slowed their balance sheet reduction from $60billion to $30billion per month and 2) continue to simply let their portfolio of mortgage-backed bonds shrink as homeowners pay down their mortgages. Finally, 3), the prime money supply measure (M2) has returned to growing, and at the same pace that was maintained for the ten years prior to the pandemic.
Fiscal Policy – With the addition of several “smallish” war support legislations, the pace of government stimulus – deficit spending during conditions of full employment – continues to approximate 7% of our $26trillion economy.
Political Influence – We are only five months away from our national elections. The voting slate looks pretty clear for most elections, but there are primary elections for local and state positions still to be held. The national conventions of the two major parties are July 15-18 (Republican) and August 19-22 (Democrats). Bookending these events are the two Presidential debates. The first is coming up fast on June 27 and the second will be on September 10th.
Geopolitical Influence – It is election year in most major economies or economic blocs this year. Several have been held with interesting political shifts, driven primarily by local or regional issues. Both Great Britain and France look to be on track for leadership changes.
The two burning wars do not look directly to be the culprit. That said, these wars continue to chew through money and public opinion. Neither looks to have a resolution in sight, and both keep threatening to “go regional”.
Japan – continues to be an economic trick question. Slowly, slowly easing out of interest rate control. Slowly, slowly trying to re-establish growth and inflation(!). Trying to keep their rates low yet trying not to continually weaken the yen. There does seem to be a move by Japanese companies to become shareholder friendly with their generated cash flows.
China – to repeat for the 100th time, China is going in their own direction, one of their choosing. Yes, they are the manufacturer for the world – that finances their aspirations. China’s direction is their vision of a Marxist/communist perfection: general prosperity for all. That will take some time and for now, look for steadily lowering of growth rates due to over and ill-incented expansion of their real estate and industrial sectors. Oh, and their policy choices have reversed away from capitalistic to state controlled. Good luck with that. China’s view? They are the only pure civilization “under the heavens” and the rest of the world can just like it.
Commentary
With all this as preamble, what to make of the current economic and political mix? For starters, admit to the obvious. When our national government is deficit spending to the tune of 7% of the total economy (GDP) at, in essence, full employment, a recession is not a reasonable expectation. As we go forward into 2025, and especially as the supplemental legislations are spent out, the “non-cyclical” stimulus fades and we will assess the economy at that point.
For those that like shorthand, this high level of government spending is called the “fiscal put”, meaning a level of spending designed to offset an economy’s cyclical downward forces.
One interesting element concerns the Fed. They have been tasked with surviving lousy fiscal policies since 2008. One of the “tools” they had to give away then was managing short term interest rates. Short term rates had to be zero. Any attempts to raise them (until 2022) caused problems in the financial markets.
The Fed now has this policy tool back – indeed short-term rates are in excess of inflation – and the Fed will be loath to lose this tool again. There is a theory of an unwritten “understanding;” the fiscal put policies conveniently “allowed” the Fed’s to get their rate tool back. No one in authority will ever admit to that, but if it walks like a duck…
There is one solid outcome from this – the current rates are the realm of the “norm”. The ultra-low rates of the past 15 years were the aberration. It is kinda interesting to think there is a generation of young people in the investment business that are saying “wait…what?”, but that is the truth. And frankly, scenarios where we would go back to those low rates are not pretty.
There’s one more very key change that has occurred in the last three years: a huge influx of people to this country, mostly via our southern border. Viewed as an economist, this is an increase in the labor pool. As vernacular, it is characterized as a labor supply shock – in the positive sense. Think in terms of supply and demand. If our economy is expanding, rather than a needed “input” (labor) becoming increasingly scarce, the supply has increased. At the very least, it has kept a lid on wage gains.
Economists are beginning to model this new reality, and enough data is emerging to sense out trends. Frankly, it is helpful. Labor costs are rising less than expected, especially at the lower wage/ skill levels. It is reasonable to have a far more constructive view of the newly arrived – don’t fall for the election year weaponization. And this labor shock will likely have a multi-year effect as these new citizens - and taxpayers - move up in skill levels. They did come here to make a better life for themselves, after all.
