We return this month with our regularly scheduled partner note. As we sweat out the dog days of summer, this month’s update combines data from the previous two months— specifically Q2 CPI, PPI, and bank earnings. The reason? The story of H1 2023 was largely a tale of transition and economic crosscurrents; this also happens to be the first earnings season since the spring banking turmoil—big banks report first! Let’s kick off with our usual dose of macroeconomic data… Per the Bureau of Labor Statistics July nonfarms were solid, but largely inconsistent with numbers released by ADP just two days before. BLS reported 187,000 jobs created in July whereas ADP’s figures came in closer to 324,000! This marks the second consecutive month that ADP’s data came in far stronger than official numbers from the Washington, D.C.- based Bureau of Labor Statistics. The way ADP and BLS collect their data has something to do with the “noise”, but more than anything we are seeing a convergence between the two datasets that has widened considerably over the last 6 or 7 months. According to BLS, the official unemployment rate fell to 3.5% last month, as U6, a broader measure of unemployment, also fell 0.2% to 6.7%. Meanwhile, June jobs were revised lower by ~24,000. Inflation remains a sticky subject in Laborland with hourly earnings ticking steadily higher by 0.4% MoM. Though the most recent data indicate job openings (JOLT’s) have broken below 10M, the labor market is still considerably out of balance. There will be some more finetuning regarding rates and balance sheet runoff from the Fed in the coming months.
Despite ongoing tightness for American labor, inflation is moderating at the consumer and producer levels. Taken at face value and extrapolating a bit, the last three months of data indicate core CPI is currently at ~4.0% on an annual basis—a marked improvement from this time last year BUT well above the Fed’s tolerance. Meanwhile, price pressures among US producers have abated to an annualized rate of ~2.0% (this is very good news)! At the same time, real M2 is hovering around $6.86T—lots of money still in the system and profitability among American businesses is still strong. This suggests that we are likely still a ways from the Fed’s 2% target especially when factoring in the tightness of the labor market. So, another rate hike or two (cumulatively 25 to 50 bps) from Mr. Powell is highly likely in the near future. Why not more pressure from the Powell Fed? Time has its own way of applying incremental financial pressure within a stressed system. Given the backdrop, it will take time for significant disinflationary forces to build. Thus, we feel the market has inappropriately priced in rate cuts to begin as early as March of next year. Operating profits have been and will be closely scrutinized among the world’s largest and best run companies as earnings season picks up speed. We have steadily marked down our expectations at the operating level for corporate profitability this year, but we remain optimistic that S&P 500 earnings won’t give up much if any ground relative to last year—please keep in mind 2022 was the most profitable year EVER on a per share basis. Forward guidance from the C-suite will likely prove the lynchpin for stock performance in the second half of 2023.
Banks, banks, banks… for all of the turmoil that was March (and to a lesser extent April) the BIG banks seem to be doing just fine. Net interest margins at the likes of Citigroup (C), JP Morgan (JPM), and Wells Fargo (WFC) are well intact and unencumbered by the current rate environment. Little wonder since these juggernauts pay next to nothing on deposits! Traditionally, banks capture the difference between what they pay on deposits and what they receive from their loans. Yes, we are back to that again… the spread between the return on assets and cost of liabilities! The relationship between assets and liabilities must be healthy for our system to thrive. So, of course, we will also be keeping a close eye on smaller peers in the banking group as the financial universe adjusts to a new reality (higher nominal and real rates for longer). The smaller the bank the more important the loan book (i.e. risk profile). Exposure to rate sensitive asset classes like commercial real estate will be a key interest in this environment. After all, banks are not designed to operate assets that land on their books; they want to charge fees and make spreads! As a side note, we will be monitoring real estate assets in general over the next two or three quarters.
The theme in today’s marketplace is heavily predicated on the concept of “relative yields.” The idea is that assets with stable and predictable cash flows are higher quality and should command a “premium” (i.e. larger multiple) relative to those with unstable or unpredictable cash flows. This seems rather intuitive. Moreover, it has the benefit of being rational! Low rates, however, bias valuations for future growth higher AND pull demand forward at the consumer level because there is little incentive to save when rates are zero. In this sort of environment companies can issue debt and buyback stock or increase dividends freely. Why? Because capital is available AND the financial cost of doing so under such circumstances is practically nothing (for certain borrowers). Sound familiar? This is largely the story of markets for the last decade and half or so. That is, of course, until the music stops or shall we say, CHANGES. This “growth model” is a tough position to hold once rates rise, which they have, and stay elevated for an extended period, which is likely. For instance, though inflation remains a popular headline and has impacted everyone across the income spectrum, the real story for assets is interest rate equilibrium. We have gone from a state of upheaval in financial markets twelve months ago with unprecedented cross asset correlation and rate volatility to one of relative symmetry. It’s a 5% world that we are living in! The earnings yield on the S&P 500 is roughly 5%; the effective fed funds rate is currently 5.33% and the average spread of investment grade corporate bonds over 10 yr US treasuries is 125 bps, which translates to roughly 5.45%. Incidentally, hourly earnings are also appreciating at an annualized clip of ~5%! Moreover, the economic backdrop forces us to seriously consider the possibility of “normal inversion” along the treasury curve. Our clients in the commodity space are very familiar with the concept of “normal backwardation,” but what about investors confronted with ongoing yield inversion in the US? Things will get interesting from here. We are in the throes of transition.
News Release: Bureau of Labor Statistics (The Employment Situation- July 2023)