There are areas of concern in our economy. The biggest is in the commercial real estate sector. Recall, many buildings were built predicated on ultra-cheap financing. Those days are gone, and that debt will need to be refinanced at some point. Second, the pandemic permanently reduced the office space needed as more working from home has become the norm. The stress in this sector is very real, there is a lot of “stay alive until ‘25” type loan extensions going on. But in the end, someone has to face the loss. A term used for the re-ignition of forest fires in Canada seems to fit here: “zombie fires”.
Finding out where these are owned and who financed them is difficult to pin down. The FDIC is helpful, and they point out the problem is most acute in smaller banks – those with less than $100billion in assets. From a macro standpoint, the issue is whether a failure of one or a handful could trigger enough falling dominoes to require Fed policy action (like March, 2023). A look at the aggregate numbers leans toward this conclusion though whether it jolts the stock market may well be a “game day call”. And reducing rates to zero is probably not part of any Fed-engineered rescue package.
There are several other financial sectors that are also suspect: private equity, private lending, “Buy Now Pay Later” financers, sub-prime/used car loans, and small bank credit card issuers. Each of these has its own root causes but are areas of concern. The likelihood that these are market moving events are a lot less than the commercial real estate issue.
A few words on the current path of retail sales. Some market commentators fear retail sales are slowing, and that this is a warning sign of a coming recession. True, “stimmy checks” are gone, so sales have slowed. But the better characterization is that the “consumer” is sated. Any pandemic-related shortages have been resolved. There are no retail categories that have pent-up demand. Well, maybe clothing, now that we have magic weight-loss medications. Think sated, not cyclically turning down.
How about about company profitability? It’s fine and generating higher margins and cash flows. Steady readers already know of my high level of respect for American corporations and their ability to continue to improve and make a buck. Within the companies of the S&P 500, the earnings trend is up through the end of this year and into 2025. And, they have a new tool: “AI” as in artificial intelligence. Realistically, it is very early days with AI and most uses will be internal for a company’s processes. That said, a lot of learning, and “training” of AI tools is in front of us. Very interesting to watch, very instructive to see what happens when it goes right and when it goes wrong. Eventually, the payoff will be better processes, higher productivity, and interesting product innovations.
Let’s look at all this as an investor. What jumps out immediately is that the stock market is expensive. By expensive, I mean the (10 year) expected return for the S&P 500 is 5% versus the long-term average of nearly twice that. It is just not compelling to be getting in right now, broadly. Price is one reason; common sense is another. First, a presidential debate is coming up soon with the key assessment being cognitive ability of both candidates. Moving past that, it’s a long hot summer of political party conventions and then the possibility of an “October Surprise”: the devastating secret about one candidate or another designed to sway the election. Every election year tends to follow this pattern, including that mid-October is the time to invest cash toward your investment objectives. That’s the plan. Have an enjoyable summer!
Does one trim equity exposures given this sketch? As a taxable investor (me included) if it’s an asset that’s going to be owned longer term, and you own it at a gain, just ride it out. The only person losing money will be your advisor (me) in terms of lower market value fees. You will continue to own the underlying assets and benefit from the compounding. Own something, or specific tax lots at a loss? Makes a lot more sense to look at that. Otherwise, enjoy the outdoors this summer and do not look at your portfolio.
As a stock picker – and yes, individual stocks are absolutely welcome and actively managed at Kennedy Investment Counsel – it will be an environment for upgrading your holdings. Interesting new stocks at attractive prices are available now and any market downdraft always broadens the selection.
Interest rates? The Fed is going to continue to use their interest rate tool to gently throttle the fiscal put. They have always said 2025 was a realistic timeframe to get back to a 2% CPI. Watch the ten-year US Treasury – it is your gauge of how the economy is doing and frankly, if it stays within a range of its current level of 4.2%, that’s fine. So, 4.0%-4.5%. My sense is significantly higher levels are not likely, and that significantly lower levels mean something fundamental is moving negative.
Finally, let me make a pitch for “studied neutrality”. Being in this business, it’s a necessity. Indeed, it is what you pay me for. Turns out, being neutral is an interesting vantage point. We are on the verge of being swamped with what will feel like a billion dollars of campaign spending. Me? I will look at it for style, strategy and tactics but then get back to studying the economy and investments in order to determine where best to invest your hard-earned money. The proper focus.